0904 Cbem

Commercial Bank
Examination
Manual
Division of Banking Supervision and Regulation

Commercial Bank
Examination
Manual
Fourth Printing, March 1994 Inquiries or comments relating to the contents of this
manual should be addressed to:
Director, Division of Banking Supervision
and Regulation
Board of Governors of the Federal Reserve System
Washington, D.C. 20551
Copies of this manual may be obtained from:

Publications Fulfillment
Mail Stop 127
Board of Governors of the Federal Reserve System
Washington, D.C. 20551
The manual is updated twice a year.

For information about ordering manuals and updates,
please call 202-452-3244.
Commercial Bank Examination Manual
Supplement 31—April 2009
Summary of Changes ized daylight overdrafts. The section also

includes a discussion of adjusting net debit caps
and other changes dealing with daylight over-
Section 3020.1
drafts. For more information on the PSR policy
This section, ‘‘Assessment of Capital Adequacy,’’ changes see the Board’s December 19, 2008,
was revised to include a reference to the guid- press release. See also 73 Fed. Reg. 79109,
ance issued in SR-09-1, ‘‘Application of the December 24, 2008.
Market-Risk Rule in Bank Holding Companies
and State Member Banks.’’ This guidance assists
banks in assessing market risk, but primarily Sections 5017.1, 5017.2, and 5017.3
ensures that banks apply the market-risk rule (12
CFR 208, appendix E) appropriately and consis- These new sections, ‘‘Internal Controls—
tently. The market-risk rule emphasizes the need Procedures, Processes, and Systems (Required
for appropriate stress testing and independent Absences from Sensitive Positions),’’ have been
market-risk management commensurate with the created to assist examiners in evaluating internal
organization’s risk profiles. Banking organiza- controls policies that pertain to procedures,
tions are to periodically reassess and adjust their processes, and systems. The sections provide a
market-risk management programs to account brief discussion on internal controls, which are
for changing firm strategies, market develop- the processes developed by a bank’s board and
ments, organizational incentive structures, and senior management that ensure the institution
evolving risk-management techniques. Specifi- (1) operates effectively and efficiently, (2) cre-
cally, SR-09-1 discusses (1) the core require- ates reliable financial reports, and (3) complies
ments of the market-risk rule, (2) the market- with applicable laws and regulations.
risk rule capital computational requirements, In particular, the sections discuss requiring
and (3) the communication and Federal Reserve absences for two consecutive weeks per year of
requirements in order for a bank to use its the bank’s employees that hold sensitive posi-
value-at-risk measurement models. tions. Examples of sensitive activities include
trading and wire transfer operations, back-office
responsibilities, executing transactions, signing
Section 4125.1 authority, and accessing the books and records
of the banking organization. Individuals who
This section, ‘‘Payment System Risk and Elec- can influence or cause such activities to occur
tronic Funds Transfer Activities,’’ has been should be absent for the minimum period, and
revised to update the information on the differ- the absence should, under all circumstances, be
ent types of payment systems such as the Clear- of sufficient duration to allow all pending trans-
ing House Interbank Payment System (CHIPS), actions (those that the absent employee was
automated clearinghouse (ACH), and Fedwire responsible for initiating or processing) to clear,
Securities Services. On December 19, 2008, the and to provide for an independent monitoring of
Board adopted major revisions to the ‘‘Federal those transactions. See SR-96-27.
Reserve Policy on Payment System Risk’’ (PSR
policy). Revisions were made to part II of the
PSR policy involving intraday credit policies. Sections 7040.1, 7040.2, 7040.3, and
This section includes this revised guidance, 7040.4
which is designed to improve intraday liquidity
management and payment flows for the banking The sections, ‘‘International—Country Risk and
system, while also helping to mitigate the credit Transfer Risk,’’ include the guidance issued in
exposures to the Federal Reserve Banks from SR-08-12, ‘‘Revisions to the Guide to the Inter-
daylight overdrafts. The PSR policy adopts a agency Country Exposure Review Committee
new approach that explicitly recognizes the role (ICERC) Process’’ and its attachments. The new
of the central bank in providing intraday bal- guidance discusses the November 2008 changes
ances and credit to healthy depository institu- to the ICERC country rating process, whose
tions predominately through zero fee collateral- main feature is the rating of countries only when
Commercial Bank Examination Manual April 2009

Page 1
in default. Default occurs when a country is not time), arrearages, forced restructuring, or roll-
complying with its external debt-service obliga- overs. The Federal Reserve and the other bank-
tions or is unable to service the existing loan ing agencies have also eliminated the following
according to its terms (as evidenced by the rating categories: Other Transfer Risk Problems,
failure to pay principal and interest fully and on Weak, Moderately Strong, and Strong.
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pages 7-10.2 pages 7-10.2
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pages 7-8.3 pages 7-8.3
4125.1, pages 1-22 4125.1, pages 1-23
5017.1, pages 1-2
5017.2, page 1
5017.3, page 1
6010.1, pages 1-2 6010.1, pages 1-2
7000.0, page 1 7000.0, page 1
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pages, 19-20 pages, 19-20
7040.1, pages 1-7 7040.1, pages 1-7
7040.2, pages 1-2 7040.2, page 1
7040.3, pages 1-8 7040.3, pages 1-7
7040.4, pages 1-2 7040.4, pages 1-2
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April 2009 Commercial Bank Examination Manual

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Supplement 30—October 2008
Summary of Changes prevention, and mitigation of identity theft

(implementation of an Identity Theft Prevention
Section 3020.1 Program); and (3) duties of credit and debit card
issuers regarding changes of address. The joint
The section ‘‘Assessment of Capital Adequacy’’ rules and guidelines were effective on January 1,
is revised to reference (1) the Board staff’s 2008. The date for mandatory compliance with
October 12, 2007, legal interpretation regarding the rule was November 1, 2008. The sections
the risk-based capital treatment of asset-backed have been revised to incorporate the rule’s
commercial paper (ABCP) liquidity facilities provisions that focus on a financial institution’s
and (2) the Board staff’s August 21, 2007, legal safety and soundness (in particular, item 2
interpretation regarding the appropriate risk- above). The examination objectives, examina-
based capital risk weight to be applied to certain tion procedures, and internal control question-
collateralized loans of cash. naire have been revised to incorporate the rule
and its guidelines. See also the October 10,
2008, letter (SR-08-7/CA 08-10) and its
Section 4030.1 interagency-generated attachments.
The section on ‘‘Asset Securitization’’ is revised

to (1) indicate that a banking organization may Section 4150.1
risk weight the credit equivalent amount of an
eligible ABCP liquidity facility by looking The section on the ‘‘Review of Regulatory
through to the underlying assets of the ABCP Reports’’ was revised significantly to include a
conduit and (2) reference the aforementioned more current discussion of the institution’s gen-
Board staff’s October 12, 2007, legal eral and specific responsibilities, and the exam-
interpretation. iner’s review responsibilities, with regard to
regulatory financial reports and refilings submit-
ted to the Federal Reserve and other federal
Sections 4060.1–4060.4 agencies, such as the Securities and Exchange
Commission and the U.S. Department of the
The sections on ‘‘Information Technology’’ have Treasury. Many of the reports’ general instruc-
been revised to incorporate the November 9, tions and descriptions have been revised and
2007, adoption of the interagency rules, ‘‘Iden- made current, including those pertaining to the
tity Theft Red Flags and Address Discrepancies submission of the bank Call Report. The section
Under the Fair and Accurate Credit Transactions clarifies the various monetary deposit transac-
Act of 2003,’’ (the FACT Act) and guidelines tion reporting categories applicable to deposi-
issued by the federal financial institution regu- tory institutions, as found in the Federal
latory agencies and the Federal Trade Commis- Reserve’s ‘‘Reserve Requirements of Deposi-
sion. The rule and guidelines implement sec- tory Institutions’’ (Regulation D). The report
tions 114 and 315 of the FACT Act. (For the titles and descriptions of domestic and interna-
Federal Reserve Board’s rule, implementing tional transactions and activities that are to be
section 315, see Part 222—Fair Credit Report- reported have been updated. In addition, a list-
ing (Regulation V and its appendix J). The rule ing of U. S. Department of Treasury reports—
and guidelines address three elements: (1) duties reports that are applicable to institutions regu-
of users of credit reports regarding address lated and supervised by the Federal Reserve
discrepancies; (2) duties regarding the detection, Board—has been updated.
Commercial Bank Examination Manual October 2008

Page 1
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pages 29–30 pages 29–30
2020.1, pages 1–2 2020.1, pages 1–2

pages 8.11–10 pages 8.11–10
2040.1, pages 1–2 2040.1, pages 1–2

pages 8.1–8.2 pages 8.1–8.2
3010.1, pages 1–4 3010.1, pages 1–4
3010.3, pages 1–2 3010.3, pages 1–2
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pages 7–10.2 pages 7–10.2
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pages 19–22.2 pages 19–22.2
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pages 7–8 pages 7–8.3
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4060.4, pages 1–4 4060.4, pages 1–5
4090.3, pages 1–2 4090.3, pages 1–2
4128.1, pages 1–2 4128.1, pages 1–2

4140.1, pages 1–2 4140.1, pages 1–2
4150.1, pages 1–9 4150.1, pages 1–11
7030.3, pages 1–6 7030.3, pages 1–7
Subject Index, pages 1–19 Subject Index, pages 1–19
October 2008 Commercial Bank Examination Manual

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Summary of Changes FDIC’s changes. For example, see footnote 4

(See also the May 2006 supplement 25).
Section 1000.1
Section 5020.1
This section, ‘‘Examination Strategy and Risk-
Focused Supervision,’’ has been revised to The section on ‘‘The Overall Conclusions
(1) state that under section 11(a)(1) of the Fed- Regarding Condition of the Bank’’ has been
eral Reserve Act, examiners and supervisory revised to refer to SR-07-19, ‘‘Confidentiality
staff have the authority to examine at their Provisions in Third-Party Agreements,’’ and to
discretion the accounts, books, and affairs of delete superseded SR-98-21. The listing of
each member bank and to require such state- examples of off-balance-sheet activities that a
ments and reports as it may deem necessary; bank may be engaged in, and the various risks
(2) include the use of standard terminology in that a bank may be exposed to, have been
examination reporting for matters that require updated and expanded. Reference is added for
the Board’s attention; and (3) provide a discus- the Uniform Financial Institutions Rating Sys-
sion of the prohibition on the release of tem (the CAMELS rating system).
confidential information and any agreements
that would authorize the release of this informa-
tion. (See SR-07-19 and SR-97-17; also 72 Section 6000.1
Fed. Reg. 17, 798.)
The ‘‘Commercial Bank Report of Examina-
tion’’ section has been revised to include changes
Sections 1010.1 to the Federal Reserve’s examination report’s
instructions for the use of standardized termi-
This section on ‘‘Internal Control and Audit nology that may involve the ‘‘Matters Requiring
Function, Oversight, and Outsourcing’’ was Board Attention’’ report page or section. To
revised to include the provisions of the FDIC’s improve the consistency and clarity of written
November 2005 rule change to Part 363 (12 CFR communications, the Federal Reserve’s staff
363) (effective December 28, 2005). The changes will use the standard terminology and defini-
increased the asset threshold from $500 million tions to differentiate among (1) Matters Requir-
to $1 billion or more for internal control ing Immediate Attention, (2) Matters Requiring
assessments by the institution’s management and Attention, and (3) Observations. (See SR-08-01,
its external auditors. For institutions having ‘‘Communication of Examination/Inspection
between $500 million and $1 billion in assets, the Findings.’’) Other limited general and technical
requirements for audit committees’ indepen- changes have been made to the examination
dence and composition were eased to require a report’s instructions to allow for ‘‘continuous
majority, rather than all, of the outside audit flow’’ reporting format. References to several
committee members to be independent of Supervision and Regulation letters and other
management. Previously, similar revisions to references have been added, while others were
section 1010.1 were made for some of the deleted as either being superseded or cancelled.
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Summary of Changes holding companies and their nonbank subsidiar-

ies. (See SR-07-1 and its attachments.)
Section 1000.1
This section, ‘‘Examination Strategy and Risk- Section 2135.1
Focused Supervision,’’ has been revised to
accommodate changes to the ‘‘Examination- This new section, ‘‘Subprime Mortgage Lend-
Frequency Guidelines for State Member Banks’’ ing,’’ sets forth the June 29, 2007, interagency
subsection. The changes resulted from an interim Statement on Subprime Mortgage Lending that
rule, effective April 10, 2007, that was jointly was issued by the agencies. The subprime state-
issued by the Federal Reserve Board and the ment was developed and issued to address is-
other federal bank regulatory agencies (the agen- sues and questions related to certain adjustable-
cies). The interim rule implemented (1) section rate mortgage (ARM) products marketed to
605 of the Financial Services Regulatory Relief subprime borrowers. The statement applies to
Act of 2006 (FSRRA) and (2) Public Law all banks and their subsidiaries as well as to
109-473 (to be codified at 12 USC 1820(d)). The bank holding companies and their nonbank
interim rule was adopted as final, without change, subsidiaries.
on September 11, 2007. (See 72 Fed. Reg. The subprime statement emphasizes the need
54347, September 25, 2007.) for institutions to have prudent underwriting
The rule permits federally insured depository standards and to provide consumers with clear
institutions that have up to $500 million in total and balanced information so that both the insti-
assets and that meet certain other criteria to tution and consumers can assess the risks arising
qualify for an 18-month (rather than a 12- from certain ARM products that have dis-
month) on-site examination cycle. Before the counted or low introductory rates. The statement
enactment of FSRRA, only insured depository is focused on these types of ARMs and uses the
institutions that had less than $250 million in interagency Expanded Guidance for Subprime
total assets were eligible for an 18-month on-site Lending issued in 2001 in order to determine
examination cycle. The rule specifies, consistent subprime-borrower characteristics. Although the
with current practice, that a small insured statement is focused on subprime borrowers, the
depository institution meets the statutory ‘‘well principles in the statement are also relevant to
managed’’ criteria for an 18-month examination ARM products offered to nonsubprime borrow-
cycle if the institution, besides having a ers. (See SR-07-12 and its attachment.)
CAMELS composite rating of 1 or 2, received a
rating of 1 or 2 for the management component
of the CAMELS rating at its most recent exami- Sections 3030.1–3030.4
nation. (See SR-07-8 and its attachment, 72 Fed.
Reg. 17798.) These new sections, ‘‘Assessing Risk-Based
Capital—Direct-Credit Substitutes Extended to
Asset-Backed Commercial Paper Programs,’’
Sections 2103.2–2103.4 consist of interagency guidance issued in March
2005. That guidance was based on the Board’s
These updated sections provide the examination adoption of the November 29, 2001, amended
objectives, examination procedures, and internal risk-based capital standards. The standards
control questionnaire for section 2103.1, ‘‘Con- established a new capital framework for bank-
centrations in Commercial Real Estate Lending, ing organizations engaged in securitization
Sound Risk-Management Practices’’ (added in activities. The interagency guidance clarifies
the May 2007 update to this manual). Section how banking organizations are to use the
2103.1 set forth the December 6, 2006, super- internal ratings they assign to asset pools
visory guidance that was jointly issued by the purchased by their asset-backed commercial
agencies. The guidance was effective December paper (ABCP) programs in order to
12, 2006, and is applicable to state member appropriately risk-weight any direct-credit
banks; it is also broadly applicable to bank substitutes (for example, guarantees) that are

Page 1
extended to such programs. Examination objec- CSFTs.’’ Such transactions typically are con-
tives, examination procedures, and an internal ducted by a limited number of large financial
control questionnaire are included. institutions. (See SR-07-05 and 72 Fed. Reg.
The guidance provides an analytical frame- 1372, January 11, 2007.)
work for assessing the broad risk characteristics
of direct-credit substitutes that a banking orga-
nization provides to an ABCP program it spon- Section 6010.1
sors. Specific information is provided on evalu-
ating direct-credit substitutes issued in the form This section, ‘‘Other Types of Examinations,’’
of program-wide credit enhancements. (See SR- has been revised to discuss the responsibilities
05-6.) Reserve Bank staff have in the examination and
supervision of, and the reporting for, an institu-
tion’s compliance with the Government Securi-
Section 4033.1 ties Act. Reserve Bank staff should report only
those findings derived from the examinations of
This new section, ‘‘Elevated-Risk Complex government securities broker or dealer opera-
Structured Finance Activities,’’ sets forth the tions of state member banks, branches, or agen-
January 11, 2007, Interagency Statement on cies subject to Federal Reserve supervision. A
Sound Practices Concerning Elevated Risk Com- Reserve Bank’s staff is required to report sepa-
plex Structured Finance Activities. This super- rately (to designated Board staff) the results of
visory guidance addresses risk-management prin- their reviews of government securities broker-
ciples that should help institutions to identify, dealer activities (and such broker-dealer’s related
evaluate, and manage the heightened legal and custodial activities). The optional reporting form,
reputational risks that may arise from their Summary Report of Examination of Govern-
involvement in complex structured financing ment Securities Broker-Dealer and Custodial
transactions (CSFTs). The guidance is focused Activities, may be used for this purpose. See the
on those CSFTs that may present heightened specific examination guidance and procedures in
levels of legal or reputational risk to an institu- SR-06-8, SR-93-40, and SR-87-37. (See also
tion and are thus defined as ‘‘elevated-risk SR-94-5, SR-90-1, and SR-88-26.)
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3030.2, pages 1–2
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4033.1, pages 1–6
4090.1, pages 1–2 4090.1, pages 1–2
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Supplement 27—May 2007
Summary of Changes Lease Losses (ALLL). (See SR-06-17.) The

guidance updates the 1993 Interagency Guid-
ance on the ALLL (SR-93-70). The revised
Sections 2010.3, 2040.3, and 4150.1
policy statement emphasizes that each institu-
The ‘‘Due from Banks (Examination Proce- tion is responsible for developing, maintaining,
dures),’’ ‘‘Loan Portfolio Management (Exami- and documenting a comprehensive, systematic,
nation Procedures),’’ and ‘‘Review of Regula- and consistently applied process for determin-
tory Reports’’ sections were revised as the result ing the amounts of the ALLL and the provision
of the Financial Services Relief Act of 2006 for loan and lease losses. Each institution
(Relief Act) and the Board’s December 6, 2006, should ensure that the adequate controls are in
approval of an interim rule amendment of Regu- place to consistently determine the appropriate
lation O (effective December 11, 2006). The balance of the ALLL in accordance with
Relief Act eliminated certain statutory reporting (1) GAAP, (2) the institution’s stated policies
and disclosure requirements pertaining to insider and procedures, and (3) management’s best
lending by federally insured financial institutions. judgment and relevant supervisory guidance.
Sections 215.9, 215.10, and Subpart B of Regu- The policy emphasizes also that an institution
lation O were deleted as a result of the rule’s should provide reasonable support and docu-
changes. (See 71 Fed. Reg. 71,472, December mentation of its ALLL estimates, including
11, 2006.) The Board approved the final rule for adjustments to the allowance for qualitative or
this amendment without change on May 25, environmental factors and unallocated portions
2007 (effective July 2, 2007). (See 72 Fed. Reg. of the allowance.
30,470, June 1, 2007.)
Section 2103.1
Sections 2043.1, 2043.2, 2043.3, and
A new section, ‘‘Concentrations in Com-
2043.4
mercial Real Estate Lending, Sound Risk-
These new ‘‘Nontraditional Mortgages— Management Practices,’’ sets forth the
Associated Risks’’ sections have been devel- December 6, 2006, interagency supervisory
oped based on the September 29, 2006, Inter- guidance, which was issued jointly by the
agency Guidance on Nontraditional Mortgage Federal Reserve and the other federal bank
Product Risks. (See SR-06-15.) The guidance regulatory agencies. The guidance, effective
addresses both the risk-management and con- December 12, 2006, is applicable to state
sumer disclosure practices that institutions (for member banks.
this manual, state member banks and their The guidance was developed to reinforce
subsidiaries) should employ to effectively man- sound risk-management practices for institu-
age the risks associated with closed-end residen- tions with high and increasing concentrations of
tial mortgage loan products that allow borrowers commercial real estate loans on their balance
to defer payment of principal and, sometimes, sheets. An institution’s strong risk-management
interest. Examination objectives, examination practices and its maintenance of appropriate
procedures, and an internal control question- levels of capital are important elements of a
naire are provided, which should be used when sound commercial real estate (CRE) lending
conducting an examination of a bank that is program, particularly when an institution has a
engaged in such lending activities. concentration in CRE or a CRE lending strategy
leading to a concentration.
The guidance applies to concentrations in
Section 2070.1 CRE loans sensitive to the cyclicality of CRE
markets. For purposes of this guidance, CRE
This ‘‘Allowance for Loan and Lease Losses’’ loans include loans where repayment is depen-
section has been fully revised to incorporate dent on the rental income or the sale or refinanc-
the December 13, 2006, Interagency Policy ing of the real estate held as collateral. The
Statement on the Allowance for Loan and guidance does not apply to owner-occupied
Commercial Bank Examination Manual May 2007

Page 1
loans and loans where real estate is taken as a sors a single-employer defined benefit postre-
secondary source of repayment or through an tirement plan, such as a pension plan or health
abundance of caution. care plan, must recognize the overfunded or
The guidance notes that risk characteristics underfunded status of each such plan as an asset
vary among CRE loans secured by different or a liability on its balance sheet with corre-
property types. A manageable level of CRE sponding adjustments recognized as accumu-
concentration risk will vary depending on the lated other comprehensive income (AOCI). The
portfolio risk characteristics and the quality of agencies’ interim decision conveys that banking
risk-management processes. The guidance, there- organizations are to exclude from regulatory
fore, does not establish a CRE concentration capital any amounts recorded in AOCI that have
limit that applies to all institutions. Rather, the resulted from their adoption and application of
guidance encourages institutions to perform on- FAS 158.
going risk assessments to identify and monitor
CRE concentrations.
The guidance provides numerical indicators Sections 2000.4, 2130.3, 4060.1, 4060.4,
as supervisory monitoring criteria to identify 4063.4, 4128.1, 4128.3, and 5020.1
institutions that may have CRE concentrations
that warrant greater supervisory scrutiny. The These sections ‘‘Cash Accounts (Internal
monitoring criteria should serve as a starting Control Questionnaire),’’ ‘‘Consumer Credit,’’
point for a dialogue between the supervisory ‘‘Information Technology’’ (including the
staff and an institution’s management about the internal control questionnaire), ‘‘Electronic
level and nature of the institution’s CRE con- Banking (Internal Control Questionnaire),’’
centration risk. (See SR-07-1 and its ‘‘Private-Banking Activities,’’ (including the
attachments.) examination procedures), and ‘‘Overall Conclu-
sions Regarding Condition of the Bank,’’ have
been amended for the revised Suspicious Activ-
Section 3020.1 ity Report by Depository Institutions (SAR-
DI) form. The Federal Reserve, along with the
The ‘‘Assessment of Capital Adequacy’’ section other federal financial institutions regulatory
was revised to include an interim interagency agencies and the Financial Crimes Enforce-
decision on the impact of the Financial Account- ment Network (FinCEN), proposed revisions to
ing Standards Board’s issuance of its September this form and the instructions in order to
2006 Statement of Financial Accounting Stan- (1) enhance their clarity, (2) allow for joint fil-
dards No. 158 (FAS 158), ‘‘Employers Account- ings of suspicious activity reports, and
ing for Defined Benefit Pension and Other (3) improve the usefulness of the SAR-DI form
Postretirement Plans.’’ The decision was to law enforcement authorities. The new form’s
announced in a December 14, 2006, joint press implementation date has not been determined.
release, which was issued by the Federal Reserve Banking organizations subject to SAR filing
Board and the other federal banking and thrift should continue using the existing SAR-DI
regulatory agencies (the agencies). FAS 158 format. (See 72 Fed. Reg. 23,891, May 1,
provides that a banking organization that spon- 2007.)
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pages 15–16 pages 15–16, 16.1
2040.3, pages 1–2 2040.3, pages 1–2

2043.1, pages 1–10
2043.2, page 1
2043.3, pages 1–3
2043.4, pages 1–4
2070.1, pages 1–12 2070.1, pages 1–15
2072.1, pages 1–2 2072.1, pages 1–2
2103.1, pages 1–5
2130.3, pages 1–2 2130.3, pages 1–2

2133.1, pages 1–2 2133.1, pages 1–2

3020.1, pages 1–2 3020.1, pages 1–2

4040.1, pages 1–2

4040.1, pages 1–2
pages 13–23
4060.1, pages 1–2 4060.1, pages 1–2

4060.4, pages 1–4 4060.4, pages 1–4
4063.4, pages 1–2 4063.4, pages 1–2
4128.1, pages 1–6 4128.1, pages 1–6

4128.3, pages 1–2 4128.3, pages 1–2
4150.1, pages 1–6, 6.1 4150.1, pages 1–6, 6.1
5020.1, pages 1–2 5020.1, pages 1–2


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Supplement 26—November 2006
Summary of Changes ated with excessive reliance on such deposits.

The advisory provides guidance on prudent risk
Sections 2040.1 and 2040.3 identification and the management for these
types of funding. (See SR-01-14.) The exami-
These ‘‘Loan Portfolio Management’’ sections nation objectives and procedures were revised to
have been revised to incorporate a May 22, incorporate the advisory’s guidance.
2006, Board staff interpretation of Regulation O
pertaining to the use of bank-owned or bank-
issued credit cards by bank insiders for the Section 3020.1
bank’s business purposes. The interpretation is
also concerned with the extension of credit This section, ‘‘Assessment of Capital Adequacy,’’
provisions and the market-terms requirement of was revised to incorporate a general discussion
Regulation O when a bank insider uses the of the risk-based capital treatment of securities-
bank-owned or bank-issued credit card to acquire lending transactions (see 12 CFR 208, appendix
goods and services for personal purposes. The A, section III.D.1.c). Included is a brief sum-
examination procedures have been revised to mary of the Board’s February 6, 2006, revision
include the provisions of this interpretation. of the Board’s market-risk measure (effective on
February 22, 2006). The revision reduced the
capital requirements for certain cash-
Sections 3000.1, 3000.2, and 3000.3 collateralized securities-borrowing transactions
of state member banks that adopt the market-
The ‘‘Deposit Accounts’’ sections have been risk rule. The action aligns the capital require-
revised to include a brief overview of the ments for those transactions with the risk
Federal Deposit Insurance Corporation’s involved. It provides a capital treatment for state
(FDIC’s) Deposit Insurance System. FDIC’s member banks that is more in line with the
deposit insurance coverage was amended by the capital treatment that applies to their domestic
issuance of its March 23, 2006, interim final and foreign competitors. (See Regulation H, 12
rules (effective on April 1, 2006). These interim CFR 208, appendix E, and 71 Fed. Reg. 8,932,
rules implemented certain provisions of (1) the February 22, 2006.)
Federal Deposit Insurance Reform Act of 2005 In addition, the revised section includes dis-
and (2) the Federal Deposit Insurance Reform cussions of the May 14, 2003, and August 15,
Conforming Amendments Act of 2005. (See 71 2006, Board interpretations that were issued in
Fed. Reg. 14,629.) For deposit accounts, the response to separate inquiries received from the
FDIC’s interim rules provided for (1) inflation same bank. The May 14, 2003, interpretation
(cost-of-living) adjustments to increase the stan- concerns an inquiry regarding the risk-based
dard maximum deposit insurance amount capital treatment of certain European agency
(SMDIA) of $100,000 on a five-year cycle, securities-lending arrangements that the bank
beginning on April 1, 2010; (2) an increase in had acquired. For these transactions (the cash-
the FDIC’s SMDIA from $100,000 to $250,000 collateral transactions), the bank, acting as agent
for certain individual retirement accounts, which for its clients, lends its clients’ securities and
includes future cost-of-living adjustments; and receives cash collateral in return. It then rein-
(3) per-participant FDIC pass-through deposit vests the cash collateral in a reverse repurchase
insurance coverage for employee benefit agreement for which it receives securities col-
accounts. (See 12 CFR 330.) The FDIC’s lateral in return. For the cash-collateral transac-
increased insurance coverage of individual tions, the bank indemnifies its client against the
retirement accounts also applies to eligible risk of default by both the securities borrower
deferred compensation plan accounts. and the reverse repurchase counterparty.
The ‘‘Deposit Accounts’’ sections also were The August 15, 2006, interpretation was also
revised to incorporate the May 11, 2001, Joint issued in regard to the risk-based capital treat-
Agency Advisory on Brokered and Rate- ment of certain other securities-lending transac-
Sensitive Deposits issued by the federal banking tions. For these transactions, the bank, acting as
agencies to highlight the potential risks associ- agent for clients, lends its clients’ securities and
Commercial Bank Examination Manual November 2006

Page 1
receives liquid securities collateral in return (the the asset-quality test for determining the eligi-
securities-collateral transactions). The bank indi- bility or ineligibility of an ABCP liquidity
cated that the liquid securities collateral was to facility and the resulting risk-based capital treat-
include government agency, government- ment of such a facility for banks. The guidance
sponsored entity, corporate debt or equity, or also re-emphasizes that the primary function of
asset-backed or mortgage-backed securities. The an eligible ABCP liquidity facility should be to
bank stated that in the event that the borrower provide liquidity—not credit enhancement. An
defaulted, the bank would be in a position to eligible liquidity facility must have an asset-
terminate a securities-collateral transaction and quality test that precludes funding against assets
sell the collateral in order to purchase securities that are (1) 90 days or more past due, (2) in
to replace the securities that were originally lent. default, or (3) below investment grade, imply-
The bank’s exposure would be limited to the ing that the institution providing the ABCP
difference between the purchase price of replace- liquidity facility should not be exposed to the
ment securities and the market value of the credit risk associated with such assets. The
securities collateral. The bank requested that it interagency statement indicates that an ABCP
receive risk-based capital treatment similar to liquidity facility will meet the asset-quality test
that which the Board had approved and extended if, at all times throughout the transaction the
to the bank in its letter dated May 14, 2003 (the (1) liquidity provider has access to certain types
prior approval). of acceptable credit enhancements that support
The Board, using its reservation of authority, the liquidity facility and (2) notional amount of
again determined that under its current risk- such credit enhancements exceeds the amount of
based capital guidelines the capital charge for underlying assets that are 90 days or more past
this specific type of securities-lending arrange- due, defaulted, or below investment grade, that
ment would exceed the amount of economic risk the liquidity provider may be obligated to fund
posed to the bank, which would result in capital under the facility. (See SR-05-13.)
charges that would be significantly out of pro-
portion to the risk. Referencing the prior
approval, the Board approved the August 15, Section 4063.1
2006, exception to its risk-based capital guide-
lines. The bank, which had adopted the market- The section ‘‘Electronic Banking’’ was revised
risk rule, will compute its regulatory capital for to incorporate a brief reference to the August 15,
these transactions using a loan-equivalent meth- 2006, Interagency Questions and Answers
odology in accordance with the prior approval. (Q&As) for the October 2005 Interagency Guid-
In so doing, the bank will assign the risk weight ance on Authentication in an Internet Banking
of the counterparty to the exposure amount of all Environment. (See SR-06-13 and SR-05-19.)
such transactions with the counterparty. The The Q&As were designed to assist financial
bank must calculate the exposure amount as the institutions and their technology service provid-
sum of its current unsecured exposure on its ers in conforming to the scope, risk assessments,
portfolio of transactions with the counterparty, timing, and other issues addressed in the Octo-
plus an add-on amount for potential future ber 2005 guidance that becomes effective at
exposure. This estimated exposure is to be year-end 2006. The section notes, again, that
calculated using the bank’s VaR model to deter- single-factor authentication, as the only control
mine the capital charge for the securities- mechanism, is inadequate for high-risk transac-
collateral transactions, subject to the certain tions involving access to customer information
specified conditions. or the movement of funds to other parties.
Section 4030.1 Sections 4133.1 and 4133.3

The section titled ‘‘Asset Securitization’’ has These ‘‘Prompt Corrective Action’’ sections
been revised to incorporate the August 4, 2005, include several changes to more closely align
Interagency Guidance on the Eligibility of Asset- the content to the Board’s prompt-corrective-
Backed Commercial Paper Liquidity Facilities action (PCA) rules. Minor technical amend-
and the Resulting Risk-Based Capital Treat- ments that were previously made to the rules
ment. The guidance clarifies the application of (effective on October 1, 1998) are also included.
November 2006 Commercial Bank Examination Manual

Page 2
For example, the definition of total assets was Revisions to Uniform Standards of Professional
revised to allow the Federal Reserve the option Appraisal Practice (USPAP), issued by the fed-
of using period-end rather than average total eral banking agencies. Under the appraisal regu-
assets for determining the PCA categories within lations, institutions must ensure that their
the rules. (See 63 Fed. Reg. 37,630, and 12 CFR appraisals supporting federally related transac-
208, subpart D.) The section now includes tions adhere to USPAP. The interagency state-
examination procedures for evaluating compli- ment provides an overview of the USPAP revi-
ance with the PCA rules. sions and the ramifications of these revisions to
regulated institutions. The 2006 USPAP, effec-
tive July 1, 2006, incorporates certain prominent
Sections 4140.1, 4140.2, 4140.3, and revisions made by the Appraisal Standards
4140.4 Board. These revisions include a new Scope of
Work Rule and the deletion of the Departure
The ‘‘Real Estate Appraisals and Evaluations’’ Rule and some of its associated terminology.
sections have been revised to incorporate the (See SR-06-9.)
June 22, 2006, interagency statement, The 2006
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pages 21–22 pages 21–22, 22.1–22.2
2040.3, pages 1–2 2040.3, pages 1–2, 2.1

page 9 pages 9–10
3000.1, pages 1–12 3000.1, pages 1–15
3000.2, page 1 3000.2, page 1
3000.3, pages 1–7 3000.3, pages 1–7
3020.1, pages 1–2 3020.1, pages 1–2

pages 7–10, 10.1–10.2 pages 7–10, 10.1–10.2
4030.1, pages 1–2 4030.1, pages 1–2

pages 19–22 pages 19–22, 22.1–22.2
4063.1, pages 1–10 4063.1, pages 1–10
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JOBNAME: No Job Name PAGE: 1 SESS: 175 OUTPUT: Mon Jun 5 11:41:57 2006
/frb3/bsr/commercial/part−1nw/sup_25

Summary Of Changes accountant and a client enter into an agreement

of indemnity, directly or through an affiliate that
Section 1000.1 seeks to assure the accountant immunity from
liability for the accountant’s own negligent acts,
This revised section, ‘‘Examination Strategy and whether they are acts of omission or commis-
Risk-Focused Examinations,’’ reaffirms the defi- sion. (See SR-06-4.)
nition of the responsible Reserve Bank (RRB)
and specifies the RRB’s responsibilities for
conducting inter-District examination and super- Section 1015.1
vision activities for a banking organization. The
section highlights and clarifies the role of the This new section, ‘‘Conflict-of-Interest Rules
RRB with respect to inter-District and local for Examiners,’’ has been developed to inform
Reserve Bank coordination of banking exami- Federal Reserve System examiners of the Sys-
nation and supervision activities. (See SR-05- tem’s policies on maintaining an independent
27/CA-05-11.) appearance by avoiding conflicts of interest.
Examiners must comply with statutory prohibi-
tions and adhere to the System’s rules on con-
flicts of interest, which are intended to ensure
Sections 1010.1, 1010.2, 1010.3, 1010.4,
the examiners’ objectivity and integrity. The
and A.1010.1
statutory prohibition (18 USC 213) on accepting
The sections titled ‘‘Internal Control and Audit any loan or gratuity from any bank under
Function, Oversight, and Outsourcing’’ have examination is discussed. The limited easing of
been revised to incorporate the February 9, examiner borrowing restrictions on obtaining
2006, Interagency Advisory on the Unsafe and credit cards and certain home mortgage loans is
Unsound Use of Limitation of Liability Provi- also discussed; the easing of these restrictions
sions in External Audit Engagement Letters. resulted from the implementation of the Preserv-
The advisory informs financial institutions that ing Independence of Financial Institution
it is unsafe and unsound to enter into external Examinations Act of 2003 (18 USC 212–213).
audit contracts (that is, engagement letters) for (See SR-05-2.) The special post-employment
the performance of auditing or attestation ser- restrictions of the Intelligence Reform and Ter-
vices when the contracts (1) indemnify the rorism Prevention Act of 2004 are also reviewed.
external auditor against all claims made by third The Board implemented these restrictions in its
parties, (2) hold harmless or release the external November 17, 2005, rule (effective December
auditor from liability for claims or potential 17, 2005). (See 12 CFR 263 and 264 and
claims that might be asserted by the client SR-05-26.)
financial institution (other than claims for puni-
tive damages), or (3) limit the remedies avail-
able to the client financial institution (other than Section 1020.1
punitive damages). Such limits on external
auditors’ liability weaken the auditor’s indepen- The ‘‘Federal Reserve System Bank Watch List
dence and performance, thus reducing the super- and Surveillance Programs’’ section has been
visory agency’s ability to rely on the auditor’s substantially revised to reflect the Federal
work. The examination objectives, examination Reserve’s replacement of the former SEER (the
procedures, and internal control questionnaire System to Estimate Examination Ratings) sur-
incorporate certain key provisions of the advi- veillance models with a new econometric frame-
sory. Section A.1010.1 provides examples of work, referred to as the Supervision and Regu-
unsafe and unsound limitation-of-liability pro- lation Statistical Assessment of Bank Risk
visions, and it discusses frequently asked ques- model, or SR-SABR. The SR-SABR model
tions and answers that were posed to the Secu- assigns a two-component surveillance rating to
rities and Exchange Commission (Office of the each bank. The first component is the current
Chief Accountant). The answers confirm that an composite CAMELS rating assigned to the bank.
accountant (auditor) is not independent when an The second component is a letter (A, B, C, D, or

Page 1
JOBNAME: No Job Name PAGE: 2 SESS: 176 OUTPUT: Tue Jun 13 11:46:25 2006
F) that reflects the model’s assessment of the of the other assets’’ threshold for the reporting
relative strength or weakness of a bank com- of the cash surrender value of life insurance
pared with other institutions within the same assets in the bank Call Report, FFIEC 031,
CAMELS rating category. The section describes Schedule RC-F item 5, other assets. As of
the new model, details the screening thresholds March 31, 2006, this item must be used to report
for SR-SABR within the State Member Bank the cash surrender value of all life insurance
Watch List program, and updates the watch list assets.
follow-up procedures. (See SR-06-2.)
Sections 4050.1 and 4128.1

Sections 2015.1, 2015.2, 2015.3, and
2015.4 Two sections, ‘‘Bank-Related Organizations’’
and ‘‘Private-Banking Activities,’’ were revised
The new ‘‘Interbank Liabilities’’ sections set to incorporate the Board’s March 15, 2006,
forth supervisory guidance that is based on approval of an amendment to Regulation K. The
Regulation F (12 CFR 206), which was devel- amendment incorporates (by reference) section
oped under the authority of section 23 of the 208.63 of Regulation H into sections 211.5 and
Federal Reserve Act (12 USC 371b-2). The 211.24 of Regulation K. As a result, Edge and
Board established standards to limit the risks agreement corporations and other foreign bank-
posed by exposure of insured depository insti- ing organizations (that is, Federal Reserve–
tutions to other depository institutions with which supervised U.S. branches, agencies, and repre-
they do business, referred to as correspondents. sentative offices of foreign banks) must establish
Regulation F applies to FDIC-insured banks, and maintain procedures reasonably designed to
savings associations, and branches of foreign ensure and monitor their compliance with the
banks (referred to collectively as banks). Banks Bank Secrecy Act and related regulations. (See
are generally required to have in place internal SR-06-7.)
policies and procedures to evaluate and control
the exposure to their correspondents. Regulation
F specifies a general ‘‘limit,’’ stated in terms of Sections 4128.1, 4128.2, and 4128.3
the exposed bank’s capital, for overnight credit
exposure to an individual correspondent. A bank The ‘‘Private-Banking Activities’’ section has
should also ordinarily limit its credit exposure to been further revised to discuss certain borrow-
an individual correspondent to an amount equal ing mechanisms that nonresident-alien custom-
to not more than 25 percent of the exposed ers may establish to keep their financial assets in
bank’s total capital, unless the bank can demon- the United States so those assets can be used as
strate that its correspondent is at least ‘‘adequately operating capital for businesses they own and
capitalized,’’ for which no capital limit is speci- operate in their home countries. Private bankers
fied. A bank is required to establish and follow need to maintain, in the United States, adequate
its own internal policies and procedures for customer-due-diligence information on such
exposure to all correspondents, regardless of nonresident-alien customers and their primary
its capital level. The rule was effective on business interests so that the customer’s home-
December 19, 1992; the Board made technical country government can identify who owns the
amendments to the rule on September 3, 2003 assets. Examination procedures for private-
(effective September 10, 2003). Examination banking activities (section 4128.3) have also
objectives, examination procedures, and an been added.
internal control questionnaire are included. (See
SR-93-36.)
Section 5020.1
Section 4042.3 The ‘‘Overall Conclusions Regarding Condition
of the Bank’’ section was revised to incorporate
The accounting considerations within the the January 20, 2006, Interagency Guidance on
‘‘Operational Risk Assessment’’ subsection Sharing Suspicious Activity Reports with Head
(examination procedure 3b) were revised to Offices and Controlling Companies. The guid-
remove the reference to ‘‘in excess of 25 percent ance confirms that (1) a U.S. branch or agency of

Page 2
a foreign bank may disclose a Suspicious companies, whether domestic or foreign. Bank-
Activity Report (SAR) to its head office outside ing organizations must maintain appropriate
the United States and (2) a U.S. bank or savings arrangements for the protection of confidential-
association may disclose a SAR to controlling ity of SARs. (See SR-06-01.)
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1010.2, page 1 1010.2, page 1
1010.3, pages 1–2 1010.3, pages 1–3
1010.4, pages 1–2 1010.4, pages 1–2

1015.1, pages 1–3
1020.1, pages 1–4 1020.1, pages 1–4
2010.1, pages 1–2 2010.1, pages 1–2
2015.1, pages 1–7
2015.2, page 1
2015.3, pages 1–2
2015.4, pages 1–2
2020.1, pages 1–2 2020.1, pages 1–2

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4042.3, pages 1–2

4042.3, pages 1–2
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pages 13–14, 14.1–14.4 pages 13–14, 14.1–14.5
4060.1, pages 1–2 4060.1, pages 1–2

4063.1, pages 1–2 4063.1, pages 1–2

4063.3, pages 1–2 4063.3, pages 1–2
4090.1, pages 1–2 4090.1, pages 1–2
4128.1, pages 1–15 4128.1, pages 1–16
4128.2, page 1 4128.2, page 1
4128.3, pages 1–2
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Page 4
LIST OF CHANGES
Section number Description of the change
2040.1, The ‘‘Loan Portfolio Management’’ section has been revised to incorporate
2040.2, the May 3, 2005, Interagency Advisory on Accounting and Reporting for
2040.3, Commitments to Originate and Sell Mortgage Loans, which was issued by
2040.4 the Federal Reserve and the other federal supervisory agencies (the agen-
cies).1 The advisory provides guidance on the appropriate accounting and
reporting for both derivative loan commitments (commitments to originate
mortgage loans that will be held for resale) and forward loan-sales
commitments (commitments to sell mortgage loans). When accounting and
reporting for derivative loan commitments, institutions are expected to use
generally accepted accounting principles (GAAP). Institutions must also
correctly report derivative loan commitments in accordance with the Call
Report instructions and forms. (See SR-05-10.) The examination objectives,
examination procedures, and internal control questionnaire have been
revised to incorporate this interagency advisory.
2090.1, The section ‘‘Real Estate Loans’’ has been revised to include the May 16,
2090.2, 2005, Interagency Credit Risk Management Guidance for Home Equity
2090.3, Lending. The agencies issued the guidance to promote a greater focus on
2090.4 sound risk-management practices at financial institutions that have home
equity lending programs, including open-end home equity lines of credit and
closed-end home equity loans. The agencies expressed concern that some
institutions’ credit-risk management practices for home equity lending had
not kept pace with the product’s rapid growth and the easing of underwriting
standards for products having higher embedded risk. The guidance highlights
the sound risk-management practices an institution should follow to align the
growth with the risk within its home equity portfolio. The guidance should
also be considered in the context of existing regulations and supervisory
guidelines. (See SR-05-11 and its attachment.) The examination objectives,
examination procedures, and internal control questionnaire were revised to
incorporate the interagency guidance.
3000.1 The ‘‘Deposit Accounts’’ section has been revised to update the statutory and
regulatory provisions for a bank soliciting, acquiring, renewing, or rolling
over brokered deposits, as those provisions are stated in section 29 of the
Federal Deposit Insurance Act (12 USC 1831f) and section 337.6 of the
Federal Deposit Insurance Corporation’s brokered-deposit rule (12 CFR
337.6). Section 3000.1 defines and discusses the three capitalization status
levels for banks: well capitalized, adequately capitalized, or undercapital-
ized. These levels determine the extent to which banks may engage in
brokered-deposit activities. These definitions are the same as those found in
the prompt-corrective-action rules of the FDIC and the Federal Reserve
Board. (See 12 CFR 325.103 and 12 CFR 208.43.)
1. The Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit
Insurance Corporation, the Office of Thrift Supervision, and the National Credit Union Administration.

Page 1
4042.1, The ‘‘Purchase and Risk Management of Life Insurance’’ section has been
4042.2, revised to include appendix C, Interagency Interpretations of the Interagency
4042.3, Statement on the Purchase and Risk Management of Life Insurance (the
4042.4 interpretations). The interpretations have been developed to clarify a variety
of matters, including financial reporting, credit-exposure limits, concentra-
tion limits, and the appropriate methods for calculating the amount of
insurance an institution may purchase.
Three new supporting sections provide examination objectives, examination

procedures, and an internal control questionnaire. The new sections are
based on the Interagency Statement on the Purchase and Risk Management
of Life Insurance. (See SR-04-19 and its attachment.)
4128.1 The ‘‘Private-Banking Activities’’ section has been revised to include

general and specific references to the relevant supervisory guidance in the
June 2005 Federal Financial Institutions Examination Council’s Bank
Secrecy Act/Anti–Money Laundering Examination Manual. (See SR-05-12
and its attachments.)
4140.1 The section ‘‘Real Estate Appraisals and Evaluations’’ has been revised to
include a summary description of the interagency responses to questions on
both the agencies’ appraisal regulations and the October 2003 interagency
statement titled Independent Appraisal and Evaluation Functions. The
agencies’ March 22, 2005, interpretive responses address common questions
on the requirements of the appraisal regulations and the October 2003
interagency statement. (See SR-05-5 and its attachment.) The section has
also been revised to include a summary of the September 8, 2005,
interagency interpretive responses to frequently asked questions that were
issued jointly to help regulated institutions comply with the agencies’
appraisal regulation and real estate lending requirements when financing
residential construction in a tract development. (See SR-05-14 and its
attachment.)
6003.1 A new section, ‘‘Community Bank Examination Report,’’ provides the

examiner with guidance on preparing examination reports for community
banks. Developments in technology, the expansion of financial services, and
a risk-focused approach to examinations necessitated a need for increased
flexibility when organizing and structuring the content of the community
bank examination report. Examiners may use certain content headings,
which follow a continuous-flow reporting format, or they may use a
separate-report-page format. The reporting instructions distinguish between
mandatory content (when warranted by the bank’s condition or circum-
stances) and optional content. The examiner has discretion in the arrange-
ment of certain content. Subject to certain limitations, the examiner may
customize and streamline the examination report to better focus on the
examiner’s findings involving matters of risk that have a significant impact
on the bank’s overall financial condition. This guidance applies only to the
preparation of community bank examination reports. (See SR-01-19.)

Page 2
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pages 21–24, 24.1–24.2, 25–28 pages 21–39
2040.2, page 1 2040.2, page 1
2040.3, pages 1–4 2040.3, pages 1–4

2040.4, pages 1–4 2040.4, pages 1–4
2090.1, pages 1–2 2090.1, pages 1–2

2090.2, page 1 2090.2, page 1
2090.3, pages 1–3 2090.3, pages 1–5
2090.4, pages 1–3 2090.4, pages 1–5
2100.1, pages 1–4 2100.1, pages 1–4
3000.1, pages 1–2 3000.1, pages 1–2

pages 4.1–4.2, 5–9 pages 5–12
3020.1, pages 55–56 3020.1, pages 55–56
4042.1, pages 1–2 4042.1, pages 1–2

page 21 pages 21–25
4042.2, page 1
4042.3, pages 1–7
4042.4, pages 1–5
4128.1, pages 1–15 4128.1, pages 1–15
4140.1, pages 1–2 4140.1, pages 1–2

6003.1, pages 1–39

Page 3
LIST OF CHANGES
1000.1, The ‘‘Examination Strategy and Risk-Focused Examinations’’ and the

4030.1 ‘‘Asset Securitization’’ sections have been updated to add references to the
new bank holding company RFI/C(D) rating system, which became effective
January 1, 2005. (See SR-04-18.)
2130.1, The ‘‘Consumer Credit’’ sections have been revised to discuss various types,
2130.3, characteristics, and fee structures of a bank’s ad hoc and automatic overdraft
2130.4 programs. Section 2130.1 includes the February 18, 2005, interagency Joint
Guidance on Overdraft Protection Programs that addresses the agencies’
concerns about the potentially misleading implementation, marketing, and
disclosure practices associated with the operation of these programs.
Financial institutions are encouraged to review their overdraft-protection
programs to make certain that their marketing and communications do not
mislead consumers or encourage irresponsible consumer financial behavior
that could increase the institution’s risk. The guidance also addresses the
safety-and-soundness considerations, risk-based capital treatment, and legal
risks associated with overdraft-protection programs. (See SR-05-3/CA-05-
2.) The examination procedures and the internal control questionnaire have
been updated to incorporate this guidance. (See also the summary for
sections 3000.1 and 3000.3.)
The consumer credit examination procedures have also been updated to
include references to and guidance on the Suspicious Activity Report (SAR)
and the Bank Secrecy Act (BSA) compliance program. (See sections
208.62–63 of the Board’s Regulation H (12 CFR 208.62–63) and SR-04-8.)
2210.1 The ‘‘Other Assets and Other Liabilities’’ section has been updated to
coincide with current accounting guidance and the instructions for the bank
Call Report. The section discusses the current examination focus, concerns,
and procedures for other assets and other liabilities, as well as their current
categories and composition. The section includes the accounting treatment
for bank-owned life insurance (BOLI) and an improved discussion of
deferred tax assets and deferred tax liabilities (including the risk-based
capital limitation on their inclusion in tier 1 capital). For more information
on BOLI, see SR-04-4 and SR-04-19.
3000.1, Two of the ‘‘Deposit Accounts’’ sections have been revised to include the
3000.3 February 18, 2005, interagency Joint Guidance on Overdraft Protection
Programs that was issued to assist banks in the responsible disclosure and
administration of their overdraft-protection services. The policy states that
banks should establish and monitor written policies and procedures for ad
hoc, automated, or other overdraft-protection programs. A bank’s policies
and procedures should be adequate to address the credit, operational, and
other risks associated with these types of programs. (See SR-05-3/CA-05-2
and the summary for the 2130 sections.) The examination procedures have
been revised to incorporate this supervisory guidance.

Page 1
3015.1 A new section, ‘‘Deferred Compensation Agreements,’’ has been added to

the ‘‘Liabilities and Capital’’ chapter. The section provides guidance from
the February 11, 2004, Interagency Advisory on Accounting for Deferred
Compensation Agreements and Bank-Owned Life Insurance. The advisory
was issued because the agencies, through the examination process, identified
many institutions that had incorrectly accounted for obligations under a type
of deferred compensation agreement commonly referred to as a revenue-
neutral plan or an indexed retirement plan. The advisory informs institutions
that they need to review their accounting for deferred compensation
agreements to ensure that the agreements have been appropriately measured
and reported. (See SR-04-4 and SR-04-19.)
4042.1 A new section, ‘‘Purchase and Risk Management of Bank-Owned Life

Insurance,’’ provides the text of the December 7, 2004, Interagency
Statement on the Purchase and Risk Management of Life Insurance. The
statement discusses the safety-and-soundness and risk-management implica-
tions of purchases and holdings of life insurance by banks. The agencies
issued the guidance because they were concerned that some institutions may
not have an adequate understanding of the risks associated with BOLI,
including its liquidity, operational, reputational, and compliance/legal risks.
Further, institutions may have committed a significant amount of capital to
BOLI holdings without properly assessing the associated risks. When an
institution is planning to acquire BOLI that will result in an aggregate cash
surrender value in excess of 25 percent of its tier 1 capital plus the allowance
for loan and lease losses, the agencies expect the institution to obtain the
prior approval of its board of directors or its designated board committee.
The guidance addresses the need for institutions to conduct comprehensive
pre- and post-purchase analyses of BOLI, including its unique characteris-
tics, risks, and rewards. Institutions are expected to have comprehensive
risk-management processes for their BOLI purchases and holdings; these
processes should be consistent with safe and sound banking practices. (See
SR-04-4 and SR-04-19.)
4043.1 The ‘‘Insurance Sales Activities and Consumer Protection in Sales of

Insurance’’ section has been revised to include the following references:
• the recently updated discussion on tying arrangements (section 2040.1)

• the new BOLI supervisory guidance (section 4042.1)
4050.1 The ‘‘Bank-Related Organizations’’ section has been revised to incorporate

the U.S. Department of the Treasury’s regulation regarding foreign corre-
spondent accounts. The regulation became effective October 28, 2002. (See
31 CFR 103.177 (amended as of December 24, 2002) and 103.185.) The
regulation implemented sections 313 and 319(b) of the USA Patriot Act. A
covered financial institution (CFI) is prohibited from establishing, maintain-
ing, administering, or managing a correspondent account in the United States
for, or on behalf of, a foreign shell bank (a foreign bank that has no physical
presence in the United States or other jurisdictions) that is not affiliated
(1) with a U.S.-domiciled financial institution or (2) with a foreign bank that
maintains a physical presence in the United States or a foreign country and
is supervised by its home-country banking authority. A CFI that maintains

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a correspondent account for a foreign bank in the United States must

maintain records in the United States identifying the owners of the foreign
bank. (See SR-03-17 and the attached October 2003 Bank Secrecy Act
Examination Procedures for Correspondent Accounts for Foreign Shell
Banks; Recordkeeping and Termination of Correspondent Accounts for
Foreign Banks. See also SR-01-29.)
4060.1, The ‘‘Information Technology’’ sections have been revised to include the
4060.2, Board’s December 16, 2004, adoption of rule changes (effective July 1,
4060.3, 2005) that implement section 216 of the Fair and Accurate Credit Transac-
4060.4 tions Act of 2003 and that amend the Interagency Guidelines Establishing
Information Security Standards. (See the Board’s December 21, 2004, press
release.) To address the risks associated with identity theft, financial
institutions are required to make modest adjustments to their information
security programs to develop, implement, maintain, and monitor, as part of
their existing information security program, appropriate measures to prop-
erly dispose of consumer and customer information derived from credit
reports (information maintained in paper-based or electronic form). Each
financial institution must contractually require its service providers to
develop appropriate measures for the proper disposal of the institution’s
consumer and customer information and, when warranted, monitor its
service providers to confirm that they have satisfied their contractual
obligations.
The sections have also been revised to include the Board’s March 21,
2005, adoption of Jointly Issued Interagency Guidance on Response Pro-
grams for Unauthorized Access to Customer Information and Customer
Notice. (See the Board’s March 23, 2005, press release.) Financial institu-
tions are to develop and implement a response program designed to address
incidents of unauthorized access to sensitive customer information, main-
tained by the institution or its service provider, that could result in substantial
harm or inconvenience to the customer. Each financial institution has the
flexibility to design a risk-based response program tailored to the size,
complexity, and nature of its operations. Customer notice is a key feature of
an institution’s response program. (See Regulation H, appendix D-2,
supplement A (12 CFR 208, appendix D-2, supplement A).) The examina-
tion objectives, examination procedures, and internal control questionnaire
have been updated to incorporate or reference these rule changes and the
interagency guidance.
4063.4 The ‘‘Electronic Banking: Internal Control Questionnaire’’ has been updated
to include the following references:
• SR-03-12 (and the attached July 2003 SAR form)

• the Board’s Regulation H requirements for suspicious-activity reporting
(12 CFR 208.62)
• the Board’s Regulation H requirements for the BSA compliance program
(12 CFR 208.63)
See also SR-04-8 and the attached May 24, 2004, Interagency Advisory—
Federal Court Reaffirms Protections for Financial Institutions Filing Suspi-
cious Activity Reports.

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4128.1 The ‘‘Private Banking’’ section has been revised to incorporate new and
enhanced statutory requirements of the USA Patriot Act. The requirements
are designed to prevent, detect, and prosecute money laundering and
terrorism. For banking organizations, the act’s provisions are implemented
through regulations issued by the U.S. Department of the Treasury (31 CFR
103). Section 326 of the Patriot Act (codified in the BSA at 31 USC 5318(l))
requires financial institutions to have customer identification programs, that
is, programs to collect and maintain certain records and documentation on
customers. Institutions should also develop and use identity verification
procedures to ensure the identity of their customers. SR-04-13 describes the
BSA examination procedures for customer identification programs; examin-
ers should follow these procedures when evaluating an institution’s compli-
ance with the regulation. (See also SR-03-17 and SR-01-29.) Relevant
interagency interpretive guidance, in a question-and-answer format, addresses
the customer identification rules. (See SR-05-9.)
4150.1 The ‘‘Review of Regulatory Reports’’ section has been revised to discuss the
termination of the Federal Reserve’s Regulatory Reports Monitoring Pro-
gram. A less formal program will continue at the Reserve Banks. (See
SR-04-15.)
5020.1 The ‘‘Overall Conclusions Regarding Condition of the Bank’’ section has
been revised to include guidance on a bank’s use of the SAR form and the
filing of a SAR with the Department of the Treasury’s Financial Crimes
Enforcement Network (FinCEN). A bank’s record-retention requirements for
documentation supporting a SAR are also discussed. (See section 208.62 of
the Board’s Regulation H (12 CFR 206.62) and SR-04-8.)
In addition, the section has been revised to include the February 28, 2005,
Interagency Advisory on the Confidentiality of the Supervisory Rating and
Other Nonpublic Supervisory Information. The advisory reminds banking
organizations of the statutory prohibitions on the disclosure of supervisory
ratings and other confidential supervisory information to third parties. (See
SR-05-4.)
7000.0 The ‘‘International’’ section has been revised to convey an overview of the
examination focus for international banking transactions and activities. The
discussion of other examination topics and Federal Reserve System and
FFIEC examination manuals has been updated for those international areas
that may be need to be reviewed during a bank examination.
7000.1 The former ‘‘International—General Introduction’’ section has been renamed

‘‘International—Examination Overview and Strategy.’’ The revised title
better reflects the content of the sections that follow, which provide the
examination and supervisory guidance for international transactions, activi-
ties, and international banking. References and other section titles were also
updated.

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LIST OF CHANGES
1000.1 The ‘‘Examination Strategy and Risk-Focused Examinations’’ section incor-

porates a May 2004 recommended-practices document promulgated by the
interagency State-Federal Working Group. The working group consists of
state bank commissioners and senior officials from the Federal Reserve and
the Federal Deposit Insurance Corporation.1 The recommended practices
highlight the importance of communication and coordination between state
and federal banking agencies in the planning and execution of supervisory
activities over state-chartered banking organizations. The recommended
practices are the common courtesies and practices examination and super-
visory staff are to follow in the implementation and execution of their
agencies’ supervisory activities. These recommended practices further rein-
force the long-standing commitment of federal and state banking supervisors
to provide efficient, effective, and seamless oversight of state banks of all
sizes. The practices apply to institutions that operate in a single state or in
more than one state. (See SR-04-12.)
2020.1, The ‘‘Investment Securities and End-User Activities’’ section has been
2020.3 updated to include the revised Uniform Agreement on the Classification of
Assets and Appraisal of Securities Held by Banks and Thrifts (the uniform
agreement) that was jointly issued by the federal banking and thrift agencies
(the agencies) on June 15, 2004. The revised uniform agreement amends the
1938 classification of securities agreement (the 1938 accord), which was
revised on July 15, 1949, and May 7, 1979. The uniform agreement sets forth
the definitions of the classification categories and the specific examination
procedures and information for classifying bank assets, including securities.
The classification of loans in the uniform agreement was not changed by the
June 2004 revision. The revised uniform agreement addresses, among other
items, the treatment of rating differences, multiple security ratings, and split
or partially rated securities. It also eliminates the automatic classification for
sub-investment-grade debt securities. (See SR-04-9.) The examination pro-
cedures were also revised to incorporate the supervisory guidance provided
in the revised uniform agreement.
2040.1, The ‘‘Loan Portfolio Management’’ section has been revised to incorporate
2040.2, a detailed discussion on tying arrangements. Section 106 of the Bank
2040.3 Holding Company Act Amendments of 1970 generally prohibits a bank from
conditioning the availability or price of one product or service (the tying
product, or the desired product) on a requirement that a customer obtain
another product or service (the tied product) from the bank or an affiliate of
the bank. Section 106 prevents banks from using their market power over
certain products (specifically credit) to gain an unfair competitive advantage
in other products.
1. The source for the recommended-practices document is the November 14, 1996, Nationwide State and Federal Supervisory
Agreement (the agreement) to enhance the overall state-federal coordinated supervision program for state-chartered banks. The
agreement provides for the supervision of state-chartered banks that have interstate branches. (See SR-96-33.)

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Section 106 also prohibits a bank from conditioning the availability or price
of one product on a requirement that a customer (1) provide another product
to the bank or an affiliate of the bank or (2) not obtain another product from
a competitor of the bank or from a competitor of an affiliate of the bank. For
example, the statute prohibits a bank from requiring that a prospective
borrower purchase homeowners’ insurance from the bank or an affiliate of
the bank to obtain a mortgage loan from the bank. Section 106 contains
several exceptions to its general prohibitions, and it authorizes the Board to
grant, by regulation or order, additional exceptions from the prohibitions
when the Board determines an exception ‘‘will not be contrary to the
purposes’’ of the statute.
Under the federal banking laws, a subsidiary of a bank is considered to be

part of the bank for most supervisory and regulatory purposes. Therefore, the
restrictions in section 106 generally apply to tying arrangements imposed by
a subsidiary of a bank in the same manner that the statute applies to the
parent bank itself. Thus, a subsidiary of a bank is generally prohibited from
conditioning the availability or price of a product on the customer’s purchase
of another product from the subsidiary, its parent bank, or any affiliate of its
parent bank. Section 106 generally does not apply to tying arrangements
imposed by a nonbank affiliate of a bank.
In addition to the regulatory prohibitions and exceptions, this section

includes the Board or Board staff interpretations on tying arrangements,
including those issued on August 18, 2003, and February 2, 2004. These two
interpretations state that bank customers that receive securities-based credit
can be required to hold their pledged securities as collateral at an account of
a bank holding company’s or bank’s broker-dealer affiliate. The examination
objectives and examination procedures have also been revised to address
tying arrangements.
3000.1, The ‘‘Deposit Accounts’’ section has been revised to incorporate the June 15,
3000.2, 2004, interagency advisory ‘‘Guidance on Accepting Accounts from Foreign
3000.3, Governments, Foreign Embassies, and Foreign Political Figures.’’ The
3000.4 advisory was issued by the federal banking and thrift agencies (the agencies)
and the U.S. Department of the Treasury’s Financial Crimes Enforcement
Network (FinCEN). The advisory was issued in response to inquiries the
agencies and FinCEN received on whether financial institutions should do
business and establish account relationships with the foreign customers cited
in the advisory. Banking organizations are advised that the decision to accept
or reject such foreign-account relationships is theirs alone to make. Financial
institutions are to be aware that there are varying degrees of risk associated
with these accounts, depending on the customer and the nature of the
services provided. Institutions should take appropriate steps to manage these
risks, consistent with sound practices and applicable anti-money-laundering
laws and regulations. (See SR-04-10.) The examination objectives, exami-
nation procedures, and internal control questionnaire were also revised to
incorporate the advisory’s supervisory guidance.
3020.1, The ‘‘Assessment of Capital Adequacy’’ section has been updated to include
3020.3 provisions of a final rule revision pertaining to a bank’s risk-based capital
requirements for asset-backed commercial paper (ABCP) programs. The

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Board approved the rule changes on July 17, 2004 (effective September 30,
2004). See appendix A of Regulation H (12 CFR 208, appendix A).
In January 2003, the Financial Accounting Standards Board (FASB) issued

FASB Interpretation No. 46, ‘‘Consolidation of Variable Interest Entities’’
(FIN 46). FIN 46 required, for the first time, the consolidation of variable
interest entities (VIEs) onto the balance sheets of companies deemed to be
the primary beneficiaries of those entities. In December 2003, FASB revised
FIN 46 as FIN 46-R. (The interpretation (FIN 46 or FIN 46-R) was effective
for reporting periods that ended as early as December 15, 2003. However,
there are various effective dates, which are determined on the basis of the
nature, size, and type of business entity.) FIN 46-R requires the consolidation
of many ABCP programs onto the balance sheets of banking organizations.
Under the Board’s revised risk-based capital rule, a bank that qualifies as a
primary beneficiary and must consolidate an ABCP program that is defined
as a variable interest entity under generally accepted accounting principles
may exclude the consolidated ABCP program’s assets from risk-weighted
assets provided that it is the sponsor of the program. Banks must also hold
risk-based capital against eligible ABCP liquidity facilities with an original
maturity of one year or less that provide liquidity support to ABCP by
applying a new 10 percent credit-conversion factor to such facilities. Eligible
ABCP liquidity facilities with an original maturity exceeding one year
remain subject to the rule’s current 50 percent credit-conversion factor.
Ineligible liquidity facilities are treated as direct-credit substitutes or
recourse obligations, which are subject to a 100 percent credit-conversion
factor. When calculating the bank’s tier 1 and total capital, any associated
minority interests must also be excluded from tier 1 capital. The examination
procedures were also revised to incorporate the revised risk-based capital
requirements.
4030.1, The ‘‘Asset Securitization’’ section has been revised to incorporate the
4030.2, Board’s July 17, 2004, approval (effective September 30, 2004) of a final
4030.3, rule to the risk-based capital requirements for ABCP programs and their
4030.4 liquidity facilities. For more details, see the summary for section 3020.1. The
examination objectives, examination procedures, and internal control ques-
tionnaire were also revised to incorporate the revised rule for ABCP
programs.
4125.1, The ‘‘Payment System Risk and Electronic Funds Transfer Activities’’
4125.3 section incorporates the Board’s September 22, 2004, changes to its Policy
on Payments System Risk (the PSR policy). (See 69 Fed. Reg. 57917,
September 28, 2004, and 69 Fed. Reg. 69926, December 1, 2004.) Effective
July 20, 2006, the PSR policy requires Reserve Banks (1) to release interest
and redemption payments on securities issued by government-sponsored
enterprises (GSEs) and certain international organizations (institutions for
which the Reserve Banks act as fiscal agents but whose securities are not
obligations of, or fully guaranteed as to principal and interest by, the United
States) only if the issuer’s Federal Reserve account contains sufficient funds
to cover them and (2) to align the treatment of the general corporate account
activity of GSEs and certain international organizations with the treatment of

Page 3
the activity of other account holders that do not have regular access to the
discount window and those account holders not eligible for intraday credit.
The examination procedures have also been updated to incorporate the
revisions to the Board’s PSR policy.
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1010.1 This revised section on internal control and audit function, oversight, and
outsourcing incorporates a brief overview of the joint final rules adopted by
the Board and the other federal bank and thrift regulatory agencies. (See the
Board’s August 8, 2003, press release.) Section 36 of the Federal Deposit
Insurance Act, as implemented by 12 CFR 363, governs the agencies’
authority to take disciplinary actions against independent accountants and
accounting firms that perform audit and attestation services required by the
act. Attestation services address management’s assertions concerning inter-
nal controls over financial reporting. An insured depository institution must
include the accountant’s audit and attestation reports in its annual report. The
joint final rules established the practices and procedures under which the
agencies can, for good cause, remove, suspend, or bar an accountant or firm
from performing audit and attestation services for federally insured deposi-
tory institutions with assets of $500 million or more. The rules became
effective October 1, 2003.
2040.1, Two of the loan portfolio management sections were revised to provide
2040.3, references to accounting pronouncements that apply to mortgage banking
A.2040.3 transactions and activities and that are consistent with the bank call report
instructions. Comprehensive mortgage banking examination procedures are
provided in the new section A.2040.3 (in the appendix to the manual). The
comprehensive procedures address the examination, supervisory, and valu-
ation concerns discussed in the following guidance: the February 25, 2003,
Interagency Advisory on Mortgage Banking; SR-03-4, ‘‘Risk Management
and Valuation of Mortgage Servicing Assets Arising from Mortgage Bank-
ing Activities’’; the mortgage banking examination modules; and many of
the mortgage banking inspection (examination) procedures found in section
3070.0 of the Bank Holding Company Supervision Manual.
2070.1 This section on the allowance for loan and lease losses (ALLL) was revised
to include references to updated accounting guidance, SR-04-5, and the
March 1, 2004, interagency Update on Accounting for Loan and Lease
Losses. The interagency update covers recent developments in accounting,
current sources of generally accepted accounting principles, and supervisory
guidance that applies to the ALLL. Other SR-letters associated with the
supervisory guidance for the ALLL are referenced. (See also section 2072.1.)
2100.1, The section on real estate construction loans and the respective internal
2100.4 control questionnaire were revised to incorporate the October 27, 2003,
interagency statement on Independent Appraisal and Evaluation Functions
and, to a limited extent, the supervisory guidance in SR-03-18. (See the
summary for section 4140.1 below.)
4050.1 The section on bank-related organizations was revised to include brief

definitions and descriptions of the limited activities and services authorized
in Regulation K for foreign bank offices and organizations (that is, foreign
bank branches, agencies, commercial lending companies, representative

Page 1
offices, and correspondent banks). For the purposes of sections 23A and 23B
of the Federal Reserve Act, the definition of affiliate was also clarified and
expanded on the basis of the provisions of the Board’s Regulation W.
4140.1, The section on real estate appraisals and evaluations and the respective
4140.3, examination procedures and internal control questionnaire were revised to
4140.4 reference and incorporate the October 27, 2003, interagency statement on
Independent Appraisal and Evaluation Functions. A banking institution’s
board of directors is responsible for reviewing and adopting policies and
procedures that establish and maintain an effective, independent real estate
appraisal and evaluation program (the program) for all of its lending
functions. Concerns about the independence of appraisals and evaluations
arise from the risk that improperly prepared appraisals may undermine the
integrity of credit-underwriting processes.
An institution’s lending functions should not have undue influence that
might compromise the program’s independence. Institutions may not use an
appraisal prepared by an individual who was selected or engaged by a
borrower. Likewise, institutions may not use ‘‘readdressed appraisals’’—
appraisal reports that are altered by the appraiser to replace any references to
the original client with the institution’s name. Altering an appraisal report in
a manner that conceals the original client or intended users of the appraisal
is misleading and violates the agencies’ appraisal regulations and the
Uniform Standards of Professional Appraisal Practice (USPAP). (See SR-
03-18.)
4180.1, These new sections discuss the January 5, 2004, Interagency Policy on
4180.2, Banks/Thrifts Providing Financial Support to Funds Advised by the Banking
4180.3, Organization or Its Affiliates. The policy alerts banking organizations,
4180.4 including their boards of directors and senior management, to the safety-
and-soundness implications of and the legal impediments to a bank provid-
ing financial support to investment funds advised by the bank, its subsidi-
aries, or affiliates (that is, an affiliated investment fund).
The interagency policy emphasizes the following three core principles. A
bank should not—
• inappropriately place its resources and reputation at risk for the benefit
of affiliated investment funds’ investors and creditors;
• violate the limits and requirements in Federal Reserve Act sections 23A
and 23B and Regulation W, other applicable legal requirements, or any
special supervisory condition imposed by the agencies; or
• create an expectation that the bank will prop up the advised fund (or
funds).
In addition, bank-affiliated investment advisers are encouraged to establish

alternative sources of financial support to avoid seeking support from
affiliated banks. A bank’s investment advisory services can pose material
risks to the bank’s liquidity, earnings, capital, and reputation and can harm
investors, if the risks are not effectively controlled. Bank management is
expected to notify and consult with its appropriate federal banking agency
before (or, in an emergency, immediately after) providing material financial
support to an affiliated investment fund. (See SR-04-1.) Examination

Page 2
objectives, examination procedures, and an internal control questionnaire

have been provided to address the supervisory concerns set forth in the
policy.
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Preface
The bank examination process is the Federal • preparing workpapers that support examina-
Reserve’s fact-finding arm in discharging its tion reports and aid in evaluating the work
regulatory and supervisory responsibilities. The performed; and
essential objectives of an examination are (1) to • using objective criteria as a basis for the
provide an objective evaluation of a bank’s overall conclusion, and for the resulting com-
soundness and compliance with banking laws ments and criticism, regarding the condition
and regulations, (2) to permit the Federal Reserve and quality of the bank and its management.
to appraise the quality of management and
directors, and (3) to identify those areas where The examiner-in-charge must properly plan
corrective action is required to strengthen the and organize the examination before work be-
bank, improve the quality of its performance, gins. Initial decisions concerning examination
and enable it to comply with applicable laws, scope can usually be made based on the nature
rulings, and regulations. of the bank’s operations; its size; the past
To accomplish these objectives, the examiner experience of the examiner-in-charge with the
should evaluate the prudency of the bank’s bank; information in the previous examination
practices, the bank’s adherence to laws and report, including the condition of the bank at
regulations, the adequacy of the bank’s liquidity that examination; communications with the bank
and capital, the quality of the bank’s assets and between examinations; and analysis from the
earnings, the nature of the bank’s operations, Uniform Bank Performance Report. The plan-
and the adequacy of the bank’s internal control ning of work and preexamination procedures are
and internal audit. The scope of an examination covered in the Examination Planning section of
may cover every phase of banking activity, or it this manual.
may concentrate on specific areas that deserve Examiners should view the manual as a work-
greater emphasis because of their potential effect ing tool rather than as a reference manual. In
on a bank’s soundness. most sections of the manual, examination pro-
cedures and internal control questionnaires are
provided to form the basis for the examination
of a bank. These procedures should lead to
consistent and objective examinations of
ABOUT THIS MANUAL varying scopes. The bank’s condition is dis-
The goal of the Commercial Bank Examination closed by the performance of examination pro-
Manual is to organize and formalize longstand- cedures, including review of internal controls
ing examination objectives and procedures that and audit function, and the evaluation of the
provide guidance to the examiner, and to en- results therefrom, not by the examiner’s judg-
hance the quality and consistent application of ment alone.
examination procedures. The manual provides For larger banks, additional examination pro-
specific guidelines for— cedures need to be incorporated into the process
to effectively examine those institutions’ com-
• determining the scope of an examination; plex organizational reporting and accounting
systems. Conversely, some of the procedures
• determining the procedures to be used in
contained in this manual do not apply to smaller-
examining all areas of a bank, including
sized banks. Additionally, state laws and local
those procedures that may lead to the early
characteristics necessitate supplemental proce-
detection of trends that, if continued, might
dures. For example, specific procedures relating
result in a deterioration in the condition of a
to various types of agricultural lending have not
bank;
been developed in this manual. Similarly, state
• evaluating the adequacy of the bank’s written banking laws must be considered when applying
policies and procedures, the degree of com- the procedures to various areas, such as lending,
pliance with them, and the adequacy of its capital adequacy, and pledging requirements.
internal controls; When modifying the procedures, the examiner-
• evaluating the work performed by internal and in-charge is responsible for determining that the
external auditors; examination objectives are met and that the
• evaluating the performance and activities of examination meets the needs of the individual
management and the board of directors; bank.
Commercial Bank Examination Manual March 1994

Page 1
Preface
The manual is also intended to guide exam- Sections in each part are made up of four
iners in their efforts to encourage banks to subsections, where applicable. They are—
develop written policies and related procedures
in all areas where none exist, and to correct • an overview
situations where there are deficiencies in or a • examination objectives
lack of compliance with existing procedures. To • examination procedures
aid the examiner, this manual includes topics • internal control questionnaire
such as loan portfolio management, investment
portfolio management, asset and liability man- The overviews, for the most part, summarize
agement, earnings analysis, capital analysis, and the respective topics. This information is ex-
service area analysis. A section on the appraisal panded on and reinforced through the Federal
of bank management guides the examiner in Reserve’s educational programs and the exam-
assembling and evaluating information from all iner’s experience on the job.
other manual sections and helps uncover incon- The examination objectives describe the goals
sistencies in the application of bank policies that should be of primary interest to the exam-
among various management groups. Examiners iner. Two of the objectives determine the scope
should be able to increase the level of profes- of the examination for the specific area of
sionalism and the soundness of the banking examination interest. They are (1) the evaluation
system by encouraging all banks to follow the of the system of internal control and of bank
best practices that currently exist in the bank- policies, practices, and procedures, and (2) the
ing industry. In no case, however, should this evaluation of the scope and adequacy of the
approach discourage the development and audit function. Other common objectives are to
implementation of conceptually sound and determine compliance with laws, regulations,
innovative practices by individual banks. and rulings, and to determine the need for
Although this manual is designed to provide corrective action.
guidance to the examiner in planning and con- The examination procedures include proce-
ducting bank examinations, it should not be dures to be performed during a full-scope,
considered a legal reference. Questions concern- comprehensive examination. In some instances
ing the applicability of and compliance with not all of the procedures apply to all banks;
federal laws and regulations should be referred examiners may exercise some flexibility depend-
to appropriate legal counsel. In addition, the ing on the particular characteristics of the bank
manual should not be viewed as a comprehen- under examination. The materiality and signifi-
sive training guide. Separate training programs cance of a given area of bank operations are the
provide more detailed instructions to assist the examiner’s primary considerations in deciding
examiner in better understanding banking oper- the scope of the examination and the procedures
ations and applying examination procedures. to be performed. Examiner flexibility results in
examinations tailored to fit the operations of the
bank.
HOW TO USE THIS MANUAL The evaluation of a bank’s internal control
environment should encompass a review of the
Organization internal audit activities and the implementation
of selected internal control questionnaires (ICQs),
The Commercial Bank Examination Manual is which set forth standards for operational con-
divided into nine major parts, each set off by a trol. Due to the difference between an examina-
divider tab: tion and an audit, it is not contemplated that all
ICQs will be implemented in any one examina-
• Part 1000—Examination Planning tion. The body of ICQs used during the course
• Part 2000—Assets of the examination should be made up of three
• Part 3000—Liabilities and Capital elements: (1) those mandated for all examina-
• Part 4000—Other Examination Areas tions, (2) those selected by the examiner-in-
• Part 5000—Assessment of the Bank charge based upon experience, knowledge of
• Part 6000—Federal Reserve Examinations problems within the bank, and perception of
• Part 7000—International risk, and (3) those that focus on areas where
• Part 8000—Statutes and Regulations on-site evaluation of operational control appears
• Appendix warranted in light of the results of the examina-
March 1994 Commercial Bank Examination Manual

Page 2
Preface
tion of internal audit activities. In addition to less of the number of subsections within a
serving as a guide during on-site evaluations, particular section.
the ICQs can be used in the appraisal of opera- The appendix sections begin with the letter A,
tional audit techniques in banks where the scope followed by the number of the section to which
of internal auditing includes such consider- the item relates. For example, the Supplement
ations. The ICQ steps marked with an asterisk on Internal Auditing for the Internal Control
require substantiation by observation or testing; section is numbered A.1010.1. Should the
they are considered to be fundamental to any Internal Control section have more than one
control program regardless of the size of the appendix item, the numbering would appear as
institution. These steps should be incorporated A.1010.1, A.1010.2, etc.
in management control programs in smaller
banks to compensate for the absence of internal
auditing. Updates
Following the main parts are a listing of
statutes and regulations administered by the Beginning with the March 1994 reprint of the
Federal Reserve and an appendix that includes Commercial Bank Examination Manual, all man-
various forms, checklists, statements, and guide- ual pages are dated March 1994. Succeeding
lines, which provide the examiner with addi- updates will be dated the month and year in
tional information regarding certain topics. which they are issued. There is an effective date
at the top of the first page of each subsection that
shows the last time that subsection was updated.
Numbering System The manual is usually updated in the spring
and fall of each year; special supplements are
The manual is arranged using a numbering issued as needed. On the back of the title page is
system based on the manual’s sections and a checklist so you can record when an update
subsections. For example, the overview subsec- has been filed. For this manual to be most
tion of the Internal Control section is numbered useful, it is essential that updated pages be filed
1010.1. 1010 is the section number for Internal as soon as possible. If you have any questions
Control, and .1 is the number for the overview. about receiving updates, please contact Publica-
The examination objectives subsection for that tions Services, Mail Stop 127, Board of Gover-
section is numbered 1010.2, and so on. Subsec- nors of the Federal Reserve System, Washing-
tions are always numbered consecutively regard- ton, D.C. 20551; 202-452-3244.

Page 3
Table of Contents
Section Section
1000 EXAMINATION PLANNING 3000 LIABILITIES AND CAPITAL

1000 Examination Strategy and 3000 Deposit Accounts
Risk-Focused Examinations 3010 Borrowed Funds
1010 Internal Control and Audit Function, 3012 Complex Wholesale Borrowings
Oversight, and Outsourcing 3015 Deferred Compensation
1015 Conflict-of-Interest Rules for Agreements
Examiners 3020 Assessment of Capital
1020 Federal Reserve System Bank Watch Adequacy
List and Surveillance Programs 3030 Assessing Risk-Based Capital—
1030 Workpapers Direct-Credit Substitutes
Extended to ABCP Programs
2000 ASSETS
2000 Cash Accounts
4000 OTHER EXAMINATION
2010 Due from Banks
AREAS
2015 Interbank Liabilities 4000 [Reserved]
2020 Investment Securities and 4010 Analytical Review and
End-User Activities Income and Expense
2030 Bank Dealer Activities 4020 Asset/Liability Management
2040 Loan Portfolio Management 4030 Asset Securitization
2043 Nontraditional Mortgages— 4033 Elevated-Risk Complex Structured
Associated Risks Finance Activities
2050 Concentrations of Credit 4040 Management of Insurable Risks
2060 Classification of Credits 4042 Purchase and Risk Management
2070 Allowance for Loan and of Life Insurance
Lease Losses 4043 Insurance Sales Activities and
2072 ALLL Methodologies and Consumer Protection in Sales
Documentation of Insurance
2080 Commercial and Industrial Loans 4050 Bank-Related Organizations
2082 Loan-Sampling Program for 4060 Information Technology
Certain Community Banks 4063 Electronic Banking
2090 Real Estate Loans 4070 Dividends
2100 Real Estate Construction Loans 4080 Employee Benefit Trusts
2103 Concentrations in Commercial Real 4090 Interest-Rate Risk Management
Estate Lending, Sound Risk- 4100 Litigation and Other Legal
Management Practices Matters; Examination-
2110 Floor-Plan Loans Related Subsequent Events
2115 Leveraged Financing 4110 Contingent Claims from Off-
2120 Direct Financing Leases Balance-Sheet Credit
2130 Consumer Credit Activities
2133 Subprime Lending 4120 Other Non-Ledger Control
2135 Subprime Mortgage Lending Accounts
2140 Agricultural Loans 4125 Payment System Risk and
2150 Energy Lending—Production Loans Electronic Funds Transfer
2160 Asset-Based Lending Activities
2170 Securities Broker and Dealer Loans 4128 Private-Banking Activities
2180 Factoring 4130 Private Placements
2190 Bank Premises and Equipment 4133 Prompt Corrective Action
2200 Other Real Estate Owned 4140 Real Estate Appraisals and
2210 Other Assets and Other Liabilities Evaluations

Page 1
Table of Contents
Section Section
4150 Review of Regulatory Reports 7110 International—Purchases, Sales,

4160 Sale of Uninsured Nondeposit Trading, Swaps, Rentals, and
Debt Obligations on Bank Options of LDC Assets
Premises
4170 Retail Sales of Nondeposit
Investment Products 8000 STATUTES AND
4180 Investment-Funds Support REGULATIONS
4200 Fiduciary Activities
8000 Statutes and Regulations
5000 ASSESSMENT OF THE Administered by the
BANK Federal Reserve
5000 Duties and Responsibilities
of Directors APPENDIX
5010 Management Assessment
5017 Internal Control—Procedures, A.1010.1 Internal Control: Supplement
Processes, and Systems (Required on Internal Auditing
Absences from Sensitive Positions) A.2000.1 Cash Accounts: Financial
5020 Overall Conclusions Regarding Recordkeeping and Reporting
Condition of the Bank Regulations—Examination
5030 Meetings with Board of Procedures
Directors A.2040.3 Comprehensive Mortgage
5040 Formal and Informal Corrective Banking Examination
Actions Procedures
A.5020.1 Overall Conclusions Regarding
6000 FEDERAL RESERVE Condition of the Bank:
EXAMINATIONS Uniform Financial Institutions
Rating System
6000 Instructions for the Report
of Examination
6003 Community Bank Examination INDEX
Report
6010 Other Types of Examinations Subject Index
7000 INTERNATIONAL
7000 International—Examination
Overview and Strategy
7010 International—Glossary
7020 International—Loan Portfolio
Management
7030 International—Loans and Current
Account Advances
7040 International—Country Risk and
Transfer Risk
7050 International—Financing
Foreign Receivables
7060 International—Banker’s Acceptances
7070 International—Due from Banks–
Time
7080 International—Letters of Credit
7090 International—Guarantees Issued
7100 International—Foreign Exchange

Page 2
Examination Strategy and Risk-Focused Examinations
Effective date October 2008 Section 1000.1
EXAMINATION AND Federal Reserve supervisory initiative or action.

SUPERVISORY AUTHORITY AND Banking organizations that have entered into
CONFIDENTIALITY PROVISIONS agreements containing such confidentiality pro-
visions are subject to legal risk. (See SR- 07-19.)
The Federal Reserve System’s statutory exami-
nation authority permits examiners to review all
books and records maintained by a financial EXAMINATION-FREQUENCY
institution that is subject to the Federal Reserve’s GUIDELINES FOR STATE
supervision. This authority extends to all docu- MEMBER BANKS
ments.1 Section 11(a)(1) of the Federal Reserve
Act provides that the Board has the authority to The Federal Reserve is required to conduct a
examine, at its discretion, the accounts, books, full-scope, on-site examination of every insured
and affairs of each member bank and to require member bank at least once during each 12-month
such statements and reports as it may deem period, with the exception that certain small
necessary. institutions can be examined once during each
Federal Reserve supervisory staff (includes the 18-month period. The 18-month examination
examination staff), therefore, may review all period can be applied to those banks that—
books and records of a banking organization that
is subject to Federal Reserve supervision. 1a In • have total assets of less than $500 million; 1d
addition, under the Board’s Rules Regarding the • are well capitalized;
Availability of Information, banking organiza- • were assigned a management rating of 1 or 2
tions are prohibited from disclosing confidential by the Federal Reserve as part of the bank’s
supervisory information without prior written rating under the Uniform Financial Institu-
permission of the Board’s General Counsel. 1b tions Rating System;
Confidential supervisory information is defined • were assigned a composite CAMELS rating of
to include any information related to the 1 or 2 by the Federal Reserve at their most
examination of a banking organization. 1c Board recent examination;
staff have taken the position that identification of • are not subject to a formal enforcement pro-
information requested by, or provided to, super- ceeding or action; and
visory staff—including the fact that an exami- • have not had a change in control during the
nation has taken or will take place—is related to preceding 12-month period in which a full-
an examination and falls within the definition of scope, on-site examination would have been
confidential supervisory information. It is con- required but for the above exceptions.
trary to Federal Reserve regulation and policy for
agreements to contain confidentiality provisions (See section 208.64 of Regulation H and 72 Fed.
that (1) restrict the banking organization from Reg. 17798, April 10, 2007, and 72 Fed. Reg.
providing information to Federal Reserve super- 54347, September 25, 2007.) The exceptions do
visory staff; 1 (2) require or permit, without the not limit the authority of the Federal Reserve to
prior approval of the Federal Reserve, the examine any insured member bank as frequently
banking organization to disclose to a counter- as deemed necessary. (See also SR-07-8 and
party that any information will be or was SR-97-8.)
provided to Federal Reserve supervisory staff; or
(3) require or permit, without the prior approval
of the Federal Reserve, the banking organization 1d. Based on jointly issued interim rules (effective April
to inform a counterparty of a current or upcoming 10, 2007) issued by the Federal Reserve Board (Board), the
Federal Deposit Insurance Corporation (FDIC), the Office of
Federal Reserve examination or any nonpublic the Comptroller of the Currency (OCC), and the Office of
Thrift Supervision (OTS). The interim rule was adopted as
1. SR-97-17 details the procedure supervisory staff should final, without change, on September 11, 2007. (See 72 Fed.
follow if a banking organization declines to provide informa- Reg. 54347, September 25, 2007.) The interim rules imple-
tion asserting a claim of legal privilege. mented section 605 of the Financial Services Regulatory
1a. Supervisory staff include individuals who are on and/or Relief Act of 2006 (FSRRA) and Public Law 109-473.
off site. Previously, the 18-month examination cycle was available
1b. 12 CFR 261.20(g). only for institutions that had total assets of $250 million or
1c. 12 CFR 261.2(c)(1)(i). less.

Page 1
1000.1 Examination Strategy and Risk-Focused Examinations
Alternate-Year Examination Program When communicating and coordinating with

other agencies, examination and supervisory
The frequency of examination may also be staff should follow the common courtesies and
affected by the alternate-year examination pro- recommended practices identified in the May
gram. Under the alternate-year examination pro- 2004 document. The recommended practices
gram, those banks that qualify are examined in reinforce the long-standing commitment of fed-
alternate examination cycles by the Reserve eral and state banking supervisors to provide
Bank and the state. Thus, a particular bank efficient, effective, and seamless oversight of
would be examined by the Reserve Bank in one state banks of all sizes, whether those institu-
examination cycle, the state in the next, and so tions operate in a single state or more than one
on. Any bank may be removed from the pro- state. The recommended practices also
gram and examined at any time by either agency, minimize, to the fullest extent possible, the
and either agency can meet with a bank’s regulatory burden placed on state-chartered
management or board of directors or initiate banks—thus further supporting and fostering a
supervisory action whenever deemed necessary. seamless supervisory process. (See SR-04-12.)
Banks that are ineligible for an alternate-year
examination are those institutions that are in
excess of $10 billion in assets and are rated a Recommended Practices for State
composite 3 or worse. De novo banks are also Banking Departments, the FDIC, and
ineligible until they are rated 1 or 2 for two the Federal Reserve
consecutive examinations after they have com-
menced operations. Also, a bank that undergoes 1. State and federal banking agencies should
a change in control must be examined by the take steps to ensure that all staff responsible
Federal Reserve within 12 months of the change for the supervision and examination of state-
in control. chartered banks are familiar with the prin-
ciples contained in the agreement. State and
federal banking agencies should ensure that
adherence to the principles in the agreement
SUPERVISION OF is communicated as a priority within their
STATE-CHARTERED BANKS respective agencies at all levels of staff—
ranging from the field examiners to the
In May 2004, the State-Federal Working Group, officers in charge of supervision and to state
an interagency group of state bank commission- bank commissioners.
ers and senior officials from the Federal Reserve 2. Home-state supervisors should make every
and the Federal Deposit Insurance Corporation effort to communicate and coordinate with
(FDIC), developed a recommended-practices host-state supervisors as an important part
document designed to reiterate and reaffirm the of supervising multistate banks as specified
need for a commonsense approach for collabo- in the Nationwide Cooperative Agreement
rating with states in the supervision of state- executed by the state banking departments
chartered banking organizations.2 The recom- and recognized by the federal agencies in
mended practices highlight the importance of the agreement.
communication and coordination between state 3. State and federal banking agencies should
and federal banking agencies in the planning consider inviting one another to participate
and execution of supervisory activities. in regional examiner training programs
and/or seminars to discuss emerging issues
2. The source for the recommended practices is the Novem- and challenges observed in the banking
ber 14, 1996, Nationwide State and Federal Supervisory industry.
Agreement (the agreement) to enhance the overall state- 4. Federal and state banking departments
federal coordinated supervision program for state-chartered should maintain and share current lists
banks. The agreement established a set of core principles to
promote coordination in the supervision of all interstate banks, of their staff members designated as
with particular emphasis on complex or larger (for example, PCPs (primary contact persons) for their
$1 billion or more of assets) institutions. (See SR-96-33.) institutions.
These principles are equally applicable and important when
supervisors from federal and state banking agencies are
5. PCPs and EICs (examiners-in-charge) from
communicating and coordinating the supervision of state- the state banking department(s) and federal
chartered banks operating within a single state. agencies should discuss and prepare super-

Page 2
Examination Strategy and Risk-Focused Examinations 1000.1
visory plans at least once during the exami- supervisory conclusions or proposed
nation cycle, and more frequently as appro- actions should only be communicated to
priate for institutions of greater size or bank management, the bank board of direc-
complexity or that are troubled. The agen- tors, or other bank staff after such matters
cies should discuss and communicate have been fully vetted within and between
changes to the plan as they may evolve over the federal banking agency and home-state
the examination cycle. The supervisory plans banking department. The vetting process
should be comprehensive, including exami- should, to the fullest extent possible, adhere
nation plans, off-site monitoring, follow-up to the exit meeting and examination report
or target reviews, supervisory actions, etc., issuance time frames specified in the agree-
as applicable. ment. All parties should make every effort
6. The PCPs from the home-state banking to expedite the process in order to deliver
department and federal banking agencies timely exam findings and efficient regula-
should make every effort to share reports tory oversight.
that their individual agencies have produced 12. When differences between the agencies arise
through their off-site monitoring program or on important matters, such as examination
through targeted supervisory activities. conclusions or proposed supervisory action,
7. State and federal banking agencies should senior management from the home-state
notify one another as early as possible if banking department and the appropriate
their agency cannot conduct a supervisory federal banking agency should communi-
event (e.g., examination) that was previ- cate to try to resolve the differences. In the
ously agreed upon—or if the agency intends event that the state and federal banking
to provide fewer examiners/resources than agency cannot reach agreement on impor-
originally planned. tant matters affecting the supervised institu-
8. Meetings with bank management and direction, the respective agencies should coordi-
tors should involve both the appropriate staff nate the communication of those differences
in the home-state banking department and in to the management or board of directors of
the responsible federal banking agency the supervised institution, including the tim-
whenever possible. If a joint meeting is not ing thereof and how the differing views will
possible or appropriate (for example, the be presented.
bank arranges the meeting with one agency
only), the other agency (the home-state
banking department or the responsible EXAMINATION OF INSURED
federal banking agency as applicable) should DEPOSITORY INSTITUTIONS
be informed of the meeting. BEFORE THEY BECOME OR
9. The home-state and responsible federal MERGE INTO STATE MEMBER
agency should make every effort to issue a BANKS
joint exam report in the 45-day time frame
identified in the agreement. If circum- Premembership examinations of state nonmem-
stances prevent adherence to time frames ber banks, national banks, and savings associa-
identified in the agreement, the state and tions seeking to convert to state-membership
federal agencies should coordinate closely status will not be required if the bank or savings
and consider benchmarks or timing require- association seeking membership meets the cri-
ments that may apply to the other agency. teria for ‘‘eligible bank,’’ as defined in section
10. All corrective-action plans (for example, 208.2(e) of Regulation H.2a Additionally,
memoranda of understanding, cease-and-
desist orders) should be jointly discussed,
coordinated, and executed to the fullest 2a. ‘‘Eligible bank’’ is defined to mean a member bank that
(1) is well capitalized; (2) has a composite CAMELS rating of
extent possible among all examination par- 1 or 2; (3) has a CRA rating of Outstanding or Satisfactory;
ties involved. Also, all information on the (4) has a rating of 1 or 2 as of its most recent consumer
institution’s corrective-action plan and compliance examination; and (5) has no major unresolved
progress made toward implementing the supervisory issues outstanding, as determined by the Board or
appropriate Federal Reserve Bank in its discretion. A major
plan should be shared. unresolved supervisory issue could also arise from significant
11. To ensure that messages to management are trust or fiduciary activities that are found to be conducted in a
consistent to the fullest extent possible, less-than-satisfactory manner.

Page 3
examinations of state nonmember banks, national an examination is waived, the Reserve Bank
banks, and savings associations seeking to merge should prepare and maintain documentation sup-
into a state member bank will not be required so porting its decision.
long as the state member bank, on an existing In all circumstances, each Reserve Bank is
and pro forma basis, meets the criteria for responsible for ensuring that the examination-
eligible bank. frequency time frames established by Federal
For those institutions not subject to a premem- Reserve policy and section 111 of the Federal
bership or premerger examination, risk assess- Deposit Insurance Corporation Improvement Act
ments and supervisory strategies should be com- (FDICIA) are adhered to. When the statutory
pleted no later than 30 days after the conversion deadline for an examination of a depository
or merger. To the extent issues or concerns arise, institution seeking membership is approaching
targeted or, if warranted, full-scope examina- or has passed, a Federal Reserve examination of
tions of the converted or merged institution the institution should be conducted as soon as
should be conducted as soon as possible after practicable after the institution becomes a state
the conversion or merger. For a state member member bank. (See SR-98-28.)
bank that was formerly a savings association or
that acquired a savings association, the risk
assessment and supervisory strategy should pay OBJECTIVES OF THE
particular attention to activities conducted by a
service corporation subsidiary that may not be
SUPERVISORY PROCESS
permissible activities for a state member bank. The Federal Reserve is committed to ensuring
Premembership or premerger examinations that the supervisory process for all institutions
should generally be conducted for an insured under its purview meets the following objectives:
depository institution that does not meet the
criteria for eligible bank. Consistent with a • Provides flexible and responsive supervision.
risk-focused approach, these examinations can The supervisory process is dynamic and
be targeted, as appropriate, to the identified area forward-looking, so it responds to technologi-
(or areas) of weakness. The Reserve Bank may, cal advances, product innovation, and new
in its discretion, waive the examination require- risk-management systems and techniques, as
ment if it is determined that conducting an well as to changes in the condition of an
examination would be (1) inconsistent with a individual financial institution and to market
risk-focused approach or (2) unlikely to provide developments.
information that would assist materially in evalu- • Fosters consistency, coordination, and com-
ating the statutory and regulatory factors that the munication among the appropriate supervi-
Federal Reserve is required to consider in acting sors. Seamless supervision, which reduces
on the membership or merger application.2b If regulatory burden and duplication, is pro-
moted. The supervisory process uses exam-
If a bank has not yet received compliance or CRA ratings iner resources effectively by using the institu-
from a bank regulatory authority, the Federal Reserve Board
will look to the bank’s holding company to determine whether
tion’s internal and external risk-assessment
the bank’s application should receive expedited processing. If and -monitoring systems; making appropriate
the bank’s holding company meets the criteria for expedited use of joint and alternating examinations; and
processing under section 225.14(c) of Regulation Y, the tailoring supervisory activities to an institu-
bank’s membership or branch application will be eligible for
expedited processing. Banks that (1) have not yet received
tion’s condition, risk profile, and unique
compliance or CRA ratings and (2) either are not owned by a characteristics.
bank holding company or are owned by a bank holding • Promotes the safety and soundness of finan-
company that does not meet the criteria for expedited process- cial institutions. The supervisory process
ing are not eligible for expedited treatment.
2b. Since membership in the Federal Reserve System does
effectively evaluates the safety and soundness
not confer deposit insurance, the membership applications do of banking institutions, including the assess-
not include the requirements of the Community Reinvestment ment of risk-management systems, financial
Act (CRA). Nevertheless, a less-than-satisfactory CRA rating, condition, and compliance with laws and
especially if it reflects a chronic record of weak CRA
performance, would presumably reflect poorly upon the abili-
regulations.
ties of the institution’s management. Consequently, a deter-
mination of whether or not to conduct a premembership CRA
examination should be based on a risk-focused assessment of being only one of the factors considered from a risk-focused
the issues involved, with an institution’s CRA performance perspective.

Page 4
• Provides a comprehensive assessment of the Compliance with Laws and

institution. The supervisory process integrates Regulations
specialty areas (for example, information tech-
nology systems, trust, capital markets, and
Compliance with relevant laws and regulations
consumer compliance) and functional risk
should be assessed at every examination. The
assessments and reviews, in cooperation with
steps taken to complete these assessments will
interested supervisors, into a comprehensive
vary depending on the circumstances of the
assessment of the institution.
institution subject to review. When an institu-
tion has a history of satisfactory compliance
with relevant laws and regulations or has an
effective compliance function, only a relatively
RISK-FOCUSED EXAMINATIONS limited degree of transaction testing need be
conducted to assess compliance. At institutions
Historically, examinations relied significantly with a less satisfactory compliance record or
on transaction-testing procedures when assess- that lack a compliance function, more-extensive
ing a bank’s condition and verifying its adher- review will be necessary.
ence to internal policies, procedures, and con-
trols. In a highly dynamic banking market,
however, transaction testing by itself is not
sufficient for ensuring the continued safe and Changes in the General Character of a
sound operation of a banking organization. Bank’s Business
Evolving financial instruments and markets have
enabled banking organizations to rapidly repo- In conjunction with assessing overall compli-
sition their portfolio risk exposures. Therefore, ance with relevant laws and regulations, exam-
periodic assessments of the condition of a finan- iners should review for compliance with the
cial institution that are based on transaction requirements of Regulation H, which sets forth
testing alone cannot keep pace with the moment- the requirements for membership of state-
to-moment changes occurring in financial risk chartered banks in the Federal Reserve System
profiles. and imposes certain conditions of membership
on applicant banks. Under the regulation, a
To ensure that institutions have in place the
member bank must ‘‘at all times conduct its
processes necessary to identify, measure, moni-
business and exercise its powers with due regard
tor, and control risk exposures, examinations
to safety and soundness’’ and ‘‘may not, without
have increasingly emphasized evaluating the
the permission of the Board, cause or permit any
appropriateness of these processes, evolving
change in the general character of its business or
away from a high degree of transaction testing.
in the scope of the corporate powers it exercises
Under a risk-focused examination approach, the
at the time of admission to membership.’’ (See
degree of transaction testing should be reduced
SR-02-9 and section 208.3(d)(1) and (2) of
when internal risk-management processes are
Regulation H (12 CFR 208.3(d)(1) and (2)).)
determined to be adequate or when risks are
minimal. However, when risk-management pro- State member banks must receive the prior
cesses or internal controls are considered inap- approval of the Board before making any sig-
propriate, such as by an inadequate segregation nificant change in business plans. The trend
of duties or when on-site testing determines toward more-diverse, more-complex, and, at
processes to be lacking, additional transaction times, riskier activities at some banks has raised
testing must be performed. Testing should be the importance of this prior-approval requirement.
sufficient to fully assess the degree of risk Changes in the general character of a bank’s
exposure in a particular function or activity. In business would include, for example, becoming
addition, if an examiner believes that a banking a primarily Internet-focused or Internet-only
organization’s management is being less than operation, or concentrating solely on subprime
candid, has provided false or misleading infor- lending or leasing activities. Depending on how
mation, or has omitted material information, they are conducted and managed, these activi-
then substantial on-site transaction testing should ties can present novel risks for banking organi-
be performed. zations and may also present risks to the deposit
insurance fund. In many cases, these activities
involve aggressive growth plans and may give

Page 4.1
rise to significant financial, managerial, and A state member bank that desires to establish a
other supervisory issues. new branch facility may be eligible for expe-
In applications for membership in the Fed- dited processing of its application by the Reserve
eral Reserve System, careful consideration is Bank if it is an eligible bank, as defined in
given to a bank’s proposed business plan to section 208.2(e) of Regulation H.
ensure, at a minimum, that appropriate finan- A member bank may also choose to submit an
cial and managerial standards are met. application that encompasses multiple branches
Likewise, the other federal banking agencies that it proposes to establish within one year of
consider a bank’s business plan when they the approval date. Unless notification is waived,
review applications for federal deposit insur- the bank must notify the appropriate Reserve
ance, in the case of the Federal Deposit Insur- Bank within 30 days of opening any branch
ance Corporation (FDIC), or applications for a approved under a consolidated application.
national bank or federal thrift charter, in the Although banks are not required to open an
case of the Office of the Comptroller of the Cur- approved branch, approvals remain valid for one
rency (OCC) or the Office of Thrift Supervi- year. During this period, the Board or the
sion (OTS). The OCC, the FDIC, and the OTS appropriate Reserve Bank may notify the bank
have been conditioning their approvals of appli- that in its judgment, based on reports of condi-
cations on a requirement that, during the first tion, examinations, or other information, there
three years of operations, the bank or thrift has been a change in the bank’s condition,
provides prior notice or obtains prior approval financial or otherwise, that warrants reconsid-
of any proposed significant deviations or eration of the approval. (See Regulation H,
changes from its original operating plan. Rather section 208.6(d).)
than use similar commitments, the Federal Insured depository institutions that intend to
Reserve has relied on the provisions of Regula- close branches must comply with the require-
tion H to address situations in which a state ments detailed in section 42 of the Federal
member bank proposes to materially change its Deposit Insurance Act (the FDI Act) (12 USC
core business plan. 1831r-1). Section 42(e) requires that banks pro-
Federal Reserve supervisors will be monitor- vide 90 days’ notice to both customers and, in
ing changes in the general character of a state the case of insured state member banks, the
member bank’s business as part of the Federal Federal Reserve Board, before the date of the
Reserve’s normal supervisory process to ensure proposed branch closings. The notice must
compliance with the requirements of Regula- include a detailed statement of the reasons for
tion H and with safe and sound banking the decision to close the branch and statistical
practices. This review should be conducted at and other information in support of those stated
least annually by the Reserve Bank. A reasons. A similar notice to customers must be
significant change in a bank’s business plan posted in a conspicuous manner on the premises
without the Board’s prior approval would be of the branch to be closed, at least 30 days
considered a violation of Regulation H and before the proposed closing. There are addi-
would be addressed through follow-up tional notice, meeting, and consultation require-
supervisory action. ments for proposed branch closings by interstate
banks in low- or moderate-income areas. Finally,
the law requires each insured depository insti-
Branches tution to adopt policies for branch closings. (See
the revised joint policy statement concerning
When reviewing domestic-branch applications, insured depository institutions’ branch-closing
the guidelines in section 208.6(b) of Regulation notices and policies, effective June 29, 1999,2c
H are followed. The Board reviews the financial Federal Reserve Regulatory Service, 3–1503.5.)
condition and management of the applying bank, Examiners and supervisors need to be mindful
the adequacy of the bank’s capital and its future of the section 42 statutory requirements and this
earning prospects, the convenience and needs of joint policy.
the community to be served, CRA and Regula- Section 208.6(f) of Regulation H states that
tion BB performance for those branches that a branch relocation, defined as a movement that
will be accepting deposits, and whether the
bank’s investment in premises for the branch is
consistent with section 208.21 of Regulation H. 2c. See also 64 Fed. Reg. 34844.

Page 4.2
occurs within the immediate neighborhood Minimum Statewide Loan-to-Deposit

and does not substantially affect the nature of Ratios
the branch’s business or customers served, is
not considered a branch closing. Section Section 109 sets forth a process to test compli-
208.2(c)(2)(ii) of Regulation H states (in one of ance with the statutory requirements. First, a
six exclusions) that a branch does not include an bank’s statewide loan-to-deposit ratio2d is com-
office of an affiliated or unaffiliated institution pared with the host-state loan-to-deposit ratio2e
that provides services to customers of the for banks in a particular state. If the bank’s
member bank on behalf of the member bank, so statewide loan-to-deposit ratio is at least one-
long as the institution is not ‘‘established or half of the published host-state loan-to-deposit
operated’’ by the bank. For example, a bank ratio, then it has complied with section 109. A
could contract with an unaffiliated or affiliated second step is conducted if a bank’s statewide
institution to receive deposits; cash and issue loan-to-deposit ratio is less than one-half of the
checks, drafts, and money orders; change published ratio for that state or if data are not
money; and receive payments of existing available at the bank to conduct the first step.
indebtedness without becoming a branch of that The second step involves determining whether
bank. The bank could also (1) have no owner- the bank is reasonably helping to meet the credit
ship or leasehold interest in the institution’s needs of the communities served by its interstate
offices, (2) have no employees who work for the branches. If a bank fails both of these steps, it
institution, and (3) not exercise any authority or has violated section 109 and is subject to
control over the institution’s employees or sanctions.
methods of operation.
RISK-MANAGEMENT PROCESSES
Prohibition on Branches Being AND INTERNAL CONTROLS
Established Primarily for Deposit
Production The Federal Reserve has always placed signifi-
cant supervisory emphasis on the adequacy of
Section 109 of the Riegle-Neal Interstate Bank- an institution’s management of risk, including
ing and Branching Efficiency Act of 1994 (the its system of internal controls, when assessing
Interstate Act) (12 USC 1835a) prohibits any the condition of an organization. An institu-
bank from establishing or acquiring a branch or tion’s failure to establish a management struc-
branches outside of its home state primarily for ture that adequately identifies, measures, moni-
the purpose of deposit production. In 1997, the tors, and controls the risks involved in its
banking agencies published a joint final rule various products and lines of business has long
implementing section 109. (See 62 Fed. Reg. been considered unsafe and unsound conduct.
47728, September 10, 1997.) Section 106 of the Principles of sound management should apply to
Gramm-Leach-Bliley Act of 1999 expanded the the entire spectrum of risks facing a banking
coverage of section 109 of the Interstate Act to institution, including, but not limited to, credit,
include any branch of a bank controlled by an market, liquidity, operational, legal, and reputa-
out-of-state bank holding company. On June 6, tional risk. (See SR-97-24 and SR-97-25.)
2002, the Board and the other banking agen-
cies published an amendment to their joint final • Credit risk arises from the potential that a
rule (effective October 1, 2002) to conform the borrower or counterparty will fail to perform
uniform rule to section 109. (See 67 Fed. Reg. on an obligation.
38844.) The amendment expands the regula- • Market risk is the risk to a financial institu-
tory prohibition against interstate branches be- tion’s condition resulting from adverse move-
ing used as deposit-production offices to include ments in market rates or prices, such as
any bank or branch of a bank controlled by an
out-of-state bank holding company, including a 2d. The statewide loan-to-deposit ratio relates to an indi-
bank consisting only of a main office. (See vidual bank and is the ratio of a bank’s loans to its deposits in
Regulation H, section 208.7(b)(2).) a particular state where the bank has interstate branches.
2e. The host-state loan-to-deposit ratio is the ratio of total
loans in a state to total deposits from the state for all banks that
have that state as their home state. For state-chartered banks,
the home state is the state where the bank was chartered.

Page 4.3
interest rates, foreign-exchange rates, or equity and the level of risk that it accepts. For smaller
prices. institutions engaged solely in traditional bank-
• Liquidity risk is the potential that an institu- ing activities and whose senior managers and
tion will be unable to meet its obligations as directors are actively involved in the details of
they come due because of an inability to day-to-day operations, relatively basic risk-
liquidate assets or obtain adequate funding management systems may be adequate. How-
(referred to as ‘‘funding liquidity risk’’), or the ever, large, multinational organizations will
potential that the institution cannot easily require far more elaborate and formal risk-
unwind or offset specific exposures without management systems to address their broader
significantly lowering market prices because and typically more-complex range of financial
of inadequate market depth or market disrup- activities, and to provide senior managers and
tions (referred to as ‘‘market liquidity risk’’). directors with the information they need to
• Operational risk arises from the potential that monitor and direct day-to-day activities. In
inadequate information systems, operational addition to the banking organization’s market
problems, breaches in internal controls, fraud, and credit risks, risk-management systems should
or unforeseen catastrophes will result in encompass the organization’s trust and fiduciary
unexpected losses. activities, including investment advisory ser-
• Legal risk arises from the potential that unen- vices, mutual funds, and securities lending.
forceable contracts, lawsuits, or adverse judg-
ments can disrupt or otherwise negatively
affect the operations or condition of a banking Active Board and Senior Management
organization. Oversight
• Reputational risk is the potential that negative
publicity regarding an institution’s business When assessing the quality of the oversight by
practices, whether true or not, will cause a boards of directors and senior management,
decline in the customer base, costly litigation, examiners should consider whether the institu-
or revenue reductions. tion follows policies and practices such as those
described below:
In practice, an institution’s business activities
present various combinations and concentra- • The board and senior management have iden-
tions of these risks, depending on the nature and tified and have a clear understanding and
scope of the particular activity. The following working knowledge of the types of risks
discussion provides guidelines for determining inherent in the institution’s activities, and they
the quality of bank management’s formal or make appropriate efforts to remain informed
informal systems for identifying, measuring, about these risks as financial markets, risk-
and containing these risks. management practices, and the institution’s
activities evolve.
• The board has reviewed and approved appro-
Elements of Risk Management priate policies to limit risks inherent in the
institution’s lending, investing, trading, trust,
When evaluating the quality of risk management fiduciary, and other significant activities or
as part of the evaluation of the overall quality of products.
management, examiners should consider find-
ings relating to the following elements of a • The board and management are sufficiently
sound risk-management system: familiar with and are using adequate record-
keeping and reporting systems to measure and
• active board and senior management oversight monitor the major sources of risk to the
• adequate policies, procedures, and limits organization.
• adequate risk-measurement, risk-monitoring, • The board periodically reviews and approves
and management information systems risk-exposure limits to conform with any
• comprehensive internal controls changes in the institution’s strategies, reviews
new products, and reacts to changes in market
Adequate risk-management programs can vary conditions.
considerably in sophistication, depending on the • Management ensures that its lines of business
size and complexity of the banking organization are managed and staffed by personnel whose

Page 4.4
knowledge, experience, and expertise is con- Adequate Risk Monitoring and

sistent with the nature and scope of the Management Information Systems
banking organization’s activities.
• Management ensures that the depth of staff When assessing the adequacy of an institution’s
resources is sufficient to operate and soundly risk measurement and monitoring, as well as its
manage the institution’s activities, and ensures management reports and information systems,
that employees have the integrity, ethical examiners should consider whether these condi-
values, and competence that are consistent tions exist:
with a prudent management philosophy and
operating style. • The institution’s risk-monitoring practices and
• Management at all levels provides adequate reports address all of its material risks.
supervision of the day-to-day activities of • Key assumptions, data sources, and proce-
officers and employees, including manage- dures used in measuring and monitoring risk
ment supervision of senior officers or heads of are appropriate and adequately documented,
business lines. and are tested for reliability on an ongoing
• Management is able to respond to risks that basis.
may arise from changes in the competitive • Reports and other forms of communication
environment or from innovations in markets are consistent with the banking organization’s
in which the organization is active. activities; are structured to monitor exposures
• Before embarking on new activities or intro- and compliance with established limits, goals,
ducing new products, management identifies or objectives; and, as appropriate, compare
and reviews all risks associated with the actual versus expected performance.
activities or products and ensures that the • Reports to management or to the institution’s
infrastructure and internal controls necessary directors are accurate and timely, and contain
to manage the related risks are in place. sufficient information for decision makers to
identify any adverse trends and to evaluate
adequately the level of risk faced by the
Adequate Policies, Procedures, and Limits institution.
Examiners should consider the following when
evaluating the adequacy of a banking organiza-
tion’s policies, procedures, and limits:
Adequate Internal Controls
When evaluating the adequacy of a financial
• The institution’s policies, procedures, and institution’s internal controls and audit proce-
limits provide for adequate identification, dures, examiners should consider whether these
measurement, monitoring, and control of the conditions are met:
risks posed by its lending, investing, trading,
trust, fiduciary, and other significant activities. • The system of internal controls is appropri-
• The policies, procedures, and limits are ate to the type and level of risks posed by
consistent with management’s experience level, the nature and scope of the organization’s
the institution’s stated goals and objectives, activities.
and the overall financial strength of the
organization. • The institution’s organizational structure
• Policies clearly delineate accountability and establishes clear lines of authority and respon-
lines of authority across the institution’s sibility for monitoring adherence to policies,
activities. procedures, and limits.
• Policies provide for the review of new activi- • Reporting lines for the control areas are inde-
ties to ensure that the financial institution has pendent from the business lines, and there is
the necessary infrastructures to identify, moni- adequate separation of duties throughout the
tor, and control risks associated with an activ- organization—such as duties relating to trad-
ity before it is initiated. ing, custodial, and back-office activities.
• Official organizational structures reflect actual
operating practices.
• Financial, operational, and regulatory reports
are reliable, accurate, and timely, and, when

Page 5
applicable, exceptions are noted and promptly (2) an understanding of the bank’s regulatory
investigated. compliance practices, and (3) its management
• Adequate procedures exist for ensuring information systems and internal and/or external
compliance with applicable laws and audit function. In addition, Reserve Banks should
regulations. contact the state banking regulator to determine
• Internal audit or other control-review prac- whether it has any special areas of concern that
tices provide for independence and objectivity. examiners should focus on.
• Internal controls and information systems are
adequately tested and reviewed. The coverage
of, procedures for, and findings and responses Reliance on Internal Risk
to audits and review tests are adequately
documented. Identified material weaknesses
Assessments
are given appropriate and timely high-level
attention, and management’s actions to address As previously discussed in the subsection ‘‘Risk-
material weaknesses are objectively verified Management Processes and Internal Controls,’’
and reviewed. the entire spectrum of risks facing an institution
• The institution’s audit committee or board should be considered when assessing a bank’s
of directors reviews the effectiveness of inter- risk portfolio. Internal audit, loan-review, and
nal audits and other control-review activities compliance functions are integral to a bank’s
regularly. own assessment of its risk profile. If applicable,
it may be beneficial to discuss with the bank’s
external auditor the results of its most recent
audit for the bank. Such a discussion gives the
RISK-FOCUSED SUPERVISION OF examiner the opportunity to review the external
COMMUNITY BANKS auditor’s frequency, scope, and reliance on
internal audit findings. Examiners should con-
Understanding the Bank sider the adequacy of these functions in deter-
mining the risk profile of the bank, and be alert
The risk-focused supervision process for com-
to opportunities to reduce regulatory burden by
munity banks involves a continuous assessment
testing rather than duplicating the work of inter-
of the bank, which leads to an understanding of
nal and external audit functions. See the subsec-
the bank that enables examiners to tailor their
tion ‘‘Risk-Focused Examinations’’ for a discus-
examination to the bank’s risk profile. In addi-
sion on transaction testing.
tion to examination reports and correspondence
files, each Reserve Bank maintains various sur-
veillance reports that identify outliers when a
bank is compared to its peer group. Review of Preparation of a Scope Memorandum
this information helps examiners identify a
bank’s strengths and vulnerabilities, and is the An integral product in the risk-focused method-
foundation for determining the examination ology, the scope memorandum identifies the
activities to be conducted. central objectives of the examination. The memo-
Contact with the organization is encouraged randum also ensures that the examination strat-
to improve the examiners’ understanding of the egy is communicated to appropriate examina-
institution and the market in which it operates. A tion staff, which is of key importance, as the
pre-examination interview or visit should be scope will likely vary from examination to
conducted as a part of each examination. This examination. Examination procedures should be
meeting gives examiners the opportunity to tailored to the characteristics of each bank,
learn about any changes in bank management keeping in mind its size, complexity, and risk
and changes to the bank’s policies, strategic profile. Procedures should be completed to the
direction, management information systems, and degree necessary to determine whether the
other activities. During this meeing, particular bank’s management understands and adequately
emphasis should be placed on learning about the controls the levels and types of risk that are
bank’s new products or new markets it may assumed. In addition, the scope memorandum
have entered. The pre-examination interview or should address the general banking environ-
visit also provides examiners with (1) management, economic conditions, and any changes
ment’s view of local economic conditions, foreseen by bank management that could affect

Page 6
the bank’s condition. Some of the key factors each module to be emphasized during the
that should be addressed in the scope memoran- examination process. In addition, any supple-
dum are described below. mental modules used should be discussed.
Preliminary Risk Assessment Summary of Loan Review

A summary of the risks associated with the On the basis of the preliminary risk assessment,
bank’s activities should be based on a review of the anticipated loan coverage should be detailed
all available sources of information on the bank, in the scope memorandum. In addition to stating
including, but not limited to, prior examination the percentage of commercial and commercial
reports, surveillance reports, correspondence real estate loans to be reviewed, the scope
files, and audit reports. The scope memorandum memorandum should identify which specialty
should include a preliminary assessment of the loan reference modules of the general loan
bank’s condition and major risk areas that will module are to be completed. The memorandum
be evaluated through the examination process. should specify activities within the general loan
For detailed discussion of risk assessments and module to be reviewed as well as the depth of
risk matrices, see the subsection ‘‘Risk-Focused any specialty reviews.
Supervision of Large, Complex Institutions.’’
Summary of Pre-Examination Meeting Job Staffing

The staffing for the examination should be
The results of the pre-examination meeting
detailed. Particular emphasis should be placed
should be summarized. Meeting results that
on ensuring that appropriate personnel are
affect examination coverage should be
assigned to the high-risk areas identified in the
emphasized.
bank’s risk assessment.
Summary of Audit and Internal Control

Environment Examination Modules
A summary of the scope and adequacy of the Standardized electronic community bank exami-
audit environment should be prepared, which nation modules have been developed and
may result in a modification of the examination designed to define common objectives for the
procedures initially expected to be performed. review of important activities within institutions
Activities that receive sufficient coverage by the and to assist in the documentation of examina-
bank’s audit system can be tested through the tion work. It is expected that full-scope exami-
examination process. Certain examination nations will use these modules.
procedures could be eliminated if their audit The modules establish a three-tiered approach
and internal control areas are deemed for the review of a bank’s activities: The first
satisfactory. tier is the core analysis, the second tier is the
expanded review, and the final tier is the impact
analysis. The core analysis includes a number of
Summary of Examination Procedures decision factors that should be considered col-
lectively, as well as individually, when evaluat-
As discussed below, examination modules have ing the potential risk to the bank. To help the
been developed for the significant areas reviewed examiner determine whether risks are adequately
during an examination. The modules are catego- managed, the core analysis section contains a
rized as primary or supplemental. The primary list of procedures that may be considered for
modules must be included in each examination. implementation. Once the relevant procedures
However, procedures within the primary mod- are performed, the examiner should document
ules can be eliminated or enhanced based on the conclusions in the core analysis decision factors.
risk assessment or the adequacy of the audit and When significant deficiencies or weaknesses are
internal control environment. The scope memo- noted in the core analysis review, the examiner
randum should specifically detail the areas within is required to complete the expanded analysis

Page 7
for those decision factors that present the great- are implemented differently: The process for
est degree of risk for the bank. However, if the complex institutions relies more heavily on a
risks are properly managed, the examiner can central point of contact and detailed risk assess-
conclude the review. ments and supervisory plans before the on-site
The expanded analysis provides guidance for examination or inspection. In comparison, for
determining if weaknesses are material to the small or noncomplex institutions and commu-
bank’s condition and if they are adequately nity banks, risk assessments and examination
managed. If the risks are material or inad- activities may be adequately described in the
equately managed, the examiner is directed to scope memorandum.
perform an impact analysis to assess the finan-
cial impact to the bank and whether any enforce-
ment action is necessary. Key Elements
The use of the modules should be tailored to
the characteristics of each bank based on its size, To meet the supervisory objectives discussed
complexity, and risk profile. As a result, the previously and to respond to the characteristics
extent to which each module should be com- of large institutions, the framework for risk-
pleted will vary from bank to bank. The indi- focused supervision of large complex institu-
vidual procedures presented for each level are tions contains the following key elements:
meant only to serve as a guide for answering the
decision factors. Not every procedure requires • Designation of a central point of contact.
an individual response, and not every procedure Large institutions typically have operations in
may be applicable at every community bank. several jurisdictions, multiple charters, and
Examiners should continue to use their discre- diverse product lines. Consequently, the
tion when excluding any items as unnecessary in supervisory program requires that a ‘‘central
their evaluation of decision factors. point of contact’’ be designated for each
institution to facilitate coordination and com-
munication among the numerous regulators
and specialty areas.
RISK-FOCUSED SUPERVISION OF • Review of functional activities. Large institu-
LARGE COMPLEX INSTITUTIONS tions are generally structured along business
lines or functions, and some activities are
The Federal Reserve recognizes a difference in managed on a centralized basis. As a result, a
the supervisory requirements for community single type of risk may cross several legal
banks and large complex banking organizations entities. Therefore, the supervisory program
(LCBOs). The complexity of financial products, incorporates assessments along functional lines
sophistication of risk-management systems to evaluate risk exposure and its impact on
(including audit and internal controls), manage- safety and soundness. These functional reviews
ment structure, and geographic dispersion of will be integrated into the risk assessments
operations are but a few of the areas in which for specific legal entities and used to support
large institutions may be distinguished from the supervisory ratings for individual legal
community banks. While close coordination entities.3
with state banking departments, the Office of the • Focus on risk-management processes. Large
Comptroller of the Currency (OCC), and the institutions generally have highly developed
Federal Deposit Insurance Corporation (FDIC) risk-management systems, such as internal
is important for fostering consistency among audit, loan review, and compliance. The
banking supervisors and reducing the regulatory supervisory program emphasizes each institu-
burden for community banks, it is critical for tion’s responsibility to be the principal source
large complex banking organizations. for detecting and deterring abusive and
The examination approaches for both large unsound practices through adequate internal
complex institutions and community banks are controls and operating procedures. The pro-
risk-focused processes that rely on an under-
standing of the institution, the performance of 3. When functions are located entirely in legal entities that
are not primarily supervised by the Federal Reserve, the
risk assessments, the development of a supervi- results of supervisory activities conducted by the primary
sory plan, and examination procedures tailored regulator will be used to the extent possible to avoid duplica-
to the risk profile. However, the two approaches tion of activities.

Page 8
gram incorporates an approach that focuses on tions with consolidated assets less than
and evaluates the institution’s risk-management $1 billion.
systems, yet retains transaction testing and Nonbank subsidiaries of large complex domes-
supervisory rating systems, such as the tic institutions are covered by the supervisory
CAMELS, bank holding company RFI/C(D), program. These institutions include nonbank
and ROCA rating systems. This diagnostic subsidiaries of the parent bank holding company
perspective is more dynamic and forward and those of the subsidiary state member banks;
looking because it provides insight into how the significant branch operations, primarily
effectively an institution is managing its foreign branches, of state member banks; and
operations and how well it is positioned to subsidiary foreign banks of the holding com-
meet future business challenges. pany. The level of supervisory activity to
• Tailoring of supervisory activities. Large be conducted for nonbank subsidiaries and for-
institutions are unique, but all possess the eign branches and subsidiaries of domestic
ability to quickly change their risk profiles. To institutions should be based on their individual
deliver effective supervision, the supervisory risk levels relative to the consolidated organiza-
program incorporates an approach that tailors tion or the state member bank. The risk associ-
supervisory activities to the risk profile of an ated with significant nonbank subsidiaries or
institution. By concentrating on an institu- branches should be identified as part of the
tion’s major risk areas, examiners can achieve consolidated risk-assessment process. The scope
a more relevant and penetrating understanding of Edge Act corporation examinations should
of the institution’s condition. also be determined through the risk-assessment
• Emphasis on ongoing supervision. Large process. In addition, specialty areas should be
institutions face a rapidly changing environ- included in the planning process in relation to
ment. Therefore, the supervisory program their perceived level of risk to the consoli-
emphasizes ongoing supervision through dated organization or to any state member bank
increased planning and off-site monitoring. subsidiary.
Ongoing supervision allows for timely adjust-
ments to the supervisory strategy as con-
ditions change within the institution and Coordination of Supervisory
economy. Activities
Many large complex institutions have interstate
Covered Institutions operations; therefore, close cooperation with the
other federal and state banking agencies is
For purposes of the risk-focused supervision critical. To facilitate coordination between the
framework, large complex institutions generally Federal Reserve and other regulators, District
have (1) a functional management structure, Reserve Banks have been assigned roles and
(2) a broad array of products, (3) operations that responsibilities that reflect their status as either
span multiple supervisory jurisdictions, and the responsible Reserve Bank (RRB) with the
(4) consolidated assets of $1 billion or more.4 central point of contact or the local Reserve
These institutions may be state member banks, Bank (LRB).
bank holding companies (including their non- The RRB is accountable for all aspects of the
bank and foreign subsidiaries), and branches supervision of a fully consolidated banking
and agencies of foreign banking organizations. organization, which includes the supervision of
However, if an institution with consolidated all the institution’s subsidiaries and affiliates
assets totaling $1 billion or more does not have (domestic, foreign, and Edge corporations) for
these characteristics, the supervisory process which the Federal Reserve has supervisory over-
adopted for community banks may be more sight responsibility. The RRB is generally
appropriate. Conversely, the complex-institution expected to work with LRBs in conducting
process may be appropriate for some organiza- examinations and other supervisory activities,
particularly where significant banking opera-
tions are conducted in a local District. Thus, for
4. Large institutions are defined differently in other regu-
state member banks, the LRB has an important
latory guidance for regulatory reports and examination role in the supervision of that subsidiary. How-
mandates. ever, the RRB retains authority and accountabil-

Page 9
ity for the results of all examinations and reviews Sharing of RRB Duties
that an LRB may perform on its behalf. See
SR-05-27/CA-05-11. To take advantage of opportunities to enhance
supervisory effectiveness or efficiency, an RRB
is encouraged to arrange for the LRB to under-
Responsible Reserve Bank take on its behalf certain examinations or other
supervisory activities. For example, an LRB
In general, the RRB for a banking institution has may have relationships with local representa-
been the Reserve Bank in the District where the tives of the institution or local supervisors;
banking operations of the organization are prin- leveraging these relationships may facilitate com-
cipally conducted. For domestic banking insti- munication and reduce costs. Additionally, LRBs
tutions, the RRB typically will be the Reserve may provide specialty examination resources—in
Bank District where the head office of the top- the case of CRA examinations, LRB staff often
tier institution is located and where its overall provide valuable insights into local communities
strategic direction is established and overseen. and lending institutions that should be factored
For foreign banking institutions, the RRB typi- into the CRA assessment. When other Reserve
cally will be the Reserve Bank District where Bank Districts conduct examinations and other
the Federal Reserve has the most direct involve- supervisory activities for the RRB, substantial
ment in the day-to-day supervision of the U.S. reliance should be placed on the conclusions and
banking operations of the institution. ratings recommended by the participating Reserve
When necessary, the Board’s Division of Bank(s).
Banking Supervision and Regulation (BS&R), in The RRB retains authority and accountability
consultation with the Division of Consumer and for the results of all examinations and reviews
Community Affairs (C&CA), may designate an performed on its behalf and, therefore, must
RRB when the general principles set forth above work closely with LRB examination teams to
could impede the ability of the Federal Reserve ensure that examination scopes and conclusions
to perform its functions under law, do not result are consistent with the supervisory approach and
in an efficient allocation of supervisory resources, message applied across the consolidated organi-
or are otherwise not appropriate. zation. If an LRB identifies major issues in the
course of directly conducting supervisory activi-
ties on behalf of an RRB, those issues should be
Duties of RRBs brought to the attention of the RRB in a timely
manner.
The RRB develops the consolidated risk assess- If an RRB arranges for an LRB to conduct
ment and supervisory plan and ensures that the supervisory activities on its behalf, the LRB is
scope and timing of planned activities con- responsible for the costs of performing the
ducted by participating Districts and agencies activities. If the LRB is unable to fulfill the
pursuant to the plan are appropriate, given the request from the RRB to perform the specified
consolidated risk assessment. The RRB desig- activities, the RRB should seek System assis-
nates the central point of contact or lead exam- tance, if needed, by contacting Board staff or
iner and ensures that all safety-and-soundness, using other established procedures for coordi-
information technology, trust, consumer compli- nating resources.
ance, Community Reinvestment Act (CRA), and In general, LRBs are responsible for the direct
other specialty examinations, inspections, and supervision of state member banks located in
visitations are conducted and appropriately coor- their district. LRBs and host states will not
dinated within the System and with other regu- routinely examine branches of state member
lators. In addition, the RRB manages all formal banks or issue separate ratings and reports of
communications with the foreign and domestic examination. Similar to the relationship between
supervised entity, including the the communica- the RRBs and LRBs, home-state supervisors6
tion of supervisory assessments, ratings, and
remedial actions.5 6. The State/Federal Supervisory Protocol and Agreement
established definitions for home and host states. The home-
state supervisor is defined as the state that issued the charter.
5. See SR-97-24, ‘‘Risk-Focused Framework for Supervi- It will act on behalf of itself and all host-state supervisors
sion of Large Complex Institutions,’’ and SR-96-33, ‘‘State/ (states into which the bank branches) and will be the single
Federal Protocol and Nationwide Supervisory Agreement.’’ state contact for a particular institution.

Page 10
will coordinate the activities of all state banking A dedicated supervisory team composed of
departments and will be the state’s principal individuals with specialized skills based upon
source of contact with federal banking agencies the organization’s particular business lines and
and with the bank itself. Also, host states will risk profile will be assigned to each institution.
not unilaterally examine branches of interstate This full-time, dedicated cadre will be supple-
banks. Close coordination among the Reserve mented by other specialized System staff, as
Banks and other appropriate regulators for each necessary, to participate in examinations and
organization is critical to ensure a consistent, targeted reviews.
risk-focused approach to supervision. In addition to designing and executing the
supervisory strategy for an organization, the
central point of contact is responsible for man-
aging the supervisory team. The supervisory
Central Point of Contact and team’s major responsibilities are to maintain a
Supervisory Teams high level of knowledge of the banking organi-
zation and to ensure that supervisory strategies
A central point of contact is critical to fulfilling and priorities are consistent with the identified
the objectives of seamless, risk-focused super- risks and institutional profile.
vision. The RRB should designate a central
point of contact for each large complex institu-
tion it supervises. Generally, all activities and Sharing of Information
duties of other areas within the Federal Reserve,
as well as those conducted with other supervi- To further promote seamless, risk-focused
sors, should be coordinated through this contact. supervision, information related to a specific
The central point of contact should— institution should be provided, as appropriate, to
other interested supervisors. The information to
• be knowledgeable, on an ongoing basis, about be shared includes the products described in the
the institution’s financial condition, manage- ‘‘Process and Products’’ subsection. However,
ment structure, strategic plan and direction, sharing these products with the institution itself
and overall operations; should be carefully evaluated on a case-by-case
• remain up-to-date on the condition of the basis.
assigned institution and be knowledgeable
regarding all supervisory activities; monitor-
ing and surveillance information; applications Confidentiality Provisions in
issues; capital-markets activities; meetings Agreements that Prevent or Restrict
with management; and enforcement issues, if Notification to the Federal Reserve
applicable;
• ensure that the objective of seamless, risk- The Federal Reserve has stated and clarified its
focused supervision is achieved for each expectations regarding confidentiality provi-
institution and that the supervisory products sions that are contained in agreements between a
described later are prepared in a timely banking organization and its counterparties (for
manner; example, mutual funds, hedge funds, and other
• ensure appropriate follow-up and tracking of trading counterparties) or other third parties. It is
supervisory concerns, corrective actions, or contrary to Federal Reserve’s regulations and
other matters that come to light through policy for agreements to contain confidentiality
ongoing communications or surveillance; and provisions that (1) restrict the banking organi-
• participate in the examination process, as zation from providing information to Federal
needed, to ensure consistency with the insti- Reserve supervisory staff; 6a (2) require or per-
tution’s supervisory plan and to ensure effec- mit, without the prior approval of the Federal
tive allocation of resources, including coordi- Reserve, the banking organization to disclose to
nation of on-site efforts with specialty a counterparty that any information will be or
examination areas and other supervisors, as was provided to Federal Reserve supervisory
appropriate, and to facilitate requests for
information from the institution, whenever 6a. Supervisory staff include individuals that are on and/or
possible. off site.

Page 10.1
staff; or (3) require or permit, without the prior

approval of the Federal Reserve, the banking
organization to inform a counterparty of a cur-
rent or upcoming Federal Reserve examination
or any nonpublic Federal Reserve supervisory
initiative or action. Banking organizations that
have entered, or enter, into agreements contain-
ing such confidentiality provisions are subject to
legal risk. (See SR-07-19 and SR-97-17.) For
information on the restrictions pertaining to the
very limited disclosure of confidential supervi-
sory ratings and other nonpublic supervisory
information, see SR-05-4, SR-96-26, and SR-
88-37. See also section 5020.1.
Functional Approach and Targeted

Examinations
Traditionally, the examination process has been
driven largely by a legal-entity approach to
banking companies. The basis for risk-focused
supervision of large complex institutions relies
more heavily on a functional, business-line ap-
proach to supervising institutions, while effec-
tively integrating the functional approach into
the legal-entity assessment.
The functional approach focuses principally
on the key business activities (for example,
lending, Treasury, retail banking) rather than
on reviewing the legal entity and its balance
sheet. This approach does not mean that the
responsibility for a legal-entity assessment is
ignored, nor should the Federal Reserve perform
examinations of institutions that other regula-
tors are primarily responsible for supervising.7
Rather, Federal Reserve examiners should inte-
grate the findings of a functional review into the
legal-entity assessment and coordinate closely
with the primary regulator to gather sufficient
information to form an assessment of the con-
solidated organization. Nonetheless, in some
cases, effective supervision of the consoli-
dated organization may require Federal Reserve
examiners to perform process reviews and pos-
sibly transaction testing at all levels of the
organization.
Functional risk-focused supervision is to be
achieved by—
7. For U.S. banks owned by FBOs, it is particularly

important to review the U.S. bank on a legal-entity basis and
to review the risk exposure to the U.S. bank of its parent
foreign bank since U.S. supervisory authorities do not super-
vise or regulate the parent bank.

Page 10.2
• planning and conducting joint examinations Process and Products

with the primary regulator in areas of mutual
interest, such as nondeposit investment prod- The risk-focused methodology for the supervi-
ucts, interest-rate risk, liquidity, and mergers sion program for large, complex institutions
and acquisitions; reflects a continuous and dynamic process. The
• leveraging off, or working from, the work methodology consists of six steps, each of
performed by the primary regulator and the which uses certain written products to facilitate
work performed by the institution’s internal communication and coordination.
and external auditors by reviewing and using
their workpapers and conclusions to avoid
duplication of effort and to lessen the burden Table 1—Steps and Products
on the institution;
• reviewing reports of examinations and other Steps Products
communications to the institution issued by
other supervisors; and 1. Understanding the 1. Institutional
• conducting a series of functional reviews or institution overview
targeted examinations of business lines, rel-
evant risk areas, or areas of significant super- 2. Assessing the 2. Risk matrix
visory concern during the supervisory cycle. institution’s risk 3. Risk assessment
Functional reviews and targeted examinations 3. Planning and 4. Supervisory plan
are increasingly necessary to evaluate the scheduling 5. Examination
relevant risk exposure of a large, complex supervisory program
institution and the effectiveness of related activities
risk-management systems.
4. Defining examina- 6. Scope
The relevant findings of functional reviews or tion activities memorandum
targeted examinations should be— 7. Entry letter
• incorporated into the annual summary super- 5. Performing 8. Functional

visory report, with follow-up on deficiencies examination examination
noted in the functional reviews or targeted procedures modules
examinations; 6. Reporting the 9. Examination
• conveyed to the institution’s management dur- findings report(s)
ing a close-out or exit meeting with the
relevant area’s line management; and
The focus of the products should be on fully
• communicated in a formal written report to achieving a risk-focused, seamless, and coordi-
the institution’s management or board of nated supervisory process, not simply on com-
directors when significant weaknesses are pleting the products. The content and format of
detected or when the finding results in a the products are flexible and should be adapted
downgrade of any rating component. to correspond to the supervisory practices of the
agencies involved and to the structure and com-
The functional approach to risk assessments plexity of the institution.
and to planning supervisory activities should
include a review of the parent company and its
significant nonbank subsidiaries. However, the
level of supervisory review should be appropri- Understanding the Institution
ate to the risk profile of the parent company or
its nonbank subsidiary in relation to the consoli- The starting point for risk-focused supervision is
dated organization. Intercompany transactions developing an understanding of the institution.
should continue to be reviewed as part of the This step is critical to tailoring the supervision
examination procedures performed to ensure program to meet the characteristics of the orga-
that these transactions comply with laws and nization and to adjusting that program on an
regulations and do not pose safety-and-soundness ongoing basis as circumstances change. Further-
concerns. more, understanding the Federal Reserve’s

Page 11
supervisory role in relation to an institution and supervisory findings. General types of informa-
its affiliates is essential. tion that may be valuable to present in the
Through increased emphasis on planning and overview include—
monitoring, supervisory activities can focus on
the significant risks to the institution and on • a brief description of the organizational
related supervisory concerns. The technological structure;
and market developments within the financial • a summary of the organization’s business
sector and the speed with which an institution’s strategies as well as changes in key business
financial condition and risk profile can change lines, growth areas, new products, etc., since
make it critical for supervisors to keep abreast of the prior review;
events and changes in risk exposure and strat- • key issues for the organization, either from
egy. Accordingly, the central point of contact for external or internal factors;
each large, complex institution should review • an overview of management;
certain information on an ongoing basis and • a brief analysis of the consolidated financial
prepare an institution overview that will com- condition and trends;
municate his or her understanding of that • a description of the future prospects of the
institution. organization;
Information generated by the Federal Reserve, • descriptions of internal and external audit;
other supervisory agencies, the institution, and • a summary of supervisory activity performed
public organizations may assist the central point since the last review; and
of contact in forming and maintaining an ongo- • considerations for conducting future
ing understanding of the institution’s risk profile examinations.
and current condition. In addition, the central
point of contact should hold periodic discus-
sions with the institution’s management to cover,
among other topics, credit-market conditions, Assessing the Institution’s Risks
new products, divestitures, mergers and acqui-
sitions, and the results of any recently completed To focus supervisory activities on the areas of
internal and external audits. When other agen- greatest risk to an institution, the central point of
cies have supervisory responsibilities for the contact should perform a risk assessment. The
organization, joint discussions should be risk assessment highlights both the strengths and
considered. vulnerabilities of an institution and provides a
The principal risk-focused supervisory tools foundation for determining the supervisory
and documents, including an institutional over- activities to be conducted. Further, the assess-
view, risk matrix, and risk assessment for the ment should apply to the entire spectrum of risks
organization, should be current. Accordingly, facing an institution (as previously discussed in
the central point of contact should distill and the subsection ‘‘Risk-Management Processes and
incorporate significant new information into Internal Controls’’).
these documents at least quarterly. Factors such An institution’s business activities present
as emerging risks; new products; and significant various combinations and concentrations of the
changes in business strategy, management, con- noted risks depending on the nature and scope of
dition, or ownership may warrant more frequent the particular activity. Therefore, when conduct-
updates. In general, the more dynamic the orga- ing the risk assessment, consideration must be
nization’s operations and risks, the more fre- given to the institution’s overall risk environ-
quently the central point of contact should ment, the reliability of its internal risk manage-
update the risk assessment, strategies, and plans. ment, the adequacy of its information technol-
ogy systems, and the risks associated with each
of its significant business activities.
Preparation of the Institutional Overview
The institutional overview should contain a Assessment of the Overall Risk
concise executive summary that demonstrates Environment
an understanding of the institution’s present
condition and its current and prospective risk The starting point in the risk-assessment process
profiles, as well as highlights key issues and past is an evaluation of the institution’s risk tolerance

Page 12
and of management’s perception of the organi- trading systems. Accordingly, the institution’s
zation’s strengths and weaknesses. This evalua- risk assessment must consider the adequacy of
tion should entail discussions with management its information technology systems.
and review of supporting documents, strategic
plans, and policy statements. In general, man-
agement is expected to have a clear understand- Preparation of the Risk Matrix
ing of both the institution’s markets and the
general banking environment, as well as how A risk matrix is used to identify significant
these factors affect the institution. activities, the type and level of inherent risks in
The institution should have a clearly defined these activities, and the adequacy of risk man-
risk-management structure, which may be for- agement over these activities, as well as to
mal or informal, centralized or decentralized. determine composite-risk assessments for each
However, the greater the risk assumed by the of these activities and the overall institution. A
institution, the more sophisticated its risk- risk matrix can be developed for the consoli-
management system should be. Regardless of dated organization, for a separate affiliate, or
the approach, the types and levels of risk an along functional business lines. The matrix is a
institution is willing to accept should reflect its flexible tool that documents the process fol-
risk appetite, as determined by the board of lowed to assess the overall risk of an institution
directors. and is a basis for preparation of the narrative
To assess the overall risk environment, the risk assessment.
central point of contact should make a prelimi- Activities and their significance can be iden-
nary evaluation of the institution’s internal risk tified by reviewing information from the insti-
management, considering the adequacy of its tution, the Reserve Bank, or other supervisors.
internal audit, loan-review, and compliance func- After the significant activities are identified, the
tions. External audits also provide important type and level of risk inherent in them should be
information on the institution’s risk profile and determined. Types of risk may be categorized as
condition, which may be used in the risk previously described or by using categories
assessment. defined either by the institution or other super-
In addition, the central point of contact should visory agencies. If the institution uses risk
review risk assessments developed by the inter- categories that differ from those defined by the
nal audit department for significant lines of supervisory agencies, the examiner should deter-
business, and compare those results with the mine if all relevant types of risk are appropri-
supervisory risk assessment. Management’s abil- ately captured. If risks are appropriately cap-
ity to aggregate risks on a global basis should tured by the institution, the examiner should use
also be evaluated. This preliminary evaluation the categories identified by the institution.
can be used when developing the scope of For the identified functions or activities, the
examination activities to determine the level of inherent risk involved in that activity should be
examiner reliance on the institution’s internal described as high, moderate, or low for each
risk management. type of risk associated with that type of activity.
Risk-monitoring activities must be supported The following definitions apply:
by management information systems that pro-
vide senior managers and directors with timely • High inherent risk exists when the activity is
and reliable reports on the financial condition, significant or positions are large in relation to
operating performance, and risk exposure of the the institution’s resources or its peer group,
consolidated organization. These systems must when the number of transactions is substan-
also provide managers engaged in the day-to- tial, or when the nature of the activity is
day management of the organization’s activities inherently more complex than normal. Thus,
with regular and sufficiently detailed reports for the activity potentially could result in a sig-
their areas of responsibility. Moreover, in most nificant and harmful loss to the organization.
large, complex institutions, management infor- • Moderate inherent risk exists when positions
mation systems not only provide reporting sys- are average in relation to the institution’s
tems, but also support a broad range of business resources or its peer group, when the volume
decisions through sophisticated risk-management of transactions is average, and when the
and decision-making tools such as credit- activity is more typical or traditional. Thus,
scoring and asset/liability models and automated while the activity potentially could result in a

Page 13
loss to the organization, the loss could be • Acceptable risk management indicates that the
absorbed by the organization in the normal institution’s risk-management systems,
course of business. although largely effective, may be lacking to
• Low inherent risk exists when the volume, some modest degree. It reflects an ability to
size, or nature of the activity is such that even cope successfully with existing and foresee-
if the internal controls have weaknesses, the able exposure that may arise in carrying out
risk of loss is remote, or, if a loss were to the institution’s business plan. While the
occur, it would have little negative impact on institution may have some minor risk-
the institution’s overall financial condition. management weaknesses, these problems have
been recognized and are being addressed.
This risk-assessment is made without consider- Overall, board and senior management over-
ing management processes and controls; those sight, policies and limits, risk-monitoring pro-
factors are considered when evaluating the cedures, reports, and management information
adequacy of the institution’s risk-management systems are considered effective in maintain-
systems. ing a safe and sound institution. Risks are
generally being controlled in a manner that
does not require more than normal supervi-
Assessing Adequacy of Risk Management sory attention.
• Weak risk management indicates risk-
When assessing the adequacy of an institution’s management systems that are lacking in
risk-management systems for identified func- important ways and, therefore, are a cause for
tions or activities, the focus should be on find- more than normal supervisory attention. The
ings related to the key elements of a sound risk- internal control system may be lacking in
management system: active board and senior important respects, particularly as indicated
management oversight; adequate policies, pro- by continued control exceptions or by the
cedures, and limits; adequate risk-management, failure to adhere to written policies and pro-
monitoring, and management information sys- cedures. The deficiencies associated in these
tems; and comprehensive internal controls. systems could have adverse effects on the
(These elements are described in the earlier safety and soundness of the institution or
subsection ‘‘Elements of Risk Management.’’) could lead to a material misstatement of its
Taking these key elements into account, the financial statements if corrective actions are
contact should assess the relative strength of the not taken.
risk-management processes and controls for each
identified function or activity. Relative strength The composite risk for each significant activ-
should be characterized as strong, acceptable, or ity is determined by balancing the overall level
weak as defined below: of inherent risk of the activity with the overall
strength of risk-management systems for that
• Strong risk management indicates that man- activity. For example, commercial real estate
agement effectively identifies and controls all loans usually will be determined to be inherently
major types of risk posed by the relevant high risk. However, the probability and the
activity or function. The board and manage- magnitude of possible loss may be reduced by
ment participate in managing risk and ensure having very conservative underwriting stan-
that appropriate policies and limits exist, which dards, effective credit administration, strong
the board understands, reviews, and approves. internal loan review, and a good early warning
Policies and limits are supported by risk- system. Consequently, after accounting for these
monitoring procedures, reports, and manage- mitigating factors, the overall risk profile and
ment information systems that provide the level of supervisory concern associated with
necessary information and analysis to make commercial real estate loans may be moderate.
timely and appropriate responses to changing To facilitate consistency in the preparation of
conditions. Internal controls and audit proce- the risk matrix, general definitions of the com-
dures are appropriate to the size and activities posite level of risk for significant activities are
of the institution. There are few exceptions to provided as follows:
established policies and procedures, and none
of these exceptions would likely lead to a • A high composite risk generally would be
significant loss to the organization. assigned to an activity in which the risk-

Page 14
management system does not significantly serving as a platform for developing the super-
mitigate the high inherent risk of the activity. visory plan.
Thus, the activity could potentially result in a The format and content of the written risk
financial loss that would have a significant assessment are flexible and should be tailored to
negative impact on the organization’s overall the individual institution. The risk assessment
condition, in some cases, even when the reflects the dynamics of the institution; there-
systems are considered strong. For an activity fore, it should consider the institution’s evolving
with moderate inherent risk, a risk-management business strategies and be amended as signifi-
system that has significant weaknesses could cant changes in the risk profile occur. Input from
result in a high composite risk assessment other affected supervisors and specialty units
because management appears to have an should be included to ensure that all the institu-
insufficient understanding of the risk and tion’s significant risks are identified. The risk
uncertain capacity to anticipate and respond to assessment should—
changing conditions.
• A moderate composite risk generally would • include an overall risk assessment of the
be assigned to an activity with moderate organization;
inherent risk, which the risk-management sys- • describe the types of risk (credit, market,
tems appropriately mitigate. For an activity liquidity, reputational, operational, legal) and
with low inherent risk, significant weaknesses their level (high, moderate, low) and direction
in the risk-management system may result in a (increasing, stable, decreasing);
moderate composite risk assessment. On the • identify all major functions, business lines,
other hand, a strong risk-management system activities, products, and legal entities from
may reduce the risks of an inherently high-risk which significant risks emanate, as well as the
activity so that any potential financial loss key issues that could affect the risk profile;
from the activity would have only a moderate • consider the relationship between the likeli-
negative impact on the financial condition of hood of an adverse event and its potential
the organization. impact on an institution; and
• describe the institution’s risk-management sys-
• A low composite risk generally would be tems. Reviews and risk assessments per-
assigned to an activity that has low inherent formed by internal and external auditors should
risks. An activity with moderate inherent risk be discussed, as should the institution’s ability
may be assessed a low composite risk when to take on and manage risk prospectively.
internal controls and risk-management sys-
tems are strong, and when they effectively The central point of contact should attempt to
mitigate much of the risk. identify the cause of unfavorable trends, not just
report the symptoms. The risk assessment should
Once the composite risk assessment of each reflect a thorough analysis that leads to conclu-
identified significant activity or function is com- sions about the institution’s risk profile, rather
pleted, an overall composite risk assessment than just reiterating the facts.
should be made for off-site analytical and plan-
ning purposes. This assessment is the final step
in the development of the risk matrix, and the
evaluation of the overall composite risk is Planning and Scheduling Supervisory
incorporated into the written risk assessment. Activities
The supervisory plan forms a bridge between
the institution’s risk assessment, which identi-
Preparation of the Risk Assessment fies significant risks and supervisory concerns,
and the supervisory activities to be conducted.
A written risk assessment is used as an internal In developing the supervisory plan and exami-
supervisory planning tool and to facilitate com- nation schedule, the central point of contact
munication with other supervisors. The goal is should minimize disruption to the institution
to develop a document that presents a compre- and, whenever possible, avoid duplicative
hensive, risk-focused view of the institution, examination efforts and requesting similar infor-
delineating the areas of supervisory concern and mation from the other supervisors.

Page 15
The institution’s organizational structure and • coordinating examinations of different

complexity are significant considerations when disciplines;
planning the specific supervisory activities to be • determining compliance with, or the potential
conducted. Additionally, interstate banking and for, supervisory action;
branching activities have implications for plan- • balancing mandated requirements with the
ning on-site and off-site review. The scope and objectives of the plan;
location of on-site work for interstate banking • providing general logistical information (for
operations will depend upon the significance exammple, a timetable of supervisory activi-
and risk profile of local operations, the location ties, the participants, and expected resource
of the supervised entity’s major functions, and requirements); and
the degree of its centralization. The bulk of • assessing the extent to which internal and
safety-and-soundness examinations for branches external audit, internal loan review, compli-
of an interstate bank would likely be conducted ance, and other risk-management systems will
at the head office or regional offices, supple- be tested and relied upon.
mented by periodic reviews of branch opera-
tions and internal controls. The supervisory plan Generally, the planning horizon to be covered
should reflect the need to coordinate these is 18 months for domestic institutions.8 The
reviews of branch operations with other overall supervisory objectives and basic frame-
supervisors. work need to be outlined by midyear to facilitate
preliminary discussions with other supervisors
and to coincide with planning for the Federal
Preparation of the Supervisory Plan Reserve’s annual scheduling conferences. The
plan should be finalized by the end of the year,
A comprehensive supervisory plan should be for execution in the following year.
developed annually, and reviewed and revised at
least quarterly to reflect any significant new
information or emerging banking trends or risks.
The supervisory plan and any revisions should
Preparation of the Examination Program
be periodically discussed with representatives of
the principal regulators of major affiliates to The examination program should provide a
reconfirm their agreement on the overall plan for comprehensive schedule of examination activi-
coordinating its implementation, when warranted. ties for the entire organization and aid in the
The plan should demonstrate that both the coordination and communication of responsibili-
supervisory concerns identified through the risk- ties for supervisory activities. An examination
assessment process and the deficiencies noted in program provides a comprehensive listing of all
the previous examination are being or will be examination activities to be conducted at an
addressed. To the extent that the institution’s institution for the given planning horizon. To
risk-management systems are adequate, the level prepare a complete examination program and
of supervisory activity may be adjusted. The reflect the institution’s current conditions and
plan should generally address all supervisory activities, and the activities of other supervisors,
activities to be conducted, the scope of those the central point of contact needs to be the focal
activities (full or targeted), the objectives of point for communications on a particular insti-
those activities (for example, review of specific tution. The role includes any communications
business lines, products, support functions, legal with the Federal Reserve, the institution’s man-
entities), and specific concerns regarding those agement, and other supervisors. The examina-
activities, if any. Consideration should be given tion program generally incorporates the follow-
to— ing logistical elements:
• prioritizing supervisory resources on areas of • a schedule of activities, period, and resource
higher risk; estimates for planned projects
• pooling examiner resources to reduce the
regulatory burden on institutions as well as
examination redundancies; 8. The examination plans and assessments of condition of
• maximizing the use of examiners who are U.S. operations that are used for FBO supervision use a
located where the activity is being conducted; 12-month period.

Page 16
• an identification of the agencies conducting • a statement of the objectives;

and participating in the supervisory activity • an overview of the activities and risks to be
(when there are joint supervisors, indicate the evaluated;
lead agency and the agency responsible for a
• the level of reliance on internal risk-
particular activity) and resources committed
management systems and internal or external
by all participants to the area(s) under review
audit findings;
• the planned product for communicating find-
ings (indicate whether it will be a formal • a description of the procedures that are to be
report or supervisory memorandum) performed, indicating any sampling process to
• the need for special examiner skills and the be used and the level of transaction testing,
extent of participation of individuals from when appropriate;
specialty functions • identification of the procedures that are
expected to be performed off-site; and
• a description of how the findings of targeted
reviews, if any, will be used on the current
Defining Examination Activities examination.
Scope Memorandum
The scope memorandum is an integral product
in the risk-focused methodology because it iden- Entry Letter
tifies the key objectives of the on-site examina-
tion. The focus of on-site examination activities, The entry letter should be tailored to fit the
identified in the scope memorandum, follow a specific character and profile of the institution to
top-down approach that includes a review of the be examined and the scope of the activities to be
organization’s internal risk-management sys- performed. Thus, effective use of entry letters
tems and an appropriate level of transaction depends on the planning and scoping of a
testing. The risk-focused methodology is flex- risk-focused examination. To eliminate duplica-
ible regarding the amount of on-site transaction tion and minimize the regulatory burden on an
testing used. Although the focus of the exami- institution, entry letters should not request
nation is on the institution’s processes, an information that is regularly provided to desig-
appropriate level of transaction testing and asset nated central points of contact or that is avail-
review will be necessary to verify the integrity able within each Federal Reserve Bank. When
of internal systems. needed for examinations of larger or more
After the areas to be reviewed have been complex organizations, the entry letter should
identified in the supervisory plan, a scope memo- be supplemented by requests for information on
randum should be prepared that documents spe- specialty activities. The specific items selected
cific objectives for the projected examinations. for inclusion in the entry letter should meet the
This document is of key importance, as the following guidelines:
scope of the examination will likely vary from
year to year. Thus, it is necessary to identify the • reflect risk-focused supervision objectives and
specific areas chosen for review and the extent the examination scope
of those reviews. The scope memorandum will • facilitate efficiency in the examination process
help ensure that the supervisory plan for the and lessen the burden on financial institutions
institution is executed and will communicate the • limit, to the extent possible, requests for
specific examination objectives to the examina- special management reports
tion staff.
• eliminate items used for audit-type procedures
The scope memorandum should be tailored to (for example, verifications)
the size, complexity, and current rating of the
institution subject to review. For large but less- • distinguish between information to be mailed
complex institutions, the scope memorandum to the examiner-in-charge for off-site exami-
may be combined with the supervisory plan or nation procedures and information to be held
the risk assessment. The scope memorandum at the institution for on-site procedures
should define the objectives of the examination, • allow management sufficient lead time to
and generally should include— prepare the requested information

Page 17
Examination Procedures • retail banking activities

• payments system risk
Examination procedures should be tailored to
the characteristics of each institution, keeping in
mind size, complexity, and risk profile. They Reporting the Findings
should focus on developing appropriate docu-
mentation to adequately assess management’s At least annually, a comprehensive summary
ability to identify, measure, monitor, and control supervisory report should be prepared that sup-
risks. Procedures should be completed to the ports the organization’s assigned ratings and
degree necessary to determine whether the encompasses the results of the entire supervi-
institution’s management understands and sory cycle. This report should (1) convey the
adequately controls the levels and types of risks Federal Reserve’s view of the condition of the
that are assumed. For transaction testing, the organization and its key risk-management pro-
volume of loans to be tested should be adjusted cesses, (2) communicate the composite supervi-
according to management’s ability to accurately sory ratings, (3) discuss each of the major
identify problems and potential problem credits business risks, (4) summarize the supervisory
and to measure, monitor, and control the insti- activities conducted during the supervisory cycle
tution’s exposure to overall credit risk. Like- and the resulting findings, and (5) assess the
wise, the level of transaction testing for compli- effectiveness of any corrective actions taken by
ance with laws and regulations should take into the organization. This report will satisfy super-
account the effectiveness of management sys- visory and legal requirements for a full-scope
tems to monitor, evaluate, and ensure compli- examination. Reserve Bank management, as
ance with applicable laws and regulations. well as Board officials, when warranted, will
During the supervisory cycle, the 10 func- meet with the organization’s board of directors
tional areas listed below will be evaluated in to present and discuss the contents of the report
most full-scope examinations. To evaluate these and the Federal Reserve’s assessment of the
functional areas, procedures need to be tailored condition of the organization. (See SR-99-15.)
to fit the risk assessment that was prepared for
the institution and the scope memorandum that
was prepared for the examination. These func-
tional areas represent the primary business Minimum Timing Standards for
activities and functions of large complex insti- Examination Report Completion
tutions as well as common sources of significant
risk to them. Additionally, other areas of signifi- Examination reports issued by the Federal
cant sources of risk to an institution or areas that Reserve must be completed and filed within a
are central to the examination assignment will maximum of 60 calendar days, commencing
need to be evaluated. The functional areas with the day following the examiner’s exit
include the following: meeting. This standard applies to reports for all
banks, regardless of the complexity of the orga-
• loan portfolio analysis nization. Additionally, for instructions with a
• Treasury activities CAMELS composite rating of 3, 4, or 5, Reserve
• trading and capital-markets activities Banks are encouraged to adopt an internal target
• internal controls and audit of 45 calendar days for processing and filing
• supervisory ratings reports. In cases where reports are issued jointly
• information systems with other agencies, this standard may be
• fiduciary activities extended at the discretion of senior management
• private banking at the Reserve Bank. (See SR-93-4.)

Page 18
Internal Control and Audit Function,
Oversight, and Outsourcing
This section sets forth the principal aspects of process: control environment, risk assessment,
effective internal control and audit and discusses control activities, information and communica-
some pertinent points relative to the internal tion, and monitoring activities. The effective
control questionnaires (ICQs). It assists the functioning of these components, which is
examiner in understanding and evaluating the brought about by an institution’s board of direc-
objectives of and the work performed by inter- tors, management, and other personnel, is essen-
nal and external auditors. It also sets forth the tial to achieving the internal control objectives.
general criteria the examiner should consider to This description of internal control is consistent
determine if the work of internal and external with the Committee of Sponsoring Organiza-
auditors can be relied on in the performance of tions of the Treadway Commission (COSO)
the examination. To the extent that audit records report Internal Control—Integrated Framework.
can be relied on, they should be used to com- In addition, under the COSO framework, finan-
plete the ICQs implemented during the exami- cial reporting is defined in terms of published
nation. In most cases, only those questions not financial statements, which, for these purposes,
fully supported by audit records would require encompass financial statements prepared in
the examiner to perform a detailed review of the accordance with generally accepted accounting
area in question. principles and regulatory reports (such as the
Effective internal control is a foundation for Reports of Condition and Income). Institutions
the safe and sound operation of a financial are encouraged to evaluate their internal control
institution. The board of directors and senior against the COSO framework.
managers of an institution are responsible for
ensuring that the system of internal control is
effective. Their responsibility cannot be del-
egated to others within or outside the organiza- AUDIT COMMITTEE OVERSIGHT
tion. An internal audit function is an important
element of an effective system of internal con- Internal and external auditors will not feel free
trol. When properly structured and conducted, to assess the bank’s operations if their indepen-
internal audit provides directors and senior man- dence is compromised. This can sometimes
agement with vital information about the condi- happen when internal and external auditors
tion of the system of internal control, and it report solely to senior management instead of to
identifies weaknesses so that management can the board of directors.
take prompt, remedial action. Examiners are to
The independence of internal and external
review an institution’s internal audit function
auditors is increased when they report to an
and recommend improvements if needed. In
independent audit committee (one made up of
addition, under the Interagency Guidelines
external directors who are not members of the
Establishing Standards for Safety and Sound-
bank’s management). The auditors’ indepen-
ness,1 pursuant to section 39 of the Federal
dence is enhanced when the audit committee
Deposit Insurance Act (FDI Act) (12 USC
takes an active role in approving the internal and
1831p-1), each institution is required to have an
external audit scope and plan.
internal audit function that is appropriate to its
size and the nature and scope of its activities. The role of the independent audit committee
In summary, internal control is a process is growing in importance. The audit commit-
designed to provide reasonable assurance that tee’s duties may include (1) overseeing the
the institution will achieve the following objec- internal audit function; (2) approving or recom-
tives: efficient and effective operations, includ- mending the appointment of external auditors
ing safeguarding of assets; reliable financial and the scope of external audits and other
reporting; and compliance with applicable laws services; (3) providing the opportunity for audi-
and regulations. Internal control consists of five tors to meet and discuss findings apart from
components that are a part of the management management; (4) reviewing with management
and external auditors the year-end financial
1. For state member banks, see appendix D-1 to 12 CFR statements; and (5) meeting with regulatory
208. authorities.

Page 1
1010.1 Internal Control and Audit Function, Oversight, and Outsourcing
Public Company Accounting and remain appropriate in light of the organiza-

Oversight Board tion’s size, operations, and resources. Further-
more, a banking organization’s policies and
The Sarbanes-Oxley Act of 2002 (the act) procedures for corporate governance, internal
became law on July 30, 2002 (Pub. L. No. controls, and auditing will be assessed during
107-204). The act addresses weaknesses in cor- the supervisory process, and supervisory action
porate governance and the accounting and may be taken if there are deficiencies or weak-
auditing professions and includes provisions nesses in these areas that are inconsistent with
addressing audits, financial reporting and disclo- sound corporate-governance practices or safety-
sure, conflicts of interest, and corporate gover- and-soundness considerations.
nance at publicly owned companies. The act,
among other things, requires public companies
to have an audit committee made entirely of DISCIPLINARY ACTIONS
independent directors. Publicly owned banking AGAINST ACCOUNTANTS AND
organizations that are listed on the New York ACCOUNTING FIRMS
Stock Exchange (NYSE) and Nasdaq must
also comply with those exchanges’ listing
PERFORMING CERTAIN AUDIT
requirements, which include audit committee SERVICES
requirements.
The act also established a Public Company Section 36 of the Federal Deposit Insurance Act
Accounting Oversight Board (PCAOB) that has (the FDI Act) authorizes the federal bank and
the authority to set and enforce auditing, attes- thrift regulatory agencies (the agencies)3 to take
tation, quality-control, and ethics (including disciplinary actions against independent public
independence) standards for auditors of public accountants and accounting firms that perform
companies (subject to Securities and Exchange audit services covered by the act’s provisions.
Commission (SEC) review). (See SR-02-20.) Section 36, as implemented by part 363 of the
Accounting firms that conduct audits of public FDIC’s rules (12 CFR 363), requires that each
companies (registered accounting firms) must federally insured depository institution with total
register with the PCAOB and be subject to its assets of $500 million or more obtain an audit of
supervision. The PCAOB is also empowered to its financial statements and a management re-
inspect the auditing operations of public account- port. Institutions with assets of $1 billion or
ing firms that audit public companies as well as more must provide an attestation on manage-
impose disciplinary and remedial sanctions for ment’s assertions concerning internal controls
violations of its rules, securities laws, and pro- over financial reporting that is performed by an
fessional auditing and accounting standards. independent public accountant (the accountant).
(See www.pcaobus.org.) The respective insured depository institution
In May 2003, the Federal Reserve, the Office must include the accountant’s audit and attesta-
of the Comptroller of the Currency, and the tion reports in its annual report, as required. See
Office of Thrift Supervision announced that they the section on ‘‘Legal Requirements Affecting
did not expect to take actions to apply the Banks and the Audit Function.’’
corporate-governance and other requirements of The agencies amended their rules, pursuant to
the Sarbanes-Oxley Act generally to nonpublic section 36, that set forth the practices and pro-
banking organizations that are not otherwise cedures to implement their authority to remove,
subject to them.2 (See SR-03-08.) Nonpublic suspend, or debar, for good cause, 3a an accoun-
banking organizations are encouraged to peri- tant or firm from performing audit and attesta-
odically review their policies and procedures
relating to corporate-governance and auditing
3. The Board of Governors of the Federal Reserve System,
matters. This review should ensure that such the Office of the Comptroller of the Currency, the Federal
policies and procedures are consistent with appli- Deposit Insurance Corporation, and the Office of Thrift
cable law, regulations, and supervisory guidance Supervision. The Board approved its rules on August 6, 2003
(press release of August 8, 2003). The rules became effective
October 1, 2003.
2. Some aspects of the auditor-independence rules estab- 3a. The rules provide that certain violations of law, negli-
lished by the Sarbanes-Oxley Act apply to all federally gent conduct, reckless violations of professional standards, or
insured depository institutions with $500 million or more in lack of qualifications to perform auditing services may be
total assets. See part 363 of the FDIC’s regulations. considered good cause.

Page 2
Internal Control and Audit Function, Oversight, and Outsourcing 1010.1
tion services for insured depository institutions of subjective judgment because attributes such
with assets of $500 million or more.3 b Immedi- as intelligence, knowledge, and attitude are
ate suspensions are permitted in limited circum- relevant. Thus, the examiner should be alert for
stances. Also, an accountant or accounting firm indications that employees have failed so sub-
is prohibited from performing audit services for stantially to perform their duties that a serious
the covered institution if an authorized agency question is raised concerning their abilities.
has taken such a disciplinary action against the
accountant or firm, or if the SEC or the PCAOB Independent performance. If employees who
has taken certain disciplinary action against the have access to assets also have access to the
accountant or firm. related accounting records or perform
The amended rules reflect the agencies’ related review operations (or immediately super-
increasing concern about the quality of audits vise the activities of other employees who main-
and internal controls for financial reporting at tain the records or perform the review opera-
insured depository institutions. The rules empha- tions), they may be able to both perpetrate and
size the importance of maintaining high quality conceal defalcations. Therefore, duties con-
in the audits of federally insured depository cerned with the custody of assets are incompat-
institutions’ financial position and in the attes- ible with recordkeeping duties for those assets,
tations of management assessments. and duties concerned with the performance of
activities are incompatible with the authoriza-
tion or review of those activities.
OBJECTIVES OF INTERNAL In judging the independence of a person, the
CONTROL examiner must avoid looking at that person as
an individual and presuming the way in which
In general, good internal control exists when no that individual would respond in a given situa-
one is in a position to make significant errors or tion. For example, an individual may be the sole
perpetrate significant irregularities without timely check signer and an assistant may prepare
detection. Therefore, a system of internal con- monthly bank reconcilement. If the assistant
trol should include those procedures necessary appears to be a competent person, it may seem
to ensure timely detection of failure of account- that an independent reconcilement would be
ability, and such procedures should be per- performed and anything amiss would be
formed by competent persons who have no reported. Such judgments are potentially erro-
incompatible duties. The following standards neous. There exist no established tests by which
are encompassed within the description of inter- the psychological and economic independence
nal control: of an individual in a given situation can be
judged. The position must be evaluated, not the
Existence of procedures. Existence of prescribed person. If the position in which the person acts
internal control procedures is necessary but not is not an independent one in itself, then the work
sufficient for effective internal control. Pre- should not be presumed to be independent,
scribed procedures that are not actually per- regardless of the apparent competence of the
formed do nothing to establish control. Conse- person in question. In the example cited above,
quently, the examiner must give thoughtful the function performed by the assistant should
attention not only to the prescribed set of pro- be viewed as if it were performed by the
cedures but also to the practices actually fol- supervisor. Hence, incompatible duties are
lowed. This attention can be accomplished present in that situation.
through inquiry, observation, testing, or a com-
bination thereof.
Competent performance. For internal control to PROCEDURES FOR COMPLETING

be effective, the required procedures must be ICQs
performed by competent persons. Evaluation of
competence undoubtedly requires some degree The implementation of selected ICQs and the
evaluation of internal audit activities provide a
3b. See the Federal Reserve’s rules on disciplinary actions
basis for determining the adequacy of the bank’s
against public accountants and accounting firms at 12 CFR control environment. To reach conclusions
263.94 and 12 CFR 263, subpart J. required by the questionnaires, the examiner

Page 3
assigned to review a given internal control develop a plan to obtain the necessary informa-
routine or area of bank operations should use any tion efficiently. Such a plan would normally
source of information necessary to ensure a full avoid a direct question-and-answer session with
understanding of the prescribed system, includ- bank officers. A suggested approach to comple-
ing any potential weaknesses. Only when the tion of the ICQ is to—
examiner completely understands the bank’s
system can an assessment and evaluation be • become familiar with the ICQ,
made of the effects of internal controls on the • review related internal audit procedures,
examination. reports, and responses,
To reach conclusions concerning a specific • review any written documentation of a bank’s
section of an ICQ, the examiner should document system of controls,
and review the bank’s operating systems and • find out what the department does and what
procedures by consulting all available sources of the functions of personnel within the depart-
information and discussing them with appropri- ment are through conversations with appropri-
ate bank personnel. Sources of information might ate individuals, and
include organization charts, procedural manuals, • answer as many individual questions as pos-
operating instructions, job specifications, direc- sible from information gained in the preceding
tives to employees, and other similar sources of steps and fill in the remaining questions by
information. Also, the examiner should not direct inquiry.
overlook potential sources such as job descrip-
tions, flow charts, and other documentation in the An effective way to begin an on-site review of
internal audit workpapers. A primary objective in internal control is to identify the various key
the review of the system is to efficiently reach a functions applicable to the area under review.
conclusion about the overall adequacy of existing For each position identified, the following ques-
controls. Any existing source of information that tions should then be asked:
will enable the examiner to quickly gain an
understanding of the procedures in effect should • Is this a critical position? That is, can a person
be used in order to minimize the time required to in this position either make a significant error
formulate the conclusions. The review should be that will affect the recording of transactions or
documented in an organized manner through the perpetrate material irregularities of some type?
use of narrative descriptions, flow charts, or other • If an error is made or an irregularity is
diagrams. If a system is properly docu- perpetrated, what is the probability that nor-
mented, the documentation will provide a ready mal routines will disclose it on a timely basis?
reference for any examiner performing work That is, what controls exist that would prevent
in the area, and it often may be carried forward or detect significant errors or the perpetration
for future examinations, which will save of significant irregularities?
time. • What are the specific opportunities open to the
Although narrative descriptions can often pro- individual to conceal any irregularity, and are
vide an adequate explanation of systems of there any mitigating controls that will reduce
internal control, especially in less complex situ- or eliminate these opportunities?
ations, they may have certain drawbacks, such
as the following: Although all employees within an organiza-
tion may be subject to control, not all have
• They may be cumbersome and too lengthy. financial responsibilities that can influence the
• They may be unclear or poorly written. accuracy of the accounting and financial records
• Related points may be difficult to integrate. or have access to assets. The examiner should be
• Annual changes may be awkward to record. primarily concerned with those positions that
have the ability to influence the records and that
To overcome these problems, the examiner have access to assets. Once those positions have
should consider using flow charts, which reduce been identified, the examiners must exercise
narrative descriptions to a picture. Flow charts their professional knowledge of bank operations
often reduce a complex situation to an easily to visualize the possibilities open to any person
understandable sequence of interrelated steps. holding a particular position. The question is not
In obtaining and substantiating the answers to whether the individual is honest, but rather
the questions in the ICQ, the examiner should whether situations exist that might permit an

Page 4
error to be concealed. By directing attention to asterisk to indicate that they require substantia-
such situations, an examiner will also consider tion through observation or testing. Those ques-
situations that may permit unintentional errors tions are deemed so critical that substantiation
to remain undetected. by inquiry is not sufficient. For those questions
The evaluation of internal control should substantiated through testing, the nature and
include consideration of other existing account- extent of the test performed should be indicated
ing and administrative controls or other circum- adjacent to the applicable step in the ICQ.
stances that might counteract or mitigate an The examiner should be alert for deviations
apparent weakness or impair an established by bank personnel from established policies,
control. Controls that mitigate an apparent weak- practices, and procedures. This applies not only
ness may be a formal part of the bank’s operat- to questions marked with an asterisk but also to
ing system, such as budget procedures that every question in the ICQ. Examples of such
include a careful comparison of budgeted and deviations include situations when (1) instruc-
actual amounts by competent management per- tions and directives are frequently not revised to
sonnel. Mitigating controls also may be infor- reflect current practices, (2) employees find
mal. For example, in small banks, management shortcuts for performing their tasks, (3) changes
may be sufficiently involved in daily operations in organization and activities may influence
to know the purpose and reasonableness of all operating procedures in unexpected ways, or
expense disbursements. That knowledge, coupled (4) employees’ duties may be rotated in ways
with the responsibility for signing checks, may that have not been previously considered. These
make irregularities by nonmanagement person- and other circumstances may serve to modify or
nel unlikely, even if disbursements are other- otherwise change prescribed procedures, thus
wise under the control of only one person. giving the examiner an inadequate basis for
When reviewing internal controls, an essential evaluating internal control.
part of the examination is being alert to Sometimes, when a substantial portion of the
indications that adverse circumstances may exist. accounting work is accomplished by computer,
Adverse circumstances may lead employees or the procedures are so different from conven-
officers into courses of action they normally tional accounting methods that the principles
would not pursue. An adverse circumstance to discussed here seem inapplicable. Care should
which the examiner should be especially alert be taken to resist drawing this conclusion. This
exists when the personal financial interests of key discussion of internal control and its evaluation
officers or employees depend directly on oper- is purposely stated in terms sufficiently general
ating results or financial condition. Although the to apply to any system. Perpetration of defalca-
review of internal control does not place the tions requires direct or indirect access to appro-
examiner in the role of an investigator or priate documents or accounting records. As
detective, an alert attitude toward possible such, perpetration requires the involvement of
conflicts of interest should be maintained people and, under any system, computerized or
throughout the examination. Also, offices staffed not, there will be persons who have access to
by members of the same family, branches assets and records. Those with access may
completely dominated by a strong personality, or include computer operators, programmers, and
departments in which supervisors rely unduly on their supervisors and other related personnel.
their assis-tants require special alertness on the The final question in each section of the ICQ
part of the examiner. Those circumstances and requires a composite evaluation of existing
other similar ones should be considered in internal controls in the applicable area of the
preparing the ICQ. It is not the formality of the bank. The examiner should base that evaluation
particular factor that is of importance but rather on answers to the preceding questions within the
its effect on the overall operation under review. section, the review and observation of the sys-
Circumstances that may affect answers to the tems and controls within the bank, and discus-
basic questions should be noted along sion with appropriate bank personnel.
with conclusions concerning their effect on the The composite evaluation does, however,
examination. require some degree of subjective judgment.
The ICQs were designed so that answers The examiner should use all information avail-
could be substantiated by (1) inquiry to bank able to formulate an overall evaluation, fully
personnel, (2) observation, or (3) testing. How- realizing that a high degree of professional
ever, certain questions are marked with an judgment is required.

Page 5
Applying the ICQ to Different of a calendar quarter, the institution is to use the
Situations Call Report for the quarter end immediately
preceding the end of the fiscal year.
The ICQs are general enough to apply to a wide
range of systems, so not all sections or questions
will apply to every situation, depending on Institutions with $500 Million or
factors such as bank size, complexity and type More but Less Than $1 Billion in
of operations, and organizational structure. When
completing the ICQs, the examiner should
Total Assets
include a brief comment stating the reason a
The regulations require these institutions to file
section or question is not applicable to the
an annual report with the FDIC that must
specific situation.
include the following:
For large banking institutions or when mul-
tiple locations of a bank are being examined, it
• Audited comparative annual financial state-
may be necessary to design supplements to the
ments;
ICQs to adequately review all phases of the
• The independent public accountant’s report on
bank’s operations and related internal controls.
the audited financial statements;
Because certain functions described in this
• A management report (comprising its state-
manual may be performed by several depart-
ments and assessments) that is signed by the
ments in some banks, it also may be necessary to
chief executive officer and chief accounting or
redesign a particular section of the ICQ so that
chief financial officer. The report should
each department receives appropriate consider-
include:
ation. Conversely, functions described in several
— A statement of management’s responsibili-
different sections of this handbook may be
ties for:
performed in a single department in smaller
banks. If the ICQ is adapted to fit a specific • preparing the annual financial state-
situation, care should be taken to ensure that its ments;
scope and intent are not modified. That requires • establishing and maintaining an ad-
professional judgment in interpreting and expand- equate internal control structure over
ing the generalized material. Any such modifi- financial reporting;
cations should be completely documented and • complying with the laws and regulations
filed in the workpapers. relating to safety and soundness that are
designated by the FDIC and the appro-
priate federal banking agency; and
LEGAL REQUIREMENTS — An assessment by management of the
AFFECTING BANKS AND THE institution’s compliance with the desig-
AUDIT FUNCTION nated laws and regulations during the
fiscal year.
The Federal Deposit Insurance Corporation Im-
provement Act of 1991 amended section 36 of If the institution is a public company or a
the FDI Act (12 USC 1831m). Since then, the subsidiary of a public company that would be
FDIC has made various revisions to its rules at subject to the provisions of section 404 of the
Part 363 (12 CFR 363) and guidelines. When Sarbanes-Oxley Act (Section 404), it must
specific reports are required to be submitted to comply with the requirement to file other reports
the FDIC to comply with the provisions of issued by the independent accountant as set forth
compliance with Part 363, the institution must in section 363.4(c) (12 CFR 363.4(c)). The
also submit the report to the appropriate federal institutions must provide a copy of the indepen-
banking agency and any appropriate state dent accountant’s report to the FDIC on the audit
supervisor. of internal control over financial reporting that is
For the purposes of determining the applica- required by section 404 with the FDIC within 15
bility of this rule, an institution should use total days after receipt. The institutions also are
assets as reported on its most recent Report of encouraged to submit a copy of management’s
Condition (the Call Report), the date that coin- section 404 report on internal control over
cides with the end of the preceding fiscal year. If financial reporting together with the independent
the fiscal year ends on a date other than the end public accountant’s internal control report.

Page 6
Institutions with $1 Billion or More regulatory reporting purposes. Each institution

in Total Assets is to have an independent public accountant
perform an audit who reports on the institution’s
Section 36 of the FDI Act and Part 363 of the annual financial statements in accordance with
FDIC’s regulations required insured depository generally accepted auditing standards and sec-
institutions with a least $1 billion in total assets tion 37 of the FDI Act (12 USC 1831n). The
to file an annual report that must include the scope of the audit engagement must be sufficient
following: to permit the accountant to determine and report
whether the financial statements are presented
• Audited comparative annual financial state- fairly and in accordance with generally accepted
ments; accounting principles. The audit is to be per-
formed using procedures that will objectively
• The independent public accountant’s report on
determine the accuracy of management’s asser-
the audited financial statements;
tions on compliance with safety-and-soundness
• A management report that contains: laws and regulations (12 USC 1831m
— A statement of management’s responsibili- (b)(2)(A)(iii)),
ties for: Each institution must file with the FDIC two
• Preparing the annual financial statements; copies of the annual report within 90 days after
• Establishing and maintaining an ad- the end of its fiscal year. Notwithstanding the
equate internal control structure over 90-day filing period, each institution must file a
financial reporting; copy of each audit and attestation report issued
• Complying with the laws and regula- by its independent accountant within 15 days of
tions relating to safety and soundness their receipt.
that are designated by the FDIC and the In addition, each institution is required to file
appropriate federal banking agency; and a copy of any management letter, qualification,
— Assessments by management of: or any other report issued by its independent
• the effectiveness of the institution’s public accountant with the FDIC within 15 days
internal control structure and procedures of receipt of such letter or report. See section
over financial reporting as of the end of 363.4(c) (12 CFR 363.4(c)).
the fiscal year (12 USC Each institution is required to establish an
1831m(b)(2)(B)(i); and audit committee of its board of directors. The
• the institution’s compliance with safety duties of the audit committee include reviewing
and soundness laws and regulations dur- with management and the independent public
ing the year (12 USC 1831n(b)(2)(B)(ii)); accountant the basis for, and the results of, the
and annual independent audit reports and the insti-
• The independent public accountant’s attesta- tution’s respective reporting requirements. Each
tion report—the independent public accoun- institution with total assets of $1 billion or more,
tant is to examine, attest to, and report sepa- as of the beginning of the fiscal year, is required
rately in an attestation report, on the assertions to have an audit committee, the members of
by management’s concerning the institution’s which must be outside directors who are inde-
internal control structure and procedures for pendent of the institution’s management. Insti-
financial reporting (12 USC 1831m(c)). The tutions with total assets of $500 million, but less
attestation is to be made in accordance with than $1 billion or more, as of the beginning of
generally accepted standards for attestation the fiscal year, must have an audit committee,
engagements. the members of which are outside directors, the
majority of whom must be independent of the
institution’s management.
For insured institutions having total assets of
Other Requirements—Institutions with more than $3 billion, the audit committee must
$500 Million or More in Total Assets (1) have members with banking or related finan-
cial management expertise, (2) have access to
Financial reporting encompasses, for the pur- outside legal counsel, and (3) not include any
poses of Part 363, both financial statements large customers of the institution. The audit
prepared in accordance with generally accepted committee also may be required to satisfy other
accounting principles and those prepared for audit committee membership criteria (12 USC

Page 6.1
831m (g)(1)(c)) and section 363.5(b) (12 CFR vices’’ (hereafter collectively referred to as out-
363.5(b)). sourcing). Typical outsourcing arrangements are
Any covered institution with a composite more fully described below.
CAMELS rating of 1 or 2 may file the two Outsourcing may be beneficial to an institu-
above-mentioned reports through its parent hold- tion if it is properly structured, carefully con-
ing company on a consolidated basis. The Guide- ducted, and prudently managed. However, the
lines and Interpretations (appendix A to Part structure, scope, and management of some
363) provide that one of the duties of a covered internal audit outsourcing arrangements may not
institution’s audit committee should include contribute to the institution’s safety and sound-
oversight of the internal audit function and its ness. Furthermore, arrangements with outsourc-
operations. (See SR-96-4.) ing vendors should not leave directors and
senior management with the erroneous impres-
sion that they have been relieved of their respon-
INTERAGENCY POLICY sibility for maintaining an effective system of
STATEMENT ON THE INTERNAL internal control and for overseeing the internal
AUDIT FUNCTION AND ITS audit function.
OUTSOURCING
The Federal Reserve and other federal banking
agencies3 c (the agencies) adopted on March 17,
Internal Audit Function (Part I)
2003, an interagency policy statement address-
ing the internal audit function and its outsourc- Board and Senior Management
ing. The policy statement revises and replaces Responsibilities
the former 1997 policy statement and incorpo-
rates recent developments in internal auditing. The board of directors and senior management
In addition, the revised policy incorporates guid-
ance on the independence of accountants who
provide institutions with both internal and
external audit services in light of the Sarbanes-
Oxley Act of 2002 (the act) and associated SEC
rules.
The act prohibits an accounting firm from
acting as the external auditor of a public com-
pany during the same period that the firm
provides internal audit services to the company.
The policy statement discusses the applicability
of this prohibition to institutions that are public
companies, to insured depository institutions
with assets of $500 million or more that are
subject to the annual audit and reporting require-
ments of section 36 of the FDI Act, and to
nonpublic institutions that are not subject to
section 36.
The statement recognizes that many institu-
tions have engaged independent public account-
ing firms and other outside professionals (out-
sourcing vendors) to perform work that
traditionally has been done by internal auditors.
These arrangements are often called ‘‘internal
audit outsourcing,’’ ‘‘internal audit assistance,’’
‘‘audit co-sourcing,’’ and ‘‘extended audit ser-
3c. The Board of Governors of the Federal Reserve Sys-

tem, the Federal Deposit Insurance Corporation, the Office of
the Comptroller of the Currency, and the Office of Thrift
Supervision.

Page 6.2
are responsible for having an effective system of audit function addresses the risks of and meets
internal control and an effective internal audit the demands posed by the institution’s current
function in place at their institution. They are and planned activities. To accomplish this
also responsible for ensuring that the importance objective, directors should consider whether
of internal control is understood and respected their institution’s internal audit activities are
throughout the institution. This overall respon- conducted in accordance with professional stan-
sibility cannot be delegated to anyone else. They dards, such as the Institute of Internal Auditors’
may, however, delegate the design, implementa- (IIA) Standards for the Professional Practice of
tion, and monitoring of specific internal controls Internal Auditing. These standards address inde-
to lower-level management and delegate the pendence, professional proficiency, scope of
testing and assessment of internal controls to work, performance of audit work, management
others. Accordingly, directors and senior man- of internal audit, and quality-assurance reviews.
agement should have reasonable assurance that Furthermore, directors and senior management
the system of internal control prevents or detects should ensure that the following matters are
significant inaccurate, incomplete, or unautho- reflected in their institution’s internal audit
rized transactions; deficiencies in the safeguard- function.
ing of assets; unreliable financial reporting
(which includes regulatory reporting); and Structure. Careful thought should be given to
deviations from laws, regulations, and the insti- the placement of the audit function in the
tution’s policies.4 institution’s management structure. The internal
Some institutions have chosen to rely on audit function should be positioned so that the
so-called management self-assessments or con- board has confidence that the internal audit
trol self-assessments, wherein business-line man- function will perform its duties with impartiality
agers and their staff evaluate the performance of and not be unduly influenced by managers of
internal controls within their purview. Such day-to-day operations. The audit committee,5
reviews help to underscore management’s using objective criteria it has established, should
responsibility for internal control, but they are oversee the internal audit function and evaluate
not impartial. Directors and members of senior its performance.6 The audit committee should
management who rely too much on these reviews assign responsibility for the internal audit func-
may not learn of control weaknesses until they tion to a member of management (that is, the
have become costly problems, particularly if manager of internal audit or internal audit man-
directors are not intimately familiar with the ager) who understands the function and has no
institution’s operations. Therefore, institutions responsibility for operating the system of inter-
generally should also have their internal controls nal control. The ideal organizational arrange-
tested and evaluated by units without business- ment is for this manager to report directly and
line responsibilities, such as internal audit solely to the audit committee regarding both
groups. audit issues and administrative matters, for exam-
Directors should be confident that the internal ple, resources, budget, appraisals, and compen-
sation. Institutions are encouraged to consider
the IIA’s Practice Advisory 2060-2: Relation-
4. As noted above, under section 36 of the FDI Act, as
implemented by part 363 of the FDIC’s regulations (12 CFR
363), FDIC-insured depository institutions with total assets of 5. Depository institutions subject to section 36 of the FDI
$500 million or more must submit an annual management Act and part 363 of the FDIC’s regulations must maintain
report signed by the chief executive officer (CEO) and chief independent audit committees (i.e., consisting of directors
accounting or chief financial officer. This report must contain who are not members of management). Consistent with the
(1) a statement of management’s responsibilities for preparing 1999 Interagency Policy Statement on External Auditing
the institution’s annual financial statements, for establishing Programs of Banks and Savings Associations, the agencies
and maintaining an adequate internal control structure and also encourage the board of directors of each depository
procedures for financial reporting, and for complying with institution that is not otherwise required to do so to establish
designated laws and regulations relating to safety and sound- an audit committee consisting entirely of outside directors.
ness, including management’s assessment of the institution’s Where the term audit committee is used in this policy
compliance with those laws and regulations, and (2) for an statement, the board of directors may fulfill the audit commit-
institution with total assets of $1 billion or more at the tee responsibilities if the institution is not subject to an audit
beginning of the institution’s most recent fiscal year, an committee requirement. See Fed. Reg., September 28, 1999
assessment by management of the effectiveness of such (64 FR 52,319).
internal control structure and procedures as of the end of such 6. For example, the performance criteria could include the
fiscal year. (See 12 CFR 363.2(b) and 70 Fed. Reg. 71,232, timeliness of each completed audit, a comparison of overall
Nov. 28, 2005.) performance to plan, and other measures.

Page 7
ship with the Audit Committee, which provides monitoring functions.

more guidance on the roles and relationships In structuring the reporting hierarchy, the
between the audit committee and the internal board should weigh the risk of diminished
audit manager. independence against the benefit of reduced
Many institutions place the manager of inter- administrative burden in adopting a dual report-
nal audit under a dual reporting arrangement: ing organizational structure. The audit commit-
the manager is functionally accountable to the tee should document its consideration of this
audit committee on issues discovered by the risk and mitigating controls. The IIA’s Practice
internal audit function, while reporting to another Advisory 1110-2: Chief Audit Executive Report-
senior manager on administrative matters. Under ing Lines provides additional guidance regard-
a dual reporting relationship, the board should ing functional and administrative reporting lines.
consider the potential for diminished objectivity
on the part of the internal audit manager with Management, staffing, and audit quality. In
respect to audits concerning the executive to managing the internal audit function, the man-
whom he or she reports. For example, a manager ager of internal audit is responsible for control
of internal audit who reports to the chief finan- risk assessments, audit plans, audit programs,
cial officer (CFO) for performance appraisal, and audit reports.
salary, and approval of department budgets may
approach audits of the accounting and treasury • A control risk assessment (or risk-assessment
operations controlled by the CFO with less methodology) documents the internal audi-
objectivity than if the manager were to report to tor’s understanding of the institution’s signifi-
the chief executive officer. Thus, the chief finan- cant business activities and their associated
cial officer, controller, or other similar officer risks. These assessments typically analyze the
should ideally be excluded from overseeing the risks inherent in a given business line, the
internal audit activities even in a dual role. The mitigating control processes, and the resulting
objectivity and organizational stature of the residual risk exposure of the institution. They
internal audit function are best served under should be updated regularly to reflect changes
such a dual arrangement if the internal audit to the system of internal control or work
manager reports administratively to the CEO. processes and to incorporate new lines of
Some institutions seek to coordinate the business.
internal audit function with several risk- • An internal audit plan is based on the control
monitoring functions (for example, loan-review, risk assessment and typically includes a sum-
market-risk-assessment, and legal compliance mary of key internal controls within each
departments) by establishing an administrative significant business activity, the timing and
arrangement under one senior executive. Coor- frequency of planned internal audit work, and
dination of these other monitoring activities a resource budget.
with the internal audit function can facilitate the • An internal audit program describes the
reporting of material risk and control issues to objectives of the audit work and lists the
the audit committee, increase the overall effec- procedures that will be performed during each
tiveness of these monitoring functions, better internal audit review.
utilize available resources, and enhance the • An audit report generally presents the pur-
institution’s ability to comprehensively manage pose, scope, and results of the audit, including
risk. Such an administrative reporting relation- findings, conclusions, and recommendations.
ship should be designed so as to not interfere Workpapers that document the work per-
with or hinder the manager of internal audit’s formed and support the audit report should be
functional reporting to and ability to directly maintained.
communicate with the institution’s audit com-
mittee. In addition, the audit committee should Ideally, the internal audit function’s only role
ensure that efforts to coordinate these monitor- should be to independently and objectively
ing functions do not result in the manager of evaluate and report on the effectiveness of an
internal audit conducting control activities nor institution’s risk-management, control, and gov-
diminish his or her independence with respect to ernance processes. Internal auditors increasingly
the other risk-monitoring functions. Further- have taken a consulting role within institutions
more, the internal audit manager should have on new products and services and on mergers,
the ability to independently audit these other acquisitions, and other corporate reorganiza-

Page 8
tions. This role typically includes helping design

controls and participating in the implementation
of changes to the institution’s control activities.
The audit committee, in its oversight of the
internal audit staff, should ensure that the func-
tion’s consulting activities do not interfere or
conflict with the objectivity it should have with
respect to monitoring the institution’s system of
internal control. In order to maintain its inde-

Page 8.1
pendence, the internal audit function should not munications and critical examination of issues
assume a business-line management role over to better understand the importance and severity
control activities, such as approving or imple- of internal control weaknesses identified by the
menting operating policies or procedures, includ- internal auditor and operating management’s
ing those it has helped design in connection with solutions to these weaknesses. Internal auditors
its consulting activities. The agencies encourage should report internal control deficiencies to the
internal auditors to follow the IIA’s standards, appropriate level of management as soon as they
including guidance related to the internal audit are identified. Significant matters should be
function acting in an advisory capacity. promptly reported directly to the board of direc-
The internal audit function should be compe- tors (or its audit committee) and senior manage-
tently supervised and staffed by people with ment. In periodic meetings with management
sufficient expertise and resources to identify the and the manager of internal audit, the audit
risks inherent in the institution’s operations and committee should assess whether management
assess whether internal controls are effective. is expeditiously resolving internal control weak-
The manager of internal audit should oversee nesses and other exceptions. Moreover, the audit
the staff assigned to perform the internal audit committee should give the manager of internal
work and should establish policies and proce- audit the opportunity to discuss his or her
dures to guide the audit staff. The form and findings without management being present.
content of these policies and procedures should Furthermore, each audit committee should
be consistent with the size and complexity of the establish and maintain procedures for employ-
department and the institution. Many policies ees of their institution to confidentially and
and procedures may be communicated infor- anonymously submit concerns to the committee
mally in small internal audit departments, while about questionable accounting, internal account-
larger departments would normally require more ing control, or auditing matters.8 In addition, the
formal and comprehensive written guidance. audit committee should set up procedures for the
timely investigation of complaints received and
Scope. The frequency and extent of internal the retention for a reasonable time period of
audit review and testing should be consistent documentation concerning the complaint and its
with the nature, complexity, and risk of the subsequent resolution.
institution’s on- and off-balance-sheet activities.
At least annually, the audit committee should Contingency planning. As with any other func-
review and approve internal audit’s control risk tion, the institution should have a contingency
assessment and the scope of the audit plan, plan to mitigate any significant discontinuity in
including how much the manager relies on the audit coverage, particularly for high-risk areas.
work of an outsourcing vendor. It should also Lack of contingency planning for continuing
periodically review internal audit’s adherence to internal audit coverage may increase the insti-
the audit plan. The audit committee should tution’s level of operational risk.
consider requests for expansion of basic internal
audit work when significant issues arise or when
significant changes occur in the institution’s Small Financial Institution’s Internal
environment, structure, activities, risk expo- Audit Function
sures, or systems.7
An effective system of internal control and an
Communication. To properly carry out their independent internal audit function form the
responsibility for internal control, directors and foundation for safe and sound operations,
senior management should foster forthright com- regardless of an institution’s size. Each institu-
tion should have an internal audit function that
7. Major changes in an institution’s environment and
conditions may compel changes to the internal control system is appropriate to its size and the nature and
and also warrant additional internal audit work. These changes scope of its activities. The procedures assigned
include (1) new management; (2) areas or activities experi- to this function should include adequate testing
encing rapid growth or rapid decline; (3) new lines of
business, products, or technologies or disposals thereof; (4) cor-
porate restructurings, mergers, and acquisitions; and (5) an
expansion or acquisition of foreign operations (including the 8. When the board of directors fulfills the audit committee
impact of changes in the related economic and regulatory responsibilities, the procedures should provide for the submis-
environments). sion of employee concerns to an outside director.

Page 9
and review of internal controls and information nal audit, and the outsourcing vendor reports to
systems. him or her. Institutions often use outsourcing
It is the responsibility of the audit committee vendors for audits of areas requiring more tech-
and management to carefully consider the extent nical expertise, such as electronic data process-
of auditing that will effectively monitor the ing and capital-markets activities. Such uses are
internal control system, after taking into account often referred to as ‘‘internal audit assistance’’
the internal audit function’s costs and benefits. or ‘‘audit co-sourcing.’’
For institutions that are large or have complex Some outsourcing arrangements may require
operations, the benefits derived from a full-time an outsourcing vendor to perform virtually all
manager of internal audit or an auditing staff the procedures or tests of the system of internal
likely outweigh the cost. For small institutions control. Under such an arrangement, a desig-
with few employees and less complex opera- nated manager of internal audit oversees the
tions, however, these costs may outweigh the activities of the outsourcing vendor and typi-
benefits. Nevertheless, a small institution with- cally is supported by internal audit staff. The
out an internal auditor can ensure that it main- outsourcing vendor may assist the audit staff in
tains an objective internal audit function by determining risks to be reviewed and may rec-
implementing a comprehensive set of indepen- ommend testing procedures, but the internal
dent reviews of significant internal controls. The audit manager is responsible for approving the
key characteristic of such reviews is that the audit scope, plan, and procedures to be per-
persons directing and/or performing the review formed. Furthermore, the internal audit manager
of internal controls are not also responsible for is responsible for the results of the outsourced
managing or operating those controls. A person audit work, including findings, conclusions, and
who is competent in evaluating a system of recommendations. The outsourcing vendor may
internal control should design the review proce- report these results jointly with the internal audit
dures and arrange for their implementation. The manager to the audit committee.
person responsible for reviewing the system of
internal control should report findings directly to
the audit committee. The audit committee should Additional Considerations for Internal
evaluate the findings and ensure that senior Audit Outsourcing Arrangements
management has or will take appropriate action
to correct the control deficiencies. Even when outsourcing vendors provide internal
audit services, the board of directors and senior
management of an institution are responsible for
ensuring that both the system of internal control
Internal Audit Outsourcing and the internal audit function operate effec-
Arrangements (Part II) tively. In any outsourced internal audit arrange-
ment, the institution’s board of directors and
Examples of Internal Audit Outsourcing senior management must maintain ownership of
Arrangements the internal audit function and provide active
oversight of outsourced activities. When nego-
An outsourcing arrangement is a contract tiating the outsourcing arrangement with an
between an institution and an outsourcing ven- outsourcing vendor, an institution should care-
dor to provide internal audit services. Outsourc- fully consider its current and anticipated busi-
ing arrangements take many forms and are used ness risks in setting each party’s internal audit
by institutions of all sizes. Some institutions responsibilities. The outsourcing arrangement
consider entering into these arrangements to should not increase the risk that a breakdown of
enhance the quality of their control environment internal control will go undetected.
by obtaining the services of a vendor with the To clearly distinguish its duties from those of
knowledge and skills to critically assess, and the outsourcing vendor, the institution should
recommend improvements to, their internal con- have a written contract, often taking the form of
trol systems. The internal audit services under an engagement letter.9 Contracts between the
contract can be limited to helping internal audit
staff in an assignment for which they lack 9. The engagement-letter provisions described are compa-
expertise. Such an arrangement is typically under rable to those outlined by the American Institute of Certified
the control of the institution’s manager of inter- Public Accountants (AICPA) for financial statement audits.

Page 10
institution and the vendor typically include pro- management or an employee and, if applica-
visions that— ble, will comply with AICPA, U.S. Securities
and Exchange Commission (SEC), PCAOB,
• define the expectations and responsibilities or regulatory independence guidance.
under the contract for both parties;
• set the scope and frequency of, and the fees to Vendor competence. Before entering an outsourc-
be paid for, the work to be performed by the ing arrangement, the institution should perform
vendor; due diligence to satisfy itself that the outsourc-
• set the responsibilities for providing and ing vendor has sufficient staff qualified to per-
receiving information, such as the type and form the contracted work. The staff’s qualifica-
frequency of reporting to senior management tions may be demonstrated, for example, through
and directors about the status of contract prior experience with financial institutions.
work; Because the outsourcing arrangement is a
• establish the process for changing the terms of personal-services contract, the institution’s
the service contract, especially for expansion internal audit manager should have confidence
of audit work if significant issues are found, in the competence of the staff assigned by the
and stipulations for default and termination of outsourcing vendor and receive timely notice of
the contract; key staffing changes. Throughout the outsourc-
• state that internal audit reports are the prop- ing arrangement, management should ensure
erty of the institution, that the institution will that the outsourcing vendor maintains sufficient
be provided with any copies of the related expertise to effectively perform its contractual
workpapers it deems necessary, and that obligations.
employees authorized by the institution will
have reasonable and timely access to the Management of the outsourced internal audit
workpapers prepared by the outsourcing function. Directors and senior management
vendor; should ensure that the outsourced internal audit
• specify the locations of internal audit reports function is competently managed. For example,
and the related workpapers; larger institutions should employ sufficient com-
• specify the period of time (for example, seven petent staff members in the internal audit depart-
years) that vendors must maintain the work- ment to assist the manager of internal audit in
papers;10 overseeing the outsourcing vendor. Small insti-
• state that outsourced internal audit services tutions that do not employ a full-time audit
provided by the vendor are subject to regula- manager should appoint a competent employee
tory review and that examiners will be granted who ideally has no managerial responsibility for
full and timely access to the internal audit the areas being audited to oversee the outsourc-
reports and related workpapers prepared by ing vendor’s performance under the contract.
the outsourcing vendor; This person should report directly to the audit
• prescribe a process (arbitration, mediation, or committee for purposes of communicating inter-
other means) for resolving disputes and for nal audit issues.
determining who bears the cost of consequen-
tial damages arising from errors, omissions, Communication when an outsourced internal
and negligence; and audit function exists. Communication between
• state that the outsourcing vendor will not the internal audit function and the audit com-
perform management functions, make man- mittee and senior management should not
agement decisions, or act or appear to act in a diminish because the institution engages an
capacity equivalent to that of a member of outsourcing vendor. All work by the outsourcing
vendor should be well documented and all
(See AICPA Professional Standards, AU section 310.) These findings of control weaknesses should be
provisions are consistent with the provisions customarily
included in contracts for other outsourcing arrangements, such
promptly reported to the institution’s manager
as those involving data processing and information technol- of internal audit. Decisions not to report the
ogy. Therefore, the federal banking agencies consider these outsourcing vendor’s findings to directors and
provisions to be usual and customary business practices. senior management should be the mutual deci-
10. If the workpapers are in electronic format, contracts
often call for the vendor to maintain proprietary software that
sion of the internal audit manager and the
enables the bank and examiners to access the electronic outsourcing vendor. In deciding what issues
workpapers for a specified time period. should be brought to the board’s attention, the

Page 11
concept of ‘‘materiality,’’ as the term is used in under section 15(d) of that act.11 The act pro-
financial statement audits, is generally not a hibits an accounting firm from acting as the
good indicator of which control weakness to external auditor of a public company during the
report. For example, when evaluating an insti- same period that the firm provides internal audit
tution’s compliance with laws and regulations, outsourcing services to the company.12 In addi-
any exception may be important. tion, if a public company’s external auditor will
be providing auditing services and permissible
Contingency planning to ensure continuity of nonaudit services, such as tax services, the
outsourced audit coverage. When an institution company’s audit committee must preapprove
enters into an outsourcing arrangement (or sig- each of these services.
nificantly changes the mix of internal and exter- According to the SEC’s final rules (effective
nal resources used by internal audit), it may May 6, 2003) implementing the act’s nonaudit-
increase its operational risk. Because the arrange- service prohibitions and audit committee preap-
ment may be terminated suddenly, the institu- proval requirements, an accountant is not inde-
tion should have a contingency plan to mitigate pendent if, at any point during the audit and
any significant discontinuity in audit coverage, professional engagement period, the accountant
particularly for high-risk areas. provides internal audit outsourcing or other
prohibited nonaudit services to the public com-
pany audit client. The SEC’s final rules gener-
ally become effective on May 6, 2003, although
Independence of the Independent there is a one-year transition period if the
Public Accountant (Part III) accountant is performing prohibited nonaudit
services and external audit services for a public
The following discussion applies only when a company pursuant to a contract in existence on
financial institution is considering using a pub- May 6, 2003. The services provided during this
lic accountant to provide both external audit transition period must not have impaired the
and internal audit services to the institution. auditor’s independence under the preexisting
independence requirements of the SEC, the
When one accounting firm performs both the Independence Standards Board, and the AICPA.
external audit and the outsourced internal audit Although the SEC’s pre-Sarbanes-Oxley inde-
function, the firm risks compromising its independence requirements (issued in November
pendence. These concerns arise because, rather 2000, effective August 2002) did not prohibit
than having two separate functions, this outsourc- the outsourcing of internal audit services to a
ing arrangement places the independent public public company’s independent public accoun-
accounting firm in the position of appearing to
audit, or actually auditing, its own work. For
example, in auditing an institution’s financial
11. 15 USC 78l and 78o(d).
statements, the accounting firm will consider the 12. In addition to prohibiting internal audit outsourcing,
extent to which it may rely on the internal the Sarbanes-Oxley Act (15 USC 78j-1) also identifies other
control system, including the internal audit func- nonaudit services that an external auditor is prohibited from
tion, in designing audit procedures. providing to a public company whose financial statements it
audits. The legislative history of the act indicates that three
broad principles should be considered when determining
whether an auditor should be prohibited from providing a
Applicability of the SEC’s Auditor nonaudit service to an audit client. These principles are that an
auditor should not (1) audit his or her own work, (2) perform
Independence Requirements management functions for the client, or (3) serve in an
advocacy role for the client. To do so would impair the
Institutions that are public companies. To auditor’s independence. Based on these three broad principles,
strengthen auditor independence, Congress the other nonaudit services that an auditor is prohibited from
providing to a public company audit client include bookkeep-
passed the Sarbanes-Oxley Act of 2002 (the ing or other services related to the client’s accounting records
act). Title II of the act applies to any public or financial statements; financial information systems design
company—that is, any company that has a class and implementation; appraisal or valuation services, fairness
of securities registered with the SEC or the opinions, or contribution-in-kind reports; actuarial services;
management or human resources functions; broker or dealer,
appropriate federal banking agency under sec- investment adviser, or investment banking services; legal
tion 12 of the Securities Exchange Act of 1934 services and expert services unrelated to the audit; and any
or that is required to file reports with the SEC other service determined to be impermissible by the PCAOB.

Page 12
tant, they did place conditions and limitations on audited by an independent public accountant.17
internal audit outsourcing. The agencies also encourage each such institu-
tion to follow the internal audit outsourcing
Depository institutions subject to the annual prohibition in the Sarbanes-Oxley Act, as dis-
audit and reporting requirements of section 36 cussed above for institutions that are public
of the FDI Act. Under section 36, as imple- companies.
mented by part 363 of the FDIC’s regulations, As previously mentioned, some institutions
each FDIC-insured depository institution with seek to enhance the quality of their control
total assets of $500 million or more is required environment by obtaining the services of an
to have an annual audit performed by an inde- outsourcing vendor who can critically assess
pendent public accountant.13 The part 363 guide- their internal control system and recommend
lines address the qualifications of an indepen- improvements. The agencies believe that a small
dent public accountant engaged by such an nonpublic institution with less complex opera-
institution by stating that ‘‘[t]he independent tions and limited staff can, in certain circum-
public accountant should also be in compliance stances, use the same accounting firm to perform
with the AICPA’s Code of Professional Conduct both an external audit and some or all of the
and meet the independence requirements and institution’s internal audit activities. These cir-
interpretations of the SEC and its staff.’’14 cumstances include, but are not limited to,
Thus, the guidelines provide for each FDIC- situations in which—
insured depository institution with $500 million
or more in total assets, whether or not it is a • splitting the audit activities poses significant
public company, and its external auditor to costs or burden;
comply with the SEC’s auditor independence • persons with the appropriate specialized knowl-
requirements that are in effect during the period edge and skills are difficult to locate and
covered by the audit. These requirements include obtain;
the nonaudit-service prohibitions and audit com- • the institution is closely held and investors are
mittee preapproval requirements implemented not solely reliant on the audited financial
by the SEC’s January 2003 auditor indepen- statements to understand the financial position
dence rules once these rule come into effect.15 and performance of the institution; and
• the outsourced internal audit services are lim-
Institutions not subject to section 36 of the FDI ited in either scope or frequency.
Act that are neither public companies nor sub-
sidiaries of public companies. The agencies In circumstances such as these, the agencies
have long encouraged each institution not sub- view an internal audit outsourcing arrangement
ject to section 36 of the FDI Act that is neither between a small nonpublic institution and its
a public company nor a subsidiary of a public external auditor as not being inconsistent with
company16 to have its financial statements their safety-and-soundness objectives for the
institution.
13. 12 CFR 363.3(a). (See FDIC Financial Institutions When a small nonpublic institution decides to
Letter FIL-17-2003 (Corporate Governance, Audits, and hire the same firm to perform internal and
Reporting Requirements), attachment II, March 5, 2003.)
14. Appendix A to part 363, Guidelines and Interpreta-
external audit work, the audit committee and the
tions, paragraph 14, Independence. external auditor should pay particular attention
15. If a depository institution subject to section 36 and part to preserving the independence of both the
363 satisfies the annual independent audit requirement by internal and external audit functions. Further-
relying on the independent audit of its parent holding com-
pany, once the SEC’s January 2003 regulations prohibiting an
more, the audit committee should document
external auditor from performing internal audit outsourcing both that it has preapproved the internal audit
services for an audit client take effect May 6, 2003, or May 6, outsourcing to its external auditor and has con-
2004, depending on the circumstances, the holding company’s sidered the independence issues associated with
external auditor cannot perform internal audit outsourcing
work for that holding company or the subsidiary institution.
this arrangement.18 In this regard, the audit
16. FDIC-insured depository institutions with less than
$500 million in total assets are not subject to section 36 of the 17. See, for example, the 1999 Interagency Policy State-
FDI Act. Section 36 does not apply directly to holding ment on External Auditing Programs of Banks and Savings
companies but provides that, for an insured depository insti- Institutions.
tution that is a subsidiary of a holding company, the audited 18. If a small nonpublic institution is considering having its
financial statements requirement and certain of the statute’s external auditor perform other nonaudit services, its audit
other requirements may be satisfied by the holding company. committee may wish to discuss the implications of the

Page 13
committee should consider the independence actions or otherwise exercising authority on

standards described in parts I and II of the policy behalf of the client. For additional details, refer
statement, the AICPA guidance discussed below, to Interpretation 101-3, Performance of Other
and the broad principles that the auditor should Services, and Interpretation 101-13, Extended
not perform management functions or serve in Audit Services, in the AICPA’s Code of Profes-
an advocacy role for the client. sional Conduct.
Accordingly, the agencies will not consider
an auditor who performs internal audit outsourc-
ing services for a small nonpublic audit client to Examination Guidance (Part IV)
be independent unless the institution and its
auditor have adequately addressed the associ-
ated independence issues. In addition, the insti- Review of the Internal Audit Function and
tution’s board of directors and management Outsourcing Arrangements
must retain ownership of and accountability for
the internal audit function and provide active Examiners should have full and timely access to
oversight of the outsourced internal audit an institution’s internal audit resources, includ-
relationship. ing personnel, workpapers, risk assessments,
A small nonpublic institution may be required work plans, programs, reports, and budgets. A
by another law or regulation, an order, or another delay may require examiners to widen the scope
supervisory action to have its financial state- of their examination work and may subject the
ments audited by an independent public accoun- institution to follow-up supervisory actions.
tant. In this situation, if warranted for safety- Examiners should assess the quality and scope
and-soundness reasons, the institution’s primary of an institution’s internal audit function, regard-
federal regulator may require that the institution less of whether it is performed by the institu-
and its independent public accountant comply tion’s employees or by an outsourcing vendor.
with the auditor-independence requirements of Specifically, examiners should consider
the act.19 whether—
AICPA guidance. As noted above, the indepen- • the internal audit function’s control risk
dent public accountant for a depository institu- assessment, audit plans, and audit programs
tion subject to section 36 of the FDI Act also are appropriate for the institution’s activities;
should be in compliance with the AICPA’s Code • the internal audit activities have been adjusted
of Professional Conduct. This code includes for significant changes in the institution’s
professional ethics standards, rules, and inter- environment, structure, activities, risk expo-
pretations that are binding on all certified public sures, or systems;
accountants (CPAs) who are members of the • the internal audit activities are consistent with
AICPA in order for the member to remain in the long-range goals and strategic direction of
good standing. Therefore, this code applies to the institution and are responsive to its inter-
each member CPA who provides audit services nal control needs;
to an institution, regardless of whether the • the audit committee promotes the internal
institution is subject to section 36 or is a public audit manager’s impartiality and indepen-
company. dence by having him or her directly report
The AICPA has issued guidance indicating audit findings to it;
that a member CPA would be deemed not • the internal audit manager is placed in the
independent of his or her client when the CPA management structure in such a way that the
acts or appears to act in a capacity equivalent to independence of the function is not impaired;
a member of the client’s management or as a • the institution has promptly responded to
client employee. The AICPA’s guidance includes significant identified internal control
illustrations of activities that would be consid- weaknesses;
ered to compromise a CPA’s independence. • the internal audit function is adequately man-
Among these are activities that involve the CPA aged to ensure that audit plans are met,
authorizing, executing, or consummating trans- programs are carried out, and the results of
audits are promptly communicated to senior
performance of these services on the auditor’s independence. management and members of the audit com-
19. 15 USC 78j-1. mittee and board of directors;

Page 14
• workpapers adequately document the internal function, whether or not it is outsourced, does
audit work performed and support the audit not sufficiently meet the institution’s internal
reports; audit needs; does not satisfy the Interagency
• management and the board of directors use Guidelines Establishing Standards for Safety
reasonable standards, such as the IIA’s Stan- and Soundness, if applicable; or is otherwise
dards for the Professional Practice of Internal inadequate, he or she should determine whether
Auditing, when assessing the performance of the scope of the examination should be adjusted.
internal audit; and The examiner should also discuss his or her
• the audit function provides high-quality advice concerns with the internal audit manager or
and counsel to management and the board of other person responsible for reviewing the sys-
directors on current developments in risk tem of internal control. If these discussions do
management, internal control, and regulatory not resolve the examiner’s concerns, he or she
compliance. should bring these matters to the attention of
senior management and the board of directors or
The examiner should assess the competence audit committee. If the examiner finds material
of the institution’s internal audit staff and man- weaknesses in the internal audit function or the
agement by considering the education, profes- internal control system, he or she should discuss
sional background, and experience of the prin- them with appropriate agency staff in order to
cipal internal auditors. In addition, when determine the appropriate actions the agency
reviewing outsourcing arrangements, examiners should take to ensure that the institution corrects
should determine whether— the deficiencies. These actions may include
formal and informal enforcement actions.
• the arrangement maintains or improves the The institution’s management and composite
quality of the internal audit function and the ratings should reflect the examiner’s conclu-
institution’s internal control; sions regarding the institution’s internal audit
• key employees of the institution and the function. The report of examination should con-
outsourcing vendor clearly understand the tain comments concerning the adequacy of this
lines of communication and how any internal function, significant issues or concerns, and
control problems or other matters noted by the recommended corrective actions.
outsourcing vendor are to be addressed;
• the scope of the outsourced work is revised Concerns about the independence of the out-
appropriately when the institution’s environ- sourcing vendor. An examiner’s initial review of
ment, structure, activities, risk exposures, or an internal audit outsourcing arrangement,
systems change significantly; including the actions of the outsourcing vendor,
• the directors have ensured that the outsourced may raise questions about the institution’s and
internal audit activities are effectively man- its vendor’s adherence to the independence stan-
aged by the institution; dards described in parts I and II of the policy
• the arrangement with the outsourcing vendor statement, whether or not the vendor is an
satisfies the independence standards described accounting firm, and in part III if the vendor
in this policy statement and thereby preserves provides both external and internal audit ser-
the independence of the internal audit func- vices to the institution. In such cases, the exam-
tion, whether or not the vendor is also the iner first should ask the institution and the
institution’s independent public accountant; outsourcing vendor how the audit committee
and determined that the vendor was independent. If
• the institution has performed sufficient due the vendor is an accounting firm, the audit
diligence to satisfy itself of the vendor’s committee should be asked to demonstrate how
competence before entering into the outsourc- it assessed that the arrangement has not com-
ing arrangement and has adequate procedures promised applicable SEC, PCAOB, AICPA, or
for ensuring that the vendor maintains suffi- other regulatory standards concerning auditor
cient expertise to perform effectively through- independence. If the examiner’s concerns are
out the arrangement. not adequately addressed, the examiner should
discuss the matter with appropriate agency staff
Examination concerns about the adequacy of prior to taking any further action.
the internal audit function. If the examiner If the agency staff concurs that the indepen-
concludes that the institution’s internal audit dence of the external auditor or other vendor

Page 15
appears to be compromised, the examiner will Competence of Internal Auditors

discuss his or her findings and the actions the
agency may take with the institution’s senior The responsibilities and qualifications of inter-
management, board of directors (or audit com- nal auditors vary depending on the size and
mittee), and the external auditor or other vendor. complexity of a bank’s operations and on the
In addition, the agency may refer the external emphasis placed on the internal audit function
auditor to the state board of accountancy, the by the directorate and management. In many
AICPA, the SEC, the PCAOB, or other authori- banks, the internal audit function is performed
ties for possible violations of applicable inde- by an individual or group of individuals whose
pendence standards. Moreover, the agency may sole responsibility is internal auditing. In other
conclude that the institution’s external auditing banks, particularly small ones, internal audit
program is inadequate and that it does not may be performed on a part-time basis by an
comply with auditing and reporting require- officer or employee.
ments, including sections 36 and 39 of the FDI The qualifications discussed below should not
Act and related guidance and regulations, if be viewed as minimum requirements but should
applicable. Issued jointly by the Board, FDIC, be considered by the examiner in evaluating the
OCC, and OTS on March 17, 2003. work performed by the internal auditors or audit
departments. Examples of the type of qualifica-
tions an internal audit department manager
should have are—
INDEPENDENCE OF INTERNAL
• academic credentials comparable to other bank
AUDITORS officers who have major responsibilities within
The ability of the internal audit function to the organization,
achieve its audit objectives depends, in large • commitment to a program of continuing edu-
part, on the independence maintained by audit cation and professional development,
personnel. Frequently, the independence of • audit experience and organizational and tech-
internal auditing can be determined by its nical skills commensurate with the responsi-
reporting lines within the organization and by bilities assigned, and
the person or level to whom these results are • oral and written communication skills.
reported. In most circumstances, the internal
audit function is under the direction of the board The internal audit department manager must
of directors or a committee thereof, such as the be properly trained to fully understand the flow
audit committee. This relationship enables the of data and the underlying operating procedures.
internal audit function to assist the directors in Training may come from college courses, courses
fulfilling their responsibilities. sponsored by industry groups such as the Bank
The auditor’s responsibilities should be Administration Institute (BAI), or in-house train-
addressed in a position description, with reporting programs. Significant work experience in
ing lines delineated in personnel policy, and various departments of a bank also may provide
audit results should be documented in audit adequate training. Certification as a chartered
committee and board of directors’ minutes. bank auditor, certified internal auditor, or certi-
Examiners should review these documents, as fied public accountant meets educational and
well as the reporting process followed by the other professional requirements. In addition to
auditor, in order to subsequently evaluate the prior education, the internal auditor should be
tasks performed by the internal audit function. committed to a program of continuing educa-
The internal auditor should be given the author- tion, which may include attending technical
ity necessary to perform the job, including free meetings and seminars and reviewing current
access to any records necessary for the proper literature on auditing and banking.
conduct of the audit. Furthermore, internal The internal auditor’s organizational skills
auditors generally should not have responsibility should be reflected in the effectiveness of the
for the accounting system, other aspects of the bank’s audit program. Technical skills may be
institution’s accounting function, or any opera- demonstrated through internal audit techniques,
tional function not subject to independent such as internal control and other question-
review. naires, and an understanding of the operational

Page 16
and financial aspects of the organization. would expose the institution to potential loss.
In considering the competence of the internal The assessment should be periodically updated
audit staff, the examiner should review the to reflect changes in the system of internal
educational and experience qualifications required control, work processes, business activities, or
by the bank for filling the positions in the the business environment. The risk-assessment
internal audit department and the training avail- methodology of the internal audit function should
able for that position. In addition, the examiner identify all auditable areas, give a detailed basis
must be assured that any internal audit super- for the auditors’ determination of relative risks,
visor understands the audit objectives and pro- and be consistent from one audit area to another.
cedures performed by the staff. The risk assessment can quantify certain risks,
In a small bank, it is not uncommon to find such as credit risk, market risk, and legal risk. It
that internal audit, whether full- or part-time, is can also include qualitative aspects, such as the
a one-person department. The internal auditor timeliness of the last audit and the quality of
may plan and perform all procedures personally management. Although there is no standard
or may direct staff borrowed from other depart- approach to making a risk assessment, it should
ments. In either case, the examiner should be appropriate to the size and complexity of the
expect, at a minimum, that the internal auditor institution. While smaller institutions may not
possesses qualifications similar to those of have elaborate risk-assessment systems, some
an audit department manager, as previously analysis should still be available to explain why
discussed. certain areas are more frequently audited than
The final measure of the competence of the others.
internal auditor is the quality of the work Within the risk assessment, institutions should
performed, the ability to communicate the clearly identify auditable units along business
results of that work, and the ability to follow up activities or product lines, depending on how the
on deficiencies noted during the audit work. institution is managed. There should be evi-
Accordingly, the examiner’s conclusions with dence that the internal audit manager is regu-
respect to an auditor’s competence should also larly notified of new products, departmental
reflect the adequacy of the audit program and changes, and new general ledger accounts, all of
the audit reports. which should be factored into the audit sched-
ule. Ratings of particular business activities or
corporate functions may change with time as the
internal audit function revises its method for
IMPLEMENTATION OF THE assessing risk. These changes should be incre-
INTERNAL AUDIT FUNCTION mental. Large-scale changes in the priority of
audits should trigger an investigation into the
The annual audit plan and budgets should be set
reasonableness of changes to the risk-assessment
by the internal audit manager and approved by
methodology.
the board, audit committee, or senior manage-
ment. In many organizations, the internal audit
manager reports to a senior manager for admin-
istrative purposes. The senior manager appraises Audit Plan
the audit manager’s performance, and the direc-
tors or an audit committee approves the The audit plan is based on the risk assessment.
evaluation. The plan should include a summary of key
internal controls within each significant business
activity, the timing and frequency of planned
Risk Assessment internal audit work, and a resource budget.
A formal, annual audit plan should be devel-
In setting the annual audit plan, a risk assess- oped based on internal audit’s risk assessment.
ment should be made that documents the inter- The audit plan should include all auditable
nal audit function’s understanding of the insti- areas and set priorities based on the rating
tution’s various business activities and their determined by the risk assessment. The schedule
inherent risks. In addition, the assessment also of planned audits should be approved by the
evaluates control risk, or the potential that board or its audit committee, as should any
deficiencies in the system of internal control subsequent changes to the plan. Many organiza-

Page 17
tions develop an audit plan jointly with the Audit Program and Related Workpapers
external auditors. In this case, the audit plan
should clearly indicate what work is being The audit program documents the audit’s objec-
performed by internal and external auditors and tives and the procedures that were performed.
what aspects of internal audit work the external Typically, it indicates who performed the work
auditors are relying on. and who has reviewed it. Workpapers document
Typically, the schedule of audit is cyclic; for the evidence gathered and conclusions drawn by
example, high risks are audited annually, mod- the auditor, as well as the disposition of audit
erate risks every two years, and low risks every findings. The workpapers should provide evi-
three years. In some cases, the audit cycle may dence that the audit program adheres to the
extend beyond three years. In reviewing the requirements specified in the audit manual.
annual plan, examiners should determine the
appropriateness of the institution’s audit cycle.
Some institutions limit audit coverage of their Audit Reports
low-risk areas. Examiners should review areas
The audit report is internal audit’s formal notice
the institution has labeled ‘‘low risk’’ to deter-
of its assessment of internal controls in the
mine if the classification is appropriate and if
audited areas. The report is given to the area’s
coverage is adequate.
managers, senior management, and directors. A
typical audit report states the purpose of the
audit and its scope, conclusions, and recommen-
Audit Manual dations. Reports are usually prepared for each
audit. In larger institutions, monthly or quarterly
summaries that highlight major audit issues are
The internal audit department should have an
prepared for senior management and the board.
audit manual that sets forth the standards of
work for field auditors and audit managers to
use in their assignments. A typical audit manual
contains the audit unit’s charter and mis- EXAMINER REVIEW OF
sion, administrative procedures, workpaper- INTERNAL AUDIT
documentation standards, reporting standards,
and review procedures. Individual audits should The examination procedures section describes
conform to the requirements of the audit manual. the steps the examiner should follow when
As a consequence, the manual should be up-to- conducting a review of the work performed by
date with respect to the audit function’s mission the internal auditor. The examiner’s review and
and changes to the professional standards it evaluation of the internal audit function is a key
follows. element in determining the scope of the exami-
nation. In most situations, the competence and
independence of the internal auditors may be
reviewed on an overall basis; however, the
Performance of Individual Audits adequacy and effectiveness of the audit program
should be determined separately for each exami-
The internal audit manager should oversee the nation area.
staff assigned to perform the internal audit work The examiner should assess if the work per-
and should establish policies and procedures to formed by the internal auditor is reliable. It is
guide them. The internal audit function should often more efficient for the examiner to deter-
be competently supervised and staffed by people mine the independence or competence of the
with sufficient expertise and resources to iden- internal auditor before addressing the adequacy
tify the risks inherent in the institution’s opera- or effectiveness of the audit program. If the
tions and to assess whether internal controls are examiner concludes that the internal auditor
effective. While audits vary according to the possesses neither the independence nor the com-
objective, the area subjected to audit, the stan- petence deemed appropriate, the examiner must
dards used as the basis for work performed, and also conclude that the internal audit work per-
documentation, the audit process generates some formed is not reliable.
common documentation elements, as described The examiner should indicate in the report of
below. examination any significant deficiencies concern-

Page 18
ing the internal audit function. Furthermore, the • surprise examinations, where appropriate;
examiner should review with management any • maintenance of control over records selected
significant deficiencies noted in the previous for audit;
report of examination to determine if these • review and evaluation of the bank’s policies
concerns have been appropriately addressed. and procedures and the system of internal
control;
• reconciliation of detail to related control
Program Adequacy and Effectiveness records; and
• verification of selected transactions and bal-
An examiner should consider the following ances through procedures such as examination
factors when assessing the adequacy of the of supporting documentation, direct confirma-
internal audit program— tion and appropriate follow-up of exceptions,
and physical inspection.
• scope and frequency of the work performed,
• content of the programs, The internal auditor should follow the specific
• documentation of the work performed, and procedures included in all work programs to
• conclusions reached and reports issued. reach audit conclusions that will satisfy the
related audit objectives. Audit conclusions
The scope of the internal audit program must be should be supported by report findings; such
sufficient to attain the audit objectives. The reports should include, when appropriate, rec-
frequency of the audit procedures performed ommendations by the internal auditor for any
should be based on an evaluation of the risk required remedial actions.
associated with each targeted area under audit. The examiner should also analyze the internal
Among the factors that the internal auditor reporting process for the internal auditor’s find-
should consider in assessing risk are the nature ings, since required changes in the bank’s inter-
of the operation of the specific assets and nal controls and operating procedures can be
liabilities under review, the existence of appro- made only if appropriate officials are informed
priate policies and internal control standards, the of the deficiencies. This means that the auditor
effectiveness of operating procedures and inter- must communicate all findings and recommen-
nal controls, and the potential materiality of dations clearly and concisely, pinpointing prob-
errors or irregularities associated with the spe- lems and suggesting solutions. The auditor also
cific operation. should submit reports as soon as practical, and
To further assess the adequacy and effective- the reports should be routed to those authorized
ness of the internal audit program, an examiner to implement the suggested changes.
needs to obtain audit workpapers. Workpapers The final measure of the effectiveness of the
should contain, among other things, audit work audit program is a prompt and effective man-
programs and analyses that clearly indicate the agement response to the auditor’s recommenda-
procedures performed, the extent of the testing, tions. The audit department should determine
and the basis for the conclusions reached. the reasonableness, timeliness, and complete-
Although audit work programs are an integral ness of management’s response to their recom-
part of the workpapers, they are sufficiently mendations, including follow-up, if necessary.
important to deserve separate attention. Work Examiners should assess management’s response
programs serve as the primary guide to the audit and follow up when the response is either
procedures to be performed. Each program incomplete or unreasonable.
should provide a clear, concise description of
the work required, and individual procedures
should be presented logically. The detailed pro- EXTERNAL AUDITS
cedures included in the program vary depending
on the size and complexity of the bank’s opera- The Federal Reserve requires bank holding com-
tions and the area subject to audit. In addition, panies with total consolidated assets of $500 mil-
an individual audit work program may encom- lion or more to have annual independent audits.
pass several departments of the bank, a single Generally, banks must have external audits for
department, or specific operations within a the first three years after obtaining FDIC insur-
department. Most audit programs include proce- ance (an FDIC requirement) and upon becoming
dures such as— a newly chartered national bank (an OCC

Page 19
requirement). The SEC also has a longstanding formed by external auditors for three principal
audit requirement for all public companies, reasons. First, situations will arise when internal
which applies to bank holding companies that audit work is not being performed or when such
are SEC registrants and to state member banks work is deemed to be of limited value to the
that are subject to SEC reporting requirements examiner. Second, the work performed by
pursuant to the Federal Reserve’s Regulation H. external auditors may affect the amount of
For insured depository institutions with fiscal testing the examiner must perform. Third, exter-
years beginning after December 31, 1992, nal audit reports often provide the examiner
FDICIA, through its amendments to section 36 with information pertinent to the examination of
of the FDI Act, requires annual independent the bank.
audits for all FDIC-insured banks that have total The major factors that should be considered
assets in excess of $500 million. (See SR-94-3 in evaluating the work of external auditors are
and SR-96-4.) In September 1999, the Federal similar to those applicable to internal auditors,
Financial Institutions Examination Council namely, the competence and independence of
(FFIEC) issued an interagency policy statement the auditors and the adequacy of the audit
on external auditing programs of banks and program.
savings associations.20 The policy encourages The federal banking agencies view a full-
banks and savings associations that have less scope annual audit of a bank’s financial state-
than $500 million in total assets and that are not ments by an independent public accountant as
subject to other audit requirements to adopt an preferable to other types of external auditing
external auditing program as a part of their programs. The September 1999 policy statement
overall risk-management process. (See the fol- recognizes that a full-scope audit may not be
lowing subsection for the complete text of the feasible for every small bank. It therefore encour-
interagency policy statement.) ages those banks to pursue appropriate alterna-
Independent audits enhance the probability tives to a full-scope audit. Small banks are also
that financial statements and reports to the FRB encouraged to establish an audit committee
and other financial-statement users will be consisting of outside directors. The policy state-
accurate and will help detect conditions that ment provides guidance to examiners on the
could adversely affect banking organizations, review of external auditing programs.
the FRB, or the public. The independent audit The policy statement is consistent with the
process also subjects the internal controls and Federal Reserve’s longstanding guidance that
the accounting policies, procedures, and records encourages the use of external auditing pro-
of each banking organization to periodic review. grams, and with its goals for (1) ensuring the
Banks often employ external auditors and accuracy and reliability of regulatory reports,
other specialists to assist management in spe- (2) improving the quality of bank internal con-
cialized fields, such as taxation and management trols over financial reporting, and (3) enhancing
information systems. External auditors and con- the efficiency of the risk-focused examination
sultants often conduct in-depth reviews of the process. The Federal Reserve adopted the FFIEC
operations of specific bank departments; the policy statement effective for fiscal years begin-
reviews might focus on operational procedures, ning on or after January 1, 2000. (See
personnel requirements, or other specific areas SR-99-33.)
of interest. After completing the reviews, the
auditors may recommend that the bank strengthen
controls or improve efficiency. INTERAGENCY POLICY
External auditors provide services at various STATEMENT ON EXTERNAL
times during the year. Financial statements are AUDITING PROGRAMS OF
examined annually. Generally, the process com- BANKS AND SAVINGS
mences in the latter part of the year, with the
report issued as soon thereafter as possible.
ASSOCIATIONS
Other types of examinations or reviews are
performed at various dates on an as-required
basis. Introduction
The examiner is interested in the work per-
The board of directors and senior managers of a
20. See 64 Fed. Reg. 52319 (September 28, 1999). banking institution or savings association (insti-

Page 20
tution) are responsible for ensuring that the considering the significant risk areas of an
institution operates in a safe and sound manner. institution, an effective external auditing pro-
To achieve this goal and meet the safety-and- gram may reduce the examination time the
soundness guidelines implementing section 39 agencies spend in such areas. Moreover, it can
of the Federal Deposit Insurance Act (FDI Act) improve the safety and soundness of an institu-
(12 USC 1831p-1),21 the institution should main- tion substantially and lessen the risk the institu-
tain effective systems and internal control22 to tion poses to the insurance funds administered
produce reliable and accurate financial reports. by the Federal Deposit Insurance Corporation
Accurate financial reporting is essential to an (FDIC).
institution’s safety and soundness for numerous This policy statement outlines the character-
reasons. First, accurate financial information istics of an effective external auditing program
enables management to effectively manage the and provides examples of how an institution can
institution’s risks and make sound business use an external auditor to help ensure the
decisions. In addition, institutions are required reliability of its financial reports. It also provides
by law23 to provide accurate and timely financial guidance on how an examiner may assess an
reports (e.g., Reports of Condition and Income institution’s external auditing program. In addi-
[call reports] and Thrift Financial Reports) to tion, this policy statement provides specific
their appropriate regulatory agency. These reports guidance on external auditing programs for
serve an important role in the agencies’24 risk- institutions that are holding company subsidi-
focused supervision programs by contributing to aries, newly insured institutions, and institutions
their pre-examination planning, off-site monitor- presenting supervisory concerns.
ing programs, and assessments of an institu- The adoption of a financial statement audit or
tion’s capital adequacy and financial strength. other specified type of external auditing pro-
Further, reliable financial reports are necessary gram is generally only required in specific
for the institution to raise capital. They provide circumstances. For example, insured depository
data to stockholders, depositors and other funds institutions covered by section 36 of the FDI Act
providers, borrowers, and potential investors on (12 USC 1831m), as implemented by part 363 of
the company’s financial position and results of the FDIC’s regulations (12 CFR 363), are
operations. Such information is critical to effec- required to have an external audit and an audit
tive market discipline of the institution. committee. Therefore, this policy statement is
To help ensure accurate and reliable financial directed toward banks and savings associations
reporting, the agencies recommend that the which are exempt from part 363 (i.e., institu-
board of directors of each institution establish tions with less than $500 million in total assets
and maintain an external auditing program. An at the beginning of their fiscal year) or are not
external auditing program should be an impor- otherwise subject to audit requirements by order,
tant component of an institution’s overall risk- agreement, statute, or agency regulations.
management process. For example, an external
auditing program complements the internal
auditing function of an institution by providing
management and the board of directors with an
Overview of External Auditing
independent and objective view of the reliability Programs
of the institution’s financial statements and the
adequacy of its financial-reporting internal con- Responsibilities of the Board of Directors
trols. Additionally, an effective external auditing
program contributes to the efficiency of the The board of directors of an institution is
agencies’ risk-focused examination process. By responsible for determining how to best obtain
reasonable assurance that the institution’s finan-
21. See 12 CFR 30 for national banks; 12 CFR 364 for cial statements and regulatory reports are reli-
state nonmember banks; 12 CFR 208 for state member banks;
and 12 CFR 510 for savings associations.
ably prepared. In this regard, the board is also
22. This policy statement provides guidance consistent responsible for ensuring that its external audit-
with the guidance established in the Interagency Policy ing program is appropriate for the institution and
Statement on the Internal Audit Function and Its Outsourcing. adequately addresses the financial-reporting
23. See 12 USC 161 for national banks; 12 USC 1817a for
state nonmember banks; 12 USC 324 for state member banks;
aspects of the significant risk areas and any
and 12 USC 1464(v) for savings associations. other areas of concern of the institution’s
24. Terms are defined at the end of the policy statement. business.

Page 21
To help ensure the adequacy of its internal tures from, professional standards. Furthermore,
and external auditing programs, the agencies when the external auditing program includes an
encourage the board of directors of each insti- audit of the financial statements, the board or
tution that is not otherwise required to do so to audit committee obtains an opinion from the
establish an audit committee consisting entirely independent public accountant stating whether
of outside directors.25 However, if this is the financial statements are presented fairly, in
impracticable, the board should organize the all material respects, in accordance with gener-
audit committee so that outside directors consti- ally accepted accounting principles (GAAP).
tute a majority of the membership. When the external auditing program includes an
examination of the internal control structure
over financial reporting, the board or audit
Audit Committee committee obtains an opinion from the indepen-
dent public accountant stating whether the
The audit committee or board of directors is financial-reporting process is subject to any
responsible for identifying at least annually the material weaknesses.
risk areas of the institution’s activities and Both the staff performing an internal audit
assessing the extent of external auditing involve- function and the independent public accountant
ment needed over each area. The audit commit- or other external auditor should have unre-
tee or board is then responsible for determining stricted access to the board or audit committee
what type of external auditing program will best without the need for any prior management
meet the institution’s needs (see the descrip- knowledge or approval. Other duties of an audit
tions under ‘‘Types of External Auditing committee may include reviewing the indepen-
Programs’’). dence of the external auditor annually, consult-
When evaluating the institution’s external ing with management, seeking an opinion on an
auditing needs, the board or audit committee accounting issue, and overseeing the quarterly
should consider the size of the institution and regulatory reporting process. The audit commit-
the nature, scope, and complexity of its opera- tee should report its findings periodically to the
tions. It should also consider the potential bene- full board of directors.
fits of an audit of the institution’s financial
statements or an examination of the institution’s
internal control structure over financial report-
ing, or both. In addition, the board or audit External Auditing Programs
committee may determine that additional or
specific external auditing procedures are war- Basic Attributes
ranted for a particular year or several years to
cover areas of particularly high risk or special External auditing programs should provide the
concern. The reasons supporting these decisions board of directors with information about the
should be recorded in the committee’s or board’s institution’s financial-reporting risk areas, e.g.,
minutes. the institution’s internal control over financial
If, in its annual consideration of the institu- reporting, the accuracy of its recording of trans-
tion’s external auditing program, the board or actions, and the completeness of its financial
audit committee determines, after considering reports prepared in accordance with GAAP.
its inherent limitations, that an agreed-upon The board or audit committee of each insti-
procedures/state-required examination is suffi- tution at least annually should review the risks
cient, they should also consider whether an inherent in its particular activities to determine
independent public accountant should perform the scope of its external auditing program. For
the work. When an independent public accoun- most institutions, the lending and investment-
tant performs auditing and attestation services, securities activities present the most significant
the accountant must conduct his or her work risks that affect financial reporting. Thus, exter-
under, and may be held accountable for depar- nal auditing programs should include specific
procedures designed to test at least annually the
risks associated with the loan and investment
25. Institutions with $500 million or more in total assets
must establish an independent audit committee made up of
portfolios. This includes testing of internal con-
outside directors who are independent of management. See 12 trol over financial reporting, such as manage-
USC 1831m(g)(1) and 12 CFR 363.5. ment’s process to determine the adequacy of the

Page 22
allowance for loan and lease losses and whether mendations on internal control (including inter-
this process is based on a comprehensive, nal auditing programs) necessary to ensure the
adequately documented, and consistently applied fair presentation of the financial statements.
analysis of the institution’s loan and lease
portfolio. Reporting by an independent public accoun-
An institution or its subsidiaries may have tant on an institution’s internal control structure
other significant financial-reporting risk areas over financial reporting. Another external audit-
such as material real estate investments, insuring program is an independent public accoun-
ance underwriting or sales activities, securities tant’s examination and report on management’s
broker-dealer or similar activities (including assertion on the effectiveness of the institution’s
securities underwriting and investment advisory internal control over financial reporting. For a
services), loan-servicing activities, or fiduciary smaller institution with less complex operations,
activities. The external auditing program should this type of engagement is likely to be less
address these and other activities the board or costly than an audit of its financial statements or
audit committee determines present significant its balance sheet. It would specifically provide
financial-reporting risks to the institution. recommendations for improving internal con-
trol, including suggestions for compensating
controls, to mitigate the risks due to staffing and
Types of External Auditing Programs resource limitations.
Such an attestation engagement may be per-
The agencies consider an annual audit of an formed for all internal controls relating to the
institution’s financial statements performed by preparation of annual financial statements or
an independent public accountant to be the specified schedules of the institution’s regula-
preferred type of external auditing program. The tory reports.26 This type of engagement is per-
agencies also consider an annual examination of formed under generally accepted standards for
the effectiveness of the internal control structure attestation engagements (GASAE).27
over financial reporting or an audit of an insti-
tution’s balance sheet, both performed by an
26. Since the lending and investment-securities activities
independent public accountant, to be acceptable generally present the most significant risks that affect an
alternative external auditing programs. How- institution’s financial reporting, management’s assertion and
ever, the agencies recognize that some institu- the accountant’s attestation generally should cover those
tions only have agreed-upon procedures/state- regulatory report schedules. If the institution has trading or
off-balance-sheet activities that present material financial-
required examinations performed annually as reporting risks, the board or audit committee should ensure
their external auditing program. Regardless of that the regulatory report schedules for those activities also are
the option chosen, the board or audit committee covered by management’s assertion and the accountant’s
should agree in advance with the external audi- attestation. For banks and savings associations, the lending,
investment-securities, trading, and off-balance-sheet sched-
tor on the objectives and scope of the external ules consist of:
auditing program.
Reports of Thrift
Condition Financial
Financial statement audit by an independent and Income Report
public accountant. The agencies encourage all Area Schedules Schedules
institutions to have an external audit performed Loans and lease-financing
in accordance with generally accepted auditing receivables RC-C, Part I SC, CF
standards (GAAS). The audit’s scope should be Past-due and nonaccrual
loans, leases,
sufficient to enable the auditor to express an and other assets RC-N PD
opinion on the institution’s financial statements Allowance for
credit losses RI-B SC, VA
taken as a whole. Securities RC-B SC, SI, CF
A financial statement audit provides assur- Trading assets
ance about the fair presentation of an institu- and liabilities RC-D SO, SI
tion’s financial statements. In addition, an audit Off-balance-sheet
items RC-L SI, CMR
may provide recommendations for management
in carrying out its control responsibilities. For These schedules are not intended to address all possible risks
example, an audit may provide management in an institution.
27. An attestation engagement is not an audit. It is per-
with guidance on establishing or improving formed under different professional standards than an audit of
accounting and operating policies and recom- an institution’s financial statements or its balance sheet.

Page 23
Balance-sheet audit performed by an indepen- examination of the effectiveness of the internal

dent public accountant. With this program, the control structure over financial reporting, and a
institution engages an independent public balance-sheet audit may be accepted in some
accountant to examine and report only on the states and for national banks in lieu of agreed-
balance sheet. As with the audit of the financial upon procedures/state-required examinations.
statements, this audit is performed in accor-
dance with GAAS. The cost of a balance-sheet
audit is likely to be less than a financial- Other Considerations
statement audit. However, under this type of
program, the accountant does not examine or Timing. The preferable time to schedule the
report on the fairness of the presentation of the performance of an external auditing program is
institution’s income statement, statement of as of an institution’s fiscal year-end. However, a
changes in equity capital, or statement of cash quarter-end date that coincides with a regulatory
flows. report date provides similar benefits. Such an
approach allows the institution to incorporate
Agreed-upon procedures/state-required exami- the results of the external auditing program into
nations. Some state-chartered depository insti- its regulatory reporting process and, if appropri-
tutions are required by state statute or regulation ate, amend the regulatory reports.
to have specified procedures performed annually
by their directors or independent persons.28 The External auditing staff. The agencies encour-
bylaws of many national banks also require that age an institution to engage an independent
some specified procedures be performed annu- public accountant to perform its external audit-
ally by directors or others, including internal or ing program. An independent public accountant
independent persons. Depending upon the scope provides a nationally recognized standard of
of the engagement, the cost of agreed-upon knowledge and objectivity by performing
procedures or a state-required examination may engagements under GAAS or GASAE. The firm
be less than the cost of an audit. However, under or independent person selected to conduct an
this type of program, the independent auditor external auditing program and the staff carrying
does not report on the fairness of the institu- out the work should have experience with
tion’s financial statements or attest to the effec- financial-institution accounting and auditing or
tiveness of the internal control structure over similar expertise and should be knowledgeable
financial reporting. The findings or results of the about relevant laws and regulations.
procedures are usually presented to the board or
the audit committee so that they may draw their
own conclusions about the quality of the finan-
cial reporting or the sufficiency of internal Special Situations
control.
When choosing this type of external auditing Holding Company Subsidiaries
program, the board or audit committee is respon-
sible for determining whether these procedures When an institution is owned by another entity
meet the external auditing needs of the institu- (such as a holding company), it may be appro-
tion, considering its size and the nature, scope, priate to address the scope of its external audit
and complexity of its business activities. For program in terms of the institution’s relationship
example, if an institution’s external auditing to the consolidated group. In such cases, if the
program consists solely of confirmations of group’s consolidated financial statements for the
deposits and loans, the board or committee same year are audited, the agencies generally
should consider expanding the scope of the would not expect the subsidiary of a holding
auditing work performed to include additional company to obtain a separate audit of its finan-
procedures to test the institution’s high-risk cial statements. Nevertheless, the board of
areas. Moreover, a financial statement audit, an directors or audit committee of the subsidiary
may determine that its activities involve signifi-
28. When performed by an independent public accountant, cant risks to the subsidiary that are not within
‘‘specified procedures’’ and ‘‘agreed-upon procedures’’
engagements are performed under standards, which are dif-
the procedural scope of the audit of the financial
ferent professional standards than those used for an audit of an statements of the consolidated entity. For exam-
institution’s financial statements or its balance sheet. ple, the risks arising from the subsidiary’s

Page 24
activities may be immaterial to the financial • the need for direct verification of loans or
statements of the consolidated entity, but mate- deposits;
rial to the subsidiary. Under such circumstances, • questionable transactions with affiliates; or
the audit committee or board of the subsidiary • the need for improvements in the external
should consider strengthening the internal audit auditing program.
coverage of those activities or implementing
an appropriate alternative external auditing The agencies may also require that the insti-
program. tution provide its appropriate supervisory office
with a copy of any reports, including manage-
ment letters, issued by the independent public
Newly Insured Institutions accountant or other external auditor. They also
may require the institution to notify the super-
Under the FDIC statement of policy on applica- visory office prior to any meeting with the
tions for deposit insurance, applicants for deposit independent public accountant or other external
insurance coverage are expected to commit the auditor at which auditing findings are to be
depository institution to obtain annual audits by presented.
an independent public accountant once it begins
operations as an insured institution and for a
limited period thereafter.
Examiner Guidance
Institutions Presenting Supervisory Review of the External Auditing Program

Concerns
The review of an institution’s external auditing
As previously noted, an external auditing pro- program is a normal part of the agencies’
gram complements the agencies’ supervisory examination procedures. An examiner’s evalua-
process and the institution’s internal auditing tion of, and any recommendations for improve-
program by identifying or further clarifying ments in, an institution’s external auditing pro-
issues of potential concern or exposure. An gram will consider the institution’s size; the
external auditing program also can greatly assist nature, scope, and complexity of its business
management in taking corrective action, particu- activities; its risk profile; any actions taken or
larly when weaknesses are detected in internal planned by it to minimize or eliminate identified
control or management information systems weaknesses; the extent of its internal audit
affecting financial reporting. program; and any compensating controls in
The agencies may require a financial institu- place. Examiners will exercise judgment and
tion presenting safety-and-soundness concerns discretion in evaluating the adequacy of an
to engage an independent public accountant or institution’s external auditing program.
other independent external auditor to perform Specifically, examiners will consider the poli-
external auditing services.29 Supervisory con- cies, processes, and personnel surrounding an
cerns may include— institution’s external auditing program in deter-
mining whether—
• inadequate internal control, including the
internal auditing program; • the board of directors or its audit committee
• a board of directors generally uninformed adequately reviews and approves external
about internal control; auditing program policies at least annually;
• evidence of insider abuse; • the external auditing program is conducted by
• known or suspected defalcations; an independent public accountant or other
• known or suspected criminal activity; independent auditor and is appropriate for the
• probable director liability for losses; institution;
• the engagement letter covering external audit-
ing activities is adequate;
29. The Office of Thrift Supervision requires an external • the report prepared by the auditor on the
audit by an independent public accountant for savings asso- results of the external auditing program
ciations with a composite rating of 3, 4, or 5 under the
Uniform Financial Institution Rating System, and on a case- adequately explains the auditor’s findings;
by-case basis. • the external auditor maintains appropriate

Page 25
independence regarding relationships with external auditing program should be communi-

the institution under relevant professional cated promptly to the appropriate supervisory
standards; office. Examples of those developments include
• the board of directors performs due diligence the hiring of an independent public accountant
on the relevant experience and competence of or other third party to perform external auditing
the independent auditor and staff carrying out work and a change in, or termination of, an
the work (whether or not an independent independent public accountant or other external
public accountant is engaged); and auditor.
• the board or audit committee minutes reflect
approval and monitoring of the external audit-
ing program and schedule, including board or
committee reviews of audit reports with man- Definitions
agement and timely action on audit findings
and recommendations. Agencies. The agencies are the Board of Gov-
ernors of the Federal Reserve System (FRB), the
Federal Deposit Insurance Corporation (FDIC),
the Office of the Comptroller of the Currency
Access to Reports
(OCC), and the Office of Thrift Supervision
Management should provide the independent (OTS).
public accountant or other auditor with access to
all examination reports and written communica- Appropriate supervisory office. The regional or
tion between the institution and the agencies or district office of the institution’s primary federal
state bank supervisor since the last external banking agency responsible for supervising the
auditing activity. Management also should pro- institution or, in the case of an institution that is
vide the accountant with access to any supervi- part of a group of related insured institutions,
sory memoranda of understanding, written agree- the regional or district office of the institution’s
ments, administrative orders, reports of action federal banking agency responsible for moni-
initiated or taken by a federal or state banking toring the group. If the institution is a subsidiary
agency under section 8 of the FDI Act (or a of a holding company, the term ‘‘appropriate
similar state law), and proposed or ordered supervisory office’’ also includes the federal
assessments of civil money penalties against the banking agency responsible for supervising
institution or an institution-related party, as well the holding company. In addition, if the institu-
as any associated correspondence. The audi- tion is state-chartered, the term ‘‘appropriate
tor must maintain the confidentiality of exami- supervisory office’’ includes the appropriate
nation reports and other confidential supervisory state bank or savings association regulatory
information. authority.
In addition, the independent public accoun-
tant or other auditor of an institution should Audit. An examination of the financial state-
agree in the engagement letter to grant examin- ments, accounting records, and other supporting
ers access to all the accountant’s or auditor’s evidence of an institution performed by an
workpapers and other material pertaining to the independent certified or licensed public accoun-
institution prepared in the course of performing tant in accordance with generally accepted
the completed external auditing program.
Institutions should provide reports30 issued
in the audited consolidated financial statements of its parent
by the independent public accountant or other company, the institution should provide a copy of the audited
auditor pertaining to the external auditing pro- financial statements of the consolidated company and any
gram, including any management letters, to the other reports by the independent public accountant in accor-
agencies and any state authority in accordance dance with their appropriate supervisory office’s guidance. If
several institutions are owned by one parent company, a single
with their appropriate supervisory office’s guid- copy of the reports may be supplied in accordance with the
ance.31 Significant developments regarding the guidance of the appropriate supervisory office of each agency
supervising one or more of the affiliated institutions and the
holding company. A transmittal letter should identify the
30. The institution’s engagement letter is not a ‘‘report’’ institutions covered. Any notifications of changes in, or
and is not expected to be submitted to the appropriate terminations of, a consolidated company’s independent public
supervisory office unless specifically requested by that office. accountant may be similarly supplied to the appropriate
31. When an institution’s financial information is included supervisory office of each supervising agency.

Page 26
auditing standards (GAAS) and of sufficient and changes in equity together with related
scope to enable the independent public accoun- notes.
tant to express an opinion on the institution’s
financial statements as to their presentation in Independent public accountant. An accountant
accordance with generally accepted accounting who is independent of the institution and regis-
principles (GAAP). tered or licensed to practice, and holds himself
or herself out, as a public accountant, and who is
Audit committee. A committee of the board of in good standing under the laws of the state or
directors whose members should, to the extent other political subdivision of the United States
possible, be knowledgeable about accounting in which the home office of the institution is
and auditing. The committee should be respon- located. The independent public accountant
sible for reviewing and approving the institu- should comply with the American Institute of
tion’s internal and external auditing programs or Certified Public Accountants’ (AICPA) Code of
recommending adoption of these programs to Professional Conduct and any related guidance
the full board. adopted by the Independence Standards Board
and the agencies. No certified public accountant
Balance-sheet audit performed by an indepen- or public accountant will be recognized as
dent public accountant. An examination of an independent who is not independent both in fact
institution’s balance sheet and any accompany- and in appearance.
ing footnotes performed and reported on by an
independent public accountant in accordance Internal auditing. An independent assessment
with GAAS and of sufficient scope to enable the function established within an institution to
independent public accountant to express an examine and evaluate its system of internal
opinion on the fairness of the balance-sheet control and the efficiency with which the various
presentation in accordance with GAAP. units of the institution are carrying out their
assigned tasks. The objective of internal audit-
Engagement letter. A letter from an independent ing is to assist the management and directors of
public accountant to the board of directors or the institution in the effective discharge of their
audit committee of an institution that usually responsibilities. To this end, internal auditing
addresses the purpose and scope of the external furnishes management with analyses, evalua-
auditing work to be performed, period of time to tions, recommendations, counsel, and informa-
be covered by the auditing work, reports tion concerning the activities reviewed.
expected to be rendered, and any limitations
placed on the scope of the auditing work. Outside directors. Members of an institution’s
board of directors who are not officers, employ-
Examination of the internal control structure ees, or principal stockholders of the institution,
over financial reporting. See ’’Reporting by an its subsidiaries, or its affiliates, and who do not
independent public accountant on an institu- have any material business dealings with the
tion’s internal control structure over financial institution, its subsidiaries, or its affiliates.
reporting.’’
Regulatory reports. These reports are the Reports
External auditing program. The performance of of Condition and Income (call reports) for banks,
procedures to test and evaluate high-risk areas Thrift Financial Reports (TFRs) for savings
of an institution’s business by an independent associations, Federal Reserve (FR) Y reports for
auditor, who may or may not be a public bank holding companies, and the H-(b)11 Annual
accountant, sufficient for the auditor to be able Report for thrift holding companies.
to express an opinion on the financial statements
or to report on the results of the procedures Reporting by an independent public accountant
performed. on an institution’s internal control structure
over financial reporting. Under this engage-
Financial statement audit by an independent ment, management evaluates and documents its
public accountant. See Audit. review of the effectiveness of the institution’s
internal control over financial reporting in the
Financial statements. The statements of finan- identified risk areas as of a specific report date.
cial position (balance sheet), income, cash flows, Management prepares a written assertion, which

Page 27
specifies the criteria on which management vices.33 The advisory informs financial institu-
based its evaluation about the effectiveness of tions’34 boards of directors, audit committees,
the institution’s internal control over financial management, and external auditors of the safety-
reporting in the identified risk areas and states and-soundness implications that may arise when
management’s opinion on the effectiveness of the financial institution enters into engagement
internal control over this specified financial letters that contain provisions to limit the audi-
reporting. The independent public accountant is tors’ liability. Such provisions may weaken the
engaged to perform tests on the internal control external auditors’ objectivity, impartiality, and
over the specified financial reporting in order to performance and, thus, reduce the agencies’
attest to management’s assertion. If the accoun- ability to rely on audits. Therefore, certain
tant concurs with management’s assertion, even limitation-of-liability provisions (described in
if the assertion discloses one or more instances the advisory) are unsafe and unsound. In addi-
of material internal control weakness, the tion, such provisions may not be consistent with
accountant would provide a report attesting to the auditor-independence standards of the SEC,
management’s assertion. the PCAOB, and the AICPA.
The advisory does not apply to previously
Risk areas. Those particular activities of an executed engagement letters. However, any
institution that expose it to greater potential financial institution subject to a multiyear audit
losses if problems exist and go undetected. The engagement letter containing unsafe and unsound
areas with the highest financial-reporting risk in limitation-of-liability provisions should seek an
most institutions generally are their lending and amendment to its engagement letter to be con-
investment-securities activities. sistent with the advisory for periods ending in
2007 or later. (See SR-06-4.)
Specified procedures. Procedures agreed upon
by the institution and the auditor to test its
activities in certain areas. The auditor reports Scope of the Advisory on
findings and test results, but does not express an
opinion on controls or balances. If performed by
Engagement Letters
an independent public accountant, these proce- The advisory applies to engagement letters
dures should be performed under generally between financial institutions and external audi-
accepted standards for attestation engagements tors with respect to financial-statement audits,
(GASAE). audits of internal control over financial report-
ing, and attestations on management’s assess-
Issued by the FFIEC on September 28, 1999. ment of internal control over financial reporting
(collectively, audit or audits).
The advisory does not apply to—
UNSAFE AND UNSOUND USE OF
LIMITATION OF LIABILITY • nonaudit services that may be performed by
PROVISIONS IN EXTERNAL financial institutions’ external auditors,
AUDIT ENGAGEMENT LETTERS • audits of financial institutions’ 401(k) plans,
pension plans, and other similar audits,
On February 9, 2006, the Federal Reserve and • services performed by accountants who are
the other financial institution regulatory agen- not engaged to perform financial institutions’
cies (the agencies)32 issued an interagency audits (e.g., outsourced internal audits or loan
advisory (the advisory) to address safety-and- reviews), and
soundness concerns that may arise when finan- • other service providers (e.g., software consult-
cial institutions enter into external audit con- ants or legal advisers).
tracts (typically referred to as engagement letters)
that limit the auditors’ liability for audit ser- While the agencies have observed several
32. The Board of Governors of the Federal Reserve System 33. The advisory is effective for audit engagement letters
(Board), the Office of the Comptroller of the Currency (OCC), issued on or after February 9, 2006.
the Office of Thrift Supervision (OTS), the Federal Deposit 34. As used in this advisory, the term financial institutions
Insurance Corporation (FDIC), and the National Credit Union includes banks, bank holding companies, savings associations,
Administration (NCUA). savings and loan holding companies, and credit unions.

Page 28
types of limitation-of-liability provisions in with all agreements that affect a financial insti-
external audit engagement letters, this advisory tution’s legal rights, the financial institution’s
applies to any agreement that a financial insti- legal counsel should carefully review audit
tution enters into with its external auditor that engagement letters to help ensure that those
limits the external auditor’s liability with respect charged with engaging the external auditor make
to audits in an unsafe and unsound manner. a fully informed decision.
The advisory describes the types of objection-
able limitation-of-liability provisions and pro-
External Audits and Their vides examples.35 Financial institutions’ boards
of directors, audit committees, and management
Engagement Letters should also be aware that certain insurance
A properly conducted audit provides an inde- policies (such as error and omission policies and
pendent and objective view of the reliability of a directors’ and officers’ liability policies) might
financial institution’s financial statements. The not cover losses arising from claims that are
external auditor’s objective in an audit is to form precluded by limitation-of-liability provisions.
an opinion on the financial statements taken as a
whole. When planning and performing the audit,
the external auditor considers the financial insti- Limitation-of-Liability Provisions
tution’s internal control over financial reporting.
Generally, the external auditor communicates The provisions of an external audit engagement
any identified deficiencies in internal control to letter that the agencies deem to be unsafe and
management, which enables management to unsound can be generally categorized as fol-
take appropriate corrective action. In addition, lows: a provision within an agreement between
certain financial institutions are required to file a client financial institution and its external
audited financial statements and internal control auditor that effectively—
audit or attestation reports with one or more of
the agencies. The agencies encourage financial • indemnifies the external auditor against claims
institutions not subject to mandatory audit made by third parties;
requirements to voluntarily obtain audits of their • holds harmless or releases the external auditor
financial statements. The FFIEC’s Interagency from liability for claims or potential claims
Policy Statement on External Auditing Pro- that might be asserted by the client financial
grams of Banks and Savings Associations institution, other than claims for punitive dam-
notes, 34a ‘‘[a]n institution’s internal and exter- ages; or
nal audit programs are critical to its safety and • limits the remedies available to the client
soundness.’’ The policy also states that an effec- financial institution, other than punitive
tive external auditing program ‘‘can improve the damages.
safety and soundness of an institution substan-
tially and lessen the risk the institution poses to Collectively, these categories of provisions are
the insurance funds administered by the FDIC.’’ referred to in this advisory as limitation-of
Typically, a written engagement letter is used liability-provisions.
to establish an understanding between the exter- Provisions that waive the right of financial
nal auditor and the financial institution regard- institutions to seek punitive damages from their
ing the services to be performed in connection external auditor are not treated as unsafe and
with the financial institution’s audit. The engage- unsound under the advisory. Nevertheless, agree-
ment letter commonly describes the objective of
the audit, the reports to be prepared, the respon-
35. In the majority of external audit engagement letters
sibilities of management and the external audi- reviewed, the agencies did not observe provisions that limited
tor, and other significant arrangements (for exam- an external auditor’s liability. However, for those reviewed
ple, fees and billing). Boards of directors, audit external audit engagement letters that did have external
committees, and management are encouraged to auditor limited-liability provisions, the agencies noted a sig-
nificant increase in the types and frequency of the provisions.
closely review all of the provisions in the audit The provisions took many forms, which made it impractical
engagement letter before agreeing to sign. As for the agencies to provide an all-inclusive list. Examples of
auditor limitation-of-liability provisions are illustrated in the
advisory’s appendix A, which can be found in section A.1010.1
34a. See 64 Fed. Reg. 52319 (September 28, 1999). of this manual.

Page 29
ments by clients to indemnify their auditors tion is public or not, or (3) whether the external
against any third-party damage awards, includ- audit is required or voluntary.
ing punitive damages, are deemed unsafe and
unsound under the advisory. To enhance trans-
parency and market discipline, public financial Auditor Independence
institutions that agree to waive claims for puni-
tive damages against their external auditors may Currently, auditor-independence standard-setters
want to disclose annually the nature of these include the SEC, PCAOB, and AICPA. Depend-
arrangements in their proxy statements or other ing on the audit client, an external auditor is
public reports. subject to the independence standards issued by
Many financial institutions are required to one or more of these standard-setters. For all
have their financial statements audited, while nonpublic financial institutions that are not
others voluntarily choose to undergo such audits. required to have annual independent audits, the
For example, federally insured banks with FDIC’s rules, pursuant to part 363, require only
$500 million or more in total assets are required that an external auditor meet the AICPA inde-
to have annual independent audits.36 Further- pendence standards. The rules do not require the
more, financial institutions that are public com- financial institution’s external auditor to comply
panies37 must have annual independent audits. with the independence standards of the SEC and
The agencies rely on the results of audits as part the PCAOB.
of their assessment of a financial institution’s In contrast, for financial institutions subject to
safety and soundness. the audit requirements in part 363 of the FDIC’s
For audits to be effective, the external audi- regulations, the external auditor should be in
tors must be independent in both fact and compliance with the AICPA’s Code of Profes-
appearance, and they must perform all necessary sional Conduct and meet the independence
procedures to comply with auditing and attesta- requirements and interpretations of the SEC and
tion standards established by either the AICPA its staff.38 In this regard, in a December 13,
or, if applicable, the PCAOB. When financial 2004, frequently asked question (FAQ) on the
institutions execute agreements that limit the application of the SEC’s auditor-independence
external auditors’ liability, the external auditors’ rules, the SEC staff reiterated its long-standing
objectivity, impartiality, and performance may position that when an accountant and his or her
be weakened or compromised, and the useful- client enter into an agreement that seeks to
ness of the audits for safety-and-soundness pur- provide the accountant immunity from liability
poses may be diminished. for his or her own negligent acts, the accountant
By their very nature, limitation-of-liability is not independent. The FAQ also stated that
provisions can remove or greatly weaken exter- including in engagement letters a clause that
nal auditors’ objective and unbiased consider- would release, indemnify, or hold the auditor
ation of problems encountered in audit engage- harmless from any liability and costs resulting
ments and may diminish auditors’ adherence to from knowing misrepresentations by manage-
the standards of objectivity and impartiality ment would impair the auditor’s indepen-
required in the performance of audits. The dence.39 The FAQ is consistent with the SEC’s
existence of such provisions in external audit Codification of Financial Reporting Policies,
engagement letters may lead to the use of less section 602.02.f.i , ‘‘Indemnification by Client.’’
extensive or less thorough procedures than would (See section A.1010.1 of this manual.)
otherwise be followed, thereby reducing the On the basis of the SEC guidance and the
reliability of audits. Accordingly, financial insti- agencies’ existing regulations, certain limits on
tutions should not enter into external audit
arrangements that include unsafe and unsound
limitation-of-liability provisions identified in the
advisory, regardless of (1) the size of the finan- 38. See part 363 of the FDIC’s regulation (12 CFR 363),
cial institution, (2) whether the financial institu- Appendix A—Guidelines and Interpretations, Guideline 14,
‘‘Role of the Independent Public Accountant-Independence.’’
36. For banks, see section 36 of the FDI Act (12 USC 39. In contrast to the SEC’s position, AICPA Ethics Ruling
1831m) and part 363 of the FDIC’s regulations (12 CFR 363). 94 (ET, section 191.188–189) currently concludes that indem-
37. Public companies are companies subject to the report- nification for ‘‘knowing misrepresentations by management’’
ing requirements of the Securities Exchange Act of 1934. does not impair independence.

Page 30
auditors’ liability are already inappropriate in • provide a fair process (for example, neutral
audit engagement letters entered into by— decision makers and appropriate hearing pro-
cedures), and
• public financial institutions that file reports • are not imposed in a coercive manner.
with the SEC or with the agencies,
• financial institutions subject to part 363, and
• certain other financial institutions that are The Advisory’s Conclusion
required to have annual independent audits.
Financial institutions’ boards of directors, audit
In addition, certain of these limits on auditors’ committees, and management should not enter
liability may violate the AICPA independence into any agreement that incorporates limitation-
standards. Notwithstanding the potential appli- of-liability provisions with respect to audits. In
cability of auditor-independence standards, the addition, financial institutions should document
limitation-of-liability provisions discussed in the their business rationale for agreeing to any other
advisory present safety-and-soundness concerns provisions that limit their legal rights.
for all financial institution audits. The inclusion of limitation-of-liability provi-
sions in external audit engagement letters and
other agreements that are inconsistent with the
advisory will generally be considered an unsafe
Alternative Dispute-Resolution and unsound practice. Examiners will consider
Agreements and Jury-Trial Waivers the policies, processes, and personnel surround-
ing a financial institution’s external auditing
The agencies observed that a review of the program in determining whether (1) the engage-
engagement letters of some financial institutions ment letter covering external auditing activities
revealed that they had agreed to submit disputes raises any safety-and-soundness concerns and
over external audit services to mandatory and (2) the external auditor maintains appropriate
binding alternative dispute resolution, binding independence regarding relationships with the
arbitration, or other binding nonjudicial dispute- financial institution under relevant professional
resolution processes (collectively, mandatory standards. The agencies may take appropriate
ADR) or to waive the right to a jury trial. By supervisory action if unsafe and unsound
agreeing in advance to submit disputes to man- limitation-of-liability provisions are included in
datory ADR, financial institutions may waive external audit engagement letters or other agree-
the right to full discovery, limit appellate review, ments related to audits that are executed
or limit or waive other rights and protections (accepted or agreed to by the financial institution).
available in ordinary litigation proceedings.
Mandatory ADR procedures and jury-trial
waivers may be efficient and cost-effective tools
for resolving disputes in some cases. Accord- CERTIFIED PUBLIC
ingly, the agencies believe that mandatory ADR ACCOUNTANTS
or waiver of jury-trial provisions in external
audit engagement letters do not present safety- This section discusses the standards for compe-
and-soundness concerns, provided that the tence and independence of certified public
engagement letters do not also incorporate accountants (CPAs) as well as the standards
limitation-of-liability provisions. Institutions are required in connection with their audits.
encouraged to carefully review mandatory ADR
and jury-trial provisions in engagement letters,
as well as review any agreements regarding Standards of Conduct
rules of procedure, and to fully comprehend the
ramifications of any agreement to waive any The Code of Professional Ethics for CPAs who
available remedies. Financial institutions should are members of the American Institute of Cer-
ensure that any mandatory ADR provisions in tified Public Accountants (AICPA) requires that
audit engagement letters are commercially rea- audits be performed according to generally
sonable and— accepted auditing standards (GAAS). GAAS, as
distinct from generally accepted accounting prin-
• apply equally to all parties, ciples, or GAAP, are concerned with the audi-

Page 31
tor’s professional qualifications, the judgment ration of the financial statements and the pre-
the auditor exercises in the performance of an sentations therein. The auditor’s responsibility
audit, and the quality of the audit procedures. is to express an opinion on the financial state-
On the other hand, GAAP represents all of the ments. GAAS (or the audit requirements previ-
conventions, rules, and procedures that are nec- ously set forth) require that audits cover the
essary to define accepted accounting practices at following financial statements: balance sheet,
a particular time. GAAP includes broad guide- income statement, statement of changes in stock-
lines of general application and detailed prac- holders’ equity, and statement of cash flows.
tices and procedures that have been issued by GAAS require that CPAs plan and perform
the Financial Accounting Standards Board auditing procedures to obtain reasonable assur-
(FASB), the AICPA, the SEC, or other authori- ance that financial statements are free from
tative bodies that set accounting standards. Thus, material misstatement. Under GAAS, an audit
GAAP provides guidance on financial-reporting includes examining on a test basis and should
and disclosure matters. include evidence supporting the amounts and
disclosures in the financial statements. An audit
also includes assessing the accounting principles
used and significant estimates made by manage-
Generally Accepted Auditing ment, as well as evaluating the overall financial-
Standards statement presentation.
GAAS are grouped into three categories: gen-

eral standards, standards of field work, and Independence
standards of reporting.
In the performance of their work, CPAs must be
The general standards require that the audit be independent of those they serve. Traditionally,
performed by a person or persons having independence has been defined as the ability to
adequate technical training and proficiency; that act with integrity and objectivity. In accordance
independence in mental attitude be maintained; with the rule on independence included in the
and that due professional care be exercised in SEC’s independence rules and the Code of
the performance of the audit and the preparation Professional Ethics and related AICPA interpre-
of the report. tations, the independence of a CPA is considered
to be impaired if, during the period of his or her
Standards of field work require that the work be professional engagement, the CPA or his or her
adequately planned; assistants, if any, be prop- firm had any direct or material indirect financial
erly supervised; a proper study and evaluation of interest in the enterprise or had any loan to or
existing internal controls be made for determin- from the enterprise or any officer, director, or
ing the audit scope and the audit procedures to principal stockholder thereof. The latter prohi-
be performed during the audit; and sufficient bition does not apply to the following loans
evidence be obtained to formulate an opinion from a financial institution when made under
regarding the financial statements under audit. normal lending procedures, terms, and
requirements:
Standards of reporting require that the CPA state
whether the financial statements are presented in • automobile loans and leases collateralized by
accordance with GAAP. The application of the automobile
GAAP in audited financial statements and • loans in the amount of the cash surrender
reports must achieve the fundamental objectives value of a life insurance policy
of financial accounting, which are to provide • borrowings fully collateralized by cash depos-
reliable financial information about the eco- its at the same financial institution (for exam-
nomic resources and obligations of a business ple, passbook loans)
enterprise. In addition, the informative disclo- • credit cards and cash advances under lines of
sures in the financial statements must follow credit associated with checking accounts with
GAAP, or the CPA must state otherwise in the aggregate unpaid balances of $5,000 or less
report.
GAAS recognizes that management—not the Such loans must, at all times, be kept current by
CPA—has primary responsibility for the prepa- the CPA as to all terms.

Page 32
Other loans have been grandfathered by the • other reports from the auditor to regulators
AICPA under recent ethics interpretations. These during the audit period.
other loans (mortgage loans, other secured loans,
and loans not material to the AICPA member’s The major types of standard audit reports will
net worth) must, at all times, be current as to all never have a heading or other statement in the
terms and shall not be renegotiated with the report that identifies which type it is. Rather, the
client financial institution after the latest of— type of report is identified by certain terminol-
ogy used in the text of the report. The major
• January 1, 1992; types of standard audit reports are described
• the date that the financial institution first below.
becomes a client;
• the date the loans are sold from a nonclient The unqualified report, sometimes referred to as
financial institution to the client financial a clean opinion, states that the financial state-
institution; or ments are ‘‘presented fairly’’ in conformity with
• the date of becoming a member in the AICPA. GAAP and that the necessary audit work was
done.
The examiner may decide under certain cir-
cumstances to test the independence of the CPA The qualified report may generally have the
through reviews of loan listings, contracts, stock- same language as the unqualified report but will
holder listings, and other appropriate measures. use the phrase ‘‘except for’’ or some other
Concerns about independence should be identi- qualification to indicate that some problem
fied in the report of examination. exists. The types of problems include a lack of
sufficient evidential matter, restrictions on the
The SEC has also released guidance relating
scope of audit work, or departures from GAAP
to the independence of auditors for public insti-
in the financial statements. This type of report is
tutions. According to SEC Rule 101, the inde-
not necessarily negative but indicates that the
pendence of an auditor would be impaired if
examiner should ask additional questions of
financial, employment, or business relationships
management.
exist between auditors and audit clients, and if
there are relationships between auditors and
An adverse report basically concludes that the
audit clients in which the auditors provide cer-
financial statements are not presented fairly in
tain nonaudit services to their audit clients.
conformity with GAAP. This type of report is
Much of the language found in the SEC’s
rarely issued because auditors and management
independence rules is incorporated in the Inter-
usually work out their differences in advance.
agency Policy Statement on the Internal Audit
Function and Its Outsourcing.
A disclaimer expresses no opinion on the finan-
cial statements. CPAs may issue a disclaimer
when they have concluded that substantial doubt
exists about the ability of the institution to
EXTERNAL AUDIT REPORTS continue as a going concern for a reasonable
period of time. This disclaimer is intended to
The external auditor generates various types of indicate that the CPA is not assuming any
reports and other documents. These reports responsibility for these statements.
typically include—
• the standard audit report, which is generally a

one-page document; REVIEW OF THE EXTERNAL
• a ‘‘management letter’’ in which the auditor AUDITOR’S INDEPENDENCE
confidentially presents detailed findings and AND AUDIT
recommendations to management; and
• an attestation report in which the auditor Because of the professional and ethical stan-
attests to management’s assertion of internal dards of the public accounting profession, the
controls and procedures over financial reports Federal Reserve has concluded that the exam-
(for public companies and institutions subject iner should conduct an in-depth review of the
to section 36 of the FDI Act); and competence and independence of the CPA only

Page 33
in unusual situations. One such situation would grams of Banks and Savings Associations
be a recent change in CPAs by a bank, particu- (effective January 1, 2000) (SR-99-33)).
larly if the change was made after an audit had
commenced.
Ordinarily, specific tests to determine inde- LIMITATIONS OF AUDITS AND
pendence are not necessary. However, there may AUDITED FINANCIAL
be occasions when the examiner has sufficient STATEMENTS
reason to question the independence of a CPA or
the quality of his or her work. For example, the Although auditing standards are designed to
examiner may discover that during the period of require the use of due care and objectivity, a
a CPA’s professional engagement, which includes properly designed and executed audit does not
the period covered by the financial statements necessarily guarantee that all misstatements of
on which the CPA has expressed an opinion, the amounts or omissions of disclosure in the finan-
CPA or a member of his or her firm— cial statements have been detected. Moreover, a
properly designed and executed audit does not
• had a direct financial interest in the bank; guarantee that the auditor addressed FRB safety-
• was connected with the bank in a capacity and-soundness considerations. Examination per-
equivalent to that of a member of management sonnel should be cognizant of the limitations
or was a director of the bank; inherent in an audit. The following examples
• maintained, completely or in part, the books illustrate some common limitations of audits:
and records of the bank and did not perform
audit tests with respect to such books and • The auditor is not responsible for deciding
records; or whether an institution operates wisely. An
• had a prohibited loan from the bank (as unqualified audit report means that the trans-
discussed earlier). actions and balances are reported in accor-
dance with GAAP. It does not mean that the
In these and similar instances, the CPA would transactions made business sense, that the
not have complied with professional standards. associated risks are managed in a safe and
The examiner should determine the scope of sound manner, or that the balances can be
the CPA’s examination by reviewing the most recovered upon disposition or liquidation.
recent report issued by the CPA. If the audit is in • The auditor’s report concerning financial state-
progress or is planned to commence in the near ments does not signify that underwriting stan-
future, the examiner should review any engage- dards, operating strategies, loan-monitoring
ment letter to the bank from the CPA. The systems, and workout procedures are adequate
examiner also should obtain and review any to mitigate losses if the environment changes.
adjusting journal entries suggested by the CPA The auditor’s report that financial statements
at the conclusion of the examination. This should fairly present the bank’s financial position is
be done to determine whether such entries were based on the prevailing evidence and current
the result of breakdowns in the internal control environment, and it indicates that reported
structure and procedures for financial reporting. assets can be recovered in the normal course
Under certain circumstances, a CPA may of business. In determining that reported assets
issue a qualified or adverse opinion or may can be recovered in the normal course of
disclaim an opinion on a bank’s financial state- business, the auditor attempts to understand
ments. In such circumstances, the examiner financial-reporting internal controls and can
should first determine the reasons for the par- substitute other audit procedures when these
ticular type of opinion issued. If the matters controls are weak or nonexistent.
involved affect specific areas of the bank’s • The quality of management and how it man-
operations, a review of the work performed by ages risk are not considered in determining
the CPA may help the examiner understand the historical cost and its recoverability. Although
problem that gave rise to this opinion. The certain assets and instruments are marked to
examination procedures (section 1010.3) market (for example, trading accounts), GAAP
describes the steps the examiner should follow generally uses historical cost as the basis of
when conducting a review of the work per- presentation. Historical cost assumes that the
formed by the CPA. (See the FFIEC interagency entity is a going concern. The going-concern
Policy Statement on the External Auditing Pro- concept allows certain mark-to-market losses

Page 34
to be deferred because management believes tion between external auditors and examiners.
the cost basis can be recovered during the Examination personnel should provide banking
remaining life of the asset. organizations with advance notice of the starting
• GAAP financial statements offer only limited date of the examination when appropriate, so
disclosures of risks, uncertainties, and the management can inform external auditors in
other safety-and-soundness factors on which advance and facilitate the planning and sched-
the institution’s viability depends. uling of their audit work.
• Under GAAP, loan-loss reserves are provided Some institutions prefer that audit work be
for ‘‘probable losses’’ currently ‘‘inherent’’ completed at different times than examination
(that is, anticipated future charge-offs are work to reduce demands on their staff members
based on current repayment characteristics) in and facilities. Other institutions prefer to have
the portfolio. GAAP defines probable as the audit work and examination work performed
likelihood that a future event will occur, during similar periods so the institution’s opera-
confirming the fact of the loss. Additionally, tions are affected only at certain times during the
the amount of the loss must be reasonably year. By knowing when examinations are
estimable. planned, institutions have the flexibility to sched-
ule external audit work concurrent with, or
separate from, examinations.
COMMUNICATION WITH
EXTERNAL AUDITORS
GAAS requires that the external auditor can
Meetings and Discussions Between
consider regulatory authorities as a source of External Auditors and Examiners
competent evidential matter when conducting an
audit of the financial statements of a banking An external auditor may request a meeting with
organization. Accordingly, an external auditor the FRB regulatory authorities involved in the
may review communications from, and make supervision of the institution or its holding
inquiries of, the regulatory authorities. company during or after completion of exami-
Generally, the Federal Reserve encourages nations to inquire about supervisory matters
auditors to attend examination exit conferences relevant to the institution under audit. External
upon completion of the examiner’s field work or auditors should provide an agenda in advance.
to attend other meetings concerning examina- The FRB regulatory authorities will generally
tion findings between supervisory examiners request that management of the institution under
and an institution’s management or board of audit be represented at the meeting. In this
directors (or a committee thereof). Banks should regard, examiners will generally only discuss
ensure that their external auditors are informed with an auditor examination findings that have
in a timely manner of scheduled exit confer- been presented to bank management.
ences and other relevant meetings with examin- In certain cases, external auditors may wish to
ers and of the FRB’s policies regarding auditor discuss with examiners matters relevant to the
attendance at such meetings. institution without bank management represen-
tation. External auditors may request such con-
When other conferences between examiners
fidential meetings with the FRB regulatory
and management are scheduled (those that do
authorities, who may also request such meetings
not involve examination findings that are rel-
with the external auditor.
evant to the scope of the external auditor’s
work), the institution should first obtain the
approval of the appropriate Federal Reserve
Bank personnel for the auditor to attend the meet- Information Required to Be Made
ings. The interagency policy statement of July 23, Available to External Auditors
1992, does not preclude the Federal Reserve
from holding meetings with the management of Section 931 of the Financial Institutions Reform,
banks without auditor attendance or from requir- Recovery, and Enforcement Act of 1989
ing that the auditor attend only certain portions (FIRREA) and section 112 of FDICIA (12 USC
of the meetings. (See SR-92-28.) 1811) pertain to depository institutions insured
The 1992 interagency policy statement was by the FDIC that have engaged the services of
issued to improve coordination and communica- an external auditor to audit the banking organi-

Page 35
zation within the past two years. FIRREA and requirements of section 931 of FIRREA (12
FDICIA require banks to provide the auditor USC 1817(a)) and section 112 of FDICIA and
with copies of the most recent Report of Con- should report instances of noncompliance in the
dition (Call Report), report of examination, and report of examination.
pertinent correspondence or reports received
from its regulator. This information is to be
provided to the external auditor by the bank Confidentiality of Supervisory
under audit, not by the FRB. In addition, bank-
ing organizations must provide the independent
Information
auditor with— While the policies of the FRB regulatory author-
ities permit external auditors to have access to
• a copy of any supervisory memorandum of the information described above, institutions
understanding or written agreement between a and their auditors are reminded that information
federal or state banking agency and the bank contained in examination reports, inspection
put into effect during the period covered by reports, and supervisory discussions—including
the audit, and any summaries or quotations—is confidential
• a report of any formal action taken by a supervisory information and must not be dis-
federal or state banking agency during such closed to any party without the written permis-
period, or any civil money penalty assessed sion of the FRB. Unauthorized disclosure of
with respect to the bank or any banking confidential supervisory information may lead
organization–affiliated party. to civil and criminal actions and fines and other
penalties.
Regulatory personnel should ascertain if the
banking organization is in compliance with the

Page 36
Internal Control and Audit Function, Oversight, and Outsourcing
Examination Objectives
Effective date May 2006 Section 1010.2
1. To determine whether internal and external tence of those who provide the internal and
audit functions exist. external audit functions.
2. To determine with reasonable assurance that 6. To consider the policies, processes, and per-
the bank has an adequate internal audit func- sonnel surrounding the bank’s external audit-
tion that ensures efficient and effective ing program and to determine if—
operations, including the safeguarding of a. any engagement letter or other agreement
assets, reliable financial reporting, and com- related to external audit activities for the
pliance with applicable laws and regulations. bank (1) provides any assurances of
3. To ascertain, through the examination pro- indemnification to the bank’s external
cess, that the bank’s internal audit function auditors that relieves them of liability for
monitors, reviews, and ensures the continued their own negligent acts (including any
existence and maintenance of sound and losses, claims, damages, or other liabili-
adequate internal controls over the bank’s ties) or (2) raises any other safety-and
management process—the control environ- soundness-concerns; and
ment, risk assessment, control activities, b. the external auditors have maintained
information and communication, and moni- appropriate independence in their relation-
toring activities. ships with the bank, in accordance with
4. To review and evaluate internal audit out- relevant professional standards.
sourcing arrangements and the actions of the 7. To determine the adequacy of the procedures
outsourcing vendor under the standards performed by the internal and external
established by the Interagency Policy State- auditors.
ment on the Internal Audit Function and Its 8. To determine, based on the criteria above, if
Outsourcing. the work performed by internal and
5. To evaluate the independence and compe- external auditors is reliable.

Page 1
Examination Procedures
This examination program must be used in 4. Audit staff qualifications. Review the
conjunction with the audit function and audit biographical data and interview the manage-
outsourcing questionnaire section to review the ment staff of the audit department to
bank’s internal and external audits and the audit determine their qualifications for their del-
procedures they encompass. The audit guide- egated responsibilities.
lines are general and all sections or questions 5. Content and use of the audit frequency and
may not be applicable to every bank. scope schedule. Review the organization
Before reviewing any specific audit proce- charts and the bank’s chart of accounts to
dures, the examiner should first determine the determine the adequacy of the audit program.
independence and competence of the auditors. If 6. Audit department participation in systems
the examiner believes the auditors to be both design projects. Determine, through inter-
competent and independent, he or she should views with the internal auditor and appro-
then determine the acceptability of their work. priate staff members and through the docu-
Based on the answers to the audit function mentation review, the department’s role in
questions and on the auditor’s work, the automated and/or manual systems design.
examiner must then determine the scope of the 7. Audit manual. Review the audit manuals
examination. The program and related support- and associated internal control question-
ing documentation should be completed in an naires to determine the adequacy of the
organized manner and should be retained as part prescribed procedures for the accomplish-
of the examination workpapers. ing the audit objectives.
Upon completion of the program, the exam- 8. Maintenance of audit records. Review a
iner should be able to formulate a conclusion on sample of the audit reports and associated
the adequacy of audit coverage. Conclusions workpapers to determine compliance
about any weaknesses in the internal or external with prescribed procedures and proper
audit work performed for the bank should be documentation.
summarized and included in the report of 9. Audit department’s formal reporting
examination. Significant recommendations procedures. Review all auditor’s reports to
should be discussed with the audit committee the board of directors (audit or examining
and senior bank management. If recommenda- committee) and a representative sample of
tions are made orally, a memorandum of the the departmental or functional reports, con-
discussion should be prepared and included in sider their distribution and follow-up proce-
the workpapers. dures, and determine how effectively the
audit department responsibility is discharged.
10. Use and effectiveness of audit computer
programs. Interview the auditor and/or the
INTERNAL AUDITORS appropriate staff members regarding the use
of the computer and access to the files for
1. Organizational structure of the audit audit purposes.
department. Review the bylaws and the
organization chart of the bank and the
minutes of the board’s audit or examining
committee to determine how effectively the INTERNAL AUDIT FUNCTION
board of directors is discharging its ADEQUACY
responsibility.
2. Independence of the audit function. Inter- 1. Adjust the scope of the examination if the
view the auditor and observe the operation bank’s internal audit function does not suf-
of the audit department to determine its ficiently meet the bank’s internal audit needs
functional responsibilities. (whether or not the audit function is out-
3. Auditors’ qualifications. Review biographi- sourced), does not satisfy the Interagency
cal data and interview the auditor to deter- Guidelines Establishing Standards for Safety
mine his or her ability to manage the and Soundness, or is otherwise inadequate.
auditor’s responsibility in the bank. 2. Discuss supervisory concerns and outstand-

Page 1
1010.3 Internal Control and Audit Function, Oversight, and Outsourcing—Examination Procedures
ing internal-external audit report comments to be compromised, discuss the exami-

with the internal audit manager or other nation findings and the supervisory actions
person responsible for reviewing the system that may be taken with the bank’s senior
of internal control. If these discussions do management, board of directors (or audit
not resolve the examiner’s comments and committee), and the external auditor or
concerns, bring these matters to the atten- other vendor.
tion of senior management and the board of
directors or the audit committee.
3. If material weaknesses in the internal audit
function or the internal control system exist, EXTERNAL AUDITORS
discuss them with appropriate Federal
Reserve Bank supervisory staff to deter- 1. If the bank has engaged any external audit
mine the appropriate actions (including for- firms to conduct audits of its financial
mal and informal enforcement actions) that statements (including their certification),
should be taken to ensure that the bank audits of internal control over financial
corrects the deficiencies. reporting, attestations on management’s
4. Incorporate conclusions about the bank’s assessment of internal control, appraisals of
internal audit function into the bank’s man- the bank’s audit function, any internal audit
agement and composite supervisory ratings. or audit function or operational review,
review any pending or past engagement
5. Include in the report of examination com-
letters and agreements. Determine if the
ments concerning the adequacy of the inter-
audit engagement letters or other agree-
nal audit function, significant issues or con-
ments include unsafe and unsound provi-
cerns, and recommended corrective actions.
sions that—
a. indemnify the external auditor against all
claims made by third parties;
INDEPENDENCE OF THE b. hold harmless, release, or indemnify the
OUTSOURCING VENDOR external auditor from liability for claims
or potential claims that the bank may
1. If the initial review of an internal audit assert (other than claims for punitive
outsourcing arrangement, including the damages), thus providing relief from lia-
actions of the outsourcing vendor, raises bility for the auditors’ own negligent
questions about the bank’s and its vendor’s acts, including any losses, claims, dam-
adherence to the independence standards ages, or other liabilities; or
discussed in parts I and II (and also in part c. limit the remedies available to the bank
III, if the vendor provides both external and (other than punitive damages).
internal audit services to the bank) of the 2. Find out whether the bank’s board of direc-
Interagency Policy Statement on the Inter- tors, audit committee, and senior manage-
nal Audit Function and Its Outsourcing— ment closely review all of the provisions of
a. ask the bank and the outsourcing vendor audit engagement letters or other agree-
how the audit committee determined that ments for providing external auditing ser-
the vendor was independent; vices for the bank before agreeing to sign
b. if the vendor is an accounting firm, ask them, thus indicating the bank’s approval
the audit committee how it assessed that and financial commitment.
the arrangement has not compromised 3. Verify that the bank has documented its
applicable SEC, PCAOB, AICPA, or business rationale qfor any engagement let-
other regulatory standards concerning ter or other agreement provisions with
auditor independence; external audit firms that limit or impair the
c. if the answers to the above supervisory bank’s legal rights.
concerns are not adequately addressed, 4. With the cooperation of the audit commit-
discuss the matter with appropriate tee, review and determine the adequacy of
Reserve Bank supervisory staff; and the bank’s external auditors’ reports, letters,
d. if the Reserve Bank supervisory staff or correspondence, including their support-
concurs that the independence of the ing workpapers, for the audit work per-
external auditor or other vendor appears formed since the previous examination.

Page 2
Internal Control and Audit Function, Oversight, and Outsourcing—Examination Procedures 1010.3
REGULATORY EXAMINATIONS member bank examination. Interview any

involved auditors to determine their respon-
1. Review any functional regulatory examina- sibilities and extent of involvement with the
tion or supervisory examination report for work in this area.
work performed since the previous state

Page 3
Audit Function Questionnaire
Review the documentation as instructed in the quality advice and counsel to management
examination procedures section to answer the and the board of directors on current devel-
following audit function and audit outsourcing opments in risk management, internal con-
questions. Where appropriate, supporting docu- trol, and regulatory compliance?
mentation and pertinent information should be
retained or noted under comments.
INDEPENDENCE AND
MANAGEMENT OF THE AUDIT
ORGANIZATIONAL STRUCTURE FUNCTION
AND INTERNAL CONTROL
ENVIRONMENT OF THE AUDIT 1. Is the audit department functionally segre-
DEPARTMENT gated from operations in the organizational
structure?
1. Has the board of directors delegated respon- 2. Does the audit committee review or approve
sibility for the audit function? If so, to the budget and salary of the auditor? If not,
whom? who does?
2. Has the board of directors established an 3. Are the reporting procedures of the auditor
audit committee? Is it composed solely of independent of the influence of any operat-
outside directors? ing personnel?
3. Are the members of the audit commit- 4. Is the internal audit function adequately
tee qualified for their particular managed to ensure that audit plans are
responsibilities? accomplished and the audit results are
4. Does the audit committee promote the promptly communicated to the audit com-
internal audit manager’s impartiality and mittee, senior management, and the board
independence by having him or her directly of directors?
report audit findings to it? How often does 5. Has the audit staff been relieved of respon-
the audit committee meet with and review sibility for conducting continuous audits?
reports issued by the auditor? 6. Has the audit department been relieved of
5. Are the audit committee meetings with the responsibility for maintaining duplicate
auditor closed to bank personnel? records?
6. Do the minutes of the audit committee 7. Do the responsibilities of the audit staff
indicate an appropriate interest in the exclude any duties to be performed in lieu
activities and findings? of operating personnel, such as preparation
7. Does the auditor report to the board of or approval of general ledger entries, offi-
directors, the audit committee, or an cial checks, daily reconcilements, dual con-
executive officer who is sufficiently high in trol, etc.?
the bank’s hierarchy? If so, which one? If
not, to whom does the auditor report?
8. Are the internal audit function’s control risk AUDITOR’S QUALIFICATIONS
assessment, audit plans, and audit programs
appropriate for the bank’s activities? 1. Are the auditor’s academic credentials
9. Are internal audit activities consistent with comparable to other bank officers who
the long-range goals and strategic direction have major responsibilities within the
of the bank, and are they responsive to its organization?
internal control needs? 2. Is the auditor certified (or in the process of
10. Do management and the board of directors becoming certified) as a chartered bank
use reasonable standards, such as the IIA’s auditor, certified internal auditor, or certi-
Standards for the Professional Practice of fied public accountant? If yes, which one
Internal Auditing, when assessing the per- (or ones)?
formance of internal audit? 3. Is the auditor’s experience in both auditing
11. Does the audit function provide high- and banking comparable both in quality and

Page 1
1010.4 Internal Control and Audit Function, Oversight, and Outsourcing: Audit Function Questionnaire
in duration to that required of the officers 6. Does the frequency and scope schedule
assigned major responsibilities? require approval by the audit committee, the
4. Does the auditor communicate and relate board of directors, regulatory authorities, or
well with all levels of personnel? others? If so, by whom, and has such
5. Does the auditor demonstrate a commit- approval been obtained?
ment to continuing education and a current 7. Does the frequency and scope schedule
knowledge of the latest developments in comply with state statutory requirements, if
banking and auditing technology? any, for internal audits, including minimum
6. Is the auditor dedicated to the standards and audit standards?
ethics of his or her profession (such as those
published by the Bank Administration 8. Does the auditor periodically report his or
Institute, the Institute of Internal her progress in completing the frequency
Auditors, and the American Institute of and scope schedule to the board’s audit
Certified Public Accountants)? committee?
a. If not to the board’s audit committee, to
whom?
AUDIT STAFF QUALIFICATIONS b. Does the committee approve significant
deviations, if any, in the original
1. Is the audit staff sufficient in number to program?
perform its tasks adequately? 9. Does the auditor prepare a time budget? Are
2. Is the staff adequately experienced in budgeted versus actual time analyses used
auditing and banking? as a guide in forward planning?
3. Are members of the staff experienced in 10. Does the depth of coverage appear to be
specialized areas, such as EDP, foreign- sufficient?
exchange trading, trust, and subsidiary
activities of the bank? 11. Are different entry dates and time periods
4. Is there a formal audit training program in between reviews scheduled so as to frus-
effect? trate reliable anticipation of entry dates by
5. Is the number of unfilled vacancies on the auditees?
audit staff considered reasonable? 12. Is the bank’s possession of all assets owned
6. Is the turnover of audit personnel acceptable? or managed in fiduciary capacities sub-
7. Does management have plans to improve its jected to verification?
audit capability, if needed? 13. Are controls on opening and closing general
ledger and subsidiary accounts adequate
and is the auditor formally advised of any
CONTENT AND USE OF THE changes?
AUDIT FREQUENCY AND SCOPE 14. If the bank has automated systems, does the
SCHEDULE program call for the application of indepen-
dently prepared computer programs that
1. Is the audit program formalized and there- employ the computer as an audit tool?
fore on record as a commitment that can 15. Will the audit staff examine the documen-
be analyzed and reviewed? tation of all bank systems and produce their
2. Are all important bank functions and ser- own documentation?
vices identified as subjects of the audits?
3. Does the audit program include procedures 16. Are all service-related activities not specifi-
necessary to ensure compliance with the cally manifested in general ledger accounts
Federal Election Campaign Act and the subject to adequate periodic review (for
Foreign Corrupt Practices Act? example, supervisory regulations, security,
4. Does the internal audit department have vacation policy, purchases, traveler’s checks,
access to all reports, records, and minutes? and safekeeping)?
5. Are internal audit activities adjusted for 17. Will appraisals of administrative control be
significant changes in the bank’s environ- made for each function, yielding audit com-
ment, structure, activities, risk exposures, or ments and suggestions for improvements of
systems? operational efficiency?

Page 2
Internal Control and Audit Function, Oversight, and Outsourcing: Audit Function Questionnaire 1010.4
AUDIT DEPARTMENT 10. Does the manual prescribe that full control
PARTICIPATION IN SYSTEMS be established at the time of entry over the
DESIGN PROJECTS records selected for audit?
11. Is proof of subsidiary to control records
1. Is there a formal or informal procedure for required?
notifying the auditor of contemplated new 12. Are subsidiary direct verification programs
systems or systems modifications in the covering all forms of customer deposit,
early planning stages? loan, safekeeping, collateral, collection, and
2. Is the auditor a member of an executive trust accounts included?
systems planning or steering committee? If 13. Are flow charts called for as evidence of
not, does the auditor have access thorough analytical auditing?
to and review the minutes of such 14. Do the procedures employ scientific sam-
committees? pling techniques that have acceptable relia-
3. Does an audit representative review the bility and precision?
activities of systems design teams for audit 15. Does the audit manual provide for the
and internal control requirements? Is the resolution of exceptions and deficiencies?
specialized training and experience of the 16. Does the audit manual contain provisions
audit staff sufficient to support effective for report format and content and an expres-
reviews? sion of the opinion of the auditor regarding
4. Does the audit department avoid over- the adequacy, effectiveness, and efficiency
participation in systems design, modifica- of internal controls?
tion, and conversion? 17. For each audit, do audit procedures provide
5. Is the auditor’s ‘‘sign-off’’ on new or modi- for a documented method of assuring audit
fied systems restricted to control and audit management that a proper study and evalu-
trail features? ation of existing internal controls has been
made, such as an internal control question-
naire or memorandum?
AUDIT MANUAL 18. Does the audit manual contain a provision
for a review and update of the procedures
1. Has responsibility for the establishment and
for each audit, where required, upon the
maintenance of the audit manual been
audit’s completion?
clearly assigned?
2. Does the audit manual require approval by 19. Does the audit manual provide for the
the board of directors, the audit committee, maintenance of a permanent file for audits
or others? If so, has such approval been conducted?
obtained? 20. Does the audit manual contain provisions
3. Is the content of the audit manual indepen- for the formal, standardized preparation and
dent from adverse influence by other inter- maintenance of workpapers?
ests, such as operating management or 21. Are applicable statutory and regulatory
independent CPAs? requirements included in the audit
4. Is the audit manual current, and are proce- procedures?
dures for keeping the manual current
adequate?
5. Does the audit manual contain the scope MAINTENANCE OF AUDIT
and objective of each audit? RECORDS
6. Does the manual provide for valid devia-
tions from audit procedures to be officially 1. Are workpapers arranged and maintained
approved by audit management? for filing and reference in—
7. Do audit procedures provide for the follow-up a. the current file?
of exceptions noted in previous audits? b. the permanent file?
8. Does the manual prescribe that each audit 2. Is a reasonable record-retention schedule
procedure be cross-referenced to the appro- and departmental index maintained for audit
priate audit workpapers? records?
9. Must an auditor initial each program step as 3. Are audit procedures being complied with
testimony of his or her performance? during each audit?

Page 3
4. Do the workpapers contain evidence that differences of opinion between audit and
all significant deviations from standard operating management effective?
audit procedures are documented and 4. Does the auditor maintain a formal record
have received the approval of audit of all audit reports that contain unresolved
management? recommendations and exceptions?
5. Are procedures for preparing and maintain- 5. Does the bank promply respond to signifi-
ing workpapers being adhered to? cant identified internal control weaknesses?
6. Do workpapers adequately document the Are exceptions and recommendations
internal audit work performed and support generally resolved within 90 days?
the audit reports? 6. Are audit reports submitted promptly?
7. Do workpapers contain a copy of the audit 7. Are responses received promptly?
report, an adequate index, an internal con-
trol questionnaire, audit procedures, and
other appropriate material? USE AND EFFECTIVENESS OF
8. Are workpapers numbered, indexed, and AUDIT COMPUTER PROGRAMS
cross-referenced to audit procedures and the
workpapers index? 1. What audit computer programs are used and
9. Is each workpaper dated and initialed by the what are their purposes?
preparer? 2. Is there a member of the audit staff qualified
a. Are sources of data clearly shown? to write and appraise the quality of audit
b. Are tick marks explained? computer programs?
10. From the workpapers, can it be determined 3. Is the auditor satisfied that he or she has
how various sample sizes were determined sufficient ‘‘free access’’ to the computer
(by judgment or statistical sampling), includ- files?
ing the range and confidence level? 4. Are audit programs run on request?
11. Do workpapers contain evidence that 5. Do direct verification programs allow the
supervisory personnel of the audit depart- auditor flexibility in selecting the criteria to
ment have reviewed the workpapers and be used in determining the sample?
resultant findings? 6. Have procedures been established for the
12. Are all significant or unresolved exceptions development and maintenance of documen-
noted in workpapers required to be included tation for audit computer programs? Are
in the report? they adhered to?
13. Are applicable statutory and regulatory 7. Are changes to audit programs controlled?
requirements being complied with?
INTERNAL AUDIT
AUDIT DEPARTMENT’S FORMAL OUTSOURCING ARRANGEMENTS
REPORTING PROCEDURES
1. If the bank outsources its internal audit
1. Does the auditor submit formal reports? If function, does it have a written contract or
so, to whom? an engagement letter with the vendor?
2. Do the reports convey to the reader the 2. Does the written contract or engagement
auditor’s general observation of the condi- letter include provisions that—
tion of the operation of the department or a. define the expectations and responsibili-
function? ties under the contract for both parties?
a. Do they adequately reflect the scope of b. set the scope and frequency of, and the
the audit? fees to be paid for, the work to be
b. Do they contain an opinion of the auditor performed by the vendor?
regarding the adequacy, effectiveness, c. set the responsibilities for providing and
and efficiency of internal controls? receiving information, such as the type
c. Do they call for a prompt response, and frequency of reporting to senior
where appropriate? management and directors about the sta-
3. With regard to audit exceptions and recom- tus of contract work?
mendations, is the method of resolving d. establish the process for changing the

Page 4
Internal Control and Audit Function, Oversight, and Outsourcing: Audit Function Questionnaire 1010.4
terms of the service contract, especially 5. Is the scope of the outsourced work revised
for expansion of audit work if significant appropriately when the bank’s environment,
issues are found, and contain stipulations structure, activities, risk exposures, or sys-
for default and termination of the contract? tems change significantly?
e. state that internal audit reports are the 6. Have the directors ensured that the out-
property of the institution, that the insti- sourced internal audit activities are effec-
tution will be provided with any copies tively managed by the bank?
of the related workpapers it deems nec- 7. Does the arrangement with the outsourcing
essary, and that employees authorized by vendor satisfy the independence standards
the institution will have reasonable and described in the Policy Statement on the
timely access to the workpapers prepared Internal Audit Function and Its Outsourcing
by the outsourcing vendor? and thereby preserve the independence of
f. specify the locations of internal audit the internal audit function, whether or not
reports and the related workpapers? the vendor is also the bank’s independent
g. specify the period of time (for example, public accountant?
seven years) that vendors must maintain 8. Has the bank performed sufficient due dili-
the workpapers?1 gence to satisfy itself of the vendor’s com-
h. state that outsourced internal audit ser- petence before entering into the outsourcing
vices provided by the vendor are subject arrangement, and are there adequate proce-
to regulatory review and that examiners dures for ensuring that the vendor maintains
will be granted full and timely access to sufficient expertise to perform effectively
the internal audit reports and related throughout the arrangement?
workpapers prepared by the outsourcing 9. Does the bank have a contingency plan to
vendor? ensure continuity in audit coverage, espe-
i. prescribe a process (arbitration, media- cially for high-risk areas?
tion, or other means) for resolving
disputes and for determining who bears
the cost of consequential damages EXTERNAL AUDIT
arising from errors, omissions, and ENGAGEMENT LETTERS AND
negligence?
OTHER AUDIT AGREEMENTS
j. state that the outsourcing vendor will not
perform management functions, make 1. Does the bank’s board of directors, audit
management decisions, or act or appear committee, and senior management closely
to act in a capacity equivalent to that of review all of the provisions in audit engage-
a member of management or an employee ment letters or other audit work agreements
and, if applicable, will comply with before agreeing to sign them?
AICPA, SEC, Public Company Account- 2. Does the bank’s legal counsel carefully
ing Oversight Board (PCAOB), or regu- review audit engagement letters to ensure
latory independence guidance? that those charged with engaging the exter-
3. Does the outsourced internal audit arrange- nal auditor make a fully informed decision?
ment maintain or improve the quality of the 3. Does the bank have any engagement letters
internal audit function and the bank’s inter- for audits of financial statements, audits of
nal control? internal control over financial reporting, or
4. Do key employees of the bank and the attestations on management’s assessment of
outsourcing vendor clearly understand the internal control that include unsafe and
lines of communication and how any inter- unsound provisions that—
nal control problems or other matters noted a. indemnify the external auditor against all
by the outsourcing vendor are to be claims made by third parties?
addressed? b. hold harmless or release the external
auditor from liability for claims or
potential claims that might be asserted
1. If the workpapers are in electronic format, contracts by the client financial institution (other
often call for the vendor to maintain proprietary software that
enables the bank and examiners to access the electronic than claims for punitive damages)?
workpapers for a specified time period. c. limit the remedies available to the client

Page 5
financial institution (other than punitive an independent CPA audit, did the bank
damages)? comply?
4. Has the bank agreed in any engagement a. If so, was the opinion rendered by the
letters or other audit work agreements to accounting firm unqualified?
submit disputes over external audit services b. If not, has the auditor taken appropriate
to mandatory and binding alternative dis- action to resolve any deficiencies?
pute resolution, binding arbitration, or other 2. Does the bank policy prohibit loans to its
binding nonjudicial dispute-resolution pro- external auditor or the engagement of an
cesses (collectively, mandatory ADR) or to external auditor who is a stockholder? If
waive the right to a jury trial. If so— not, has the board considered the materiality
a. has the bank’s senior management care- of any existing transactions regarding the
fully reviewed mandatory ADR and jury- auditor’s independence?
trial provisions in engagement letters, as 3. Has an external auditor been engaged to
well as reviewed any agreements regard- perform special reviews of specific depart-
ing rules of procedure, in order to fully ments or areas of the bank since the previ-
comprehend the ramifications of any ous examination? If deficiencies were cited,
agreement to waive any available have they been corrected?
remedies? 4. Has the same public accounting firm been
b. has the bank’s senior management engaged for the prior two years? If not,
obtained written assurances that its insur- obtain a reason for change.
ance policies (for example, the bank’s 5. Have management letters from the external
errors and omissions policies and direc- auditors or other reports from consultants
tors’ and officers’ liability policies) will been presented to management since the
cover losses from claims that are pre- last examination?
cluded by limitation-of-liability provi- 6. Do deficiencies in management letters
sions in audit engagement letters or other receive appropriate attention?
audit agreements? 7. Are the notes pertaining to the financial
5. Has the bank’s senior management ensured statements reviewed for any information
that any mandatory ADR provisions in that may allude to significant accounting or
audit engagement letters are commercially control problems?
reasonable and— 8. Does the report of examination or the man-
a. apply equally to all parties? agement letter submitted by the public
b. provide a fair process (e.g., neutral deci- accounting firm comprehensively define the
sion makers and appropriate hearing scope of the examination conducted?
procedures)?
c. are not imposed in a coercive manner?
6. Has the bank’s board of directors, audit REGULATORY EXAMINATION
committee, or senior management docu- ACTIVITIES
mented their business rationale for agreeing
to any provisions that limit their legal rights? 1. Does the internal audit department have
access to the examination reports?
2. Does the internal audit department investi-
gate the reasons for adverse comments and
EXTERNAL AUDIT ACTIVITIES recommendations in the examination reports?
3. Does the internal audit department monitor
1. When state, federal, or supervisory regula- the progress in dealing with these com-
tions or stock-exchange listing require ments and recommendations?

Page 6
Conflict-of-Interest Rules for Examiners
The Federal Reserve System (System) maintains rules as a result of the Preserving Independence
a long-standing policy that compels System of Financial Institution Examinations Act of
employees, including examiners, to avoid any 2003 (18 USC 212–213). The act included
action that may result in an employee (or create provisions that liberalized examiner borrowing
the appearance that an employee) is— restrictions by providing narrow exceptions that
enable bank examiners to obtain credit cards and
• using his or her Federal Reserve position for certain home mortgage loans from a broader
private gain, range of lenders. (See SR-05-2.)
• giving preferential treatment to any person or Under the act, a Reserve Bank examiner may
institution, accept a credit card or a loan secured by a
• losing independence or impartiality, or mortgage on the examiner’s principal residence
• making decisions outside of official channels. from an institution supervised by the Federal
Reserve, as long as the examiner meets the
Federal Reserve examiners are also subject to financial requirements to obtain such credit or
conflict-of-interest rules that are designed to loan. The terms of the credit or loan cannot be
ensure (1) both the objectivity and integrity of more favorable than the terms that are generally
bank examinations and (2) that Federal Reserve offered to other borrowers. Federal Reserve
examiners comply with criminal statutory policy, however, does not permit examiners to
prohibitions. participate in the examination of any banking
The conflict-of-interest rules are set forth in organization from which they have obtained
section 5 of the Federal Reserve Administrative home mortgage loans.
Manual and in each Reserve Bank’s uniform
codes of conduct.
POST-EMPLOYMENT
RESTRICTIONS FOR ‘‘SENIOR
EXAMINER BORROWING RULES EXAMINERS’’
On November 17, 2005, the federal bank regu-
A bank examiner is prohibited from accepting a
latory agencies1 adopted a rule (effective Decem-
loan or gratuity from any bank examined by the
ber 17, 2005) to implement the post-employment
individual (18 USC 213). An officer, director, or
restriction found in the Intelligence Reform and
employee of a bank is prohibited from making
Terrorism Prevention Act of 2004 (see 12 USC
or granting any loan or gratuity to any examiner
1820).2 (See the Board’s rules at 12 CFR 263
who examines or has authority to examine the
and 264, as well as SR-05-26 and its attach-
bank (18 USC 212). These statutory provisions
ments.) The restriction prohibits an examiner
may also be applicable to a loan obtained by a
who served as a ‘‘senior examiner’’ for a deposi-
System employee who has been issued a special,
tory institution or depository institution holding
temporary, or ad hoc examiner credential. An
company for two or more months during the
examiner found to be in violation of these
examiner’s final twelve months of employment
provisions can be—
with a Reserve Bank from knowingly accepting
compensation as an employee, an officer, a
• fined under title 18 of the U.S. Code (Crimes
director, or a consultant from that depository
and Criminal Procedure), imprisoned not more
institution or holding company, or from certain
than one year, or both;
related entities.3 The rule is expected to affect a
• further fined a sum equal to the money loaned
or gratuity given; and
1. The Board of Governors of the Federal Reserve System
• disqualified from holding office as an examiner. (Board), the Office of the Comptroller of the Currency, the
Federal Deposit Insurance Corporation, and the Office of
On February 3, 2005, the director of the Thrift Supervision.
Board’s Division of Banking Supervision and 2. Pub. L. 108-458, 118 Stat. 3638, 3751–53 (Decem-
ber 17, 2004).
Regulation and the Board’s general counsel, 3. The Board’s rule applies to a covered examiner who
acting under delegated authority, approved leaves the Federal Reserve’s service after December 17, 2005.
changes to the System’s examiner borrowing Because the statute has a one-year look-back provision, an

Page 1
1015.1 Conflict-of-Interest Rules for Examiners
relatively small number of Federal Reserve state member bank, bank holding company,
examiners, primarily the ‘‘central points of con- or foreign bank or its respective affiliates.
tact’’ (CPC) or other examiners in functionally
equivalent positions for the largest and most The rule does not cover an examiner who
complex institutions. Table 1 summarizes how performs only periodic, short-term examinations
the restriction applies to ‘‘senior examiners’’ of of a depository institution or holding company
the different types of organizations within the and who does not have ongoing, continuing
Federal Reserve’s jurisdiction. responsibility for the institution or holding com-
pany. The rule also does not cover an examiner
who spends a substantial portion of his or her
Definition of ‘‘Senior Examiner’’ time conducting or leading a targeted examina-
tion (such as a review of an institution’s credit-
For purposes of this rule, an officer or employee risk management, information systems, or inter-
of the Federal Reserve is considered to be the nal audit functions) and who does not have
‘‘senior examiner’’ for a particular state member broad and lead responsibility for the overall
bank, bank holding company, or foreign bank if examination program for the institution or hold-
the individual meets all of the following criteria: ing company.
The restriction applies to a covered individual
• The officer or employee has been authorized for one year after the individual terminates his
by the Board to conduct examinations or or her employment with the Reserve Bank. If an
inspections on behalf of the Board. examiner violates the one-year restriction, the
• The officer or employee has been assigned statute requires the appropriate federal banking
continuing, broad, and lead responsibility for agency to seek an order of removal and industry-
examining or inspecting that state member wide employment prohibition, a civil money
bank, bank holding company, or foreign bank. penalty of up to $250,000, or both. In special
• The officer’s or employee’s responsibilities circumstances, the Chairman of the Board of
for examining, inspecting, and supervising the Governors may waive the restriction for the
state member bank, bank holding company, or ‘‘senior examiner’’ of the Federal Reserve by
foreign bank— certifying in writing that granting the individual
– represent a substantial portion of the offic- a waiver of the restriction would not affect the
er’s or employee’s assigned responsibilities integrity of the Federal Reserve’s supervisory
and program.
– require the officer or employee to interact
routinely with officers or employees of the
examiner’s responsibilities from as far back as December 17,

2004, may subject the "senior examiner" to the post-
employment restriction.

Page 2
Conflict-of-Interest Rules for Examiners 1015.1
Table 1—Summary of Prohibited Employment Based on Examination

Responsibility
Examiner Responsibility Restriction
If during two or more months of the last Then for one year after leaving the Reserve
twelve months of service, the examiner serves Bank, the ‘‘senior examiner’’ may not know-
as the ‘‘senior examiner’’ for a— ingly accept compensation as an employee,
officer, director, or consultant from—
State member bank • the state member bank (including any sub-
sidiary of the state member bank) or
• any company (including a bank holding
company) that controls the state member
bank.
Bank holding company • the bank holding company or

• any depository institution controlled by the
bank holding company (including any sub-
sidiary of the depository institution).
Foreign bank • the foreign bank,

• any U.S. branch or agency of the foreign
bank, or
• any U.S. depository institution controlled by
the foreign bank (including any subsidiary
of the depository institution).

Page 3
Federal Reserve System Bank Watch List and
Surveillance Programs
The Federal Reserve System (the System) uses sures that correspond to areas of supervisory
automated screening systems to conduct routine concern. The monitoring screens and watch
monitoring of the financial condition and per- list are designed and used to spot trends and
formance of state member banks. These surveil- changes in an institution’s financial condition
lance systems rely on Call Reports and other and performance to determine if identified
financial regulatory reports, as well as examina- companies require further review.
tion data, to identify institutions exhibiting finan- 3. Corrective action and follow-up. Reserve
cial deterioration or increased risk profiles. This Bank follow-up action is performed for out-
surveillance process ensures that these banks lier institutions. The nature and extent of
receive timely supervisory attention and that follow-up depend on current conditions at
examination resources can be directed to weak the identified bank. Actions range from com-
and potentially troubled banks to supplement pleting a written analysis of the factors con-
on-site examinations. tributing to the outlier status to conducting an
System surveillance screens focus on many on-site examination. These efforts ensure that
areas evaluated in the supervisory process, identified problems are monitored until they
including capitalization, asset growth, loan qual- can be corrected or resolved.
ity, loan concentrations, interest-rate risk, and
liquidity. In addition, the screens flag banks
engaging in new or complex activities. The
surveillance information helps identify weak or
SYSTEM BANK WATCH LIST
deteriorating banks and those with changing risk PROGRAM
profiles.
The State Member Bank Watch List Program,
Examiners also use the surveillance results in detailed in SR-06-2, ‘‘Enhancements to the Sys-
preexamination planning. For example, before tem’s Off-Site Bank Surveillance Program,’’ is
an on-site review, the examiner will determine the Federal Reserve’s primary means for moni-
whether a bank is on the System’s State Member toring state member bank performance and con-
Bank Watch List (the watch list) and if the bank dition between on-site examinations. The watch
has failed any surveillance monitoring screens. list is a record of banks that failed selected
This information is useful in determining the monitoring screens or ratings criteria. The watch
type of examination scope (full, limited, or list helps the Reserve Banks track and address
targeted) and staff resources that will be needed. troubled or potentially weak banks and identify
The surveillance results can also be used to common supervisory issues in the banks meet-
identify bank activities that may warrant a ing watch list criteria. The program consists of
higher degree of review or focus during an five phases: (1) generating, reviewing, and modi-
on-site examination. Thus, the surveillance fying a watch list of banks meeting certain
information helps examination and supervision inclusion criteria; (2) analyzing the financial
staff plan and schedule more-forward-looking condition and risk profile of each bank on the
risk-focused examinations. final watch list and specifying the factors re-
The surveillance program activities generally sponsible for the bank’s appearance on the
consist of the following three supervisory watch list; (3) determining whether the safety-
components: and-soundness examination schedule should be
accelerated for those banks listed on the watch
1. A set of System monitoring screens of finan- list; (4) preparing or updating a surveillance
cial data. The process, referred to as ‘‘screen- write-up for each bank listed on the watch
ing,’’ involves a routine monitoring of the list; and (5) developing a suitable supervisory
financial condition, performance, and risk of response, including possible corrective action,
banks. that addresses identified problems.
2. Analysis based on the watch list and other The Watch List Program applies to all state
reports. System staff use the watch list and member banks and includes both state member
other data derived from the surveillance pro- banks with known weaknesses and those with
cess to flag outlier institutions, using mea- characteristics that could affect supervisory

Page 1
1020.1 Bank Watch List and Surveillance Programs
assessments of the quality of bank management a bank is reporting poor financial results or
or of the overall safety and soundness of a bank. showing other signs of significant weakness
The program helps to ensure that weaknesses compared with similarly rated banks. For exam-
existing at supervised banks are being addressed ple, a 1A rating signifies a 1-rated bank that
appropriately and that potential emerging prob- reports strong financial and supervisory indi-
lems can be promptly identified in between cators when compared with all 1- and 2-rated
regularly scheduled on-site safety-and-soundness banks, while a 1F indicates that, while the bank
examinations. State member banks are included currently maintains the strongest possible com-
on a watch list and require quarterly written posite CAMELS rating, its financial or other
analyses when they meet any of the following supervisory indicators place it among the weak-
criteria: est of the banks currently rated either 1 or 2.
SR-SABR ratings that include a ‘‘B’’ generally
• overall Supervision and Regulation Statistical correspond to banks with financial and super-
Assessment of Bank Risk (SR-SABR) surveil- visory measures that are comparable to most
lance rating of 1D, 1F, 2D, or 2F banks in the CAMELS rating category. Those
• CAMELS composite rating of 3 or worse with a ‘‘C’’ have weaker measures than those of
• Management or Risk Management component most other banks in their CAMELS rating cate-
rating of 3 or worse gory, and those with a ‘‘D’’ have significantly
• composite rating in either of the worst two weaker financial or supervisory measures com-
categories under the Trust, Information Tech- pared with other banks in their rating category.
nology, Consumer Compliance, or Commu- Three separate econometric models contrib-
nity Reinvestment Act rating systems ute to SR-SABR surveillance ratings. Two of
the models estimate the probability of an adverse
Reserve Banks and Board staff may add state supervisory rating change for a bank if it was
member banks to the watch list for reasons other examined within the next quarter. The first
than those listed above. For example, they may estimates the probability of an adverse rating
elect to include selected de novo banks, banks change for banks currently rated CAMELS 1 or
reporting rapid asset or loan growth or signifi- 2. The second estimates the probability of an
cant changes in business mix, and other institu- adverse rating change for banks currently rated
tions with financial characteristics that suggest 3, 4, or 5.2 Together, these models are used to
the need for heightened off-site monitoring in assign an ‘‘adverse change’’ rating. They utilize
between on-site examinations. seven financial variables computed using Call
Report data and seven supervisory variables that
have been statistically significant in explaining
SR-SABR Model adverse ratings assigned over the past three
years. The third model is retained from the
The SR-SABR model assigns a two-component System to Estimate Examination Ratings (SEER)
surveillance rating to each bank. The first com- framework and estimates the probability that a
ponent is the current composite CAMELS rating bank will fail or become critically undercapital-
assigned to the bank. The second component is ized within the next two years. This model is
a letter (A, B, C, D, or F), reflecting the model’s referred to as the ‘‘viability’’ model and includes
assessment of the relative strength or weakness 11 financial variables computed using Call
of a bank compared with other institutions Report data. The model was estimated and
within the same CAMELS rating category.1 An developed based on the financial results from
SR-SABR rating that includes an ‘‘A’’ denotes the large group of banks that failed in the late
a bank with particularly strong financial and 1980s and early 1990s.
supervisory indicators compared with other
banks within its CAMELS rating category. An
SR-SABR rating including an ‘‘F’’ indicates that Quarterly Watch List Procedures
Board staff will distribute a preliminary quar-
1. For banks currently rated 1 or 2, ‘‘CAMELS rating
category’’ refers to all banks with satisfactory (1 or 2) terly watch list to surveillance contacts at each
CAMELS ratings. Banks with less than satisfactory CAMELS
ratings are compared only with other banks that have the same 2. For 5-rated banks, an adverse rating change is defined as
CAMELS rating. the continuation of the current rating.

Page 2
Bank Watch List and Surveillance Programs 1020.1
Reserve Bank upon the finalization of quarterly Holding Company Performance Reports, and
Call Report processing. To assist examiners and results of the System Bank Monitoring Screens
analysts in interpreting SR-SABR model results, and the System BHC Monitoring Screens.
Board staff will also distribute SR-SABR Sched- • Determine whether the safety-and-soundness
ule of Risk Factors (SRFs) reports. The SRFs examination schedule should be accelerated
highlight financial ratios that cause the model to for each watch list bank. In cases where
flag a bank as particularly strong or weak. These substantial deterioration in a bank’s financial
reports also include peer statistics to highlight condition is evident or where a bank’s risk
the relative position of a bank compared with profile has increased significantly, Reserve
other institutions that have similar CAMELS Banks should commence an on-site review of
composite ratings. In addition, supplemental the bank no later than 60 days after the release
monitoring screens will be distributed to assist of the final watch list. Unless an on-site
in analyzing watch list banks and in identifying examination has been completed within the
other banks that may require additional super- last six months or the Reserve Bank can
visory attention. document that SR-SABR results do not reflect
Upon notification from Board staff that quar- material safety-and-soundness concerns,
terly surveillance materials are ready for review, Reserve Banks should generally accelerate
Reserve Banks should perform the following examinations when a state member bank is
procedures: assigned an SR-SABR rating of 1F, 2F, or 3F.
The scope of on-site reviews conducted for
• Review and modify the watch list. Review the watch list banks may vary, depending on the
preliminary watch list and add any other state risk factors present and knowledge about
member banks from their districts that have the bank and its management. In some cases,
significant safety-and-soundness weaknesses. discussing the issues with management may
For each bank to be added, the Reserve Bank suffice; in others, a full-scope safety-and-
should submit the name, ID RSSD number, soundness examination may be necessary.
location, asset size, and the reasons for its • Prepare surveillance write-ups for each watch
inclusion on the watch list by e-mail to the list bank. No more than 30 days after receiv-
manager of the Surveillance, Financial Trends, ing the quarter’s final watch list, Reserve
and Analysis Section at the Board within five Banks should document conclusions on the
business days of receiving the preliminary watch list banks in a write-up posted to the
watch list. Reserve Banks also may recom- System’s Central Data and Text Repository
mend removal of banks that they previously (CDTR) using the Banking Organization
had added to the watch list and that no longer National Desktop (BOND) application.3 Each
appear to warrant watch list status. In these write-up should be posted as a ‘‘State Member
cases, the Reserve Bank should also provide Bank Watch List Write-Up’’ and assigned an
a brief written rationale to Board staff for ‘‘as of’’ date that corresponds to the quarterly
removing any banks from the watch list. Ten surveillance cycle. The write-ups should—
days after the distribution of the draft, the — briefly summarize the cause for a bank’s
watch list will be deemed final, and the time appearance on the watch list and assess
frame for completing all follow-up work will whether it poses risks to the safety and
commence. soundness of the bank;
• Assess the financial condition and risk profile
of each final watch list bank. Reserve Banks
should review each final watch list bank in
their Districts to assess the bank’s financial 3. In general, Reserve Banks should create a separate
condition and risk profile. Reserve Banks quarterly watch list document for each state member bank
should consider recent examination findings included on the watch list. However, for bank subsidiaries of
the largest banking organizations, which are subject to con-
for the bank and its affiliates, relevant infor- tinuous supervision and already require separate quarterly
mation included in correspondence between written analyses, the factors required for a quarterly watch list
the bank and the Reserve Bank, and other write-up, if applicable, may be addressed within the standard
outside sources of information. Reserve Banks quarterly documentation posted in the CDTR and BOND.
Reserve Bank surveillance contacts, however, should notify
also should use all appropriate surveillance the manager of the Surveillance, Financial Trends, and Analy-
tools in evaluating each bank, including the sis section of the specific CDTR documents that address these
Uniform Bank Performance Report, Bank requirements.

Page 3
1020.1 Bank Watch List and Surveillance Programs
— detail the supervisory actions that have For state member banks that have been
been taken in response to safety-and- included on the watch list in the prior quarter,
soundness concerns; write-ups should focus on new developments or
— describe bank management’s response to changes in the condition or performance of the
safety-and-soundness concerns; bank. Key background information, however,
— address whether the current CAMELS should be carried forward so that the write-up
rating accurately reflects the bank’s conserves as a stand-alone summary document of
dition, considering adverse SR-SABR the bank’s current condition and prospects for
results when applicable; improvement.
— assess whether the timing of the next
safety-and-soundness examination should
be accelerated; and
— describe the Reserve Bank’s plans for
addressing any safety-and-soundness issues
over the next quarter.

Page 4
Federal Reserve System Bank Watch List and Surveillance
Programs
Effective date November 2000 Section 1020.2
1. To identify major changes in the financial 3. To check the validity of the data being
condition of the bank between examinations. reported by the bank.
2. To assist in determining the scope of the 4. To investigate areas where an in-depth review
examination and the priority of work to be is indicated.
performed.

Page 1
Federal Reserve System Bank Watch List and Surveillance
Programs
1. Obtain any surveillance screening reports, report. This analysis should be considered
such as the watch list and Federal Reserve when determining the scope of the examina-
System monitoring screens, or other analysis tion, and when making staffing decisions.
reports prepared by the Reserve Bank or 4. Follow up on unusual aspects revealed in the
Board that have been generated for the bank. surveillance screening reports, in analysis
2. Review the reports obtained in step 1 reports, or on newly obtained data signifi-
and discuss with surveillance staff, if neces- cantly different from prior information.
sary, for clarification or for further back- 5. Perform validity checks necessary to ensure
ground information. the quality of reported data. This would
3. If a pre-examination analysis has not been include such normal examination procedures
prepared, create one from information con- as validating call report information and
tained in the bank performance report, cur- confirming the accuracy and soundness of
rent call report, and previous examination past-due and accrual accounting practices.

Page 1
Workpapers
Effective date March 1984 Section 1030.1
INTRODUCTION • information that is of a continuing or perma-

nent nature.
Workpapers are the written documentation of • guidance in preparation of workpapers for the
the procedures followed and the conclusions current examination.
reached during the examination of a bank. • an indication of changes or inconsistencies in
Accordingly, they include, but are not necessar- accounting procedures or methods of their
ily limited to, examination procedures and application since the last examination.
verifications, memoranda, schedules, question-
naires, checklists, abstracts of bank documents Accumulation of relevant documentation con-
and analyses prepared or obtained by examiners. sistent with prior examinations, however, is
The definition of workpapers, their purpose, often insufficient. Workpapers should be pre-
and their quality and organization are important pared in a manner designed to facilitate an
because the workpapers as a whole should objective review, should be organized to support
support the information and conclusions con- an examiner’s current findings and should doc-
tained in the related report of examination. The ument the scope of the current examination.
primary purposes of workpapers are to— Minimum content necessary for each section of
workpapers includes:
• organize the material assembled during an
examination to facilitate review and future Source of Information—This is important, not
reference. only in identifying the bank, but also in identi-
• aid the examiner in efficiently conducting the fying the preparer. In subsequent examinations,
examination. the preparer should be able to readily determine
• document the policies, practices, procedures the bank personnel from whom the information
and internal controls of the bank. was obtained during the previous examination
• provide written support of the examination as well as the examiner who prepared the
and audit procedures performed during the workpapers. Accordingly, each workpaper should
examination. include—
• document the results of testing and formalize
the examiner’s conclusions. • bank name and subdivision thereof, either
• substantiate the assertions of fact or opinion functional or financial.
contained in the report of examination. • statement of title or purpose of the specific
analysis or schedule.
They also are useful as— • specific identification of dates, examination
date and work performance date.
• a tool for the examiner-in-charge to use in • initials of preparer and initials indicating
planning, directing, and coordinating the work review by the examiner designated to perform
of the assistants. that function. Although appropriate use may
• a means of evaluating the quality of the work be made of initials, the full names and initials
performed. of all examiners should appear on a time and
• a guide in estimating future personnel and planning summary or on an attachment to the
time requirements. file to facilitate future identification.
• a record of the procedures used by the bank to • name and title of person, or description of
assemble data for reports to the Board of records, that provided the information needed
Governors of the Federal Reserve System. to complete the workpaper.
• a guide to assist in the direction of subsequent • an index number identifying the workpaper
examinations, inquiries and studies. and facilitating organization of the workpaper
files.
The initial step in preparing workpapers is to
review, where available, the applicable sections Scope of Work—This includes an indication of
of supporting data prepared during the prior the nature, timing and extent of testing in
examination. When reviewing prior workpapers, application of examination and audit proce-
the examiner should consider the data prepared dures. It also includes the examiner’s evaluation
in each area for— of and reliance on internal and external audit

Page 1
1030.1 Workpapers
procedures and compliance testing of internal • Condense information for simplicity.

controls. To the extent that this information is
contained in other workpapers, such as an Frequently, time can be saved by carrying
examination procedure or a questionnaire, a forward workpapers from one examination to
reference to the appropriate workpaper will be the next. Thus, when laying out an analysis that
sufficient. might be repeated in future examinations, the
examiner should arrange it in a manner to
Conclusions—The examiner should develop con- facilitate future use. For example, extra columns
clusions, in accordance with the examination may be left blank within an account analysis
objectives, with respect to the information displaying little activity for insertion of transac-
obtained, documentation provided and the tion information during future examinations. In
results of the examination and audit procedures such a situation, appropriate space (boxes and
performed. Such conclusions provide the ba- column headings) should be provided for the
sis for information contained in the report of signature or initials of the preparer and reviewer
examination. during each examination. When a workpaper is
removed from one examination file and carried
To develop workpapers that have the qualities forward, a notation should be made in the file
of clarity, completeness and conciseness, ade- from which the paper is extracted. This is
quate planning and organization of content are important in the event workpapers applicable to
essential. Therefore, before the workpaper is a particular examination are needed several
prepared, the examiner should determine the years after the completion of the examination.
following:
• What examination objective will be satisfied INITIAL PREPARATION BY

by preparing the analysis or workpaper?
• Can preparation of the analysis be avoided
OTHERS
by testing the bank’s records and indicating
Although all items included in the report of
the nature and extent of testing in an exami-
examination should be supported by workpa-
nation or an audit procedure or by comment
pers, their preparation may not always require
on a related schedule or another supporting
document? original work by the examiner. Frequently, ar-
• Is the analysis necessary to support the infor- rangements can be made for bank personnel,
mation in the report of examination? including internal auditors, to prepare workpa-
pers for examination use or to make available
Subsequent to the determination that an anal- papers prepared by them as part of their regular
ysis is required, but before initiating prepara- duties. Examples include outstanding checklists,
tion, the examiner should decide if— lists of outstanding certificates of deposit, sched-
ules of employee borrowings, and debt maturity
• previous examination analyses can be schedules. The extent to which examiners can
adapted and carried forward to the current utilize analyses and data prepared by bank
examination. personnel increases the efficiency with which
• the analysis can be prepared by an internal examination procedures are completed.
auditor or other bank personnel. As part of the initial examination planning
• the format of the analysis may be designed process, arrangements should be made with
in a manner to facilitate its use in future appropriate bank management for the timely
examinations. completion of bank-prepared data and informa-
tion. The coordinating bank officer(s) must un-
Once it has been determined that preparation derstand what information is being requested
of an analysis is required, the examiner should and why it is being requested, in order to avoid
consider the following techniques that promote confusion and unnecessary regulatory burden.
clarity of workpaper preparation: Arrangements, however, may have to be made
for the bank to supply supporting details or other
• Restrict writing to only one side of the paper. schedules or items to comply with the requests.
• Use a standard size sheet of paper large Upon receipt of bank-prepared analyses, an
enough to avoid overcrowding. examiner should review the documents for over-

Page 2
Workpapers 1030.1
all completeness and note the date of receipt. dures should not be made available to bank
This facilitates future planning and provides a employees.
ready reference as to which analyses have been In cases where customary examination prac-
received from the bank at any given point during tices are not practical, alternative procedures
the examination. Also, all bank-prepared work- and the extent to which they are applied should
papers should be tested and the nature and be documented. The need for completeness
extent of testing performed by the examiner requires that there be no open items, unfinished
should be indicated on the papers. operations or unanswered questions in the work-
papers at the conclusion of the examination.
The clarity of workpapers should be such that
an examiner or Federal Reserve official unfamil-
INITIAL APPROACH IN iar with the work could readily understand it.
WORKPAPER PREPARATION Handwritten commentaries should be legible,
concise and should support the examiner’s con-
The initial approach in preparing workpapers
clusions. Descriptions of work done, notations
that support balances in the statement of condi-
of conferences with bankers, conclusions reached
tion is quantitative. In using this approach, the
and explanations of symbols used should be free
examiner obtains an analysis of the composition
from ambiguity or obscurity. Excessive use of
of the account balance as of the examination
symbols usually can be avoided by expanding a
date. This inventory of the composition may be
comment to include the nature and extent of
represented by a trial balance of loans, a listing
work performed instead of using separate sym-
of outstanding official checks, a listing of indi-
bols for each portion of the work performed. In
vidual deposit accounts, or other similar items.
addition, instructions to assisting personnel con-
Only after determining the composition and
cerning standards or workpaper content are
insuring that the total agrees with the bank’s
necessary to ensure that they will meet the
records is the examiner in a position to perform
quality standards of the Federal Reserve. When
examination procedures and to arrive at a con-
workpapers have the necessary qualities of com-
clusion about the overall quality of the items
pleteness, clarity, conciseness and neatness, a
comprising the balance.
qualified reviewer may easily determine their
For certain analyses, however, it is preferable
relative value in support of conclusions and
to include account activity (transactions) in the
objectives reached. Incomplete, unclear or vague
workpapers. Typical examples of such analyses
workpapers should, and usually will, lead a
are those of bank premises and equipment and
reviewer to the conclusion that the examination
of reserve for possible loan losses. The format
has not been adequately performed.
for reserve for possible loan losses should include
beginning balances (prior examination ending
balances), provisions for loan losses, collec-
tions, charge-offs, other transactions (transfers
REVIEW PROCEDURES
to/from undivided profits) and ending balances
Experienced personnel must review all workpa-
as of the examination date.
pers prepared during an examination. Usually
that review is performed by the examiner-in-
charge, although in some cases, the examiner-
CONTROL AND REVIEW in-charge may designate other experienced per-
sonnel to perform an initial review. An overall
All examiners assigned to an examination should review is then performed by the examiner-in-
insure that workpapers are controlled at all times charge. The two primary purposes of a review of
while the examination is in progress. For exam- workpapers by senior personnel are to determine
ple, when in the bank’s offices, the workpapers that the work is adequate given the circum-
should be secured at night and safeguarded stances, and to ensure that the record is suffi-
during the lunch hour or at other times when no cient to support the conclusions reached in the
examining personnel are present in the immedi- report of examination. The timely review of
ate vicinity. It is essential to completely control workpapers and subsequent discussion of them
confidential information provided by the bank. with the individual who prepared them also is
In addition, information relating to the extent of one of the more effective procedures for on-the-
tests and similar details of examination proce- job training.

Page 3
1030.1 Workpapers
Normally, the review should be performed as • loans.

soon as practicable after the completion of each • reserve for possible loan losses.
work area. This review ideally occurs at the • bank premises and equipment.
bank’s office so that if the need for obtaining • other assets.
additional information arises or additional work • deposits.
is required the matter can be promptly attended • other liabilities.
to with minimum loss of efficiency. • capital accounts and dividends.
When the review of workpapers is completed,
the reviewer should sign or initial the applicable Each individual file would normally include—
documents. Although all workpapers should be
reviewed, the depth and degree of detail depends • related examination and audit procedures.
on factors such as: • detailed information and other documentation
necessary to indicate the specific procedures
• The nature of the work and its relative performed, the extent of such procedures and
importance to the overall examination the examiner’s conclusions for the specific
objectives. area.
• The extent to which the reviewer has been • a summary, in comparative form, of the sup-
associated with the area during the porting general ledger balances with appropri-
examination. ate cross-references.
• The experience of the examiners who have
carried out the various operations. Judgment is required as to what the file
should include on any specific examination.
Professional judgment must be exercised Lengthy documents should be summarized or
throughout the review process. highlighted (underlined) so that the examiner
who is performing the work in the related area
can readily locate the important provisions,
ORGANIZATION OF WORKPAPER without having to read the entire document. It
FILES also may be desirable to have a complete copy
of the document in the file to support the
Administration of an examination includes— summaries or answer questions of a specific
legal nature.
• organizing the workpaper files. Examples of documents that might be con-
• delegating authority for completion of all tained in the files are—
applicable workpaper sections.
• reviewing and assembling the completed • a brief history and organization of the bank.
workpapers. • organization charts of applicable departments
within the bank.
To ensure efficiency in locating information • copies of, or excerpts from, the charter and
contained in the workpapers and completion of bylaws.
all necessary procedures, workpapers should be • copies of capital stock certificates, debentures
filed and indexed in a standard manner. agreements and lease agreements.
• excerpts from minutes or contracts that are of
interest beyond the current year.
FILES • a chart of accounts and an accounting manual,
if available, supplemented by descriptions of
The file provides the organizational vehicle to unique accounts and unusual accounting
assemble workpapers applicable to specific areas methods.
of the examination. Files might include detailed • lists of names and titles of the board of
workpapers related to— directors, important committees and relevant
departmental personnel.
• management appraisal.
• overall conclusions about the condition of the
bank. Indexing and Cross-Referencing
• cash accounts.
• investments. To promote efficiency and help ensure that all

Page 4
Workpapers 1030.1
applicable areas of an examination have been • facilitates the review of the workpapers.
considered and documented, the use of an in- • helps in following the workpapers during the
dexing system aids in the organization of work- succeeding examination.
paper files. A general outline or index including
all examination areas provides a basis for orga-
nization to which a numbering or other sequen-
tial system can be assigned and applied to each WORKPAPER RETENTION
workpaper file.
When all workpapers pertinent to a specific Examiners should retain on a readily available
area of the examination have been completed, a basis those workpapers from—
cover sheet listing the contents of each file
should be attached to the front to provide a • the most recent full-scope Federal Reserve
permanent record for reference. This permits not examination.
only efficient location of a set of workpapers
• the most recent general EDP examination.
pertinent to a specific area of the examination
(for example, cash or commercial loans), but • examinations of banks requiring or recom-
also facilitates the location of a specific analysis mended for more than normal or special
(or other document) within the set. supervisory attention (composite rating of 3, 4
Amounts or other pertinent information or 5; consumer compliance rating of 3, 4 or 5;
appearing in more than one place in the work- EDP departments rated 4 or 5; or those subject
papers should be cross-referenced between the to administrative action such as civil money
analyses. A notation on the index, including penalties) until such banks are no longer the
appropriate cross-referencing of those items subject of such scrutiny.
removed or filed elsewhere, facilitates location • examinations disclosing conditions that may
of specific data and records and also helps to lead eventually to more than normal or special
prevent inadvertent loss of documents. An supervisory attention, as described above,
example is the cross-referencing of net charge- until the supporting workpapers are no longer
offs obtained in the review of the reserve for appropriate.
possible loan losses to the amount approved in • examinations disclosing conditions that lead,
the board of director’s minutes. Proper cross- or may eventually lead, to a criminal referral
referencing is important because it— or criminal investigation.
• serves as a means of locating work performed These guidelines are the minimum required
for a particular account or group of accounts. retention period for workpapers; longer reten-
• identifies the source of supporting amounts in tion periods may be set by individual Reserve
a particular analysis. Banks.

Page 5
Cash Accounts
Cash accounts include U.S. and foreign coin and ment, a check-processing department, an out-
currency on hand and in transit, clearings, and clearing department, or some other department
cash items. that is characteristic of the area of the country
where the bank operates. The functions may be
centralized or decentralized, manual or auto-
mated, depending on the size of the bank and the
CASH volume of transactions. The volume of clearings
may be so great that the bank’s proof operations
Every bank maintains a certain amount of U.S.
are conducted after time deadlines for trans-
currency and some may have foreign currency
action posting or courier delivery. In these cases,
on hand. To avoid having excess nonearning
daily clearings customarily are determined as of
assets and to minimize exposure to misappro-
a specific cutoff time. Checks processed to that
priation and robbery, each bank should establish
time are carried in one day’s totals, and checks
a policy to maintain cash balances at the mini-
processed after that time are carried in the
mum levels necessary to serve its customers.
following day’s totals. However, no matter who
The amount will vary from bank to bank
performs the function or how large the bank, the
depending on anticipated needs of customers
objectives of a proof and transit system are the
and the availability of replenishment monies,
same:
with a reasonable allowance made for unusual
demands.
• to forward items for collection so that funds
Foreign currency may not be included in cash are available as soon as possible
positions for management purposes when the
• to distribute all incoming checks and deposits
amounts are not significant. However, the coin
to their destinations
and currency of other countries are foreign-
• to establish whether deposit totals balance
currency assets, as are loans or nostro accounts,
with the totals shown on deposit tickets
and should be included in the foreign-currency
positions. • to prove the totals of general ledger entries
and other transactions
• to collect data for computing the individual
customer’s service charges and determining
CLEARINGS the availability of the customer’s funds
• to accomplish the assigned functions at the
Clearings are checks, drafts, notes, and other lowest possible cost
items that a bank has cashed or received for
deposit that are drawn on other local banks and
cleared directly with them. These items can
usually be exchanged more efficiently among CASH ITEMS
local banks than through correspondent banks or
the Federal Reserve System. Many communities Cash items are checks or other items in the
with two or more banks have formally organized process of collection that are payable in cash
clearinghouse associations, which have adopted upon presentation. A separate control of all cash
rules governing members in the exchange of items is usually maintained on the bank’s gen-
checks. Clearinghouse associations often extend eral ledger and, if applicable, on the interna-
their check-exchange arrangements to other tional division general ledger. The ledger is
nearby cities and towns. In most banks, clear- supported by a subsidiary record of individual
ings will be found in the department responsible amounts and other pertinent data. Cash items
for processing checks. and the related records are usually in the custody
Proof and transit were once two separate of one employee at each banking office.
functions in a bank: the proving of work (proof) In their normal daily operations, banks have
and the sending of out-of-town cash items (tran- an internal charge, on the general ledger, to total
sit) for collection. Most banks have now com- demand deposits not charged to individual
bined these two functions. Proof and transit may accounts because of insufficient funds, computer
be performed by any combination of tellers or misreads, or other problems. Commonly known
proof clerks, a separate proof and transit depart- as return items or rejected or unposted debits,

Page 1
2000.1 Cash Accounts
these items may consist of checks received in In addition to those items carried in the
the ordinary course of business, loan-payment separate ‘‘cash items’’ account on the general
debits, and other debit memos. In some banks, ledger, most banks will have several sources of
return items are separated by the bookkeepers internal float in which irregular cash items can
and an entry is made reclassifying them to a be concealed. Such items include any memo-
separate asset account entitled ‘‘bookkeepers’ randa slips; checks drawn on the bank; checks
return items.’’ Other banks do not use a separate returned by other banks; checks of directors,
asset account; instead, the bookkeepers include officers, employees, and their interests; checks
the items in a subsidiary control account in the of affiliates; debits purporting to represent cur-
individual demand deposit ledgers. In that case, rency or coin shipments; notes, usually past due;
the account would have a debit balance and and all aged and unusual items of any nature that
would be credited when the bank processes might involve fictitious entries, manipulations,
items for posting or returns the checks to their or uncollectible accounts.
source.
Since bookkeepers’ return items are usually
processed and posted to an individual account or
returned to their source on the next business day, CURRENCY TRANSACTIONS
the balance of the bookkeepers’ return items
account should represent the total of only one The Financial Recordkeeping and Reporting of
day’s returned items. Currency and Foreign Transactions regulation,
When data processing systems are used, the 31 CFR 103, requires financial institutions to
common practice is to post all properly encoded maintain records that might be useful in crimi-
debit items, regardless of whether an overdraft is nal, tax, or regulatory investigations. The regu-
created. The resulting preliminary overdraft list, lation also seeks to identify persons who attempt
together with the items charged, is subsequently to avoid payment of taxes through transfers of
reviewed by bank employees, and unapproved cash to or from foreign accounts. The examina-
items are reversed and separated as bookkeep- tion procedures for determining compliance with
ers’ return items. The total of the resulting final the regulation require the examiner to ascertain
overdraft list becomes the final overdraft figure the quality of the bank’s auditing procedures
shown on the general ledger. The examination and operating standards relating to financial
of overdrafts is discussed in ‘‘Deposit Accounts,’’ recordkeeping.1 Examiners also determine the
section 3000.1. The examination of international adequacy of written policies and bank training
overdrafts is discussed in ‘‘Due from Banks,’’ programs. The Financial Recordkeeping and
‘‘Borrowed Funds,’’ and ‘‘International—Foreign Reporting of Currency and Foreign Transactions
Exchange,’’ sections 2010.1, 3010.1, and 7100.1, checklist (see the Bank Secrecy Act Examination
respectively. Manual) is to be used in checking compliance
Several types of cash items should be consid- and for reporting apparent violations. Any vio-
ered ‘‘cash items not in the process of collec- lations noted should be listed with appropriate
tion’’ and shown in an appropriate ‘‘other assets’’ comments in the report of examination. Inad-
account. Some examples are (1) items that are equate compliance could result in a cease-and-
payable upon presentation but which the bank desist order to effect prompt compliance with
has elected to accumulate and periodically for- the statute.
ward to the payor, such as Series EE bonds or
food stamps; (2) items that are not immediately
1. Section 208.63 of Regulation H establishes procedures
payable in cash upon presentation; and (3) items to ensure that state member banks establish and maintain
that were not paid when presented and require procedures reasonably designed to ensure and monitor com-
further collection effort. pliance with the regulation.

Page 2
Cash Accounts
1. To determine if the policies, practices, pro- 4. To determine compliance with laws and
cedures, and internal controls regarding ‘‘cash regulations.
accounts’’ are adequate. 5. To initiate corrective action when policies,
2. To determine if bank officers and employees practices, procedures, or internal controls are
are operating in conformance with the estab- deficient or when violations of laws or regu-
lished guidelines. lations have been noted.
3. To determine the scope and adequacy of the
audit function.

Page 1
Cash Accounts
1. If selected for implementation, complete or tive inquiry of responsible bank officials

update the cash accounts section of the and review of documentation, whether a
internal control questionnaire. security program that equals or exceeds
2. Based on the evaluation of internal controls the standards prescribed by Regulation H
and the work performed by internal or (12 CFR 208.61(c)) is in effect and that
external auditors, determine the scope of the the annual compliance report and any
examination. other reports requested by the Federal
3. Test for compliance with policies, practices, Reserve System have been filed.
procedures and internal controls in conjunc- 8. Review compliance with the Financial
tion with performing the remaining exami- Recordkeeping and Reporting of Currency
nation procedures. Also obtain a listing of and Foreign Transactions Act, 31 CFR 103.
any deficiencies noted in the latest review 9. Review tellers’ over and short accounts for
done by internal or external auditors from recurring patterns and any large or unusual
the examiner assigned to that area of exami- items and follow up as considered neces-
nation, and determine if appropriate correc- sary. Investigate differences centered in any
tions have been made. one teller or banking office. Determine
4. Scan the general ledger cash accounts for whether corrective action has been taken, if
any unusual items or abnormal fluctuations. required.
Investigate any such items and document 10. Determine, by discreet corroborative inquiry
any apparent noncompliance with policies, of responsible bank officials and review of
practices and procedures for later review documentation, whether defalcations and/or
with appropriate management personnel. mysterious disappearances of cash since the
5. Obtain teller settlement sheet recap or simi- preceding examination have been properly
lar document as of the examination date and reported pursuant to current requirements of
agree to the general ledger. Scan for reason- the Board of Governors.
ableness and conformity to bank 11. Review foreign-currency control ledgers
policy. and dollar book value equivalents for the
6. Obtain detailed listings of cash items, includ- following:
ing any bank items which are carried in the a. accuracy of calculations and booking
general ledger under ‘‘other assets,’’ agree procedures
listings to general ledger balances and scan b. unusual fluctuations
for propriety and conformity to bank policy.
c. concentrations
7. Test compliance with Regulation H
d. unusual items
(12 CFR 208) by—
a. selecting teller and banking office cash- 12. Review international division revaluation
balance sheets and determining that calculations and procedures.
balances are within currency limits 13. Review the following items with appropri-
established; ate management personnel (or prepare a
b. selecting bait money and agreeing serial memo to other examining personnel for
numbers to applicable records; their use in reviewing with management):
c. reviewing documentation showing train- a. internal-control exceptions and deficien-
ing sessions held since the preceding cies in, or noncompliance with, written
examination; policies, practices and procedures
d. performing any visual inspections deemed b. uncorrected audit deficiencies
appropriate; c. violations of law
e. analyzing the bank’s system of security d. inaccurate booking of U.S. dollar book
and protection against external crimes value equivalents for foreign currencies
(Guidance for this analysis is provided in e. inaccurate revaluation calculations and
the internal control questionnaire in this procedures performed by cash-account
section of the manual.); and operations staff
f. determining, through discreet corrobora- 14. Prepare comments on deficiencies or

Page 1
2000.3 Cash Accounts: Examination Procedures
violations of law noted above for inclusion 15. Update the workpapers with any informa-
in the examination report. tion that will facilitate future examinations.

Page 2
Cash Accounts
Internal Control Questionnaire
Review the bank’s internal-control policies, prac- 15. Are maximum amounts established for
tices, and procedures for cash accounts. The tellers’ cashing checks or allowing with-
bank’s system should be documented com- drawal from time deposit accounts without
pletely and concisely and should include, where officer approval?
appropriate, narrative descriptions, flow charts, 16. Does the currency at each location include
copies of forms used, and other pertinent infor- a supply of bait money?
mation. Items marked with an asterisk require 17. Are tellers provided with operational guide-
substantiation by observation or testing. lines on check-cashing procedures and
dollar limits?
18. Is a record maintained showing amounts
and denominations of reserve cash?
CASH ON HAND *19. Is reserve cash under dual custody?
*1. Do all tellers, including relief tellers, have *20. Are currency shipments—
sole access to their own cash supply, and a. prepared and sent under dual control
are all spare keys kept under dual control? and
*2. Do tellers have their own vault cubicle or b. received and counted under dual control?
controlled cash drawer in which to store *21. If the bank uses teller machines—
their cash supply? a. is the master key controlled by some-
3. When a teller is leaving for vacation or for one independent of the teller function,
any other extended period of time, is that b. is the daily proof performed by some-
teller’s total cash supply counted? one other than the teller, and
4. Is each teller’s cash verified periodically c. are keys removed by the teller during
on a surprise basis by an officer or other any absence?
designated official (if so, is a record of *22. Is dual control maintained over mail
such count retained)? deposits?
*5. Are cash drawers or teller cages provided 23. Is the night depository box under a dual
with locking devices to protect the cash lock system?
during periods of the teller’s absence? 24. Is the withdrawal of night deposits made
6. Is a specified limit in effect for each under dual control?
teller’s cash? 25. Regarding night depository transactions—
*7. Is each teller’s cash checked daily to an a. are written contracts in effect;
independent control from the proof or b. are customers provided with lockable
accounting control department? bags; and
8. Are teller differences cleared daily? c. are the following procedures completed
9. Is an individual, cumulative over and short with two employees present:
record maintained for all persons han- • opening of the bags
dling cash, and is the record reviewed by • initial recording of bag numbers,
management? envelope numbers, and depositors’
10. Does the teller prepare and sign a daily names in the register
proof sheet detailing currency, coin, and • counting and verification of the
cash items? contents
*11. Are large teller differences required to be *26. Regarding vault control—
reported to a responsible official for a. is a register maintained which is signed
clearance? by the individuals opening and closing
12. Is there a policy against allowing teller the vault;
‘‘kitties’’? b. are time-clock settings checked by a
*13. Are teller transactions identified through second officer;
use of a teller stamp? c. is the vault under dual control; and
*14. Are teller transfers made by tickets or d. are combinations changed periodically
blotter entries which are verified and and every time there is a change in
initialed by both tellers? custodianship?

Page 1
2000.4 Cash Accounts: Internal Control Questionnaire
27. Are tellers prohibited from processing their an ATM and the central processing unit
own checks? trigger the alarm system?
*28. Are tellers required to clear all checks 43. Are alarm devices connected to all auto-
from their funds daily? mated teller machines?
*29. Are tellers prevented from having access 44. For on-line operations, are all messages to
to accounting department records? and from the central processing unit and
*30. Are teller duties restricted to teller the ATM protected from tapping, message
operations? insertion, modification of message or sur-
veillance by message encryption (scram-
bling techniques)? (One recognized encryp-
CASH-DISPENSING MACHINES tion formula is the National Bureau of
Standards Algorithm.)
*31. Is daily access to the automated teller *45. Are PINs mailed separately from cards?
machine (ATM) made under dual control? *46. Are bank personnel who have custody of
*32. When maintenance is being performed on cards prohibited from also having custody
a machine, with or without cash in it, is a of PINs at any stage (issuance, verifica-
representative of the bank required to be in tion, or reissuance)?
attendance? 47. Are magnetic stripe cards encrypted
*33. Are combinations and keys to the machines (scrambled) using an adequate algorithm
controlled (if so, indicate controls)? (formula) including a total message
34. Do the machines and the related system control?
have built-in controls that— 48. Are encryption keys, i.e., scramble plugs,
a. limit the amount of cash and number of under dual control of personnel not asso-
times dispensed during a specified pe- ciated with operations or card issuance?
riod (if so, indicate detail) and *49. Are captured cards under dual control of
b. capture the card if the wrong PIN (per- persons not associated with bank operation
sonal identification number) is consecu- card issuance or PIN issuance?
tively used? *50. Are blank plastics and magnetic stripe
35. Does the machine automatically shut down readers under dual control?
after it experiences recurring errors?
51. Are all cards issued with set expiration
36. Is lighting around the machine provided?
dates?
37. Does the machine capture cards of other
banks or invalid cards? 52. Are transaction journals provided that
enable management to determine every
38. If the machine is operated ‘‘off line,’’ does
transaction or attempted transaction at the
it have negative-file capability for present
ATM?
and future needs, which includes lists of
lost, stolen, or other undesirable cards
which should be captured?
39. Is use of an ATM by an individual cus-
tomer in excess of that customer’s past CASH ITEMS
history indicated on a Suspicious Activity
Report by Depository Institutions (SAR- *53. Are returned items handled by someone
DI) form to be checked out by bank other than the teller who originated the
management (for example, three uses dur- transaction?
ing past three days as compared with a 54. Does an officer or other designated indi-
history of one use per month)? vidual review the disposition of all cash
40. Have safeguards been implemented at the items over a specified dollar limit?
ATM to prevent, during use, the disclosure 55. Is a daily report made of all cash items,
of a customer’s PIN by others observing and is it reviewed and initialed by the
the PIN pad? bank’s operations officer or other desig-
41. Are ‘‘fish-proof’’ receptacles provided for nated individual?
customers to dispose of printed receipts, 56. Is there a policy requiring that all cash
rather than insecure trash cans, etc.? items uncollected for a period of 30 days
42. Does a communication interruption between be charged off?

Page 2
Cash Accounts: Internal Control Questionnaire 2000.4
57. Do the bank’s present procedures forbid this section and are clearing on a
the holding of overdraft checks in the timely basis,
cash-item account? *c. scrutinized for employee items, and
58. Are all cash items reviewed at least d. reviewed for large or repeat items?
monthly at an appropriate level of 67. Are holdover items—
management? a. appropriately identified in the general
*59. Are cash items recommended for charge- ledger,
off reviewed and approved by the board *b. handled by an independent section of
of directors, a designated committee the department, and
thereof, or an officer with no operational c. reviewed periodically by responsible
responsibilities? supervisory personnel to determine that
items are clearing on a timely basis?
68. Does the proof and transit department
PROOF AND TRANSIT maintain a procedures manual describing
the key operating procedures and func-
60. Are individuals working in the proof and tions within the department?
transit department precluded from work- *69. Are items reported missing from cash
ing in other departments of the bank? letter promptly traced and a copy sent for
61. Is the handling of cash letters such that— credit?
a. they are prepared and sent on a daily *70. Is there a formal system to ensure that
basis; work distributed to proof machine opera-
b. they are photographed before they leave tors is formally rotated?
the bank; 71. Are proof machine operators prohibited
c. copy of proof or hand-run tape is prop- from—
erly identified and retained; a. filing checks or deposit slips or
d. records of cash letters sent to correspon- b. preparing deposit account statements?
dent banks are maintained with identi- 72. Are proof machine operators instructed to
fication of the subject bank, date, and report unusually large deposits or with-
amount; and drawals to a responsible officer (if so, over
e. remittances for cash letters are received what dollar amount $ )?
by employees independent of those who
send out the cash letters?
62. Are all entries to the general ledger either
originated or approved by the proof REGULATION H (12 CFR 208)—
department? COMPLIANCE QUESTIONNAIRE
63. Are all entries prepared by the general
ledger and/or customer accounts depart- 73. Has a security officer been designated by
ment reviewed by responsible supervisory the board of directors in accordance with
personnel other than the person preparing Regulation H (12 CFR 208.61(b))?
the entry? 74. Has a security program been developed
64. Are errors detected by the proof operator and implemented in accordance with Regu-
in proving deposits corrected by another lation H (12 CFR 208.61(c))?
employee or designated officer? 75. Does the bank have security devices that
65. Are all postings to the general ledger and give a general level of protection and that
subsidiary ledgers supported by source are at least equivalent to the minimum
documents? requirements of Regulation H?
66. Are returned items— 76. Has the installation, maintenance, and
*a. handled by an independent section of operation of security devices considered
the department or delivered unopened the operating environment of each office
to personnel not responsible for pre- and the requirements of Regulation H (12
paring cash letters or handling cash, CFR 206.61(c))?
b. reviewed periodically by responsible 77. Does the security officer report at least
supervisory personnel to determine that annually to the bank’s board of directors
items are being handled correctly by on the administration and effectiveness of

Page 3
2000.4 Cash Accounts: Internal Control Questionnaire
the security program in accordance with racy by someone other than the foreign-
Regulation H (12 CFR 206.61(d))? currency tellers?
*82. Does the internal auditor periodically
review for accuracy revaluation calcu-
lations, including the verification of
31 CFR 103—COMPLIANCE rates used and the resulting general ledger
QUESTIONNAIRE entries?
78. Is the bank in compliance with the

financial recordkeeping and reporting regu- CONCLUSION
lations?
83. Is the foregoing information considered an
adequate basis for evaluating internal con-
trol in that there are no significant defi-
INTERNATIONAL DIVISION ciencies in areas not covered in this ques-
tionnaire that impair any controls? Explain
*79. Are foreign-currency control ledgers and negative answers briefly, and indicate any
dollar-book-value equivalents posted additional examination procedures deemed
accurately? necessary.
*80. Is each foreign currency revalued at least 84. Based on a composite evaluation as evi-
monthly, and are profit and loss entries denced by answers to the foregoing
passed on to the appropriate income questions, internal control is considered
accounts? (adequate/inadequate). A separate evalua-
*81. Are revaluation calculations, including the tion should be made for each area, i.e.,
rates used, periodically reviewed for accu- cash on hand, cash items, etc.

Page 4
Due from Banks
Effective date April 2008 Section 2010.1
Banks maintain deposits in other banks to facili- form, and maturity of the exposure. Sec-
tate the transfer of funds. Those bank assets, tion 206.4(a) of Regulation F stipulates that any
known as ‘‘due from bank deposits’’ or ‘‘corre- FDIC-insured depository institution must limit
spondent bank balances’’1 are a part of the its interday credit exposure to an individual
primary, uninvested funds of every bank. A correspondent that is not ‘‘adequately capital-
transfer of funds between banks may result from ized’’2 to 25 percent of the institution’s total
the collection of cash items and cash letters, the capital.3 For a more detailed discussion of Regu-
transfer and settlement of securities transac- lation F, refer to sections 2015.1–.4 and SR-93-
tions, the transfer of participating loan funds, the 36 (‘‘Examiner Guidelines for Regulation F—
purchase or sale of federal funds, and many Interbank Liabilities’’).
other causes.
In addition to deposits kept at the Federal
Reserve Bank and with correspondent banks, a BALANCES WITH FEDERAL
bank may maintain interest-bearing time depos-
its with international banks. Those deposits are a
RESERVE BANKS
form of investment, and relevant examination All state member banks are required by Regu-
considerations are included in ‘‘Investment lation D (12 CFR 204) to keep reserves equal to
Securities and End-User Activities,’’ section specified percentages of the deposits on their
2020.1, and ‘‘International—Due from Banks— books. These reserves are maintained in the
Time,’’ section 7070.1. form of vault cash or deposits with the Federal
Banks also use other banks to provide certain Reserve Bank. The Federal Reserve Bank moni-
services that can be performed more economi- tors the deposits of each bank to determine that
cally or efficiently by another facility because of reserves are kept at required levels. The reserves
its size or geographic location. These services provide the Federal Reserve System with a
include processing of cash letters, packaging means of controlling the nation’s money supply.
loan agreements, performing EDP services, col- Changes in the level of required reserves affect
lecting out-of-area items, providing safekeeping the availability and cost of credit in the econ-
for bank and customer securities, exchanging omy. The examiner must determine that the
foreign currency, and providing financial advice information supplied to the Federal Reserve
in specialized loan areas. When the service is Bank for computing reserves is accurate.
one way, the receiving bank usually maintains a The Monetary Control Act of 1980 enables a
minimum balance at the providing bank to nonmember financial institution to borrow from
compensate in full or in part for the services the Reserve Bank’s discount window on the
received. same terms and conditions as member banks.
For member banks, loan transactions are usually
effected through their reserve account. For non-
DEPOSITS WITH OTHER member banks, the Reserve Bank typically
DEPOSITORY INSTITUTIONS requires the institution to open a special account
called a clearing account. The loan transactions
Section 206.3 of Regulation F (12 CFR 206) are then processed through the clearing account.
requires FDIC-insured depository institutions to However, in some instances, the Reserve Bank
adopt written policies and procedures to address may allow a nonmember institution to process
the risk arising from exposure to a correspon- discount loan transactions through the account
dent, and to prevent excessive exposure to any of a member bank. In most of these isolated
individual correspondent. These policies and
procedures should take into account the finan- 2. See section 206.5(a) of Regulation F for the capital
cial condition of a correspondent and the size, ratios necessary for a correspondent bank to be considered
adequately capitalized.
3. The Board may waive this requirement if the primary
1. Balances due from such institutions include all interest- federal supervisor of the insured institution advises the Board
bearing and non-interest-bearing balances, whether in the that the institution is not reasonably able to obtain necessary
form of demand, savings, or time balances, including certifi- services, including payment-related services and placement of
cates of deposit, but excluding certificates of deposit held in funds, without incurring exposure to a correspondent in excess
trading accounts. of the otherwise applicable limit.

Page 1
2010.1 Due from Banks
cases, a transaction of a nonmember institution of its international customers. This can be

is being processed through the account of the accomplished by maintaining accounts (nostro
bank with which the nonmember institution has balances) with banks in foreign countries in
a correspondent relationship. whose currencies receipts and payments are
Under the reserve account charge agreements made.
used by most Federal Reserve Banks, the Nostro balances may be compared with an
member bank’s reserve account may be charged inventory of goods and must be supervised in
if the nonmember bank defaults on the loan the same manner. For example, payment to
processed through the member bank’s account. import goods manufactured in Switzerland to
Since member banks may not act as the guarantor the United States can be made through a U.S.
of the debts of another, member banks may only bank’s Swiss franc account with another bank in
legally enter into revocable reserve account Switzerland. Upon payment in Switzerland, the
charge agreements. Revocable agreements allow U.S. bank will credit its nostro account with the
the member bank, at its option, to revoke the Swiss bank and charge its U.S. customer’s dollar
charge and thus avoid liability for the debt of the account for the appropriate amount in dollars.
nonmember correspondent. In contrast, irrevo- Conversely, exporting U.S. goods to Switzerland
cable charge agreements constitute a binding results in a debit to the U.S. bank’s Swiss
guarantee of the nonmember correspondent’s correspondent account. The first transaction
debt and generally cannot be entered into by a results in an outflow of the U.S. bank’s ‘‘inven-
member bank. Banks that enter into revocable tory’’ of Swiss francs, while the second transac-
charge agreements should establish written tion results in an inflow of Swiss francs. The
procedures to ensure their ability to make U.S. bank must maintain adequate balances in its
prudent, timely decisions. nostro accounts to meet unexpected needs and to
avoid overdrawing those accounts for which
interest must be paid. However, the bank should
not maintain excessive idle nostro balances that
DEPOSIT BROKERS do not earn interest, causing a loss of income.
The U.S. bank also runs risks by being either
On the asset side of the balance sheet, examiners
long or short in a particular foreign currency or
should review the activities of banks that place
by maintaining undue gaps. Losses could result
deposits through money brokers. These banks
if that currency appreciates or depreciates sig-
should have sufficient documentation to, among
nificantly or if the bank must purchase or
other things, verify the amounts and terms of
borrow the currency at a higher rate.
individual deposits and the names of depository
Excessive nostro overages and shortages can
institutions in which the deposits are placed.
be avoided by entering into spot and forward
Banks should also be able to demonstrate that
exchange contracts to buy or sell such nostro
they have exercised appropriate credit judgment
inventories. Those contracts are discussed in
with respect to each depository institution in
‘‘International—Foreign Exchange,’’ section
which they have placed funds. Deficiencies in
7100.1. However, all foreign-currency transac-
this area could constitute an unsafe or unsound
tions, except over-the-counter cash trades, are
banking practice. A more detailed discussion of
settled through nostro accounts. Therefore, the
brokered deposits is included in ‘‘Deposit
volume of activity in those accounts may be
Accounts,’’ sections 3000.1–3000.3 of this
substantial, and the accounts must be properly
manual.
controlled.
In addition, an account service known as a
payable-through account is being marketed by
DUE FROM FOREIGN BANKS U.S. banks, Edge corporations, and the U.S.
branches and agencies of foreign banks to for-
Due from foreign banks demand or nostro eign banks that otherwise would not have the
accounts are handled in the same manner as due ability to offer their customers access to the U.S.
from domestic bank accounts, except that the banking system. This account service, referred
balances due are generally denominated in for- to by other names such as pass-through accounts
eign currency. and pass-by accounts, involves a U.S. banking
A bank must be prepared to make and receive entity’s opening of a deposit account for the
payments in foreign currencies to meet the needs foreign bank. Policies and procedures should be

Page 2
Due from Banks 2010.1
developed to guard against the possible improper Examination procedures relating to this area are
or illegal use of payable-through account facili- part of the FFIEC Bank Secrecy Act/Anti-Money
ties by foreign banks and their customers. Laundering Examination Manual.

Page 3
Due from Banks
1. To determine if the policies, practices, pro- 5. To determine the scope and adequacy of the
cedures, and internal controls regarding due audit coverage.
from banks are adequate.
6. To determine compliance with laws, rulings,
2. To determine if bank officers and employees
and regulations.
are operating in conformance with the estab-
lished guidelines. 7. To initiate corrective action when policies,
3. To determine that all due from accounts are practices, procedures, or internal controls are
reasonably stated and represent funds on deficient or when violations of law, rulings,
deposit with other banks. or regulations have been noted.
4. To evaluate the credit quality of banks with
whom demand accounts are maintained.

Page 1
Due From Banks
1. If selected for implementation, complete or a bank supplied list, of correspondent banks.

update the Due From Banks Internal Con- (This effort should be coordinated with the
trol Questionnaire. examiner assigned to ‘‘Deposit Accounts’’
2. Determine the scope of the examination, to avoid duplication of work.)
based on the evaluation of internal controls 9. Review the maximum deposit balance
and the work performed by internal/external established for each due from bank account
auditors. and determine if the maximum balance:
3. Test for compliance with policies, practices, a. Is established after consideration of com-
procedures and internal controls in conjunc- pensating balance requirements resulting
tion with performing the remaining exami- from commitments or credit lines made
nation procedures. Also, obtain a listing of available to the bank or its holding
any deficiencies noted in the latest review company. Coordinate this effort with
done by internal/external auditors from examiner assigned ‘‘Bank-Related Orga-
the examiner assigned ‘‘Internal Control,’’ nizations.’’
and determine if corrections have been b. Appears to be related to loans of execu-
accomplished. tive officers or directors or to loans
4. Scan the most recent bank-prepared recon- which have been used to acquire stock
cilements for any unusual items and deter- control of the bank under examination.
mine that closing balances listed on recon- • If such due from accounts are detected,
cilements agree with the general ledger and provide full details of the account to
with the balance shown on the cut-off state- the examiner assigned to check for
ment if one has been obtained. compliance with the law relating to
5. If the bank’s policy for charge-off of old loans to insiders of correspondent
open items provides for exceptions in banks (12 USC 1972(2)).
extenuating circumstances, review excepted 10. Determine the existence of any concentra-
items and determine if charge-off is tions of assets with other banks. Include
appropriate. correspondent accounts, time deposits and
6. If the bank has no policy for charge-off of any federal funds sold in computation. For
old open items, review any items which are concentrations exceeding 25 percent of the
large or unusual or which have been out- bank’s capital structure, forward the infor-
standing for over two months, along with mation to examiners assigned ‘‘Concentra-
related correspondence, and determine if tions of Credit’’ for possible inclusion in the
charge-off is appropriate. report of examination.
7. Test the bank’s calculation of its Federal Note: Procedures 11 through 21 apply to
Reserve requirement and determine that due from foreign banks—demand (nostro
reports are accurate and complete by: accounts).
a. Performing a limited review of a sample
of line items if the bank has effective 11. Obtain or prepare a trial balance (including
operating procedures and has an audit local currency book values) of due from
program covering the required reports. foreign banks—demand by bank customer
b. Performing a detailed review of all line and:
items if the bank has not established a. Agree or reconcile balances to depart-
operating procedures or does not have an ment controls and the general ledger.
audit program covering the required b. Review reconciling items for reasonable-
reports. ness.
8. Confer with the examiner assigned to check 12. Using the appropriate sampling technique,
for compliance with the laws and regula- select demand account banks for
tions relating to insider loans at correspon- examination.
dent banks and loans to insiders of corre- 13. Prepare credit line sheets to include:
spondent banks (Regulation O and 12 USC a. Customer’s aggregate due from banks—
1972(2)) and either provide a list, or verify demand liability in foreign currency

Page 1
2010.3 Due From Banks: Examination Procedures
amount and local currency equivalent. ance to determine which due from
b. Amount of customer’s line designated by foreign banks—demand deposits are
the bank. portions of Interagency Country Expo-
c. Frequency of recent overdrawn nostro sure Review Committee credits.
accounts. • For each due from foreign bank—
demand deposit so identified, tran-
(Overdrawn nostro accounts as they relate
scribe appropriate information to
to foreign exchange activities are discussed
line sheets and forward the informa-
in the International—Foreign Exchange sec-
tion to the examiner assigned
tion. Also, the examiner assigned ‘‘Bor-
‘‘International—Loan Portfolio Man-
rowed Funds’’ must obtain (or prepare) a
agement.’’
listing of overdrawn nostro accounts for
c. Loans criticized during the previous
inclusion in the borrowing section of the
examination (due from foreign banks—
report of examination.)
demand portion):
d. Past compliance with customer’s line • Determine the disposition of the due
limitation as determined from review of from foreign banks—demand so criti-
liability ledger records. cized by transcribing:
14. Obtain from the examiner assigned — Current balance and payment
‘‘International—Loan Portfolio Manage- status, or
ment,’’ schedules on the following, if they — Date the deposit was paid and the
are applicable to the due from foreign source of repayment.
banks—demand: 16. Transcribe or compare information from the
a. Delinquencies. above schedules to credit line sheets, where
b. Miscellaneous loan debit and credit sus- appropriate, and indicate any cancelled
pense accounts. bank lines.
c. Criticized shared national credits. 17. Prepare credit line cards for any due from
d. Interagency Country Exposure Review foreign banks—demand not in the sample
Committee credits. which, based on information derived from
e. Loans criticized during the previous the above schedules, requires in-depth re-
examination. view.
f. Information on directors, officers and 18. Obtain liability and other information on
their interests, as contained in statements common borrowers from examiners as-
required under Regulation O (12 CFR signed to cash items, overdrafts and loan
215). areas and together decide who will review
g. Specific guidelines in the bank policy the borrowing relationship. Pass or retain
relating to due from banks—demand. completed credit line cards.
h. Current listing of due from foreign 19. Obtain credit files for all due from foreign
banks—demand approved customer banks—demand for whom credit line cards
lines. were prepared and complete credit line
i. Any useful information resulting from cards where appropriate. To analyze the
the review of the minutes of the loan loans, perform the procedures set forth in
and discount committee or any similar step 14 of the International—Due From
committee. Banks–Time section.
j. Reports furnished to the board of directors. 20. By reviewing appropriate bank records,
15. Review the information received and per- determine that:
form the following for: a. Profit or losses resulting from revalua-
a. Miscellaneous loan debit and credit sus- tion adjustment on net open positions
pense accounts: spot are passed properly to the respective
• Discuss with management any large or due from foreign bank—demand
old items. (nostro) account (usually monthly).
• Perform additional procedures as b. At the delivery of the ‘‘swap’’ forward
deemed appropriate. contract, proper entries are made to the
b. Interagency Country Exposure Review respective due from foreign bank—
Committee Credits: demand (nostro) and swap adjustment
• Compare the schedule to the trial bal- accounts.

Page 2
Due From Banks: Examination Procedures 2010.3
21. Determine compliance with laws, regula- demand deposits that exceed the required
tions and rulings pertaining to due from reserve balance at the Federal Reserve
foreign banks—demand activities by per- Bank and that exceed the working bal-
forming the following for: ances at correspondent banks.
a. Reporting of Foreign Exchange Activities: 24. Discuss with appropriate officer(s) and pre-
• Determine that Foreign Currency Forms pare in suitable report form of:
FC-1, FC-2, FC-1a and FC-2a, as a. Cancelled due from foreign banks—
required, are submitted to the Depart- demand deposit lines that are unpaid.
ment of the Treasury under the provi- b. Violations of laws, regulations and rulings.
sions of 31 CFR 128. c. Internal control exceptions and deficien-
• Check that copies of those forms are cies, or noncompliance with written pol-
forwarded by each state member bank icies, practices and procedures.
to the Federal Reserve at each filing d. A n y i t e m s t o b e c o n s i d e r e d f o r
time specified in 31 CFR 128. charge-off.
Note: Due from foreign banks—demand e. Uncorrected audit deficiencies.
(nostro) deposits will be reviewed, dis- f. Due from foreign banks—demand depos-
cussed with appropriate bank officers, and its not supported by current and com-
prepared in suitable report form by the plete financial information.
examiner assigned ‘‘International—Due g. Due from foreign banks—demand depos-
From Banks–Time’’, if the bank maintains its on which documentation is deficient.
international due from banks—time and/or h. Concentrations.
call money deposits. i. Criticized loans (portions applicable to
22. Forward list of due from banks accounts to due from foreign banks—demand
the examiner assigned to ‘‘Investment deposits).
Securities’’ and to ‘‘Loan Portfolio j. Due from foreign banks—demand depos-
Management.’’ its which for any other reason are
23. Consult with the examiner assigned ‘‘Asset/ questionable as to quality and ultimate
Liability Management’’ and provide the collection.
following, if requested: k. Other matters regarding condition of the
a. A listing, by maturity and amount, of due department.
from banks—time deposits. 25. Update the workpapers with any informa-
b. The amounts of due from banks— tion that will facilitate future examinations.

Page 3
Due From Banks
Review the bank’s internal controls, policies, sign of alteration and are payments or paid
practices and procedures for due from bank drafts compared with such statements by
accounts. The bank’s system should be docu- the persons who prepare bank reconcile-
mented in a complete and concise manner and ments (if so, skip question 5)?
should include, where appropriate, narrative *5. If the answer to question 4 is no, are bank
descriptions, flowcharts, copies of forms used statements and paid drafts or payments
and other pertinent information. Items marked handled before reconcilement only by per-
with an asterisk require substantiation by obser- sons who do not also:
vation or testing. a. Issue drafts or official checks and pre-
pare, add or post the general or subsid-
iary ledgers?
POLICIES FOR DUE FROM BANK b. Handle cash and prepare, add or
DOMESTIC AND FOREIGN— post the general ledger or subsidiary
DEMAND ACCOUNTS ledgers?
*6. Are bank reconcilements prepared by per-
1. Has the board of directors, consistent with sons who do not also:
its duties and responsibilities, adopted a. Issue drafts or official checks?
written policies for due from bank accounts b. Handle cash?
that: c. Prepare general ledger entries?
a. Provide for periodic review and approval 7. Concerning bank reconcilements:
of balances maintained in each such a. Are amounts of paid drafts or repay-
account? ments compared or tested to entries on
b. Indicate person(s) responsible for mon- the ledgers?
itoring balances and the application of b. Are entries or paid drafts examined or
approved procedures? reviewed for any unusual features?
c. Establish levels of check-signing
c. Whenever a delay occurs in the clear-
authority?
ance of deposits in transit, outstanding
d. Indicate officers responsible for approval
drafts and other reconciling items, are
of transfers between correspondent
such delays investigated?
banks and procedures for documenting
such approval? d. Is a record maintained after an item has
e. Indicate the supervisor responsible for cleared regarding the follow-up and
regular review of reconciliations and reason for any delay?
reconciling items? e. Are follow-up and necessary adjusting
f. Indicate that all entries to the accounts entries directed to the department orig-
are to be approved by an officer or inating or responsible for the entry for
appropriate supervisor and that such correction with subsequent review of
approval will be documented? the resulting entries by the person
g. Establish time guidelines for charge-off responsible for reconcilement?
of old open items? f. Is a permanent record of the account
2. Are the policies for due from bank accounts reconcilement maintained?
reviewed at least annually by the board or g. Are records of the account reconcile-
the board’s designee to determine their ments safeguarded against alteration?
adequacy in light of changing conditions? h. Are all reconciling items clearly
described and dated?
i. Are details of account reconcilement
BANK RECONCILEMENTS reviewed and approved by an officer or
supervisory employee?
3. Are bank reconcilements prepared j. Does the person performing reconcile-
promptly upon receipt of the statements? ments sign and date them?
*4. Are bank statements examined for any k. Are reconcilement duties for foreign

Page 1
2010.4 Due From Banks: Internal Control Questionnaire
demand accounts rotated on a formal *a. They are delivered unopened and
basis? reviewed by someone who is not
responsible for preparation of cash
letters?
DRAFTS b. All large unusual items or items on
which an employee is listed as maker,
8. Are procedures in effect for the handling payee or endorser are reported to an
of drafts so that: officer?
*a. All unissued drafts are maintained c. Items reported missing from cash let-
under dual control? ters are promptly traced and a copy
b. All drafts are prenumbered? sent for credit?
c. A printer’s certificate is received with
each supply of new prenumbered
drafts? FOREIGN EXCHANGE
d. A separate series of drafts is used for
each bank?
ACTIVITIES
e. Drafts are never issued payable to *11. Are persons handling and reconciling due
cash? from foreign bank—demand accounts
f. Voided drafts are adequately cancelled excluded from performing foreign ex-
to prevent possible reuse? change and position clerk functions?
*g. A record of issued and voided drafts is *12. Is there a daily report of settlements made
maintained? and other receipts and payments of foreign
*h. Drafts outstanding for an unreason- currency affecting the due from foreign
able period of time (perhaps six months bank—demand accounts?
or more) are placed under special *13. Is each due from foreign bank—-demand
controls? foreign currency ledger revalued monthly
i. All drafts are signed by an authorized and are appropriate profit or loss entries
employee? passed to applicable subsidiary ledgers
*j. The employees authorized to sign and the general ledger?
drafts are prohibited from doing so *14. Does an officer not preparing the calcula-
before a draft is completely filled out? tions review revaluations of due from
*k. If a check-signing machine is used, foreign bank—demand ledgers, including
controls are maintained to prevent its the verification of rates used and the
unauthorized use? resulting general ledger entries?
FOREIGN CASH LETTERS

OTHER—FOREIGN
9. Is the handling of foreign cash letters such
that: *15. Are separate dual currency general ledger
a. They are prepared and sent on a daily or individual subsidiary accounts main-
basis? tained for each due from foreign bank—
b. They are copied or photographed prior demand account, indicating the foreign
to leaving the bank? currency balance and a U.S. dollar (or
c. A copy of proof or hand run tape is local currency) equivalent balance?
properly identified and retained? 16. Do the above ledger or individual subsid-
d. Records of foreign cash letters sent to iary accounts clearly reflect entry and
correspondent banks are maintained, value dates?
identifying the subject bank, date and 17. Are the above ledger or individual sub-
amount? sidiary accounts balanced to the general
ledger on a daily basis?
18. Does international division management
FOREIGN RETURN ITEMS receive a daily trial balance of due from
foreign bank—demand customer balances
10. Are there procedures for the handling of by foreign currency and U.S. dollar (or
return items so that: local currency) equivalents?

Page 2
Due From Banks: Internal Control Questionnaire 2010.4
OTHER ment are reviewed to ensure they do not

include asset items ineligible for meet-
19. Is a separate general ledger account or ing the reserve requirement, and that
individual subsidiary account maintained all liability items are properly classified
for each due from bank account? as required by Regulation D and its
20. Are overdrafts of domestic and foreign interpretations?
due from bank accounts properly recorded 22. Does the foregoing information constitute
on the bank’s records and promptly re- an adequate basis for evaluating internal
ported to the responsible officer? control in that there are no significant
21. Are procedures for handling the Federal deficiencies in areas not covered in this
Reserve account established so that: questionnaire that impair any controls?
Explain negative answers briefly and indi-
a. The account is reconciled on a daily cate any additional examination proce-
basis? dures deemed necessary.
b. Responsibility is assigned for assuring 23. Based on a composite evaluation, as
that the required reserve is maintained? evidenced by answers to the foregoing
c. Figures supplied to the Federal Reserve questions, internal control is considered
for use in computing the reserve require- (adequate/inadequate).

Page 3
Interbank Liabilities
It is important for a federally insured depository ‘‘soft charges’’ in the form of balances instead
institution 1 (bank) to control and limit the risk of ‘‘hard charges’’ in the form of fees.
exposures posed to it by another domestic bank Exposure to a correspondent may be signifi-
(whether or not that institution is an insured cant, particularly when a bank uses one corre-
depository institution) or foreign bank with spondent for all of its check collections and
which it does business (referred to as a corre- other payment services; loans excess reserve
spondent). These exposures may include all account balances (federal, or fed, funds) to the
extensions of credit to a correspondent; deposits correspondent,2 or engages in other banking
or reverse repurchase agreements with a corre- transactions with correspondents.3 This expo-
spondent; guarantees, acceptances, or standby sure may increase when interest rates fall, as
letters of credit on behalf of a correspondent; higher levels of compensating balances may be
purchases or acceptance as collateral of required to provide adequate compensation to
correspondent-issued securities; and all similar the correspondent.
transactions. A bank needs to develop internal Money-center banks and large regional banks
procedures to evaluate and control the risk may have significant exposure to correspon-
exposures to the bank from its correspondents. dents 4 through their activities in interbank mar-
Such procedures would help prevent a situation kets, such as the securities, swap, and foreign-
whereby the failure of a single correspondent exchange markets. Interbank transactions that
could trigger the failure of a federally insured call for performance in the future (such as
depository institution having claims on the failed swaps, foreign-exchange contracts, and over-the-
correspondent. (See SR-93-36.) counter options) give rise to exposure to the
A bank’s principal sources of exposure to its correspondents that act as counterparties 5 in
correspondent tend to arise from two types of such transactions. In addition to credit risk, such
activity. First, banks may become exposed when transactions may involve interest-rate risk,
obtaining services from (such as check-collection
services), or providing services to, their corre-
spondents. Second, exposure may arise when 2. In the fed funds market, a loan of fed funds is often
referred to as a sale. Borrowing of fed funds is referred to as
banks engage in transactions with correspon- a purchase.
dents in the financial markets. Each type of 3. Although a bank’s primary correspondent often will
exposure has its own characteristics and its own borrow (purchase) fed funds as principal directly from the
risks. bank, a correspondent may act as agent to place the funds with
another institution. In such agency arrangements, a bank may
Correspondent banking services are the pri- provide its correspondent with a preapproved list of institu-
mary source of interbank exposure for the tions with which the correspondent may place the funds.
majority of banks, particularly small and medium- When a correspondent is acting as the bank’s agent in placing
sized banks. In connection with check-collection fed funds, the bank’s exposure would be to the ultimate
purchaser of the funds, not to the correspondent placing the
services and other trade- or payment-related funds on its behalf.
correspondent services, banks often maintain Generally, fed funds loans are unsecured. A bank may also
balances with their correspondents in order to provide funds to a correspondent through transactions known
settle transactions and compensate the correspon- as reverse repurchase agreements, in which the bank provides
funds to the correspondent by buying an asset, generally a
dents for the services provided. These balances government security. The correspondent agrees that it will
give rise to exposure to the correspondents. repurchase the asset from the bank at the expiration of a set
Although correspondent services are in some period, generally overnight, at a repurchase price calculated to
cases provided on a fee basis, many correspon- compensate the bank for the use of its funds. Unlike fed funds
loans, these transactions are essentially secured transactions.
dents may prefer compensating-balance arrange- 4. Although the depository institutions that are parties to
ments, as these balances provide the correspon- transactions in the interbank markets discussed above gener-
dents with a stable source of funding. Also, ally are referred to as counterparties, the term correspondent
some banks may prefer to pay for services with is used in this discussion to denote any domestic depository
institution or a foreign bank to which a bank is exposed. The
term correspondent does not include a commonly controlled
correspondent, as defined in section 206.2(b) of Regulation F.
1. A federally insured depository institution refers to a 5. In other banking transactions, such as foreign-exchange,
bank, as defined in section 3 of the Federal Deposit Insurance money market, and other permissible transactions, activi-
Act (12 USC 1813), and includes a federally insured national ties, or contractual arrangements, the other party to the
bank, state bank, District bank, or savings association, and a transaction is referred to as the counterparty rather than as the
federally insured branch of a foreign bank. correspondent.

Page 1
2015.1 Interbank Liabilities
foreign-exchange risk, and settlement risk. Settle- and foreign banks. Regulation F sets forth these
ment risk is the risk that a counterparty will fail standards. All depository institutions insured by
to make a payment or delivery in a timely the FDIC are subject to the Federal Reserve
manner. Settlement risk may arise from unse- Board’s Regulation F.6 Regulation F was first
cured transactions in the government securities, adopted in 1992 and has remained substantially
foreign-exchange, or other markets, and it may the same, except for the technical amendments
result from operational, liquidity, or credit adopted by the Board on September 10, 2003.
problems. (See 68 Fed. Reg. 53,283.) Regulation F con-
Lending limits prohibit national banks from sists of two primary parts: (1) prudential stan-
lending amounts equal to more than 15 percent dards that apply to exposures generally (sec-
of a national bank’s unimpaired capital and tion 206.3) and (2) special rules that apply to
surplus to a single borrower on an unsecured credit exposure under certain circumstances (sec-
basis (12 USC 84(a)(1)); these limits also pro- tion 206.4).
hibit a national bank from lending an additional The ‘‘Prudential Standards’’ section requires
10 percent on a secured basis (12 USC 84(a)(2)). depository institutions to develop and adopt
The national bank lending limits apply only to internal policies and procedures to evaluate and
‘‘loans and extensions of credit,’’ and the limits control all types of exposures to correspondents
do not include most off-balance-sheet transac- with which they do business.7 Policies and
tions that may provide significant sources of procedures are to be established and maintained
exposure to correspondents. Additionally, the to prevent excessive exposure to any individual
national bank lending limits do not apply to correspondent in relation to the condition of the
overnight fed funds loans, a significant source of correspondent. The ‘‘Prudential Standards’’ sec-
short-term exposure to correspondents. State tion requires a bank to adopt internal exposure
limits generally do not apply to a broader range limits when the financial condition of the corre-
of transactions than the national bank limits, spondent and the form or maturity of the expo-
although some states include fed funds transac- sure create a significant risk that payments will
tions within their limits. not be made in full or on time. This section also
State-chartered banks generally are subject to provides that a bank shall structure the transac-
lending limits under state law. Almost all states tions of a correspondent or monitor exposures to
impose lending limits on the banks they charter. a correspondent such that the bank’s exposure
Most of these limits are patterned on the national ordinarily does not exceed its internal limits.
bank lending limits, although the specific per- The ‘‘Credit Exposure’’ section provides that
centages or transactions covered vary. The state a bank’s internal limit on interday credit expo-
limits generally do not apply to a broader range sure to an individual correspondent may not be
of off-balance-sheet transactions, although some more than 25 percent of the exposed bank’s total
states include fed funds transactions within their capital, unless the bank can demonstrate that its
limits. A number of states, however, exclude correspondent is at least ‘‘adequately capital-
interbank transactions from their lending limits ized,’’ as defined in section 206.5(a) of the rule.
entirely. No limit is specified for credit exposure to
correspondents that are at least adequately capi-
talized, but prudential standards are required for
all correspondents, regardless of capital level.
LIMITS ON INTERBANK The term correspondent includes both domesti-
LIABILITIES cally chartered depository institutions that are
FDIC insured and foreign banks; the term does
Regulation F, Limitations on Interbank Liabili- not include a commonly controlled correspondent.
ties (12 CFR 206), implemented section 308
of the Federal Deposit Insurance Corporation
Improvement Act of 1991 (FDICIA), which
amended section 23 of the Federal Reserve Act
(12 USC 371b-2). Section 23, as amended, 6. Correspondent is defined in section 206.2(c) of Regula-
requires the Board of Governors of the Federal tion F to mean a U.S. depository institution or a foreign bank
to which a bank has exposure, but does not include commonly
Reserve System (the Board) to prescribe stan- controlled correspondents.
dards to limit the risks posed by exposure of 7. Banks had to have the internal policies and procedures in
banks to other domestic depository institutions place on June 19, 1993.

Page 2
Interbank Liabilities 2015.1
Prudential Standards financial condition.9 Factors bearing on the finan-

cial condition of the correspondent include, but
Standards for Selecting Correspondents are not necessarily limited to, (1) the capital
level of the correspondent, (2) the level of
Banks are to address the risk arising from nonaccrual and past-due loans and leases, and
exposure to a correspondent, taking into account (3) the level of earnings.
the financial condition of the correspondent and Examiners should determine that a bank has
the size, form, and maturity of its exposure to periodically reviewed the financial condition of
the correspondent. Banks must adopt internal any correspondent to which the bank has sig-
policies and procedures that evaluate the credit nificant exposure. The frequency of these reviews
and liquidity risks, including operational risks, will depend on the size and maturity of the
in selecting correspondents and terminating those exposure and the condition of the correspon-
relationships. Depository institutions are permit- dent. For example, the policies of many banks
ted to adopt flexible policies and procedures in provide for an extensive annual review of a
order to permit resources to be allocated in a correspondent’s financial condition; such poli-
manner that will result in real reductions in risk. cies may also provide for less extensive interim
The policies and procedures must be reviewed reviews under some circumstances, such as
annually by the bank’s board of directors, but when exposure to a correspondent is very high
individual correspondent relationships need not or when a correspondent has experienced finan-
be approved by the board. Examiners should cial difficulty. A bank need not require periodic
determine that the policies and procedures review of the financial condition of all corre-
adopted by the board provide for a determina- spondents. For example, periodic reviews would
tion of the credit, liquidity, and operational risks not be necessary for a correspondent to which
of a correspondent when the relationship with the bank has only insignificant levels of expo-
the correspondent is established and as it is sure, such as small balances maintained for
maintained.8 Additionally, if the bank has sig- clearing purposes.10 Significant levels of expo-
nificant operational risk—such as relying on a sure should reflect those amounts that a prudent
correspondent for extensive data processing— bank believes deserve analysis for risk of loss.
that exposure could also lead to liquidity prob- A bank may base its review of the financial
lems. This exposure may not be an issue for condition of a correspondent on publicly avail-
institutions that are not operationally dependent able information, such as bank Call Reports,
on any particular correspondent. Many banks financial statements or reports, Uniform Bank
may also address this exposure elsewhere in Performance Reports, or annual reports, or the
their operational procedures. bank may use financial information obtained
A bank’s policies and procedures should pro- from a rating service. A bank generally is not
vide for periodic review of the financial condi- required to obtain nonpublic information to use
tion of any correspondent to which the bank has as the basis for its analysis and review of the
significant exposure. This review should evalu- financial condition of a correspondent.11 For
ate whether the size and maturity of the expo-
sure is commensurate with the correspondent’s
9. Because exposure to a Federal Reserve Bank or Federal
Home Loan Bank poses minimal risk to a respondent, Federal
Reserve Banks and Federal Home Loan Banks are not
8. Liquidity risk and operational risk are terms used in the included in the definition of correspondent.
definition of exposure. Liquidity risk is the risk that payment 10. Other forms of exposure that generally would not be
will be delayed for some period of time. For example, a bank considered significant include (1) a collecting bank’s risk that
is subject to the liquidity risk that a payment due from a failed a check will be returned, (2) an originating bank’s risk that an
correspondent will not be made on time; the bank’s credit risk automated clearinghouse (ACH) debit transfer will be returned
may be a lesser amount due to later distributions from the or its settlement reversed, (3) a receiving bank’s remote risk
correspondent’s receiver. Liquidity risk is included in the that settlement for an automated credit transfer could be
definition of exposure. reversed, or (4) a credit card transaction. In these types of
Operational risk is the risk that a correspondent’s opera- transactions, the amounts involved are generally small, and
tional problems may prevent it from making payments, the exposed bank usually has prompt recourse to other parties.
thereby creating liquidity risks for other banks. For example, 11. A bank is required to obtain nonpublic information to
a computer failure at a correspondent that a bank relies on for evaluate a correspondent’s condition for those foreign banks
extensive data processing support may prevent the correspon- for which no public financial statements are available. In these
dent from making payments, and thus may create liquidity limited circumstances, the bank would need to obtain financial
problems for the bank and other banks as well. Operational information for its review (including information obtained
risk is also included in the definition of exposure. directly from the correspondent).

Page 3
correspondents with which a bank has a signifi- policy and procedural limits are consistent with
cant relationship, a bank may have considerable the risk undertaken, given the maturity of the
nonpublic information, such as information on exposure and the condition of the correspon-
the quality of management, general portfolio dent. Inflexible dollar limits may not be neces-
composition, and similar information, but such sary in all cases. As stated earlier, limits can be
information is not always available and is not flexible and be based on factors such as the level
required. of the bank’s monitoring of its exposure and the
Regardless of whether public or nonpublic condition of the correspondent. For example, a
sources of information are used, a bank may rely bank may choose not to establish a specific limit
on another party, such as a bank rating agency, on exposure to a correspondent when the bank is
its bank holding company, or another correspon- able to ascertain account balances with the
dent, to assess the financial condition of or select correspondent on a daily basis, because such
a correspondent, provided that the board of balances could be reduced rapidly if necessary.
directors has reviewed and approved the general In appropriate circumstances, a bank may estab-
assessment or selection criteria used by that lish limits for longer-term exposure to a corre-
party. Examiners should ascertain that the bank spondent, while not setting limits for interday
reviews and approves the assessment criteria (overnight) or intraday (within the day) expo-
used by such other parties. Additionally, when a sure. Generally, banks do not need to set one
bank relies on its bank holding company to overall limit on their exposure to a correspon-
select and monitor correspondents—or relies on dent. Banks may prefer instead to set separate
a correspondent, such as a bankers’ bank, to limits for different forms of exposure, products,
choose other correspondents with which to place or maturities. A bank’s evaluation of its overall
the bank’s federal funds or other deposits— facility with a correspondent should take into
examiners should ensure that the bank has account utilization levels and procedures for
reviewed and approved the selection criteria further limiting or monitoring overall exposure.
used. When a bank has established internal limits
for its significant exposure, examiners should
ensure that the bank either (1) has procedures to
Internal Limits on Exposure monitor its exposure to remain within estab-
lished limits or (2) structures transactions with
When the financial condition of the correspon- the correspondent to ensure that the exposure
dent and the form or maturity of the exposure ordinarily remains within the bank’s established
represent a significant risk that payments will internal limits. While some banks may monitor
not be made in full or in a timely manner, a actual overall exposure, others may establish
bank’s policies and procedures must limit its individual lines for significant sources of expo-
exposure to the correspondent, either by the sure, such as federal funds sales. For such banks,
establishment of internal limits or by other the examiner should ensure that the bank has
means. Limits are to be consistent with the risks established procedures to ensure that exposure
undertaken, considering the financial condition generally remains within the established lines.
and the form and maturity of the exposure to the In some instances, a bank may accomplish this
correspondent. Limits may specify fixed expo- objective by establishing limits on exposure that
sure amounts, or they may be more flexible and are monitored by a correspondent, such as for
be based on factors such as the monitoring of sales of federal funds through the correspondent
exposure and the financial condition of the as agent.
correspondent. Different limits may be set for When a bank monitors its exposures, the
different forms of exposure, different products, appropriate level of monitoring will depend on
and different maturities. (1) the type and volatility of the exposure,
When a bank has exposure to a correspondent (2) the extent to which the exposure approaches
that has a deteriorating financial condition, the bank’s internal limits for the correspondent,
examiners should determine if the bank took and (3) the condition of the correspondent.
that deterioration into account when it evaluated Generally, monitoring may be conducted retro-
the correspondent’s creditworthiness. The exam- spectively. Examples of retrospective monitor-
iner should also evaluate if the bank’s level of ing include checking close-of-business balances
exposure to the correspondent was appropriate. at a correspondent for the prior day or obtaining
Examiners need to determine that the bank’s daily balance records from a correspondent at

Page 4
the end of each month. Thus, banks are not demonstrate that its correspondent is at least
expected to monitor exposure to correspondents adequately capitalized.12 The credit exposure of
on a real-time basis. a bank to a correspondent shall consist of the
The purpose of requiring banks to monitor or bank’s assets and off-balance-sheet items that
structure their transactions that are subject to are (1) subject to capital requirements under the
limits is to ensure that the bank’s exposure capital adequacy guidelines of the bank’s pri-
generally remains within established limits. mary federal supervisor and (2) involve claims
However, occasional excesses over limits may on the correspondent or capital instruments
result from factors such as unusual market issued by the correspondent.13 Credit exposure
disturbances, unusual favorable market moves, therefore includes items such as deposit bal-
or other unusual increases in activity or opera- ances with a correspondent, fed funds sales, and
tional problems. Unusual late incoming wires or credit-equivalent amounts of interest-rate and
unusually large foreign cash letters (interna- foreign-exchange-rate contracts and other off-
tional pouch) would be considered examples of balance-sheet transactions. Credit exposure does
activities that could lead to excesses over inter- not include settlement of transactions, transac-
nal limits and that would not be considered tions conducted in an agency or similar capacity
impermissible under the rule. Examiners should where losses will be passed back to the principal
verify that banks have established appropriate or other party, and other sources of exposure that
procedures to address any excesses over internal are not covered by the capital adequacy guide-
limits. lines or that do not involve exposure to a
A bank’s internal policies and procedures correspondent.14 A bank may exclude the fol-
must address intraday exposure. However, as lowing from the calculation of credit exposure
with other exposure of longer maturities (i.e., to a correspondent: (1) transactions, including
interday or longer), the rule does not necessarily reverse repurchase agreements, to the extent that
require that limits be established on intraday the transactions are secured by government
exposure. Examiners should expect to see such securities or readily marketable collateral; (2) the
limits or frequent monitoring of balances only if proceeds of checks and other cash items depos-
the size of the intraday exposure and the condi-
tion of the correspondent indicate a significant 12. Total capital is the total of a bank’s tier 1 and tier 2
risk that payments will not be made as contem- capital calculated according to the risk-based capital guide-
plated. Examiners should keep in mind that lines of the bank’s primary federal supervisor. For an insured
branch of a foreign bank organized under the laws of a country
intraday exposure may be difficult for a bank to that subscribes to the principles of the Basel Capital Accord,
actively monitor and limit. Consequently, like total capital means total tier 1 and tier 2 capital as calculated
interday exposure, intraday exposure may be under the standards of that country. For an insured branch of
monitored retrospectively. In addition, smaller a foreign bank organized under the laws of a country that does
not subscribe to the principles of the Basel Capital Accord,
banks may limit their focus on intraday expo- total capital means total tier 1 and tier 2 capital as calculated
sure to being aware of the range of peak intraday under the provisions of the accord. The limit on credit
exposure to particular institutions and the effect exposure of the insured branch of a foreign bank is based on
that exposure may have on the bank. For exam- the foreign bank’s total capital, as defined in this section, not
on the imputed capital of the branch.
ple, a bank may receive reports on intraday For purposes of Regulation F, an adequately capitalized
balances from a correspondent on a monthly correspondent is a correspondent with a total risk-based
basis and would only need to take actions to capital ratio of 8.0 percent or greater, a tier 1 risk-based capi-
limit or more actively monitor such exposure if tal ratio of 4.0 percent or greater, and a leverage ratio of
4.0 percent or greater. The leverage ratio does not apply to
the bank becomes concerned about the size of correspondents that are foreign banks. See section 206.5(e) for
the intraday exposure relative to the condition of definitions of these terms.
the correspondent. 13. A bank is required to include with its own credit
exposure 100 percent of the credit exposure of any subsidiary
that the bank is required to consolidate on its bank Call
Report. This provision generally captures the credit exposure
of any majority-owned subsidiary of the bank. Therefore,
Credit Exposure none of a minority-owned subsidiary’s exposure and all of a
majority-owned subsidiary’s exposure would be included in
A bank’s internal policies and procedures must the parent bank’s exposure calculation.
14. For example, when assets of a bank, such as securities,
limit overnight credit exposure to an individual are held in safekeeping by a correspondent, there is no
correspondent to not more than 25 percent of the exposure to the correspondent, even though the securities
exposed bank’s total capital, unless the bank can themselves may be subject to a capital charge.

Page 5
ited in an account at a correspondent that are not credit-exposure level rather than as a safe-
yet available for withdrawal, (3) quality assets harbor level of credit exposure.
on which the correspondent is secondarily liable, Examiners should ensure that the bank has in
or obligations of the correspondent on which a place policies and procedures that ensure the
creditworthy obligor in addition to the corre- quarterly monitoring of the capital of its domes-
spondent is available; (4) exposure that results tic correspondents. This quarterly schedule
from the merger with or acquisition of another allows the bank to pick up information from the
bank for one year after that merger or acquisi- correspondent’s most recent bank Call Report,
tion is consummated; and (5) the portion of the financial statement, or bank rating report. Cur-
bank’s exposure to the correspondent that is rently, it is difficult to obtain information on the
covered by federal deposit insurance. (See sec- risk-based capital levels of a correspondent.
tion 206.4(d) for a more detailed discussion of Regulation F requires that a bank must be able
these exclusions.) This regulatory limit on credit to demonstrate only that its correspondent’s
exposure should be implemented as part of the capital ratios qualify it as at least adequately
bank’s policies and procedures required under capitalized.
the ‘‘Prudential Standards’’ section. Regula- A bank is not limited to a single source of
tion F does not impose regulatory limits for information for capital ratios. A bank may rely
‘‘credit exposure’’ to adequately or well- on capital information obtained from a corre-
capitalized correspondents. spondent, a bank rating agency, or another
Quarterly monitoring of capital is only reliable source of information. Further, examin-
required for correspondents to which a bank’s ers should anticipate that most banks will receive
potential credit exposure is more than 25 percent information on their correspondent’s capital
of its total capital.15 If the internal systems of a ratios either directly from the correspondents or
bank ordinarily limit credit exposure to a corre- from a bank rating agency. The standard used in
spondent to 25 percent or less of the exposed the rule is based solely on capital ratios and does
bank’s total capital, no monitoring of the corre- not require disclosure of CAMELS ratings. For
spondent’s capital would be necessary, although foreign bank correspondents, monitoring fre-
periodic reviews of the correspondent’s finan- quency should be related to the frequency with
cial condition may be required under the ‘‘Pru- which financial statements or other regular
dential Standards’’ section if exposure to the reports are available. Although such information
correspondent is significant. Every effort should is available quarterly for some foreign banks,
be made to allow banks to use existing risk- financial statements for many foreign banks are
monitoring and -control systems and practices generally available only on a semiannual basis.
when these systems and practices effectively Information on risk-based capital ratios may
maintain credit exposure within the prescribed not be available for many foreign bank corre-
limits. For smaller institutions, it is relatively spondents. As with domestic correspondents,
easy to determine how their measure of expo- however, examiners should anticipate that in
sure compares with the definition of credit most instances the correspondent will provide
exposure in Regulation F because these institu- the information to the banks with which it does
tions have relatively simple types of exposure. business.
Examiners should remember that the regulation A bank’s internal policies and procedures
emphasizes appropriate levels of exposure based should limit overnight credit exposure to a
on the exposed bank’s analysis of the credit- correspondent to not more than 25 percent of the
worthiness of its correspondents. Accordingly, exposed bank’s total capital, unless the bank can
for those correspondents that the bank has not demonstrate that its correspondent is at least
demonstrated are at least adequately capitalized, adequately capitalized, as defined by the rule.
this limit should be viewed as a maximum However, examiners should not necessarily
expect banks to have formal limits on credit
exposure to a correspondent for which the bank
15. Because information on risk-based capital ratios for does not maintain quarterly capital information
banks is generally based on the bank Call Report, a bank or that is a less than adequately capitalized
would be justified in relying on the most recently available correspondent if the banks’ policies and proce-
reports based on Call Report data. While there may be a
significant lag in such data, Call Reports are useful for
dures effectively limit credit exposure to an
monitoring trends in the condition of a correspondent— amount below the 25 percent limit of total
especially when a bank follows the data on a continuing basis. capital. Such situations include those in which

Page 6
only small balances are maintained with the the regulatory limit, the provisions of sec-
correspondent or in which the correspondent has tion 206.3 (prudential standards) concerning
only been approved for a limited relationship. excesses over internal limits also apply to limits
Although in many cases it will be necessary for established for the purpose of controlling credit
a bank to establish formal internal limits to meet exposure under section 206.4 of Regulation F.

Page 7
The following examination objectives should be 5. To determine if (1) exposure ordinarily
considered when examiners are (1) evaluating remains within the established internal limits
the bank’s interbank liabilities with respect to and (2) appropriate procedures have been
its credit exposures to correspondents and established to address excesses over internal
(2) assessing the bank’s compliance with Regu- limits.
lation F. 6. To determine that a bank’s credit exposure to
less than adequately capitalized correspon-
1. To determine if the policies, practices, pro- dents is not more than 25 percent of the
cedures, and internal controls for interbank exposed bank’s total capital. (Note that Regu-
liabilities adequately address the risks posed lation F places greater emphasis on maintain-
by the bank’s exposure to other domestic ing appropriate levels of exposure based on a
depository institutions and foreign banks. bank’s analysis of the creditworthiness of its
2. To determine if bank officers and employees correspondents as opposed to merely staying
are operating in compliance with the policies within regulatory established limits.)
and procedures established by the bank. 7. To determine if those correspondents to which
3. To determine if the financial condition of the bank has credit exposure exceeding
correspondents to which the bank has signifi- 25 percent of total capital are monitored
cant exposure—significant both in the size quarterly to ensure that such correspondents
and maturity of the exposure and the finan- remain at least adequately capitalized.
cial condition of the correspondent—is 8. To reach agreement with the board of direc-
reviewed periodically. tors and senior management to initiate cor-
4. To determine if internal limits on exposure rective action when policies, procedures, or
(1) have been established where necessary internal controls are deficient, or when there
and (2) are consistent with the risk undertaken. are violations of laws or regulations.

Page 1
Examiners should obtain or prepare the infor- the assessment criteria used by the other
mation necessary to perform the appropriate party.
procedural steps. e. When the bank relies on its bank holding
company or on a correspondent, such as a
1. If selected for implementation, complete or bankers’ bank, to select and monitor cor-
update the ‘‘Interbank Liabilities’’ section of respondents or to choose other correspon-
the internal control questionnaire. dents with which to place the depository
2. On the basis of an evaluation of the bank’s institution’s federal funds, ensure that the
internal controls, determine the scope of the bank’s board of directors has reviewed
examination. and approved the selection criteria used.
3. Test for compliance with policies, practices, f. If the bank is exposed to a correspondent
procedures, and internal controls in conjunc- that has experienced deterioration in its
tion with performing the remaining examina- financial condition, ascertain whether the
tion procedures. bank has taken the deterioration into
4. Request bank files relating to its exposure to account in its evaluation of the credit-
its correspondents, as exposure is defined worthiness of the correspondent and of
in Regulation F and applied and used in the appropriate level of exposure to the
the ‘‘Prudential Standards’’ section of the correspondent.
regulation. g. When the bank has established internal
a. Request documentation demonstrating that limits for significant exposure, determine
the bank has periodically reviewed the that the bank either monitors its exposure
financial condition of any correspondent or structures transactions with the corre-
to which the depository institution has spondent to ensure that exposure ordi-
significant exposure. Factors bearing on narily remains within the bank’s internal
the financial condition of the correspon- limits for the risk undertaken.
dent that should be addressed by the bank h. If the bank chooses to set separate limits
(depository institution) include the capital for different forms of exposure, products,
level of the correspondent, the level of or maturities and does not set an overall
nonaccrual and past-due loans and leases, internal limit on exposure to a correspon-
the level of earnings, and other factors dent, review information on actual inter-
affecting the financial condition of the day exposure to determine if the aggregate
correspondent. exposure (especially for less than ade-
b. Request that the bank provide information quately capitalized correspondents or
indicating its level of exposure to each financially deteriorating correspondents)
correspondent, as measured by the bank’s is consistent with the risk undertaken.
internal control systems (for smaller banks, i. When a bank monitors its exposures, deter-
this information may include correspon- mine if the level of monitoring of signifi-
dent statements and a list of securities cant exposure (especially for less than
held in the investment portfolio). adequately capitalized correspondents or
c. Determine if the frequency of the bank’s financially deteriorating correspondents)
reviews of its correspondents’ financial is adequate, commensurate with the type
condition is adequate for those correspon- and volatility of exposure, the extent to
dents to which the bank has very large or which the exposure approaches the bank’s
long maturities or for correspondents in internal limits, and the condition of the
deteriorating condition. correspondent.
d. If a bank relies on another party (such as j. Determine if the bank had any occasional
a bank rating agency, its bank holding excesses in exposure over its internal
company, or another correspondent) to limits. If so, verify that the bank used
provide financial analysis of a correspon- appropriate and adequate procedures to
dent, determine if the bank’s board of address such excesses.
directors has reviewed and approved k. If the size of intraday exposure to a

Page 1
2015.3 Interbank Liabilities: Examination Procedures
correspondent and the condition of the monitoring and -control systems and prac-
correspondent indicate a significant risk tices when these systems and practices effec-
that payments will not be made in full or tively maintain credit exposure within the
in a timely manner, verify that the bank prescribed limits). Review the bank’s files
has established intraday limits consistent to—
with the risk undertaken and that it has a. verify that the correspondent’s capital lev-
monitored its intraday exposure. els are monitored quarterly;
5. Request and review a list of the correspon- b. verify that these correspondents are at
dent transaction files for all domestic deposi- least adequately capitalized, in compli-
tory institutions and foreign banks to which ance with Regulation F; and
the bank regularly has credit exposure (as c. determine that the credit exposure to those
defined in section 206.4 of Regulation F) correspondents that are at risk of dropping
exceeding 25 percent of the bank’s total below the adequately capitalized capital
capital during a specified time interval. levels could be reduced to 25 percent or
(Where appropriate, every effort should be less of the bank’s total capital in a timely
made to allow banks to use existing risk- manner.

Page 2
Review the bank’s internal controls, policies, 9. If a party other than bank management
practices, and procedures for interbank liabili- conducts the financial analysis of or selects
ties and compliance with the Board’s Regula- a correspondent, has the bank’s board of
tion F. The bank’s system should be documented directors reviewed and approved the gen-
completely and concisely and should include, eral assessment and selection criteria used
where appropriate, narrative descriptions, flow by that party?
charts, copies of forms used, and other pertinent 10. If the financial condition of a correspon-
information. When identifying and resolving dent, or the form or maturity of the bank’s
any existing deficiencies, examiners should seek exposure to that correspondent, creates sig-
the answers to the following key questions. nificant risk, do the bank’s written policies
and procedures establish internal limits or
other procedures, such as monitoring, to
PRUDENTIAL STANDARDS control exposure?
1. Has the bank developed written policies and 11. Are the bank’s internal limits or controls
procedures to evaluate and control its expo- appropriate for the level of its risk exposure
sure to all of its correspondents? to correspondents? If no internal limits have
2. Have the written policies and procedures been established, is this appropriate based
been reviewed and approved by the board of on the financial condition of a correspon-
directors annually? dent and the size, form, and maturity of the
3. Do the written policies and procedures bank’s exposure? What are your reasons for
adequately address the bank’s exposure(s) this conclusion?
to a correspondent, including credit risk, 12. When internal limits for significant expo-
liquidity risk, operational risk, and settle- sure to a correspondent have been set, has
ment risk? the bank established procedures and struc-
4. Has the bank adequately evaluated its intra- tured its transactions with the correspondent
day exposure? Does the bank have signifi- to ensure that the exposure ordinarily
cant exposure to its correspondent from remains within the bank’s established inter-
operational risks, such as extensive reliance nal limits?
on a correspondent for data processing? If 13. If not, is actual exposure to a correspondent
so, has the bank addressed these operational monitored to ensure that the exposure ordi-
risks? narily remains within the bank’s established
5. Do the bank’s written policies and proce- internal limits?
dures establish criteria for selecting a cor- 14. Is the level (frequency) of monitoring per-
respondent or terminating that relationship? formed appropriate for—
6. Do the bank’s written policies and proce- a. the type and volatility of the exposure?
dures require a periodic review of the finan- b. the extent to which the exposure
cial condition of a correspondent whenever approaches the bank’s internal limits?
the size and maturity of exposure is consid- c. the financial condition of the correspon-
ered significant in relation to the financial dent?
condition of the correspondent? 15. Are transactions and monitoring reports on
7. When exposure is considered significant, is exposure reviewed for compliance with
the financial condition of a correspondent internal policies and procedures? If so, by
periodically reviewed? whom and how often?
8. Does the periodic review of a correspon- 16. Do the bank’s written policies and proce-
dent’s financial condition include— dures address deterioration in a correspon-
a. the level of capital? dent’s financial condition with respect to—
b. the level of nonaccrual and past-due a. the periodic review of the correspon-
loans and leases? dent’s financial condition?
c. the level of earnings? b. appropriate limits on exposure?
d. other factors affecting the financial con- c. the monitoring of the exposure, or the
dition of the correspondent? structuring of transactions with the cor-

Page 1
2015.4 Interbank Liabilities: Internal Control Questionnaire
respondent, to ensure that the exposure sure to 25 percent or less of the bank’s total
remains within the established internal capital, if a correspondent is less than ade-
limits? quately capitalized?
Are these measures appropriate and realistic? 2. If credit exposure is not limited to 25 percent
17. Do the bank’s written procedures establish or less of the bank’s total capital, does the
guidelines to address excesses over its bank—
internal limits? (Such excesses could include a. obtain quarterly information to determine
unusual late incoming wires, unusually large its correspondent’s capital levels (if so,
foreign cash letters (international pouch), determine the source of the information)?
unusual market moves, or other unusual b. monitor its overnight credit exposure to
increases in activity or operational prob- its correspondents (if so, determine the
lems.) Are the procedures appropriate? frequency)?
CREDIT-EXPOSURE LIMITS
1. Do the bank’s written policies and proce-
dures effectively limit overnight credit expo-

Page 2
Investment Securities and End-User Activities
This section provides guidance on the manage- LIMITATIONS AND

ment of a depository institution’s investment RESTRICTIONS ON SECURITIES
and end-user activities. The guidance applies to HOLDINGS
(1) all securities in held-to-maturity and available-
for-sale accounts as defined in the Statement of Many states extend the investment authority that
Financial Accounting Standards No. 115 (FAS is available to national banks to their chartered
115), (2) all certificates of deposit held for banks—often by direct reference. The security
investment purposes, and (3) all derivative con- investments of national banks are governed in
tracts not held in trading accounts (end-user turn by the seventh paragraph of 12 USC 24
derivative contracts).1 The guidance also covers (section 5136 of the Revised Statutes) and by
all securities used for investment purposes, the investment securities regulations of the Office
including money market instruments, fixed- and of the Comptroller of the Currency (OCC). If
floating-rate notes and bonds, structured notes, state law permits, state member banks are sub-
mortgage pass-through and other asset-backed ject to the same limitations and conditions for
securities, and mortgage-derivative products. All purchasing, selling, underwriting, and holding
end-user derivative instruments used for non- investment securities and stocks as national
trading purposes, such as swaps, futures, and banks under 12 USC 24 (seventh). To determine
options, are also discussed. whether an obligation qualifies as a permissible
Institutions must ensure that their investment investment for state member banks, and to
and end-user activities are permissible and calculate the limits with respect to the purchase
appropriate within established limitations and of such obligations, refer to the OCC’s invest-
restrictions on bank holdings of these instrument securities regulation at 12 CFR 1. (See also
ments. Institutions should also employ sound section 208.21(b) of Regulation H (12 CFR
risk-management practices consistently across 208.21(b)).)
these varying product categories, regardless of Under 12 USC 24, an ‘‘investment security’’
their legal characteristics or nomenclature. This is defined as a debt obligation that is not pre-
section provides examiners with guidance on— dominantly speculative. A security is not pre-
dominantly speculative if it is rated investment
• the permissibility and appropriateness of grade. An ‘‘investment-grade security’’ is a
securities holdings by state member banks; security that has been rated in one of the four
• sound risk-management practices and internal highest rating categories by two or more nation-
controls used by banking institutions in their ally recognized statistical rating organizations
investment and end-user activities; (one rating may suffice if the security has been
rated by only one organization). For example,
• the review of securities and derivatives securities rated AAA, AA, A, and BBB by
acquired by the bank’s international division Standard and Poor’s and Aaa, Aa, A or A-1, and
and overseas branches for its own account as Baa-1 or Baa by Moody’s are considered invest-
well as the bank’s foreign equity investments ment grade. In the case of split ratings—
that are held either directly or through Edge different ratings from different rating
Act corporations; organizations—the lower rating applies. Although
• banking agency policies on certain high-risk the analyses of major rating agencies are basi-
mortgage-derivative products; and cally sound and are updated frequently, bank
personnel should keep in mind that ratings are
• unsuitable investment practices. only evaluations of probabilities. To determine
appropriate credit limits for a particular coun-
terparty, the bank should supplement bond rat-
1. Derivatives, in general, are financial contracts whose
values are derived from the value of one or more underlying
ings with its own credit analysis of the issuer.
assets, interest rates, exchange rates, commodities, or financial (See table 1 for a summary of the above-
or commodity indexes. mentioned rating systems.)

Page 1
2020.1 Investment Securities and End-User Activities
Table 1—Summary of Rating Systems

Standard & Poor’s Moody’s Description
Bank-quality investments
AAA Aaa Highest-grade obligations
AA Aa High-grade obligations
A A, A-1 Upper-medium grade
BBB Baa-1, Baa Medium-grade, on the borderline between defi-

nitely sound obligations and those containing
predominantly speculative elements
Speculative and defaulted issues
BB Ba Lower-medium grade with only minor investment

characteristics
B B Low-grade, default probable
CCC, CC, C, D Caa, Ca, C Lowest-rated class, defaulted, extremely poor pros-
pects
Bank-Eligible Securities capital and surplus that such holdings represent.

For calculating concentration limits, the term
The OCC’s investment securities regulation iden- ‘‘capital and surplus’’ includes the balance of a
tifies five basic types of investment securities bank’s allowance for loan and lease losses not
(types I, II, III, IV, and V) and establishes included in tier 2 capital. Table 2 on the next
limitations on a bank’s investment in those types page summarizes bank-eligible securities and
of securities based on the percentage of their investment limitations.

Page 2
Investment Securities and End-User Activities 2020.1
Table 2—Summary of New Investment-Type Categories

Type Category Characteristics Limitations
Type I securities • U.S. government securities No limitations on banks’ investment,

• general obligations of a state or dealing, or underwriting abilities.
political subdivision With respect to all municipal securi-
• municipal bond activities by well- ties, a member bank that is well
capitalized* banks, other than capitalized* may deal in, underwrite,
types II, III, IV, or V securities purchase, and sell any municipal
• obligations backed by the full bond for its own account without any
faith and credit of the U.S. limit tied to the bank’s capital and
government surplus.
• FHLB, Fannie Mae, and FHLMC
debt or similarly collateralized
debt of a state or political subdi-
vision backed by the full faith and
credit of the U.S. government
Type II securities • state obligations for housing, uni- Banks may deal in, underwrite, or
versity, or dormitory purposes that invest subject to the limitation that the
would not qualify as a type I aggregate par value of the obligation of
municipal security any one obligor may not exceed 10 per-
• obligations of international devel- cent of a bank’s capital and surplus.
opment banks
• debt of Tennessee Valley
Authority
• debt of U.S. Postal Service
• obligations that a national bank is
authorized to deal in, underwrite,
purchase, or sell under 12 USC
24 (seventh), other than type I
securities
Type III securities • an investment security that does The aggregate par value of a bank’s
not qualify as type I, II, IV, or V purchases and sales of the securities
• municipal revenue bonds, except of any one obligor may not exceed
those that qualify as a type I 10 percent of a bank’s capital and
municipal security surplus.
• corporate bonds
continued
* subject to the statutory prompt-corrective-action standards (12 USC 1831o)

Page 3
Type Category Characteristics Limitations
Type IV securities • small business–related securities For securities rated AA or Aa or higher,

that are rated investment-grade or no investment limitations.
the equivalent and that are fully
secured by a loan pool For lower-rated investment-grade secu-
• residential or commercial rities, the aggregate par value of a
mortgage–related securities rated bank’s purchases and sales of the se-
AA or Aa or higher curities of any one obligor may not
exceed 25 percent of a bank’s capital
and surplus.
For mortgage-related securities, no

investment limitations.
A bank may deal in type IV securities

with limitation.
Type V securities • asset-backed securities (credit The aggregate par value of a bank’s
card, auto, home equity, student purchases and sales of the securities of
loan, manufactured housing) any one obligor may not exceed 25 per-
that are investment-grade and are cent of a bank’s capital and surplus.
marketable
• residential and commercial
mortgage–related securities rated
below AA or Aa, but still
investment-grade
Type I securities are those debt instruments versity, or dormitory purposes that do not qualify
that national and state member banks can deal as a type I security and other issuers specifically
in, underwrite, purchase, and sell for their own identified in 12 USC 24(7).
accounts without limitation. Type I securities Type III is a residual securities category
are obligations of the U.S. government or its consisting of all types of investment securities
agencies; general obligations of states and not specifically designated to another security
political subdivisions; municipal bonds (includ- ‘‘type’’ category and that do not qualify as a
ing municipal revenue bonds) other than a type type I security. Banks cannot deal in or under-
II, III, IV, or V security by a bank that is well write type III securities, and their holdings of
capitalized; and mortgage-related securities. A these instruments are limited to 10 percent of the
bank may purchase type I securities for its own bank’s capital and surplus for any one obligor.
account subject to no limitations, other than the Type IV securities include the following asset-
exercise of prudent banking judgment. (See 12 backed securities (ABS) that are fully secured
USC 24(7) and 15 USC 78(c)(a)(41).) by interests in pools of loans made to numerous
Type II securities are those debt instruments obligors:
that national and state member banks may deal
in, underwrite, purchase, and sell for their own • investment-grade residential mortgage–related
account subject to a 10 percent limitation of a securities that are offered or sold pursuant to
bank’s capital and surplus for any one obligor. section 4(5) of the Securities Act of 1933 (15
Type II investments include obligations issued USC 77d(5))
by the International Bank for Reconstruction • residential mortgage–related securities as
and Development, the Inter-American Develop- described in section 3(a)(41) of the Securities
ment Bank, the Asian Development Bank, the Exchange Act of 1934 (15 USC 78c(a)(41))
Tennessee Valley Authority, and the U.S. Postal that are rated in one of the two highest
Service, as well as obligations issued by any investment-grade rating categories
state or political subdivision for housing, uni- • investment-grade commercial mortgage secu-

Page 4
rities offered or sold pursuant to section 4(5) finance corporate takeovers, are usually not
of the Securities Act of 1933 (15 USC 77d(5)) considered to be of investment quality because
• commercial mortgage securities as described they are predominately speculative and have
in section 3(a)(41) of the Securities Exchange limited marketability.
Act of 1934 (15 USC 78c(a)(41)) that are The purchase of type II and type III securities
rated in one of the two highest investment- is limited to 10 percent of equity capital and
grade rating categories surplus for each obligor when the purchase is
• investment-grade, small-business-loan securi- based on adequate evidence of the maker’s
ties as described in section 3(a)(53)(A) of the ability to perform. That limitation is reduced to
Securities Exchange Act of 1934 (15 USC 5 percent of equity capital and reserves for all
78c(a)(53)(A)) obligors in the aggregate when the judgment of
the obligor’s ability to perform is based predomi-
For all type IV commercial and residential nantly on ‘‘reliable estimates.’’ The term ‘‘reli-
mortgage securities and for type IV small- able estimates’’ refers to projections of income
business-loan securities rated in the top two and debt-service requirements or conditional
rating categories, there is no limitation on the ratings when factual credit information is not
amount a bank can purchase or sell for its own available and when the obligor does not have a
account. Type IV investment-grade, small- record of performance.
business-loan securities that are not rated in the OCC regulations specifically provide for sepa-
top two rating categories are subject to a limit of rate type I, II, III, IV, and V limits. In the
25 percent of a bank’s capital and surplus for extreme, therefore, national banks can lend
any one issuer. In addition to being able to 15 percent of their capital to a corporate bor-
purchase and sell type IV securities, subject to rower, buy the borrower’s corporate bonds
the above limitation, a bank may deal in those amounting to another 10 percent of capital and
type IV securities that are fully secured by type surplus (type III securities), and purchase the
I securities. borrower’s ABS up to an additional 25 percent
Type V securities consist of all ABS that are of capital (type V securities), for a total expo-
not type IV securities. Specifically, they are sure of 50 percent of the bank’s capital and
defined as marketable, investment-grade-rated surplus. This could be expanded even further if
securities that are not type IV and are ‘‘fully the borrower also issued highly rated type IV
secured by interests in a pool of loans to securities, upon which there is no investment
numerous obligors and in which a national bank limitation. However, an exposure to any one
could invest directly.’’ Type V securities include issuer of 25 percent or more should be consid-
securities backed by auto loans, credit card ered a credit concentration, and banks are
loans, home equity loans, and other assets. Also expected to justify why exposures in excess of
included are residential and commercial mort- 25 percent do not entail an undue concentration.
gage securities as described in section 3(a)(41) (See table 2 for a summary of the new
of the Securities Exchange Act of 1934 (15 USC investment-type categories.)
78c(a)(41)) that are not rated in one of the two
highest investment-grade rating categories but
that are still investment grade. A bank may Municipal Revenue Bonds
purchase or sell type V securities for its own
Upon enactment of the Gramm-Leach-Bliley
account provided the aggregate par value of type
Act (the GLB Act), most state member banks
V securities issued by any one issuer held by the
were authorized to deal in, underwrite, purchase,
bank does not exceed 25 percent of the bank’s
and sell municipal revenue bonds (12 USC 24
capital and surplus.
(seventh)). Effective March 13, 2000, these
As mentioned above, type III securities rep-
activities (involving type I securities) could be
resent a residual category. The OCC requires a
conducted by well-capitalized1a banks, without
national bank to determine (1) that the type III
limitation as to the level of these activities
instrument it plans to purchase is marketable
relative to the bank’s capital. Previously, banks
and of sufficiently high investment quality and
were limited to only underwriting, dealing in, or
(2) that the obligor will be able to meet all
payments and fulfill all the obligations it has 1a. See the prompt corrective action at 12 USC 1831o and
undertaken in connection with the security. For see subpart D of the Federal Reserve’s Regulation H (12 CFR
example, junk bonds, which are often issued to 208).

Page 5
investing in, without limitation, general obliga- source; these limits help ensure adequate risk
tion municipal bonds backed by the full faith diversification. Furthermore, examiners and other
and credit of an issuer with general powers of supervisory staff should be aware of the extent
taxation. Member banks could purchase for their to which state laws place further restrictions on
own account, but not underwrite or deal in, municipal securities activities but should defer
municipal revenue bonds, but the purchases and to state banking regulators on questions of legal
sales of such investment securities for any authority under state laws and regulations.
obligor were limited to 10 percent of a member For underwriting and dealing activities, the
bank’s capital and surplus. As a result of the nature and extent of due diligence should be
GLB Act amendment, municipal revenue bonds commensurate with the degree of risk posed by
are the equivalent of type I securities for well- and the complexity of the proposed activity.
capitalized state member banks. 1b (See SR-01- Bank dealer activities should be conducted sub-
13.) ject to the types of prudential limitations
The expanded municipal revenue bond author- described above but should also be formulated
ity under the GLB Act necessitates heightened in light of the reputational risk that may accom-
awareness by banks, examiners, and supervisory pany underwriting and dealing activities. Senior
staff of the particular risks of municipal revenue management and the board of directors should
bond underwriting, dealing, and investment establish credit-quality and position-risk guide-
activities. Senior management of a state member lines, including guidelines for concentration risk.
bank has the responsibility to ensure that the A bank serving as a syndicate manager would
bank conducts municipal securities underwrit- be expected to conduct extensive due diligence
ing, dealing, and investment activities in a safe to mitigate its underwriting risk. Due diligence
and sound manner, in compliance with applica- should include an assessment of the creditwor-
ble laws and regulations. Sound risk-management thiness of the issuer and a full analysis of
practices are critical. State member banks primary and any contingent sources of repay-
engaged in municipal securities activities should ment. Offering documents should be reviewed
maintain written policies and procedures gov- for their accuracy and completeness, as well as
erning these activities and make them available for full disclosure of all of the offering’s rel-
to examiners upon request. evant risks.
Prudent municipal securities investment in-
volves considering and adopting risk-
management policies, including appropriate limi- UNIFORM AGREEMENT ON THE
tations, on the interest-rate, liquidity, price,
credit, market, and legal risks in light of the
CLASSIFICATION OF ASSETS
bank’s appetite and tolerance for risk. Histori- AND THE APPRAISAL OF
cally, municipal revenue bonds have had higher SECURITIES
default rates than municipal general obligation
bonds. The risks of certain industrial develop- On June 15, 2004, the agencies 1c issued a joint
ment revenue bonds have been akin to the risks interagency statement that revised the Uniform
of corporate bonds. Therefore, when bondhold- Agreement on the Classification of Assets and
ers are relying on a specific project or private- Appraisal of Securities Held by Banks and
sector obligation for repayment, banks should Thrifts (the uniform agreement). (See SR-04-9.)
conduct a credit analysis, using their normal The uniform agreement amends the examination
credit standards, to identify and evaluate the procedures that were established in 1938 and
source of repayment before purchasing the then revised and issued on July 15, 1949, and on
bonds. Banks must also perform periodic credit May 7, 1979. The uniform agreement sets forth
analyses of those securities that remain in the the definitions of the classification categories
bank’s investment portfolio. Prudent banking and the specific examination procedures and
practices require that management adopt appro- information for classifying bank assets, includ-
priate exposure limits for individual credits and ing securities. The uniform agreement’s classi-
on credits that rely on a similar repayment
1c. The statement was issued by the Board of Governors of
1b. The OCC published final amendments to its investment the Federal Reserve System, the Office of the Comptroller of
securities regulation (12 CFR 1) on July 2, 2001 (66 Fed. Reg. the Currency, the Federal Deposit Insurance Corporation, and
34784). the Office of Thrift Supervision (the agencies).

Page 6
fication of loans remains unchanged from the the collateral pledged, if any. Assets so classi-
1979 revision. fied must have a well-defined weakness or
The June 15, 2004, agreement changes the weaknesses that jeopardize the liquidation of the
classification standards applied to banks’ hold- debt. They are characterized by the distinct
ings of debt securities by— possibility that the institution will sustain some
loss if the deficiencies are not corrected. An
• eliminating the automatic classification of sub- asset classified Doubtful has all the weaknesses
investment-grade debt securities when a bank- inherent in one classified Substandard, with the
ing organization has developed an accurate, added characteristic that the weaknesses make
robust, and documented credit-risk- collection or liquidation in full, on the basis of
management framework to analyze its securi- currently existing facts, conditions, and values,
ties holdings; highly questionable and improbable. Assets clas-
• conforming the uniform agreement to current sified Loss are considered uncollectible and of
generally accepted accounting principles by such little value that their continuance as bank-
basing the recognition of depreciation on all able assets is not warranted. This classification
available-for-sale securities on the bank’s does not mean that the asset has absolutely no
determination as to whether the impairment of recovery or salvage value but rather that it is not
the underlying securities is ‘‘temporary’’ or practical or desirable to defer writing off this
‘‘other than temporary’’; basically worthless asset even though partial
• eliminating the preferential treatment given to recovery may be effected in the future. Amounts
defaulted municipal securities; classified Loss should be promptly charged off.
• clarifying how examiners should address
securities that have two or more different
ratings, split or partially rated securities, and Appraisal of Securities in Bank
nonrated debt securities;
• identifying when examiners may diverge from
Examinations
conforming their ratings to those of the rating
agencies; and In an effort to streamline the examination pro-
cess and achieve as much consistency as pos-
• addressing the treatment of Interagency Coun-
sible, examiners will use the published ratings
try Exposure Review Committee ratings.
provided by nationally recognized statistical
ratings organizations (NRSROs) as a proxy for
The uniform agreement’s classification catego-
the supervisory classification definitions. Exam-
ries also apply to the classification of assets held
iners may, however, assign a more- or less-
by the subsidiaries of banks. Although the clas-
severe classification for an individual security,
sification categories for bank assets and assets
depending on a review of applicable facts and
held by bank subsidiaries are the same, the
circumstances.
classification standards may be difficult to apply
to the classification of subsidiary assets because
of differences in the nature and risk character-
istics of the assets. Despite the differences that Investment-Quality Debt Securities
may exist between assets held directly by a bank
and those held by its subsidiary, the standards Investment-quality debt securities are market-
for classifying investment securities are to be able obligations in which the investment char-
applied directly to securities held by a bank and acteristics are not distinctly or predominantly
its subsidiaries. speculative. This group generally includes invest-
ment securities in the four highest rating cate-
gories provided by NRSROs and includes
unrated debt securities of equivalent quality.
Classification of Assets in Because investment-quality debt securities do
Examinations not exhibit weaknesses that justify an adverse
classification rating, examiners will generally
Classification units are designated as Substan- not classify them. However, published credit
dard, Doubtful, and Loss. A Substandard asset is ratings occasionally lag demonstrated changes
inadequately protected by the current sound in credit quality, and examiners may, in limited
worth and paying capacity of the obligor or of cases, classify a security notwithstanding an

Page 7
investment-grade rating. Examiners may use Nonrated Debt Securities

such discretion, when justified by credit infor-
mation the examiner believes is not reflected in The agencies expect institutions holding indi-
the rating, to properly reflect the security’s vidually large nonrated debt security exposures,
credit risk. or having significant aggregate exposures from
small individual holdings, to demonstrate that
they have made prudent pre-acquisition credit
Sub-Investment-Quality Debt Securities decisions and have effective, risk-based stan-
dards for the ongoing assessment of credit risk.
Sub-investment-quality debt securities are those Examiners will review the institution’s program
in which the investment characteristics are dis- for monitoring and measuring the credit risk of
tinctly or predominantly speculative. This group such holdings and, if the assessment process is
generally includes debt securities, including considered acceptable, generally will rely upon
hybrid equity instruments (for example, trust those assessments during the examination pro-
preferred securities), in grades below the four cess. If an institution has not established inde-
highest rating categories; unrated debt securities pendent risk-based standards and a satisfactory
of equivalent quality; and defaulted debt process to assess the quality of such exposures,
securities. examiners may classify such securities, includ-
In order to reflect asset quality properly, an ing those of a credit quality deemed to be the
examiner may in limited cases ‘‘pass’’ a debt equivalent of subinvestment grade, as appropriate.
security that is rated below investment quality.
Examiners may use such discretion when, for Some nonrated debt securities held in invest-
example, the institution has an accurate and ment portfolios represent small exposures rela-
robust credit-risk-management framework and tive to capital, both individually and in aggre-
has demonstrated, based on recent, materially gate. While institutions generally have the same
positive credit information, that the security is supervisory requirements (as applicable to large
the credit equivalent of investment grade. holdings) to show that these holdings are the
credit equivalent of investment grade at pur-
chase, comprehensive credit analysis subse-
Rating Differences quent to purchase may be impractical and not
cost effective. For such small individual expo-
Some debt securities may have investment- sures, institutions should continue to obtain and
quality ratings by one (or more) rating agencies review available financial information, and as-
and sub-investment-quality ratings by others. sign risk ratings. Examiners may rely upon the
Examiners will generally classify such securi- bank’s internal ratings when evaluating such
ties, particularly when the most recently as- holdings.
signed rating is not investment quality. How-
ever, an examiner has discretion to ‘‘pass’’ a
debt security with both investment-quality and Foreign Debt Securities
sub-investment-quality ratings. The examiner
may use that discretion if, for example, the The Interagency Country Exposure Review
institution has demonstrated through its docu- Committee (ICERC) assigns transfer-risk rat-
mented credit analysis that the security is the ings for cross-border exposures. Examiners
credit equivalent of investment grade. should use the guidelines in this uniform agree-
ment rather than ICERC transfer-risk ratings in
assigning security classifications, except when
Split or Partially Rated Securities the ICERC ratings result in a more-severe clas-
sification.
Some individual debt securities have ratings for
principal but not interest. The absence of a
rating for interest typically reflects uncertainty
regarding the source and amount of interest the Treatment of Declines in Fair Value
investor will receive. Because of the speculative Below Amortized Cost on Debt Securities
nature of the interest component, examiners will
generally classify such securities, regardless of Under generally accepted accounting principles
the rating for the principal. (GAAP), an institution must assess whether a

Page 8
decline in fair value 1d below the amortized cost onstrates through its trading activity a short-
of a security is a ‘‘temporary’’ or an ‘‘other-than- term holding period or holds the security as a
temporary’’ impairment. When the decline in hedge for a customer’s valid derivative contract.
fair value on an individual security represents
‘‘other-than-temporary’’ impairment, the cost
basis of the security must be written down to fair Credit-Risk-Management Framework
value, thereby establishing a new cost basis for for Securities
the security, and the amount of the write-down
must be reflected in current-period earnings. If When an institution has developed an accurate,
an institution’s process for assessing impairment robust, and documented credit-risk-management
is considered acceptable, examiners may use framework to analyze its securities holdings,
those assessments in determining the appropri- examiners may choose to depart from the gen-
ate classification of declines in fair value below eral debt security classification guidelines in
amortized cost on individual debt securities. favor of individual asset review in determining
Any decline in fair value below amortized whether to classify those holdings. A robust
cost on defaulted debt securities will be classi- credit-risk-management framework entails
fied as indicated in table 3. Apart from classifi- appropriate pre-acquisition credit due diligence
cation, for impairment write-downs or charge- by qualified staff that grades a security’s credit
offs on adversely classified debt securities, the risk based on an analysis of the repayment
existence of a payment default will generally be capacity of the issuer and the structure and
considered a presumptive indicator of ‘‘other- features of the security. It also involves the
than-temporary’’ impairment. ongoing monitoring of holdings to ensure that
risk ratings are reviewed regularly and updated
in a timely fashion when significant new infor-
Classification of Other Types of mation is received.
Securities The credit analysis of securities should vary
based on the structural complexity of the secu-
Some investments, such as certain equity hold- rity, the type of collateral, and external ratings.
ings or securities with equity-like risk and return The credit-risk-management framework should
profiles, have highly speculative performance reflect the size, complexity, quality, and risk
characteristics. Examiners should generally clas- characteristics of the securities portfolio; the
sify such holdings based on an assessment of the risk appetite and policies of the institution; and
applicable facts and circumstances. the quality of its credit-risk-management staff,
and should reflect changes to these factors over
time. Policies and procedures should identify
the extent of credit analysis and documentation
Summary Table of Debt Security required to satisfy sound credit-risk-management
Classification Guidelines standards.
Table 3 outlines the uniform classification
approach the agencies will generally use when Transfers of Low-Quality Securities
assessing credit quality in debt securities and Assets
portfolios.
The general debt security classification guide- The purchase of low-quality assets by a bank
lines do not apply to private debt and equity from an affiliated bank or nonbank affiliate is a
holdings in a small business investment com- violation of section 23A of the Federal Reserve
pany or an Edge Act corporation. The uniform Act. The transfer of low-quality securities from
agreement does not apply to securities held in one depository institution to another may be
trading accounts, provided the institution dem- done to avoid detection and classification dur-
ing regulatory examinations; this type of trans-
1d. As currently defined under GAAP, the fair value of an fer may be accomplished through participations,
asset is the amount at which that asset could be bought or sold purchases or sales, and asset swaps with other
in a current transaction between willing parties, that is, other
than in a forced or liquidation sale. Quoted market prices are
affiliated or nonaffiliated financial institutions.
the best evidence of fair value and must be used as the basis Broadly defined, low-quality securities include
for measuring fair value, if available. depreciated or sub-investment-quality securi-

Page 8.1
Table 3—General Debt Security Classification Guidelines

Type of security Classification
Substandard Doubtful Loss
Investment-quality debt securities with — — —

‘‘temporary’’ impairment
Investment-quality debt securities with — — Impairment

‘‘other-than-temporary’’ impairment
Sub-investment-quality debt securities Amortized — —

with ‘‘temporary’’ impairment1 cost
Sub-investment-quality debt securities Fair — Impairment

with ‘‘other-than-temporary’’ impair- value
ment, including defaulted debt
securities
Note. Impairment is the amount by which amortized cost gains and losses on AFS debt securities are excluded from
exceeds fair value. earnings and reported in a separate component of equity
1. For sub-investment-quality available-for-sale (AFS) debt capital. In contrast, these unrealized gains and losses are
securities with ‘‘temporary’’ impairment, amortized cost rather excluded from regulatory capital. Accordingly, the amount
than the lower amount at which these securities are carried on classified Substandard on these AFS debt securities, i.e.,
the balance sheet, i.e., fair value, is classified Substandard. amortized cost, also excludes the balance-sheet adjustment for
This classification is consistent with the regulatory capital unrealized losses.
treatment of AFS debt securities. Under GAAP, unrealized
ties. Situations in which an institution appears to rities from another depository institution. This
be concealing low-quality securities to avoid procedure applies to transfers involving savings
examination scrutiny and possible classification associations and savings banks, as well as com-
represent an unsafe and unsound activity. mercial banking organizations.
Any situations involving the transfer of low- Situations may arise when transfers of secu-
quality or questionable securities should be rities are undertaken for legitimate reasons. In
brought to the attention of Reserve Bank super- these cases, the securities should be properly
visory personnel who, in turn, should notify the recorded on the books of the acquiring institu-
local office of the primary federal regulator of tion at their fair value on the date of transfer. If
the other depository institution involved in the the transfer was with the parent holding com-
transaction. For example, if an examiner deter- pany or a nonbank affiliate, the records of the
mines that a state member bank or holding affiliate should be reviewed as well.
company has transferred or intends to transfer
low-quality securities to another depository
institution, the Reserve Bank should notify the Permissible Stock Holdings
recipient institution’s primary federal regulator
of the transfer. The same notification require- The purchase of securities convertible into stock
ment holds true if an examiner determines that a at the option of the issuer is prohibited (12 CFR
state member bank or holding company has 1.6). Other than as specified in table 4, banks are
acquired or intends to acquire low-quality secu- prohibited from investing in stock.

Page 8.2
Table 4—Permitted Stock Holdings by Member Banks

Type of stock Authorizing statute and limitation
Federal Reserve Bank Federal Reserve Act, sections 2 and 9 (12 USC 282 and 321) and
Regulation I (12 CFR 209). Subscription must equal 6 percent of
the bank’s capital and surplus, 3 percent paid in.
Safe deposit corporation 12 USC 24. 15 percent of capital and surplus.
Corporation holding bank Federal Reserve Act, section 24A (12 USC 371(d)). 100 percent of
premises capital stock. Limitation includes total direct and indirect invest-
ment in bank premises in any form (such as loans). Maximum
limitation may be exceeded with permission of the Federal
Reserve Bank for state member banks and the Comptroller of the
Currency for national banks.
Small business investment Small Business Investment Act of August 21, 1958, section 302(b)
company (15 USC 682(b)). Banks are prohibited from acquiring shares of
such a corporation if, upon making the acquisition, the aggregate
amount of shares in small business investment companies then
held by the bank would exceed 5 percent of its capital and surplus.
Edge Act and agreement Federal Reserve Act, sections 25 and 25A (12 USC 601 and 618).
corporations and The aggregate amount of stock held in all such corporations may
foreign banks not exceed 10 percent of the member bank’s capital and surplus.
Also, the member bank must possess capital and surplus of
$1 million or more before acquiring investments pursuant to
section 25.
Bank service company Bank Service Corporation Act of 1958, section 2 (12 USC 1861
and 1862). (Redesignated as Bank Service Company Act.) 10 per-
cent of paid in and unimpaired capital and surplus. Limitation
includes total direct and indirect investment in any form. No
insured banks shall invest more than 5 percent of their total assets.
Federal National Mortgage National Housing Mortgage Association Act of 1934, sec-
Corporation tion 303(f) (12 USC 1718(f)). No limit.
Bank’s own stock 12 USC 83. Shares of the bank’s own stock may not be acquired
or taken as security for loans, except as necessary to prevent loss
from a debt previously contracted in good faith. Stock so acquired
must be disposed of within six months of the date of acquisition.
Corporate stock acquired Case law has established that stock of any corporation debt may be
through debt previously acquired to prevent loss from a debt previously contracted in good
contracted (DPC) transaction faith. See Oppenheimer v. Harriman National Bank & Trust Co. of
the City of New York, 301 US 206 (1937). However, if the stock
is not disposed of within a reasonable time period, it loses its status
as a DPC transaction and becomes a prohibited holding under
12 USC 24(7).
Operations subsidiaries 12 CFR 250.141. Permitted if the subsidiary is to perform, at

locations at which the bank is authorized to engage in business,
functions that the bank is empowered to perform directly.

Page 8.3
Type of stock Authorizing statute and limitation
State housing corporation 12 USC 24. 5 percent of its capital stock, paid in and unimpaired,
incorporated in the state plus 5 percent of its unimpaired surplus fund when considered
in which the bank is located together with loans and commitments made to the corporation.
Agricultural credit 12 USC 24. 20 percent of capital and surplus unless the bank owns
corporation over 80 percent. No limit if the bank owns 80 percent or more.
Government National 12 USC 24. No limit.

Mortgage Association
Student Loan Marketing 12 USC 24. No limit.

Association
Bankers’ banks 12 USC 24. 10 percent of capital stock and paid-in and unimpaired
surplus. Bankers’ banks must be insured by the FDIC, owned
exclusively by depository institutions, and engaged solely in
providing banking services to other depository institutions and
their officers, directors, or employees. Ownership shall not result in
any bank’s acquiring more than 5 percent of any class of voting
securities of the bankers’ bank.
Mutual funds 12 USC 24(7). Banks may invest in mutual funds as long as the
underlying securities are permissible investments for a bank.
Community development Federal Reserve Act, section 9, paragraph 23 (12 USC 338a). Up
corporation to 10 percent of capital stock and surplus1 subject to 12 CFR
208.22.
1. Section 208.2(d) of Regulation H defines ‘‘capital stock under this law to approve public-welfare or other such
and surplus’’ to mean tier 1 and tier 2 capital included in a investments, up to the sum of 5 percent of paid-in and
member bank’s risk-based capital and the balance of a unimpaired capital stock and 5 percent of unimpaired surplus,
member bank’s allowance for loan and lease losses not unless the Board determines by order that the higher amount
included in its tier 2 capital for calculation of risk-based will pose no significant risk to the affected deposit insurance
capital, based on the bank’s most recent consolidated Report fund, and the bank is adequately capitalized. In no case may
of Condition and Income. Section 9 of the Federal Reserve the aggregate of such investments exceed 10 percent of the
Act (12 USC 338a) provides that the Board has the authority bank’s combined capital stock and surplus.
LIMITED EQUITY INVESTMENTS increased volatility of both earnings and capital.

The supervisory guidance in SR-00-9 on private
Investing in the equity of nonfinancial compa- equity investments and merchant banking activi-
nies and lending to private-equity-financed com- ties is concerned with a BO’s proper risk-
panies (that is, companies financed by private focused management of its private equity invest-
equity) have emerged as increasingly important ment activities so that these investments do not
sources of earnings and business relationships at adversely affect the safety and soundness of the
a number of banking organizations (BOs). In affiliated insured depository institutions.
this guidance, the term private equity refers to An institution’s board of directors and senior
shared-risk investments outside of publicly management are responsible for ensuring that
quoted securities and also covers activities such the risks associated with private equity activities
as venture capital, leveraged buyouts, mezza- do not adversely affect the safety and soundness
nine financing, and holdings of publicly quoted of the banking organization or any other affili-
securities obtained through these activities. While ated insured depository institutions. To this end,
private equity securities can contribute substan- sound investment and risk-management prac-
tially to earnings, these activities can give rise to tices and strong capital positions are critical

Page 8.4
elements in the prudent conduct of these ownership, middle-market business expansions,

activities. and mergers and acquisitions.
Legal and Regulatory Authority Oversight by the Board of Directors

Depository institutions are able to make limited
and Senior Management
equity investments under the following statutory
Equity investment activities require the active
and regulatory authorities:
oversight of the board of directors and senior
management of the depository institution that is
• Depository institutions may make equity
conducting the private equity investment activi-
investments through small business invest-
ties. The board should approve portfolio objec-
ment corporations (SBICs). Investments made
tives, overall investment strategies, and general
by SBIC subsidiaries are allowed up to a total
investment policies that are consistent with the
of 50 percent of a portfolio company’s out-
institution’s financial condition, risk profile, and
standing shares, but can only be made in
risk tolerance. Portfolio objectives should ad-
companies defined as a small business, accord-
dress the types of investments, expected busi-
ing to SBIC rules. A bank’s aggregate invest-
ness returns, desired holding periods, diversifi-
ment in the stock of SBICs is limited to
cation parameters, and other elements of sound
5 percent of the bank’s capital and surplus.
investment-management oversight. Board-
• Under Regulation K, which implements sec-
approved objectives, strategies, policies, and
tions 25 and 25A of the Federal Reserve Act
procedures should be documented and clearly
(FRA) and section 4(c)(13) of the Bank Hold-
communicated to all the personnel involved in
ing Company Act of 1956 (BHC Act), a
their implementation. The board should actively
depository institution may make portfolio
monitor the performance and risk profile of
investments in foreign companies, provided
equity investment business lines in light of the
the investments do not in the aggregate exceed
established objectives, strategies, and policies.
25 percent of the tier 1 capital of the bank
The board also should ensure that there is an
holding company. In addition, individual
effective management structure for conducting
investments must not exceed 19.9 percent of a
the institution’s equity activities, including
portfolio company’s voting shares or 40 per-
adequate systems for measuring, monitoring,
cent of the portfolio company’s total equity.1e
controlling, and reporting on the risks of equity
investments. The board should approve policies
Equity investments made under the authori-
that specify lines of authority and responsibility
ties listed above may be in publicly traded
for both acquisitions and sales of investments.
securities or privately held equity interests. The
The board should also approve (1) limits on
investment may be made as a direct investment
aggregate investment and exposure amounts;
in a specific portfolio company, or it may be
(2) the types of investments (for example, direct
made indirectly through a pooled investment
and indirect, mezzanine financing, start-ups,
vehicle, such as a private equity fund.1f In
seed financing); and (3) appropriate
general, private equity funds are investment
diversification-related aspects of equity invest-
companies, typically organized as limited part-
ments such as industry, sector, and geographic
nerships, that pool capital from third-party
concentrations.
investors to invest in shares, assets, and owner-
For its part, senior management must ensure
ship interests in companies for resale or other
that there are adequate policies, procedures, and
disposition. Private-equity-fund investments may
management information systems for managing
provide seed or early-stage investment funds to
equity investment activities on a day-to-day and
start-up companies or may finance changes in
longer-term basis. Management should set clear
1e. Shares of a corporation held in trading or dealing
lines of authority and responsibility for making
accounts or under any other authority are also included in the and monitoring investments and for managing
calculation of a depository institution’s investment. Portfolio risk. Management should ensure that an institu-
investments of $25 million or less can be made without prior tion’s equity investment activities are conducted
notice to the Board. See Regulation K for more detailed
information.
by competent staff whose technical knowledge
1f. For additional stock holdings that state member banks and experience are consistent with the scope of
are authorized to hold, see table 4. the institution’s activities.

Page 8.5
Management of the Investment strategies should identify limits on hedged

Process exposures and permissible hedging instruments.
Depository institutions engaging in equity invest-

ment activities should have a sound process for Procedures
executing all elements of investment manage-
ment, including initial due diligence, periodic Management and staff compensation play a
reviews of holdings, investment valuation, and critical role in providing incentives and control-
realization of returns. This process requires ling risks within a private equity business line.
appropriate policies, procedures, and manage- Clear policies should govern compensation
ment information systems, the formality of which arrangements, including co-investment struc-
should be commensurate with the scope, com- tures and staff sales of portfolio company
plexity, and nature of an institution’s equity interests.
investment activities. The supervisory review Institutions have different procedures for
should be risk-focused, taking into account the assessing, approving, and reviewing invest-
institution’s stated tolerance for risk, the ability ments based on the size, nature, and risk profile
of senior management to govern these activities of an investment. The procedures used for direct
effectively, the materiality of activities in com- investments may be different than those used for
parison to the institution’s risk profile, and the indirect investments made through private equity
capital position of the institution. funds. For example, different levels of due
Depository institutions engaging in equity diligence and senior management approvals may
investment activities require effective policies be required. When constructing management
that (1) govern the types and amounts of invest- infrastructures for conducting these investment
ments that may be made, (2) provide guidelines activities, management should ensure that oper-
on appropriate holding periods for different ating procedures and internal controls appropri-
types of investments, and (3) establish param- ately reflect the diversity of investments.
eters for portfolio diversification. Investment The potential diversity in investment practice
strategies and permissible types of investments should be recognized when conducting supervi-
should be clearly identified. Portfolio- sory reviews of the equity investment process.
diversification policies should identify factors The supervisory focus should be on the appro-
pertinent to the risk profile of the investments priateness of the process employed relative to
being made, such as industry, sector, geo- the risk of the investments made and on the
graphic, and market factors. Policies establish- materiality of this business line to the overall
ing expected holding periods should specify the soundness of the depository institution, as well
general criteria for liquidation of investments as the potential impact on affiliated depository
and guidelines for the divestiture of an under- institutions. The procedures employed should
performing investment. Decisions to liquidate include the following:
underperforming investments are necessarily
made on a case-by-case basis considering all • Investment analysis and approvals, including
relevant factors. Policies and procedures, how- well-founded analytical assessments of invest-
ever, should require more frequent review and ment opportunities and formal investment-
analysis for investments that are performing approval processes.
poorly or that have been in a portfolio for a The methods and types of analyses conducted
considerable length of time, as compared with should be appropriately structured to adequately
the other investments overall. assess the specific risk profile, industry
dynamics, management, specific terms and
conditions of the investment opportunity, and
Policies and Limits other relevant factors. All elements of the
analytical and approval processes, from initial
Policies should identify the aggregate exposure review through the formal investment deci-
that the institution is willing to accept, by type sion, should be documented and clearly
and nature of investment (for example, direct or understood by the staff conducting these
indirect, industry sectors). The limits should activities.
include funded and unfunded commitments. For- The evaluation of existing and potential
mal and clearly articulated hedging policies and investments in private equity funds should

Page 8.6
involve an assessment of the adequacy of a — internal investment-risk ratings and rating-

fund’s structure. Consideration should be given change triggers;
to the (1) management fees, (2) carried inter- — exit strategies, both primary and contin-
est and its computation on an aggregate port- gent, and expected internal rates of return
folio basis,1g (3) sufficiency of capital com- upon exit; and
mitments that are provided by the general — other pertinent information for assessing
partners in providing management incentives, the appropriateness, performance, and
(4) contingent liabilities of the general partner, expected returns of investments.
(5) distribution policies and wind-down pro- Portfolio reviews should include an aggre-
visions, and (6) performance benchmarks and gation of individual investment-risk and per-
return-calculation methodologies. formance ratings; an analysis of appropriate
• Investment-risk ratings. industry, sector, geographic, and other perti-
Internal risk ratings should assign each invest- nent concentrations; and total portfolio valu-
ment a rating based on factors such as the ations. Portfolio reports that contain the cost
nature of the company, strength of manage- basis, carrying values, estimated fair values,
ment, industry dynamics, financial condition, valuation discounts, and other factors summa-
operating results, expected exit strategies, mar- rizing the status of individual investments are
ket conditions, and other pertinent factors. integral tools for conducting effective port-
Different rating factors may be appropriate for folio reviews. Reports containing the results
indirect investments and direct investments. of all reviews should be available to supervi-
• Periodic and timely investment strategy and sors for their inspection.
performance (best, worst, and probable case Given the inherent uncertainties in equity
assessment) reviews of equity investments, investment activities, institutions should
conducted at the individual and portfolio include in their periodic reviews consideration
levels. of the best case, worst case, and probable case
Management should ensure that periodic and assessments of investment performance. These
timely review of the institution’s equity invest- reviews should evaluate changes in market
ments takes place at both individual-investment conditions and the alternative assumptions
and portfolio levels. Depending on the size, used to value investments—including expected
complexity, and risk profile of the investment, and contingent exit strategies. Major assump-
reviews should, when appropriate, include tions used in valuing investments and fore-
factors such as— casting performance should be identified.
— the history of the investment, including These assessments need not be confined to
the total funds approved; quantitative analyses of potential losses, but
— commitment amounts, principal-cash- may also include qualitative analyses. The
investment amounts, cost basis, carrying formality and sophistication of investment
value, major-investment cash flows, and reviews should be appropriate for the overall
supporting information including valua- level of risk the depository institution incurs
tion rationales and methodologies; from this business line.
— the current actual percentage of ownership • Assessment of the equity investment valuation
in the portfolio company on both a diluted and accounting policies and the procedures
and undiluted basis; used, their impact on earnings, and the extent
— a summary of recent events and current of their compliance with generally accepted
outlook; accounting principles (GAAP).
— the recent financial performance of port- Valuation and accounting policies and proce-
folio companies, including summary com- dures can have a significant impact on the
pilations of performance and forecasts, earnings of institutions engaged in equity
historical financial results, current and investment activities. Many equity invest-
future plans, key performance metrics, and ments are made in privately held companies,
other relevant items; for which independent price quotations are
either unavailable or not available in sufficient
volume to provide meaningful liquidity or a
1g. The carried interest is the share of a partnership’s
market valuation. Valuations of some equity
return that is received by the general partners or investment investments may involve a high degree of
advisers. judgment on the part of management or the

Page 8.7
skillful use of peer comparisons. Similar cir- Accounting and valuation of equity invest-
cumstances may exist for publicly traded ments should be subject to regular periodic
securities that are thinly traded or subject to review. In all cases, valuation reviews should
resale and holding-period restrictions, or when produce documented audit trails that are avail-
the institution holds a significant block of a able to supervisors and auditors. These reviews
company’s shares. It is of paramount impor- should assess the consistency of the method-
tance that an institution’s policies and proce- ologies used in estimating fair value.
dures on accounting and valuation methodolo- Accounting and valuation treatments should
gies for equity investments be clearly be assessed in light of their potential for
articulated. abuse, such as through the inappropriate man-
Under GAAP, equity investments held by agement or manipulation of reported earnings
investment companies, held by broker-dealers, on equity investments. For example, high
or maintained in the trading account are valuations may produce overstatements of
reported at fair value, with any unrealized earnings through gains and losses on invest-
appreciation or depreciation included in earn- ments reported at ‘‘fair value.’’ On the other
ings and flowing to tier 1 capital. For some hand, inappropriately understated valuations
holdings, fair value may reflect adjustments can provide vehicles for smoothing earnings
for liquidity and other factors. by recognizing gains on profitable invest-
Equity investments that are not held in ments when an institution’s earnings are oth-
investment companies, by broker-dealers, or erwise under stress. While reasonable people
in the trading account and that have a readily may disagree on valuations given to illiquid
determinable fair value (quoted market price) private equity investments, institutions should
are generally reported as available-for-sale have rigorous valuation procedures that are
(AFS). They are marked to market with unre- applied consistently.
alized appreciation or depreciation recognized Increasingly, equity investments are contrib-
in GAAP-defined ‘‘comprehensive income’’ uting to an institution’s earnings. The poten-
but not earnings. Appreciation or depreciation tial impact of these investments on the com-
flows to equity, but, for regulatory capital position, quality, and sustainability of overall
purposes only, depreciation is included in tier earnings should be appropriately recognized
1 capital.1h Equity investments without readily and assessed by both management and
determinable fair values generally are held at supervisors.
cost, subject to write-downs for impairments • A review of assumed and actual equity-
to the value of the asset. Impairments of value investment exit strategies and the extent of
should be promptly and appropriately recog- their impact on the returns and reported
nized and written down. earnings.
In determining fair value, the valuation The principal means of exiting an equity
methodology plays a critical role. Formal investment in a privately held company include
valuation and accounting policies should be initial public stock offerings, sales to other
established for investments in public compa- investors, and share repurchases. An institu-
nies; direct private investments; indirect fund tion’s assumptions on exit strategies can sig-
investments; and, where appropriate, other nificantly affect the valuation of the invest-
types of investments with special characteris- ment. Management should periodically review
tics. When establishing valuation policies, investment exit strategies, with particular focus
institutions should consider market condi- on larger or less-liquid investments.
tions, taking account of lockout provisions, • Policies and procedures governing the sale,
the restrictions of Securities and Exchange exchange, transfer, or other disposition of
Commission Rule 144, liquidity features, the equity investments.
dilutive effects of warrants and options, and Policies and procedures to govern the sale,
industry characteristics and dynamics. exchange, transfer, or other disposition of the
institution’s investments should state clearly
the levels of management or board approval
1h. Under the risk-based capital rule, supplementary (tier required for the disposition of investments.
2) capital may include up to 45 percent of pretax unrealized
holding gains (that is, the excess, if any, of the fair value over
• Internal methods for allocating capital based
historical cost) on AFS equity securities with readily deter- on the risk inherent in the equity investment
minable fair values. activities, including the methods for identify-

Page 8.8
ing all material risks and their potential sible in smaller, less-complex institutions, alter-
impact on the safety and soundness of the native checks and balances should be estab-
institution. lished. These alternatives may include random
Consistent with SR-99-18, depository institu- internal audits, reviews by senior management
tions that are conducting material equity who are independent of the function, or the use
investment activities should have internal of outside third parties.
methods for allocating economic capital. These
methods should be based on the risk inherent
in the equity investment activities, including Documentation
the identification of all material risks and their
Documentation of key elements of the invest-
potential impact on the institution. Organiza-
ment process, including initial due diligence,
tions that are substantially engaged in these
approval reviews, valuations, and dispositions,
investment activities should have strong capi-
is an integral part of any private equity invest-
tal positions supporting their equity invest-
ment internal control system. This documenta-
ments. The economic capital that organiza-
tion should be accessible to supervisors.
tions allocate to their equity investments
should be well in excess of the current regu-
latory minimums applied to lending activities. Legal Compliance
The amount of percentage of capital dedicated
to the equity investment business line should An institution’s internal controls should focus
be appropriate to the size, complexity, and on compliance with all federal laws and regula-
financial condition of the institution. Assess- tions that are applicable to the institution’s
ments of capital adequacy should cover not investment activities. Regulatory compliance
only the institution’s compliance with regula- requirements, in particular, should be incorpo-
tory capital requirements and the quality of rated into internal controls so managers outside
regulatory capital, but should also include an of the compliance or legal functions understand
institution’s methodologies for internally the parameters of permissible investment
allocating economic capital to this business activities.
line. To ensure compliance with federal securities
laws, institutions should establish policies, pro-
cedures, and other controls addressing insider
Internal Controls trading. A ‘‘restricted list’’ of securities for
which the institution has inside information is
An adequate system of internal controls, with one example of a widely used method for
appropriate checks and balances and clear audit controlling the risk of insider trading. In addi-
trails, is critical to conducting equity investment tion, control procedures should be in place to
activities effectively. Appropriate internal con- ensure that appropriate reports are filed with
trols should address all the elements of the functional regulators.
investment-management process. The internal The limitations in sections 23A and 23B of
controls should focus on the appropriateness of the FRA, which deal with transactions between
existing policies and procedures; adherence to a depository institution and its affiliates, are
policies and procedures; and the integrity and presumed by the Gramm-Leach-Bliley Act (GLB
adequacy of investment valuations, risk identi- Act) to apply to certain transactions between a
fication, regulatory compliance, and manage- depository institution and any portfolio com-
ment reporting. Any departures from policies pany in which an affiliate of the institution owns
and procedures should be documented and at least a 15 percent equity interest. This own-
reviewed by senior management, and this docu- ership threshold is lower than the ordinary
mentation should be available for examiner definition of an affiliate, which is typically
review. 25 percent.
As with other financial activities, the assess-
ments of an organization’s compliance with
both written and implied policies and proce- Compensation
dures should be independent of line decision-
making functions to the fullest extent possible. Often, key employees in the private equity
When fully independent reviews are not pos- investment units of banking organizations may

Page 8.9
co-invest in the direct or fund investments made • the accounting techniques and valuation meth-
by the unit. These co-investment arrangements odologies, including key assumptions and
can be an important incentive and risk-control practices affecting valuation and changes in
technique, and they can help to attract and retain those practices
qualified management. However, ‘‘cherry pick- • the realized gains (or losses) arising from
ing,’’ or selecting only certain investments for sales and unrealized gains (or losses)
employee participation while excluding others, • insights regarding the potential performance
should be discouraged. of equity investments under alternative mar-
The employees’ co-investment may be funded ket conditions
through loans from the depository institution or
its affiliates, which, in turn, would hold a lien
against the employees’ interests. The adminis-
tration of the compensation plan should be Lending to or Engaging in Other
appropriately governed pursuant to formal agree- Transactions with Portfolio
ments, policies, and procedures. Among other Companies
matters, policies and procedures should address
the terms and conditions of employee loans and Additional risk-management issues may arise
the sales of participants’ interests before the when a depository institution or an affiliate lends
release of the lien. to or has other business relationships with (1) a
company in which the depository institution or
an affiliate has invested (that is, a portfolio
Disclosure of Equity Investment company), (2) the general partner or manager of
Activities a private equity fund that has also invested in a
portfolio company, or (3) a private-equity-
Given the important role that market discipline financed company in which the banking institu-
plays in controlling risk, institutions should tion does not hold a direct or indirect ownership
ensure that they adequately disclose the infor- interest but which is an investment or portfolio
mation necessary for the markets to assess the company of a general partner or fund manager
institution’s risk profile and performance in this with which the banking organization has other
business line. Indeed, it is in the institution’s investments. Given the potentially higher-than-
interest, as well as that of its creditors and normal risk attributes of these lending relation-
shareholders, to publicly disclose information ships, institutions should devote special atten-
about earnings and risk profiles. Institutions are tion to ensuring that the terms and conditions of
encouraged to disclose in public filings informa- such relationships are at arm’s length and are
tion on the type and nature of investments, consistent with the lending policies and proce-
portfolio concentrations, returns, and their con- dures of the institution. Similar issues may arise
tributions to reported earnings and capital. in the context of derivatives transactions with or
Supervisors should fully review and use these guaranteed by portfolio companies and general
disclosures, as well as periodic regulatory reports partners. Lending and other business transac-
filed by publicly held banking organizations, as tions between an insured depository institution
part of the information they review routinely. and a portfolio company that meet the definition
The following topics are relevant for public of an affiliate must be negotiated on an arm’s-
disclosure, though disclosures on each of these length basis, in accordance with section 23B of
topics may not be appropriate, relevant, or the FRA.
sufficient in every case: When a depository institution lends to a
private-equity-financed company in which it has
• the size of the portfolio no equity interest but in which the borrowing
• the types and nature of investments (for exam- company is a portfolio investment of private
ple, direct or indirect, domestic or interna- equity fund managers or general partners with
tional, public or private, equity or debt with which the institution may have other private-
conversion rights) equity-related relationships, care must be taken
• initial cost, carrying value, and fair value of to ensure that the extension of credit is con-
investments and, when applicable, compari- ducted on reasonable terms. In some cases,
sons to publicly quoted share values of port- lenders may wrongly assume that the general
folio companies partners or another third party implicitly guar-

Page 8.10
antees or stands behind such credits. Reliance on This section identifies basic factors that examiners
implicit guarantees or comfort letters should not should consider in evaluating these elements for
substitute for reliance on a sound borrower that investment and end-user activities; it reiterates
is expected to service its debt with its own and supplements existing guidance and direc-
resources. As with any type of credit extension, tives on the use of these instruments for non-
absent a written contractual guarantee, the credit trading purposes as provided in various super-
quality of a private equity fund manager, general visory letters and examination manuals.2
partner, or other third party should not be used to In evaluating an institution’s risk-management
upgrade the internal credit-risk rating of the process, examiners should consider the nature
borrower company or to prevent the classifica- and size of its holdings. Examiner judgment
tion or special mention of a loan. plays a key role in assessing the adequacy of an
When an institution lends to a portfolio com- institution’s risk-management process for secu-
pany in which it has a direct or an indirect rities and derivative contracts. Examiners should
interest, implications arise under sections 23A focus on evaluating an institution’s understand-
and 23B of the FRA, which govern crediting of the risks involved in the instruments it
related transactions and asset purchases between holds. Regardless of any responsibility, legal or
a depository institution and its affiliates. Section otherwise, assumed by a dealer or counterparty
23A applies to transactions between a deposi- for a particular transaction, the acquiring insti-
tory institution and any company in which the
institution’s holding company or shareholders
own at least 25 percent of the company’s voting
shares. The GLB Act extends this coverage by
establishing a presumption that a portfolio com-
pany is an affiliate of a depository institution if
the financial holding company (FHC) uses the
merchant banking authority of the GLB Act to
own or control more than 15 percent of the
equity of the company. Institutions should obtain
the assistance of counsel in determining whether
such issues exist or would exist if loans were
extended to a portfolio company, general part-
ner, or manager. Supervisors, including examin-
ers, should ensure that the institution has con-
ducted a proper review of these issues to avoid
violations of law or regulations.
EVALUATING RISK
MANAGEMENT AND
INTERNAL CONTROLS
Examiners are expected to conduct an adequate
evaluation of the risk-management process used
to acquire and manage the securities and deriva-
tive contracts used in nontrading activities. In 2. Existing policies and examiner guidance on various
conducting this analysis, examiners should evalu- supervisory topics applicable to securities and off-balance-
ate the following four key elements of a sound sheet instruments can be found in this manual, and the Bank
risk-management process: Holding Company Supervision Manual, as well as in various
supervision and regulation (SR) letters, including SR-90-16,
‘‘Implementation of Examination Guidelines for the Review
• active board and senior management oversight of Asset Securitization Activities’’; SR-91-4, ‘‘Inspection of
• adequate risk-management policies and limits Investment-Adviser Subsidiaries of Bank Holding Compa-
• appropriate risk-measurement and reporting nies’’; SR-93-69, ‘‘Risk Management and Internal Controls
for Trading Activities’’; and SR-98-12, ‘‘FFIEC Policy State-
systems ment on Investment Securities and End-User Derivatives
• comprehensive internal controls Activities.’’

Page 8.11
tution is ultimately responsible for understand- periodically review information that is suffi-
ing and managing the risks of the transactions ciently detailed and timely to allow them to
into which it enters. Failure of an institution to understand and assess the credit, market, and
adequately understand, monitor, and evaluate liquidity risks facing the institution as a whole
the risks involved in its securities or derivative and its securities and derivative positions in
positions, either through lack of internal exper- particular. These reviews should be conducted at
tise or inadequate outside advice, constitutes an least quarterly and more frequently when the
unsafe and unsound banking practice. institution holds significant positions in complex
As with all risk-bearing activities, institutions instruments. In addition, the board should peri-
should fully support the risk exposures of non- odically reevaluate the institution’s business
trading activities with adequate capital. Banking strategies and significant risk-management poli-
organizations should ensure that their capital cies and procedures, placing special emphasis
positions are sufficiently strong to support all the on the institution’s financial objectives and risk
risks associated with these activities on a fully tolerances. The minutes of board meetings and
consolidated basis and should maintain adequate accompanying reports and presentation materi-
capital in all affiliated entities engaged in these als should clearly demonstrate the board’s ful-
activities. In evaluating the adequacy of an fillment of these basic responsibilities. The sec-
institution’s capital, examiners should consider tion of this guidance on managing specific risks
any unrecognized net depreciation or apprecia- provides guidance on the types of objectives,
tion in an institution’s securities and derivative risk tolerances, limits, and reports that directors
holdings. Further consideration should also be should consider.
given to the institution’s ability to hold these The board of directors should also conduct
securities and thereby avoid recognizing losses. and encourage discussions between its members
and senior management, as well as between
senior management and others in the institution,
on the institution’s risk-management process
Board of Directors and Senior and risk exposures. Although it is not essential
Management Oversight for board members to have detailed technical
knowledge of these activities, if they do not, it is
Active oversight by the institution’s board of their responsibility to ensure that they have
directors and relevant senior management is adequate access to independent legal and pro-
critical to a sound risk-management process. fessional advice on the institution’s securities
Examiners should ensure that these individuals and derivative holdings and strategies. The
are aware of their responsibilities and that they familiarity, technical knowledge, and awareness
adequately perform their appropriate roles in of directors and senior management should be
overseeing and managing the risks associated commensurate with the level and nature of an
with nontrading activities involving securities institution’s securities and derivative positions.
and derivative instruments. Accordingly, the board should be knowledge-
able enough or have access to independent
advice to evaluate recommendations presented
Board of Directors by management or investment advisors.
The board of directors has the ultimate respon-

sibility for the level of risk taken by the institu- Senior Management
tion. Accordingly, the board should approve
overall business strategies and significant poli- Senior management is responsible for ensuring
cies that govern risk taking, including those that there are adequate policies and procedures
involving securities and derivative contracts. In for conducting investment and end-user activi-
particular, the board should approve policies ties on both a long-range and day-to-day basis.
identifying managerial oversight and articulat- Management should maintain clear lines of
ing risk tolerances and exposure limits for secu- authority and responsibility for acquiring instru-
rities and derivative activities. The board should ments and managing risk, setting appropriate
also actively monitor the performance and risk limits on risk taking, establishing adequate sys-
profile of the institution and its various securi- tems for measuring risk, setting acceptable stan-
ties and derivative portfolios. Directors should dards for valuing positions and measuring per-

Page 9
formance, establishing effective internal controls, tive holdings and the adequacy of the process
and enacting a comprehensive risk-reporting used in managing those exposures. Depending
and risk-management review process. To pro- on the size and nature of the institution, this
vide adequate oversight, management should review function may be carried out by either
fully understand the institution’s risk profile, management or a board committee. Regard-
including that of its securities and derivative less of size and sophistication, institutions
activities. Examiners should review the reports should ensure that back-office, settlement, and
to senior management and evaluate whether transaction-reconciliation responsibilities are
they provide both good summary information conducted and managed by personnel who
and sufficient detail to enable management to are independent of those initiating risk-taking
assess the sensitivity of securities and derivative positions.
holdings to changes in credit quality, market
prices and rates, liquidity conditions, and other
important risk factors. As part of its oversight Policies, Procedures, and Limits
responsibilities, senior management should peri-
odically review the organization’s risk- Institutions should maintain written policies and
management procedures to ensure that they procedures that clearly outline their approach
remain appropriate and sound. Senior manage- for managing securities and derivative instru-
ment should also encourage and participate in ments. These policies should be consistent with
active discussions with members of the board the organization’s broader business strategies,
and with risk-management staff regarding risk capital adequacy, technical expertise, and gen-
measurement, reporting, and management pro- eral willingness to take risks. They should
cedures. identify relevant objectives, constraints, and
Management should ensure that investment guidelines for both acquiring instruments and
and end-user activities are conducted by com- managing portfolios. In doing so, policies should
petent staff whose technical knowledge and establish a logical framework for limiting the
experience is consistent with the nature and various risks involved in an institution’s securi-
scope of the institution’s activities. There should ties and derivative holdings. Policies should
be sufficient depth in staff resources to manage clearly delineate lines of responsibility and
these activities if key personnel are not avail- authority over securities and derivative activi-
able. Management should also ensure that back- ties. They should also provide for the systematic
office and financial-control resources are suffi- review of products new to the firm. Examiners
cient to manage and control risks effectively. should evaluate the adequacy of an institution’s
risk-management policies and procedures in
relation to its size, its sophistication, and the
Independence in Managing Risks scope of its activities.
The process of measuring, monitoring, and con-
trolling risks within an institution should be Specifying Objectives
managed as independently as possible from
those individuals who have the authority to Institutions can use securities and derivative
initiate transactions. Otherwise, conflicts of inter- instruments for several primary and complemen-
est could develop. The nature and extent of this tary purposes.3 Banking organizations should
independence should be commensurate with articulate these objectives clearly and identify
the size and complexity of an institution’s secu- the types of securities and derivative contracts to
rities and derivative activities. Institutions with be used for achieving them. Objectives also
large and complex balance sheets or with sig- should be identified at the appropriate portfolio
nificant holdings of complex instruments would and institutional levels. These objectives should
be expected to have risk managers or risk- guide the acquisition of individual instruments
management functions fully independent of the
individuals who have the authority to conduct
transactions. Institutions with less complex hold- 3. Such purposes include, but are not limited to, generating
earnings, creating funding opportunities, providing liquidity,
ings should ensure that there is some mechanism hedging risk exposures, taking risk positions, modifying and
for independently reviewing both the level of managing risk profiles, managing tax liabilities, and meeting
risk exposures created by securities and deriva- pledging requirements.

Page 10
and provide benchmarks for periodically evalu- limit excesses. Positions that exceed established
ating the performance and effectiveness of an limits should receive the prompt attention of
institution’s holdings, strategies, and programs. appropriate management and should be resolved
Whenever multiple objectives are involved, man- according to approved policies.
agement should identify the hierarchy of poten- Limits should implement the overall risk
tially conflicting objectives. tolerances and constraints articulated in general
policy statements. Depending on the nature of
an institution’s holdings and its general sophis-
Identifying Constraints, Guidelines, and tication, limits can be identified for individual
Limits business units, portfolios, instrument types, or
specific instruments. The level of detail of risk
An institution’s policies should clearly articulate limits should reflect the characteristics of the
the organization’s risk tolerance by identifying institution’s holdings, including the types of risk
its willingness to take the credit, market, and to which the institution is exposed. Regardless
liquidity risks involved in holding securities and of their specific form or level of aggregation,
derivative contracts. A statement of authorized limits should be consistent with the institution’s
instruments and activities is an important vehi- overall approach to managing various types of
cle for communicating these risk tolerances. risks. They should also be integrated to the
This statement should clearly identify permis- fullest extent possible with institution-wide lim-
sible instruments or instrument types and the its on the same risks as they arise in other
purposes or objectives for which the institution activities of the firm. Later in this section,
may use them. The statement also should identify specific examiner considerations for evaluating
permissible credit quality, market-risk sensitivity, the policies and limits used in managing each
and liquidity characteristics of the instruments of the various types of risks involved in non-
and portfolios used in nontrading activities. For trading securities and derivative activities are
example, in the case of market risk, policies addressed.
should address the permissible degree of price
sensitivity and/or effective maturity volatility,
taking into account an instrument’s or port-
folio’s option and leverage characteristics. Speci- New-Product Review
fications of permissible risk characteristics
should be consistent with the institution’s over- An institution’s policies should also provide for
all credit-, market-, and liquidity-risk limits and effective review of any products being consid-
constraints, and should help delineate a clear set ered that would be new to the firm. An institu-
of institutional limits for use in acquiring spe- tion should not acquire a meaningful position in
cific instruments and managing portfolios. Lim- a new instrument until senior management and
its can be specified either as guidelines within all relevant personnel (including those in internal-
the overall policies or in management operating control, legal, accounting, and auditing func-
procedures. Further guidance on managing spe- tions) understand the product and can integrate
cific risks and on the types of constraints and it into the institution’s risk-measurement and
limits an institution might use in managing the control systems. An institution’s policies should
credit, market, and liquidity risk of securities define the terms ‘‘new product’’ and ‘‘meaning-
and derivative contracts is provided later in this ful position’’ consistent with its size, complex-
section. ity, and sophistication. Institutions should not be
Limits should be set to guide acquisition and hesitant to define an instrument as a new prod-
ongoing management decisions, control expo- uct. Small changes in the payment formulas or
sures, and initiate discussion within the organi- other terms of relatively simple and standard
zation about apparent opportunities and risks. products can greatly alter their risk profiles and
Although procedures for establishing limits and justify designation as a new product. New-
operating within them may vary among institu- product reviews should analyze all of the rel-
tions, examiners should determine whether the evant risks involved in an instrument and assess
organization enforces its policies and proce- how well the product or activity achieves speci-
dures through a clearly identified system of risk fied objectives. New-product reviews also should
limits. The organization’s policies should also include a description of the relevant accounting
include specific guidance on the resolution of guidelines and identify the procedures for mea-

Page 11
suring, monitoring, and controlling the risks exposures arising from lending and other busi-
involved. ness activities to obtain the institution’s overall
risk profile.
Examiners should evaluate whether the risk
Accounting Guidelines measures and the risk-measurement process
are sufficient to accurately reflect the different
The accounting systems and procedures used for types of risks facing the institution. Institutions
general-purpose financial statements and regu- should establish clear risk-measurement stan-
latory reporting purposes are critically important dards for both the acquisition and ongoing
to enhancing the transparency of an institution’s management of securities and derivative posi-
risk profile. Accordingly, an institution’s poli- tions. Risk-measurement standards should pro-
cies should provide clear guidelines on account- vide a common framework for limiting and
ing for all securities and derivative holdings. monitoring risks and should be understood
Accounting treatment should be consistent with by relevant personnel at all levels of the
specified objectives and with the institution’s institution—from individual managers to the
regulatory requirements. Furthermore, institu- board of directors.
tions should ensure that they designate each
cash or derivative contract for accounting pur- Acquisition standards. Institutions conducting
poses consistent with appropriate accounting securities and derivative activities should have
policies and requirements. Accounting for non- the capacity to evaluate the risks of instruments
trading securities and OBS derivative contracts before acquiring them. Before executing any
should reflect the economic substance of the transaction, an institution should evaluate the
transactions. When instruments are used for instrument to ensure that it meets the various
hedging purposes, the hedging rationale and objectives, risk tolerances, and guidelines iden-
performance criteria should be well docu- tified by the institution’s policies. Evaluations of
mented. Management should reassess these des- the credit-, market-, and liquidity-risk exposures
ignations periodically to ensure that they remain should be clearly and adequately documented
appropriate. for each acquisition. Documentation should be
appropriate for the nature and type of instru-
ment; relatively simple instruments would prob-
ably require less documentation than instru-
Risk-Measurement and Reporting ments with significant leverage or option
Systems characteristics.
Institutions with significant securities and
Clear procedures for measuring and monitoring derivative activities are expected either to con-
risks are the foundation of a sound risk- duct in-house preacquisition analyses or use
management process. Examiners should ensure specific third-party analyses that are indepen-
that an institution sufficiently integrates these dent of the seller or counterparty. Analyses
functions into its ongoing management process provided by the originating dealer or counter-
and that relevant personnel recognize their role party should be used only when a clearly defined
and understand the instruments held. investment advisory relationship exists. Less
active institutions with relatively uncomplicated
holdings may use risk analyses provided by the
Risk Measurement dealer only if the analyses are derived using
standard industry calculators and market con-
An institution’s system for measuring the credit, ventions. Such analyses must comprehensively
market, liquidity, and other risks involved in depict the potential risks involved in the acqui-
cash and derivative contracts should be as com- sition, and they should be accompanied by
prehensive and accurate as practicable. The documentation that sufficiently demonstrates that
degree of comprehensiveness should be com- the acquirer understands fully both the analyses
mensurate with the nature of the institution’s and the nature of the institution’s relationship
holdings and risk exposures. Exposures to each with the provider of these analyses. Notwith-
type of risk (that is, credit, market, liquidity) standing information and analyses obtained from
should be aggregated across securities and outside sources, management is ultimately
derivative contracts and integrated with similar responsible for understanding the nature and

Page 12
risk profiles of the institution’s securities and provided by dealers or counterparties. More
derivative holdings. active institutions should conduct periodic
When reviewing an instrument, it is a prudent revaluations and portfolio analyses using either
practice for institutions to obtain and compare in-house capabilities or outside-party analytical
price quotes and risk analyses from more than systems that are independent of sellers or coun-
one dealer before acquisition. Institutions should terparties. Institutions should recognize that
ensure that they clearly understand the respon- indicative price quotes and model revaluations
sibilities of any outside parties that provide may differ from the values at which transactions
analyses and price quotes. If analyses and price can be executed.
quotes provided by dealers are used, institutions
should assume that each party deals at arm’s Stress testing. Analyzing the credit, market, and
length for its own account unless a written liquidity risk of individual instruments, port-
agreement stating otherwise exists. Institutions folios, and the entire institution under a variety
should exercise caution when dealers limit the of unusual and stressful conditions is an impor-
institution’s ability to show securities or deriva- tant aspect of the risk-measurement process.
tive contract proposals to other dealers to receive Management should seek to identify the types of
comparative price quotes or risk analyses. As a situations, or the combinations of credit and
general sound practice, unless the dealer or market events, that could produce substantial
counterparty is also acting under a specific losses or liquidity problems. Typically, manage-
investment advisory relationship, an investor or ment considers the institutions’s consolidated
end-user should not acquire an instrument or exposures when managing nontrading securities
enter into a transaction if its fair value or the and derivative contracts; therefore, the effect of
analyses required to assess its risk cannot be stress on these exposures should be reviewed.
determined through a means that is independent Stress tests should evaluate changes in market
of the originating dealer or counterparty. conditions, including alternatives in the under-
lying assumptions used to value instruments. All
Portfolio-management standards. Institutions major assumptions used in stress tests should be
should periodically review the performance and identified.
effectiveness of instruments, portfolios, and Stress tests should not be limited to quantita-
institutional programs and strategies. This review tive exercises that compute potential losses or
should be conducted at least quarterly and should gains, but should include qualitative analyses of
evaluate the extent to which the institution’s the tools available to management to deal with
securities and derivative holdings meet the vari- various scenarios. Contingency plans outlining
ous objectives, risk tolerances, and guidelines operating procedures and lines of communication,
established by the institution’s policies.4 Institu- both formal and informal, are important prod-
tions with large or highly complex holdings ucts of such qualitative analyses.
should conduct reviews more frequently. The appropriate extent and sophistication of
For internal measurements of risk, effective an institution’s stress testing depend heavily on
measurement of the credit, market, and liquidity the scope and nature of its securities and deriva-
risks of many securities and derivative contracts tive holdings and on its ability to limit the effect
requires mark-to-market valuations. Accord- of adverse events. Institutions holding securities
ingly, the periodic revaluation of securities and or derivative contracts with complex credit,
derivative holdings is an integral part of an market, or liquidity risk profiles should have an
effective risk-measurement system. Periodic established regime of stress testing. Examiners
revaluations should be fully documented. When should consider the circumstances at each insti-
available, actual market prices should be used. tution when evaluating the adequacy or need for
For less liquid or complex instruments, institu- stress-testing procedures.
tions with only limited holdings may use prop-
erly documented periodic prices and analyses
Risk Reporting
4. For example, the performance of instruments and port- An accurate, informative, and timely manage-
folios used to meet objectives for tax-advantaged earnings
should be evaluated to ensure that they meet the necessary
ment information system is essential. Examiners
credit-rating, market-sensitivity, and liquidity characteristics should evaluate the adequacy of an institution’s
established for this objective. monitoring and reporting of the risks, returns,

Page 13
and overall performance of security and deriva- necessary expertise to identify and evaluate the
tive activities to senior management and the important assumptions incorporated in the risk-
board of directors. Management reports should measurement methodologies it uses.
be frequent enough to provide the responsible
individuals with adequate information to judge
the changing nature of the institution’s risk
profile and to evaluate compliance with stated Comprehensive Internal Controls and
policy objectives and constraints. Audit Procedures
Management reports should translate mea-
sured risks from technical and quantitative for- Institutions should have adequate internal
mats to formats that can be easily read and controls to ensure the integrity of the manage-
understood by senior managers and directors, ment process used in investment and end-user
who may not have specialized and technical activities. Internal controls consist of proce-
knowledge of all financial instruments used by dures, approval processes, reconciliations,
the institution. Institutions should ensure that reviews, and other mechanisms designed to
they use a common conceptual framework for provide a reasonable assurance that the institu-
measuring and limiting risks in reports to senior tion’s risk-management objectives for these
managers and directors. These reports should activities are achieved. Appropriate internal con-
include the periodic assessment of the perfor- trols should address all of the various elements
mance of appropriate instruments or portfolios of the risk-management process, including
in meeting their stated objective, subject to the adherence to polices and procedures, the adequacy
relevant constraints and risk tolerances. of risk identification, and risk measurement and
reporting.
An important element of a bank’s internal
Management Evaluation and Review controls for investment and end-user activities is
comprehensive evaluation and review by man-
Management should regularly review the insti- agement. Management should ensure that the
tution’s approach and process for managing various components of the bank’s risk-
risks. This includes regularly assessing the meth- management process are regularly reviewed and
odologies, models, and assumptions used to evaluated by individuals who are independent of
measure risks and limit exposures. Proper docu- the function they are assigned to review.
mentation of the elements used in measuring Although procedures for establishing limits and
risks is essential for conducting meaningful for operating within them may vary among
reviews. Limits should be compared with actual banks, management should conduct periodic
exposures. Reviews should also consider whether reviews to determine whether the organization
existing measures of exposure and limits are complies with its investment and end-user risk-
appropriate in view of the institution’s holdings, management policies and procedures. Positions
past performance, and current capital position. that exceed established limits should receive the
The frequency of the reviews should reflect prompt attention of appropriate management
the nature of an institution’s holdings and the and should be resolved according to the process
pace of market innovations in measuring and described in approved policies. Periodic reviews
managing risks. At a minimum, institutions with of the risk-management process should also
significant activities in complex cash or deriva- address any significant changes in the nature of
tive contracts should review the underlying instruments acquired, limits, and internal con-
methodologies of the models they use at least trols that have occurred since the last review.
annually—and more often as market conditions Examiners should also review the internal
dictate—to ensure that they are appropriate and controls of all key activities involving securities
consistent. Reviews by external auditors or other and derivative contracts. For example, for trans-
qualified outside parties, such as consultants action recording and processing, examiners
with expertise in highly technical models and should evaluate and assess adherence to the
risk-management techniques, may often supple- written policies and procedures for recording
ment these internal evaluations. Institutions transactions. They should also analyze the
depending on outside parties to provide various transaction-processing cycle to ensure the integ-
risk-measurement capabilities should ensure that rity and accuracy of the institution’s records and
the outside institution has personnel with the management reports. Examiners should review

Page 14
all significant internal controls associated with ating, and legal risks involved in securities and
the management of the credit, market, liquidity, derivative contracts for nontrading activities are
operational, and legal risks involved in securi- described below.
ties and derivative holdings.
The examiner should review the frequency,
scope, and findings of any independent internal Credit Risk
and external auditors relative to the institution’s
securities and derivative activities. When appli- Broadly defined, credit risk is the risk that an
cable, internal auditors should audit and test the issuer or counterparty will fail to perform on an
risk-management process and internal controls obligation to the institution. The policies of an
periodically. Internal auditors are expected to institution should recognize credit risk as a
have a strong understanding of the specific significant risk posed by the institution’s secu-
products and risks faced by the organization. In rities and derivative activities. Accordingly, poli-
addition, they should have sufficient expertise to cies should identify credit-risk constraints, risk
evaluate the risks and controls of the institution. tolerances, and limits at the appropriate instru-
The depth and frequency of internal audits ment, portfolio, and institutional levels. In doing
should increase if weaknesses and significant so, institutions should ensure that credit-risk
issues exist or if portfolio structures, modeling constraints are clearly associated with specified
methodologies, or the overall risk profile of the objectives. For example, credit-risk constraints
institution has changed. and guidelines should be defined for instruments
In reviewing risk management of nontrading used to meet pledging requirements, generate
securities and derivative activities, internal tax-advantaged income, hedge positions, gener-
auditors should thoroughly evaluate the effec- ate temporary income, or meet any other spe-
tiveness of the internal controls used for mea- cifically defined objective.
suring, reporting, and limiting risks. Internal As a matter of general policy, an institution
auditors should also evaluate compliance with should not acquire securities or derivative con-
risk limits and the reliability and timeliness of tracts until it has assessed the creditworthiness
information reported to the institution’s senior of the issuer or counterparty and determined that
management and board of directors, as well as the risk exposure conforms with its policies. The
the independence and overall effectiveness of credit risk arising from these positions should be
the institution’s risk-management process. The incorporated into the overall credit-risk profile
level of confidence that examiners place in an of the institution to the fullest extent possible.
institution’s audit programs, the nature of the Given the interconnectedness of the various
audit findings, and management’s response to risks facing the institution, organizations should
those findings will influence the scope of the also evaluate the effect of changes in issuer or
current examination of securities and derivative counterparty credit standing on an instrument’s
activities. market and liquidity risk. As a matter of policy,
Examiners should pay special attention to the board of directors and responsible senior
significant changes in the nature of instruments management should be informed of the institu-
acquired, risk-measurement methodologies, lim- tion’s total credit-risk exposures at least quarterly.
its, and internal controls that have occurred
since the last examination. Significant changes Selection of securities dealers. In managing
in earnings from securities and derivative con- their credit risk, institutions also should consider
tracts, in the size of positions, or in the value- settlement and presettlement credit risk. The
at-risk associated with these activities should selection of dealers, investment bankers, and
also receive attention during the examination. brokers is particularly important in managing
these risks effectively. An institution’s policies
should identify criteria for selecting these orga-
nizations and list all approved firms. The
Evaluating Management of Specific approval process should include a review of
Risks each firm’s financial statements and an evalua-
tion of its ability to honor its commitments. An
Specific considerations in evaluating the key inquiry into the general reputation of the dealer
elements of sound risk-management systems as is also appropriate. The board of directors or a
they relate to the credit, market, liquidity, oper- committee thereof should set limits on the

Page 15
amounts and types of transactions authorized for • in those instances when the institution relies
each firm. They should also periodically review on the advice of a dealer’s sales representa-
and reconfirm the list of authorized dealers, tive, the experience and expertise of the sales
investment bankers, and brokers. representative with whom business will be
The management of a depository institution conducted
should have sufficient knowledge about the
securities firms and personnel with whom they In addition, the board of directors (or an appro-
are doing business. A depository institution priate committee of the board) must ensure that
should not engage in securities transactions with the depository institution’s management has
any securities firm that is unwilling to provide established appropriate procedures to obtain and
complete and timely disclosure of its financial maintain possession or control of securities
condition. Management should review the secu- purchased. Purchased securities and repurchase-
rities firm’s financial statements and evaluate agreement collateral should only be left in
the firm’s ability to honor its commitments both safekeeping with selling dealers when (1) the
before entering into transactions with the firm board of directors or an appropriate committee
and periodically thereafter. An inquiry into the thereof is completely satisfied as to the credit-
general reputation of the dealer also is neces- worthiness of the securities dealer and (2) the
sary. The board of directors or an appropriate aggregate market value of securities held in
committee of the board should periodically safekeeping is within credit limitations that have
review and approve a list of securities firms with been approved by the board of directors (or an
whom management is authorized to do business. appropriate committee of the board) for unse-
The board or an appropriate committee thereof cured transactions (see the October 22, 1985,
should also periodically review and approve FFIEC policy statement ‘‘Repurchase Agree-
limits on the amounts and types of transactions ments of Depository Institutions with Securities
to be executed with each authorized securities Dealers and Others’’).
firm. Limits to be considered should include State lending limits generally do not extend to
dollar amounts of unsettled trades, safekeeping the safekeeping arrangements described above.
arrangements, repurchase transactions, securi- Notwithstanding this general principle, a bank’s
ties lending and borrowing, other transactions board of directors should establish prudent lim-
with credit risk, and total credit risk with an its for safekeeping arrangements. These pruden-
individual dealer. tial limits generally involve a fiduciary relation-
At a minimum, depository institutions should ship, which presents operational rather than
consider the following in selecting and retaining credit risks.
a securities firm: To avoid concentrations of assets or other
types of risk, banking organizations should, to
• the ability of the securities dealer and its the extent possible, try to diversify the firms
subsidiaries or affiliates to fulfill commit- they use for safekeeping arrangements. Further,
ments as evidenced by their capital strength, while certain transactions with securities dealers
liquidity, and operating results (This evidence and safekeeping custodians may entail only
should be gathered from current financial operational risks, other transactions with these
data, annual reports, credit reports, and other parties may involve credit risk that could, under
sources of financial information.) some limited circumstances, be subject to statu-
tory lending limits, depending on applicable
• the dealer’s general reputation or financial state laws. If certain transactions are deemed
stability and its fair and honest dealings with subject to a state’s legal lending limit statute
customers (Other depository institutions that because of a particular safekeeping arrange-
have been or are currently customers of the ment, the provisions of the state’s statutes would,
dealer should be contacted.) of course, control the extent to which the safe-
• information available from state or federal keeping arrangement complies with an indi-
securities regulators and securities industry vidual state’s legal lending limit.
self-regulatory organizations, such as the
Financial Industry Regulatory Authority Limits. An institution’s credit policies should
(FINRA), concerning any formal enforcement also include guidelines on the quality and quan-
actions against the dealer, its affiliates, or tity of each type of security that may be held.
associated personnel Policies should provide credit-risk diversifica-

Page 16
tion and concentration limits, which may define For derivative contracts and certain types of
concentrations to a single or related issuer or cash transactions, master agreements (including
counterparty, in a geographical area, or in obli- netting agreements) and various credit enhance-
gations with similar characteristics. Policies ments (such as collateral or third-party guaran-
should also include procedures, such as increased tees) can reduce settlement, issuer, and counter-
monitoring and stop-loss limits, for addressing party credit risk. In such cases, an institution’s
deterioration in credit quality. credit exposures should reflect these risk-
Sound credit-risk management requires that reducing features only to the extent that the
credit limits be developed by personnel who agreements and recourse provisions are legally
are independent of the acquisition function. In enforceable in all relevant jurisdictions. This
authorizing issuer and counterparty credit lines, legal enforceability should extend to any insol-
these personnel should use standards that are vency proceedings of the counterparty. Institu-
consistent with those used for other activities tions should be prepared to demonstrate suffi-
conducted within the institution and with the cient due diligence in evaluating the enforceability
organization’s overall policies and consolidated of these contracts.
exposures. To assess the creditworthiness of In reviewing credit exposures, examiners
other organizations, institutions should not rely should consider the extent to which positions
solely on outside sources, such as standardized exceed credit limits and whether exceptions are
ratings provided by independent rating agencies, resolved according to the institution’s adopted
but should perform their own analysis of a policies and procedures. Examiners should also
counterparty’s or issuer’s financial strength. In evaluate whether the institution’s reports
addition, examiners should review the credit- adequately provide all personnel involved in the
approval process to ensure that the credit risks acquisition and management of financial instru-
of specific products are adequately identified ments with relevant, accurate, and timely infor-
and that credit-approval procedures are followed mation about the credit exposures and approved
for all transactions. credit lines.
For most cash instruments, credit exposure is
measured as the current carrying value. In the
case of many derivative contracts, especially
those traded in OTC markets, credit exposure is Market Risk
measured as the replacement cost of the posi-
tion, plus an estimate of the institution’s poten- Market risk is the exposure of an institution’s
tial future exposure to changes in the replace- financial condition to adverse movements in the
ment value of that position in response to market market rates or prices of its holdings before such
price changes. Replacement costs of derivative holdings can be liquidated or expeditiously off-
contracts should be determined using current set. It is measured by assessing the effect of
market prices or generally accepted approaches changing rates or prices on either the earnings or
for estimating the present value of future pay- economic value of an individual instrument, a
ments required under each contract, at current portfolio, or the entire institution. Although
market rates. many banking institutions focus on carrying
The measurement of potential future credit- values and reported earnings when assessing
risk exposure for derivative contracts is more market risk at the institutional level, other mea-
subjective than the measurement of current sures focusing on total returns and changes in
exposure and is primarily a function of the time economic or fair values better reflect the poten-
remaining to maturity; the number of exchanges tial market-risk exposure of institutions, port-
of principal; and the expected volatility of the folios, and individual instruments. Changes in
price, rate, or index underlying the contract. fair values and total returns directly measure the
Potential future exposure can be measured using effect of market movements on the economic
an institution’s own simulations or, more sim- value of an institution’s capital and provide
ply, by using add-ons such as those included in significant insights into their ultimate effects on
the Federal Reserve’s risk-based capital guide- the institution’s long-term earnings. Institutions
lines. Regardless of the method an institution should manage and control their market risks
uses, examiners should evaluate the reasonable- using both an earnings and an economic-value
ness of the assumptions underlying the institu- approach, and at least on an economic or fair-
tion’s risk measure. value basis.

Page 17
When evaluating capital adequacy, examiners procedures to validate the models and periodi-
should consider the effect of changes in market cally review all elements of the modeling pro-
rates and prices on the economic value of the cess, including its assumptions and risk-
institution by evaluating any unrealized losses in measurement techniques. Institutions relying on
an institution’s securities or derivative positions. third parties for market-risk measurement sys-
This evaluation should assess the ability of the tems and analyses should fully understand the
institution to hold its positions and function as a assumptions and techniques used by the third
going concern if recognition of unrealized losses party.
would significantly affect the institution’s capi- Institutions should evaluate the market-risk
tal ratios. Examiners also should consider the exposures of their securities and derivative posi-
impact that liquidating positions with unrealized tions and report this information to their boards
losses may have on the institution’s prompt- of directors regularly, not less frequently than
corrective-action capital category. each quarter. These evaluations should assess
Market-risk limits should be established for trends in aggregate market-risk exposure and the
both the acquisition and ongoing management performance of portfolios relative to their estab-
of an institution’s securities and derivative hold- lished objectives and risk constraints. They also
ings and, as appropriate, should address expo- should identify compliance with board-approved
sures for individual instruments, instrument limits and identify any exceptions to established
types, and portfolios. These limits should be standards. Examiners should ensure that institu-
integrated fully with limits established for the tions have mechanisms to detect and adequately
entire institution. At the institutional level, the address exceptions to limits and guidelines.
board of directors should approve market-risk Examiners should also determine that manage-
exposure limits that specify percentage changes ment reporting on market risk appropriately
in the economic value of capital and, when addresses potential exposures to basis risk, yield
applicable, in the projected earnings of the curve changes, and other factors pertinent to the
institution under various market scenarios. Simi- institution’s holdings. In this connection, exam-
lar and complementary limits on the volatility of iners should assess an institution’s compliance
prices or fair value should be established at the with broader guidance for managing interest-
appropriate instrument, product-type, and port- rate risk in a consolidated organization.
folio levels, based on the institution’s willing- Complex and illiquid instruments often involve
ness to accept market risk. Limits on the vari- greater market risk than broadly traded, more
ability of effective maturities may also be liquid securities. Often, this higher potential
desirable for certain types of instruments or market risk arising from illiquidity is not cap-
portfolios. tured by standardized financial-modeling tech-
The scenarios an institution specifies for niques. This type of risk is particularly acute for
assessing the market risk of its securities and instruments that are highly leveraged or that are
derivative products should be sufficiently rigor- designed to benefit from specific, narrowly
ous to capture all meaningful effects of any defined market shifts. If market prices or rates
options. For example, in assessing interest-rate do not move as expected, the demand for these
risk, scenarios such as 100, 200, and 300 basis instruments can evaporate. When examiners
point parallel shifts in yield curves should be encounter such instruments, they should review
considered as well as appropriate nonparallel how adequately the institution has assessed its
shifts in structure to evaluate potential basis, potential market risks. If the risks from these
volatility, and yield curve risks. instruments are material, the institution should
Accurately measuring an institution’s market have a well-documented process for stress test-
risk requires timely information about the curing their value and liquidity assumptions under a
rent carrying and market values of its securities variety of market scenarios.
and derivative holdings. Accordingly, institu-
tions should have market-risk measurement sys-
tems commensurate with the size and nature of Liquidity Risk
these holdings. Institutions with significant hold-
ings of highly complex instruments should Banks face two types of liquidity risk in their
ensure that they have independent means to securities and derivative activities: risks related
value their positions. Institutions using internal to specific products or markets and risks related
models to measure risk should have adequate to the general funding of their activities. The

Page 18
former, market-liquidity risk, is the risk that an money on derivative transactions may be required
institution cannot easily unwind or offset a to deliver collateral or settle a contract early,
particular position at or near the previous market possibly at a time when the institution may face
price because of inadequate market depth or other funding and liquidity pressures. Early
disruptions in the marketplace. The latter, terminations may also open additional, unin-
funding-liquidity risk, is the risk that the bank tended market positions. Management and
will be unable to meet its payment obligations directors should be aware of these potential
on settlement dates. Since neither type of liquid- liquidity risks and address them in the institu-
ity risk is unique to securities and derivative tion’s liquidity plan and in the broader context
activities, management should evaluate these of the institution’s liquidity-management pro-
risks in the broader context of the institution’s cess. In their reviews, examiners should con-
overall liquidity. sider the extent to which such potential obliga-
When specifying permissible securities and tions could present liquidity risks to the institution.
derivative instruments to accomplish established
objectives, institutions should take into account
the size, depth, and liquidity of the markets for
specific instruments, and the effect these char- Operating and Legal Risks
acteristics may have on achieving an objective.
Operating risk is the risk that deficiencies in
The market liquidity of certain types of instru-
information systems or internal controls will
ments may make them entirely inappropriate for
result in unexpected loss. Some specific sources
achieving certain objectives. Moreover, institu-
of operating risk include inadequate procedures,
tions should consider the effects that market risk
human error, system failure, or fraud. Inaccu-
can have on the liquidity of different types of
rately assessing or controlling operating risks is
instruments. For example, some government-
one of the more likely sources of problems
agency securities may have embedded options
facing institutions involved in securities and
that make them highly illiquid during periods of
derivative activities.
market volatility and stress, despite their high
credit rating. Accordingly, institutions should Adequate internal controls are the first line of
clearly articulate the market-liquidity character- defense in controlling the operating risks involved
istics of instruments to be used in accomplishing in an institution’s securities and derivative
institutional objectives. activities. Of particular importance are internal
The funding risk of an institution becomes a controls to ensure that persons executing trans-
more important consideration when its unreal- actions are separated from those individuals
ized losses are material; therefore, this risk responsible for processing contracts, confirming
should be a factor in evaluating capital adequacy. transactions, controlling various clearing
Institutions with weak liquidity positions are accounts, approving the accounting methodol-
more likely to be forced to recognize these ogy or entries, and performing revaluations.
losses and suffer declines in their accounting Institutions should have approved policies,
and regulatory capital. In extreme cases, these consistent with legal requirements and internal
effects could force supervisors to take prompt policies, that specify documentation require-
corrective actions. ments for transactions and formal procedures for
Examiners should assess whether the institu- saving and safeguarding important documents.
tion adequately considers the potential liquidity Relevant personnel should fully understand the
risks associated with the liquidation of securities requirements. Examiners should also consider
or the early termination of derivative contracts. the extent to which institutions evaluate and
Many forms of standardized contracts for control operating risks through internal audits,
derivative transactions allow counterparties to stress testing, contingency planning, and other
request collateral or terminate their contracts managerial and analytical techniques.
early if the institution experiences an adverse An institution’s operating policies should
credit event or a deterioration in its financial establish appropriate procedures to obtain and
condition. In addition, under situations of mar- maintain possession or control of instruments
ket stress, customers may ask for the early purchased. Institutions should ensure that trans-
termination of some contracts within the context actions consummated orally are confirmed as
of the dealer’s market-making activities. In soon as possible. As noted earlier in this section,
these circumstances, an institution that owes banking organizations should, to the extent pos-

Page 19
sible, seek to diversify the firms used for their nately securities issued by various governmental
safekeeping arrangements to avoid concentra- entities of the countries in which the bank’s
tions of assets or other types of risk. foreign branches are located. These investments
Legal risk is the risk that contracts are not are held for a variety of purposes:
legally enforceable or documented correctly.
This risk should be limited and managed through • They are required by various local laws.
policies developed by the institution’s legal • They are used to meet foreign reserve
counsel. At a minimum, guidelines and pro- requirements.
cesses should be in place to ensure the enforce- • They result in reduced tax liabilities.
ability of counterparty agreements. Examiners • They enable the bank to use new or increased
should determine whether an institution is re-discount facilities or benefit from greater
adequately evaluating the enforceability of its deposit or lending authorities.
agreements before individual transactions are
consummated. Institutions should also ensure • They are used by the bank as an expression of
that the counterparty has sufficient authority to ‘‘goodwill’’ toward a country.
enter into the transaction and that the terms of
the agreement are legally sound. Institutions The examiner should be familiar with the
should further ascertain that their netting agree- applicable sections of Regulation K (12 CFR
ments are adequately documented, have been 211) governing a member bank’s international
executed properly, and are enforceable in all investment holdings, as well as other regulations
relevant jurisdictions. Institutions should know discussed in this section. Because of the man-
relevant tax laws and interpretations governing datory investment requirements of some coun-
the use of netting instruments. tries, securities held cannot always be as ‘‘liq-
uid’’ and ‘‘readily marketable’’ as required in
An institution’s policies should also provide
domestic banking. However, the amount of a
conflict-of-interest guidelines for employees who
bank’s ‘‘mandatory’’ holdings will normally be
are directly involved in purchasing securities
a relatively small amount of its total investments
from and selling securities to securities dealers
or capital funds.
on behalf of their institution. These guidelines
should ensure that all directors, officers, and A bank’s international division may also hold
employees act in the best interest of the institu- securities strictly for investment purposes; these
tion. The board of directors may wish to adopt are expected to provide a reasonable rate of
policies prohibiting these employees from return commensurate with safety considerations.
engaging in personal securities transactions with As with domestic investment securities, the
the same securities firms the institution uses bank’s safety must take precedence, followed by
without the specific prior approval of the board. liquidity and marketability. Securities held by
The board of directors may also wish to adopt a international divisions are considered to be liq-
policy applicable to directors, officers, and uid if they are readily convertible into cash at
employees that restricts or prohibits them from their approximate carrying value. They are mar-
receiving gifts, gratuities, or travel expenses ketable if they can be sold in a very short time at
from approved securities dealer firms and their a price commensurate with yield and quality.
personnel. Speculation in marginal foreign securities to
generate more favorable yields is an unsound
banking practice and should be discouraged.
Banks are generally prohibited from investing
INTERNATIONAL DIVISION in stocks. However, a number of exceptions
INVESTMENTS (detailed earlier in this section) are often appli-
cable to the international division. For example,
The same types of instruments exist in interna- the bank may, under section 24A of the Federal
tional banking as in domestic banking. Securi- Reserve Act (12 USC 371d), hold stock in
ties and derivative contracts may be acquired by overseas corporations that hold title to foreign
a bank’s international division and overseas bank premises. Both stock and other securities
branches for its own account, and foreign equity holdings are permissible under certain circum-
investments may be held by the bank directly or stances and in limited amounts under section
through Edge Act corporations. The investments 211.4 of Regulation K—Permissible Activities
held by most international divisions are predomi- and Investments of Foreign Branches of

Page 20
Member Banks (12 CFR 211). Other sections of some of these products can be relatively thin,
Regulation K permit the bank to make equity making them difficult to liquidate if the need
investments in Edge Act and agreement corpo- arises. Finally, new variants of these instruments
rations and in foreign banks, subject to certain continue to be introduced, whose price perfor-
limitations. mance under varying market and economic
Standard & Poor’s, Moody’s, and other pub- conditions has not been tested.
lications from U.S. rating-services rate Canadian Under the February 10, 1992, supervisory
and other selected foreign securities that are policy statement of the Federal Financial Insti-
authorized for U.S. commercial bank investment tutions Examination Council (FFIEC), the bank-
purposes under 12 USC 24(7). However, in ing agencies call for special management of
many other countries, securities-rating services mortgage-derivative products. A general prin-
are limited or nonexistent. When they do exist, ciple underlying this policy is that mortgage-
the ratings are only indicative and should be derivative products possessing average life or
supplemented with additional information on price volatility in excess of a benchmark fixed-
legality, credit soundness, marketability, and rate 30-year mortgage-backed pass-through
foreign-exchange and country-risk factors. The security are high-risk mortgage securities and
opinions of local attorneys are often the best are not suitable investments. All high-risk mort-
source of determining whether a particular for- gage securities (defined later in this section)
eign security has the full faith and credit backing acquired by depository institutions after Febru-
of a country’s government. ary 10, 1992, must be carried in the institution’s
Sufficient analytical data must be provided to trading account or as assets available for sale.
the bank’s board of directors and senior man- Mortgage-derivative products that do not meet
agement so they can make informed judgments the definition of a high-risk mortgage security at
about the effectiveness of the international divi- the time of purchase may be reported as held-
sion’s investment policy and procedures. The to-maturity, available-for-sale, or held-for-
institution’s international securities and deriva- trading, as appropriate. Institutions must ascer-
tive contracts should be included on all board tain at least annually whether such products
and senior management reports detailing domes- have become high-risk mortgage securities. Pur-
tic securities and derivative contracts received. chases of high-risk mortgage securities before
These reports should be timely and sufficiently February 10, 1992, generally will be reviewed in
detailed to allow the board of directors and accordance with previously existing supervisory
senior management to understand and assess the policies.
credit, market, and liquidity risks facing the Institutions generally should hold mortgage-
institution and its securities and derivative derivative products that meet the definition of a
positions. high-risk mortgage security only to reduce
interest-rate risk, in accordance with safe and
sound practices. Before taking a position in any
high-risk mortgage security, an institution should
MORTGAGE-DERIVATIVE conduct an analysis to ensure that the position
PRODUCTS will reduce its overall interest-rate risk. Further-
more, depository institutions that purchase high-
Some mortgage-derivative products exhibit con- risk mortgage securities must demonstrate that
siderably more price volatility than mortgages they understand and are effectively managing
or ordinary mortgage pass-through securities. If the risks associated with these instruments. First,
not managed in a safe and sound manner, these a depository institution must determine whether
products can expose investors to significant risk a mortgage-derivative product is high risk before
of loss. The price volatility of these products is purchasing it. A prospectus supplement or other
caused in part by the uncertain cash flows that supporting analysis that fully details the cash
result from changes in the prepayment rates of flows covering each of the securities held by the
the underlying mortgages. institution should be obtained and analyzed
Mortgage-derivative products are complex; a before purchase and retained for examiner
high degree of technical expertise is required to review. In any event, a prospectus supplement
understand how their prices and cash flows may should be obtained as soon as it becomes avail-
behave in various interest-rate and prepayment able. Levels of activity involving high-risk mort-
scenarios. Moreover, the secondary market for gage securities should be reasonably related to

Page 21
an institution’s capital, capacity to absorb losses, — shortens by more than 6.0 years, assuming
and level of in-house management sophistica- an immediate and sustained parallel shift
tion and expertise. Appropriate managerial and in the yield curve of minus 300 basis
financial controls must be in place, and the points.
institution must analyze, monitor, and prudently • Price-sensitivity test. The estimated change in
adjust its holdings of high-risk mortgage secu- the price of the mortgage-derivative product is
rities to correspond with changing price and more than 17 percent, due to an immediate
maturity expectations. and sustained parallel shift in the yield curve
An institution should consider the liquidity of plus or minus 300 basis points.
and price volatility of high-risk mortgage secu-
rities before purchasing them. In certain circum- In applying any of the above tests, all of the
stances, the appropriate federal regulatory author- underlying assumptions (including prepayment
ity may deem an institution’s purchase or assumptions) for the underlying collateral must
retention of high-risk mortgage securities to be be reasonable. All of the assumptions under-
contrary to safe and sound practices for deposi- lying the analysis must be available for exam-
tory institutions, which will result in criticism iner review. For example, if an institution’s
by examiners. Examiners may require the orderly prepayment assumptions differ significantly from
divestiture of high-risk mortgage securities. the median prepayment assumptions of several
Securities and other products with risk charac- major dealers as selected by examiners, the
teristics similar to those of high-risk mortgage examiners may use these median prepayment
securities, whether carried on or off the balance assumptions to determine if a particular mortgage-
sheet (such as CMO swaps, but excluding ser- derivative product is high risk. The above tests
vicing assets), will be subject to the same may be adjusted to consider significant move-
supervisory treatment as high-risk mortgage ments in market interest rates, to fairly measure
securities. the risk characteristics of new mortgage-backed
products, and to take appropriate action to
prevent circumvention of the definition of a
high-risk mortgage security and other such
standards.
High-Risk Mortgage Securities Generally, a CMO floating-rate debt class will
not be subject to the average-life and average-
In general, any mortgage-derivative product that life sensitivity tests described above if it bears a
exhibits greater price volatility than a bench- rate that, at the time of purchase or at a
mark fixed-rate 30-year mortgage-backed pass- subsequent testing date, is below the contractual
through security will be deemed to be high risk. cap on the instrument. (An institution may
For purposes of the FFIEC policy statement, a purchase interest-rate contracts that effectively
high-risk mortgage security is defined as any uncap the instrument.) For purposes of this
mortgage-derivative product that at the time of guidance, a CMO floating-rate debt class is a
purchase, or at a subsequent testing date, meets debt class whose rate adjusts at least annually on
any of the following tests. (In general, a a one-for-one basis with the debt class’s index.
mortgage-derivative product that does not meet The index must be a conventional, widely used
any of the three tests below will be considered to market-interest-rate index such as the London
be a non-high-risk mortgage security.) Interbank Offered Rate (LIBOR). Inverse
floating-rate debt classes are not included in the
• Average-life test. The mortgage-derivative definition of a floating-rate debt class.
product has an expected weighted average life
greater than 10.0 years.
• Average-life sensitivity test. The expected Holdings of High-Risk Mortgage
weighted average life of the mortgage- Securities
derivative product—
An institution generally may only acquire a
— extends by more than 4.0 years, assuming high-risk mortgage-derivative product to reduce
an immediate and sustained parallel shift its overall interest-rate risk. (Institutions meet-
in the yield curve of plus 300 basis points ing the previously discussed guidance on the use
or of these securities in a trading account may

Page 22
also purchase these securities for trading pur- internal analyses by the institution are unaccept-
poses.) An institution that has acquired high-risk able, and reliance on these third-party analyses
mortgage securities to reduce interest-rate risk will be subject to examiner criticism.
needs to frequently assess its interest-rate risk Management should also maintain documen-
position and the performance of these securities. tation demonstrating it took reasonable steps to
Since interest-rate positions constantly change, ensure that the prices paid for high-risk mort-
an institution may determine that its high-risk gage securities represented fair market value.
mortgage securities no longer reduce interest- Generally, price quotes should be obtained from
rate risk. Therefore, mortgage-derivative prod- at least two brokers before executing a trade. If
ucts that are high risk when acquired shall not be price quotes cannot be obtained from more than
reported as held-to-maturity securities at amor- one broker, management should document those
tized cost. reasons (such as the unique or proprietary nature
In appropriate circumstances, examiners may of the transaction). In addition, a depository
seek the orderly divestiture of high-risk mort- institution that owns high-risk mortgage securi-
gage securities that do not reduce interest-rate ties must demonstrate that it has established the
risk. Appropriate circumstances are those in following:
which the examiner determines that continued
ownership of high-risk mortgage securities rep- • a board-approved portfolio policy that
resents an undue safety-and-soundness risk to addresses the goals and objectives the institu-
the institution. This risk can arise from (1) the tion expects to achieve through its securities
size of a bank’s or thrift’s holdings of high-risk activities, including objectives for interest-
mortgage securities in relation to its capital rate risk reduction with respect to high-risk
and earnings, (2) management’s inability to mortgage securities
demonstrate an understanding of the nature of • limits on the amounts of funds that may be
the risks inherent in the securities, (3) the committed to high-risk mortgage securities
absence of internal monitoring systems and • specific financial-officer responsibility for and
other internal controls to appropriately measure authority over securities activities involving
the market and cash-flow risks of these securi- high-risk mortgage securities
ties, (4) management’s inability to prudently • adequate information systems
manage its overall interest-rate risk, or (5) simi- • procedures for periodic evaluation of high-
lar factors. risk mortgage securities and their actual per-
An institution that owns or plans to acquire formance in reducing interest-rate risk
high-risk mortgage securities must have a moni- • appropriate internal controls
toring and reporting system in place to evaluate
their expected and actual performance. Institu- The board of directors or an appropriate
tional analysis must show that the proposed committee thereof and the institution’s senior
acquisition of a high-risk mortgage security will management should regularly (at least quarterly)
reduce overall interest-rate risk. After purchase, review all high-risk mortgage securities to deter-
the institution must evaluate at least quarterly mine whether they are adequately satisfying the
whether the high-risk mortgage security has objectives for interest-rate risk reduction set
actually reduced interest-rate risk. forth in the portfolio policy. The depository
institution’s senior management should be fully
Analyses performed before the purchase of knowledgeable about the risks associated with
high-risk mortgage securities, and subsequent prepayments and their subsequent impact on its
analyses, must be fully documented and will be high-risk mortgage securities. Failure to comply
subject to examiner review. This review will with this policy will be viewed as an unsafe and
include an analysis of all management assump- unsound practice.
tions about the interest-rate risk associated with
the institution’s assets, liabilities, and off-
balance-sheet positions. Analyses performed and
records constructed to justify purchases on a
post-acquisition basis are unacceptable and will
Non-High-Risk Mortgage Securities
be subject to examiner criticism. Reliance on Mortgage-derivative products that do not meet
analyses and documentation obtained from a the definition of high-risk mortgage securities at
securities dealer or other outside party without the time of purchase should be reported as

Page 23
held-to-maturity, available-for-sale, or held-for- Securities that are intended to be held princi-

trading, as appropriate. Institutions must ascer- pally for the purpose of selling in the near term
tain and document before purchase and at least should be classified as trading assets. Trading
annually thereafter that non-high-risk mortgage activity includes the active and frequent buying
securities that are held to maturity remain out- and selling of securities for the purpose of
side the high-risk category. If an institution is generating profits on short-term fluctuations in
unable to make these determinations through price. Securities held for trading purposes must
internal analysis, it must use information derived be reported at fair value, with unrealized gains
from a source that is independent of the party and losses recognized in current earnings and
from whom the product is being purchased. regulatory capital. The proper categorization of
Standard industry calculators used in the securities is important to ensure that trading
mortgage-related securities marketplace are gains and losses are promptly recognized—
acceptable and considered independent sources. which will not occur when securities intended to
If relying on this type of independent analysis, be held for trading purposes are categorized as
institutions are responsible for ensuring that the held-to-maturity or available-for-sale.
assumptions underlying the analysis and the It is an unsafe and unsound practice to report
resulting calculation are reasonable. Documen- securities held for trading purposes as available-
tation verifying this determination will be sub- for-sale or held-to-maturity securities. A close
ject to examiner review. examination of an institution’s actual securities
A mortgage-derivative product that was not a activities will determine whether securities it
high-risk mortgage security when it was pur- reported as available-for-sale or held-to-maturity
chased as an investment may later fall into the are, in reality, held for trading. When the fol-
high-risk category. When this occurs, the deposi- lowing securities activities are conducted in
tory institution may continue to designate the available-for-sale or held-to-maturity accounts,
mortgage-derivative product as held-to-maturity, they should raise supervisory concerns. The first
providing that management intends and is able five practices below are considered trading ac-
to hold the security to maturity. Furthermore, tivities and should not occur in available-for-
examiners should consider any unrecognized net sale or held-to-maturity securities portfolios,
depreciation in held-to-maturity high-risk secu- and the sixth practice is wholly unacceptable
rities when the adequacy of the depository under all circumstances.
institution’s capital adequacy is evaluated.
Once a mortgage-derivative product has been
designated as high risk, it may be redesignated
as nonhigh risk only if, at the end of two Gains Trading
consecutive quarters, it does not meet the defi-
nition of a high-risk mortgage security. Upon ‘‘Gains trading’’ is the purchase of a security
redesignation as a non-high-risk security, it does and the subsequent sale of that same security at
not need to be tested for another year. a profit after a short holding period. However, at
the same time, securities acquired for this pur-
pose that cannot be sold at a profit are retained
in the available-for-sale or held-to-maturity port-
folio; unrealized losses on debt securities in
UNSUITABLE INVESTMENT these two categories do not directly affect regu-
PRACTICES latory capital and are not reported in income
until the security is sold. Examiners should note
Institutions should categorize each of their institutions that exhibit a pattern or practice of
security activities as trading, available-for-sale, reporting significant amounts of realized gains
or held-to-maturity consistent with GAAP (that on sales of nontrading securities (typically,
is, Statement of Financial Accounting Standards available-for-sale securities) after short holding
No. 115, ‘‘Accounting for Certain Investments periods, while continuing to hold other non-
in Debt and Equity Securities,’’ as amended) and trading securities with significant amounts of
regulatory reporting standards. Management unrealized losses. In these situations, examiners
should reassess the categorizations of its secu- may designate some or all of the securities
rities periodically to ensure that they remain reported outside of the trading category as
appropriate. trading assets.

Page 24
When-Issued Securities Trading held-to-maturity portfolio should not be reported

as a short sale. Instead, it should be reported as
‘‘When-issued’’ securities trading is the buying a sale of the underlying security with gain or
and selling of securities in the period between loss recognized.
the announcement of an offering and the issu-
ance and payment date of the securities. A
purchaser of a when-issued security acquires all
of the risks and rewards of owning a security Adjusted Trading
and may sell this security at a profit before
having to take delivery and pay for it. Adjusted trading involves the sale of a security
to a broker or dealer at a price above the
prevailing market value and the simultaneous
purchase and booking of a different security,
Pair-Offs frequently a lower-grade issue or one with a
longer maturity, at a price above its market
‘‘Pair-offs’’ are security purchases that are closed value. Thus, the dealer is reimbursed for its
out or sold at, or before, settlement date. In a losses on the purchase from the institution and
pair-off, an institution commits to purchase a ensured a profit. Adjusted-trading transactions
security. Then, before the predetermined settle- inappropriately defer the recognition of losses
ment date, the institution will pair off the pur- on the security sold and establish an excessive
chase with a sale of the same security. Pair-offs reported value for the newly acquired security.
are settled net when one party to the transaction Consequently, these transactions are prohibited
remits the difference between the purchase and and may be in violation of 18 USC sections
sale price to the counterparty. Other pair-off 1001 (False Statements or Entries) and 1005
transactions may involve the same sequence of (False Entries).
events using swaps, options on swaps, forward
commitments, options on forward commit-
ments, or other off-balance-sheet derivative
contracts.
ACCOUNTING FOR SECURITIES
AND FINANCIAL CONTRACTS
Extended Settlements A single class of a financial instrument that
can meet trading, investment, or hedging objec-
Regular-way settlement for U.S. government tives may have a different accounting treatment
and federal-agency securities (except mortgage- applied to it, depending on management’s
backed securities and derivative contracts) is purpose for holding it. Therefore, an examiner
one business day after the trade date. Regular- reviewing investment or trading activities should
way settlement for corporate and municipal be familiar with the different accounting
securities is three business days after the trade methods to ensure that the particular accounting
date, and settlement for mortgage-backed secu- treatment being used is appropriate for the
rities can be up to 60 days or more after the trade purpose of holding a financial instrument
date. The use of a settlement period that exceeds and the economic substance of the related
the regular-way settlement periods to facilitate transaction.
speculation is considered a trading activity. The accounting principles that apply to secu-
rities portfolios, including trading accounts, and
to off-balance-sheet (OBS) derivative instru-
Short Sales ments are complex and have evolved over time—
both with regard to authoritative standards and
A short sale is the sale of a security that is not related banking practices. The objective of this
owned. Generally, the purpose of a short sale is section is to summarize the major aspects of the
to speculate on a fall in the price of the security. accounting principles in this important area to
Short sales should be conducted in the trading make the accounting guidance for both financial
portfolio. A short sale that involves the delivery reporting and regulatory reporting purposes
of the security sold short by borrowing it from understandable and useful to examiners and
the depository institution’s available-for-sale or supervisors. Accordingly, it is not intended to

Page 25
set forth new accounting policies for investment ing for Certain Marketable Securities,’’ and
activities. While this section provides a sum- related interpretations. It also amends other
mary of important accounting principles for standards, including FASB 65, ‘‘Accounting for
financial reporting and regulatory reporting pur- Certain Mortgage-Banking Activities,’’ to elimi-
poses in this area, it does not list or explain the nate mortgage-backed securities from that state-
detailed line items of financial reports that must ment’s scope. FASB 115 addresses investments
be reported for securities portfolios or OBS in equity securities that have readily determin-
derivative instruments in financial reports. able fair values and all investments in debt
Examiners should consult the sources of gener- securities.6 The accounting standard was effec-
ally accepted accounting principles (GAAP) and tive for fiscal years beginning after December
regulatory reporting requirements that are referred 15, 1993, for regulatory reporting and financial
to in this section for more detailed guidance in reporting purposes. It was to be initially applied
these areas. as of the beginning of an institution’s fiscal year
Examiners should be aware that accounting and cannot be applied retroactively to prior
practices in foreign countries may differ from years’ financial statements. Investments subject
the accounting principles followed in the United to the standard are to be classified in three
States. Nevertheless, foreign institutions are categories and accounted for as follows:
required to submit regulatory reports prepared in
accordance with U.S. banking agency regulatory • Held-to-maturity account. Debt securities that
reporting instructions, which to a large extent the institution has the positive intent and
incorporate GAAP. This section will focus on ability to hold to maturity are classified as
reporting requirements of the United States. held-to-maturity securities and reported at
The major topics covered in this section are amortized cost.
listed below. The discussion of specific types of • Trading account. Debt and equity securities
balance-sheet instruments (for example, securi- that are bought and held principally for the
ties) and OBS derivative instruments (for exam- purpose of selling them in the near term are
ple, swaps, futures, forwards, and options) is classified as trading securities and reported at
interwoven with the discussion of these topic fair value, with unrealized gains and losses
areas: included in earnings. Trading generally reflects
active and frequent buying and selling, and
• overview of the broad framework for account- trading securities are generally used with the
ing for securities portfolios, including the objective of generating profits on short-term
general framework for trading activities differences in price.
• general framework for OBS derivative instru- • Available-for-sale account. Debt and equity
ments, including hedges securities not classified as either held-to-
• summaries of specific accounting principles maturity securities or trading securities are
for OBS derivative instruments classified as available-for-sale securities and
reported at fair value, with unrealized gains
Accounting for Securities Portfolios

change in net assets. Examples of those institutions are
Treatment under FASB Statement No. 115 brokers and dealers in securities, defined-benefit pension
plans, and investment companies.
In May 1993, the Financial Accounting Stan- 6. FASB 115 states that the fair value of an equity security
dards Board issued Statement of Financial is readily determinable if sales prices or bid-asked quotations
are currently available on a securities exchange registered
Accounting Standards No. 115, ‘‘Accounting for with the SEC or in the over-the-counter market, provided that
Certain Investments in Debt and Equity Securi- those prices or quotations for the over-the-counter market are
ties.’’5 FASB 115 supersedes FASB 12, ‘‘Account- publicly reported by the FINRA Automated Quotations sys-
tems or by the National Quotation Bureau, Inc. Restricted
stock does not meet that definition.
5. FASB 115 does not apply to investments in equity The fair value of an equity security traded only in a foreign
securities accounted for under the equity method or to market is readily determinable if that foreign market is of a
investments in consolidated subsidiaries. This statement does breadth and scope comparable to one of the U.S. markets
not apply to institutions whose specialized accounting prac- referred to above. The fair value of an investment in a mutual
tices include accounting for substantially all investments in fund is readily determinable if the fair value per share (unit)
debt and equity securities at market value or fair value, with is determined and published and is the basis for current
changes in value recognized in earnings (income) or in the transactions.

Page 26
and losses excluded from earnings and reported debt securities used for regulatory risk-based
as a net amount in a separate component of capital purposes
shareholders’ equity.
Furthermore, FASB 115 recognizes that other
Under FASB 115, mortgage-backed securities events that are isolated, nonrecurring, and
that are held for sale in conjunction with unusual for the reporting institution and could
mortgage-banking activities should be reported not have been reasonably anticipated may cause
at fair value in the trading account. The standard the institution to sell or transfer a held-to-
does not apply to loans, including mortgage maturity security without necessarily calling
loans, that have not been securitized. into question its intent to hold other debt secu-
Upon the acquisition of a debt or equity rities to maturity. However, all sales and trans-
security, an institution must place the security fers of held-to-maturity securities must be dis-
into one of the above three categories. At each closed in the footnotes to the financial statements.
reporting date, the institution must reassess An institution must not designate a debt
whether the balance-sheet designation continues security as held-to-maturity if the institution has
to be appropriate. Proper classification of secu- the intent to hold the security for only an
rities is a key examination issue. (See SR-94-25 indefinite period. Consequently, a debt security
and SR-93-72; see also SR-96-32.) should not, for example, be designated as held-
FASB 115 recognizes that certain changes in to-maturity if the banking organization or other
circumstances may cause the institution to company anticipates that the security would be
change its intent to hold a certain security to available to be sold in response to—
maturity without calling into question its intent
to hold other debt securities to maturity in the • changes in market interest rates and related
future. Thus, the sale or transfer of a held-to- changes in the security’s prepayment risk,
maturity security due to one of the following • needs for liquidity (for example, due to the
changes in circumstances will not be viewed withdrawal of deposits, increased demand for
as inconsistent with its original balance-sheet loans, surrender of insurance policies, or pay-
classification: ment of insurance claims),
• changes in the availability of and the yield on
• evidence of a significant deterioration in the alternative investments,
issuer’s creditworthiness • changes in funding sources and terms, or
• changes in foreign-currency risk.
• a change in tax law that eliminates or reduces
the tax-exempt status of interest on the debt According to FASB 115, an institution’s asset-
security (but not a change in tax law that liability management may take into consider-
revises the marginal tax rates applicable to ation the maturity and repricing characteristics
interest income) of all investments in debt securities, including
• a major business combination or major dispo- those held to maturity or available for sale,
sition (such as the sale of a segment) that without tainting or casting doubt on the stan-
necessitates the sale or transfer of held-to- dard’s criterion that there be a ‘‘positive intent
maturity securities to maintain the institu- to hold until maturity.’’7 However, securities
tion’s existing interest-rate risk position or should not be designated as held-to-maturity if
credit risk policy they may be sold. Further, liquidity can be
• a change in statutory or regulatory require- derived from the held-to-maturity category by
ments that significantly modifies either what
constitutes a permissible investment or the
maximum level of investments in certain kinds 7. In summary, under FASB 115, sales of debt securities
that meet either of the following two conditions may be
of securities, thereby causing an institution to considered as ‘‘maturities’’ for purposes of the balance-sheet
dispose of a held-to-maturity security classification of securities: (i) The sale of a security occurs
near enough to its maturity date (or call date if exercise of the
• a significant increase by the regulator in the call is probable)—for example, within three months—that
industry’s capital requirements that causes the interest-rate risk has been substantially eliminated as a pricing
institution to downsize by selling held-to- factor. (ii) The sale of a security occurs after the institution has
maturity securities already collected at least 85 percent of the principal outstand-
ing at acquisition from either prepayments or scheduled
• a significant increase in the risk weights of payments.

Page 27
the use of repurchase agreements that are des- is judged to be other than temporary, the cost
ignated as financings, but not sales. basis of the individual security should be written
Transfers of a security between investment down to its fair value, and the write-down
categories should be accounted for at fair value. should be accounted in earnings as a realized
FASB 115 requires that at the date of the loss. This new cost basis should not be written
transfer, the security’s unrealized holding gain up if there are any subsequent recoveries in fair
or loss must be accounted for as follows: value.
• For a security transferred from the trading

category, the unrealized holding gain or loss at Other Regulatory Reporting Guidance
the date of the transfer will have already been
recognized in earnings and should not be As mentioned above, FASB 115 has been
reversed. adopted for regulatory reporting purposes. In
• For a security transferred into the trading January 1992, the Federal Reserve Board issued
category, the unrealized holding gain or loss at a policy statement on securities activities that,
the date of the transfer should be recognized among other things, provided supervisory
in earnings immediately. accounting guidance for securities portfolios
• For a debt security transferred into the owned by banks. Elements of this policy state-
available-for-sale category from the held-to- ment have been incorporated within this section.
maturity category, the unrealized holding gain Other supervisory accounting guidance on
or loss at the date of the transfer should be securities portfolios and related matters is pre-
recognized in a separate component of share- sented in—
holders’ equity.
• For a debt security transferred into the held- • the Federal Reserve Board staff’s examination
to-maturity category from the available-for- guidelines for asset-securitization activities
sale category, the unrealized holding gain or (specifically, volume 2, which addresses related
loss at the date of the transfer should continue accounting issues), and
to be reported in a separate component of • the Call Report instructions, particularly, the
shareholders’ equity but should be amortized glossary entries on—
over the remaining life of the security as an
adjustment of its yield in a manner consistent — coupon stripping, treasury securities, and
with the amortization of any premium or STRIPS;
discount. — trade fails;
— foreign debt–exchange transactions;
Transfers from the held-to-maturity category — market value of securities;
should be rare, except for transfers due to the — nonaccrual status;
changes in circumstances that were discussed
— premiums and discounts;
above. Transfers from the held-to-maturity
account not meeting the exceptions indicated — short positions;
above may call into question management’s — sales of assets (see also ‘‘participations in
intent to hold other securities to maturity. pools of residential mortgages’’ for
According to the standard, transfers into or from mortgage-backed securities);
the trading category should also be rare. — trading accounts;
FASB 115 requires that institutions deter- — trade-date and settlement-date account-
mine whether a decline in fair value below the ing;8 and
amortized cost for individual securities in the — when-issued securities.
available-for-sale or held-to-maturity accounts
is ‘‘other than temporary’’ (that is, whether this These sources should be reviewed for more
decline results from permanent impairment). detailed guidance in the above areas involving
For example, if it is probable that the investor securities portfolios and related transactions.
will be unable to collect all amounts due accord-
ing to the contractual terms of a debt security
that was not impaired at acquisition, an other- 8. As described in this glossary entry, for Call Report
than-temporary impairment should be consid- purposes, the preferred method for reporting securities trans-
ered to have occurred. If the decline in fair value actions is recognition on the trade date.

Page 28
General Framework for OBS same purpose as an OBS derivative instrument

Derivative Instruments in effectively hedging an institution’s risk expo-
sures, the gains and losses, or income and
expense, on that balance-sheet instrument can-
As discussed in the previous subsection, the
not be deferred to a future period when the
general accounting framework for securities port-
income or expense on the item being hedged is
folios divides them into three categories: held-
recognized.
to-maturity (accounted for at amortized cost),
The following addresses important GAAP
available-for-sale (accounted for at fair value,
and call report rules for netting of the assets
with changes in fair value recorded in equity),
and liabilities arising from OBS derivative
and trading (accounted for at fair value, with
instruments.
changes in fair value recorded in earnings). On
the other hand, the traditional accounting frame-
work (that is, trading, investment, and held-for-
sale) continues to be relevant for loans and other SPECIFIC ACCOUNTING
assets that are not in the legal form of a security. PRINCIPLES FOR OBS
In contrast, the general accounting framework DERIVATIVE INSTRUMENTS
for OBS derivative instruments under GAAP is
set forth below: Instruments Covered by Authoritative
Accounting Standards
• If the instrument meets certain speci- Futures Contracts Not Associated with
fied hedge-accounting criteria, the gains or Foreign-Currency Exposures
losses (income or expense) associated with the (‘‘Domestic Futures Contracts’’)
OBS derivative instrument can be deferred
and realized on a basis consistent with the Futures contracts are firm (legally binding) com-
income or expense of the item that is being mitments to purchase or sell a particular finan-
hedged. cial instrument or index, foreign currency, or
• Otherwise, gains or losses must be recognized commodity at a specified future date, quantity,
as they occur, and OBS derivative instruments and price or yield. Futures contracts have stan-
generally must be marked to market. Of course, dardized contractual terms, are traded on orga-
any OBS derivative instruments that are used nized exchanges, and are typically settled in
for trading purposes should be placed in a cash rather than actual delivery.
well-supervised trading account and marked Under GAAP, all futures contracts, except for
to market. foreign-currency futures contracts, should be
reported in accordance with FASB 80, ‘‘Account-
As discussed more fully below, this general ing for Futures Contracts.’’ Foreign-currency
framework is derived from FASB 52, ‘‘Foreign- futures contracts should be reported in accor-
Currency Translation,’’ and FASB 80, ‘‘Account- dance with the guidance contained in FASB 52,
ing for Futures Contracts.’’ Each statement ‘‘Foreign-Currency Translation.’’ These state-
presents different hedging criteria and related ments should be referred to for more detailed
guidance. Furthermore, reporting requirements accounting guidance in these areas.
for the call report differ from GAAP with regard
to domestic futures and forward contracts and Treatment of open contracts. Contracts are out-
written options. However, the call report follows standing (open) until they have been terminated
GAAP for foreign-currency OBS derivative by either the acquisition or delivery of the
instruments and interest-rate swaps. underlying financial instruments, or by offset.
It is important to note that while GAAP ‘‘Offset’’ is the purchase and sale of an opposite
permits hedge accounting for OBS derivative position using an equal number of futures con-
instruments, both GAAP and the call report tracts on the same delivery month executed
prohibit the use of hedge-accounting treatment through the same broker or dealer and executed
for securities (sometimes called ‘‘cash-market on the same exchange.
securities’’) or other on-balance-sheet items that Transactions in futures contracts generally
may serve as economic hedges of other balance- involve a deposit of cash as margin, which will
sheet or OBS items. Thus, even if a security or generally be reported within ‘‘other assets’’ on
other balance-sheet instrument would serve the the balance sheet. As discussed below, changes

Page 29
in the market values of open positions may • The institution must have determined that the
affect general ledger accounts and related item to be hedged (that is, an identifiable
balance-sheet amounts. However, since open asset, liability, firm commitment, or antici-
positions are executory contracts (firm commit- pated transaction) will expose it to price or
ments) for delivery of the underlying financial interest-rate risk.
instrument, the underlying instrument should • The futures contract must reduce the exposure
not be reflected as an asset or liability on the to risk. This must be demonstrated at the
balance sheet.9 Only when the closing of an inception of the hedge by an expectation that
open position results in the acquisition or dis- changes in the prices of both the contract and
position of the underlying financial instrument the hedged item will be highly correlated.
would an asset be recorded, or removed from, Furthermore, ongoing results must show a
the balance sheet. high degree of correlation, or the hedge will
As a prudent management measure, all open be considered ineffective and consequently
positions in futures contracts must be reviewed marked to market. In other words, the
at least monthly (or more often, if material), and bank must monitor the price movements of
their current market values should be deter- both the hedge contract and the hedged item to
mined using published price quotations. These determine that it is probable (that is, likely to
futures positions must be revalued at their cur- occur) that the results of the futures contract
rent market value on these valuation dates, and will offset changes in the market value of the
any changes in value should be reported in hedged item and that these results have done
accordance with the guidance presented below so from inception to the determination date.
for hedge or non-hedge contracts. • The futures contract must be designated as a
hedge by management at the inception of the
Criteria for hedge-accounting treatment. If cer- hedge.
tain criteria are met, the accounting under GAAP
for a futures contract that is used to hedge an In order for a futures contract to qualify as a
asset, liability, commitment, or anticipated trans- hedge of an anticipated transaction, the follow-
action (‘‘hedged item’’) should be similar to the ing two additional criteria must be met:
method of accounting for the hedged item. This
means that changes in the market value of the • Significant characteristics and expected
futures contract are recognized in income when terms of the anticipated transaction must be
the related changes in the price or interest rate of identified.
the hedged item are recognized. Where an • The occurrence of the anticipated transaction
anticipated transaction is the hedged item, the must be probable.10
change in value of the futures contract is included
in the measurement of the anticipated transac- If the criteria for applying hedge-accounting
tion. Realized gains or losses from changes in methods have been met, the gain or loss on a
the market value of futures contracts that qualify futures contract, instead of being currently rec-
as a hedge of an existing asset or liability should ognized in income, is an adjustment to the cost
be recognized as an adjustment of the carrying of the asset or liability being hedged. The
amount (often called ‘‘book value’’) of the adjustment, then, will be recognized in income
hedged item. A change in the market value of a when gain or loss on the hedged asset or liability
futures contract that is a hedge of a firm com- is determined. For example, if the item being
mitment should be included in the measurement hedged is an interest-bearing liability that is
of the transaction that satisfies the commitment. reported at amortized cost, the changes in the
Under FASB 80, a futures contract should be market value of the futures contract would be
accounted for as a hedge when the following reflected as adjustments to the carrying amount
conditions are met: (or book value) of the liability. The historical
cost of the liability and the adjustments brought
about by the hedge would then be amortized in
9. Although the underlying instruments or notional amounts
of these commitments are not reported in the balance sheet,
they are disclosed in footnotes to the financial statement. For 10. It will be particularly difficult to meet this criteria when
regulatory reporting purposes, open positions in futures con- an anticipated transaction is not expected to take place in the
tracts are to be reported in the call report, Schedule RC-L. near future.

Page 30
interest expense over the expected remaining contracts used to hedge mortgage-banking
life of the liability. operations, and those foreign-currency futures
If the hedged asset or liability is marked to contracts that are covered by FASB 52.
market, the hedge position will also be marked
to market. There is no deferral of gains or losses
in this situation; likewise, there is no deferral of Foreign-Currency Off-Balance-Sheet
gains or losses if the futures contract hedges an Instruments
anticipated transaction if the asset to be acquired
or liability incurred will be reported at fair The primary source of authoritative guidance for
value. accounting for foreign-currency translations and
If a futures contract qualifying as a hedge is foreign-currency transactions is FASB 52. The
closed before the date of the related anticipated standard encompasses futures contracts, forward
transaction, the accumulated change in value of agreements, and currency swaps as they relate to
the contract should be carried forward (assum- foreign-currency hedging.
ing high correlation has occurred) and included FASB 52 draws a distinction between foreign-
in the measurement of the related transaction. exchange translation and transactions. Transla-
When it becomes probable that the quantity of tion, generally, focuses on the combining of
the anticipated transaction will be less than that foreign and domestic entities for presentation in
originally hedged, a pro rata portion of the the consolidated financial statements and for
futures results that would have been included in reporting these financial statements in one cur-
the measurement of the transaction should be rency. Foreign-currency transactions, in con-
recognized as a gain or loss. trast, are transactions (such as purchases or
If high correlation between price changes of sales) by a business operation in currencies
the hedged item and the futures position is no other than its functional currency. For U.S.
longer evident, the bank should discontinue depository institutions, the functional currency
accounting for the futures contracts as a hedge. will generally be the dollar for its U.S. opera-
If this were to occur, the portion of the change in tions and will typically be the local currency
the market value of the contract that has not where its foreign operations transact business.11
offset the market-value changes of the hedged
item should be reflected in income. The contract Foreign-currency translation. Translation is the
should thereafter be accounted for as a non- conversion to U.S. dollars of the financial state-
hedge contract with subsequent changes in the ment of a foreign operation (branch, division, or
contract’s market value reflected in current subsidiary) that is denominated in the opera-
income. When a futures position that has been tion’s functional currency for inclusion in the
an effective hedge is terminated before disposi- parent’s consolidated financial statements. The
tion of the hedged item, the gain or loss on the foreign operation’s balance sheet is translated at
terminated contracts must be deferred and the exchange rate in effect on the statement date,
amortized over the remaining life of the hedged and the income statement is translated at an
item. If the contacts do not qualify as hedges, appropriate weighted-average rate for the report-
the gain or loss is recognized currently in ing period. Gains or losses arising from foreign-
income or expense, as appropriate. currency translation are not recognized currently
Call report treatment. Regulatory reporting stan-

dards, as a general rule, do not permit the 11. Detailed guidance of determining the functional cur-
rency is set forth in appendix 1 of FASB 52:
deferral of gains or losses by banks on domestic ‘‘An entity’s functional currency is the currency of the
futures and forwards, whether or not the con- primary economic environment in which the entity operates;
tracts are used for hedging purposes. All changes normally, that is the currency of the environment in which an
in market value of futures and forward contracts entity primarily generates and expends cash. The functional
currency of an entity is, in principle, a matter of fact. In some
are reported in income in the period they occur. cases, the facts will clearly identify the functional currency; in
The banking agencies adopted this reporting other cases they will not.’’
standard as a supervisory policy before the FASB 52 indicates the salient economic indicators, and
issuance of FASB 80. As exceptions to the possibly other factors, that should be considered both indi-
vidually and collectively when determining the functional
general prohibition, hedge accounting in accor- currency. These factors include cashflow, price and market
dance with FASB 80 is permitted by the three sales indicators, expense indicators, financing indicators, and
banking agencies only for futures and forward intercompany transactions and arrangements.

Page 31
in income; instead, they are treated as adjust- on the items that were hedged occurs. Losses
ments to a separate component of equity. Rec- should not be deferred, however, if it is esti-
ognition in income of these cumulative foreign- mated that deferral would lead to recognizing
currency adjustments will take place when the losses in later periods. A foreign-currency trans-
foreign operation is either sold or substantially action should be considered a hedge of an
liquidated. identifiable foreign-currency commitment if both
An institution may engage in hedging trans- of the following conditions are met:
actions to reduce the risk of exchange losses on
translating its net equity investments in foreign • The foreign-currency transaction is designated
operations for presentation in its financial state- as, and is effective as, a hedge of a foreign-
ments, thus avoiding the consequent volatility in currency commitment.
its capital position. The effect of the special • The foreign-currency commitment is firm.
hedging treatment is to include the change in
value of the hedging instrument as a part of the Thus, FASB 52 is distinguished from
same separate component of equity as the trans- FASB 80 in that hedging the risks from arrange-
lation adjustment. ments that have not matured into a firm com-
mitment (that is, an anticipated transaction),
Foreign-currency transactions. Gains or losses such as forecasted foreign sales, do not qualify
on foreign-currency transactions, in contrast to for hedge treatment. Another dissimilarity
translation, are recognized in income as they between FASB 52 and 80 is that the hedge of
occur, unless they arise from a qualifying hedge. a foreign-currency exposure can be considered
FASB 52 provides the following guidance about in isolation; there is no requirement that the
the types of foreign-currency transactions for overall risk of the institution must be reduced
which gain or loss is not currently recognized in by the hedge as there is under FASB 80. Under
earnings. the latter accounting standard, an institution is,
Gains and losses on the following foreign- in effect, required to consider the presence of
currency transactions should not be included in any natural hedges that may be present in its
determining net income but should be reported balance sheet. To illustrate, an institution with
in the same manner as translation adjustments: foreign-currency-denominated receivables has
foreign-exchange risk; however, any accounts
• foreign-currency transactions that are desig- payable that are denominated in the same cur-
nated as, and are effective as, economic hedges rency as the receivables reduce the overall
of a net investment in a foreign entity, com- exposure. Under FASB 52, however, the insti-
mencing as of the designation date tution could hedge the gross amount of receiv-
• intercompany foreign-currency transactions ables and qualify for deferring gain or loss
that are of a long-term-investment nature (that recognition. Note, however, that by neutralizing
is, settlement is not planned or anticipated in the exposure from the receivables, the institu-
the foreseeable future), when the entities to tion now has exchange risk equal to its payables
the transaction are consolidated, combined, or position. Thus, gains or losses from a hedge of a
accounted for by the equity method in the foreign-currency risk may be deferred, even
reporting institution’s financial statements though the hedge position may increase the
overall foreign-exchange risk of the institution.
In addition to hedges of the balance sheet, a To qualify for deferral, a foreign-currency-
gain or loss on a forward contract or other hedge position is required to be denominated in
foreign-currency transaction that is intended to the same currency as the items it is hedging,
hedge an identifiable foreign-currency commit- unless such a hedge is impracticable. ‘‘Imprac-
ment (for example, a firm commitment to sell or ticable’’ means there are severe impediments to
purchase equipment) should be deferred and using the currency, such as illiquidity or a
included in the measurement of the related limited exchange market in the currency that is
foreign-currency transaction (as an adjustment to be hedged, not merely that it is uneconomical.
to the revenue or cost of the equipment in the Since the foreign-exchange-hedge position is
example). If a foreign-currency hedge is termi- generally denominated in the same currency as
nated before the transaction date of the related the items that are being hedged, there will be
commitment, any deferred gain or loss is to perfect correlation (that is, no basis risk) between
remain deferred until recognition of gain or loss the hedged items and the hedge position. There-

Page 32
fore, ongoing monitoring of the correlation guidance for accounting for ‘‘synthetic instru-
between the foreign-exchange hedge and the ments’’ (for example, the transformation of
hedged items is required only if a substitute or fixed-rate debt into floating-rate debt by use of
proxy currency is being used. an interest-rate swap) where there is no risk
reduction per se. Interest-rate swaps denomi-
nated in a foreign currency, including cross-
Instruments That Are Not Covered by currency interest-rate swaps, are generally
accounted for by analogy to the accounting
Authoritative Accounting Standards guidance set forth in FASB 52. Financial insti-
Forward Contracts tutions engaging in swaps should have written
policies that govern the accounting for these
Domestic forward contracts, including forward- instruments, and should be consistently follow-
rate agreements, are generally accounted for by ing these policies.
analogy to the accounting guidance for futures
contracts set forth in FASB 80, which is sum-
marized above. As noted above, the accounting Options
for foreign-currency-forward contracts is
addressed by FASB 52. Forward-rate agree- Options involve two parties: the writer (or
ments denominated in a foreign currency are seller) and the purchaser (or holder). The pur-
generally accounted for by analogy to the chaser of an option has the right, but not the
accounting guidance for forward contracts set obligation, to purchase or sell the option’s
forth in FASB 52. Of course, any such instru- underlying instrument according to the terms
ments that are used for trading purposes should specified in the option. The option writer, in
be placed in a well-supervised trading account return for receiving the option premium, is
and marked to market. obligated to perform according to the terms of
the option.
Interest-Rate Swaps
Purchased Options
Consistent with the general requirement that
trading assets or liabilities be marked to mar- When held as a trading asset, a purchased option
ket, a dealer or market maker in swap instru- is to be marked to market under GAAP for
ments is required to mark its swap trading presentation in the financial statements. For
book to fair value. While the Emerging Issues regulatory reporting purposes, the call report
Task Force (EITF) has provided limited inter- instructions state that purchased options are
pretations on interest-rate swaps used as hedges, generally not to be reported at market value. For
authoritative standards from the FASB, AICPA, call report purposes, the only purchased options
or SEC do not yet exist. In this vacuum, diverse that have specifically been permitted to be
industry practice has resulted. EITF Issue marked to market are those that have been used
No. 84-7 applies to the early termination of for trading purposes and have been placed in a
swaps that hedge some financial instrument. well-supervised trading account.
According to this issue, gain or loss from early Purchased options can be an effective hedge
termination is to be deferred and amortized of anticipated transactions, where they can be
as a yield adjustment to the underlying finan- exercised if the anticipated transaction matures
cial instrument. Issue No. 84-36 applies if into a firm commitment or can be allowed to
there is an underlying debt obligation on the lapse if the anticipated transaction does not
balance sheet of the company entering into a occur. Alternatively, options can be used to pro-
swap. The company should account for the tect against unfavorable price movements, but
swap like a hedge of the obligation and record allow the institution to benefit from favorable
interest expense using the revised interest price changes of the hedged items. Virtually no
rate. Situations where the swap does not hedge authoritative literature has been issued for the
an asset or liability were excluded from the accounting of options. The AICPA released an
scope of the two issues, other than to note a issues paper in 1986 that proposed certain meth-
diversity of accounting treatment. Some accoun- ods of accounting for options that included cri-
tants view the EITF’s discussion of hedging as teria for hedging that were similar to FASB 80.

Page 33
The paper, however, is not authoritative. One noted that FASB 52 did not specifically consider
recommendation of the report was to account for options. The EITF used certain elements from
purchased options used for hedging purposes in FASB 80 in identifying appropriate criteria
two discrete amounts: (a) the intrinsic value for applying hedge-accounting treatment: the
(that is the difference, if positive, between the requirement that overall risk be reduced, that
option’s exercise price and the market price of high correlation between the hedge position and
the underlying instrument) and (b) the time the hedged items be present, and that anticipated
value of the option. The former would be an transactions could be hedged if they are identi-
adjustment to determining the gain or loss on fiable and probable. This guidance is narrowly
exercise or expiration; the latter would be amor- applied to strategies using at-the-money options
tized over the term of the option. Another at the inception of the hedge. When it examined
recommendation was that if the option qualifies other option-based hedge strategies (Issue No. 91-
as a hedge of an item carried at historical cost, 4), the EITF was unable to reach a consensus
changes in intrinsic value would be included in because of objections by the SEC about the
a separate component of equity. While parts of deferral of gains or losses related to anticipated
the issues paper have become industry practice, transactions. The SEC also objected to any
some of the approaches advocated, such as these deferral of losses from written options, since to
two examples, are rarely seen. write options does not, in the SEC’s view,
For presentation in the call report, purchased reduce risk.
options that are held for hedging purposes gen-
erally are to be recorded at cost and amortized
over the term of the option. No periodic valua- Netting or Offsetting On- and
tion for balance-sheet presentation of open posi- Off-Balance-Sheet Assets and
tions is permitted. Liabilities
Written options. By their inherent risk profile, The FASB issued Interpretation 39 in 1992,
written options, whether covered or not, do not which went into effect for 1994 financial state-
generally qualify as a hedge for accounting ments of banks and other companies. This
purposes. The premium received by an option’s interpretation applies to the netting of assets and
writer should be deferred until the point at liabilities arising from (i) ‘‘traditional’’ activi-
which the option either expires or is exercised. If ties, such as loans and deposits, and (ii) OBS
the option is exercised, the premium is an derivative instruments. The assets and liabilities
adjustment to the amount realized on the sale of from derivatives primarily are their fair value, or
the underlying obligation. If the option expires estimated market value, and the receivables and
out of the money, the premium is considered payables on these instruments. FIN 39 clarifies
earned and is reported as other fee income. the definition of a ‘‘right of setoff’’ that GAAP
Options that are in the money (and thus an has long indicated must exist before netting of
obligation to the writer) are to be marked to assets and liabilities can occur in the balance
market, according to the SEC. sheet. One of the main purposes of FIN 39 was
The call report instructions provide guidance to clarify that FASB’s earlier guidance on net-
for written ‘‘standby contracts,’’ which are a ting of assets and liabilities (TB 88-2) applies to
form of option. Standby contracts are to be amounts recognized for OBS derivative instru-
valued at the lower of cost or market (since the ments as well.
written option is a liability, the absolute amount Balance-sheet items arise from off-balance-
reported is the higher of cost (the premium sheet interest-rate and foreign-currency instru-
received) or market value). Market value in this ments primarily in two ways. First, those
context is the loss exposure, which would be banking organizations and other companies that
based on the difference between the option’s trade OBS derivative instruments (for example,
strike price and the market price of the under- interest-rate and currency swaps, forwards, and
lying instrument. options) are required by GAAP to mark to
market these positions by recording their fair
Purchased options that hedge foreign-exchange values (estimated market values) on the balance
exposures related to anticipated transactions. In sheet and recording any changes in these fair
issuing guidance on foreign-currency hedges values (unrealized gains and losses) in earnings.
that use options (Issue No. 90-17), the EITF Second, interest-rate and currency swaps have

Page 34
receivables and payables that accrue over time, on an interim basis, adopted for the call report
reflecting expected cash inflows and outflows the provisions of FIN 39 that are applicable
that must periodically be exchanged under these to derivative contracts, effective for 1994 call
contracts, and these receivables and payables reports. The general instructions to the call
must be recorded on the balance sheet as assets report, however, explicitly prohibit the netting
and liabilities, respectively.12 of assets and liabilities by banks unless specifi-
Under FIN 39, setoff, or the netting of assets cally required by the instructions. Thus, FIN 39
and liabilities to a particular counterparty, is not is not to be applied to traditional balance-sheet
permitted unless all of the following four criteria assets and liabilities for call report purposes.
are met:
• Two parties must owe each other determin-

able amounts. DISCLOSURE FOR SECURITIES
• The reporting entity must have a right to set AND FINANCIAL CONTRACTS
off its obligation with the amount due to it.
• The reporting entity must actually intend to In addition to issuing authoritative guidance on
set off these amounts. methods of accounting (that is, how a particular
• The right of setoff must be enforceable at law. transaction is to be reported on the balance sheet
or statements of income or cash flow), the FASB
When all four criteria are met, a bank or other (and SEC) also set standards for minimum
company may offset the related asset and liabil- disclosure of the financial activities, condition,
ity and report the net amount in its GAAP and other issues that should be incorporated in a
financial statements. FIN 39 also indicates, with- company’s annual report. Information to meet
out regard to the third criterion (the parties’ these disclosure requirements is audited by the
intent), the netting of fair values of OBS deriva- company’s independent accountants and may be
tive contracts executed with the counterparty presented either as footnotes to the financial
under a legally enforceable master netting agree- statements or incorporated in management’s
ment is permitted. If any one of the other three discussion and analysis (MD&A). In MD&A,
criteria is not met, the fair value of contracts in management reviews in some detail the com-
a loss position with the counterparty cannot be pany’s results from operations, its liquid resources
offset against the fair value of contracts in a gain and capital position, significant events occurring
position with that counterparty, and the organi- after the date of the financial statements, and
zation would be required to record gross unreal- other matters. MD&A is required for reports
ized gains on such contracts as assets and gross filed with the SEC, such as the annual 10-K and
unrealized losses as liabilities. quarterly 10-Q. Since it is fixed-form, the call
report does not have a direct analogue to MD&A.
There is, however, considerable overlap as many
Call Report Requirements of the call report’s supporting schedules and
memoranda state much of the information
The call report instructions provide guidance on required under the disclosure standards of GAAP.
netting for purposes of reporting risk-based The following section briefly describes the
capital information.13 Furthermore, the FFIEC, GAAP requirements for disclosure relating to
financial instruments.
As an interim step in a project to improve
12. In contrast, the notional amounts of off-balance-sheet the accounting for financial instruments, par-
derivative instruments, or the principal amounts of the under-
lying asset or assets to which the values of the contracts are
indexed, are not recorded on the balance sheet. Note, however,
that if the OBS instrument is carried at market value, that potential future credit exposure. The credit-equivalent amount
value will include any receivable or payable components. is then assigned to the appropriate risk-weight category.
Thus, for those OBS instruments that are subject to a master Netting of swaps and similar contracts is recognized for
netting agreement, the accrual components in fair value are risk-based capital purposes only when accomplished through
also netted. ‘‘netting by novation.’’ This is defined as a written bilateral
13. The risk-based capital guidelines provide generally that contract between two counterparties under which any obliga-
a credit-equivalent amount is calculated for each individual tion to each other is automatically amalgamated with all other
interest-rate and exchange-rate contract. The credit-equivalent obligations for the same currency and value date, legally
amount is determined by summing the positive mark-to- substituting one single net amount for the previous gross
market values of each contract with an estimate of the obligations.

Page 35
ticularly OBS instruments, the FASB wrote described earlier. FASB 105 was required to be
new disclosure standards intended to increase followed for annual reports beginning in 1991.
the transparency of contractual terms, risks, and The second standard issued by the FASB was
market values of both on- and off-balance-sheet FASB 107, ‘‘Disclosures about Fair Value of
financial instruments. To date, three standards Financial Instruments,’’ which was effective for
have been written, requiring additional dis- the 1993 annual reports of institutions with
closure about instruments having certain risks assets of $150 million or more and will be
(including a lack of diversification), the fair effective for the 1996 annual reports of smaller
market value of financial instruments (including institutions. Under the standard, a company is
such classes as securities, loans, and deposits), required to disclose the fair value of virtually all
and the discussion of the risk-management classes of financial instruments. The company
strategies when the company uses OBS should disclose its methods for estimating fair
instruments. value, such as the use of market quotes or
The first standard resulting from the financial valuation techniques (and disclose the assump-
instruments project was FASB 105, ‘‘Disclosure tions used if values are estimated) for instru-
of Information about Financial Instruments with ments without active markets. FASB 107 requires
Off-Balance-Sheet Risk and Financial Instru- that demand deposits be reported at face value
ments with Concentrations of Credit Risk.’’ and the value of long-term relationships and
Under the standard, a company is required to other intangibles not be taken into account,
describe the notional amounts and significant although these and other nonfinancial assets and
contractual terms for financial instruments that liabilities may be separately disclosed. In
have off-balance-sheet risk of accounting loss.14 response to criticisms from industry analysts
Secondly, the company is required to disclose about the difficulty in following some compa-
the amount of accounting loss that would occur nies’ disclosures, the FASB amended FASB 107
as a result of credit risk.15 As a part of the when it issued FASB 119, ‘‘Disclosure about
disclosure of credit risk, the company is required Derivative Financial Instruments and Fair Value
to discuss its policies for requiring collateral and of Financial Instruments.’’ FASB 119 requires
a description of the collateral or other security that the fair-value disclosure separate OBS in-
supporting the contracts. Lastly, the company is struments used as hedges from the instruments
required to report significant credit concentra- on the balance sheet being hedged. FASB 107
tions across all classes of financial instruments. was also amended to require fair-value disclo-
This may be done by industry, region, or other sure in a single place rather than scattered
economic characteristics. FASB 105 was throughout the annual report.
amended by FASB 119 (see below) to require In response to calls for further improvement
the disclosure of notional amount and significant in the disclosure of derivatives activities,
contract terms of financial instruments without FASB 119 requires a firm that issues or holds
off-balance-sheet risk of loss (for example, pur- derivatives to differentiate in its disclosures
chased options) in addition to the disclosures between derivatives that it uses for trading
purposes and derivatives used for risk-
management or other end-user reasons.
14. An off-balance-sheet accounting loss occurs when • Trading activities. A dealer is required to
there is the potential for loss because of market or credit risks report the fair value (both year-end and annual
that exceed the amount reported on the balance sheet for the average) of its derivatives positions and to
OBS instrument. In other words, the loss in the event of a
default or adverse market movement could exceed the reported
disaggregate derivatives trading profits. This
value of the contract. For example, a purchased-put option disaggregation may be reported either for
does not have accounting risk of loss because the most that derivative instruments alone or broken down
could be lost by the holder is the amount of the premium paid by some other method by the firm, such as
(of course, the economic loss would be the fair value of the
option). The writer of the put, on the other hand, would have
lines of business, risk exposures (for example,
an accounting loss to the writer if it must pay cash to settle the interest-rate or foreign-exchange), or another
contract in excess of the premium it received. Thus the writer method as long as trading profits from deriva-
has off-balance-sheet risk of loss while the holder does not. tive instruments are disclosed. The FASB
15. For example, an interest-rate swap accounted for using
the accrual method that has a market value of $1,000 and an
encouraged, but did not require, the disclosure
accrued net receivable of $10 has an accounting risk of loss of of both year-end and average fair values of
only $10. trading assets and liabilities that are not

Page 36
derivatives, whether they are financial instru- fair values of end-user derivatives must also
ments or nonfinancial items, to give a more be separately disclosed from the fair value of
comprehensive picture of the firm’s trading items hedged by the derivatives.
pursuits.
• End-user activities. For derivatives not used Finally, FASB 119 encourages a firm to
in trading, but instead used for hedging or disclose quantitative information, consistent with
other risk-management purposes, a firm is its method for managing risk, that would be
now required to describe its objectives for useful to financial statement readers in assessing
using derivatives and discuss its strategies for its activities. Suggested approaches include gap
achieving those objectives. The firm is also analyses, the effect of hypothetical price shocks
required to describe how it reports derivatives on reported earnings, and the disclosure of value
in its financial statements as well as give at risk at the report date and its average during
certain details (such as the amount of gains or the year. FASB 119 first applied to annual
losses explicitly deferred) about derivatives reports for year-end 1994.
used to hedge anticipated transactions. The

Page 37
1. To determine if policies, practices, proce- investment portfolio and how that quality
dures, and internal controls regarding invest- relates to the soundness of the bank.
ments are adequate. 5. To determine compliance with laws and
2. To determine if bank officers are operating in regulations.
conformance with the established guidelines. 6. To initiate corrective action when policies,
3. To determine the scope and adequacy of the practices, procedures or internal controls are
audit function. deficient or when violations of laws or regu-
4. To determine the overall quality of the lations have been noted.

Page 1
1. If used, answer the questions in section b. A list of any assets carried in loans, and
2020.4, the ‘‘Investment Securities and a list of discounts on which interest is
End-User Activities’’ internal control exempt from federal income taxes and
questionnaire. which are carried in the investment
2. On the basis of an evaluation of internal account on Call Reports.
controls and the work performed by internal c. A list of open purchase and sale
or external auditors, determine the scope of commitments.
the examination. d. A schedule of all securities, forward
3. Test for compliance with policies, practices, placement contracts, futures contracts,
procedures, and internal controls in conjunc- contracts on exchange-traded puts and
tion with performing the following exami- calls, option contracts on futures puts and
nation procedures. Also, obtain a listing of calls, and standby contracts purchased or
any deficiencies noted in the latest review sold since the last examination.
conducted by internal or external auditors, e. A maturity schedule of securities sold
and determine if any corrections have been under repurchase agreements.
accomplished. Determine the extent and f. A list of pledged assets and secured
effectiveness of investment-policy supervi- liabilities.
sion by— g. A list of the names and addresses of all
a. reviewing the abstracted minutes of meet- securities dealers doing business with the
ings of the board of directors or appro- bank.
priate committees; h. A list of the bank’s personnel authorized
b. determining that proper authorizations to trade with dealers.
have been made for investment officers i. A list of all U.S. government–guaranteed
or committees; loans that are recorded and carried as an
c. determining any limitations or restric- investment-account security.
tions on delegated authorities; j. For international division and overseas
d. evaluating the sufficiency of analytical branches, a list of investments—
data used by the board or investment • held to comply with various foreign
committee; governmental regulations requiring
e. reviewing the reporting methods used by such investments;
department supervisors and internal • used to meet foreign reserve require-
auditors to ensure compliance with ments;
established policy; and • required as stock exchange guarantees
f. preparing a memo for the examiner who or used to enable the bank to provide
is assigned ‘‘Duties and Responsibilities securities services;
of Directors’’ and the examiner who is in • representing investment of surplus
charge of the international examination, funds;
if applicable, stating conclusions on the • used to obtain telephone and telex
effectiveness of directors’ supervision of services;
the domestic or international division • representing club and school member-
investment policy. All conclusions should ships;
be documented. • acquired through debts previously
4. Obtain the following: contracted;
a. Trial balances of investment-account • representing minority interests in non-
holdings and money market instruments, affiliated companies;
such as commercial paper, banker’s • representing trading-account securi-
acceptances, negotiable certificates of ties;
deposit, securities purchased under agree- • representing equity interests in Edge
ments to resell, and federal funds sold. Act and agreement corporations and
Identify any depository instruments foreign banks;
placed through money brokers. • representing portfolio investments made

Page 1
2020.3 Investment Securities and End-User Activities: Examination Procedures
pursuant to Regulation K; and lished data outlining legal status.

• held for other purposes. b. If market prices are provided to the bank
5. Using updated data available from reports by an independent party (excluding
of condition, UBPR printouts, and invest- affiliates and securities dealers selling
ment adviser and correspondent bank investments to the bank) or if they are
portfolio-analysis reports, obtain or prepare independently tested as a documented
an analysis of investment and money mar- part of the bank’s audit program, accept
ket holdings that includes— those prices. If the independence of the
a. a month-by-month schedule of par, book, prices cannot be established, test market
and market values of issues maturing in values by reference to one of the follow-
one year; ing sources:
b. schedules of par, book, and market val- • published quotations, if available
ues of holdings in the investment port- • appraisals by outside pricing services,
folio (schedules should be indexed by if performed
maturity date, and individual schedules c. If market prices are provided by the bank
should be detailed by maturity dates over and cannot be verified by reference to
the following time periods: over one published quotations or other sources,
through five years, over five through test those prices by using the ‘‘compara-
10 years, and over 10 years); tive yield method’’ to calculate approxi-
c. book-value totals of holdings by obligor mate yield to maturity:
or industry; related obligors or indus-
tries; geographic distribution; yield; and approximate yield to maturity =
special characteristics, such as moral par value − book value
obligations, conversion, or warrant annual interest +
features; number of years to maturity
d. par-value schedules of type I, II, and III ⁄ (bank-provided market price + par value)
12
investment holdings, by those legally

defined types; and • Compare the bank-provided market
e. for the international division, a list of price and the examiner-calculated
international investment holdings approximate yield to maturity with an
(foreign-currency amounts and U.S. dol- independent publicly offered yield or
lar equivalents) to include— market price for a similar type of
• descriptions of securities held (par, investment with similar rating,
book, and market values), trading-volume, and maturity or call
• names of issuers, characteristics.
• issuers’ countries of domicile, • Compare nonrated issues with fourth-
• interest rates, and rated (BBB, Baa) bonds.
• pledged securities. • Investigate market-value variances in
6. Review the reconcilement of investment excess of 5 percent.
and money market account (or accounts) d. For investments and money market
trial balances to the general-ledger control obligations in the sample that are rated,
account (or accounts). compare the ratings provided with the
7. Using either an appropriate sampling tech- most recent published ratings.
nique or the asset-coverage method, select
Before continuing, refer to steps 16
from the trial balance (or balances) the
through 18. They should be performed in
international investments, municipal invest-
conjunction with steps 9 through 15. Inter-
ments, and money market holdings for
national division holdings should be
examination. If transaction volume permits,
reviewed with domestic holdings to ensure
include all securities purchased since the
compliance, when combined, with applica-
last general examination in the population
ble legal requirements.
of items to be reviewed.
8. Perform the following procedures for each 9. To the extent practical under the circum-
investment and money market holding stances, perform credit analyses of—
selected in step 7: a. the obligors on securities purchased under
a. Check appropriate legal opinions or pub- agreements to resell, when the readily

Page 2
Investment Securities and End-User Activities: Examination Procedures 2020.3
marketable value of the securities is not Securities Held by Banks and Thrifts. (See
sufficient to satisfy the obligation; SR-04-9.) Classify speculative and defaulted
b. all international investments, nonrated issues according to the sub-investment-
securities, and money market instru- quality debt securities category of the agree-
ments selected in step 7 or acquired since ment. No preferential treatment should be
the last examination; given to defaulted municipal securities.
c. all previously detailed or currently known Comments to be included in the examina-
speculative issues; tion report are—
d. all defaulted issues; and a. a description of the issue;
e. any issues in the current Interagency b. how and when each issue was acquired;
Country Exposure Review Committee c. the default date, if appropriate;
credit schedule obtained from the inter- d. the date up to which interest was paid;
national loan portfolio manager by— e. the rating (or ratings)1 at time of acqui-
• comparing the schedule with the for- sition; and
eign securities trial balance obtained in f. other comments supporting the classifi-
step 4 to ascertain which foreign secu- cation.
rities are to be included in Interagency 12. Review the bank’s investment-security
Country Exposure Review Committee maturity program.
credits; a. Review the maturity schedules.
• for each security so identified, tran- • Compare the book values and the fair
scribing the following appropriate values and, after considering the gain
information to a separate examiner’s or loss on year-to-date sales, determine
line sheet or a related examiner’s credit if the costs of selling intermediate and
line sheet: long-term issues appear prohibitive.
— amount (and U.S. dollar equivalent • Determine if recent acquisitions show
if a foreign currency) to include a trend toward lengthened or shortened
par, book, and fair values maturities. Discuss such trends with
— how and when acquired management, particularly with regard
— maturity date (or dates) to investment objectives approved by
— default date, if appropriate the investment committee.
— any pertinent comments; and
b. Review the pledged asset and secured
• returning the schedule and the appro-
liability schedules and isolate pledged
priate examiner’s line sheet (or
securities by maturity segment. Then
sheets) to the examiner who is
determine the fair value of securi-
assigned ‘‘International—Loan Port-
ties pledged in excess of net secured
folio Management.’’
liabilities.
10. Review the most recent reports of examina-
c. Review the schedule of securities sold
tion of the bank’s Edge Act and agreement
under repurchase agreement and
corporation affiliates and foreign subsidi-
determine—
aries to determine their overall conditions.
Also, compile data on Edge Act and agree- • whether financing for securities pur-
ment corporations and foreign subsidi- chases is provided by repurchase agree-
aries necessary for the commercial report ment by the securities dealer who origi-
of examination (that is, asset criticisms, nally sold the security to the bank;
transfer risk, and other material examination • whether funds acquired through the
findings). Review portfolio investments sale of securities under agreement to
made by Edge and agreement corporations repurchase are invested in money mar-
under Regulation K for compliance with the ket assets, or if short-term repurchase
investment limitations in Regulation K. agreements are being used to fund
11. Review the asset quality and the liquidity of longer-term, fixed-rate assets;
all investment securities. Debt securities
that have nontemporary impairments should
1. The June 2004 interagency uniform agreement also
be classified according to the June 15, 2004, addresses multiple ratings, the treatment of foreign debt
interagency Uniform Agreement on the securities, split or partially rated securities, and nonrated
Classification of Assets and Appraisal of securities.

Page 3
• the extent of matched asset repo and to calculate investments as a percentage

liability repo maturities and the overall of total assets, and use average yields on
effect on liquidity resulting from U.S. government and nontaxable invest-
unmatched positions; ments to—
• whether the interest rate paid on secu- • compare r e s u l t s w i t h p e e r-g r o u p
rities sold under agreement to repur- statistics,
chase is appropriate relative to current • determine the reasons for significant
money market rates; and variances from the norm, and
• whether the repurchase agreement is • determine if trends are apparent and
at the option of the buying or selling the reasons for such trends.
bank. b. Calculate current market depreciation as
d. Review the list of open purchase and sale a percentage of gross capital funds.
commitments and determine the effect of c. Review the analysis of municipal and
their completion on maturity scheduling. corporate issues by rating classification
e. Submit investment portfolio information and—
regarding the credit quality and practical • determine the total in each rating class
liquidity of the investment portfolio to and the total of nonrated issues,
the examiner who is assigned to review • determine the total of nonrated invest-
the ‘‘Asset/Liability Management.’’ ment securities issued by obligors
13. Consult with the examiner responsible for located outside of the bank’s service
the asset/liability management analysis to area (exclude U.S. government–
determine what information is needed to guaranteed issues), and
assess the bank’s sensitivity to interest-rate • review acquisitions since the prior
fluctuations and its ability to meet short- examination and ascertain reasons for
term funding requirements. If requested, trends that may suggest a shift
compile the information using bank records in the rated quality of investment
or other appropriate sources. See section holdings.
6000.1, ‘‘Instructions for the Report of d. Review coupon rates or yields (when
Examination,’’ for factors to be taken into available) and compare those recently
account when compiling this information. acquired investments and money market
Information which may be required to be holdings with coupon rates or yields that
furnished includes— appear high or low with similarly acquired
a. the fair value of unpledged government instruments of analogous types, ratings,
and federal-agency securities maturing and maturity characteristics (Discuss
within one year; significant rate or yield variances with
b. the fair value of other unpledged govern- management.)
ment and federal-agency securities which e. Review the schedule of securities, futures,
would be sold without loss; forward, and standby contracts pur-
c. the fair value of unpledged municipal chased and sold since the last examina-
securities maturing within one year; tion, and determine whether the volume
d. the book value of money market instru- of trading is consistent with policy
ments, such as banker’s acceptances, objectives. (If the bank does not have a
commercial paper, and certificates of separate trading account, determine
deposit (provide amounts for each cate- whether such an account should be
gory); and established, including appropriate record-
e. commitments to purchase and sell secu- keeping and controls.)
rities, including futures, forward, and f. If the majority of sales resulted in gains,
standby contracts. (Provide a description determine if profit-taking is consistent
of the security contract, the purchase or with stated policy objectives or is moti-
sales price, and the settlement or expira- vated by anxiety for short-term income.
tion date.) g. Determine whether the bank has dis-
14. Determine whether the bank’s investment counted or has plans to discount future
policies and practices are satisfactorily bal- investment income by selling interest
ancing earnings and risk considerations. coupons in advance of interest-payment
a. Use UBPR or average Call Report data dates.

Page 4
h. Review the list of commitments to pur-

chase or sell investments or money mar-
ket investments. (Determine the effect

Page 4.1
of completion of these contracts on future acted in accordance with authorized

earnings.). objectives;
15. Review the bank’s federal income tax posi- c. the board of directors or its designee has
tion and established specific contract position
a. determine, by discussion with appropri- limits and reviews contract positions at
ate officer(s), if the bank is taking advan- least monthly to ascertain conformance
tage of procedures to minimize tax lia- with those limits;
bility in view of other investment d. gross and net positions are within autho-
objectives; rized positions and limits, and if trades
b. review or compute actual and budgeted— were executed by persons authorized to
• tax-exempt holdings as a percentage of trade futures; and
total assets and e. the bank maintains general-ledger memo-
randum accounts or commitment regis-
• applicable income taxes as a percent-
ters which, at a minimum, include—
age of net operating income before
• the type and amount of each contract,
taxes; and
• the maturity date of each contract,
c. discuss with management the tax impli-
• the current market price and cost of
cations of losses resulting from securities
each contract, and
sales.
• the amount held in margin accounts:
16. Determine that proper risk diversification — All futures contracts and forward
exists within the portfolio by— and standby and options contracts
a. reviewing totals of holdings by single are revalued on the basis of market
obligor or industry, related obligors or or the lower of cost or market at
industries, geographic distribution, yields, each month-end.
and securities that have special charac- — Securities acquired as the result of
teristics (include individual due from completed contracts are valued at
bank accounts from the list received the lower of cost or market upon
from the bank or from the examiner settlement.
assigned ‘‘Due from Banks’’ and all — Fee income received by the bank
money market instruments) and— on standby contracts is accounted
• detail, as concentrations, all holdings for properly.
equaling 25 percent or more of capital — Financial reports disclose futures,
funds and forwards, options, and standby
• list all holdings equaling at least activity.
10 percent but less than 25 percent of — The bank has instituted a system
capital funds and submit that informa- for monitoring credit-risk exposure
tion to the examiner assigned ‘‘Loan in forward and standby contract
Portfolio Management’’ (These hold- activity.
ings will be combined with any addi- — The bank’s internal controls, man-
tional advances in the lending areas.) agement reports, and audit proce-
and dures are adequate to ensure adher-
b. performing a credit analysis of all non- ence to policy.
rated holdings determined to be a con- 18. If the bank is engaged in financial futures,
centration if not performed in step 9. forward placement, options, or standby con-
17. If the bank is engaged in financial futures, tracts, determine if the contracts have a
exchange-traded puts and calls, forward reasonable correlation to the bank’s busi-
placement, or standby contracts, determine ness needs (including gap position) and
if— capacity to fulfill its obligations under the
a. the policy is specific enough to outline contracts by—
permissible contract strategies and their a. comparing the contract commitment and
relationships to other banking activities; maturity dates to anticipated offset,
b. recordkeeping systems are sufficiently b. reporting significant gaps to the examiner
detailed to permit a determination of assigned ‘‘Asset/Liability Management’’
whether operating personnel have (refer to step 13),

Page 5
c. comparing the amounts of outstanding d. reviewing pledge agreements and secured

contracts to the amounts of the antici- liabilities and determining that—
pated offset, • proper custodial procedures have been
d. ascertaining the extent of the correlation followed,
between expected interest-rate move- • eligible securities are pledged,
ments on the contracts and the antici- • securities pledged are sufficient to
pated offset, and secure the liability that requires
e. determining the effect of the loss recog- securing,
nition on future earnings, and, if sig- • Treasury Tax and Loan Remittance
nificant, reporting it to the examiner Option and Note Option are properly
assigned ‘‘Analytical Review and secured, and
Income and Expense.’’ • private deposits are not being secured;
19. On the basis of pricings, ratings, and credit
analyses performed above, and using the (Information needed to perform the
investments selected in step 7 or from lists above steps will be contained in the
previously obtained, test for compliance pledge agreement; Treasury circulars 92
with applicable laws and regulations by— and 176, as amended.)
a. determining if the bank holds type II or e. reviewing accounting procedures to
III investments that are predominantly determine that—
speculative in nature or securities that • investment premiums are being extin-
are not marketable (12 CFR 1.3(b)); guished by maturity or call dates (12
b. reviewing the recap of investment CFR 1.11),
securities by legal types, as defined by
• premium amortization is charged to
12 CFR 1, on the basis of the legal
operating income (12 CFR 1.11),
restrictions of 12 USC 24 and competent
legal opinions, as follows: • accretion of discount is included in
• If a type II or III security is readily current income for banks required to
marketable, and if the purchaser’s judg- use accrual accounting for reporting
ment was based on evidence of the purposes,
obligor’s ability to perform, determine • accretion of bond discount requires a
if the par value of such securities concurrent accrual of deferred income
issued by a single obligor, which the tax payable, and
bank owns or is committed to pur- • securities gains or losses are reported
chase, exceeds 10 percent of the bank’s net of applicable taxes and net gains or
capital funds (12 CFR 1.5(a) and losses are reflected in the period in
1.7(a)). which they are realized;
• If the holding of a type II or III f. determining if securities purchased under
security was based on a reliable esti- agreement to resell are in fact securities
mate of the obligor’s ability to per- (not loans), are eligible for investment
form, determine if the aggregate par by the bank, and are within prescribed
value of such issues exceeds 5 percent limits (12 USC 24 and 12 CFR 1). If not,
of the bank’s capital funds (12 CFR determine whether the transaction is
1.5(b) and 1.7(b)); within applicable state legal lending
c. for those investment securities that are limits;
convertible into stock or which have g. reviewing securities sold under agree-
stock purchase warrants attached— ment to repurchase and determining
• determining if the book value has been whether they are, in fact, deposits (Regu-
written down to an amount that repre- lation D, 12 CFR 204.2(a)(1));
sents the investment value of the secu- h. determining that securities and money
rity, independent of the conversion or market investments held by foreign
warrant provision (12 CFR 1.10) and branches comply with section 211.3 of
• determining if the par values of other Regulation K—Foreign Branches of
securities that have been ruled eligible Member Banks (12 CFR 211.3) as to—
for purchase are within specified capi- • acquiring and holding securities (sec-
tal limitations; tion 211.3(b)(3)) and

Page 6
• underwriting, distributing, buying, and market instruments of affiliated banks

selling obligations of the national gov- or firms (section 23A, Federal Reserve
ernment of the country in which the Act, and 12 USC 371(c)).
branch is located (section 211.3(b)(4)); • Determine if transactions involving
and affiliates, insiders, or their interests
have terms that are less favorable to
(Further considerations relating to the
the bank than transactions involving
above are contained in other sections of
unrelated parties (sections 23A and 22,
Regulation K. Also review any applica-
Federal Reserve Act, and 12 USC
ble sections of Regulation T—Credit by
371c, 375, 375a, and 375b).
Brokers and Dealers (12 CFR 220),
b. Determine if Federal Reserve stock
Regulation X—Borrowers of Securities
equals 3 percent of the subject bank’s
Credit (12 CFR 224), and Board Inter-
booked capital and surplus accounts
pretations 6150 (regarding securities
(Regulation I, 12 CFR 209).
issued or guaranteed by the International
c. Review the nature and duration of
Bank for Reconstruction and Develop-
federal-funds sales to determine if term
ment) and 6200 (regarding borrowing
federal funds are being sold in an amount
by a domestic broker from a foreign
exceeding the limit imposed by state
broker). Edge Act and agreement corpo-
legal lending limits.
rations are discussed in the Bank-Related
21. With regard to potential unsafe and unsound
Organizations section.
investment practices and possible violations
i. determining that the bank’s equity of the Securities Exchange Act of 1934,
investments in foreign banks comply review the list of securities purchased and/or
with the provisions of section 25 of the sold since the last examination and—
Federal Reserve Act and section 211.5 of a. determine if the bank engages one
Regulation K as to— securities dealer or salesperson for virtu-
• investment limitations (section ally all transactions. If so—
211.5(b)) and • evaluate the reasonableness of the
• investment procedures (section relationship on the basis of the dealer’s
211.5(c)). location and reputation and
20. Test for compliance with other laws and • compare purchase and sale prices to
regulations as follows: independently established market prices
a. Review lists of affiliate relationships and as of trade dates, if appropriate;
lists of directors and principal officers b. determine if investment-account securi-
and their interests. ties have been purchased from the bank’s
• Determine if the bank is an affiliate of own trading department. If so—
a firm that primarily is engaged in • independently establish the market
underwriting or selling securities (12 price as of trade date,
USC 377). • review trading-account purchase and
• Determine if directors or officers are sale confirmations and determine if the
engaged in or employed by firms that security was transferred to the invest-
are engaged in similar activities (12 ment portfolio at market price, and
USC 78, 377, and 378). (It is an • review controls designed to prevent
acceptable practice for bank officers to dumping; and
act as directors of securities companies c. determine if the volume of trading
not doing business in the United States, activity in the investment portfolio
the stock of which is owned by the appears unwarranted. If so—
bank as authorized by the Board of • review investment-account daily led-
Governors of the Federal Reserve gers and transaction invoices to deter-
System.) mine if sales were matched by a like
• Review the list of federal funds sold, amount of purchases,
securities purchased under agreements • determine whether the bank is financ-
to resell, interest-bearing time deposits, ing a dealer’s inventory,
and commercial paper, and determine • compare purchase and sale prices with
if the bank is investing in money independently established market prices

Page 7
as of trade dates, if appropriate. The transferred were nonperforming at the

carrying value should be determined by time of transfer, classified at the previ-
the market value of the securities as of ous examination, depreciated or sub-
the trade date, and investment-grade, or for any other reason
• cross-reference descriptive details on were considered to be of questionable
investment ledgers and purchase con- quality.
firmations to the actual bonds or safe- c. Review the bank’s policies and proce-
keeping receipts to determine if the dures to determine whether or not secu-
bonds delivered are those purchased. rities purchased by the bank are given an
22. Discuss with appropriate officer(s) and pre- independent, complete, and adequate
pare report comments on— credit evaluation. If the bank is a holding
a. defaulted issues; company subsidiary or a member of a
b. speculative issues; chain banking organization, review secu-
c. incomplete credit information; rities purchases or participations from
d. absence of legal opinions; affiliates or other known members of the
e. s i g n i f i c a n t c h a n g e s i n m a t u r i t y chain to determine if the securities pur-
scheduling; chases are given an arm’s-length and
f. shifts in the rated quality of holdings; independent credit evaluation by the pur-
g. concentrations; chasing bank.
h. u n b a l a n c e d e a r n i n g s a n d r i s k d. Determine whether or not any bank pur-
considerations; chases of securities from an affiliate are
i. unsafe and unsound investment practices; in conformance with section 23A, which
j. apparent violations of laws, rulings, and generally prohibits purchases of low-
regulations and the potential personal quality assets from an affiliate.
liability of the directorate; e. Determine that any securities purchased
k. significant variances from peer-group by the bank are properly reflected on its
statistics; books at fair market value (fair market
l. market-value depreciation, if significant; value should at a minimum reflect both
m. weaknesses in supervision; the rate of return being earned on such
n. policy deficiencies; and assets and an appropriate risk premium).
o. material problems being encountered by Determine that appropriate write-offs are
the bank’s Edge Act and agreement taken on any securities sold by the bank
corporation affiliates, and other related at less than book value.
international concerns, that could affect f. Determine that transactions involving
the condition of the bank. transfers of low-quality securities to the
23. The following guidelines are to be imple- parent holding company or a nonbank
mented while reviewing securities partici- affiliate are properly reflected at fair
pations, purchases/sales, swaps, or other market value on the books of both the
transfers. The guidelines are designed to bank and the holding company affiliate.
ensure that securities transfers involving g. If poor-quality securities were trans-
state member banks, bank holding compa- ferred to or from another financial insti-
nies, and nonbank affiliates are carefully tution for which the Federal Reserve is
evaluated to determine if they were carried not the primary regulator, prepare a
out to avoid classification and to determine memorandum to be submitted to the
the effect of the transfer on the condition of Reserve Bank supervisory personnel. The
the institution. In addition, the guidelines Reserve Bank will then inform the local
are designed to ensure that the primary office of the primary federal regulator of
regulator of the other financial institution the other institution involved in the trans-
involved in the transfer is notified. fer. The memorandum should include the
a. Investigate any situations in which secu- following information, as applicable:
rities were transferred before the date of • name of originating and receiving
examination to determine if any were institutions
transferred to avoid possible criticism • type of securities involved and type of
during the examination. transfer (i.e., participation, purchase/
b. Determine whether any of the securities sale, swap)

Page 8
• date(s) of transfer conclusion to the examiner assigned ‘‘Man-

• total number and dollar amount of agement Assessment’’ and the examiner
securities transferred who is in charge of the international exami-
• status of the securities when trans- nation, if applicable.
ferred (e.g., rating, depreciation, non- 25. Update workpapers with any information
performing, classified, etc.) that will facilitate future examination. If the
• any other information that would be bank has overseas branches, indicate those
helpful to the other regulator. securities requiring review during the next
24. Reach a conclusion regarding the quality of overseas examination and the reasons for
department management. Communicate your the review.

Page 9
Review the bank’s internal controls, policies, board of directors or its investment
practices, and procedures regarding purchases, committee,
sales, and servicing of the investment portfolio. c. are maximums established for the
The bank’s system should be documented in a amount of each type of asset,
complete, concise manner and should include, d. are maximums established for the
where appropriate, narrative descriptions, flow amount of each type of asset that may
charts, copies of forms used, and other pertinent be purchased from or sold to any one
information. Items marked with an asterisk bank,
require substantiation by observation or testing. e. do money market investment policies
outline acceptable maturities, and
f. have credit standards and review proce-
POLICIES dures been established?
1. Has the board of directors, consistent with

its duties and responsibilities, adopted writ-
ten investment securities policies, includ- CUSTODY OF SECURITIES
ing WI securities, futures, and forward
placement contracts, that outline— *8. Do procedures preclude the custodian of
a. objectives, the bank securities from—
b. permissible types of investments, a. having sole physical access to securities;
c. diversification guidelines to prevent b. preparing release documents without
undue concentration, the approval of authorized persons;
d. maturity schedules, c. preparing release documents not subse-
e. limitation on quality ratings, quently examined or tested by a second
f. policies regarding exceptions to stan- custodian; and
dard policy, and d. performing more than one of the fol-
g. valuation procedures and frequency? lowing transactions: (1) execution of
2. Are investment policies reviewed at least trades, (2) receipt or delivery of secu-
annually by the board to determine if they rities, (3) receipt and disbursement of
are compatible with changing market proceeds?
conditions? *9. Are securities physically safeguarded to
3. Are securities designated at time of pur- prevent loss or unauthorized removal or
chase as to whether they are investments use?
for the portfolio or trading account? 10. Are securities, other than bearer securities,
4. Have policies been established governing held only in the name or nominee of the
the transfer of securities from the trading bank?
account to the investment-securities
account? 11. When a negotiable certificate of deposit is
acquired, is the certificate safeguarded in
5. Have limitations been imposed on the
the same manner as any other negotiable
investment authority of officers?
investment instrument?
*6. Do security transactions require dual
authorization?
7. If the bank has due from commercial
banks or other depository institutions time, RECORDS
federal funds sold, commercial paper,
securities purchased under agreements to 12. Do subsidiary records of investment
resell, or any other money market type of securities show all pertinent data describ-
investment— ing the security; its location; pledged or
a. is purchase or sale authority clearly unpledged status; premium amortization;
defined, discount accretion; and interest earned,
b. are purchases or sales reported to the collected, and accrued?

Page 1
2020.4 Investment Securities and End-User Activities: Internal Control Questionnaire
*13. Is the preparation and posting of subsidi- b. notified in writing of revocation of

ary records performed or reviewed by trading authority?
persons who do not also have sole custody 22. Has the bank established futures and for-
of securities? ward trading limits—
*14. Are subsidiary records reconciled at least a. for individual traders,
monthly to the appropriate general-ledger b. for total outstanding contracts,
accounts, and are reconciling items inves- c. which are endorsed by the board or an
tigated by persons who do not also have appropriate board committee, and
sole custody of securities? d. the basis of which is fully explained?
15. For international-division investments, are 23. Does the bank obtain prior written approval
entries for U.S. dollar carrying values of detailing amount of, duration, and reason—
foreign currency–denominated securities a. for deviations from individual limits
rechecked at inception by a second and
person? b. for deviations from gross trading limits?
24. Are these exceptions subsequently submit-
ted to the board or an appropriate board
PURCHASES, SALES, AND committee for ratification?
REDEMPTIONS 25. Does the trader prepare a prenumbered
trade ticket?
*16. Is the preparation and posting of security 26. Does the trade ticket contain all of the
and open contractual commitments pur- following information:
chase, sale, and redemption records per- a. trade date
formed or reviewed by persons who do not b. purchase or sale
also have sole custody of securities or c. contract description
authorization to execute trades? d. quantity
*17. Are supporting documents, such as brokers’ e. price
confirmations and account statements for f. reason for trade
recorded purchases and sales checked or g. reference to the position being matched
reviewed subsequently by persons who do (immediate or future case settlement)
not also have sole custody of securities or h. signature of trader
authorization to execute trades? 27. Are the accounting records maintained and
*18. Are purchase confirmations compared to controlled by persons who cannot initiate
delivered securities or safekeeping re- trades?
ceipts to determine if the securities deliv- 28. Are accounting procedures documented in
ered are the securities purchased? a procedures manual?
29. Are all incoming trade confirmations—
a. received by someone independent
of the trading and recordkeeping
FUTURES CONTRACTS, functions and
FORWARD PLACEMENT b. verified to the trade tickets by this
CONTROLS independent party?
30. Does the bank maintain general-ledger
19. Do futures and forward contract policies— control accounts disclosing, at a
a. outline specific strategies and minimum—
b. relate permissible strategies to other a. futures or forward contracts memo-
banking activities? randa accounts,
20. Are the formalized procedures used by the b. deferred gains or losses, and
trader— c. margin deposits?
a. documented in a manual and 31. Are futures and forward contracts
b. approved by the board or an appropriate activities—
board committee? a. supported by detailed subsidiary records
21. Are the bank’s futures commission mer- and
chant(s) and/or forward brokers— b. agreed daily to general-ledger controls
a. notified in writing to trade with only by someone who is not authorized to
those persons authorized as traders and prepare general-ledger entries?

Page 2
Investment Securities and End-User Activities: Internal Control Questionnaire 2020.4
32. Do periodic statements received from OTHER

futures commission merchants reflect—
a. trading activity for the period, 39. Does the board of directors receive regular
b. open positions at the end of the period, reports on domestic and international-
c. market value of open positions, division investment securities which
d. unrealized gains and losses, and include—
e. cash balances in accounts? a. valuations,
33. Are all of these periodic statements— b. maturity distributions,
a. received by someone independent of c. average yield, and
both the trading and recordkeeping d. reasons for holding and benefits received
functions and (international-division and overseas
b. reconciled to all of the bank’s account- holdings only)?
ing records? 40. Are purchases, exchanges, and sales of
34. Are the market prices reflected on the securities and open contractual commit-
statements— ments ratified by action of the board of
a. verified with listed prices from a pub- directors or its investment committee and
lished source and thereby made a matter of record in the
b. used to recompute gains and losses? minutes?
35. Are daily reports of unusual increases in
trading activity reviewed by senior
management?
36. Are weekly reports prepared for an
CONCLUSION
appropriate board committee which 41. Is the foregoing information an adequate
reflect— basis for evaluating internal control in
a. all trading activity for the week, that there are no significant deficiencies
b. open positions at the end of the week, in areas not covered in this questionnaire
c. market value of open positions, that impair any controls? Explain nega-
d. unrealized gains and losses, tive answers briefly and indicate any
e. total trading limits outstanding for the additional examination procedures deemed
bank, and necessary.
f. total trading limits for each authorized 42. Based on a composite evaluation, as
trader? evidenced by answers to the foregoing
37. Is the futures and forward contracts port- questions, internal control is considered
folio revalued monthly to market value or (adequate/inadequate).
to the lower of cost or market?
38. Are revaluation prices provided by per-
sons or sources totally independent of the
trading function?

Page 3
Bank Dealer Activities
A bank operates as a securities dealer when it The volume of bank dealer activity and the
underwrites, trades, or deals in securities. These dealer’s capacity in the transaction are critical to
activities may be administered in a separately an examiner’s assessment regarding the exami-
identifiable trading department or incorporated nation scope and the required examiner resources
within the overall treasury department. The and expertise. Dealers engaging primarily in
organizational structure will generally be a agency or riskless-principal transactions are
function of the level of activity and the merely accommodating customers’ investment
importance of the activity as a product line. If a needs. Market risk will be nominal, and the key
repetitive pattern of short-term purchases and examination concern will be operational risk
sales demonstrates that the bank holds itself out and efficiency. Active dealers generally carry
to other dealers or investors as a securities larger inventory positions and may engage in
dealer, the bank is trading, regardless of what some degree of proprietary trading. Their market-
department or section of the bank is engaged in risk profile may be moderate to high.
the activity. Bank dealers’ securities transactions involve
The authority under which a bank may customers and other securities dealers. The word
engage in securities trading and underwriting is ‘‘customer,’’ as used in this section, means an
found in section 5136 of the Revised Statutes investor. Correspondent banks purchasing secu-
(12 USC 24 (seventh)). That authority is rities for an investment account would also be
restricted by limitations on the percentage hold- considered a customer. Transactions with other
ing of classes of securities as found in 12 CFR dealers are not considered customer transactions
1.3. This regulation allows banks to deal, unless the dealer is buying or selling for invest-
underwrite, purchase, and sell (1) type I securi- ment purposes.
ties without limit and (2) type II securities The following subsections include general
subject to a limit of 10 percent of capital and descriptions of significant areas of bank trading
unimpaired surplus per issue. Banks are and underwriting activities. Foreign exchange is
prohibited from underwriting or dealing in type covered in detail in the ‘‘International’’ sections
III securities for their own accounts. See sec- of this manual. Additional bank dealer activities,
tion 2020.1, ‘‘Investment Securities and End- particularly in derivative products, are exten-
User Activities,’’ for further information on sively covered in the Trading and Capital-
types I, II, and III securities. Markets Activities Manual. In addition, many
Banks are involved in three major types of money-center banks and larger regional banks
securities transactions. First, the bank, acting as have transferred dealing activities to separately
broker, buys and sells securities on behalf of a capitalized holding company subsidiaries (known
customer. These are agency transactions in which as underwriting affiliates). The Bank Holding
the agent (bank) assumes no substantial risk and Company Supervision Manual contains a sepa-
is compensated by a prearranged commission or rate section on nonbank subsidiaries engaged in
fee. A second type of securities transaction underwriting and dealing in bank-ineligible
banks frequently execute is a ‘‘riskless-principal’’ securities.
trade. Upon the order of an investor, the dealer
buys (or sells) securities through its own account,
with the purchase and sale originating almost OVERVIEW OF RISK
simultaneously. Because of the brief amount of
time the security is held in the dealer’s own For bank dealer activities, risk is generally
account, exposure to market risks is limited. defined as the potential for loss on an instrument
Profits result from dealer-initiated markup (the or portfolio. Significant risk can also arise from
difference between the purchase and sale prices). operational weakness and inadequate controls.
Finally, as a dealer, the bank buys and sells Risk management is the process by which man-
securities for its own account. This is termed a agers identify, assess, and control all risks asso-
principal transaction because the bank is acting ciated with a financial institution’s activities.
as a principal, buying or selling qualified secu- The increasing complexity of the financial
rities through its own inventory and absorbing industry and the range of financial instruments
whatever market gain or loss is made on banks use have made risk management more
the transaction. difficult to accomplish and evaluate.

Page 1
2030.1 Bank Dealer Activities
The four fundamental elements for evaluating basis. In more sophisticated institutions, the role
the risk-management process for bank dealer of risk management is to identify the risks
activities are— associated with particular business activities
and to aggregate summary data into generic
• active board and management oversight, components, ultimately allowing exposures to
• adequate risk-management policies and limits, be evaluated on a common basis. This method-
• appropriate risk measurement and manage- ology enables institutions to manage risks by
ment information systems, and portfolio and to consider exposures in relation-
• comprehensive internal controls and audit ship to the institution’s global strategy and risk
procedures. tolerance.
A review of the global organization may
For risk management to be effective, an institu- reveal risk concentrations that are not readily
tion’s board and senior management must be identifiable from a limited, stand-alone evalua-
active participants in the process. They must tion of a branch, agency, Edge Act institution,
ensure that adequate policies and risk-tolerance nonbank subsidiary, or head office. Consolidated
limits are developed for managing the risk in risk management also allows the institution to
bank dealer activities, and they must understand, identify, measure, and control its risks, while
review, and approve these limits across all giving necessary consideration to the break-
established product lines. For policies and limits down of exposure by legal entity. Sometimes, if
to be effective and meaningful, risk measures, applicable rules and laws allow, identified risks
reports, and management information systems at a branch or subsidiary may be offset by
must provide management and the board with exposures at another related institution. How-
the information and analysis necessary to make ever, risk management across separate entities
timely and appropriate responses to changing must be done in a way that is consistent with the
conditions. Risk management must also be sup- authorities granted to each entity. Some finan-
ported by comprehensive internal controls and cial institutions and their subsidiaries may not
audit procedures that provide appropriate checks be permitted to hold, trade, deal, or underwrite
and balances to maintain an ongoing process of certain types of financial instruments unless they
identifying any emerging weaknesses in an have received special regulatory approval.
institution’s management of risk.1 At a mini- Examiners should ensure that a financial insti-
mum, the effectiveness of the institution’s tution only engages in those activities for which
policies, limits, reporting systems, and internal it has received regulatory approval. Further-
controls must be reviewed annually. more, examiners should verify that the activities
In assessing the adequacy of the above ele- are conducted in accordance with any Board
ments at individual institutions, examiners should conditions or commitments attached to the regu-
consider the nature and volume of a bank’s latory approval.
dealer activities and its overall approach toward Ideally, an institution should be able to iden-
managing the various types of risks involved. tify its relevant generic risks and should have
The sophistication or complexity of policies and measurement systems in place to quantify and
procedures used to manage risk depends on the control these risks. While it is recognized that
bank dealer’s chosen products, activities, and not all institutions have an integrated risk-
lines of business. Accordingly, examiners should management system that aggregates all business
expect risk-management activities to differ activities, the ideal management tool would
among institutions. incorporate a common measurement denomina-
As a financial institution’s product offerings tor. Risk-management methodologies in the
and geographic scope expand, examiners must marketplace and an institution’s scope of busi-
review the risk-management process not only by ness are continually evolving, making risk man-
business line, but on a global, consolidated agement a dynamic process. Nonetheless, an
institution’s risk-management system should
1. Existing policies and examiner guidance on various always be able to identify, aggregate, and con-
topics applicable to the evaluation of risk-management sys- trol all risks posed by underwriting, trading, or
tems can be found in SR-93-69, ‘‘Examining Risk Manage- dealing in securities that could have a significant
ment and Internal Controls for Trading Activities of Banking
Organizations.’’ Many of the managerial and examiner prac-
impact on capital or equity.
tices contained in this document are fundamental and are Trading and market-risk limits should be
generally accepted as sound practices for trading activities. customized to address the nature of the products

Page 2
Bank Dealer Activities 2030.1
and any unique risk characteristics. Common • Clearing or settlement risk is (1) the risk that
types of limits include earnings-at-risk limits, a counterparty who has received a payment or
stop-loss limits, limits on notional amounts delivery of assets defaults before delivery of
(both gross and duration-weighted), maturity the asset or payment or (2) the risk that
limits, and maturity-gap limits. The level of technical difficulties interrupt delivery or
sophistication needed within the limit matrix settlement despite the counterparty’s ability or
will depend on the type of instrument involved willingness to perform.
and the relative level of trading activity. Straight- • Operations and systems risk is the risk of
forward notional and tenor limits may be human error or fraud, or the risk that systems
adequate for most dealers; however, dealers will fail to adequately record, monitor, and
involved in a wide array of products and more account for transactions or positions.
complex transactions will need stronger tools to • Legal risk is the risk that a transaction cannot
measure and aggregate risk across products. be consummated as a result of some legal
In general, risk from trading and dealing barrier, such as inadequate documentation, a
activities can be broken down into the following regulatory prohibition on a specific counter-
categories: party, non-enforceability of bilateral and mul-
tilateral close-out netting, or collateral arrange-
• Market or price risk is the exposure of an ments in bankruptcy.
institution’s financial condition to adverse
movements in the market rates or prices of its The Trading and Capital-Markets Activities
holdings before such holdings can be liqui- Manual contains a comprehensive discussion of
dated or expeditiously offset. It is measured these risks, including examination objectives,
by assessing the effect of changing rates or procedures, and internal control questionnaires
prices on either the earnings or economic by risk category.
value of an individual instrument, a portfolio,
or the entire institution.
• Funding-liquidity risk refers to the ability to
meet investment and funding requirements GOVERNMENT AND AGENCY
arising from cash-flow mismatches. SECURITIES
• Market-liquidity risk refers to the risk of being
unable to close out open positions quickly The government securities market is dominated
enough and in sufficient quantities at a reason- by a number of investment banks, broker-
able price. dealers, and commercial banks known as pri-
• Credit risk is the risk that a counterparty to a mary dealers in government securities. These
transaction will fail to perform according to dealers make an over-the-counter market in
the terms and conditions of the contract, thus most government and federal-agency securities.
causing the security to suffer a loss in cash- Primary dealers are authorized to deal directly
flow or market value. Because securities settle- with the Open Market Desk of the Federal
ments are typically ‘‘delivery vs. payment’’ Reserve Bank of New York. As market makers,
and settlement periods are relatively short, primary dealers quote bid-ask prices on a wide
securities transactions do not involve a signifi- range of instruments, and many publish daily
cant level of counterparty credit risk. Repur- quotation sheets or provide live electronic data
chase transactions, securities lending, and feeds to larger customers or other dealers.
money market transactions, however, involve Government securities trading inventories are
significantly higher levels of credit risk if not generally held with the objective of making
properly controlled. As a result, credit risk is short-term gains through market appreciation
discussed in greater detail in the subsections and dealer-initiated markups. Common factors
addressing these products. Credit risk can also that affect the markup differential include the
arise from positions held in trading inventory. size of a transaction, the dealer efforts extended,
Although U.S. government and agency secu- the type of customer (active or inactive), and the
rities do not generally involve credit risk, nature of the security. Markups on government
other securities (for example, municipal and securities generally range between 1⁄32 and 4⁄32 of
corporate securities) carried in inventory can a point. Long-maturity issues or derivative prod-
decline in price due to a deterioration in credit ucts may have higher markups due to the higher
quality. risk and potentially larger volatility that may be

Page 3
inherent in these products. profit. Short sales are conducted to (1) accom-
According to industry standards, payments modate customer orders, (2) obtain funds by
for and deliveries of U.S. government and most leveraging existing assets, (3) hedge the market
agency securities are settled one business day risk of other assets, or (4) allow a dealer to profit
following the trade date, although government from a possible future decline in market price by
dealers and customers can negotiate same-day purchasing an equivalent security at a later date
or delayed settlement for special situations. at a lower price.
When-Issued Trading Government Securities Clearing

A significant potential source of risk to dealers
Securities-clearing services for the bulk of U.S.
involves ‘‘when-issued’’ (WI) trading in govern-
government securities transactions and many
ment securities. WI trading is the buying and
federal-agency securities transactions are pro-
selling of securities in the one- to two-week
vided by the Federal Reserve as part of its
interim between the announcement of an offer-
electronic securities-transfer system. The vari-
ing and the security auction and settlement.
ous Federal Reserve Banks will wire-transfer
Although the vast majority of transactions settle
most government securities between the book-
on the next business day, WI trading results in a
entry safekeeping accounts of the seller and
prolonged settlement period. This could increase
buyer. The Federal Reserve’s systems are also
both the market risk and counterparty credit risk
used to facilitate security borrowings, loans, and
associated with trading these instruments. The
pledges.
prolonged settlement period also provides an
opportunity for a dealer to engage in a large
volume of off-balance-sheet trading without hav-
ing to fund the assets or cover the short posi- Government Securities Act
tions. In essence, WI trading allows the dealers
to create securities. If the overall level of WI In response to the failures of a number of
trading is significant in relation to the size of the unregulated government securities dealers
issue, the resulting squeeze on the market could between 1975 and 1985, Congress passed the
increase volatility and risk. Given these poten- Government Securities Act of 1986 (GSA).
tial risk characteristics, WI trading should be GSA established, for the first time, a federal
subject to separate sublimits to cap the potential system for the regulation of the entire govern-
exposure. ment securities market, including previously
unregulated brokers and dealers. The primary
goal of GSA was to protect investors and ensure
Short Sales the maintenance of a fair, honest, and liquid
market.
Another area of U.S. government securities The GSA granted the Department of the
activity involves short-sale transactions. A short Treasury (Treasury) authority to develop and
sale is the sale of a security that the seller does implement rules for transactions in government
not own at the time of the sale. Delivery may and agency securities effected by government
be accomplished by buying the security or by securities brokers or dealers (that is, securities
borrowing the security. When the security deliv- firms as well as other financial institutions), and
ered is borrowed, the short seller likely will to develop and implement regulations relating to
ultimately have to acquire the security in order the custody of government securities held by
to satisfy its repayment obligation. The borrow- depository institutions. The rules were intended
ing transaction is collateralized by a security (or to prevent fraudulent and manipulative acts and
securities) of similar value or cash (most likely practices and to protect the integrity, liquidity,
the proceeds of the short sale). Reverse repur- and efficiency of the government securities mar-
chase transactions are also used to obtain the ket. At the same time, the rules were designed to
security needed to make delivery on the security preclude unfair discrimination among brokers,
sold short. Carrying charges on borrowed gov- dealers, and customers. Enforcement of the rules
ernment securities should be deducted from the for the GSA is generally carried out by an
short sale and purchase spread to determine net institution’s primary regulatory organization.

Page 4
The rules for the GSA had the most U.S. Treasury securities are exempt from
significant effect on those entities that were not registration.
previously subject to any form of federal Limited government securities brokerage
registration and regulation. These entities activities are also exempt from registration under
included not only firms registered as govern- certain circumstances. Banks that engage in
ment securities brokers or dealers but also firms fewer than 500 government securities transac-
registered as brokers or dealers trading in other tions annually (excluding savings bond transac-
securities and financial products. For the first tions and Treasury tender offers) are exempt.
time, the government securities activities of Similarly, banks are exempt if they deal with a
these entities were subject to the discipline of registered broker-dealer under a ‘‘networking’’
financial responsibility, customer protection, arrangement, assuming they meet the following
recordkeeping, and advertising requirements. conditions: (1) the transacting broker must be
For nonbank dealers, this regulation is enforced clearly identified, (2) bank employees perform
by a self-regulatory organization, the Financial only clerical or administrative duties and do not
Industry Regulatory Authority (FINRA), which receive transaction-based compensation, and
conducts routine examinations under the (3) the registered broker-dealer receives and
oversight of the Securities and Exchange Com- maintains all required information on each cus-
mission (SEC). tomer. Exempt networking arrangements must
The provisions of the GSA that had the most be fully disclosed to the customer. Finally, banks
significant effect on government securities bro- are exempt from registration requirements if their
kers and dealers (both bank and nonbank broker- activities are limited to purchases and sales in a
dealers) relate to hold-in-custody repurchase fiduciary capacity or purchases and sales of
agreement rules. Congress targeted this area repurchase or reverse repurchase agreements.
because of abuses that had resulted in customer The preceding exemptions provide relief from
losses. Several requirements to strengthen cus- registration, but exempt banks must comply (if
tomer protection were imposed: (1) written applicable) with regulations addressing custo-
repurchase agreements must be in place, (2) the dial holdings for customers (17 CFR 450).
risks of the transactions must be disclosed to the Additionally, banks effecting repurchase/reverse
customer, (3) specific repurchase securities must repurchase agreements must comply with
be allocated to and segregated for the customer, repurchase-transaction requirements detailed in
and (4) confirmations must be made and pro- 17 CFR 403.5(d).
vided to the customer by the end of the day on
which a transaction is initiated and on any day
on which a substitution of securities occurs. For
a more detailed description of the rules for the MUNICIPAL SECURITIES
GSA requirements, see the procedures for the
examination of government securities activities Municipal securities are debt obligations issued
issued by the Board of Governors of the Federal by state and local governments and certain
Reserve System, or 17 CFR 400–450 for the agencies and authorities. There are two broad
actual text of the regulations. categories of municipal bonds: general obliga-
tion bonds and revenue bonds. General obliga-
tion bonds (GOs) are backed by the full faith
and credit and taxing authority of the govern-
Registration Exemptions ment issuer. General obligation bonds are either
limited or unlimited tax bonds. Limited tax
Most banks acting as government securities bonds are issued by government entities whose
brokers or dealers are required to file a form taxing authority is limited to some extent by law
known as a G-FIN. This form details the bank’s or statute. For instance, a local government may
capacity, the locations where government secu- face restrictions on the level of property taxes it
rities activities are performed, and the persons can levy on property owners. State and local
responsible for supervision. However, cer- entities may also issue special tax bonds, which
tain bank government securities activities are are supported by a specific tax. For instance, a
exempt from the filing requirements. Banks highway project may be financed by a special
handling only U.S. savings bond transactions or gasoline tax levied to pay for the bonds. Unlim-
submitting tender offers on original issue ited tax bonds are issued by government

Page 5
entities that are not restricted by law or statute in security issues have complex structures that
the amount of taxes they can levy; however, require an increased level of technical expertise
there may be some political limitations. to evaluate. As with all areas of banking, dealers
Municipal revenue bonds are backed by a who invest in complex instruments are expected
specific project or government authority, and to understand the characteristics of the instru-
they are serviced by fees and revenues paid by ments and how these instruments might affect
users of the government entity. Revenue bonds their overall risk profile. While there are some
are backed by public power authorities, non- large issuers, like the states of New York and
profit hospitals, housing authorities, transporta- California, most issuers are small government
tion authorities, and other public and quasi- entities that place modest amounts of debt.
public entities. Many of these issues are exempt from federal,
Effective March 13, 2000, well-capitalized state, and local income taxes; these exemptions,
state member banks were authorized by the in part, determine the investor base for munici-
Gramm-Leach-Bliley Act (GLB Act) to deal in, pal bonds.
underwrite, purchase, and sell municipal rev- The customer base for tax-exempt municipal
enue bonds without any limitations based on the securities is investors who benefit from income
bank’s capital. (See 12 USC 24 (seventh).) that is exempt from federal income tax. This
Previously, banks were limited to only under- group includes institutional investors, such as
writing, dealing in, or investing in, without insurance companies, mutual funds, and retail
limitation, general obligation municipal bonds investors, especially individuals in high income-
backed by the full faith and credit of an issuer tax brackets.
with general powers of taxation. Member banks
could invest in, but not underwrite or deal in,
municipal revenue bonds, but the purchases and
sales of such investment securities for any Credit Risk
obligor were limited to 10 percent of a member
bank’s capital and surplus. As a result of the Municipal securities activities involve differing
GLB Act amendment, municipal revenue bonds degrees of credit risk depending on the financial
are the equivalent of type I securities for well- capacity of the issuer. Larger issuers of munici-
capitalized state member banks.2 (See SR-01- pal securities are rated by nationally recognized
13.) Banks that are not well capitalized may rating agencies (Moody’s, S&P, etc.). Other
engage in more limited municipal securities municipalities achieve an investment-grade
activities relating to type II and type III securi- rating through the use of credit enhancements,
ties. For example, banks may also deal in, usually in the form of a standby letter of credit
underwrite, or invest in revenue bonds that are issued by a financial institution. Banks are also
backed by housing, university, or dormitory involved in underwriting and placing nonrated
projects. municipal securities. Nonrated issues are typi-
In addition to municipal bonds, state and local cally small and are placed with a limited number
governments issue obligations to meet short- of investors. Liquidity in the secondary market
term funding needs. These obligations are nor- is limited, and bank dealers rarely carry non-
mally issued in anticipation of some specific rated issues in trading inventory.
revenue. The types of debt issued include tax-
anticipation notes (TANs), revenue-anticipation Management should take steps to limit undue
notes (TRANs), grants-anticipation notes concentrations of credit risk arising from
(GANs), bond-anticipation notes (BANs), municipal-security underwriting and dealing.
commercial paper, and others. Exposure to nonrated issuers should be approved
Because of the large number and diverse through the bank’s credit-approval process with
funding needs of state and local governments appropriate documentation to support the issu-
(over 50,000 state and local governments have er’s financial capacity. Activity in nonrated
issued debt in the United States), there is a wide issues outside the bank’s target or geographic
variety of municipal securities. Some municipal market should also be avoided. In addition,
2. The Office of the Comptroller of the Currency published

final amendments to its investment securities regulation (12
CFR 1) on July 2, 2001. (See 66 Fed. Reg. 34784.)

Page 6
exposure should be aggregated on a consoli- detailed procedures performed by the Federal

dated basis, taking into account additional credit Reserve examiners, see the Municipal Securities
risk arising from traditional banking products Dealer Bank Examination Manual issued by the
(loans, letters of credit, etc.). Board of Governors of the Federal Reserve
System.
Municipal Securities Rulemaking

Board REPURCHASE AGREEMENTS
AND SECURITIES LENDING
The Securities Act Amendments of 1975 (15 USC
78o-4) extended a comprehensive network of Repurchase agreements (repos) play an impor-
federal regulation to the municipal securities tant role in the securities markets. A repo is the
markets. Pursuant to the act, municipal securi- simultaneous agreement to sell a security and
ties brokers and dealers are required to register repurchase it at a later date. Reverse repos are
with the SEC. The act also created a separate, the opposite side of the transaction, securities
self-regulatory body, the Municipal Securities purchased with a later agreement to resell. From
Rulemaking Board (MSRB), to formulate work- the dealer’s perspective, a repo is a financing
ing rules for the regulation of the municipal transaction (liability), and a reverse repo is a
securities industry. The Federal Reserve is lending transaction (asset). Overnight repos are
required to ensure compliance with those rules a one-day transaction; anything else is referred
as they apply to state member banks. to as a ‘‘term repo.’’ Approximately 80 percent
A bank engaged in the business of buying and of the repo market is overnight. Although any
selling municipal securities must register with security can be used in a repurchase transaction,
the SEC as a municipal securities dealer if it is the overwhelming majority of transactions
involved in— involve government securities.
Securities dealers use repos as an important
• underwriting or participating in a syndicate or source of liquidity. The majority of government
joint account for the purpose of purchasing securities trading inventory will typically be
securities; financed with repos. Reverse repos are used to
• maintaining a trading account or carrying obtain securities to meet delivery obligations
dealer inventory; or arising from short positions or from the failure
• advertising or listing itself as a dealer in trade to receive the security from another dealer.
publications, or otherwise holding itself out to Reverse repos also are an effective and low-risk
other dealers or investors as a dealer. means to invest excess cash on a short-term
basis.
Generally, a bank that buys and sells municipal The repo rate is a money market rate that is
securities for its investment portfolio or in a lower than the federal funds rate due to the
fiduciary capacity is not considered a dealer. collateralized nature of the transaction. Oppor-
If a bank meets the SEC’s criteria for regis- tunities also arise to obtain below-market-rate
tering as a municipal securities dealer, it must financing. This situation arises when demand
maintain a separately identifiable department or exceeds supply for a specific bond issue and it
division involved in municipal securities dealing goes on ‘‘special.’’ Dealers who own the bond or
that is under the supervision of officers desig- control it under a reverse repo transaction can
nated by the bank’s board of directors. These earn a premium by lending the security. This
designated officers are responsible for municipal premium comes in the form of a below-market-
securities dealer activities and should maintain rate financing cost on a repo transaction.
separate records. Many of the larger dealers also engage in
The Federal Reserve conducts a separate proprietary trading of a matched book, which
examination of the municipal securities dealer consists of a moderate to large volume of
activities in banks that engage in such activities. offsetting repos and reverse repos. The term
This examination is designed to ensure compli- ‘‘matched book’’ is misleading as the book is
ance with the rules and standards formulated by rarely perfectly matched. Although profit may
the MSRB. For a complete description of the be derived from the capture of a bid/ask spread
activities of a municipal securities dealer and on matched transactions, profit is more often

Page 7
derived from maturity mismatches. In a falling- tions have historically been centered in corpo-
rate environment, traders lend long (reverse rate debt and equity obligations, the market
repos) and borrow short (repos). It is more increasingly involves loans of large blocks of
difficult to profit in rising-rate environments U.S. government and federal-agency securities.
because of the shape of the yield curve, which is To participate in this market, a bank may lend
usually upward-sloping. The overall size of the securities held in its investment account or
matched book and the length of the maturity trading account. Like repos, securities are lent to
mismatches will generally decline in a rising cover fails (securities sold but not available for
environment. Matched books are also used to delivery) and short sales. Collateral for the
create opportunities to control securities that transactions can consist of other marketable
may go on special, resulting in potential profit securities or standby letters of credit; however,
opportunities. Dealers engaging in matched- the large majority of transactions are secured by
book trading provide important liquidity to the cash. Investors are willing to lend securities due
repo market. to the additional investment income that can be
Risk in a matched book should be minimized earned by investing the cash collateral. When a
by establishing prudent limits on the overall size securities loan is terminated, the securities are
of the book, size of maturity mismatches, and returned to the lender and the collateral to the
restrictions on the maximum tenor of instru- borrower.
ments. The overall risk of a matched book is
usually small in relation to other trading port-
folios. Maturity mismatches are generally short-
term, usually 30 to 60 days, but may extend up
Credit Risk
to one year. Risk can be quickly neutralized
by extending the maturity of assets or liabilities. Since repurchase agreements and securities lend-
Financial instruments (futures and forward rate ing transactions are collateralized, credit risk is
agreements) can also be used to reduce risk. relatively minor if properly controlled. Some
Securities dealers may also engage in ‘‘dollar- dealers have underestimated the credit risk
roll’’ transactions involving mortgage-backed associated with the performance of the counter-
securities, which are treated as secured financ- party and have not taken adequate steps to
ings for accounting purposes. The ‘‘seller’’ of ensure their control of the securities serving as
the security agrees to repurchase a ‘‘substan- collateral. The market volatility of the securities
tially identical’’ security from the ‘‘buyer,’’ rather held as collateral can also add to the potential
than the same security. Many of the supervisory credit risk associated with the transaction.
considerations noted above for repurchase agree- As an added measure of protection, dealers
ments also apply to dollar-roll transactions. require customers to provide excess collateral.
However, if the security to be repurchased is not This excess is referred to as ‘‘margin.’’ The size
substantially identical to the security sold, the of the margin will be a function of the volatility
transaction generally should be accounted for as of the instrument serving as collateral and the
a sale and not as a financing arrangement. The length of the transaction. In addition to initial
accounting guidance for ‘‘substantially identi- margin, term repos and security lending arrange-
cal’’ is described in American Institute of Cer- ments require additional margin if the value of
tified Public Accountants (AICPA) Statement of the collateral declines below a specified level.
Position 90-3, which generally requires debt Excess margin is usually returned to the coun-
instruments to have the same primary obligor or
terparty if the value of the collateral increases. A
guarantor, the same form and type, the identical
daily ‘‘mark-to-market’’ or valuation procedure
contractual interest rate, the same maturity or
weighted average maturity, and other factors. must be in place to ensure that calls for addi-
In addition, securities dealers may engage in tional collateral are made on a timely basis. The
securities lending or borrowing transactions. In valuation procedures should be independent of
substance, these transactions are very similar to the trader and take into account the value of
repo transactions except the transactions have accrued interest on debt securities. It is impor-
no stated maturity. The transactions are con- tant to point out that credit risk can arise from
ducted through open-ended ‘‘loan’’ agreements both asset transactions (reverse repos and secu-
that may be terminated on short notice by the rities borrowed) and liability transactions (repos
lender or borrower. Although lending transac- and securities lent) because of market fluctua-

Page 8
tions in collateral provided and received. Deal- should take steps to ensure that cash collateral is
ers should take steps to ensure that collateral invested in appropriate instruments. Cash should
provided is not excessive. be invested in high-quality, short-term money
Policies and procedures should be in place market instruments. Longer-term floating-rate
to ensure transactions are conducted only with instruments may also be appropriate; however,
approved counterparties. Credit-limit approvals illiquid investments and products with custom-
should be based on a credit analysis of the ized features (for example, structured notes with
borrower. An initial review should be per- imbedded options) should be avoided. Several
formed before establishing a relationship, with banks have reported significant losses associated
with inappropriate investments in securities
periodic reviews thereafter. Credit reviews
lending areas.
should include an analysis of the bor-rower’s
financial statement, capital, management, earn-
ings, business reputation, and any other relevant
factors. Analyses should be performed in an Securities-Lending Capacity
independent department of the lender institu-
tion, by persons who routinely perform credit Securities lending may be done in various
analyses. Analyses performed solely by the capacities and with differing associated liabili-
person managing the repo or securities lending ties. It is important that all parties involved
programs are not sufficient. Credit and concen- understand in what capacity the lender institu-
tration limits should take into account other tion is acting. The relevant capacities are
extensions of credit by other departments of the described below.
bank or affiliates. Procedures should be estab-
lished to ensure that credit and concentration
limits are not exceeded without proper authori- Principal
zation from management.
A lender institution offering securities from its
own account is acting as principal. A lender
institution offering customers’ securities on an
Other Uses and Implications of undisclosed basis is also considered to be acting
Securities Lending as principal.
In addition to lending their own securities,

financial institutions have become increasingly Agent
involved in lending customers’ securities held in
custody, safekeeping, trust, or pension accounts. A lender institution offering securities on behalf
These activities are typically organized within of a customer-owner is acting as an agent. To be
the bank’s trust department. Not all institutions considered a bona fide or ‘‘fully disclosed’’
that lend securities or plan to do so have relevant agent, the lending institution must disclose the
experience. Because the securities available for names of the borrowers to the customer-owners
lending often greatly exceed the demand, inex- and the names of the customer-owners to the
perienced lenders may be tempted to ignore borrowers (or give notice that names are avail-
commonly recognized safeguards. Bankruptcies able upon request). In all cases, the agent’s
of broker-dealers have heightened regulatory compensation for handling the transaction should
sensitivity to the potential for problems in this be disclosed to the customer-owner. Undis-
area. closed agency transactions, that is, ‘‘blind bro-
Fees received on securities loans are divided kerage’’ transactions in which participants can-
between the custodial institution and the cus- not determine the identity of the contra party, are
tomer account that owns the securities. In situ- treated as if the lender institution were the
ations involving cash collateral, part of the principal.
interest earned on the temporary investment of
cash is returned to the borrower and the remain-
der is divided between the lender institution and Directed Agent
the customer account that owns the securities.
In addition to a review of controls, examiners A lender institution that lends securities at the

Page 9
direction of the customer-owner is acting as a occur with items such as Eurodollar CDs, bank-
directed agent. The customer directs the lender er’s acceptances, and federal funds, and with
institution in all aspects of the transaction, financial instruments such as futures and
including to whom the securities are loaned, the forwards.
terms of the transaction (rebate rate and maturity/ Although the risk of money market trading is
call provisions on the loan), acceptable collat- relatively straightforward, the potential risk can
eral, investment of any cash collateral, and be significant based on the volume of trading
collateral delivery. and size of the mismatches. Despite the potential
risk, these activities may offer attractive profit
opportunities if effectively controlled. Short-
Fiduciary term interest-rate markets are very liquid, and
risk can be quickly neutralized by changing the
A lender institution that exercises discretion in maturity profile of either assets or liabilities.
offering securities on behalf of and for the Financial instruments (such as futures and for-
benefit of customer-owners is acting as a fidu- ward rate agreements) can also be an effective
ciary. For supervisory purposes, the under- tool to manage risk. Money market trading may
lying relationship may be as agent, trustee, or be managed as a separate product line or may be
custodian. integrated with trading in other interest-rate
products (such as swaps, caps, or floors). Exam-
iners should take steps to ensure that appropriate
Finder limits are in place for money market trading,
including restrictions on aggregate notional size,
A finder brings together a borrower and a lender the size of maturity mismatches, and the maxi-
of securities for a fee. Finders do not take mum tenor of instruments.
possession of the securities or collateral. Deliv-
ery of securities and collateral is directly between
the borrower and the lender, and the finder does Federal Funds
not become involved. The finder is simply a
fully disclosed intermediary. Commercial banks actively use the federal funds
market as a mechanism to manage fluctuations
in the size and composition of their balance
sheet. Federal funds are also an efficient means
MONEY MARKET INSTRUMENTS to manage reserve positions and invest excess
cash on a short-term basis. Although transac-
In addition to bank-eligible securities activities,
tions are generally unsecured, they can also be
banks may engage in a substantial volume of
secured. The majority of transactions are con-
trading in money market instruments. Federal
ducted overnight; however, term transactions
funds, banker’s acceptances, commercial paper,
are also common. Federal funds trading will
and certificates of deposit are forms of money
often involve term transactions in an attempt to
market instruments. While these instruments
generate positive net interest spread by varying
may be used as part of the overall funding
the maturities of assets and liabilities.
strategy, many firms actively engage in discre-
tionary or proprietary trading in these instru- Banks have traditionally engaged in federal
ments. As in matched-book repo activities, prof- funds transactions as principal, but an increasing
its from trading money market instruments are number of banks are conducting business as
derived from the bid/ask spread on matched agent. These agency-based federal funds trans-
transactions and the net interest spread from actions are not reported on the agent’s balance
maturity mismatches. sheet. Dealer banks may also provide federal
funds clearing services to their correspondent
This activity may result in overall money
banks.
market arbitrage. Arbitrage is the coordinated
purchase and sale of the same security or its
equivalent, for which there is a relative price
imbalance in the market. The objective of such Banker’s Acceptances
activity is to obtain earnings by taking advan-
tage of changing yield spreads. Arbitrage can Banker’s acceptances are time drafts drawn on

Page 10
and accepted by a bank. They are the customary the former Glass-Steagall Act. As a result, banks
means of effecting payment for merchandise were generally prohibited from underwriting
sold in import-export transactions, as well as a and dealing in commercial paper. Despite this
source of financing used extensively in interna- restriction, banks participated in this market in
tional trade. Banker’s acceptances are an obli- an ‘‘agency capacity.’’ When establishing a
gation of the acceptor bank and an indirect commercial paper dealership, many of the larger
obligation of the drawer. They are normally banks pursued business through an aggressive
secured by rights to the goods being financed interpretation of an agency-transaction role. In
and are available in a wide variety of principal practice, bank dealers engage in riskless-principal
amounts. Maturities are generally less than nine or best-efforts placement of commercial paper.
months. Acceptances are priced like Treasury Taking this logic a step further, others actively
bills, with a discount figured for the actual engage in competitive bidding and intraday
number of days to maturity based on a 360-day distribution of newly issued paper. Because the
year. The bank can market acceptances to paper settles on a same-day basis, the transac-
the general public but must guarantee their tions are never part of the official end-of-day
performance. records of the bank. Although this technical
point has been the subject of discussion, the
practice has not been subject to regulatory
challenge.
Commercial Paper Commercial paper may be issued as an
interest-bearing instrument or at a discount.
Commercial paper is a generic term that is used Market trades are priced at a current yield, net of
to describe short-term, unsecured promissory accrued interest due the seller or, if the commer-
notes issued by well-recognized and generally cial paper was issued at a discount, at a discount
sound corporations. The largest issuers of com- figured for the actual number of days to maturity
mercial paper are corporations, bank holding based on a 360-day year.
companies, and finance companies, which use
The sale of commercial paper issued by bank
the borrowings as a low-cost alternative to bank
affiliates must conform to legal restrictions and
financing. Commercial paper is exempt from
avoid conflicts of interest. Each certificate
registration under the Securities Act of 1933 if it
and confirmation should disclose the facts that
meets the following conditions:
the commercial paper is not a deposit and is not
insured by the Federal Deposit Insurance
• prime quality and negotiable
Corporation.
• not ordinarily purchased by the general public
• issued to facilitate current operational busi-
ness requirements
• eligible for discounting by a Federal Reserve Certificates of Deposit
Bank
• maturity does not exceed nine months Negotiable certificates of deposit (CDs) issued
by money-center banks are actively traded in
Actively traded commercial paper is ordi- denominations of $100,000 to $1 million. Inter-
narily issued in denominations of at least est generally is calculated on a 360-day year and
$100,000 and often in excess of $1 million. paid at maturity. Secondary-market prices are
Commercial paper issuers usually maintain computed based on current yield, net of accrued
unused bank credit lines to serve as a source of interest due the seller. Eurodollar CDs trade like
back-up liquidity or contingency financing, prin- domestic CDs except their yields are usually
cipally in the form of standby letters of credit. higher and their maturities are often longer.
Major commercial paper issuers are rated by
nationally recognized rating agencies (Moody’s,
S&P, and others). Other issuers achieve higher
ratings through the use of a credit enhancement, Credit-Risk and Funding
usually in the form of a standby letter of credit Concentrations
issued by a financial institution.
Based on Supreme Court rulings, commercial In addition to market risk, money market policies
paper was considered a security for purposes of and guidelines should recognize the credit risk

Page 11
inherent in these products. Federal funds sold trading transactions. Because of the dollar vol-
and deposit placements are essentially unsecured ume and speed of trading activities, opera-
advances. To avoid undue concentrations of credit tional inefficiencies can quickly result in major
risk, activity with these products should be problems.
limited to approved counterparties. Limits should
be established for each prospective counterparty.
Tenor limits should also be considered to reduce
the potential for credit deterioration over the life Sound Practices for Front- and
of the transaction. The size of limits should be Back-Office Operations
based on both anticipated activity and the coun-
terparty’s financial capacity to perform. The Bank dealer activities vary significantly among
credit analysis should be performed by qualified financial institutions, depending on the size and
individuals in a credit department that is inde- complexity of the trading products; trading,
pendent from the money market dealing func- back-office, and management expertise; and the
tion. In assessing the creditworthiness of other sophistication of systems. As a result, practices,
organizations, institutions should not rely solely policies, and procedures in place in one insti-
on outside sources, such as standardized ratings tution may not be necessary in another. The
provided by independent rating agencies, but adequacy of internal controls requires sound
should perform their own analysis of a counter- judgment on the part of the examiner. The
party’s or issuer’s financial strength. At a mini- following is a list of policies and procedures that
mum, limits should be reassessed and credit should be reviewed:
analyses updated annually. Once established,
limits should be monitored with exceptions • Every organization should have comprehen-
documented and approved by the appropriate sive policies and procedures in place that
level of senior management. Exposure should describe the full range of bank dealer activi-
also be aggregated on a consolidated basis with ties performed. These documents, typically
any other credit exposure arising from other organized into manuals, should at a minimum
product areas. Exposure to foreign bank coun- address front- and back-office operations;
terparties should also be aggregated by country reconciliation guidelines and frequency;
of domicile to avoid country-risk concentra- revaluation and accounting guidelines;
tions. The limit structure should be reviewed to descriptions of accounts; broker policies;
ensure compliance with the requirements of a code of ethics; and the risk-measurement
Regulation F, Limitations on Interbank Liabili- and -management methods, including a com-
ties, which places prudent limits on credit expo- prehensive limit structure.
sure to correspondent banks. • Every institution should have existing policies
Maintaining a presence in the wholesale fund- and procedures to ensure the segregation of
ing markets requires a strong reputation and duties among the trading, control, and pay-
increases potential liquidity risk. The prolonged ment functions.
use of a large volume of purchased funds to • Revaluation sources should be independent
support a money market trading operation could from the traders for accounting purposes, risk
also reduce the capacity to tap this market, if oversight, and senior management reporting,
needed, for core funding. Guidelines should be although revaluation of positions may be con-
in place to diversify sources of funding. Contin- ducted by traders to monitor positions.
gency plans should include strategies to exit or • Trader and dealer telephone conversations
reduce the profile in these markets if the situa- should be taped to facilitate the resolution of
tion warrants. disputes and to serve as a valuable source
of information to auditors, managers, and
examiners.
• Trade tickets and blotters (or their electronic
OPERATIONS AND INTERNAL equivalents) should be timely and complete to
CONTROLS allow for easy reconciliation and for appropri-
ate position and exposure monitoring. The
A bank dealer’s operational functions should be volume and pace of trading may warrant
designed to regulate the custody and movement virtually simultaneous creation of these records
of securities and to adequately account for in some cases.

Page 12
• Computer hardware and software applications • The organization should have an efficient
must have the capacity to accommodate the confirmation-matching process that is fully
current and projected level of trading activity. independent from the dealing function. Docu-
Appropriate disaster-recovery plans should be mentation should be completed and exchanged
tested regularly. as close to completion of a transaction as
• Every institution should have a methodology possible.
to identify and justify any off-market transac- • Auditors should review trade integrity and
tions. Ideally, off-market transactions would monitoring on a schedule in accordance with
be forbidden. its appropriate operational-risk designation.
• A clear institutional policy should exist for • Organizations that have customers who trade
personal trading. If such trading is permitted on margin should establish procedures for
at all, procedures should be established to collateral valuation and segregated custody
avoid even the appearance of conflicts of accounts.
interest.
• Every institution should ensure that the man-
agement of after-hours and off-premises trad-
ing, if permitted at all, is well documented so
that transactions are not omitted from the Fails
automated blotter or the bank’s records.
• Every institution should ensure that staff is In some cases, a bank may not receive or deliver
both aware of and complies with inter- a security by settlement date. ‘‘Fails’’ to deliver
nal policies governing the trader-broker for an extended time or a substantial number of
relationship. cancellations are sometimes characteristic of
• Every institution that uses brokers should poor operational control or questionable trading
monitor the patterns of broker usage, be alert activities.
to possible undue concentrations of business, Fails should be controlled by prompt report-
and review the list of approved brokers at least ing and follow-up procedures. The use of multi-
annually. copy confirmation forms enables operational
• Every institution that uses brokers should personnel to retain and file a copy by settlement
establish a policy that minimizes name sub- date and should allow for prompt fail reporting
stitutions of brokered transactions. All such and resolution.
transactions should be clearly designated as
switches, and relevant credit authorities should
be involved.
• Every institution that uses brokers for foreign-
exchange transactions should establish a clear Revaluation
statement forbidding the lending or borrowing
of brokers’ points as a method to resolve The frequency of independent revaluation should
discrepancies. be driven by the level of an institution’s trading
• Every organization should have explicit com- activity. Trading operations with high levels of
pensation policies to resolve disputed trades activity may need to perform daily revaluation;
for all traded products. Under no circum- however, it is important to note that independent
stances should ‘‘soft-dollar’’ (the exchange of revaluations are less critical when inventory is
services in lieu of dollar compensation) or turning over quickly or end-of-day positions are
off-the-books compensation be permitted for small. In these situations, the majority of profit
dispute resolution. and loss is realized rather than unrealized. Only
• Every institution should have know-your- unrealized profit and loss on positions carried in
customer policies, and they should be under- inventory are affected by a revaluation. At a
stood and acknowledged by trading and sales minimum, every institution should conduct an
staff. independent revaluation at the end of each
• The designated compliance officer should per- standard accounting period (monthly or quar-
form a review of trading practices at least terly). There will be situations when certain
annually. In institutions with a high level securities will be difficult to price due to lack of
of trading activity, interim reviews may be liquidity or recent trading activity. If manage-
warranted. ment relies on trader estimates in these situa-

Page 13
tions, a reasonableness test should be performed mum, provisions should cover the following
by personnel who are independent from the issues:
trading function. A matrix-pricing approach may
also be employed. This involves the use of • acceptable types and maturities of collateral
prices on similar securities (coupon, credit qual- securities
ity, and tenor) to establish market prices. • initial acceptable margin for collateral securi-
ties of various types and maturities
• margin maintenance, call, default, and sellout
Control of Securities provisions
• rights to interest and principal payments
Depository institutions need to adopt procedures • rights to substitute collateral
to ensure that ownership of securities is • individuals authorized to transact business on
adequately documented and controlled. While behalf of the depository institution and its
this documentation and control once involved counterparty
taking physical possession of the securities either
directly or through a third-party custodian, the Written agreements should be in place before
securities markets are quickly moving to a commencing activities.
book-entry system. In this context, safekeeping
is more of a concept than a reality. As the
markets change, documenting the chain of own-
ership becomes the primary mechanism to pre- TRADING AND CAPITAL-
vent losses arising from a counterparty default. MARKETS ACTIVITIES MANUAL
This documentation involves the matching of
incoming and outgoing confirmations and fre- The Trading and Capital-Markets Activities
quent reconcilements of all accounts holding Manual, developed by the Federal Reserve Sys-
securities (Federal Reserve, customer, custo- tem, is a valuable tool to help examiners under-
dian, and other dealers). When the dealer holds stand the complex and often interrelated risks
securities on behalf of its customers, similar arising from capital-markets activities. The prod-
safeguards also need to be in place. Although ucts addressed in the previous subsections and
this documentation process can be burdensome, their associated risks are covered in greater
it is necessary to protect a dealer’s interest in detail in the manual.
securities owned or controlled. Many active As noted in the preceding sections, and fur-
dealers have automated the reconcilement and ther addressed in the Trading and Capital-
matching process. This reduces the potential for Markets Activities Manual, other trading instru-
human error and increases the likelihood that ments could be included in the bank dealer or
exceptions can be uncovered and resolved money market trading operation. Financial
quickly. instruments such as futures and forward rate
Because of the relatively short periods of agreements are often used to modify or hedge
actual ownership associated with repurchase the risk associated with cash instruments (dealer
agreements, potential losses could be significant inventory and money market positions). The
if prudent safeguards are not followed. Signifi- bank dealer may also be involved in other
cant repo volume or matched-book trading instruments including asset-backed securities
activities only heighten this concern. To further (mortgage-backed and consumer-receivable-
protect their interests, dealers should enter into backed). Other departments of the bank may
written agreements with each prospective also use securities products as part of an unre-
repurchase-agreement counterparty. Although the lated trading activity. For example, interest-rate-
industry is moving toward standardized master swap traders often use cash bonds to hedge or
agreements, some degree of customization may modify market-risk exposure. In this capacity,
occur. The agreements should be reviewed by the swap desk would be a customer of the
legal counsel for their content and compliance government securities dealer. These overlaps in
with established minimum documentation stan- product focus and usage make it critical for
dards. In general, these agreements should examiners to understand the organizational struc-
specify the terms of the transaction and the ture and business strategies before establishing
duties of both the buyer and seller. At a mini- examination scope.

Page 14
OTHER ISSUES
Intercompany Transactions
Examiners should review securities and
repurchase-agreement transactions with affili-
ates to determine compliance with sections 23A
and 23B of the Federal Reserve Act. Money
market transactions may also be subject to
limitations under section 23A; however, these
restrictions generally do not apply to trans-
actions between bank subsidiaries that are80
percent or more commonly owned by a bank
holding company. Intercompany transactions
between securities underwriting affiliates and
their bank affiliates should be carefully reviewed
to ensure compliance with Board operating stan-
dards and sections 23A and 23B.
Agency Relationships
Many dealer banks engage in securities transac-
tions only in an agency capacity. Acting as an
agent means meeting customers’ investment
needs without exposing the firm to the price risk
associated with dealing as principal. Risk is
relatively low as long as appropriate disclosures
are made and the bank does not misrepresent the
nature or risk of the security.
Agency-based federal funds transactions are
also becoming more common. By serving only
as an agent to facilitate the transaction, a bank
can meet its correspondent’s federal funds needs
without inflating the balance sheet and using
capital. Examiners should review agency-based

Page 14.1
money market transactions to ensure that the this situation would appear to be more analo-
transactions are structured in a manner that gous to acting as a principal and suggests that
insulates the bank from potential recourse, either the transactions should be reported on the
moral or contractual. If legal agreements are not ‘‘agent’s’’ balance sheet.)
structured properly, the courts could conclude
that the agent bank was acting a principal. In this By structuring agency agreements to include
situation, the loss could be recognized by the provisions that encompass these factors and by
agent bank, not its customer. conducting agency activities accordingly, agent
Although no single feature can determine banks can lower the possibility that they would
whether an agency relationship really exists, the be considered a principal in the event of a failure
courts have recognized a variety of factors in of a financial institution that had purchased
distinguishing whether the persons to whom funds through the agent. Generally, as a matter
‘‘goods’’ were transferred were buyers or merely of prudent practice, each bank acting as an agent
agents of the transferor. Although some of these should have written agreements with principals
distinguishing factors may not apply to federal- encompassing the above elements and have a
funds transactions because they involve the written opinion from legal counsel as to the
transfer of funds rather than material goods, bona fide nature of the agency relationships.
some parallels can be drawn. An agency rela- Selling through an agent should not cause a
tionship would appear to encompass, although bank to neglect a credit evaluation of the ulti-
not necessarily be limited to, the following mate purchasers of these funds. Under the more
elements: traditional mode of conducting federal-funds
transactions, banks sell their federal funds to
• The agent bank must agree to act on behalf of other banks, which in many instances are larger
the seller of the federal funds (‘‘seller’’) and regional correspondents. These correspondent
not on its own behalf. banks in turn may resell the federal funds to
• The agent should fully disclose to all parties to other institutions. Since the correspondent is
the transaction that it is acting as agent on acting as a principal in these sales, the banks
behalf of the seller and not on its own behalf. selling the funds to the correspondent are gen-
• The seller, not the agent bank, must retain title erally not concerned about the creditworthiness
to the federal funds before their sale to a of those purchasing the federal funds from the
purchasing institution. correspondent/principal. Rather, the original sell-
• The seller, not the agent bank, must bear the ing banks need to focus solely on the credit-
risk of loss associated with the federal-funds worthiness of their correspondent banks, with
sale. which they should be quite familiar.
• The agent bank’s authority in selling federal However, when conducting federal-funds sales
funds and accounting for these sales to the through an agent, selling banks, in addition to
seller should be controlled by the seller or by considering the financial condition of their agent,
some guidelines to which the seller has agreed. should also subject the ultimate purchasing banks
The agent bank should sell only to those banks to the same type of credit analysis that would be
stipulated on a list of banks approved, re- considered reasonable and prudent if the seller
viewed, and confirmed periodically by the banks were lending directly to the ultimate
seller bank. borrowers rather than through agents. Banks
• The agent bank should be able to identify the selling federal funds through agents should not
specific parties (sellers and purchasers) to a relinquish their credit-evaluation responsibilities
federal-funds sale and the amount of each to their agent banks.
transaction for which the agent has acted.
• The agent bank’s compensation should gen-
erally be based on a predetermined fee sched-
ule or percentage rate (for example, a percent- REPORTING
age based on the number or size of transactions).
The agent should generally not receive com- Securities held for trading purposes and the
pensation in the form of a spread over a income and expense that results from trading
predetermined rate that it pays to the seller. (If activities should be isolated by specific general
the agent bank’s compensation is in the form ledger or journal accounts. The balances
of a spread over the rate it pays to the seller, in those accounts should be included in the

Page 15
appropriate reporting categories for regulatory transaction and that adequate records and con-
reporting. trols are maintained for securities transactions.
Instructions for the Consolidated Report of Under the rules, banks are required to maintain
Condition and Income (call report) require that certain detailed records concerning securities
securities, derivative contracts, and other items transactions, to provide written confirmations to
held in trading accounts be reported consistently customers under certain circumstances, and to
at market value, or at the lower of cost or market establish certain written policies and proce-
value, with unrealized gains and losses recog- dures. The requirements generally do not apply
nized in current income. For further detail, refer to banks that make 200 or fewer securities
to the glossary section of the call report instruc- transactions a year for customers (exclusive of
tions under ‘‘trading account.’’ With either transactions in U.S. government and agency
method, the carrying values of trading-security obligations) and to transactions subject to the
inventories should be evaluated periodically requirements of the MSRB.
(monthly or quarterly), based on current market
prices. The increase or decrease in unrealized
appreciation or depreciation resulting from that Due Bills
revaluation should be credited or charged to
income. Periodic independent revaluation is the A ‘‘due bill’’ is an obligation that results when
most effective means of measuring the trading a firm sells a security or money market instru-
decisions of bank management. ment and receives payment, but does not deli-
For reporting purposes, the trading depart- ver the item sold. Due bills issued should be
ment’s income should include not only revalu- considered as borrowings by the issuing firm,
ation adjustments, but also profits and losses and alternatively, due bills received should be
from the sale of securities, and other items considered as lending transactions. Dealers
related to the purchase and sale of trading should not issue due bills as a means of obtain-
securities. Interest income from trading assets, ing operating funds or when the underlying
salaries, commissions, and other expenses should security can be delivered at settlement. Custom-
be excluded from trading income for reporting ers of the dealer enter transactions with an
purposes; however, these items should be con- implicit understanding that securities transac-
sidered by management when evaluating the tions will be promptly executed and settled
overall profitability of the business. unless there is a clear understanding to the
When the lender institution is acting as a fully contrary. Consequently, dealers should promptly
disclosed agent, securities-lending activities need disclose the issuance of a due bill to a customer
not be reported on the call report. However, when funds are taken but securities or money
lending institutions offering indemnification market instruments are not delivered to the
against loss to their customer-owners should customer. Such disclosure should reference the
report the associated contingent liability gross in applicable transaction; state the reason for the
Schedule RC-L as ‘‘other significant commit- creation of a due bill; describe any collateral
ments and contingencies.’’ securing the due bill; and indicate that to the
extent the market value of the collateral is
insufficient, the customer may be an unsecured
Recordkeeping and Confirmation creditor of the dealer.
Due bills that are outstanding for more than
Rules three days and are unsecured could be construed
as funding and should be reported as ‘‘liabilities
Regulation H contains rules establishing uni- for borrowed monies’’ on the call report. These
form standards for bank recordkeeping, balances are subject to reserve requirements
confirmation, and other procedures in executing imposed by Regulation D.
securities transactions for bank customers. The
regulation applies, in general, to those retail
commercial activities where the bank effects
securities transactions at the direction and for ESTABLISHING SCOPE
the account of customers. The purpose of the
rules is to ensure that purchasers of securities Obtaining an overview of the organization, man-
are provided adequate information concerning a agement structure, products offered, and control

Page 16
environment is a critical step in the examination pliance. The assigned examiners should be
process. Based on this assessment, an examiner familiar with the provisions of GSA and
should determine the appropriate resources and MSRB as well as with the related examination
skill level. In situations where an institution is procedures. For active proprietary trading units,
active in either the government or municipal it is important to assign examiners who have a
securities markets, it is essential to allocate reasonable working knowledge of the concepts
additional resources for GSA and MSRB com- outlined in the Trading Activities Manual.

Page 17
1. To determine if the policies, practices, pro- 5. To determine compliance with applicable

cedures, and internal controls regarding bank laws and regulations.
dealer activities are adequate. 6. To ensure investor protection.
2. To determine if bank officers are operating in 7. To initiate corrective action when policies,
conformance with the established guidelines. practices, procedures, or internal controls are
3. To evaluate the trading portfolio for credit deficient or when violations of law or regu-
quality and marketability. lations have been noted.
audit compliance functions.

Page 1
Effective date December 1985 Section 2030.3
1. If selected for implementation, complete or were acquired by negotiation or compet-

update the Bank Dealer Activities section of itive bid.
the Internal Control Questionnaire. l. A l i s t o f a l l f i n a n c i a l a d v i s o r y
2. Based on the evaluation of internal controls relationships.
and the work performed by internal/ 5. Agree balances of appropriate schedules to
external auditors determine the scope of the general ledger and review reconciling items
examination. for reasonableness.
3. Test for compliance with policies, practices, 6. Determine the extent and effectiveness of
procedures, and internal controls in conjunc- trading policy supervision by:
tion with performing the remaining exami- a. Reviewing the abstracted minutes of
nation procedures. Also, obtain a listing of meetings of the board of directors and/or
any deficiencies noted in the latest review of any appropriate committee.
done by internal/external auditors from b. Determining that proper authorization
the examiner assigned ‘‘Internal Control,’’ for the trading officer or committee has
and determine if corrections have been been made.
accomplished.
c. Ascertaining the limitations or restric-
4. Request that the bank provide the following
tions on delegated authorities.
schedules:
d. Evaluating the sufficiency of analytical
a. An aged schedule of securities that have
data used in the most recent board or
been acquired as a result of underwriting
committee trading department review.
activities.
b. An aged schedule of trading account e. Reviewing the methods of reporting by
securities and money market instruments department supervisors and internal
held for trading or arbitrage purposes. auditors to ensure compliance with
Reflect commitments to purchase and established policy and law.
sell securities and all joint account f. Reaching a conclusion about the effec-
interests. tiveness of director supervision of the
c. A schedule of short-sale transactions. bank’s trading policy. Prepare a memo
d. An aged schedule of due bills. for the examiner assigned ‘‘Duties and
Responsibilities of Directors’’ stating
e. A list of bonds borrowed.
your conclusions. All conclusions should
f. An aged schedule of ‘‘fails’’ to receive or
be supported by factual documentation.
deliver securities on unsettled contracts.
g. A schedule of approved securities bor- (Before continuing, refer to steps 14 and
rowers and approved limits. 15. They should be performed in conjunc-
h. A schedule of loaned securities. tion with the remaining examination steps.)
i. A schedule detailing account names
and/or account numbers of the following 7. Ascertain the general character of underwrit-
customer accounts: ing and direct placement activities and the
• Own bank trust accounts. effectiveness of department management by
• Own bank permanent portfolio. reviewing underwriter files and ledgers,
• Affiliated banks’ permanent portfolio committee reports and offering statements
accounts. to determine:
• Personal accounts of employees of a. The significance of underwriting activi-
other banks. ties and direct placements of type III
• Accounts of brokers or other dealers. securities as reflected by the volume of
• Personal accounts of employees of sales and profit or loss on operations.
other brokers or dealers. Compare current data to comparable prior
j. A list of all joint accounts entered into periods.
since the last examination. b. Whether there is a recognizable pattern
k. A list of underwriting since the last in:
examination and whether such securities • The extent of analysis of material

Page 1
2030.3 Bank Dealer Activities: Examination Procedures
information relating to the ability of tions taken since the prior examination
the issuer to service the obligation. and determining if:
• Rated quality of offerings. • The quality and maturity of the inven-
• Point spread of profit margin for tory position was compatible with pru-
unrated issues. dent banking practices.
• Geographic distribution of issuers. • The size of the position was within
• Syndicate participants. prescribed limits and compatible with
• Bank’s trust department serving as a sound trading strategy.
corporate trustee, paying agent and d. Determining the bank’s exposure on off-
transfer agent for issuers. setting repurchase transactions by:
• Trustee, paying agent and transfer agent • Reviewing the maturities of offsetting
business being placed with institutions re-po and reverse re-po agreements to
that purchase a significant percentage ascertain the existence, duration,
of the underwriter or private placement amounts and strategy used to manage
offering. unmatched maturity ‘‘gaps’’ and
c. The volume of outstanding bids. Com- extended (over 30 days) maturities.
pare current data to comparable prior • Reviewing records since the last exam-
periods. ination to determine the aggregate
d. The maturity, rated quality and geo- amounts of:
graphic distribution of takedowns from — Matched repurchase transactions.
syndicate participations. — Reverse re-po financing extended
e. The extent of transfer to the bank’s own to one or related firms(s).
or affiliated investment or trading port- • Performing credit analysis of signifi-
folios or to trust accounts and any poli- cant concentrations with any single or
cies relating to this practice. related entity(ies).
8. Determine the general character of trading • Reporting the relationship of those
account activities and whether the activities concentrations to the examiners as-
are in conformance with stated policy by signed ‘‘Concentration of Credits’’ and
reviewing departmental reports, budgets and ‘‘Funds Management.’’
position records for various categories of
10. Determine the extent of risk inherent in
trading activity and determining:
trading account securities which have been
a. The significance of present sales volume
in inventory in excess of 30 days and:
compared to comparable prior periods
and departmental budgets. a. Determine the dollar volume in extended
b. Whether the bank’s objectives are holdings.
compatible with the volume of trading b. Determine the amounts of identifiable
activity. positions with regard to issue, issuer,
9. Review customer ledgers, securities posi- yield, credit rating, and maturity.
tion ledgers, transaction or purchase and c. Determine the current market value for
sales journals and analyze the soundness of individual issues which show an internal
the bank’s trading practices by: valuation mark-down of 10 percent or
a. Reviewing a representative sample of more.
agency and contemporaneous principal d. Perform credit analyses on the issuers of
trades and determining the commission non-rated holdings identified as signifi-
and price mark-up parameters for vari- cant positions.
ous sizes and types of transactions. e. Perform credit analyses on those issues
b. Selecting principal transactions that have with valuation write-downs considered
resulted in large profits and determining significant relative to the scope of trad-
if the transaction involved: ing operations.
• ‘‘Buy-backs’’ of previously traded f. Discuss plans for disposal of slow mov-
securities. ing inventories with management and
• Own bank or affiliated bank portfolios. determine the reasonableness of those
• A security that has unusual quality and plans in light of current and projected
maturity characteristics. market trends.
c. Reviewing significant inventory posi- 11. Using an appropriate technique, select issues

Page 2
Bank Dealer Activities: Examination Procedures 2030.3
from the schedule of trading account inven- • For each type of agency relationship, a
tory. Test valuation procedures by: summary of the extent of the activity
a. Reviewing operating procedures and sup- including:
porting workpapers and determining if — The number of institutions ser-
prescribed valuation procedures are viced as principals.
being followed. — The size range of the institutions
b. Comparing bank prepared market prices, (i.e., institutions serviced have
as of the most recent valuation date, to an total assets ranging from $
independent pricing source (use trade to $ ).
date ‘‘bid’’ prices). — General location of sellers and pur-
c. Investigating any price differences noted. chasers serviced under agency
12. Using an appropriate technique, select trans- relationships (i.e., New York State,
actions from the schedule of short sales and Midwest, etc.)
determine: — Estimate of average daily volume
a. The degree of speculation reflected by of federal funds or money market
basis point spreads. instruments purchased and sold
b. Present exposure shown by computing under agency relationships and the
the cost to cover short sales. high and low volume over the
c. If transactions are reversed in a reason- period since the last examination
able period of time. inquiry (or since activity was begun,
d. If the bank makes significant use of due- if more recent).
bill transactions to obtain funds for its — Names of individuals in the bank
banking business: that are responsible for these agency
• Coordinate with the examiner assigned relationships.
‘‘Review of Regulatory Reports’’ to • A historical file of this information
determine if the bank’s reports of con- should be maintained in order to deter-
dition reflect due bill transactions as mine the nature, extent and growth of
‘‘liabilities for borrowed money.’’ these activities over time.
• Report amounts, duration, seasonal pat- b. Once the examination work in this area
terns and budgeted projections for due has been started, the examiner should
bills to the examiner assigned ‘‘Funds attempt to discern any situation, activity
Management.’’ or deficiency in this area that might
13. If the bank is involved in agency-based suggest that an agency relationship does
federal funds activity: not actually exist. A negative response to
a. At the beginning or in advance of each the following examination guidelines sec-
examination of a banking organization tion dealing with agency agreements may
which has been acting as an agent in the signal such a deficiency. In addition, any
purchase and sale of federal funds for other money market agency relationships
other institutions, examiners should that involve new or unusual financial
obtain certain information which will transactions should be evaluated to de-
help them determine the nature and extent termine the nature of the risks involved
of this activity. The information should and compliance, to the extent applicable,
include: with the guidelines.
• A brief description of the various types c. The examiner should determine that the
of agency relationships (i.e., involving banking organization’s written policies,
federal funds or other money market procedures, and other documentation
activities) and the related transactions. associated with this activity are consis-
• For each type of agency relationship, tent with the Federal Reserve System’s
copies of associated forms, agency Examination Guidelines. If the bank does
agreements, documents, reports and not have written policies the examiner
legal opinions. In addition, if the bank- should strongly advise that they be
ing organization has documented its developed due to the complex nature of
analysis of the risks associated with this activity and the potential risks asso-
the activity, a copy of the analysis ciated with it.
should be requested by the examiner. d. After reviewing the policies, procedures,

Page 3
and appropriate documentation, the 2. limits on the amounts that

examiner should be able to respond pos- can be sold to these banks?
itively to the following questions: — Does the agent have a written opin-
• Banking organizations acting as agents ion from its legal counsel as to the
in the sale of federal funds1 bona fide nature of the agency
— Has this form of activity been ap- relationship?
proved by the board of directors? — Does the accounting and reporting
— Are the bank’s individual agency system of the agent bank enable it
arrangements and transactions: to account for the federal funds
• supported by written agency transactions on a period basis (i.e.,
agreements, and at least weekly) to the sellers?
• reviewed and approved by appro- (Although more frequent account-
priate officers? ing may not be required by the
— Do the written agency agreements sellers, the agent on any day should
that support this activity include have the capacity to identify for the
provisions indicating that (a nega- seller the banks to whom the sell-
tive answer may indicate that the er’s funds have been sold.)
bank is not in fact an agent): — Does the agent’s accounting sys-
• the agent bank will be acting on tem identify each bank which has
behalf of the original or princi- purchased federal funds from a
pal seller of federal funds particular seller bank and include
(‘‘seller’’) in conducting these (at least) the following information
activities and not on the agent for each bank in which the funds
bank’s own behalf? are being invested?3
• the agency relationship will be • information to clearly identify
fully disclosed to all banks the name and location of the
involved in the transactions? bank (or other entity)
• the seller, and not the agent bank, • amount of federal funds sold and
must retain legal title to the fed- amount of interest earned
eral funds before they are sold to • terms of transaction, and matu-
a third party bank? rity date
• the seller, and not the agent bank, • lending limits agreed to
bears the risk of loss? — Does the agent bank actually dis-
• the agent bank’s authority in sell- close to banks or other organiza-
ing federal funds and in account- tions that are part of these agency-
ing for this activity to the seller based transactions that it is acting
should be controlled by the seller as agent?
or by standards to which it has — Is the agent bank’s compensation
agreed? To implement this, does in the form of a predetermined fee
the agreement or its attachments schedule or percentage rate based,
include the following seller- for example, on the size of trans-
approved items: actions, as opposed to compensa-
1. lists of banks to whom the tion in the form of a spread over
agent may sell federal funds,2 the rate that it pays to the seller
and bank? (If the agent bank’s compen-
sation is in the form of a spread
over the rate it pays to the selling
1. Although it is conceivable that a purchaser could engage bank, this situation would appear
an agent to obtain federal funds on its behalf, these guidelines
focus primarily on situations where the seller has engaged an
to be more akin to acting as an
agent to sell federal funds on its behalf because the associated intermediary and suggests that the
risks of such transactions are borne by the sellers and their
agents.
2. Seller banks could conceivably design their lists of 3. The entities referred to as ‘‘ultimate purchasers’’ or
approved banks to encompass a large number of financially ‘‘ultimate borrowers’’ are those that have the responsibility to
sound institutions and still be considered to be fulfilling this repay the original seller bank, and not any intervening agents
supervisory requirement. that may pass on the federal funds to these purchasers.

Page 4
Bank Dealer Activities: Examination Procedures 2030.3
transactions should be reported on examiner should discuss these matters

its balance sheet.) with bank management and seek reme-
• Banking organizations that are in- dial action.
volved in agency-based federal funds 14. Analyze the effectiveness of operational
relationships as sellers controls by reviewing recent cancellations
— Does the bank support its trans- and fail items that are a week or more
actions with written agency beyond settlement date and determine:
agreements? a. The amount of extended fails.
— Does the seller bank evaluate the b. The planned disposition of extended fails.
credit worthiness of the ultimate c. If the control system allows a timely,
borrowers of federal funds and productive follow-up on unresolved fails.
establish limits for each and are d. The reasons for cancellations.
these limits periodically reviewed e. The planned disposition of securities that
at least every six months? 3,4 have been inventoried prior to the recog-
— Does the bank periodically (i.e., at nition of a fail or a cancellation.
least weekly) receive an account- 15. Determine compliance with applicable laws,
ing from the agent which includes rulings, and regulations by performing the
the following information for each following for:
bank to whom the seller bank’s a. 12 CFR 1.3—Eligible Securities:
federal funds were sold? • Review inventory schedules of under-
• information to identify name and writing and trading accounts and
location of bank determine if issues whose par value is
• amount of federal funds sold and in excess of 10 percent of the bank’s
interest earned captial and unimpaired surplus are
• federal funds sales limits agreed type I securities.
to (if the seller bank is a • Determine that the total par value of
principal) type II investments does not exceed
— Is the bank’s management and 10 percent of the bank’s capital and
board of directors aware of and unimpaired surplus, based on the
have they approved the agency combination of holdings and perma-
relationship? nent portfolio positions in the same
• Do internal and/or external auditors securities.
periodically review the policies, proce- • Elicit management’s comments and
dures, and internal controls associated review underwriting records on direct
with this activity and the activity’s placement of type III securities, and
impact on the earnings and financial determine if the bank is dealing in
condition of the banking organization? type III securities for its own account
Is their evaluation reported to manage- by ascertaining if direct placement
ment? (Applies to banks acting as issues have been placed in own bank
agents in the sale of federal funds, and or affiliated investment portfolios or if
those banks involved as sellers of underwriting proceeds were used to
federal funds.) reduce affiliate loans.
• In addition to the items considered b. Section 23A of the Federal Reserve Act
above, the examiner should determine (12 USC 371(c) and 375)—Preferential
what the impact of these transactions Treatment: Obtain a list of domestic
has been on the bank’s earnings and affiliate relationships and a list of direc-
financial condition. If the impact has tors and principal officers and their busi-
been negative, or if the answer to any ness interests from appropriate examin-
of the above questions is negative, the ers and determine whether transactions,
include securities clearance services,
involving affiliates, insiders or their
4. This requirement is intended to mean that seller banks interests are on terms less favorable to
should conduct the type of credit analysis that would be
considered reasonable and prudent for a direct federal funds
the bank than those transactions involv-
activity (i.e., those federal funds activities not conducted ing unrelated parties.
through agents). c. Regulation D (12 CFR 204.2)—Due Bills:

Page 5
• Review outstanding due bills and nals or confirmations to determine if the

determine if: bank sells affiliate commercial paper. If
— The customer was informed that a so, determine if:
due bill would be issued instead of • The bank sells affiliate-issued commer-
the purchased security. cial paper to institutions and finan-
— Safekeeping receipts are sent to cially sophisticated individuals only.
safekeeping customers only after • Sales are generally denominated in
the purchased security has been amounts of $25,000 or more.
delivered. • Each sale confirmation discloses that
• Review due bills outstanding over three the affiliate-issued commercial paper
business days and determine if they are is not an insured bank deposit.
collateralized or properly reserved. e. Reviewing securities position records and
• Review collateralized due bills and customer ledgers with respect to large
determine if the liability is secured by volume repetitive purchase and sales
securities of the same type and of transactions and:
comparable maturity and with a mar- • Independently testing market prices of
ket value at least equal to that of the significant transactions which involve
security that is the subject of the due the purchase and resale of the same
bill. security to the same or related parties.
d. Regulation H (12 CFR 208.8(k))— • Investigating the purchase of large
Recordkeeping and Confirmation Re- blocks of securities from dealer firms
quirements: If the bank effects securities just prior to month end and their sub-
transactions at the direction and for the sequent resale to the same firm just
account of customers, determine if it is after the beginning of the next month.
in compliance with this regulation by f. Reviewing lists of approved dealer firms
substantiating Internal Control questions and determining that the approval of any
24–35. firm that handles a significant volume
16. Test for unsafe and unsound practices and of agency transactions is based on
possible violations of the Securities competitive factors rather than deposit
Exchange Act of 1934 by: relationships.
a. Reviewing customer account schedules g. Reviewing customer complaint files
of own bank and affiliated bank perma- and determining the reasons for such
nent portfolios, trusts, other broker- complaints.
dealers, employees of own or other banks 17. Discuss with an appropriate officer and
and other broker-dealers. Use an appro- prepare report comments concerning:
priate technique to select transactions a. The soundness of trading objectives, pol-
and compare trade prices to indepen- icies and practices.
dently established market prices as of the b. The degree of legal and market risk
date of trade. assumed by trading operations.
b. Reviewing transactions, including U.S. c. The effectiveness of analytical, reporting
government tender offer subscription and control systems.
files, involving employees and directors d. Violations of law.
of own or other banks and determine if e. Internal control deficiencies.
the funds used in the transactions were f. Apparent or potential conflicts of interest.
misused bank funds or the proceeds of g. Other matters of significance.
reciprocal or preferential loans. 18. Reach a conclusion regarding the quality of
c. Reviewing sales to affiliated companies department management and state your
to determine that the sold securities were conclusions on the management brief pro-
not subsequently repurchased at an addi- vided by the examiner assigned ‘‘Manage-
tional mark-up and that gains were not ment Assessment.’’
recognized a second time. 19. Update workpapers with any information
d. Reviewing commercial paper sales jour- that will facilitate future examinations.

Page 6
Review the bank’s internal controls, policies, • The bank’s trust department acting as
practices and procedures regarding bank dealer trustee, paying agent, and transfer
activities. The bank’s system should be docu- agent for issues which have an under-
mented in a complete, concise manner and writing relationship with the trading
should include, where appropriate, narrative department?
descriptions, flowcharts, copies of forms used
d. State procedures for periodic, monthly
and other pertinent information. Items marked
or quarterly, valuation of trading inven-
with an asterisk require substantiation by obser-
vation or testing. tories to market value or to the lower of
This section applies to all bank dealer activ- cost or market price?
ities except those involving municipal securi- e. State procedures for periodic indepen-
ties, which are reviewed as part of a separate and dent verification of valuations of the
distinct Municipal Bond Dealer Examination. trading inventories?
f. Outline methods of internal review and
reporting by department supervisors and
SECURITIES UNDERWRITING internal auditors to insure compliance
TRADING POLICIES with established policy?
g. Identify permissible types of securities?
1. Has the board of directors, consistent with h. Ensure compliance with the rules of fair
its duties and responsibilities, adopted writ- practice that:
ten securities underwriting/trading policies
that: • Prohibit any deceptive, dishonest or
a. Outline objectives? unfair practice?
b. Establish limits and/or guidelines for: • Adopt formal suitability checklists?
• Price mark-ups? • Monitor gifts and gratuities?
• Quality of issues? • Prohibit materially false or mislead-
• Maturity of issues? ing advertisements?
• Inventory positions (including when
issued (WI) positions)? • Adopt a system to determine the
• Amounts of unrealized loss on inven- existence of possible control
tory positions? relationships?
• Length of time an issue will be car- • Prohibit the use of confidential, non-
ried in inventory? public information without written
• Amounts of individual trades or approval of the affected parties?
underwriter interests? • Prohibit improper use of funds held
• Acceptability of brokers and syndi- on another’s behalf?
cate partners?
c. Recognize possible conflicts of interest • Allocate responsibility for transac-
and establish appropriate procedures tions with own employees and em-
regarding: ployees of other dealers?
• Deposit and service relationships with • Require disclosure on all new issues?
municipalities whose issues have i. Provide for exceptions to standard
underwriting links to the trading policy?
department?
2. Are the underwriting/trading policies
• Deposit relationships with securities
firms handling significant volumes of reviewed at least quarterly by the board to
agency transactions or syndicate determine their adequacy in light of chang-
participations? ing conditions?
• Transfers made between trading 3. Is there a periodic review by the board to
account inventory and investment assure that the underwriting/trading depart-
portfolio(s)? ment is in compliance with its policies?

Page 1
2030.4 Bank Dealer Activities: Internal Control Questionnaire
OFFSETTING RESALE AND determined collateral margins or

REPURCHASE TRANSACTIONS discounts?
• If so, indicate margin or discount
4. Has the board of directors, consistent with percentage .
its duties and responsibilities, adopted writ- e. Collateral margins or discounts are
ten offsetting repurchase transaction poli- predicated upon:
cies that: • The type of security pledged as
a. Limit the aggregate amount of offset- collateral?
ting repurchase transactions? • Maturity of collateral?
b. Limit the amounts in unmatched or • Historic and anticipated price volatil-
extended (over 30 days) maturity ity of the collateral?
transactions? • Maturity of the reverse re-po
c. Determine maximum time gaps for agreements?
unmatched maturity transactions? f. Maintenance agreements are required
to support predetermined collateral
d. Determine minimumly acceptable
margin or discount?
interest rate spreads for various matu-
rity transactions. g. Maintenance agreements are structured
to allow margin calls in the event of
e. Determine the maximum amount of collateral price declines?
funds to be extended to any single or
h. Collateral market value is frequently
related firms through reverse re-po
checked to determine compliance with
transactions, involving unsold (through
margin and maintenance requirements
forward sales) securities?
(if so, indicate frequency )?
f. Require firms involved in reverse re-po
transactions to submit corporate resolu-
tions stating the names and limits of
individuals, who are authorized to CUSTODY AND MOVEMENT OF
commit the firm? SECURITIES
g. Require submission of current financial
information by firms involved in *6. Are the bank’s procedures such that per-
reverse re-po transactions? sons do not have sole custody of securities
h. Provide for periodic credit reviews and in that:
approvals for firms involved in reverse a. They do not have sole physical access
re-po transactions? to securities?
i. Specify types of acceptable offsetting b. They do not prepare disposal docu-
repurchase transaction collateral (if so, ments that are not also approved by
indicate type ). authorized persons?
c. For the security custodian, supporting
5. Are written collateral control procedures
disposal documents are examined or
designed so that:
adequately tested by a second
a. Collateral assignment forms are used? custodian?
b. Collateral assignments of registered d. No person authorizes more than one of
securities are accompanied by powers the following transactions: execution of
of attorney signed by the registered trades, receipt and delivery of securi-
owner? ties, and collection or disbursement
• Registered securities are registered in of payment?
bank or bank’s nominee name when 7. Are securities physically safeguarded to
they are assigned as collateral for prevent loss, unauthorized disposal or use?
extended maturity (over 30 days) And:
reverse re-po transactions? a. Are negotiable securities kept under
c. Funds are not disbursed until reverse dual control?
re-po collateral is delivered into the b. Are securities counted frequently, on a
physical custody of the bank or an surprise basis, reconciled to the securi-
independent safekeeping agent? ties record, and the results of such
d. Funds are only advanced against pre- counts reported to management?

Page 2
Bank Dealer Activities: Internal Control Questionnaire 2030.4
c. Does the bank periodically test for RECORDS MAINTENANCE

compliance with provisions of its insur-
ance policies regarding custody of 16. Does the bank maintain:
securities? a. Order tickets which include:
d. For securities in the custody of others: • Capacity as principal or agent?
• Are custody statements agreed peri- • If order is firm or conditional?
odically to position ledgers and • Terms, conditions or instructions and
any differences followed up to a modifications?
conclusion? • Type of transaction (purchase or sale)?
• Are statements received from brokers • Execution price?
and other dealers reconciled promptly,
• Description of security?
and any differences followed up to a
• Date and time of order receipt?
conclusion?
• Are positions for which no statements • Date and time of execution?
are received confirmed periodically, • Dealer’s or customer’s name?
and stale items followed up to a • Delivery and payment instructions?
conclusion? • Terms, conditions, date and time of
8. Are trading account securities segregated cancellation of an agency order?
from other bank owned securities or secu- b. Customer confirmations:
rities held in safekeeping for customers? • Bank dealer’s name, address and
*9. Is access to the trading securities vault phone number?
restricted to authorized employees? • Customer’s name?
10. Do withdrawal authorizations require • Designation of whether transaction
countersignature to indicate security count was a purchase from or sale to the
verifications? customer?
11. Is registered mail used for mailing securi- • Par value of securities?
ties, and are adequate receipt files main- • Description of securities, including at
tained for such mailings (if registered mail a minimum:
is used for some but not all mailings, — Name of issuer?
indicate criteria and reasons)? — Interest rate?
12. Are prenumbered forms used to control — Maturity date?
securities trades, movements and
— Designation, if securities are sub-
payments?
ject to limited tax?
13. If so, is numerical control of prenumbered
forms accounted for periodically by per- — Subject to redemption prior to
sons independent of those activities? maturity (callable)?
14. Do alterations to forms governing the — Designation, if revenue bonds and
trade, movement, and payment of securi- the type of revenue?
ties require: — The name of any company or
*a. Signature of the authorizing party? person in addition to the issuer
b. Use of a change of instruction form? who is obligated, directly or indi-
15. With respect to negotiability of registered rectly, to pay debt service on
securities: revenue bonds? (In the case of
a. Are securities kept in non-negotiable more than one such obligor, the
form whenever possible? phrase ‘‘multiple obligors’’ will
b. Are all securities received, and not suffice.)
immediately delivered, transferred to — Dated date, if it affects price or
the name of the bank or its nominee and interest calculations?
kept in non-negotiable form whenever — First interest payment date, if other
possible? than semi-annual?
c. Are securities received checked for nego- — Designation, if securities are
tiability (endorsements, signature, guar- ‘‘fully registered’’ or ‘‘registered
antee, legal opinion, etc.) and for com- as principal’’?
pleteness (coupons, warrants, etc.) before — Designation, if securities are
they are placed in the vault? ‘‘pre-refunded’’?

Page 3
— Designation, if securities have — ‘‘Flat’’ (traded without interest)?

been ‘‘called,’’ maturity date fixed — ‘‘In default’’ as to principal or
by call notice and amount of call interest?
price? c. Dealer confirmations:
— Denominations of bearer bonds, • Bank dealer’s name, address and tele-
if other than denominations of phone number?
$1,000 and $5,000 par value? • Contra-party identification?
— Denominations of registered • Designation of purchase from or sale
bonds, if other than multiples of to?
$1,000 par value up to $100,000 • Par value of securities?
par value? • Description of securities, including at
— Denominations of municipal a minimum:
notes? — Name of issuer?
• Trade date and time of execution, or a — Interest rate?
statement that time of execution will — Maturity date?
be furnished upon written request of — Designation, if securities are lim-
the customer? ited tax?
• Settlement date? — Subject to redemption prior to
• Yield and dollar price? Only the dol- maturity (callable)?
lar price need to be shown for secu- — Designation, if revenue bonds and
rities traded at par. the type of revenue?
— For transactions in callable secu- — Dated date, if it affects price or
rities effected on a yield basis, the interest calculations?
resulting price calculated to the — First interest payment date, if other
lowest of price to call premium, than semi-annual?
par option (callable at par) or to — Designation, if securities are
maturity, and if priced to pre- ‘‘fully registered’’ or ‘‘registered
mium call or par option, a state- as principal’’?
ment to that effect and the call or — Designation, if securities are
option date and price used in the ‘‘pre-refunded’’?
calculation? — Designation, if securities have
• Amount of accrued interest? been ‘‘called,’’ maturity date fixed
• Extended principal amount? by call notice and amount of call
• Total dollar amount of transaction? price?
• The capacity in which the bank dealer — Denominations of bearer bonds,
effected the transaction: if other than denominations of
— As principal for own account? $1,000 and $5,000 par value?
— As agent for customer? — Denominations of registered
— As agent for a person other than bonds, if other than multiples of
the customer? $1,000 par value up to $100,000
— As agent for both the customer par value?
and another person (dual agent)? • CUSIP number, if assigned (effective
• If a transaction is effected as agent for January 1, 1979)?
the customer or as dual agent: • Trade date?
— Either the name of the contra- • Settlement date?
party or a statement that the in- • Yield to maturity and resulting dollar
formation will be furnished upon price? Only the dollar price need be
request? shown for securities traded at par or
— The source and amount of any on a dollar basis.
commission or other remunera- — For transactions in callable secu-
tion to the bank dealer? rities effected on a yield basis, the
• Payment and delivery instructions? resulting price calculated to the
• Special instructions, such as: lowest of price to call premium,
— ‘‘Ex-legal’’ (traded without legal par option (callable at par) or to
opinion)? maturity?

Page 4
— If applicable, the fact that securi- • Aggregate par value?

ties are priced to premium call or • Cost?
par option and the call or option • Average cost?
date and price used in the • Location?
calculation? • Count differences classified by the
• Amount of accrued interest? date on which they were discovered?
• Extended principal amount? g. Securities transfer or validation ledgers
• Total dollar amount of transaction? which include:
• Payment and delivery instructions? • Address where securities were sent?
• Special instructions, such as: • Date sent?
— ‘‘Ex-legal’’ (traded without legal • Description of security?
opinion)? • Aggregate par value?
— ‘‘Flat’’ (traded without interest)? • If registered securities:
— ‘‘In default’’ as to principal or — Present name of record?
interest? — New name to be registered?
d. Purchase and sale journals or blotters • Old certificate or note numbers?
which include: • New certificate or note numbers?
• Trade date? • Date returned?
• Description of securities? h. Securities received and delivered jour-
• Aggregate par value? nals or tickets which include:
• Unit dollar price or yield? • Date of receipt or delivery?
• Aggregate trade price? • Name of sender and receiver?
• Accrued interest? • Description of security?
• Name of buyer or seller? • Aggregate par value?
• Name of party received from or • Trade and settlement dates?
delivered to? • Certificate numbers?
• Bond or note numbers? i. Cash or wire transfer receipt and dis-
• Indication if securities are in regis- bursement tickets which include:
tered form? • Draft or check numbers?
• Receipts or disbursements of cash? • Customer accounts debited or
• Specific designation of ‘‘when issued’’ credited?
transactions? • Notation of the original entry item
• Transaction or confirmation numbers that initiated the transaction?
recorded in consecutive sequence to j. Cash or wire transfer journals which
insure that transactions are not additionally include:
omitted? • Draft or check reconcilements?
• Other references to documents of orig- • Daily totals of cash debits and
inal entry? credits?
e. Short sale ledgers which include: • Daily proofs?
• Sale price? k. Fail ledgers which include:
• Settlement date? • Description of security?
• Present market value? • Aggregate par value?
• Basis point spread? • Price?
• Description of collateral? • Fail date?
• Cost of collateral or cost to acquire • Date included on fail ledger?
collateral? • Customer or dealer name?
• Carrying charges? • Resolution date?
f. Security position ledgers, showing sep- • A distinction between a customer and
arately for each security positioned for a dealer fail?
the bank’s own account: • Follow-up detail regarding efforts to
• Description of the security? resolve the fail?
• Posting date (either trade or settle- l. Securities borrowed and loaned ledgers
ment date, provided posting date is which include:
consistent with other records of orig- • Date of transaction?
inal entry)? • Description of securities?

Page 5
• Aggregate par value? • All receipts and deliveries of

• Market value of securities? securities?
• Contra-party name? • All receipts and disbursements of
• Value at which security was loaned? cash?
• Date returned? • All other charges or credits?
• Description of collateral? p. Records of syndicates’ joint accounts or
• Aggregate par value of collateral? similar accounts formed for the pur-
• Market value of collateral? chase of municipal securities which
• Collateral safekeeping location? include:
• Dates of periodic valuations? • Underwriter agreements? And:
m. Records concerning written or oral put
— Description of the security?
options, guarantee and repurchase agree-
ments which include: — Aggregate par value of the issue?
• Description of the securities? • Syndicate or selling group agree-
• Aggregate par value? ments? And:
• Terms and conditions of the option, — Participants’ names and percent-
agreement or guarantee? ages of interest?
n. Customer account information which — Terms and conditions governing
includes: the formation and operation of the
• Customer’s name and residence or syndicate?
principal business address? — Date of closing of the syndicate
• Whether customer is of legal age? account?
• Occupation? — Reconcilement of syndicate prof-
• Name and address of employer? And: its and expenses?
— Whether customer is employed • Additional requirements for syndi-
by a securities broker or dealer or cate or underwriting managers which
by a municipal securities dealer? include:
• Name and address of beneficial owner
— All orders received for the pur-
or owners of the account if other than
chase of securities from the syn-
customer? And:
dicate or account, except bids at
— Whether transactions are con-
other than the syndicate price?
firmed with such owner or
owners? — All allotments of securities and
• Name and address of person(s) autho- the price at which sold?
rized to transact business for a corpo- — Date of settlement with the
rate, partnership or trusteed account? issuer?
And: — Date and amount of any good
— Copy of powers of attorney, res- faith deposit made with the
olutions or other evidence of issuer?
authority to effect transactions for q. Files which include:
such an account? • Advertising and sales literature
• With respect to borrowing or pledg- • Prospectus delivery information?
ing securities held for the accounts of r. Internal supervisory records which
customers: include:
— Written authorization from the
• Account reconcilement and follow-
customer authorizing such
up?
activities?
• Customer complaints including: • Profit analysis by trader?
— Records of all written customer • Sales production reports?
complaints? • Periodic open position reports com-
— Record of actions taken concern- puted on a trade date or when issued
ing those complaints? basis?
o. Customer and the bank dealer’s own • Reports of own bank credit exten-
account ledgers which include: sions used to finance the sale of
• All purchases and sales of securities? trading account securities?

Page 6
PURCHASE AND SALES a. The account or customer for which

TRANSACTIONS each such transaction was effected?
b. The description of the securities?
17. Are all transactions promptly confirmed in c. The unit and aggregate purchase or sale
writing to the actual customers or dealers? price (if any)?
18. Are confirmations compared or adequately d. The trade date?
tested to purchase and sales memoranda e. The name or other designation of the
and reports of execution of orders, and any broker-dealer or other person from
differences investigated and corrected whom purchased or to whom sold?
(including approval by a designated respon- If the bank has had an average of 200 or
sible employee)? more securities transactions per year for
a. Are confirmations and purchase and customers over the prior three-calendar-
sale memoranda checked or adequately year period, exclusive of transactions in
tested for computation and terms by a U.S. government and federal agency obli-
second individual? gations, answer questions 26, 27 and 28.
19. Are comparisons received from other deal-
ers or brokers compared with confirma- 26. Does the bank maintain account records
tions, and any differences promptly for each customer which reflect:
investigated? a. All purchases and sales of securities?
a. Are comparisons approved by a desig- b. All receipts and deliveries of securities?
nated individual (if so, give name c. All receipts and disbursements of cash
)? for transactions in securities for such
account?
d. All other debits and credits pertaining
to transactions in securities?
CUSTOMER AND DEALER 27. Does the bank maintain a separate memo-
ACCOUNTS randum (order ticket) of each order to
purchase or sell securities (whether exe-
20. Do account bookkeepers periodically trans- cuted or cancelled) which includes:
fer to different account sections or other- a. The account(s) for which the transac-
wise rotate posting assignments? tion was effected?
21. Are letters mailed to customers requesting b. Whether the transaction was a market
confirmation of changes of address? order, limit order, or subject to special
22. Are separate customer account ledgers instructions?
maintained for: c. The time the order was received by the
• Employees? trader or other bank employee respon-
• Affiliates? sible for affecting the transaction?
• Own bank’s trust accounts? d. The time the order was placed with the
23. Are customer inquiries and complaints broker-dealer, or if there was no broker-
handled exclusively by designated individ- dealer, the time the order was executed
uals who have no incompatible duties? or cancelled?
e. The price at which the order was
executed?
f. The broker-dealer used?
RECORDKEEPING AND 28. Does the bank maintain a record of all
CONFIRMATION REQUIREMENTS broker-dealers selected by the bank to
FOR CUSTOMER SECURITIES effect securities transactions and the amount
TRANSACTIONS of commissions paid or allocated to each
(REGULATION H) such broker during the calendar year?
29. Does the bank, subsequent to effecting a
24. Are chronological records of original entry securities transaction for a customer, mail
containing an itemized daily record of or otherwise furnish to such customer
all purchases and sales of securities either a copy of the confirmation of a
maintained? broker-dealer relating to the securities
25. Do the original entry records reflect: transaction or a written trade confirmation

Page 7
of a broker-dealer relating to the securities tion will be furnished within a reason-

transaction or a written trade confirmation able time upon written request?
prepared by the bank? 33. Does the bank maintain the above records
30. If customer notification is provided by and evidence of proper notification for a
furnishing the customer with a copy of the period of at least three years?
confirmation of a broker-dealer relating to 34. Does the bank furnish the written notifica-
the transaction, and if the bank is to tion described above within five business
receive remuneration from the customer or days from the date of the transaction, or if
any other source in connection with the a broker-dealer is used, within five busi-
transaction, and the remuneration is not ness days from the receipt by the bank of
determined pursuant to a written agree- the broker-dealer’s confirmation? If not,
ment between the bank and the customer, does the bank use one of the alternative
does the bank also provide a statement of procedures described in Regulation H?
the source and amount of any remunera-
tion to be received? 35. Unless specifically exempted in Regula-
31. If customer notification is provided by tion H, does the bank have established
furnishing the customer with a trade con- written policies and procedures ensuring:
firmation prepared by the bank, does the a. That bank officers and employees who
confirmation disclose: make investment recommendations or
a. The name of the bank? decisions for the accounts of customers,
b. The name of the customer? who particpate in the determination of
c. Whether the bank is acting as agent for such recommendations or decisions, or
such customer, as principal for its own who, in connection with their duties,
account, or in any other capacity? obtain information concerning which
securities are being purchased or sold
d. The date of execution and a statement
or recommended for such action, report
that the time of execution will be fur-
to the bank, within 10 days after the end
nished within a reasonable time upon
of the calendar quarter, all transactions
written request of such customer?
in securities made by them or on their
e. The identity, price and number of shares behalf, either at the bank or elsewhere
of units (or principal amount in the case in which they have a beneficial interest
of debt securities) of such securities (subject to certain exemptions)?
purchased or sold by such customer?
b. That in the above required report the
32. For transactions which the bank effects in
bank officers and employees identify
the capacity of agent, does the bank, in
the securities purchased or sold and
addition to the above, disclose:
indicate the dates of the transactions
a. The amount of any remuneration and whether the transactions were pur-
received or to be received, directly or chases or sales?
indirectly, by any broker-dealer from
such customer in connection with the c. The assignment of responsibility for
transaction? supervision of all officers or employees
b. The amount of any remuneration who (1) transmit orders to or place
received or to be received by the bank orders with broker-dealers, or (2) exe-
from the customer and the source and cute transactions in securities for
amount of any other remuneration to be customers?
received by the bank in connection with d. The fair and equitable allocation of
the transaction, unless remuneration securities and prices to accounts when
is determined pursuant to a written orders for the same security are re-
agreement between the bank and the ceived at approximately the same time
customer? and are placed for execution either
c. The name of the broker-dealer used. individually or in combination?
Where there is no broker-dealer, the e. Where applicable, and where permissi-
name of the person from whom the ble under local law, the crossing of buy
security was purchased or to whom it and sell orders on a fair and equitable
was sold, or the fact that such informa- basis to the parties to the transaction?

Page 8
OTHER a. Are details periodically reconciled to

the general ledger, and any differences
36. Are the preparation, additions, and posting followed up to a conclusion?
of subsidiary records performed and/or b. Are positions confirmed periodically (if
adequately reviewed by persons who do so, indicate frequency )?
not also have sole custody of securities? 40. Is the compensation of all department
37. Are subsidiary records reconciled, at least employees limited to salary and a non-
monthly, to the appropriate general ledger departmentalized bonus or incentive plan?
accounts and are reconciling items ade- a. Are sales representatives’ incentive pro-
quately investigated by persons who do grams based on sales volume and not
not also have sole custody of securities? department income?
38. Are fails to receive and deliver under a
separate general ledger control?
a. Are fail accounts periodically recon-
ciled to the general ledger, and any CONCLUSION
d i ff e r e n c e s f o l l o w e d u p t o a
conclusion? 41. Is the foregoing information an adequate
b. Are periodic aging schedules prepared basis for evaluating internal control in that
(if so, indicate frequency )? there are no significant deficiencies in
c. Are stale fail items confirmed and fol- areas not covered in this questionnaire that
lowed up to a conclusion? impair any controls? Explain negative
d. Are stale items valued periodically and, answers briefly, and indicate any addi-
if any potential loss is indicated, is a tional examination procedures deemed
particular effort made to clear such necessary.
items or to protect the bank from loss 42. Based on a composite evaluation, as evi-
by other means? denced by answers to the foregoing
39. With respect to securities loaned and bor- questions, internal control is considered
rowed positions: (adequate/inadequate).

Page 9
Loan Portfolio Management
This section will help the examiner perform two municated and understood through each level of
separate, but related, functions: the organization, it greatly helps bank manage-
ment (1) maintain sound credit-underwriting
• evaluate the depth and scope of the formalized standards; (2) control and manage risk; (3) evalu-
policies and procedures the bank uses to ate new business opportunities; and (4) identify,
manage and control its loan portfolio administer, and collect problem loans.
• form an overview of the performance of the The lending policy must clearly state the
entire lending operation by consolidating the philosophies and principles that govern safe and
results of the examination programs from the sound banking practices and procedures, as well
various lending departments as the mission and objectives of the particular
institution. Throughout this manual, consider-
able emphasis is placed on formal written poli-
cies established by the board of directors that
management can implement, administer, and
BANK LOAN POLICY amplify. The board of directors, in discharg-
ing its duty to both depositors and share-
The purpose of a bank’s lending policy is to holders, must ensure that loans in the bank’s
establish the authority, rules, and framework to portfolio are made based on the following three
operate and administer its loan portfolio effec- objectives:
tively, that is, to ensure profitability while man-
aging risk. The policy serves as a framework to • to grant loans on a sound and collectible basis
set basic standards and procedures in a clear and • to invest the bank’s funds profitably for the
concise manner. The policy’s guidelines should benefit of shareholders and the protection of
be derived from a careful review of internal and depositors
external factors that affect the institution, such • to serve the legitimate credit needs of the
as the bank’s market position, historical experi- bank’s community
ence, present and prospective trade area, prob-
able future loan and funding trends, facilities, The written loan policy is the cornerstone for
staff capabilities, and technology. Such guide- sound lending and loan administration. An
lines, however, must be void of any discrimina- adequate loan policy promotes—
tory policies or practices.
The complexity and scope of the lending • a bank’s business and lending philosophy,
policy and procedures should be appropriate despite changes in management;
to the size of the institution and the nature of • stability, as it provides a reference for lenders;
its activities and should be consistent with • clarity, to minimize confusion concerning lend-
prudent banking practices and relevant regula- ing guidelines; and
tory requirements. Examiners should keep in • sound objectives for evaluating new business
mind that a loan policy that is appropriate for opportunities.
one bank is not necessarily suitable for another
bank. Each bank’s policy will differ, given the The loan policy should define who will receive
institution’s strategic goals and objectives, credit, what type, and at what price, as well as
coupled with factors such as economic condi- what credit documentation will be permitted or
tions, the experience and ability of the lending required. Other internal factors to be addressed
personnel, and competition. The policy should include who will grant the credit and in what
be reviewed at least annually to ensure that amount, as well as what organizational structure
it is not outdated or ineffective, remains flexible, will ensure compliance with the bank’s guide-
and continues to meet the needs of the commu- lines and procedures. Because loan authority is
nity. Changes in federal and other regulatory spread throughout the organization, the bank
requirements also must be incorporated into the must have an efficient internal review and
policy. reporting system to monitor adherence to estab-
The policy should be broad and not overly lished guidelines. This system should adequately
restrictive. If carefully formulated and adminis- inform the directorate and senior management
tered by senior management, and clearly com- of how policies are being carried out and should

Page 1
2040.1 Loan Portfolio Management
provide them with sufficient information to ance for Loan and Lease Losses1 stipulates that
evaluate the performance of lending officers and federally insured depository institutions must
the condition of the loan portfolio. maintain an ALLL at an appropriate level to
The loan policy should establish (1) what absorb estimated credit losses associated with
information will be required from the borrower the loan and lease portfolio.
during the application process, (2) what infor- Examiners must evaluate management’s esti-
mation the borrower will be required to submit mate of losses existing in the bank’s loan
while the credit remains outstanding, and portfolio as well as the methodologies and
(3) which bank personnel are responsible for procedures used in making and documenting the
obtaining the information. In addition, the pol- estimate. That evaluation provides the basis for
icy should specify who is responsible for review- determining the appropriateness and reasonable-
ing the adequacy of loan documentation and for ness of a bank’s ALLL.
citing and correcting documentation exceptions.
A high level of documentation exceptions indi- Collections and charge-offs. The lending policy
cates a deficiency in the bank’s policy, proce- should define the criteria and procedures for
dures, monitoring, or enforcement. reporting relevant information concerning delin-
A loan policy will differ from loan proce- quent obligations to the board of directors. The
dures. A policy represents a plan, guiding prin- policy should establish the mechanism for pre-
ciple, or course of action designed to establish a senting problem loans to the directorate. Reports
framework for handling decisions, actions, and submitted to the board of directors should include
other matters, thereby influencing them. A pro- sufficient detail for it to determine the risk
cedure is a set of established methods or steps factor, loss potential, and alternative courses of
for performing a task. The lending policy should action. The policy should outline a follow-up
include issues relevant to all departments of the collection notice procedure that is systematic
bank. Written procedures approved and enforced and progressively stronger. Guidelines should
in various departments should be referenced in be established to ensure that all accounts are
the bank’s general lending policy. The policy presented to and reviewed by the board of
must be flexible enough to allow for fast adap- directors or a board committee for charge-off.
tation to changing conditions in the bank’s
earning assets mix and trade area. Concentrations of credit. The lending policy
should encourage both diversification within the
portfolio and a balance between maximum yield
and minimum risk. Concentrations of credit
Components of a Sound Lending depend heavily on a key factor, and when
Policy weaknesses develop in that key factor, every
individual loan within the concentration is
As mentioned previously, a bank’s loan policy affected. The directorate should evaluate the
should be appropriate to its size and complexity. additional risk involved in various concentra-
Sound loan policy generally is based on the tions and determine which concentrations should
components described below. be avoided or limited. The lending policy also
should establish thresholds for acceptable con-
Allowance for loan and lease losses. A sound centrations of credit and require that all concen-
lending policy establishes a systematic loan- trations be reviewed and reported to the board
review program to detect and identify problem on a periodic basis.
loans and other portfolio weaknesses. (See the Institutions that have effective controls to
‘‘Internal Loan Review’’ subsection for the manage and reduce undue concentrations over
requirements of a loan-review program.) time need not refuse credit to sound borrowers
Guidelines and methodologies need to be simply because of the borrower’s industry or
established to determine the adequacy of the geographic location. This principle applies to
bank’s allowance for loan and lease losses
(ALLL), and they should be based on a
conservative analysis of the risk in the loan
portfolio. This analysis should ensure that an
appropriate ALLL is maintained. The 2006 1. See section 2070.1 (SR-06-17) and section 2072.1 (SR-
Interagency Policy Statement on the Allow- 01-17).

Page 2
Loan Portfolio Management 2040.1
prudent loan renewals and rollovers, as well as Credit files should include all financial state-
to new extensions of credit that are underwritten ments, credit reports, collateral-inspection docu-
in a sound manner. (See section 2050 for further ments, reference letters, past loan applications,
details.) memoranda, correspondence, and appraisals. In
many cases, particularly those involving real
Consumer and equal credit opportunity laws. estate loans, appraisals and other collateral docu-
Compliance with the many consumer-related mentation may be maintained in a separate
laws, regulations, rulings, interpretations, and collateral file.
policy statements requires complex and detailed Documentation requirements will vary accord-
policies and procedures that should be addressed ing to the type of loan, borrower, and collateral.
in a separate policy. However, the loan policy For example, a bank may not require financial
should require adherence to the Federal Reserve’s statements from borrowers whose loans are fully
Regulation B, 12 CFR 202, which implements secured by certificates of deposit it issues. In a
the Equal Credit Opportunity Act. This regula- more general sense, information requirements
tion prohibits creditors from discriminating between amortizing consumer loans and com-
against loan applicants on the basis of age, race, mercial or real estate loans vary greatly. More
color, religion, national origin, sex, marital sta- specific examples of the types and frequency of
tus, or receipt of income from public assistance financial information often obtained for various
programs. As additional prohibitions are added types of credit are detailed in the following
under the regulation, they should be incorpo- paragraphs.
rated into the policy statement. Also, the loan For many consumer installment and residen-
policy should include a requirement that the tial mortgage loan borrowers, the borrowers’
bank give applicants a written notification of financial information generally is collected only
rejection of a loan application, a statement of the at the time of loan application. The underwriting
applicant’s rights under the Equal Credit Oppor- process for these types of loans emphasizes
tunity Act, and a statement either of the reasons factors such as the borrower’s income and job
for rejection or of the applicant’s right to such stability, credit history, and debt load, as well as
information. the loan-to-value requirements for obtained
collateral.
Credit files. Obtaining and maintaining com- In factoring and other asset-backed lending
plete and accurate information on every relevant activities, while financial information is a sig-
detail of a borrower’s financial condition is nificant part of the underwriting process, collat-
essential to approving credit in a safe and sound eral is the key component of the lending deci-
manner. The loan policy should establish what sion. Close monitoring of the collateral’s
information will be required from the borrower existence, value, and marketability are essential
during the application process and what infor- to sound underwriting of these types of loans.
mation the borrower will be required to submit For typical commercial, commercial real
while the credit remains outstanding. Credit files estate, and agricultural loans, significant empha-
should be maintained on all borrowing relation- sis is placed on the financial strength, profit-
ships, regardless of size, with the exception of ability, and cash flow of the core business for
the latitude provided by the Interagency Policy loan repayment. Close monitoring of the busi-
Statement on Documentation of Loans. A cur- ness’s financial condition and profitability
rent credit file should provide the loan officer, throughout the life of the loan is key to the
loan committee, and internal and external sound administration of these types of credits.
reviewers with all information necessary to Other pertinent information requirements, such
analyze the credit before it is granted and to as collateral-inspection documentation for agri-
monitor and evaluate the credit during its life. cultural credits or lease/rental information for
Such information should (1) identify the borrow- income-producing commercial real estate cred-
er’s business or occupation; (2) document the its, may also be necessary to properly administer
borrower’s past and current financial condition; these loans. As part of the sound underwriting
(3) state the purposes of all loans granted to the process for these loans, a bank may include
borrower, the sources of repayment, and the loan covenants requiring the business to main-
repayment programs; and (4) identify the collat- tain financial soundness, submit periodic finan-
eral and state its value and the source of the cial statements, and provide other needed
valuation. information.

Page 3
As a practice, a bank should not ask for may indicate a lessening of underwriting stan-
information it does not need to adequately dards on the one hand, or a need to adjust the
underwrite and monitor the quality of its loans. policy to allow flexibility within safe and sound
With proper use of loan covenants, a bank can parameters on the other. The underlying reasons
protect its right to receive additional or more behind frequently granted exceptions should be
frequent information if a borrower’s financial assessed, and appropriate recommendations
condition deteriorates or collateral values decline. should be made accordingly.
When determining the financial and other infor-
mation to request from the borrower, bankers Financing other real estate. If the bank wants to
should consider the requirements of the under- finance a parcel of other real estate that it owns,
writing process for particular types of loans and special accounting rules may apply. Conse-
the repayment risks. A bank’s loan policy should quently, the lending policy should include an
clearly delineate the type and frequency of such outline of certain provisions of Financial
information requirements. Accounting Standards Board (FASB) Statement
The lending policy also should define the No. 66, ‘‘Accounting for Sales of Other Real
financial-statement requirements for businesses Estate.’’
and individuals at various borrowing levels.
Specifically, requirements for audited, unaudited, Geographic limits. A bank’s trade area should
annual, or interim balance sheets; income and be clearly delineated and consistent with defined
cash-flow statements; statements of changes in Community Reinvestment Act (CRA) criteria.
capital accounts; and supporting notes and sched- Loan officers and directors should be fully
ules should be included, as appropriate. In addi- aware of specific geographic limitations for
tion, the lending policy should require external lending purposes. The bank’s defined trade area
credit checks as appropriate, at the inception of should not be so large that, given its resources,
the loan and during periodic updates. The loan the bank cannot properly and adequately moni-
policy should be written so that credit-data tor and administer its credits. A sound loan
exceptions would be a violation of the policy. policy restricts or discourages loan approval for
customers outside the trade area. The bank’s
Distribution by category. Limitations based on primary trade area should be distinguished from
aggregate percentages of total loans in commer- any secondary trade area, which is especially
cial, real estate, consumer, or other categories important for new banks. Specific restrictions or
are common. Aggregate percentages for loans to exceptions should be listed separately.
deposits, assets, and capital (with regard to
concentrations of credit) would provide guid- Lender liability. Banking organizations must be
ance for effective portfolio management. Such careful that their actions to make, administer,
policies are beneficial but should allow for and collect loans—including assessing and con-
deviations, with the approval by the board or a trolling environmental liability—cannot be con-
board committee. This allows credit to be dis- strued as taking an active role in the manage-
tributed in response to the community’s chang- ment or day-to-day operations of the borrower’s
ing needs. During times of heavy loan demand business. Such actions could lead to potential
in one category, an inflexible loan-distribution liability under the Comprehensive Environmen-
policy would cause that category to be slighted tal Response, Compensation, and Liability Act
in favor of another. (CERCLA). (See the ‘‘Environmental Liability’’
subsection.)
Exceptions to the loan policy. A lending policy
should require loan officers to present credits Limitation on aggregate outstanding loans.
they believe are fundamentally sound and wor- Banks should establish guidelines limiting the
thy of consideration, even though they may not total amount of loans outstanding in relation to
conform with the bank’s written lending policy other balance-sheet accounts. This type of con-
or procedures. The reason for the exception trol over the loan portfolio usually is expressed
should be detailed in writing and submitted for relative to deposits and total assets. In setting
approval to a designated authority. The direc- such limitations, various factors, such as the
tors’ loan committee or a similar body should credit demands of the community, the volatility
review and approve all exceptions at reasonable of deposits, and the credit risks involved, must
intervals. The frequency of exceptions granted be considered.

Page 4
Loan authority. The lending policy should who might otherwise seek credit elsewhere.
establish limits for all lending officers and ensure Conversely, many banks purchase loans or
controls are in place to monitor compliance with participate in loans originated by others. In some
the bank’s legal lending limit. An individual cases, such transactions are conducted with
officer’s lending limit is usually based on his or affiliates or members of a chain-banking orga-
her experience, tenure, and past adherence to the nization, with the goal of benefiting the whole
bank’s loan policy. Lending limits also should organization. A purchasing bank may also wish
be set for group authority, thereby allowing a to supplement its loan portfolio when loan
combination of officers or a committee to demand is weak. In still other cases, a bank may
approve larger loans than the members would be purchase or participate in a loan to accommo-
permitted to approve individually. The loan date an unrelated originating bank with which it
policy should describe the manner in which has an ongoing business relationship.
loans will be approved and ultimately reported Purchasing or selling loans, if done properly,
to the board of directors, as well as the fre- can have a legitimate role in a bank’s overall
quency of any loan committee meetings, as asset and liability management and can contrib-
applicable. ute to the efficient functioning of the financial
system. In addition, these activities help a bank
Loan pricing. At a minimum, interest rates on diversify its risks and improve its liquidity.
loans must be sufficient to cover (1) the cost of Banks should avoid purchases of loans that
the funds loaned, (2) the bank’s loan services generate unacceptable concentrations of credit.
(including general overhead), and (3) probable Such concentrations may arise solely from the
losses—while providing for a reasonable profit bank’s purchases, or they may arise when loans
margin. Policymakers must know these costs or participations purchased are aggregated with
before establishing rates. Periodic review allows loans originated and retained by the purchasing
rates to be adjusted in response to changes in bank. The policy should state the limits (1) for
costs, competitive factors, or risks of a particular the aggregate amount of loans purchased from
type of extension of credit. Specific guidelines and sold to any one outside source and (2) of all
for other relevant factors, such as compensating- loans purchased and sold. It should also estab-
balance requirements and fees on commitments, lish limits for the aggregate amount of loans to
are also germane to pricing credit. particular types of industries. The extent of
contingent liability, holdback and reserve
Loan purchases and sales. If sufficient loan requirements, and the manner in which loans
demand exists, lending within the bank’s trade will be handled and serviced should be clearly
area is safer and less expensive than purchasing defined. In addition, the policy should require
paper from a dealer or a correspondent bank. that loans purchased from another source be
Direct lending promotes customer relationships, evaluated in the same manner as loans origi-
serves the credit needs of customers, and devel- nated by the bank itself. Guidelines should be
ops additional business. Occasionally, a bank established for the type and frequency of credit
may not be able to advance a loan to a customer and other information the bank needs to obtain
for the full amount requested because of indi- from the originating institution to keep itself
vidual state lending limitations or other reasons. continually updated on the status of the credit.
In such situations, the bank may extend credit to Guidelines should also be established for sup-
a customer up to its internal or legal lending plying complete and regularly updated credit
limit and sell a participation to a correspondent information to the purchasers of loans originated
bank for the amount exceeding the bank’s lend- and sold by the bank.
ing limit or the amount it wishes to extend
on its own. Generally, such sales arrangements Loans to employees, officers, directors, princi-
are established before the credit is ultimately pal shareholders, and their related interests.
approved. These sales should be on a nonre- Loans to insiders are strictly defined in federal
course basis by the bank, and the originating and statutes and require close supervision to ensure
purchasing banks should share in the risks and compliance. Federal and state statutes provide
contractual payments on a pro rata basis. Selling the basis for defining insider loans, and they
or participating out portions of loans to accom- specify requirements and limitations that should
modate the credit needs of customers promotes be incorporated in the policy. (See the Federal
goodwill and enables a bank to retain customers Reserve’s Regulation O, 12 CFR 215.)

Page 5
The policy should ensure, through a system of service generally is varied or conditioned upon a
controls over authority and funding, that exten- customer’s obtaining or providing some addi-
sions of credit to insiders are legally permissible tional product or service from or to the bank or
and that they are made on substantially the same an affiliate. Section 106(b) of the Bank Holding
terms and conditions as those prevailing at the Company Act Amendments of 1970 generally
time for comparable transactions with other prohibits a bank from tying a product or service
borrowers. Furthermore, the policy should con- to any of its other products or services, including
tain guidelines for loans to employees who are those offered by its affiliates. Certain tying
not subject to the provisions of Regulation O. arrangements are permissible when the two
products tied are loans, deposits, or trust ser-
Maximum maturities. Loans should be granted vices available from the same bank or when the
with realistic repayment plans, with the maturity Board has determined that a particular tying
related to the anticipated source of repayment, arrangement is permissible.2 To the extent pos-
the purpose of the loan, and the useful life of the sible, examiners should ascertain that member
collateral. For term loans, a lending policy banks have not extended credit voluntarily or
should state the maximum number of months involuntarily based on impermissible tying
over which loans may be amortized. Specific arrangements.
procedures should be developed for situations
requiring balloon payments and modification of Types of loans. The lending policy should state
original loan terms. If the bank requires a the types of loans management considers desir-
cleanup (out-of-debt) period for lines of credit, it able or prohibited. It also should set forth
should be stated explicitly. guidelines for extensions-of-credit types such as
commercial loans; real estate loans; secured and
Maximum ratio of loan amount to collateral unsecured loans; and off-balance-sheet activi-
value. The loan policy should set forth proce- ties, such as letters of credit and loan commit-
dures for ordering, preparing, and reviewing ments. The decision about the types of loans
appraisals for real or personal property pledged granted should be based on the expertise of the
as collateral. The bank’s lending policy should lending officers, the deposit structure of the
outline guidelines for appraisals or internal evalu- bank, and the community’s anticipated credit
ations, including regulatory requirements, and, demands. Credits involving complex structures
in the case of renewals or extensions, procedures or repayment arrangements, or loans secured by
for possible reappraisals or re-evaluations. collateral that requires more-than-normal moni-
Acceptable types of appraisals or evaluations toring, should be avoided unless the bank has
should be outlined. Circumstances requiring the the personnel, policies, controls, and systems
use of in-house staff appraisers instead of fee necessary to administer such advances properly.
appraisers should be identified. Maximum loan- Types of credits that have caused an abnormal
to-value ratios and the methods of valuation to loss to the bank should be identified, scrutinized,
be used for various types of collateral should be and controlled within the framework of stated
detailed. (See sections 2090 and 2100 for further policy. A bank also should consider its overall
details.) exposure to term lending relative to its stable
The maximum ratio of loan amount to the funds.
market value of pledged securities is restricted
by the Federal Reserve’s Regulation U, Continued rigorous credit-risk assessment dur-
12 CFR 221. The lending policy should set forth ing favorable economic conditions. Internal pro-
margin requirements for all types of securities cesses and requirements for loan-underwriting
acceptable as collateral. Margin requirements decisions should be consistent with the nature,
should be related to the marketability of the size, and complexity of the banking organiza-
security, that is, whether it is actively traded, tion’s activities and with the institution’s lend-
over the counter, or closely held. The policy also ing policies. Any departures therefrom can have
should assign responsibility and set a frequency serious consequences for institutions of all sizes.
for periodic pricing of the collateral. (See SR-99-23.) Departures can be evident in
three pivotal and related areas:
Prohibitions against tying arrangements. In a
tying arrangement, the extension of credit, pro-
vision of a service, or consideration for credit or 2. See SR-95-32.

Page 6
1. An undue reliance on optimistic outlooks for Underlying a banking organization’s (BO)

prospective borrowers and for continued overly optimistic assessment of a borrower’s
favorable economic and financial market prospects may be an overreliance on its
conditions. A long and continuing economic continued ready access to financial markets
expansion can lead banks to more frequently on favorable terms. Examples of overreliance
base their decision to lend on a very optimis- include the following:
tic assessment of the borrower’s operating
prospects. Timely principal repayment may • explicit reliance on future, public market
often be based on the assumption that the debt or equity offerings or on other sources
borrower will have ready access to financial of refinancing as the ultimate source of
markets in the future. Such reliance, espe- principal repayment, which presumes that
cially if across a significant volume of loans, market liquidity and the appetite for such
is not consistent with sound credit-risk man- instruments will be favorable at the time
agement. Undue reliance on continued favor- that the facility is to be repaid
able economic conditions can be demon- • ambiguous or poorly supported BO analy-
strated by— sis of the repayment sources of the loan’s
principal (This results in an implicit reli-
• dependence on very rapid growth in a ance, for repayment, on some realization of
borrower’s revenue as the ‘‘most likely’’ the implied market valuation of the bor-
case; rower (for example, through refinancing,
• heavy reliance on favorable collateral asset sales, or some form of equity infu-
appraisals and valuations that may not be sion) and presumes, as above, that markets
sustainable over the longer term; will be receptive to such transactions at the
• greater willingness to make loans without time that the facility is to be repaid.)
scheduled amortization before the loan’s • measuring a borrower’s leverage (for exam-
final maturity; or ple, debt-to-equity) based solely on the
• ready willingness to waive violations of market capitalization of the firm without
key covenants, release collateral, or guar- regard to ‘‘book’’ equity, and thereby
antee requirements, or even to restructure implicitly assuming that currently unreal-
loan agreements, without corresponding ized appreciation in the value of the firm
concessions on the part of the borrower on can be readily realized if needed
the assumption that a favorable environ- • more generally, extending bank loans with
ment will allow the borrower to recover a risk profile that more closely resembles
quickly. that of an equity investment and under
circumstances in which additional bank
Among the adverse effects of undue reli- credit or default are the borrower’s only
ance on a favorable economy is the possibil- resort if favorable expectations are not met
ity of delay in properly identifying problem
loans. Timely identification of problem loans As a result of this overreliance, some bank-
is critical for providing a full awareness of ing organizations may find themselves with a
the institution’s risk position, informing man- potentially significant concentration of credit
agement and directors of that position, taking exposure that is at risk to a possible reversal
steps to mitigate risk, and properly assessing in financial markets. Turmoil in financial
the adequacy of the allowance for credit markets, however, may contribute to signifi-
losses and capital. 2a cant liquidity pressures in some sectors of the
economy and prevent ready access to finan-
cial markets by certain borrowers. Moreover,
2a. With respect to these issues, see SR-98-25, ‘‘Sound there is no assurance that any such market
Credit Risk Management and the Use of Internal Credit Risk
Rating Systems at Large Banking Organizations’’; SR-99-22,
turmoil will quickly resolve itself. Under
‘‘Joint Interagency Letter on the Loan Loss Allowance’’; and these circumstances, a borrower’s ability to
SR-99-18, ‘‘Assessing Capital Adequacy in Relation to Risk at raise new funds in public debt or equity
Large Banking Organizations and Others with Complex Risk markets to repay maturing bank loans is far
Profiles.’’ As discussed therein, the Federal Reserve’s guid-
ance on credit-risk management and mitigation covers both
from guaranteed.
loans and other forms of on- and off-balance-sheet credit
exposure. 2. Insufficient consideration of stress testing.

Page 7
An institution’s lending policies should pre- to raise new equity. In particular, the evalu-
scribe meaningful stress testing of the pro- ation should focus not only on the borrower’s
spective borrower’s ability to meet its obli- ability to meet near-term interest obligations,
gations. Failure to recognize the potential for but also on its ability to repay the principal of
adverse events—whether specific to the bor- the obligation.
rower or its industry (for example, a change
in the regulatory climate or the emergence of 3. Weakening of key internal controls in the
new competitors) or to the economy as a lending process. An institution’s lending pol-
whole (for example, a recession)—can prove icy should require the use of adequate inter-
costly to a banking organization. nal controls within the lending process.
Mechanical reliance on threshold financial Internal controls such as loan review or
ratios (and the ‘‘cushion’’ they imply) is credit audit are critical for maintaining proper
generally not sufficient, particularly for com- incentives for bank staff to be rigorous and
plex loans and loans to leveraged borrowers disciplined in their credit analysis and lend-
or others that must perform exceptionally ing decisions. A bank’s credit analyses, loan
well to meet their financial obligations suc- terms and structures, credit decisions, and
cessfully. Scenario analysis specific to the internal rating assignments should be reviewed
borrower, its industry, and its business plan is in detail by experienced and independent
critical to identify the key risks of a loan. loan-review staff. These reviews provide both
Such analysis should have a significant influ- motivation for better credit discipline within
ence on both the decision to extend credit at an institution and greater comfort for
all and, if credit is extended, on decisions on examiners—and management—that internal
appropriate loan size, repayment terms, col- policies are being followed and the institu-
lateral or guarantee requirements, financial tion continues to adhere to sound lending
covenants, and other elements of the loan’s practice.
structure. Economic prosperity and relatively low
When properly conducted, meaningful levels of problem loans and credit losses
stress testing includes assessing the effect on should not encourage institutions to dramati-
the borrower when the following situations cally or suddenly reduce staff resources or
or events occur: portfolio coverage for the loan-review func-
tion. Likewise, thorough reviews of indi-
• unexpected reductions or reversals in rev- vidual loans should continue. When eco-
enue growth, including shocks to revenue nomic prosperity and relatively low levels of
of the type (or types) and magnitude that problem loans and credit losses exist, there
would normally be experienced during a may be increasing internal pressure within
recession the institution to reduce loan-review staff, to
• unfavorable movements in market interest conduct more limited loan portfolio reviews,
rates, especially for firms with high debt and to perform less thorough reviews of
burdens individual loans. Although some useful effi-
• unplanned increases in capital expendi- ciencies may be desired, the danger is that
tures due to technological obsolescence or the scope and depth of loan-review activities
competitive factors may be reduced beyond prudent levels over a
• deterioration in the value of collateral, longer horizon. If reduced too far, the integ-
guarantees, or other potential sources of rity of the lending process and the discipline
principal repayment of identifying unrealistic assumptions and
• adverse developments in key product or discerning problem loans in a timely fashion
input markets may deteriorate, particularly as a result of a
• reversals in or reduced access by the bor- downturn in a credit cycle.
rower to public debt and equity markets
Other. Management should establish appropriate
Proper stress testing typically incorporates an policies, procedures, and information systems to
evaluation of the borrower’s alternatives for ensure that the impact of the bank’s lending
meeting its financial obligations under each activities on its interest-rate exposure is care-
scenario, including asset sales, access to fully analyzed, monitored, and managed. In this
alternative funding or refinancing, or ability regard, consideration should also be given to

Page 8
off-balance-sheet instruments that may be asso- (the tying product) on a requirement that the
ciated with lending arrangements, including com- customer obtain another product or service (the
mitments, letters of credit, or swaps. (See sec- tied product) from the bank or an affiliate of the
tion 4110.1 for further details.) bank. The central purpose of section 106(b) is to
Under the provisions of the Financial Institu- prevent banks from using their market power in
tions Reform, Recovery, and Enforcement Act banking products, including credit, to gain an
of 1989 (FIRREA) and the Federal Deposit unfair competitive advantage in other products.
Insurance Corporation Improvement Act of 1991 The restrictions of section 106(b) on banks are
(FDICIA), a financial institution is required to broader than those of the antitrust laws, as no
develop, adopt, and maintain policies, proce- proof of economic power in the tying-product
dures, and guidelines consistent with safe and (or desired-product) market or anticompetitive
sound banking practices. The federal banking effects in the tied-product market are required
agencies have issued interagency guidelines for a violation to occur. Although banks, like
based on the provisions. Taken together, these their nonbank competitors, are subject to gen-
guidelines should strengthen supervision of eral antitrust prohibitions on tying, section 106
financial institutions and provide guidance in was enacted because Congress concluded that
developing and maintaining policies: special restrictions were necessary given the
unique role of banks in the economy.
• Regulation H—subpart E, 12 CFR 208.50–51 The intent behind section 106(b) is to affirm
• Regulation Y—subpart G, 12 CFR 225.61–67 the principles of fair competition by eliminating
• Interagency Statement on Independent the use of tying arrangements that have the
Appraisal and Evaluation Functions (See potential to suppress competition. A prohibited
SR-03-18.) tie-in can occur if a bank (1) varies the consid-
• Uniform Standards of Professional Appraisal eration (that is, the amount charged) for a bank
Practice promulgated by the Appraisal Stan- product or service (the tying product) on the
dards Board of the Appraisal Foundation condition that a customer obtain another product
• Interagency Policy Statement on Appraisal or service (the tied product) from the bank or its
and Evaluation Guidelines (See SR-94-55 and affiliate or (2) requires a customer to purchase
SR-94-35.) another product or service from the bank or any
• Interagency Guidance on Accounting for Dis- of its affiliates as a condition for providing a
position of Other Real Estate Owned (See product or service to the customer.
SR-93-42.) Section 106(b) of the Bank Holding Company
• Interagency Policy Statement for Loan and Act Amendments has five restrictions that are
Lease Losses (See SR-06-17.) applicable to banks. The first two restrictions
• Interagency Policy Statement on Supervisory prohibit conditions constituting traditional tying
Initiatives/Credit Availability (See SR-93-30.) arrangements; restrictions three and four pro-
• Interagency Policy Statement on Documenta- hibit reciprocal-dealing arrangements; and the
tion of Loans (See SR-93-26.) fifth, with certain exceptions, prohibits an
• Regulation Y, section 225.7 ‘‘Tying Restric- exclusive-dealing arrangement. Exempted from
tions’’ (12 CFR 225.7.) these prohibited conditional transactions are tra-
ditional bank products. Specifically, section
An institution’s policies and procedures as they 106(b) prohibits a bank, in any manner, from
relate to interagency statements should be fixing or varying the consideration for extending
reviewed as part of the examination of the credit, leasing or selling property of any kind, or
institution’s overall lending activities. furnishing any service on the condition or
requirement that the customer—
• obtain additional credit, property, or service

PROHIBITIONS AGAINST TYING from the bank, other than a loan, discount,
ARRANGEMENTS deposit, or trust service (a traditional bank
product);
Section 106(b) of the Bank Holding Company • obtain additional credit, property, or service
Act Amendments of 1970 (12 USC 1972(b)) from the bank’s parent holding company or
generally prohibits a bank from conditioning the other subsidiaries;
availability or price of one product or service • provide additional credit, property, or service

Page 8.1
to the bank, other than those related to and product exception of section 106(b) permits a
usually provided in connection with a loan, bank to tie any product to a traditional bank
discount, deposit, or trust service; product (a loan, discount, deposit, or trust ser-
• provide additional credit, property, or service vice) offered by that bank, but not by any
to the bank’s parent holding company or any affiliated bank or nonbank. For example, a bank
of the holding company’s other subsidiaries; could condition the use of its messenger service
or on a customer’s maintaining a deposit account at
• not obtain other credit, property, or service the bank. Section 106(b) also grants the Board
from the competitors of the bank, the bank’s the authority to prescribe exceptions by regula-
parent holding company, or the holding com- tion or order when it determines that an excep-
pany’s other subsidiaries, except that the lend- tion will not be contrary to the purposes of this
ing bank may reasonably impose conditions section.
and requirements in a credit transaction to
ensure the soundness of the credit.
Regulatory Exceptions
As stated above, section 106(b) prohibits
reciprocity arrangements. In a reciprocity Traditional-bank-product exception. The
arrangement, a bank conditions the availability traditional-bank-product exception of Regula-
of, or varies the consideration of, one product on tion Y (12 CFR 225.7(b)(1)) permits a bank to
a customer’s provision of another product to the extend credit, lease or sell property, provide any
bank or one of its affiliates. The statutory service, or fix or vary its consideration on the
prohibition on reciprocity arrangements con- condition that a customer obtain a traditional
tains an exception intended to preserve tradi- bank product (a loan, discount, deposit, or trust
tional banking practices. The exception provides service) from an affiliate of the bank. This
that a bank may condition the availability of a regulatory exception is a limited extension of
product or service on a customer’s providing to the traditional-bank-product exception provided
the bank some product or service ‘‘related to and in section 106(b) and is coextensive with the
usually provided in connection with’’ a loan, statutory exception.
discount, deposit, or trust service.3
Because a subsidiary of a bank is considered Combined-balance discount. On April 19, 1995
to be part of the bank for most supervisory and (effective May 26, 1995), the Board issued a
regulatory purposes under the federal banking revised rule on the anti-tying provisions of
laws, the restrictions in section 106(b) generally section 106 of the Bank Holding Company Act
apply to tying arrangements imposed by a sub- Amendments of 1970.4 The rule established a
sidiary of a bank in the same manner that the combined-balance discount safe harbor for a
statute applies to the parent bank itself. Thus, a banking organization offering varieties of ser-
subsidiary of a bank is generally prohibited from vices to its customers and wishing to offer them
conditioning the availability or price of a prod- discounts based on the customers’ overall rela-
uct on a customer’s purchase of another product tionship with the bank or its holding company
from the subsidiary, its parent bank, or any and subsidiaries. A bank may vary the consid-
affiliate of its parent bank. Section 106(b) generation for any product or package of products
erally does not apply to tying arrangements based on a customer’s maintaining a combined
imposed by a nonbank affiliate of the bank. minimum balance in certain products specified
by the bank (eligible products)5 if—
Exceptions
4. With the Board’s approval of the 1997 revisions to
Statutory Exception Regulation Y, tie-in prohibitions were eliminated for BHCs
and their nonbank subsidiaries, except when electronic benefit
There is a statutory exception to the anti-tying transfer services are provided. BHCs and their nonbank
subsidiaries are still subject to anti-tying restrictions with
restrictions. The statutory traditional-bank- respect to electronic benefit transfer services, as set forth in
section 7(i)(11) of the Food Stamp Act of 1977 (7 USC
3. The 1997 Regulation Y revisions extended this statutory 2016(i)(11)).
exception to cover reciprocity requirements imposed by banks 5. Eligible products under the safe harbor are those ‘‘prod-
that require customers to provide a ‘‘usually related’’ product ucts specified by the bank’’ as part of the combined-balance
or service to an affiliate of the bank. discount program. (See 12 CFR 225.7(b)(2).)

Page 8.2
• the bank offers deposits, and all such deposits size of the customer’s balance in eligible prod-
are eligible products, and ucts, as may the premiums paid in a given policy
• balances in deposits count at least as much as year on non-annuity insurance products. The
nondeposit products toward the minimum principal amount of an annuity is closely analo-
balance. gous to the principal amount of a deposit, as
both represent a customer’s initial cash invest-
ment with the relevant financial institution. Simi-
Board Staff Opinions on Exceptions to the larly, insurance premiums are money actually
Anti-tying Restrictions paid by the customer to the insurance underwriter.
Offering insurance products in a combined- Combined-balance discount—Members of a

balance discount program. A question was raised household or family, taken together, may consti-
as to whether insurance products may be tute a ‘‘customer.’’ A BHC’s legal counsel raised
included among the products offered by a bank a question as to whether members of a house-
as part of a combined-balance discount program hold or family, taken together, may be consid-
(eligible products) operated pursuant to the ered a ‘‘customer’’ for purposes of the combined-
Board’s safe harbor, if the program otherwise balance discount safe harbor set forth in section
meets the requirements of the safe harbor. If 225.7(b) of Regulation Y. The BHC desired to
insurance products are deemed to be eligible offer its customers discounts on the products and
products, it was also questioned whether the services of its subsidiary banks if a customer’s
principal amount of annuity products may be household maintains a specific minimum bal-
counted towards the minimum balance, and ance with its banks and their affiliates. The
whether insurance premiums may be counted minimum balance would be computed by add-
towards the minimum balance for non-annuity ing the balances held by an individual customer
insurance products. in products (both bank and nonbank) specified
Board staff issued the following response to by the company’s affiliated bank, including
the questions: To qualify for the Board’s safe deposits, to balances held in the same products
harbor, all deposits must be eligible products by all other members of that customer’s house-
under the combined-balance discount program, hold.
and deposit balances must be weighed at least as Board staff noted that the safe harbor would
much as nondeposit products towards the mini- be available only if all deposits are eligible
mum balance.6 The Board’s requirement that products under the combined-balance discount
deposit balances be weighed at least as much as program and deposit balances are weighed at
nondeposit products towards the minimum bal- least as much as nondeposit products towards
ance was included in the safe harbor to allow the minimum balance. Board staff also noted
banks and their affiliates to price products they that aggregating balances held at the BHC’s
include in a combined-balance program in an affiliates by members of a family or household
economically rational way—while limiting the would make it easier for customers to achieve
bank’s ability to use product weighting to require the minimum balance necessary to receive the
the purchase of certain nontraditional products. favorable pricing on bank products and services,
This requirement specifically provides for the and thus appears to be pro-consumer and not
inclusion of certain products with values that anticompetitive.
could be greater than the typical retail deposit, Accordingly, Board staff opined in a Novem-
while allowing deposits to remain a viable way ber 26, 2002, letter that the term customer, as
for customers to reach the minimum balance. used in section 225.7(b)(2) of Regulation Y,
On this basis, any financial products offered may include separate individuals who (1) are all
by a bank or its affiliates, including insurance members of the same immediate family (as
products, may be properly included among the defined in section 225.41(b)(3) of Regulation Y)
eligible products in that bank’s combined- and (2) reside at the same address. Staff also
balance discount program. The principal amount indicated that the program must not be operated
of an annuity may be counted in determining the in an anticompetitive manner.
6. As previously noted, eligible products are those ‘‘prod-

A BHC’s subsidiary banks issuing securities-
ucts specified by the bank’’ as part of the combined-balance based credit can require borrowers to keep the
discount program. securities collateral in an account at the BHC’s

Page 8.3
broker-dealer affiliate. A BHC’s legal counsel each trade.7 These restrictions would both pro-
requested that the Board grant an exception to tect the banks’ interest in and the value of the
the anti-tying prohibitions of section 106 of the collateral pledged and ensure that the banks do
Bank Holding Company Act Amendments of not require customers to establish brokerage
1970. The exception would allow the subsidiary accounts for a purpose other than protecting
banks (the banks) of the BHC to require bor- bank collateral. The BHC proposed to require
rowers whose bank loans are secured with the use of affiliated broker-dealer accounts solely
publicly traded securities to keep those securi- for the purpose of securing and monitoring
ties in accounts at the BHC’s broker-dealer collateral pledged for loans extended by the
affiliate. banks to their account holders.
The request stated that the banks often make The Board’s response letter stated that (1) sec-
loans that are collateralized by marketable secu- tion 106 permits this practice when securities
rities, and that these securities are generally held collateralizing a loan are maintained in trust
in accounts at broker-dealers unaffiliated with accounts in the banks or their affiliates or are
the BHC, subject to collateral agreements. The otherwise provided to and held by the banks;
BHC requested its subsidiary banks be granted (2) the proposal would not appear to give the
an exception from section 106 that would allow BHC any competitive advantage over other
them to require borrowers to keep securities broker-dealers in obtaining general securities
pledged as loan collateral from the banks in an brokerage business from customers; and (3) the
account at a broker-dealer affiliate. The require- described restrictions would cause the securities
ment would give the BHC more control over the accounts at the broker-dealer to be the func-
collateral (for example, to prevent it from being tional equivalent of bank trust accounts, in
sold or exchanged for different securities) and which the banks currently may require borrow-
would allow the BHC to monitor the value of ers to place securities used to collateralize loans.
the collateral more closely than when the secu- The Board’s response also stated that the Board
rities are held at an unaffiliated institution. continues to evaluate whether the BHC’s pro-
The Board’s August 18, 2003, response to the posed program is prohibited by section 106.
request was as follows: Section 106 allows the Subject to this potential determination, the Board
banks to require borrowers to place securities believed that granting an exception for the
pledged as collateral in trust accounts at the program would not be contrary to the purposes
banks. A specific exception in section 106 of section 106. The response noted that the
allows banks to condition the availability of any limitations on when an affiliated broker-dealer
product, including credit, on the customer’s account would be required and how the account
obtaining a trust service. The BHC preferred, would be used help ensure that the accounts at
however, to use the systems for holding and the BHC’s broker-dealer affiliate would only be
monitoring securities in brokerage accounts at used to preserve customers’ collateral pledged
its broker-dealer affiliate for reasons based on for loans and would not be used to gain a
cost, efficiency, and improved monitoring. The competitive advantage over the broker-dealer
banks, it was contended, would receive more affiliate’s competitors, particularly because a
cooperation when inquiring about the status of customer’s ability to trade in the account would
securities pledged as collateral from the BHC’s be severely restricted. Accordingly, on this basis,
broker-dealer affiliate than they would receive the Board granted an exception to the restric-
from unaffiliated broker-dealers, who have little tions of section 106 for the BHC’s proposed
incentive to help the banks protect their collateral. program. Approval of the exception was subject
The BHC made the following representations to the restrictions on the relevant accounts at the
in support of its request: (1) The banks would BHC’s broker-dealer affiliate described in the
only require the customer to use an account BHC’s request and in its correspondence, and to
of the BHC’s broker-dealer affiliate for the the Board’s potential determination that the
purpose of holding securities that collateralize proposed requirement is not in fact subject to
a loan from the banks; (2) no securities other section 106. Any changes in the facts and
than those pledged as collateral for a loan from representations are to be reported to Board staff.
the banks could be held in these accounts; and
(3) securities held in these accounts could not
be traded by the customer without the prior 7. The BHC will not give customers permission to trade
approval of the BHC’s credit department for generally through these accounts.

Page 8.4
Bank customers receiving securities-based credit requirement that the customer obtain another
can be required to hold securities collateral at a separate product from, or provide another sepa-
broker-dealer affiliate account. A bank’s exter- rate product to, the bank or an affiliate of the
nal legal counsel inquired about the application bank. Board staff stated that it believed the
of section 106 to certain lending programs securities-based lending programs, when con-
offered by the bank and its broker-dealer affili- ducted in the manner described in the inquiry
ate. In a letter dated February 2, 2004, Board and in the bank’s correspondence with the
staff responded that section 106 does not pro- Board, are permissible under and consistent
hibit a bank from requiring borrowers that with the purposes of section 106. In support of
obtain securities-based credit from the bank to this determination, Board staff stated that (1) by
keep the securities collateral in an account at a requiring collateral for a securities-based loan,
bank’s broker-dealer affiliate, so long as the the bank and its broker-dealer affiliate are not
collateral requirement is limited in scope. requiring that the customer obtain any product
The inquiry stated that the bank and its separate from the loan itself and (2) the fact that
broker-dealer affiliate offer securities-based the bank and its affiliate require the pledged
loans—that is, loans collateralized by securities securities to be held in an account at an affiliate
or other marketable investment assets does not make the collateral or the account a
(securities)—subject to the requirement that the product separate from the loan that the collateral
securities collateralizing the loans be kept in secures. The Board’s staff opinion was not
collateral accounts with their broker-dealer altered by the fact that (1) borrowers are per-
affiliate.8 The inquiry also stated that customers mitted to hold securities in the collateral account
are (1) not charged for establishing or maintain- beyond those minimally required to satisfy the
ing the collateral accounts or for transferring lender’s collateral requirement and to trade
securities to the collateral accounts; (2) not securities in the collateral; 9a (2) a customer must
obligated to trade in the collateral accounts or pay the broker-dealer affiliate its standard bro-
any other accounts or to purchase any other kerage commission if the customer decided to
products or services from the bank, its affiliate, effect trades in the collateral account; 9b or (3) in
or the broker-dealer affiliate, or any of their the event that the value of the securities in the
affiliates; (3) not required to maintain any secu- collateral account falls below the lender’s col-
rities in the collateral accounts beyond those lateral requirement for the related loan, the
necessary, in the bank’s credit judgment or that customer must eliminate the collateral shortfall.
of its affiliate, as the case may be, to support the
credit extensions;9 (4) required to obtain prior
approval from the bank or its affiliate, as appro-
priate, before withdrawing assets from the col-
lateral accounts; (5) not charged a fee for
LOAN ADMINISTRATION
effecting such withdrawals; and (6) required to Loan administration is a term that refers to
ensure that the value of the securities in the several aspects of lending. It can be used to
collateral account equals or exceeds the lender’s describe the entire credit-granting process, as
(the bank or its broker-dealer affiliate) collateral well as the monitoring of various lending activ-
requirement for the loan on an ongoing basis. ities, such as ensuring that loans remain ade-
Board staff responded by stating that section quately collateralized, properly graded, and
106 generally prohibits a bank from condition- appropriately serviced (administered). The ser-
ing the availablility or price of a product on a
8. The inquiry stated that the bank and its broker-dealer 9a. Allowing a customer to trade securities or to place
affiliate generally allow customers to trade securities held in excess securities in a collateral account underlying a securities-
the collateral accounts (however, see footnote 3 of the based loan enhances customer choice without reducing the
response letter) and that the broker-dealer affiliate charges integral connection between the loan and the collateral account.
customers its standard brokerage fee for any trades made by The inquiry represented that the customer is allowed to trade
customers that involve securities held in the collateral accounts. and deposit excess securities in the account, and the customer
Customers are also not restricted in their ability to maintain is not required to trade or deposit excess securities. Thus, any
brokerage accounts with other securities firms not affiliated trading in the account or placement of excess securities in the
with the bank or its affiliate. account is voluntary.
9. All securities in the collateral accounts are pledged as 9b. A customer is not required to trade in the account, and
collateral to support the securities-based loans extended by the trades effected by the customer in the account generally would
bank or its affiliate. be unrelated to the loan.

Page 8.5
vicing of an extension of credit involves tasks size and complexity. Managers should empha-
ranging from obtaining current financial infor- size integrity and ethical values, as well as hire
mation to sending out renewal notices and competent staff. In addition, the following fac-
preparing loan agreements. In addition to facili- tors positively influence loan-administration
tating the entire lending process, the individual control:
tasks also serve as controls (checks and bal-
ances) over the lending activities. Given the • a board of directors and/or senior management
wide breadth of responsibilities that the loan- that takes an active role in monitoring lending
administration function encompasses, its orga- policies and practices
nizational structure varies with the size and • a reporting system that provides the bank with
sophistication of the bank. In larger banks, the information needed to manage the lending
responsibilities for the various components of function and make sound credit decisions
loan administration are usually assigned to dif-
ferent departments, while in smaller institutions, • a well-defined lending-approval and -review
a few individuals might handle several of the system that includes established credit limits;
functional areas. For example, a large bank’s limits and controls over the types of loans
independent credit department may be respon- made and their minimum collateral require-
sible for analyzing borrowers’ financial informa- ments (for example, loan-to-collateral-value
tion, making a determination or recommenda- ratios); limits on maturities of loans; and
tion as to the quality of the loan (its risk rating policies on interest rates, pricing, and fee
or grade), or obtaining/following up on credit- charges
related information and documentation. On the • an independent loan-review function that iden-
other hand, smaller banks may assign each of tifies and evaluates existing and potential
these tasks to individual loan officers. problem loans in a timely manner
Examiners will encounter many different
organizational structures for loan administra- • an independent reporting system that notifies
tion. Therefore, when considering the safety and appropriate personnel when financial informa-
soundness of a bank, they should determine tion, insurance policies, or other loan docu-
whether it has effective and appropriate internal mentation needs to be obtained
controls in place. The assessment of loan admin- • a system of procedures that correct documen-
istration and related internal controls involves tation exceptions
evaluating the bank’s operations by reviewing
the— Loan administration is responsible for miti-
gating the operational risks associated with loan-
• efficiency and effectiveness of loan- related transactions, such as approving credit,
administration operations; disbursing loan proceeds, receiving loan pay-
• ability of the different components to safe- ments, recording accrued interest and fee income,
guard assets, primarily loans and leases; posting to subsidiary ledgers, and reconciling
subsidiary and general ledgers. Typically,
• adequacy of the management information sys-
employees working with these types of activities
tems and the accuracy of their reporting;
have the capability to transfer funds between
• adequacy and accuracy of its loan-review accounts on the bank’s and the customer’s
function (discussed in the next subsection); behalf, which opens up an area of potential
and abuse. Additional potential areas for unethical
• compliance with prescribed management employee behavior include the maintenance of
policies, procedures, applicable laws, and loan notes and related documentation, as well as
regulations. the credit and collateral files on borrowers. The
bank must ensure it has adequate controls in
For the components of loan administration to place to avoid any improprieties; controls might
function appropriately, management must under- include having separate departments for loan
stand and demonstrate that it recognizes the activities within a large organizational structure
importance of controls. This includes not only or rotating and/or segregating loan duties in
establishing appropriate policies and procedures smaller community banks. Some specific issues
but also enforcing them and ensuring that the related to these responsibilities are described
bank’s organizational structure is suitable for its below.

Page 8.6
Applications and Loan-Approval sions, and fee computations to confirm their

Process accuracy. Payment notices should be prepared
by someone other than a loan teller. In addition,
The bank should have written policies and loan officers should be prohibited from process-
procedures for obtaining and reviewing loan
applications and for ensuring sufficient borrower
information (both financial and collateral-related)
is required and analyzed in support of the loan
approval. Approvals should be made in accor-
dance with the bank’s written guidelines and
should also address the disbursal of loan pro-
ceeds. Additional issues that bank policies and
procedures should address include—
• the requirement that loan commitments be in

writing;
• requirements for letters of credit;
• the requirement for an annual review of bor-
rowers, including a reassessment of the appro-
priateness of credit lines; and
• the requirement for a process for extending or
renewing loans and credit lines.
Exceptions to the bank’s written policies and

procedures should reflect the appropriate level
of approval and should be documented in writing.
Account Records
Bank staff should compare the approved terms
for new and renewed extensions of credit
(amount, maturity, interest rate, payment sched-
ule) to the note or loan agreement for accuracy.
The former should then be compared with the
trial balance, if it is automated. If a manual
system is used, the approved amount of the
extension of credit should be checked against
deposit tickets to ensure the correct amount was
transferred to the borrower’s account. Adjust-
ments to loan accounts or accrued interest
receivable accounts should be checked and tested
by an individual independent of the loan-
processing area. Subsidiary records should be
routinely reconciled with the appropriate gen-
eral ledger accounts.
Payments
Regardless of the type of payment, principal,
interest, or fee, certain controls are necessary to
ensure the effectiveness of operations, as well as
the safeguarding of bank assets. An individual
who cannot originate loan entries should per-
form an independent test of interest, commis-

Page 8.7
ing loan payments. Payments received by mail, Management Information Systems

tellers, or other departments should be separate
from the loan-recording function. Supervisory Management information systems, an increas-
approvals should be required for processing ingly important component of the loan admin-
payments that are less than the amount contrac- istration function, allow a bank to manage its
tually due, pertain to delinquent loans, are lending decisions more efficiently and effec-
received irregularly, or involve waiving late tively. Whether the bank uses a computerized or
fees. Collection notices should also be handled manual system to manage its loan portfolio, the
by someone not associated with loan processing. following types of information should be readily
available and routinely reviewed by management:
Credit File Documentation • total loans and commitments

• loans in excess of existing credit limits
The bank should establish and maintain credit • new extensions of credit, credit renewals, and
files for all borrowers. The bank’s written loan restructured credits
policy should detail the minimum acceptable • a listing of all delinquent and/or nonaccrual
amount of information to be included in a loans
borrower’s credit file. The credit file should • credits adversely graded or requiring special
contain information on the extension of credit attention
that identifies its purpose, source of repayment, • credits to insiders and their related interests
repayment terms, and disposition of loan pro- • credits not in compliance with policies, laws,
ceeds. Additionally, information should be on or regulations
file relating to and/or analyzing the borrower’s • specific lending activity aspects, including
financial condition, including tax returns as automated financial statement spreads of bor-
appropriate; collateral, its valuation and related rowers and analyses of the bank’s credit
hazard insurance; the loan officer’s contact with exposure by type, geographic areas, collateral,
the borrower; and other pertinent documents, and large employers
such as guarantor information, loan agreements,
and loan covenant check sheets. Banks should
maintain this information to support their evalu-
ation of the borrower’s creditworthiness and to
INTERNAL LOAN REVIEW
leave a paper trail for auditors. The bank should
The internal loan review function should not be
also implement a file documentation tickler
merely an after-the-fact, loan-by-loan review,
system to help bank personnel obtain updated
but a process to detect weaknesses in the various
information on borrowers, thereby facilitating
levels of an institution’s credit approval and
continuous assessment and monitoring of credit
monitoring system.
risk.
The nature of loan review systems may vary
based on an institution’s size, complexity, and
management practices. For example, a loan
Collateral Records review system may include components of a
traditional loan review function that is indepen-
Banks should maintain a register to document dent of the lending function. Or, it may place
collateral received from and released to borrow- some reliance on loan officers. While the former
ers, which should correspond to the actual method is preferred, reliance on the lending staff
collateral being held. Negotiable collateral should could be appropriate if the loan officers are not
be maintained under dual control in a fireproof permitted sole discretion to assign credit-quality
vault. The receiving and releasing of collateral ratings. In addition, the term ‘‘loan review
to customers should be handled by individuals system’’ can refer to various responsibilities
other than those who make entries in the collat- assigned to credit administration, loan adminis-
eral register. The bank should issue a receipt to tration, problem-loan workout, or other areas.
customers for each item of collateral it is hold- These responsibilities may range from adminis-
ing in safekeeping. Signed customer receipts tering the internal problem loan–reporting pro-
should be obtained and filed after the collateral cess to maintaining the integrity of the credit-
is released. grading process (for example, ensuring that

Page 9
changes are made in credit grades as needed) • the freedom to communicate directly, without
and coordinating the information necessary to fear of reprisal, with senior management and
assess ALLL adequacy. Regardless of the struc- the bank’s board of directors
ture of the loan review function, an effective • skilled personnel who are experienced in credit
system should— analysis and knowledgeable of sound lending
operations
• ensure consistent application of the credit- • training and continuing education resources
grading system, for the loan review staff
• promptly and accurately identify loans with
potential or well-defined credit weaknesses
and ensure the development and implementa- Credit-Grading Systems
tion of an appropriate action plan to minimize
credit losses, The foundation of any loan review system is
• project relevant trends that affect the collect- accurate and timely credit grading (also referred
ibility of the portfolio and isolate potential to as risk rating), which involves assessing
problem areas, credit quality and, ultimately, identifying prob-
• act as an information source concerning emerg- lem loans. An effective credit-grading system
ing trends in the portfolio and the bank’s area provides that the bank’s risk ratings on ‘‘non-
economy, pass’’ credits be updated periodically (at least
• provide senior management and the board of quarterly) so that (1) the ALLL is appropriate
directors with an objective and timely assess- for the risk contained in the portfolio and
ment of the overall quality of the loan portfolio, (2) strategies relative to workout action plans
• provide essential information to determine the are up-to-date. Regardless of the type of loan
adequacy of the ALLL, review system employed, an effective credit-
• assess the adequacy of and adherence to grading framework generally places primary
internal credit policies and loan administra- reliance on loan officers to identify emerging
tion procedures, and monitor compliance with loan problems. However, given the importance
relevant laws and regulations, and the subjective nature of credit grading, a
• ensure that relevant supporting loan documen- loan officer’s judgment on the assignment of a
tation has been obtained, particular credit grade to a loan should be
• help develop and revise lending policy and subject to review by (1) peers, superiors, or loan
procedures, committees; (2) an independent, qualified part-
• evaluate the activities of lending personnel, time or full-time person(s); (3) an internal depart-
and ment staffed with credit review specialists; or
• provide management with accurate and timely (4) outside credit review consultants. A review
information related to credit quality that can of the credit-quality assessment independent of
be used for financial and regulatory reporting the lending function is preferred because it
purposes. typically provides a more conservative and
realistic assessment of credit quality. Accurate
and timely credit grading is a critical component
Characteristics of Loan Review of an effective loan review system. Each insti-
Program tution should ensure that its loan review system
includes the following attributes:
To accomplish the preceding loan review objec-
tives effectively, the program must possess the • a formal credit-grading system that can be
following components: reconciled with the framework used by the
federal regulatory agencies 10
• a policy that clearly defines responsibilities of
the loan review function and that communi- 10. An institution may have a credit-grading system that
cates directorate and management support to differs from the credit-grading framework used by the Federal
all personnel involved in the lending function Reserve. However, each institution that maintains a credit-
• a policy that explicitly describes the bank’s grading system that differs from the Federal Reserve’s frame-
work should maintain documentation that translates its credit-
credit-grading system and grading definitions grading system into the pass/special mention/substandard/
• the capacity for objective judgment of loan doubtful/loss credit-grading framework used by the Federal
quality and the autonomy to exercise it Reserve. This documentation should be sufficient to enable

Page 10
• an identification or grouping of loans that addition, loan review personnel should be aware
warrants the special attention of management, of relevant laws and regulations affecting lend-
with documentation supporting the reasons a ing activities.
particular loan deserves special attention
• a mechanism for direct, periodic, and timely Independence of Loan Review Personnel—An
reporting to senior management and the board effective loan review system uses (1) a loan
of directors on the status of loans identified as officer’s initial identification of emerging prob-
needing special attention, and the actions lem loans and (2) the credit review of loans by
taken by management individuals independent of the credit approval
• appropriate documentation of the institution’s decisions. The first element of an effective
credit loss experience for various components system recognizes the loan officer’s responsibil-
of its loan and lease portfolio 11 ity to continually analyze his or her portfolio
and to promptly identify and report problem
An institution should maintain a written loans. Due to their frequent contact with bor-
description of its credit-grading system, includ- rowers, loan officers can usually identify poten-
ing a discussion of the factors used to assign tial problems before they become apparent to
appropriate credit grades to loans. Loan grades the nonlending staff. However, banks should not
should reflect the risk of credit losses. In addi- rely completely on loan officers for identifica-
tion, the loan review program should be in tion of problem loans because they may not be
writing, and the board of directors should review entirely objective in assessing the borrower’s
and approve it at least annually to evidence its credit quality. The second element of an effec-
endorsement. tive loan review system recognizes that loans
should be reviewed by individuals that do not
have responsibility for the loans they review and
Loan Review System Elements that the evaluation of the credit should not be
influenced by anyone associated with the loan
An institution’s written policy and documenta- approval/management process.
tion of its loan review system should address the While larger institutions typically establish a
following elements: separate department of credit review specialists,
cost and volume considerations may not justify
• qualifications of loan review personnel such a system in smaller institutions. As a result,
• independence of loan review personnel in many smaller institutions, management, a
• frequency of reviews loan committee, or even loan officers may fill
• scope of reviews this role—or it may be filled by outside consult-
• depth of reviews ants who periodically come to the bank and
• review of findings and follow-up review parts or all of the loan portfolio. Whether
• workpaper and report distribution, including or not the institution has an independent loan
distribution of reports to senior management review department, the loan review function
and the board of directors should report directly to the board of directors or
a board committee. (Senior management may
Qualifications of Loan Review Personnel— be responsible for appropriate administrative
Persons involved in the loan review function functions as long as the independence of the
should be selected based on level of education, loan review function is not compromised.)
experience, and extent of formal credit training.
They should be knowledgeable of both sound Frequency of Reviews—Optimally, the loan
lending practices and the institution’s lending review function provides useful, continual feed-
guidelines for the types of loans it offers. In back on the effectiveness of the lending process
to identify any emerging problems. For example,
significant credits should be reviewed at least
examiners to reconcile the totals for the various credit grades annually, upon renewal, or more frequently
under the institution’s system to the Federal Reserve’s cate- when internal or external factors indicate a
gories listed above. potential for deteriorating credit quality of a
11. Institutions are encouraged to maintain records of net
credit loss experience for credits in each of the following
borrower or a particular type of loan or pool of
categories: pass, special mention, substandard, doubtful, and loans. A system of ongoing or periodic portfolio
loss. reviews is particularly important to the ALLL

Page 11
determination process, which depends on the nesses that remain unresolved beyond the as-
accurate and timely identification of problem signed correction timeframes should be promptly
loans. reported to senior management and, if still
unresolved, to the board of directors.
Scope of Reviews—The review should cover all
borrowers whose exposure is significant to the Workpaper and Report Distribution—Work-
size of the bank. Additionally, each review papers should contain a list of the borrowers
should typically include the following compo- included in the scope of the review and all
nents of the portfolio under review: a sample of supporting information needed to substantiate
smaller loans; past-due, nonaccrual, renewed, the findings. Reports to management discussing
and restructured loans; loans previously classi- the findings of a portfolio review should indi-
fied or designated as special mention by the cate the ‘‘as of’’ review date; address the credit
institution or its examiners; insider loans; and grading (risk rating) of the individual borrowers
concentrations of credit, including other loans (loans) reviewed, as well as of the specific port-
affected by common repayment factors. It is folio; assess the adequacy of and adherence to
important that the scope-related information indi- internal policies and procedures; indicate loan,
cates that these components have been included credit file, and collateral deficiencies; and evalu-
in the review of the portfolio and that the ate compliance with laws and regulations. The
percentage of the portfolio selected for review reports also should include summary analyses
provides reasonable assurance that review supporting the assignment of special-mention or
results identify major problems in that portion of classified designations to borrowers (loans). A
the portfolio and accurately reflect its quality. summary report to the board of directors should
On a larger scale, the scope of management’s be submitted at least quarterly and include
review of the entire loan portfolio should attest findings relative to the areas previously men-
to the fact that its reviews identify problem tioned for all reviews conducted during that
loans significant to the bank and accurately timeframe (more frequently if material adverse
reflect portfolio quality on an ongoing basis. trends are noted.) This summary report might
The scope of loan reviews should be approved include, in addition to the issues found in the
annually by the institution’s board of directors reports to management, comparative trends iden-
or when significant changes are made to the tifying significant changes in the overall quality
scope. of the portfolio.
Depth of Reviews—Reviews should analyze a
number of important aspects of selected loans,
including—
Examination Scope Guidance
• credit quality; An effective loan review function can greatly

• sufficiency of credit and collateral assist examiners in their review of the bank’s
documentation; loan portfolio. The examination process should
• proper lien perfection; evaluate the internal loan-review function by
• proper approval by the loan officer and loan assessing the scope and depth of the review and
committee(s); the quality of the output. While examiners
• adherence to any loan-agreement covenants; should not rely entirely on the bank’s findings,
• compliance with laws, regulations, and inter- they can limit the scope of their loan examina-
nal policies and procedures; and tion by developing a comfort level with the
• the appropriateness and timeliness of problem- bank’s internal loan-review function. To deter-
loan identification by loan officers. mine the reliability, if any, of the internal
loan-review function, examiners should assess
Review of Findings and Follow-Up—Findings the adequacy of management’s ability to iden-
should be reviewed with appropriate loan offi- tify problem loans. Two issues should be evalu-
cers, department managers, and members of ated in this regard: timeliness and accuracy. The
senior management. Management’s responses to first issue deals with the ability of loan review to
all noted deficiencies and identified weaknesses distinguish a problem loan and/or borrower
should include existing or planned corrective from a nonproblem one when it initially becomes
actions and the timeframes for correction. Sig- a problem. The second issue deals with the
nificant noted deficiencies and identified weak- accuracy of loan review in identifying the

Page 12
severity of the problem. The Extent that exam- Exceptions—A loan does not need to be placed
iners rely on an internal loan-review function on nonaccrual status if (1) the criteria for amor-
depends upon their comfort level with the bank tization specified in AICPA Practice Bulletin
in the aforementioned regard. No. 6 are met with respect to a loan acquired
The examiner will be able to determine the at a discount from an unaffiliated third party,
degree to which the bank’s loan review function including those that the seller has maintained
can be relied upon by reviewing prior examina- on nonaccrual status, or (2) the loan is a con-
tion criticisms, as well as management’s response sumer loan or secured by a one- to four-family
to them, and a sufficient sample of the bank’s residential property. However, the bank may
portfolio. Whether the borrower being reviewed elect to carry these loans on a nonaccrual status.
as a part of the sampling process is a pass or Also, if a bank has a significant consumer or
nonpass credit, examiners should consider nar- residential mortgage loan portfolio in relation
rowing the scope of the pass credits included in to its total loans and tier 1 capital, a thorough
the loan examination if they concur with the review of the delinquency status should be
bank’s risk ratings. However, examiners still performed to ensure that the bank has not
should continue their analysis of all ‘‘nonpass’’ materially misstated its financial condition and
credits due to their importance to the adequacy earnings.
of the ALLL.
Treatment of Cash Payments and Criteria for
the Cash-Basis Treatment of Income—When a
NONACCRUAL LOANS bank places a loan on nonaccrual status, it must
consider how to account for subsequent pay-
Loans and lease-financing receivables are to be ments. When the collectibility of the remaining
placed on nonaccrual status if (1) principal or book balance of a loan on nonaccrual status is
interest has been in default for 90 days or more, uncertain, any payments received must be
unless the loan is both well secured and in the applied to reduce principal to the extent neces-
process of collection; (2) payment in full of sary to eliminate such doubt. Placing an asset on
principal or interest is not expected; or (3) they nonaccrual status does not require a charge-off,
are maintained on a cash basis because the in whole or in part, of the asset’s principal.
financial condition of the borrower has However, any identified loss must be charged
deteriorated. off.
When a loan is on nonaccrual status, some
Definition of ‘‘well secured’’ and ‘‘in the process or all of the cash interest payments received
of collection’’—A debt is ‘‘well secured’’ if it is may be treated as interest income on a cash
secured (1) by collateral in the form of liens on basis, as long as the remaining book balance
or pledges of real or personal property, includ- of the asset after the charge-off, if any, is
ing securities, that have a realizable value suf- deemed fully collectible. A bank’s determina-
ficient to discharge the debt (including accrued tion of the collectibility of an asset’s remaining
interest) in full or (2) by the guarantee of a book balance must be supported by a current,
financially responsible party. A debt is ‘‘in the well-documented credit evaluation of the bor-
process of collection’’ if collection of the asset is rower’s financial condition and repayment
proceeding in due course either (1) through legal prospects.
action, including judgment enforcement proce- When recognition of interest income on a
dures, or (2) through collection efforts (not cash basis is appropriate, the amount of income
involving legal action) that are reasonably recognized should be limited to what would
expected to result in repayment of the debt or in have been accrued on the loan’s remaining book
its restoration to a current status in the near balance at the contractual rate. Any cash interest
future. Statutory bad debt, ‘‘A paper,’’ is defined payments received over this limit (and not
in section 5204 of the U.S. Revised Statutes applied to reduce the loan’s remaining book
(12 USC 56) as all debts to a bank on which balance) should be recorded as recoveries of
interest is past due and unpaid for six months, prior charge-offs until these charge-offs have
unless the same is well secured and in the been fully recovered. (A bank should have a
process of collection. Delinquent loans that are well-defined policy governing the treatment of
not covered under the definition of statutory bad interest income and the charge-off of accrued
debt are designated ‘‘B paper.’’ interest receivables.)

Page 13
Treatment of Previously Accrued But Uncol- interest, unless the loan has been formally
lected Interest—When a bank places a loan on restructured and qualifies for accrual status under
nonaccrual status, its policy should address an the restructured terms, or the asset has been
appropriate treatment of previously accrued but acquired at a discount from an unaffiliated third
uncollected interest. One acceptable method is party due to uncertainty about the amounts
to reverse all previously accrued but uncollected or timing of future cash flows and meets the
interest against appropriate income and balance- amortization criteria (that is, accretion of dis-
sheet accounts. For interest accrued in the cur- count) specified in AICPA Practice Bulletin
rent accounting period, the entry is made directly No. 6.
against the interest income account. For prior A nonaccrual loan is considered in the pro-
accounting periods, if accrued-interest provi- cess of collection if the borrower has resumed
sions to the ALLL were not made, the amount of paying contractual interest and principal pay-
accrued but uncollected interest should be ments, even if the past-due amount has not been
charged against current earnings. Also for prior brought totally current. These loans may be
accounting periods when provisions to the ALLL returned to accrual status provided two criteria
for possible loss of interest had been made, the are met: All principal and interest amounts due
bank generally reverses the accrued but uncol- (including arrearages) are reasonably assured of
lected interest by charging the ALLL to the repayment within a reasonable period, and the
extent of those specific provisions. Generally borrower has a sustained period of performance
accepted accounting principles do not require (generally a minimum of six months) in accor-
the write-off of previously accrued interest if dance with the contractual terms.
principal and interest are ultimately protected Until the loan is restored to accrual status,
by sound collateral values. A bank is expected cash payments received must be treated accord-
to have a well-defined policy, subject to exam- ing to the criteria stated above. In addition, after
iner review, governing the write-off of accrued a formal restructuring, if the loan that has been
interest. returned to accrual status later meets the criteria
for placement in nonaccrual status (as a result of
past-due status based on its modified terms or
Treatment of Multiple Extensions of Credit to
for any other reason), the asset must be placed
One Borrower—As a general rule, nonaccrual
on nonaccrual status.
status for an asset should be determined by
assessing its collectibility, repayment ability,
Treatment of Nonaccrual Loans with Partial
and performance. Thus, when one loan to a
Charge-Offs—GAAP and regulatory reporting
borrower is placed in nonaccrual status, a bank
requirements do not explicitly address whether
does not automatically have to place all of that
partial charge-offs associated with a nonaccrual
borrower’s other extensions of credit in non-
loan (that has not been formally restructured)
accrual status. The bank should evaluate its
must be fully recovered before a loan can be
other extensions of credit to that borrower to
restored to accrual status.
determine if one or more of them also should be
According to call report instructions, restora-
placed in nonaccrual status.
tion to accrual status is permitted when (1) the
loan has been brought fully current with respect
Restoration to Accrual Status—As a general to principal and interest and (2) the bank expects
rule, a nonaccrual loan may be restored to the loan’s full contractual balance (including
accrual status when (1) its principal and interest any amounts charged off), plus interest, will be
are no longer past due and unpaid, and the bank fully collectible under the terms of the loan.
expects repayment of the remaining principal Thus, to return a partially charged-off loan that
and interest, or (2) when it otherwise becomes has been brought fully current to accrual status,
well secured and in the process of collection. the bank should determine if it expects to
Before restoring a loan to accrual status, the receive the full amount of principal and interest
bank should consider the borrower’s prospects called for by the loan’s terms.
for continuing future contractual payments. If When the contractual principal and interest of
reasonable doubt exists, reinstatement may not a loan have been brought fully current, and the
be appropriate. borrower’s financial condition and repayment
To meet the first test, the bank must have prospects have improved so that the full con-
received payment of the past-due principal and tractual principal (including any amounts charged

Page 14
off) and interest is expected to be repaid, the involving only a modification of terms in accor-
loan may be restored to accrual status with- dance with FASB 114.12
out having to first recover the charge-off. A bank should develop a policy for renegoti-
Conversely, this treatment would be inappro- ated troubled debt to ensure that such items are
priate when the charge-off indicates continuing identified, monitored, and properly accounted
doubt about the collectibility of principal or for and controlled. These restructurings should
interest. occur infrequently. If not, the bank is probably
The reasons for restoring a partially charged- experiencing significant problems. Before
off loan to accrual status must be documented. troubled-debt concessions are made to a bor-
These actions should be supported by a current, rower, it is a good practice to have the transac-
well-documented credit evaluation of the bor- tions receive prior approval of the board of
rower’s financial condition and prospects for directors or a board committee. All these trans-
full repayment of contractual principal (includ- actions should be reported to the board of
ing any amounts charged off) and interest. This directors upon enactment.
documentation will be subject to review by Bankers may be involved in formally restruc-
examiners. turing loans when borrowers experience finan-
cial difficulties or in light of the borrower’s
Examiner Review—Some states have promul- condition and repayment prospects. 12a These
gated regulations or adopted policies for non- actions, if consistent with prudent lending prin-
accrual of interest on delinquent loans that may ciples and supervisory practices, can improve a
differ from the above procedures. In these cases, bank’s collection prospects. GAAP and regula-
the bank should comply with the more restric- tory reporting requirements provide a reporting
tive policy. The examiner should ensure that the framework that may alleviate some of the lend-
bank is complying with such guidelines. In all er’s concerns about working constructively with
cases, each bank should formulate its own borrowers experiencing financial difficulties. The
policies to ensure that net income is not being accounting standards for troubled-debt restruc-
overstated. These policies are subject to exam- turings are set forth in FASB Statement No. 15.
iner review. The interagency policy statement on credit
availability, issued March 1, 1991, clarifies a
number of supervisory policies on restructured-
RESTRUCTURED OR
12. FASB establishes a new approach for recognizing
RENEGOTIATED ‘‘TROUBLED’’ impairment on problem loans and new disclosure require-
DEBT ments for impaired loans for financial reporting purposes.
FASB 118 amends FASB 114 to allow creditors to use
In a ‘‘troubled-debt restructuring,’’ a bank grants existing methods for recognizing interest income on impaired
loans. This statement also clarifies the existing accounting for
a borrower concessions (for example, a reduc- in-substance foreclosure. Under the new impairment standard
tion of interest or principal payments) that it and related amendments to FASB 15, a collateral-dependent
would not otherwise consider for economic or real estate loan (that is, a loan for which repayment is
legal reasons related to a borrower’s financial expected to be provided solely by the underlying collateral)
would be reported as OREO only if the lender has taken
difficulties. Renegotiated ‘‘troubled’’ debt in- possession of the collateral. For other collateral-dependent
cludes those loans and lease-financing receiv- real estate loans, loss recognition would be based on the fair
ables restructured or renegotiated to provide value of the collateral if foreclosure is probable. However,
concessions to the borrower. A loan extended or these loans would no longer be reported as OREO. Rather,
they would remain in the loan category. In light of the
renewed at a stated rate equal to the current significance of these changes to accounting standards, the
interest rate for new debt with similar risk is not Federal Reserve is reevaluating regulatory disclosure and
considered renegotiated debt. For further infor- nonaccrual requirements and expects to issue revised policies
mation, see the instructions for the Reports of at a later date. (See SR-93-30 (FIS).) FASB 15 is also
amended by FASB statements 71, 111, 121, 141, 145, and
Condition and Income; FASB Statement No. 15, 149. (See FASB’s current text.)
‘‘Accounting by Debtors and Creditors for 12a. For further guidance on loan restructuring and work-
Troubled Debt Restructurings’’; and FASB State- out arrangements, refer to the Interagency Supervisory Guid-
ment No. 114, ‘‘Accounting by Creditors for ance for Financial Institutions Affected by Hurricane Katrina
(see SR-06-3 and SR-07-3) and the Statement on Working
Impairment of Loan,’’ which amends FASB 15 with Mortgage Borrowers that was issued by the Federal
to require creditors to measure all loans that are Reserve and the other federal financial institution regulatory
restructured in a troubled-debt restructuring agencies (see SR-07-6).

Page 15
loan issues. Two of these clarifications indicate be sufficient to warrant returning a restructured
that when certain criteria are met, (1) nonaccrual loan to accrual status. The restructured terms
assets can be restored to accrual status when must reasonably ensure performance and full
subject to formal restructurings in accordance repayment.
with FASB Statement No. 15 and (2) restructur- It is imperative that the reasons for restoring
ings that yield a market rate of interest would restructured debt to accrual status be docu-
not have to be included in restructured loan mented. A restoration should be supported by a
amounts reported in the years following the current, well-documented evaluation of the bor-
restructuring. These clarifications, which are rower’s financial condition and prospects for
consistent with GAAP, have been fully incorpo- repayment. This documentation will be reviewed
rated into the instructions for the Reports of by examiners.
Condition and Income (Call Reports). The formal restructuring of a loan or other
debt instrument should be undertaken in ways
that will improve the likelihood that the credit
will be repaid in full in accordance with reason-
Nonaccrual Assets Subject to FASB ably restructured repayment terms. A restruc-
Statement No. 15 Restructurings tured loan may not be restored to accrual status
unless there is reasonable assurance of repay-
A loan or other debt instrument that has been ment and performance under its modified terms
formally restructured to ensure repayment and in accordance with a reasonable repayment
performance need not be maintained in non- schedule. Regulatory reporting requirements and
accrual status. In deciding whether to return an GAAP do not require a banking organization
asset to accruing status, payment performance that restructures a loan to grant excessive con-
that had been sustained for a reasonable time cessions, forgive principle, or take other steps
before the restructuring may be considered. For not commensurate with the borrower’s ability to
example, a loan may have been restructured, in repay to use the reporting treatment specified
part, to reduce the amount of the borrower’s in FASB Statement No. 15. Furthermore, the
contractual payments. It may be that the amount restructured terms may include prudent contin-
and frequency of payments under the restruc- gent payment provisions that permit an insti-
tured terms do not exceed those of the payments tution to obtain appropriate recovery of con-
that the borrower had made over a sustained cessions granted in the restructuring, if the
period within a reasonable time before the borrower’s condition substantially improves.
restructuring. In this situation, if the lender is Moreover, while restructured debt that quali-
reasonably assured of repayment and perfor- fies for accrual status and yields a market rate of
mance according to the modified terms, the loan interest must be disclosed as a FASB Statement
can be immediately restored to accrual status. No. 15 troubled debt in the year of the restruc-
Clearly, a period of sustained performance, turing, it need not be disclosed in subsequent
whether before or after the date of the years. This clarification was particularly impor-
restructuring, is very important in determining tant because, while this guidance is derived from
whether there is reasonable assurance of repay- FASB Statement No. 15 and is generally fol-
ment and performance. In certain lowed for Securities and Exchange Commission
circumstances, other information may be suf- reporting purposes, previously it was not clear
ficient to demonstrate an improvement in the that this treatment could be followed for Call
borrower’s condition or in economic condi- Report purposes.
tions that may affect the borrower’s ability to
repay. This information may reduce the need to
rely on the borrower’s performance to date in
assessing repayment prospects. For example, if Reporting Guidance on Loan Fees
the borrower has obtained substantial and reli- and Interest
able sales, lease, or rental contracts or if other
important developments are expected to The accounting standards for nonrefundable fees
significantly increase the borrower’s cash flow and costs associated with lending, committing to
and debt-service capacity and strength, then the lend, and purchasing a loan or group of loans are
borrower’s commitment to repay may be suf- set forth in FASB Statement No. 91, ‘‘Account-
ficient. A preponderance of such evidence may ing for Nonrefundable Fees and Costs Associ-

Page 16
ated with Originating or Acquiring Loans and

Initial Direct Costs of Leases.’’ In general, this
statement says loan-origination fees should be
deferred and recognized over the life of the
related loan as an adjustment of yield. The
statement applies to all types of loans, as well as
to debt securities (but not to loans or securities
carried at market value), and to all types of

Page 16.1
lenders. It must be applied to all lending and Any transfers of low-quality or questionable
leasing transactions in fiscal years beginning assets should be brought to the attention of
after December 15, 1987. Earlier application is Reserve Bank supervisory personnel. In turn,
encouraged, and retroactive application is per- these individuals should notify the local offices
mitted. For further information, see FASB State- of primary federal and state regulators (if appli-
ment No. 91 and instructions for preparing the cable) of the other depository institutions
Report of Condition and Income. involved in the transaction. For example, Reserve
Banks should notify the primary federal and
state regulators (if applicable) of any depository
TRANSFER OF LOW-QUALITY institution to which a state member bank or
LOANS OR OTHER ASSETS holding company is transferring or has trans-
ferred low-quality loans. Reserve Banks should
Low-quality loans include those classified or also notify the primary federal and state regula-
specially mentioned at the most recent exami- tors (if applicable) of any depository institution
nation or loans that would most likely be clas- from which a state member bank or holding
sified or specially mentioned if subjected to a company is acquiring or has acquired low-
review. In addition, low-quality loans include quality loans. This procedure applies to transfers
past-due loans, nonaccrual loans, loans on which involving savings and loan associations, savings
the terms have been renegotiated because of a banks, and commercial banking organizations.
borrower’s poor financial condition, and any If the examiner determines a permissible
other loans the examiner believes are question- transfer of assets was undertaken, he or she
able. Other assets of questionable quality include should ensure the assets have been properly
depreciated or subinvestment-grade securities recorded at fair market value on the books of the
and other real estate. A low-quality asset shall acquiring institution. If the transfer involved the
not be acceptable as collateral for a loan or parent holding company or a nonbank affiliate,
extension of credit to, or guarantee, acceptance, the examiner should determine if the transaction
or letter of credit issued on behalf of an affiliate. also was recorded properly on the affiliate’s
Furthermore, a low-quality asset cannot be books.13
involved in a loan participation or an asset swap. Whenever asset transfers occur, examiners
The transfer of low-quality loans or other should determine whether the assets in question
assets from one depository institution to another were independently and completely evaluated
may raise supervisory concerns. These transfers for conformance with bank policy and proce-
may be made to avoid detection and classifica- dures. Examiners should be guided by the
tion during regulatory examinations and may be inspection procedures outlined in sec-
accomplished through participation, purchases/ tion 2020.7.2 of the Bank Holding Company
sales, and asset swaps with other affiliated or Supervision Manual.
nonaffiliated financial institutions. Section 23A
of the Federal Reserve Act, 12 USC 371c,
prohibits bank purchases of low-quality assets ENVIRONMENTAL LIABILITY
from an affiliate. Examiners should be alert to
situations in which an institution’s intention Banks may be liable for cleaning up hazardous
appears to be concealing low-quality assets substance contamination under both federal and
to avoid examiners’ scrutiny and possible state environmental liability statutes. This liabil-
classification. ity can arise through a bank’s ownership or
During bank examinations, examiners are acquisition of real estate, in its role as a creditor,
requested to identify situations when low- or in a fiduciary role. Banks may also be
quality assets have been transferred between the exposed to environmental liability indirectly
institution being examined and another deposi- through the increased possibility that a borrow-
tory institution. The transfer of assets to avoid er’s creditworthiness may be impaired by a
supervisory review is a highly improper and liability to pay for cleanup of contaminated
unsound banking practice and, if an affiliate is property, even if the property does not secure
involved, is a violation of section 23A of the bank debt.
Federal Reserve Act. If necessary, it should be
addressed through formal supervisory enforce-
ment action. 13. See SR-83-24 (FIS).

Page 17
The Comprehensive Environmental Response, acquire property without knowing about exist-
Compensation and Liability Act (CERCLA), the ing conditions (the ‘‘innocent landowner
federal superfund statute, authorizes the Envi- defense’’). However, the courts have applied a
ronmental Protection Agency (EPA) to clean up stringent standard to qualify for this defense.
hazardous waste sites and to recover costs asso- Since the statute provides little guidance as to
ciated with the cleanup from entities specified in what constitutes the appropriate timing and
the statute. While the superfund statute is the degree of due diligence to successfully employ
primary federal law dealing with hazardous this exemption, banks should exercise caution
substance contamination, numerous other fed- before relying on it.
eral and state statutes establish environmental
liability that could place banks at risk.
CERCLA defines who is subject to liability
for the costs of cleaning up hazardous substance Overview of Environmental Hazards
contamination. The definition includes ‘‘. . . the
owner and operator of a vessel or a facility, (or) Environmental risk can be characterized as
any person who at the time of disposal of any adverse consequences that result from generat-
hazardous substance owned or operated any ing or handling hazardous substances or from
facility at which such hazardous substances being associated with the aftermath of
were disposed of . . . .’’14 Under the statute, a contamination.
person or entity that transports or arranges to Hazardous substance contamination is most
transport hazardous substances can also be held often associated with industrial or manufactur-
liable for cleaning up contamination. ing processes that involve chemicals as ingredi-
The superfund statute imposes a standard of ents or waste products. For years, these types of
strict liability, which means the government hazardous substances were frequently disposed
does not have to prove that the owners or of in landfills or dumped on industrial sites.
operators knew about or caused the hazardous However, hazardous substances are also found
substance contamination in order for them to be in many other lines of business. The following
liable for the cleanup costs. Moreover, liability examples demonstrate the diverse sources of
under the statute is joint and several, which hazardous substances, but by no means cover
allows the government to seek recovery of the them all:
entire cost from any individual party that is
liable for those costs under CERCLA. • farmers and ranchers (fuel, fertilizers, herbi-
CERCLA provides an exemption for secured cides, insecticides, and feedlot runoff)
creditors in the definition of ‘‘owner and opera- • dry cleaners (various cleaning solvents)
tor’’ by stating that these terms do not include • service station and convenience store opera-
‘‘. . . a person, who, without participating in the tors (underground storage tanks)
management of a vessel or facility, holds indicia • fertilizer and chemical dealers and applicators
of ownership primarily to protect his security (storage and transportation of chemicals)
interest in the vessel or facility.’’15 However, this • lawn care businesses (application of lawn
exception has not provided banks with an effec- chemicals)
tive defense from liability because courts have • trucking firms (transportation of substances
limited its applicability. Specifically, courts have such as fuel or chemicals)
held that some lenders’ actions to protect their
security interests have resulted in the bank Environmental liability has had the greatest
‘‘participating in the management of a vessel or impact on the real estate industry. Not only has
facility,’’ thereby voiding the exemption. Addi- land itself been contaminated with toxic sub-
tionally, once the title to a foreclosed property stances, construction methods for projects such
passes to the bank, some courts have held that as commercial buildings have used materials
the exemption no longer applies and that the that have been subsequently determined to be
bank is liable under the superfund statute as an hazardous—resulting in significant declines in
‘‘owner’’ of the property. Under some circum- project values. For example, asbestos was com-
stances, CERCLA may exempt landowners who monly used in commercial construction from the
1950s to the late 1970s. Asbestos has since been
14. CERCLA, section 107(a). found to be a health hazard and now, in many
15. CERCLA, section 101(20)(A). cases, must be removed or its effects abated by

Page 18
enclosing or otherwise sealing off the contami- determining whether to foreclose, the bank must
nated areas. compare the estimated cleanup costs against the
Another common source of hazardous sub- value of the collateral. In many cases, this
stance contamination is underground storage estimated cost has been well in excess of the
tanks. Leaks from these tanks not only contami- outstanding loan balance, and the bank has
nate the surrounding ground, but often flow into elected to abandon its security interest in the
ground water and travel a significant distance property and charge off the loan. This situation
from the original contamination site. As con- occurs because some courts have not allowed
tamination spreads to other sites, cleanup costs banks that have foreclosed on a property to avail
escalate. themselves of the secured-creditor exemption.
These rulings have been based on a strict read-
Effect on Banks—A bank may encounter losses ing of the superfund statute that provides the
from environmental liability through direct own- exemption to ‘‘security interests’’ only.
ership, lending and trust activities, or mergers or A bank may also expose itself to environmen-
acquisitions of borrowers. The greatest risk to a tal liability in its role as a secured or unsecured
bank is the possibility of being held solely liable creditor if it involves bank personnel or contrac-
for costly environmental cleanups. Under the tors engaged by the bank in day-to-day manage-
doctrine of joint and several liability, a bank ment of the facility or takes actions designed to
may find itself solely responsible for cleaning up make the contaminated property salable, possi-
a contaminated site at a cost that exceeds any bly resulting in further contamination.
outstanding loan balance or property value.
Bank Premises—Banks may also be exposed to
environmental liability for property held as bank
Direct Ownership
premises. A review of historical uses of proper-
A bank may be held liable for the cleanup of ties to be acquired for relocation or future
hazardous substance contamination in situations expansion should provide insight into the like-
when it— lihood that contamination may have occurred
and whether additional steps may be warranted.
• takes title to property through foreclosure or
acquires property to satisfy debts previously Mergers and Acquisitions of Borrowers—Bor-
contracted; rowers may face environmental risk through the
• owns or acquires for future expansion prem- activities of subsidiaries or by merging with or
ises that have been contaminated by hazard- acquiring other companies whose activities result
ous substances; or in environmental liability. Some courts have
• owns, acquires, or merges with another entity held that for the purposes of determining liabil-
involved in activities that might result in a ity under the superfund statute, the corporate
finding of environmental liability. veil may not protect parent companies that
participate in the day-to-day operations of their
Lending Activity—While real estate loans present subsidiaries from environmental liability and
the greatest risk, almost any type of loan, court-imposed cleanup costs. Additionally, bor-
unsecured or secured, can expose a bank to the rowers and, ultimately, banks can be held liable
effects of environmental liability. A borrower for contamination that occurred before they
who is required to pay for the cleanup of a owned or used the real estate.
contaminated property may be unable to provide
the necessary funds both to remove contami-
nated materials and to service the debt. Even if Protection Against Environmental
the bank does not have a security interest in the Liability
borrower’s real estate, it must be aware that
significant cleanup costs could threaten the bor- Banks may avoid or mitigate potential environ-
rower’s solvency and net worth (and jeopardize mental liability by having sound policies and
the collection of working-capital or equipment procedures designed to identify, assess, and
loans). If the loan is secured by the contami- control environmental liability. The following
nated real estate, the bank may find that the discussion briefly describes methods that banks
property value has declined dramatically, may employ to minimize potential environmen-
depending on the degree of contamination. In tal liability.

Page 19
Loan policies and procedures should address fying and minimizing potential environmental
methods for identifying potential environmental liability, their effectiveness depends on the finan-
problems relating to credit requests. The loan cial strength of the borrower and does not
policy should describe an appropriate degree of represent a substitute for environmental reviews,
due diligence investigation required for credit assessments, and audits.
requests. Borrowers in high-risk industries or Banks must be careful that any policies and
localities should be investigated more strin- procedures undertaken to assess and control
gently than borrowers in low-risk industries or environmental liability cannot be construed as
localities. taking an active role in the management or
After a loan is granted, periodic credit analy- day-to-day operations of the borrower’s busi-
sis of the borrower’s ability to repay should ness. Some activities that courts could consider
include an assessment of environmental risk. If active participation in the management of the
the credit is secured by real property collateral, borrower’s business and that could subject the
the bank should remain aware of the property’s bank to potential liability include—
uses and the potential environmental risk asso-
ciated with those uses. Even if the credit is not • having bank employees serve as members of
secured by real property, periodic credit reviews the borrower’s board of directors or actively
should determine whether repayment prospects participate in board decisions,
may be jeopardized by any activities that might • assisting in day-to-day management and
expose the borrower to environmental liability. operating decisions, and
The first step in identifying environmental • actively determining management changes.
risk is an environmental review. These reviews
may be performed by loan officers or others. These considerations are especially important
They typically identify past uses of the property; when the bank is actively involved in loan
evaluate regulatory compliance, if applicable; workouts or debt restructuring.
and identify potential problems. The reviewer
should interview persons familiar with present
and past uses of the facility and property, review LOAN PROBLEMS
relevant records and documents, and inspect the
site. The failure of directors to establish a sound
When the environmental review reveals pos- lending policy, require management to establish
sible hazardous substance contamination, an adequate written procedures, and monitor and
environmental assessment or audit may be administer the lending function within estab-
required. Environmental assessments are made lished guidelines has resulted in substantial
by personnel trained in identifying potential problems for many institutions. Loan problems
environmental hazards and provide a more thor- may be caused by a number of factors affecting
ough inspection of the facility and property. the bank or its borrowers. For a discussion of the
Environmental audits differ markedly from indicators of troubled commercial real estate
environmental assessments because independent loans, see the 2090 sections of this manual. The
environmental engineers are employed to inves- major sources and causes of problem credits are
tigate the property in great detail. Engineers test explained below.
for hazardous substance contamination, which
might require collecting and analyzing air Competition—Competition among banks for size
samples, surface soil samples, or subsurface soil and community influence may result in compro-
samples or drilling wells to sample ground mising credit principles and making or acquiring
water. unsound loans. The ultimate cost of unsound
Other measures some banks use to help iden- loans always outweighs temporary gains in
tify and minimize environmental liability to the growth and influence.
bank include obtaining indemnities from bor-
rowers for any cleanup costs incurred by the Complacency—The following items manifest
bank and writing affirmative covenants into loan complacency and should always be guarded
agreements (and attendant default provisions) against:
that require the borrower to comply with all
applicable environmental regulations. Although • lack of adequate supervision of long-term and
these measures may provide some aid in identi- familiar borrowers

Page 20
• dependence on oral information the borrower Lack of supervision. Many loans that are sound
furnished in lieu of reliable and verifiable at their inception develop into problems and
financial data losses because of ineffective supervision. This
• optimistic interpretation of known credit weak- lack of supervision usually results from a lack of
nesses based on past survival of recurrent knowledge about the borrower’s affairs over the
hazards and distress lifetime of the loan.
• ignorance or disregard of warning signs about
the borrower, economy, region, industry, or Overlending. In one sense, overlending could
other related factors come under the heading of technical incompe-
tence. However, overlending is a weakness found
Compromise of credit principles. For various in some lenders that are otherwise competent.
reasons, bank management may grant loans Loans beyond the borrower’s reasonable capac-
carrying undue risks or unsatisfactory terms, ity to repay are unsound. Nowhere are technical
with full knowledge of the violation of sound competence and credit judgment more important
credit principles. The reasons management may than in determining a sound borrower’s safe,
compromise basic credit principles include maximum loan level.
timidity in dealing with individuals with domi-
nating personalities or influential connections, Poor selection of risks. When banks are willing
friendships, or personal conflicts of interest. to assume more-than-normal risk levels, they
Self-dealing, salary incentives, and bonuses often experience serious loan problems. The
based on loan portfolio growth, as well as following general loan types may fall within the
competitive pressures, may also lead to a com- category of poor risk selection:
promise of credit principles.
• loans in which the bank advances an excessive
Failure to obtain or enforce repayment agree- proportion of the required capital relative to
ments. Loans granted without a clear repayment the borrower’s equity investment
agreement are, at the very least, a departure • loans based more on the expectation of suc-
from fundamental banking principles. These cessfully completing a business transaction
loans are likely to become significant problems. than on the existing net worth and repayment
A more common problem, but just as undesir- capacity
able, occurs when the bank and borrower agree • loans for the speculative purchase of securities
on repayment or progressive liquidation of a or goods
loan, but the bank fails to collect the principal • loans collateralized by marketable assets car-
payments when and how it should. A study of ried without adequate margins of security
loan losses will show that, in many cases, • loans made for other benefits, such as control
amortization never equaled the principal pay- of large deposit balances in the bank, instead
ments the borrower agreed to make. Good of sound net worth, collateral, or repayment
lending and good borrowing both require con- capacity
sistent liquidation. • loans secured solely by the nonmarketable
stock of a local corporation, made in conjunc-
Incomplete credit information. Complete credit tion with loans directly to that corporation
information is necessary to make a reasonable (The bank may consider itself forced to finance
and accurate determination of a borrower’s finan- the corporation far beyond warranted limits to
cial condition and repayment capacity. Ade- avoid loss on a loan that relies on the corpo-
quate and comparative financial statements, ration’s stock.)
operating statements, and other pertinent statis- • loans predicated on collateral of uncertain
tical data should be available. Other essential liquidation value (A moderate amount of these
information, such as the purpose of the borrow- loans, when recognized by bank management
ing and the intended plan and repayment source, as subject to inherent weakness, may cause
progress reports, inspections, and memoranda of few problems. However, the bank can encoun-
outside information and loan conferences, should ter trouble if this practice becomes the rule.)
be contained in the bank’s credit files. The lack
of adequate credit information can limit man- Revenue-driven lending. The loan portfolio is
agement’s ability to react quickly and effec- usually a bank’s most important revenue-
tively when problems develop. producing asset. The earnings factor, however,

Page 21
must never compromise sound credit judgment tured and have a legitimate business purpose so
and allow credits carrying undue risks or unsat- that all parties are treated equitably. However,
isfactory repayment terms to be granted. Unsound absent the protection of an arm’s-length trans-
loans usually cost far more than the revenue action, the potential for or appearance of abuse
they produce. is greater and requires intensified regulatory
review. Examiners should pay close attention to
Self-Dealing. Self-dealing is found in many all credit extensions of a member bank to its
serious problem banks. Self-dealing often takes insiders and their related interests. The terms of
the form of an overextension of credit on an the credit, particularly interest-rate and collat-
unsound basis to directors or principal share- eral terms, may not be preferential, and the
holders, or to their related interests, who have credit may not involve more than a normal
improperly used their positions to obtain funds repayment risk. Examiners must also ensure that
in the form of unjustified loans (or sometimes as the amount of credit extended to an insider or a
fees, salaries, or payments for goods or ser- related interest, both to a single borrower and in
vices). Officers, who hold their positions at the the aggregate, conforms to the provisions of
pleasure of the board, may be pressured to Regulation O.
approve loan requests by insiders that, coming A member bank’s extension of credit may be
from customers, would have been rejected. In considered abusive or self-serving if its terms
that situation, management may attempt to are unfavorable to the lender or if the credit
defend unsound loans or other self-dealing prac- would not have been extended on the same
tices by bank insiders. terms absent the official relationship. That is, it
would be improbable that each party to the
Technical incompetence. All able and experi- credit would have entered into the credit trans-
enced bankers should possess the technical abil- action under the same terms if the relationship
ity to analyze financial statements and to obtain did not exist. When a transaction appears ques-
and evaluate other credit information. When this tionable, a complete inquiry into the facts and
ability is absent, unwarranted losses are certain circumstances should be undertaken so that a
to develop. Credit incompetence of management legal determination can be obtained. If credit
should be discussed promptly with the board of extensions appear to circumvent the intent of
directors. Regulation O, they should be identified and
discussed with management and disclosed in the
examination report for follow-up review and
possible formal corrective action by regulatory
REGULATION O authorities. (See Regulation O for further details.)
The Federal Reserve’s Regulation O (12 CFR

215) governs any extension of credit, including
overdrafts, by a member bank to an executive Insider Use of a Bank-Owned Credit
officer, director, or principal shareholder of Card
(1) the member bank, (2) a bank holding com-
pany of which the member bank is a subsidiary, Board staff issued a May 22, 2006, legal opinion
and (3) any other subsidiary of that bank holding in response to an FDIC request for clarification
company. The regulation also applies to any on the application of the Board’s Regulation O
extension of credit by a member bank to (1) a (12 CFR 215) to credit cards that are issued to
company controlled by such a person and (2) a bank insiders for the bank’s business purposes.
political or campaign committee that benefits or The FDIC asked whether, and under what cir-
is controlled by such a person. Regulation O cumstances, an insider’s use of a bank-owned
also implements the reporting requirements for credit card would be deemed an extension of
credit extensions by a member bank to its credit by the bank to the insider for purposes of
executive officers, directors, or principal share- Regulation O.
holders or to the related interests of such persons The FDIC indicated that insiders of a bank
(insiders). often use a bank-owned credit card to purchase
Business transactions between a member bank goods and services for the bank’s business
and insiders require close supervisory review. purposes. A bank-owned credit card is a credit
Most of these transactions are soundly struc- card that is issued by a third-party financial

Page 22
institution to a bank to enable the bank (through of Regulation O if—and to the extent that—the
its employees) to finance the purchase of goods amount of outstanding personal charges made to
and services for the bank’s business. Board staff the card, when aggregated with all other indebt-
commented that it was understood that (1) a edness of the insider that qualifies for the credit
bank that provides a bank-owned credit card to card exception in section 215.3(b)(5) of Regu-
its employees typically forbids or discourages lation O, exceeds $15,000.
use of the card by employees for their personal The FDIC also asked whether incidental per-
purposes and that an employee who uses the sonal expenses charged by an insider to a
card for personal purposes is obligated to bank-owned credit card are per se violations of
promptly reimburse the bank and (2) a bank is the market-terms requirement in section 215.4(a)
liable to the card-issuing institution for all of Regulation O because non-insiders do not
extensions of credit made under the card have access to this form of credit from the bank.
(whether for the bank’s business purposes or for In response, Board staff stated that section
an employee’s personal purposes). 15a 215.4(a) requires extensions of credit by a bank
Although section 215.3(a) of Regulation O to its insiders to (1) be on substantially the same
broadly defines an extension of credit broadly to terms (including interest rates and collateral) as,
include ‘‘a making or renewal of a loan, a and subject to credit underwriting standards that
granting of a line of credit, or an extending of are not less stringent than, those prevailing at the
credit in any manner whatsoever,’’ the rule also time for comparable transactions with non-
provides several important exceptions to the insiders and (2) not involve more than the
definition that are relevant to the FDIC’s inquiry. normal risk of repayment or other features
Section 215.3(b)(1) of Regulation O excludes unfavorable to the bank.
from the definition of extension of credit any The opinion states that a bank may be able to
advance by a bank to an insider for the payment satisfy the market-terms requirement, however,
of authorized or other expenses incurred or to be if the bank approves an insider for use of a
incurred on behalf of the bank. Also, section bank-owned credit card only if (1) the insider
215.3(b)(5) of Regulation O excludes from the meets the bank’s normal credit underwriting
definition of extension of credit indebtedness of standards and (2) the card does not have prefer-
up to $15,000 incurred by an insider with a bank ential terms (or the card does not have prefer-
under an ordinary credit card. ential terms in connection with uses of the card
Considering the provisions of Regulation O for personal purposes). Nonetheless, use of a
and the purposes of the insider lending restric- bank-owned credit card by an insider for per-
tions in the Federal Reserve Act, Board legal sonal purposes may violate the market-terms
staff opined that a bank does not make an requirement of Regulation O if the card carries a
extension of credit to an insider for purposes of lower interest rate or permits a longer repayment
Regulation O at the time of issuance of a bank- period than comparable consumer credit offered
owned credit card to the insider (regardless of by the bank.
whether the line of credit associated with the The Board staff’s legal opinion applies only
card is greater than $15,000). The opinion states to the specific issues and circumstances described
also that a bank does not extend credit to an in the letter and does not address any other
insider for the purposes of Regulation O when issues or circumstances.
the insider uses the card to purchase goods or
services for the bank’s business purposes. How-
ever, when an insider uses the card to purchase
goods or services for the insider’s personal EXAMINATION OF THE LENDING
purposes, the bank may be making an extension FUNCTION
of credit to the insider. The opinion states that an
extension of credit would occur for the purposes Banks are expected to clearly delineate their
lending objectives, policies, and procedures in
15a. In the responding letter, Board legal staff notes that it writing. Lending practices are then expected to
was understood that some banks directly issue credit cards to adhere to policies and procedures, with excep-
their employees to enable the employees to finance the tions properly justified and documented. The
purchase of goods and services for the bank’s business
(bank-issued credit cards). Also, the letter states that the
complexity and scope of a bank’s lending policy
principles set forth with regard to bank-owned credit cards and procedures should be appropriate to the
also would apply to bank-issued credit cards. bank’s size and the nature of its activities, and

Page 22.1
they should be consistent with prudent banking

practices and relevant regulatory requirements.
Historically, examiners have primarily identi-
fied loan-portfolio-management concerns through
a detailed review of credits and credit documen-
tation. This approach remains valid, but it must
be combined with a full evaluation of a bank’s

Page 22.2
lending objectives, policy, and procedures. reliance on favorable assumptions about borrow-
Therefore, the scope of each examination should ers or the economy and about financial markets
encompass a review of the bank’s lending policy more generally—or observe that this reliance
and procedures and an assessment of how lend- has slowed the institution’s recognition of loan
ing practices adhere to the policy and procedures. problems—they should carefully consider down-
When conducting a review of loan portfolio grading, under the applicable supervisory rating
management, examiners should pay particular framework, an institution’s risk-management,
attention to management’s approach to and management, or asset-quality ratings (or all
handling of the following: three). If those assumptions are deemed suffi-
ciently significant to the institution, examiners
• monitoring of lending practices by individual should also consider downgrading its capital
lending officers adequacy rating. Similarly, if supervisors or
• identification of concentrations of credit examiners find that loan-review activities or
• documentation of credit and collateral other internal-control and risk-management pro-
exceptions cesses have been weakened by staff turnover,
• identification of problem credits failure to commit sufficient resources, or inad-
• accounting for nonaccrual loans and for equate training, such findings should be consid-
renegotiated and restructured loans ered in supervisory ratings as well.
• collection of past-due loans When developing their findings, examiners
should review internal risk-management loan-
In addition, examiners should be aware of any review systems, conduct sufficient loan reviews,
evidence of self-dealing in lending transactions. and perform transaction testing of the lending
An examiner’s final assessment of a bank’s function to determine accurately the quality of
lending function should consider the adequacy bank loan portfolios and other credit exposures.
of internal policy and procedures, the effective- If deficiencies in lending practices or credit
ness of management oversight and control, and discipline are indicated as a result of the pre-
the overall quality of the loan portfolio. More- examination risk assessment or of performing
over, consideration should be given to all perti- the examination, sufficient supervisory resources
nent internal and external factors, including the should be committed to in-depth reviews, includ-
continuity of management; bank’s historical ing transaction testing. Adequate, in-depth
lending experience; and current and projected reviews and transaction testing should be per-
economic condition for the bank’s market area, formed to ensure that the Reserve Bank achieves
particularly for any industries in which the bank a full understanding of the nature, scope, and
has concentrations of credit. implications of the deficiencies.
Supervisors and examiners should watch for Important findings should be noted in the
indications of insufficiently rigorous risk assess- examination or report. Plans for remedial actions
ment. In particular, examiners should be alert to should be discussed with bank management and
circumstances indicating excessive reliance on the boards of directors, as appropriate. In addi-
strong economic conditions and robust financial tion, any identified weaknesses or deficiencies
markets, such as (1) borrowers whose financial that could adversely affect affiliated insured
capacity is inadequate to service their debts or depository institutions should be conveyed to
(2) inadequate stress testing. Examiners also the insured institution’s primary federal or state
should be attentive when reviewing an institu- supervisor.
tion’s assessment and monitoring of credit risk
to ensure that undue reliance on favorable con-
ditions does not lead the institution to delay
recognition of emerging weaknesses in some
MORTGAGE BANKING
loans.16
If examiners observe significant and undue Loan-Brokerage and -Servicing
Activities
16. Examiners should recognize that an increase in classi-
fied or special-mention loans is not per se an indication of lax Loan-brokerage and -servicing activities are
lending standards. Examiners should review and consider the
nature of such increases and surrounding circumstances as
undertaken by mortgage banking enterprises and
they reach their conclusions about the asset quality and risk the mortgage banking operations of commercial
management of an institution. banks. Mortgage banking activities consist pri-

Page 23
marily of two separate but related activities: the bank may find itself responsible for servic-
(1) the origination or acquisition of mortgage ing more loans than it can prudently manage.
loans and the sale of the loans to permanent Failure to properly administer loans may lead to
investors and/or (2) the subsequent long-term legal or financial liabilities that could adversely
servicing of the loans. A mortgage banking affect the bank’s capital.
enterprise usually retains the right to service
mortgage loans it sells to permanent investors.
An enterprise’s right to service mortgage loans
other than its own is an intangible asset that may
Accounting Guidance
be acquired separately. The rights to service
The following accounting pronouncements issued
mortgage loans are purchased and sold fre-
by the Financial Accounting Standards Board
quently. Mortgage loans are acquired to sell to
(FASB) apply to mortgage banking activities:
permanent investors from a variety of sources,
including applications received directly from
• FAS 5, Accounting for Contingencies
borrowers (in-house originations), purchases
from brokers, purchases from investors, and • FAS 65, Accounting for Certain Mortgage
conversions of various forms of interim financ- Banking Activities
ing to permanent financing. A service fee, usu- • FAS 91, Accounting for Nonrefundable Fees
ally based on a percentage of the outstanding and Costs Associated with Originating or
principal balance of the mortgage loan, is Acquiring Loans and Initial Direct Costs of
received for performing loan-administration Leases
functions. When servicing fees exceed the cost • FAS 115, Accounting for Certain Investments
of performing servicing functions, the existing in Debt and Equity Securities (paragraph 7
contractual right to service mortgage loans has was amended by FAS 140)
economic value. • FAS 133, Accounting for Derivative Instru-
A number of bank services may result in ments and Hedging Activities (amended by
assets and liabilities that do not have to be FAS 140)
entered on the general ledger. These services are • FAS 134, Accounting for Mortgage-Backed
considered off-balance-sheet activities and may Securities Retained After the Securitization of
include the origination, sale, and servicing of Mortgage Loans Held for Sale by a Mortgage
various loans. Servicing and accounting activi- Banking Enterprise
ties cover functions related to initially recording • FAS 138, Accounting for Certain Derivative
the loan, collecting and recording payments, and Instruments and Certain Hedging Activities
reporting loan transactions and balances (includ- • FAS 140, Accounting for Transfers and Ser-
ing reporting past-due loans). Unlike the other vicing of Financial Assets and Extinguish-
activities in this section, servicing and account- ments of Liabilities
ing activities are not directly related to credit • FAS 149, Amendment of Statement 133
risk. However, some aspects of accounting and on Derivative Instruments and Hedging
servicing activities, such as the accounting sys- Activities
tem’s ability to produce accurate past-due loan • FAS 154, Accounting Changes and Error
reports, indirectly contribute to controlling credit Corrections
risk. Also, poorly designed or ineffective servic-
ing and accounting activities can contribute to The accounting standards for nonrefundable fees
increased risk in areas besides credit, such as and costs associated with lending, committing to
fraud and insider abuse. lend, and purchasing a loan or group of loans are
The origination, sale, and servicing of various set forth in FASB Statement No. 91, ‘‘Account-
types of loans usually have been associated with ing for Nonrefundable Fees and Costs Associ-
mortgage loans. But increasingly, origination ated with Originating or Acquiring Loans and
and servicing activity has also been observed Initial Direct Costs of Leases,’’ (FAS 91). A
in government-guaranteed loans (or portions summary of the statement follows. The state-
thereof), consumer loans, and commercial loans. ment applies to all types of loans as well as to
Improper management and control of these debt securities (but not to loans or debt securi-
activities by the servicer presents certain super- ties carried at market value if the changes in
visory concerns. If the bank servicer is continu- market value are included in earnings) and all
ally originating additional loans to be serviced, types of lenders.

Page 24
Nonrefundable loan fees paid by the borrower retained. If the yield on the portion of the loan
to the lender may have many different names, retained by the syndicator is less than the
such as origination fees, points, placement fees, average yield to the other syndication partici-
commitment fees, application fees, management pants after considering the fees passed through
fees, restructuring fees, and syndication fees. by the syndicator, the syndicator should defer
FAS 91 applies to both a lender and a purchaser a portion of the syndication fee to produce a
and should be applied to individual loan con- yield on the portion of the loan retained that is
tracts. Aggregation of similar loans for purposes not less than the average yield on the loans
of recognizing net fees or costs, purchase pre- held by the other syndication participants.
miums, or discounts is permitted under certain • Loan fees, certain direct loan-origination costs,
circumstances specified in FAS 91, or if the and purchase premiums and discounts on
result does not differ materially from the amount loans are to be recognized as an adjustment of
that would have been recognized on an indi- yield generally by the interest method based
vidual loan-by-loan basis. In general, FAS 91 on the contractual term of the loan. However,
specifies the following: if the bank holds a large number of similar
loans for which prepayments are probable and
• Loan-origination fees should be deferred and if the timing and amount of prepayments can
recognized over the life of the related loan as be reasonably estimated, the bank may con-
an adjustment of yield (interest income). Once sider estimates of future principal prepay-
a bank adopts FAS 91, recognizing a portion ments in the calculation of the constant effec-
of loan fees as revenue to offset all or part of tive yield necessary to apply the interest
origination costs in the reporting period in method. Fees should not be recognized over
which a loan is originated is no longer the estimated average life of a group of loans.
acceptable.
• Certain direct loan-origination costs specified Examiners should review the extent and nature
in FAS 91 should be deferred and recognized of servicing activities to ensure that they are
over the life of the related loan as a reduction conducted in a safe and sound manner. Loan-
of the loan’s yield. Loan-origination fees and origination fees and related direct loan-
related direct loan-origination costs for a given origination costs of loans held for sale should be
loan should be offset and only the net amount accounted for in accordance with FAS 91, as
deferred and amortized. discussed above. Improper practices should be
• Direct loan-origination costs should be offset criticized.
against related commitment fees and the net
amounts should be deferred except for—
— commitment fees (net of costs) when the
likelihood that the commitment will be
exercised is remote; in these cases, the Risk Management and the Valuation
fees should generally be recognized as and Hedging of Mortgage-Servicing
service-fee income on a straight-line basis Assets Arising from Mortgage
over the loan-commitment period, and Banking Activities
— retrospectively determined fees, which are
recognized as service-fee income when A bank’s board of directors and senior manage-
the amount of the fees are determined. ment are expected to take into account the
potential exposure of both earnings and capital
All other commitment fees (net of costs) are to to changes in a bank’s mortgage banking assets
be deferred over the entire commitment period and operations under expected and stressed
and recognized as an adjustment of yield over market conditions. Banks are expected to have
the related loan’s life or, if the commitment comprehensive documentation that adequately
expires unexercised, recognized in income upon substantiates and validates the carrying values
expiration of the commitment. of its mortgage-servicing assets (MSAs) and the
underlying assumptions used to derive those
• Loan-syndication fees should be recognized values. The analyses and processes should be
by the bank managing a loan syndication (the fully documented to support the amortization
syndicator) when the syndication is complete and timely recognition of impairment of the
unless a portion of the syndication loan is bank’s MSAs. (See SR-03-4.)

Page 25
The guidance that follows focuses on the risks Quoted market prices in active markets for
associated with these aspects of mortgage bank- similar assets provide the best evidence of fair
ing: valuation and modeling processes, hedging value and must be used as the basis for the
activities, management information systems, and measurement, if available. If quoted market
internal audit processes. When banks originate prices are not available, the estimate of fair
mortgage loans, they often sell the loans into the value must be based on the best information
secondary market. Yet banks often retain and available. The estimate of fair value must con-
recognize the servicing of those MSAs, which sider prices for similar assets and the results of
are complex and volatile assets that are subject valuation techniques to the extent available.
to interest-rate risk. MSAs can become impaired
as interest rates fall and borrowers refinance or
prepay their mortgage loans. This impairment
can lead to earnings volatility and the erosion of Examination Concerns on the Valuation
capital, if the risks inherent in the MSAs are not of Mortgage-Servicing Assets
properly hedged.
Banks are expected to follow Financial Banks involved in mortgage-servicing opera-
Accounting Standards Board Statement No. 140 tions should use market-based assumptions that
(FAS 140), ‘‘Accounting for Transfers and Ser- are reasonable and supportable in estimating the
vicing of Financial Assets and Extinguishments fair value of servicing assets. Specifically, bulk,
of Liabilities,’’ when accounting for MSAs. In flow, and daily MSA/loan pricing activities
summary, FAS 140 requires the following observed in the market should be evaluated to
accounting treatment for servicing assets (includ- ensure that a bank’s MSA valuation assump-
ing MSAs):17 tions are reasonable and consistent with market
activity for similar assets. Many banks also use
• initially record servicing assets at fair value, models to estimate the fair value of their MSAs
presumably the price paid if purchased, or at and substantiate their modeled estimate of MSA
their allocated carrying amount based on rela- fair value by comparing the model output with
tive fair values if retained in a sale or general or high-level peer surveys. Such a com-
securitization;18 parison, however, is often performed without
• amortize servicing assets in proportion to, and adequate consideration of the specific attributes
over the period of, estimated net servicing of the bank’s own MSAs.
income; and Examiners should consider the following con-
• stratify servicing assets based on one or more cerns as an indication that additional scrutiny is
of the predominant risk characteristics of the necessary:
underlying financial assets, assess the strata
for impairment based on fair value, and report • The use of unsupported prepayment speeds,
them on the balance sheet at the lower of discount rates, and other assumptions in MSA
unamortized cost or fair value through the use valuation models.
of valuation allowances. (Assumptions are unsupported when they are
not benchmarked to market participants’
Fair value is defined in FAS 140 as the amount assumptions and the bank’s actual portfolio
at which an asset could be bought or sold in a performance across each product type.)
current transaction between willing parties, that • Questionable, inappropriate, or unsupported
is, other than in a forced or liquidation sale. items in the valuation models (examples
include retention benefits,19 deferred tax bene-
fits, captive reinsurance premiums, and income
17. Further guidance on the accounting for servicing assets
and liabilities can be found in the instructions for the Reports from cross-selling activities).
of Condition and Income (call report); FAS 140 FASB Staff (The inclusion of these items in the MSA
Implementation Guide; and the AICPA Statement on Auditing valuation must be appropriate under generally
Standards 101, ‘‘Auditing Fair Value Measurements and accepted accounting principles (GAAP) and
Disclosures.’’
18. FAS 140 indicates: ‘‘Typically, the benefits of servic- must also be consistent with what a willing
ing are expected to be more than adequate compensation to a
servicer for performing the servicing, and the contract results
in a servicing asset. However, if the benefits of servicing are 19. Retention benefits arise from the portion of the
not expected to adequately compensate a servicer for perform- serviced portfolio that is expected to be refinanced with the
ing the servicing, the contract results in a servicing liability.’’ bank in the future.

Page 26
buyer would pay for the mortgage-servicing existence of an impairment for which a direct
contract. For example, when the inclusion of write-down should be recorded.
retention benefits as part of the MSA valua- • Failure to assess actual cash-flow performance.
tion is not adequately supported with market (The actual cash flows received from the
data, such inclusion will result in an overstate- serviced portfolio must be established in order
ment of reported mortgage-servicing assets. to determine the benefit of MSAs to the bank.)
Therefore, the inclusion will be deemed an • Failure to validate or update models for new
unsafe and unsound practice.) information.
• Disregard of comparable market data coupled (Inaccuracies in valuation models can result in
with overreliance on peer-group surveys as a erroneous MSA values and affect future hedg-
means of supporting assumptions and the fair ing performance. Models should be invento-
value of MSAs. ried and periodically revalidated, including
(Management may use survey data for com- an independent assessment of all key
parative purposes; however, such data are not assumptions.)
a measure of or substitute for fair value.)
• Frequent changing of assumptions from period
to period for no compelling reason, and
undocumented policies and procedures relat- Risk Management of Mortgage
ing to the MSA valuation process and over- Banking Activities
sight of that process.
• Inconsistencies in the MSA valuation assump- The Federal Reserve expects state member banks
tions used in valuation, bidding, pricing, and to perform mortgage banking operations in a
hedging activities as well as, where relevant, safe and sound manner. Management should
in mortgage-related activities in other aspects ensure that detailed policies and procedures are
of a bank’s business. in place to monitor and control mortgage bank-
• Poor segregation of duties from an organiza- ing activities, including loan production, pipe-
tional perspective between the valuation, hedg- line (unclosed loans) and warehouse (closed
ing, and accounting functions. loans) administration, secondary-market trans-
• Failure to properly stratify MSAs for actions, servicing operations, and management
impairment-testing purposes. (including hedging) of mortgage-servicing assets.
(FAS 140 requires MSAs to be stratified based Reports and limits should focus on key risks,
on one or more of the predominant risk profitability, and proper accounting practices.
characteristics of the underlying mortgage MSAs possess interest rate–related option
loans. Such characteristics may include finan- characteristics that may weaken a bank’s earn-
cial asset type, size, interest rate, origination ings and capital strength when interest rates
date, term, and geographic location. Banks are change. Accordingly, banks engaged in mort-
expected to identify a sufficient number of risk gage banking activities should fully comply
characteristics to adequately stratify each MSA with all aspects of the federal banking agencies’
and provide for a reasonable and valid impair- policy on interest-rate risk.20 In addition, banks
ment assessment. Stratification practices that with significant mortgage banking operations or
ignore predominant risk characteristics are a mortgage-servicing assets should incorporate
supervisory concern.) these activities into their critical planning pro-
• Inadequate amortization of the remaining cost cesses and risk-management oversight. The plan-
basis of MSAs, particularly during periods of ning process should include careful consider-
high prepayments. ation of how the mortgage banking activities
(Inadequate amortization often occurs because affect the bank’s overall strategic, business, and
prepayment models are not adequately cali- asset-liability plans. Risk-management consid-
brated to periods of high prepayments. When erations include the potential exposure of both
these models underestimate runoff, the amount earnings and capital to changes in the value and
and period of estimated net servicing income performance of mortgage banking assets under
are overstated.) expected and stressed market conditions. Fur-
• Continued use of a valuation allowance for thermore, a bank’s board of directors should
the impairment of a stratum of MSAs when
repayment of the underlying loans at a rate 20. See SR-96-13, Joint Agency Policy Statement on
faster than originally projected indicates the Interest Rate Risk (June 26, 1996), and section 4090.1.

Page 27
establish limits on investments in mortgage assumptions and projections used in each

banking assets and evaluate and monitor such quarterly valuation. In addition, a comparison
investment concentrations (on the basis of both of the first month’s actual cash received on
asset and capital levels) on a regular basis. new MSAs with the projected gross cash
During examinations of mortgage banking flows can help validate the reasonableness of
activities, examiners should review mortgage initial MSA values prior to the impact of
banking policies, procedures, and management prepayments and discount rates. ‘‘Economic
information systems to ensure that the directors, value’’ analysis is a critical tool in understand-
managers, and auditors are adequately addressing the profitability of mortgage servicing to a
ing the following matters. bank; however, it is not a substitute for the
estimation of the fair value of MSAs under
GAAP.)
Valuation and Modeling Processes • Review and approval of results and assump-
tions by management.
• Comprehensive documentation standards for (Given the sensitivity of the MSA valuation to
all aspects of mortgage banking, including changes in assumptions and valuation policy,
mortgage-servicing assets. any such changes should be reviewed and
(In particular, management should substanti- approved by management and, where appro-
ate and validate the initial carrying amounts priate, by the board of directors.)
assigned to each pool of MSAs and the • Comparison of models used throughout the
underlying assumptions, as well as the results company including valuation, hedging, pric-
of periodic reviews of each asset’s subsequent ing, and bulk acquisition.
carrying amount and fair value. The validation (Companies often use multiple models and
process should compare actual performance assumption sets in determining the values for
with predicted performance. Management MSAs depending on their purpose—pricing
should ensure proper accounting treatment for versus valuation. Any inconsistencies between
MSAs on a continuing basis.) these values should be identified, supported,
• MSA impairment analyses that use reasonable and reconciled.)
and supportable assumptions. • Appropriate amortization practices.
(Analyses should employ realistic estimates of (Amortization of the remaining cost basis of
adequate compensation,21 future revenues, pre- MSAs should reflect actual prepayment expe-
payment speeds, market-servicing costs, rience. Amortization speeds should corre-
mortgage-default rates, and discount rates. spond to and be adjusted to reflect changes in
Fair values should be based on market prices the estimated remaining net servicing income
and underlying valuation assumptions for period.)
transactions in the marketplace involving simi- • Timely recognition of impairment.
lar MSAs. Management should avoid relying (Banks must evaluate MSAs for impairment at
solely on peer-group surveys or the use of least quarterly to ensure amounts reported in
unsupportable assumptions. The Federal the call report22 are accurately stated. Banks
Reserve encourages banks to obtain periodic will generally be expected to record a direct
third-party valuations by qualified market pro- write-down of MSAs when, and for the amount
fessionals to support the fair values of their by which, any portion of the unamortized cost
MSAs and to update internal models.) of a mortgage-servicing asset is not likely to
• Comparison of assumptions used in valuation be recovered in the future.)
models to the bank’s actual experience in
order to substantiate the value of MSAs.
(Management should measure the actual per- Mortgage Banking Hedging Activities
formance of MSAs by analyzing gross monthly
cash flows of servicing assets relative to the • Systems to measure and control interest-rate
risk.
21. As defined in FAS 140, ‘‘adequate compensation’’ is (Hedging activities should be well developed
‘‘the amount of benefits of servicing [i.e., revenues from and communicated to responsible personnel.
contractually specified servicing fees, late charges, and other
ancillary sources] that would fairly compensate a substitute
Successful hedging systems will mitigate the
servicer should one be required, which includes the profit that
would be demanded in the marketplace.’’ 22. Schedule RC-M, Memoranda, Item 2a.

Page 28
impact of prepayments on MSA values and systems are in place for broker and correspon-
the effects of interest-rate risk in the mortgage dent approvals and ongoing monitoring, includ-
pipeline and warehouse.) ing controls on the appraisal and credit-
• Approved hedging products and strategies. underwriting process of third-party originated
(Management should ensure appropriate sys- loans. Adequate due diligence of third-party
tems and internal controls are in place to relationships is necessary to help prevent the
oversee hedging activities, including monitor- origination of loans that are of poor credit
ing the effectiveness of hedging strategies and quality or are fraudulent. Delegated underwrit-
reviewing concentrations of hedge instru- ing to brokers or correspondents warrants
ments and counterparties.) close supervision from senior management.)
• Hedge accounting policies and procedures.
(Banks should ensure their hedge accounting
methods are adequately documented and con- Internal Audit
sistent with GAAP.)
• Adequate internal audit coverage.
(Because of the variety of risks inherent in
Management Information Systems mortgage banking activities, internal auditors
should evaluate the risks of and controls over
• Accurate financial reporting systems, con- their bank’s mortgage banking operations.
trols, and limits. They should report audit findings, including
(At a minimum, the board should receive identified control weaknesses, directly to the
information on hedged and unhedged posi- audit committee of the board or to the board
tions, mark-to-market analyses, warehouse itself. Board and management should ensure
aging, the valuation of MSAs, various rate that internal audit staff possess the necessary
shock-scenario and risk exposures, the cre- qualifications and expertise to review mort-
ation of economic value, and policy excep- gage banking activities or obtain assistance
tions whenever material exposure to MSAs from qualified external sources.)
exists.)
• Systems that track quality-control exceptions.
(Quality-control reports should be analyzed to INTERAGENCY ADVISORY ON
determine credit quality, loan characteristics
and demographics, trends, and sources of
ACCOUNTING AND REPORTING
problems. Sound quality-control programs are FOR COMMITMENTS TO
also beneficial in the early detection of dete- ORIGINATE AND SELL
riorating production quality and salability, as MORTGAGE LOANS
well as in the prevention and detection of
fraudulent activities.) On May 3, 2005, the Federal Reserve and the
• Systems that track and collect required mort- other federal financial institution regulatory agen-
gage loan documents. cies23 (the agencies) issued an Interagency
(Management should ensure adequate control Advisory on Accounting and Reporting for Com-
processes are in place for both front-end- mitments to Originate and Sell Mortgage Loans.
closing and post-closing loan documents. If (See SR-05-10.)
mortgages are not properly documented, a The advisory provides guidance on the appro-
bank may be forced to hold unsold mortgages priate accounting and reporting for commit-
for extended periods or repurchase mortgages ments to—
that have been sold. Further, management
should ensure that adequate analyses are per- • originate mortgage loans that will be held for
formed and allowances are established for resale, and
estimated probable losses arising from docu- • sell mortgage loans under mandatory-delivery
mentation deficiencies on closed loans.) and best-efforts contracts.
• Systems that monitor and manage the risks
associated with third-party originated loans. 23. The agencies are the Board of Governors of the Federal
Reserve System, the Federal Deposit Insurance Corporation,
(Banks often originate loans through broker the National Credit Union Administration, the Office of the
and correspondent channels. Management Comptroller of the Currency, and the Office of Thrift Super-
should ensure that prudent risk-management vision.

Page 29
Commitments to originate mortgage loans Accounting and Reporting

that will be held for resale are derivatives and
must be accounted for at fair value on the Accounting Policies
balance sheet by the issuer. All loan-sales agree-
ments, including both mandatory-delivery and Well-managed financial institutions have written
best-efforts contracts, must be evaluated to deter- and consistently applied accounting policies for
mine whether the agreements meet the definition commitments to originate mortgage loans that
of a derivative under Statement of Financial will be held for resale and to sell mortgage loans
Accounting Standards No. 133, ‘‘Accounting for under mandatory-delivery and best-efforts con-
Derivative Instruments and Hedging Activi- tracts, including approved valuation methodolo-
ties,’’ as amended by Statement of Financial gies and procedures to formally approve changes
Accounting Standards No. 149, ‘‘Amendment of to those methodologies. The methodologies
Statement 133 on Derivative Instruments and should be reasonable, objectively supported, and
Hedging Activities’’ (collectively, FAS 133). A fully documented. Procedural discipline and
financial institution should also account for consistency are key concepts in any valuation
loan-sales agreements that meet the definition of measurement technique. Institutions should
a derivative at fair value on the balance sheet. ensure that internal controls, including effective
The advisory discusses the characteristics that independent review or audit, are in place to
should be considered in determining whether provide integrity to the valuation process. Insti-
mandatory-delivery and best-efforts contracts tutions’ practices should, therefore, reflect these
are derivatives and the accounting and regula- concepts to ensure the reliability of their valua-
tory reporting treatment for both commitments tions of derivative loan commitments and for-
to originate mortgage loans that will be held for ward loan-sales commitments.
resale and those loan-sales agreements that meet
the definition of a derivative. The advisory also
addresses the guidance that should be consid- Derivative Loan Commitments
ered in determining the fair value of derivatives.
A financial institution should account for deriva-
The advisory provides additional guidance on
tive loan commitments at fair value on the
the application of FAS 133. Financial institu-
balance sheet, regardless of the manner in which
tions are expected, including those that are not
the intended sale of the mortgage loans will be
required to file reports with the Securities and
executed (e.g., under a best-efforts contract, a
Exchange Commission (SEC), to follow the
mandatory-delivery contract, or the institution’s
guidance in SEC Staff Accounting Bulletin No.
own securitization). An institution should report
105, ‘‘Application of Accounting Principles to
each fixed, adjustable, and floating derivative
Loan Commitments’’ (SAB 105).24
loan commitment as an ‘‘other asset’’ or an
A financial institution is expected to account ‘‘other liability’’ in their regulatory reports based
for and report derivative loan commitments and upon whether the individual commitment has a
forward loan-sales commitments as derivatives positive (asset) or negative (liability) fair value.25
in accordance with GAAP, which includes the With respect to floating derivative loan com-
use of valuation techniques that are reasonable mitments, because the interest rate on such a
and supportable in the determination of fair commitment ‘‘floats’’ on a daily basis with
value. An institution’s failure to account for and market interest rates, the fair value of a floating
report derivative loan commitments and forward derivative loan commitment approximates zero
loan-sales commitments in regulatory reports in as long as the creditworthiness of the borrower
accordance with GAAP may be an unsafe and has not changed. However, as with other deriva-
unsound practice. tive loan commitments, an institution must report
the entire gross notional amount of floating
25. When preparing Reports of Condition and Income

(Call Reports), fixed, adjustable, and floating derivative loan
commitments should not be reported as unused commitments
24. Staff accounting bulletins (SAB) summarize the views in Schedule RC-L, Derivatives and Off-Balance Sheet Items,
of the SEC’s staff regarding the application of generally because such commitments are to be reported as derivatives in
accepted accounting principles. this schedule.

Page 30
derivative loan commitments in its regulatory the fair value of forward loan-sales commit-
reports. ments against the fair value of derivative loan
Commitments to originate mortgage loans commitments (the pipeline) or mortgage loans
that will be held for investment purposes and held for sale (warehouse loans). Rather, forward
commitments to originate other types of loans loan-sales commitments must be accounted for
are not within the scope of FAS 133 and, separately at fair value, and warehouse loans
therefore, are not accounted for as derivatives.26 must be accounted for at the lower of cost or
An institution should report the unused portion market (commonly referred to as ‘‘LOCOM’’)30
of these types of commitments, which are not (that is, ‘‘fair value’’) with certain adjustments
considered derivatives, as ‘‘unused commit- to the cost basis of the loans if hedge accounting
ments’’ in its regulatory reports. is applied.
Forward Loan-Sales Commitments Hedge Accounting

A financial institution should account for for- A financial institution should follow the guid-
ward loan-sales commitments for mortgage loans ance in FAS 133 when applying hedge account-
as derivatives at fair value on the balance sheet. ing to its mortgage banking activities. If the FAS
Each forward loan-sales commitment should be 133 qualifying criteria are met, an institution
reported as an ‘‘other asset’’ or an ‘‘other may apply—
liability’’ based upon whether the individual
commitment has a positive (asset) or negative • fair-value hedge accounting in a hedging
(liability) fair value.27 relationship between forward loan-sales com-
mitments (hedging instrument) and fixed-rate
warehouse loans (hedged item), or
Netting of Contracts • cash-flow hedge accounting in a hedging
relationship between forward loan-sales com-
For balance-sheet-presentation purposes, FAS mitments (hedging instrument) and the fore-
133 does not provide specific guidance on casted sale of the warehouse loans and/or the
financial-statement presentation.28 A financial loans to be originated under derivative loan
institution may not offset derivatives with nega- commitments (forecasted transaction).31
tive fair values (liabilities) against those with
positive fair values (assets), unless the criteria If a financial institution does not apply hedge
for ‘‘netting’’ under GAAP have been satis- accounting, either because the FAS 133 hedge
fied.29 In addition, an institution may not offset criteria are not met or the institution chooses not
to apply hedge accounting, forward loan-sales
26. See FAS 133, paragraph 10(i).
commitments should be treated as nonhedging
27. Regardless of whether the underlying mortgage loans derivatives. If hedge accounting is not applied,
will be held for investment or for resale, commitments to an institution will account for its warehouse
purchase mortgage loans from third parties under either loans at the lower of cost or fair value. Because
mandatory-delivery contracts or best-efforts contracts are
derivatives if, upon evaluation, the contracts meet the defini-
nonhedging forward loan-sales commitments are
tion of a derivative under FAS 133. An institution should accounted for at fair value through earnings,
report its loan-purchase commitments that meet the definition such an approach causes volatility in reported
of a derivative at fair value on the balance sheet. earnings if the fair value of the warehouse loans
28. That is, FAS 133 does not provide specific guidance
where, in the financial statements, the fair value of derivatives
increases above their cost basis. In this situation,
or the changes in the fair value of derivatives should be the volatility is a result of recognizing the full
classified and presented on the financial statement.
29. When an institution has two (or more) derivatives with condition, fair-value amounts recognized for derivative con-
the same counterparty, contracts with positive fair values and tracts executed with the same counterparty under a master
negative fair values may be netted if the conditions set forth in netting arrangement may be offset.
FASB Interpretation No. 39, ‘‘Offsetting of Amounts Related 30. See Statement of Financial Accounting Standards No.
to Certain Contracts’’ (FIN 39), are met. Those conditions are 65, ‘‘Accounting for Certain Mortgage Banking Activities’’
as follows: (1) each of the parties owes the other determinable (FAS 65), paragraph 4.
amounts; (2) the reporting party has the right to set off the 31. See FAS 133, paragraphs 20–21, and related FAS 133
amount owed with the amount owed by the other party; (3) the guidance for hedging instruments, hedged items, and fore-
reporting party intends to set off; and (4) the right of setoff is casted transactions that qualify for fair-value and cash-flow
enforceable at law. In addition, without regard to the third hedge accounting.

Page 31
amount of any decline in the fair value of the (2) observable prices of other current market
forward loan-sales commitments in earnings transactions, or (3) other observable data sup-
while not adjusting the carrying amount of the porting a valuation technique, the transaction
warehouse loans above their cost basis. price represents the best information available
with which to estimate fair value at the inception
of an arrangement.
Income-Statement Effect A financial institution should not recognize an
unrealized gain or loss at inception of a deriva-
Unless cash-flow hedge accounting is applied, a
tive instrument unless the fair value of that
financial institution should include the periodic
instrument is obtained from a quoted market
changes in the fair value of derivative loan
price in an active market or is otherwise evi-
commitments and forward loan-sales commit-
denced by comparison to other observable cur-
ments in current-period earnings. An institution
rent market transactions or based on a valuation
should report these changes in fair value in
technique incorporating observable market
either ‘‘other noninterest income’’ or ‘‘other
data.34 Based on this guidance, derivative loan
noninterest expense,’’ but not as trading rev-
commitments generally would have a zero fair
enue, in their regulatory reports. However, an
value at inception.35 However, subsequent
institution’s decision as to whether to report the
changes in the fair value of a derivative loan
changes in fair value in its regulatory reports in
commitment must be recognized in financial
an income or expense line item should be
statements and regulatory reports (e.g., changes
consistent with its presentation of these changes
in fair value attributable to changes in market
in its general-purpose external financial state-
interest rates).
ments (including audited financial statements)32
When estimating the fair value of derivative
and should be consistent from period to period.
loan commitments and those best-efforts con-
tracts that meet the definition of a derivative, a
financial institution should consider predicted
Valuation ‘‘pull-through’’ (or, conversely, ‘‘fallout’’) rates.
Fair Value A pull-through rate is the probability that a
derivative loan commitment will ultimately result
FAS 133 indicates that the guidance in State- in an originated loan. Some factors that may be
ment of Financial Accounting Standards No. considered in arriving at appropriate pull-
107, ‘‘Disclosures about Fair Value of Financial through rates include (but are not limited to) the
Instruments’’ (FAS 107), should be followed in origination channel [which may be either inter-
determining the fair value of derivatives.33 That nal (retail) or external (wholesale or correspon-
guidance provides that quoted market prices are dent, to the extent the institution rather than the
the best evidence of the fair value of financial correspondent closes the loan36)], current mort-
instruments. However, when quoted market gage interest rates in the market versus the
prices are not available, which is typically the interest rate incorporated in the derivative loan
case for derivative loan commitments and for- commitment, the purpose of the mortgage (pur-
ward loan-sales commitments, estimates of fair chase versus refinancing), the stage of comple-
value should be based on the best information tion of the underlying application and underwrit-
available in the circumstances (e.g., valuation ing process, and the time remaining until the
techniques based on estimated expected future
34. See footnote 3 in Emerging Issues Task Force Issue
cash flows). When expected future cash flows No. 02-3 (EITF 02-3), ‘‘Issues Involved in Accounting for
are used, they should be the institution’s best Derivative Contracts Held for Trading Purposes and Contracts
estimate based on reasonable and supportable Involved in Energy Trading and Risk Management Activi-
assumptions and projections. ties.’’
35. If a potential borrower pays the lender a fee upon
Estimates of fair value should consider prices entering into a derivative loan commitment (e.g., a rate-lock
for similar assets or similar liabilities and the fee), there is a transaction price, and the lender should
results of valuation techniques to the extent recognize the derivative loan commitment as a liability at
available in the circumstances. In the absence of inception using an amount equal to the fee charged to the
potential borrower.
(1) quoted market prices in an active market, 36. If an institution commits to purchase a loan that will be
closed by a correspondent in the correspondent’s name, the
32. See footnote 28 above. institution would have a loan-purchase commitment rather
33. See FAS 133, paragraph 17. than a derivative loan commitment. Refer to footnote 27.

Page 32
expiration of the derivative loan commitment. ologies for derivative loan commitments and
Estimates of pull-through rates should be based forward loan-sales commitments as well as mea-
on historical information for each type of loan suring and recognizing such derivatives.
product adjusted for potential changes in market
interest rates that may affect the percentage of
loans that will close. An institution should not Changes in Accounting for Derivative
consider the pull-through rate when reporting
the notional amount of derivative loan commit-
Loan Commitments and Loan-Sales
ments in regulatory reports but, rather, must Agreements
report the entire gross notional amount.
Financial institutions should follow Accounting
Principles Board Opinion No. 20 (APB 20),
‘‘Accounting Changes,’’38 if a change in their
SAB 105 accounting for derivative loan commitments,
best-efforts contracts, or mandatory-delivery con-
In March 2004, the SEC issued SAB 105 to
tracts is necessary. APB 20 defines various types
provide guidance on the proper accounting and
of accounting changes and addresses the report-
disclosures for derivative loan commitments.
ing of corrections of errors in previously issued
SAB 105 is effective for derivative loan com-
financial statements. APB 20 states, ‘‘[e]rrors in
mitments entered into after March 31, 2004.
financial statements result from mathematical
SAB 105 indicates that the expected future cash
mistakes, mistakes in the application of account-
flows related to the associated servicing of loans
ing principles, or oversight or misuse of facts
should not be considered in recognizing deriva-
that existed at the time the financial statements
tive loan commitments. Incorporating expected
were prepared.’’
future cash flows related to the associated ser-
For regulatory reporting purposes, a financial
vicing of the loan essentially results in the
institution must determine whether the reason
immediate recognition of a servicing asset. Ser-
for a change in its accounting meets the APB 20
vicing assets should only be recognized when
definition of an accounting error. If the reason
the servicing asset has been contractually sepa-
for the change meets this definition, the error
rated from the underlying loan by sale or secu-
should be reported as a prior-period adjustment
ritization of the loan with servicing retained.37
if the amount is material. Otherwise, the effect
Further, no other internally developed intangible
of the correction of the error should be reported
assets (such as customer-relationship intangible
in current earnings.
assets) should be recognized as part of deriva-
If the effect of the correction of the error is
tive loan commitments. Recognition of such
material, a financial institution should also con-
assets would only be appropriate in a third-party
sult with its primary federal regulatory agency
transaction (for example, the purchase of a
to determine whether any of its prior regulatory
derivative loan commitment either individually,
reports should be amended. If amended regula-
in a portfolio, or in a business combination).
tory reports are not required, the institution
should report the effect of the correction of the
error on prior years’ earnings, net of applicable
Standard-Setter Activities taxes, as an adjustment to the previously reported
beginning balance of equity capital. For the Call
Financial institutions should be aware that the Report, the institution should report the amount
SEC or the Financial Accounting Standards of the adjustment in Schedule RI-A, item 2,
Board (FASB) may issue additional fair-value, ‘‘Restatements due to corrections of material
measurement, or recognition guidance in the accounting errors and changes in accounting
future (e.g., a fair-value measurement state- principles,’’ with an explanation in Schedule
ment). To the extent that additional guidance is RI-E, item 4.
issued, institutions must also consider the guid- The effect of the correction of the error on
ance in developing fair-value-estimate method- income and expenses since the beginning of the
37. See Statement of Financial Accounting Standards No. 38. Effective December 15, 2005, APB 20 will be replaced
140 (FAS 140), ‘‘Accounting for Transfers and Servicing of by FASB Statement No. 154, ‘‘Accounting Changes and Error
Financial Assets and Extinguishments of Liabilities,’’ para- Corrections-A replacement of APB Opinion No. 20 and FASB
graph 61. Statement No. 3.’’

Page 33
year in which the error is corrected should be after the commitment date). Additionally, de-
reflected in each affected income and expense rivative loan commitments generally do not bind
account on a year-to-date basis beginning in the the potential borrower to obtain the loan, nor do
next quarterly income statement (Call Report) to they guarantee that the lender will approve the
be filed and not as a direct adjustment to loan once the creditworthiness of the potential
retained earnings. borrower has been determined.
Forward Loan-Sales Commitment

Definitions of Terms Used in the
Advisory The term forward loan-sales commitment refers
to either (1) a mandatory-delivery contract or
Derivative Loan Commitment
(2) a best-efforts contract that, upon evaluation
The term derivative loan commitment refers to a under FAS 133, meets the definition of a
lender’s commitment to originate a mortgage derivative.
loan that will be held for resale. Notwithstand-
ing the characteristics of a derivative set forth in Mandatory-Delivery Contract
FAS 133, these commitments to originate mort-
gage loans must be accounted for as derivatives A mandatory-delivery contract is a loan-sales
by the issuer under FAS 133 and include, but are agreement in which a financial institution com-
not limited to, those commonly referred to as mits to deliver a certain principal amount of
interest-rate-lock commitments. mortgage loans to an investor at a specified price
In a derivative loan commitment, the lender on or before a specified date. If the institution
agrees to extend credit to a borrower under fails to deliver the amount of mortgages neces-
certain specified terms and conditions in which sary to fulfill the commitment by the specified
the interest rate and the maximum amount of the date, it is obligated to pay a ‘‘pair-off’’ fee,
loan39 are set prior to or at funding. Under the based on then-current market prices, to the
agreement, the lender commits to lend funds to investor to compensate the investor for the
a potential borrower (subject to the lender’s shortfall. Variance from the originally commit-
approval of the loan) on a fixed- or adjustable- ted principal amount is usually permitted, but
rate basis, regardless of whether interest rates typically may not exceed 10 percent of the
change in the market, or on a floating-rate basis. committed amount.
In a typical derivative loan commitment, the All loan-sales agreements must be evaluated
borrower can choose to— to determine whether they meet the definition of
a derivative under FAS 133.40 A mandatory-
• ‘‘lock in’’ the current market rate for a fixed- delivery contract has a specified underlying (the
rate loan (i.e., a fixed derivative loan commit- contractually specified price for the loans) and
ment); notional amount (the committed loan-principal
• ‘‘lock in’’ the current market rate for an amount), and requires little or no initial net
adjustable-rate loan that has a specified for- investment. Additionally, a mandatory-delivery
mula for determining when and how the contract requires or permits net settlement or the
interest rate will adjust (i.e., an adjustable equivalent thereof as the institution is obligated
derivative loan commitment); or under the contract to either deliver mortgage
• wait until a future date to set the interest rate loans or pay a pair-off fee (based on the then-
and allow the interest rate to ‘‘float’’ with current market prices) on any shortfall on the
market interest rates until the rate is set (i.e., a delivery of the committed loan-principal amount.
floating derivative loan commitment). Since the option to pay a pair-off fee accom-
plishes net settlement, it is irrelevant as to
Derivative loan commitments vary in term and whether the mortgage loans to be delivered are
expire after a specified time period (e.g., 60 days considered readily convertible to cash.41 Based
39. In accordance with the ‘‘Background Information and

Basis for Conclusions’’ in Statement of Financial Accounting 40. See FAS 133, paragraph 6, for the characteristics of a
Standards No. 149 (FAS 149), the notional amount of a financial instrument or other contract that meets the definition
derivative loan commitment is the maximum amount of the of a derivative.
borrowing. See FAS 149, paragraph A27. 41. See FAS 133, paragraph 57(c)(1), for a description of

Page 34
on these characteristics, a mandatory-delivery to govern the relationship between the institu-

contract meets the definition of a derivative at tion and the investor and set the parameters
the time an institution enters into the commitment. under which the institution will deliver indi-
vidual mortgage loans through separate best-
efforts contracts. Such an arrangement might
Best-Efforts Contract include, for example, a master agreement or an
umbrella contract. These arrangements may
The term best-efforts contract refers to a loan-
specify an overall maximum principal amount
sales agreement in which a financial institution
of mortgage loans that the institution may deliver
commits to deliver an individual mortgage loan
to the investor during a specified time period,
of a specified principal amount and quality to an
but generally they do not specify the price the
investor if the loan to the underlying borrower
investor will pay for individual loans. Further,
closes. Generally, the price the investor will pay
while these arrangements may include pair-off-
the seller for an individual loan is specified prior
fee provisions for loans to be sold under indi-
to the loan being funded (e.g., on the same day
vidual best efforts contracts covered by the
the lender commits to lend funds to a potential
arrangements, the seller is neither contractually
borrower). A best-efforts contract that has all of
obligated to deliver the amount of mortgages
the following characteristics would meet the
necessary to fulfill the maximum principal
definition of a derivative:
amount specified in the arrangement nor required
to pay a pair-off fee on any shortfall. Because
• an underlying (e.g., the price the investor will
these arrangements generally either do not have
pay the seller for an individual loan is speci-
a specified underlying or determinable notional
fied in the contract)
amount or do not require or permit net settle-
• a notional amount (e.g., the contract specifies
ment or the equivalent thereof, the arrangements
the principal amount of the loan as an exact
typically do not meet the definition of a deriva-
dollar amount or as a principal range with a
tive. As discussed above, an individual best-
determinable maximum amount42)
efforts contract governed by one of these
• requires little or no initial net investment (e.g.,
arrangements may, however, meet the definition
no fees are exchanged between the seller and
of a derivative.
investor upon entering into the agreement, or
As the terms of individual best-efforts con-
a fee that is similar to a premium on other
tracts and master agreements or umbrella con-
option-type contracts is exchanged)
tracts vary, a financial institution must carefully
• requires or permits net settlement or the
evaluate such contracts to determine whether the
equivalent thereof (for example, the seller is
contracts meet the definition of a derivative in
contractually obligated to either deliver the
FAS 133.
loan to the investor if the loan closes or pay a
pair-off fee, based on then-current market
prices, to the investor to compensate the
investor if the loan closes and is not delivered. Example of the Accounting for
Since the option to pay a pair-off fee accom- Commitments to Originate and Sell
plishes net settlement, it is irrelevant as to Mortgage Loans43
whether the loan to be delivered is considered
readily convertible to cash.). ABC Mortgage Financial Institution
(Best-Efforts Contracts and No
Application of Fair-Value Hedge
Master Agreement Accounting)
A financial institution may enter into one of The following simplified example was devel-
several types of arrangements with an investor oped to provide a financial institution that has a
limited number of derivative loan commitments
contracts that have terms that implicitly or explicitly require
or permit net settlement. 43. This example uses the definitions and concepts pre-
42. The use of a maximum amount as the notional amount sented in the body of the Interagency Advisory on Accounting
of a best-efforts contract is consistent with the loan- and Reporting for Commitments to Originate and Sell Mort-
commitment discussion in the ‘‘Background Information and gage Loans (the interagency advisory). Reference should be
Basis for Conclusions’’ in FAS 149. See FAS 149, paragraph made to the interagency advisory for clarification of the terms
A27. and concepts used in this example.

Page 35
general guidance on one approach that may be individual loan and the notional amount of the
used to value such commitments.44 This exam- loan are specified, and ABC is obligated to
ple also illustrates the regulatory reporting deliver the loan to the investor if the loan closes,
requirements for derivative loan commitments the contract represents a forward loan-sales
and forward loan-sales commitments. commitment. Under FAS 133, ABC accounts
The guidance in this example is for illustra- for these forward loan-sales commitments as
tive purposes only as there are several ways that derivative financial instruments.
a financial institution might estimate the fair At December 31 of a given year, the notional
value of its derivative loan commitments. A amounts of ABC’s mortgage banking derivative
second approach to valuing derivative loan com- loan commitments and forward loan-sales com-
mitments is described in Derivative Loan Com- mitments are as follows:
mitments Task Force Illustrative Disclosures on
Derivative Loan Commitments, a practice aid
developed by staff of the American Institute of Table 1—Notional Amounts of
Certified Public Accountants (AICPA) and a
task force comprising representatives from the
Derivative Loan Commitments and
financial services, mortgage banking, and public Forward Loan-Sales Commitments
accounting communities.45 As indicated in the Notional
body of the interagency advisory, a financial amount
institution must consider the guidance in FAS
Derivative loan
133, FAS 107, EITF 02-3, and SAB 105 in
commitments
measuring and recognizing derivative loan com-
mitments and forward loan-sales commitments. Fixed-rate commitments $ 8,500,000
In addition, an institution should be aware that Adjustable-rate
the SEC or the FASB may issue additional commitments 1,500,000
guidance in the future that may alter certain Floating-rate commitments 2,000,000
aspects of this example.
Total derivative loan
Background. ABC Mortgage Financial Institu- commitments $12,000,000 [A]46
tion (ABC) enters into fixed, adjustable, and
floating derivative loan commitments to origi- Forward loan-sales
nate mortgage loans that it intends to sell. The commitments
institution accounts for the commitments as Pipeline loan commitments $12,000,000
derivative financial instruments as required under
FAS 133. Warehouse loan
ABC enters into best-efforts contracts with a commitments 8,000,000
mortgage investor under which it commits to Total forward loan-sales
deliver certain loans that it expects to originate commitments $20,000,000 [B]
under derivative loan commitments (i.e., the
pipeline) and loans that it has already originated
and currently holds for sale (i.e., warehouse Market interest rates have changed through-
loans). ABC and the mortgage investor agree on out the time period that ABC’s derivative loan
the price that the investor will pay ABC for an commitments and forward loan-sales commit-
individual loan with a specified principal amount ments have been outstanding. Some of the
prior to the loan being funded. Once the price fixed-rate commitments are at rates above cur-
that the mortgage investor will pay ABC for an rent market rates while others are at rates at or
below current market rates. All of ABC’s
adjustable-rate commitments are at rates below
44. Estimating fair values when quoted market prices are current market rates.
unavailable requires considerable judgment. Valuation tech-
niques using simplified assumptions may sometimes be used Based on its past experience, ABC estimates
(with appropriate disclosure in the financial statements) to a pull-through rate of 70 percent on its fixed-rate
provide a reliable estimate of fair value at a reasonable cost. commitments for which the locked-in rate is
See FAS 107, paragraphs 60–61.
45. The practice aid is available at www.aicpa.org/
download/members/div/acctstd/ Illustrative_Disclosure_on- 46. Alpha references in table 1 and the text of this example
_Derivative_Loan_Commitments.pdf. refer to the ‘‘Reference’’ column in table 3.

Page 36
above current market rates (i.e., 70 percent of appropriate reference price for the underlying
the commitments will actually result in loan loans on the day that each derivative loan
originations) and a pull-through rate of 85 per- commitment was given to a borrower and
cent for its fixed-rate commitments for which assigned an initial fair value of zero to each loan
the locked-in rate is at or below current market commitment consistent with the guidance in
rates. ABC also estimates a pull-through rate of SAB 105 and EITF 02-3. At the end of the
85 percent for all of its adjustable-rate commit- month, ABC compares the current reference
ments that are below market rates. price of each underlying loan with its initial
The pull-through-rate assumptions in this reference price and calculates the price differ-
example have been simplified for illustrative ence. ABC then calculates the fair value of these
purposes. In determining appropriate pull- derivatives by multiplying the price difference
through rates, a financial institution must con- by the estimated pull-through rate. This approach
sider all factors that affect the probability that is illustrated in table 2 below.
derivative loan commitments will ultimately As illustrated in table 2, ABC excludes time
result in originated loans. Therefore, an institu- value from its fair-value-estimate methodology
tion is expected to have more granularity (i.e., due to the short-term nature of the derivative
stratification) in its application of pull-through- loan commitments. As the exclusion of time
rate assumptions to its derivative loan value is not appropriate for all fair-value esti-
commitments. mates, an institution must consider the terms of
its specific agreements in determining an appro-
Discussion of ABC’s approach to valuing priate estimation methodology.
derivative loan commitments and forward loan- In the example in table 2, ABC estimated the
sales commitments. ABC estimates the fair value initial reference price of the underlying loan to
of its derivative loan commitments using the be originated under the commitment, excluding
best information available in the circumstances the value of the associated servicing rights, to be
because quoted market prices are not available. $100,000. That is, at the date it entered into the
In this case, ABC uses valuation techniques that fixed derivative loan commitment with the bor-
take into account current secondary-market loan- rower, ABC estimated it would receive $100,000,
pricing information.47 ABC had noted the excluding the value of the associated servicing
47. In general, source data for secondary-market loan- loan investors. When secondary-market loan-pricing informa-
pricing information may include, for example, quotations tion that includes the value of servicing rights is used, the fair
from rate sheets; brokers; or electronic systems such as those value of the derivative loan commitments ultimately must
provided by third-party vendors, market makers, or mortgage exclude any value attributable to servicing rights.
Table 2—ABC’s Calculation of the Fair Value of Derivative Loan

Commitments: An Example of a Fixed Derivative Loan Commitment for
Which the Locked-In Rate Is Above the Current Market Rate*
Initial reference Current reference
price of loan to be price of loan to be
originated under originated under Fair value of
Notional commitment— commitment— Pull- derivative
amount of excluding servicing excluding servicing Price through loan
loan rights rights difference rate commitment
(1) (2) (3) [(3) - (2)] (4) [(3) - (2)] × (4)
$100,000 $100,000 $100,500 $500 70% $350
* The example in this table presents the fair-value calculation for one derivative loan commitment. The fair value of this
derivative, which is positive, would be added to all the other derivative loan commitments with positive fair values. Netting
derivatives with positive fair values (assets) against derivatives with negative fair values (liabilities) is not permitted unless the
conditions stipulated in FIN 39 are met. Refer to footnote 29 of the interagency advisory.

Page 37
rights, if the underlying loan was funded and liability, because current market interest rates
sold in the secondary market on that day. Because for comparable mortgage loans are lower than
this amount is equal to the notional amount of the rates in effect when the derivative loan
the loan, ABC would not experience a gain or commitments were initiated. (Consequently, cur-
loss on the sale of the underlying loan (before rent offered delivery prices for similar commit-
considering the effect of the loan-origination ments are greater than the delivery prices of
fees and costs associated with the loan). As ABC’s existing forward loan-sales commit-
such, the fair value of this derivative loan ments. Therefore, the change in the fair value of
commitment would be zero, and there would not ABC’s forward loan-sales commitments since
be any unrealized gain or loss at the inception of they were entered into represents a loss.) The
the derivative loan commitment. This may not fair value of ABC’s forward loan-sales commit-
be true for all derivative loan commitments. ments related to its derivative loan commitments
ABC defers all unrealized gains and losses at and warehouse loans with at- or below-market
the inception of its derivative loan commitments rates is estimated to be $50,000, which is an
until the underlying loans are sold. ABC’s asset.48
policy is based on the short-term nature of its
derivative loan commitments and was adopted Regulatory reporting. The following table illus-
in order to not accelerate the timing of gain trates the regulatory reporting requirements for
recognition. As this practice may not be appro- the derivative-related dollar amounts cited in the
priate for all derivative loan commitments or example.
other derivatives initially accounted for under
EITF 02-3, and due to the lack of authoritative
guidance in this area, an institution should
consult with its accounting advisers concerning
the appropriate accounting for its specific
agreements.
After applying the methodology described
above to individual derivative loan commit-
ments, ABC aggregates the fair values of the
derivative loan commitments by type (i.e., fixed,
adjustable, and floating) and by whether the
commitments have above-, at-, or below-market
rates. The fair values of the fixed derivative loan
commitments with above-market rates, adjusted
for the appropriate pull-through rate, total
$21,000 [C], which represents an asset. The
aggregate fair value of the fixed derivative loan
commitments that have at- or below-market
rates, adjusted for the appropriate pull-through
rate, sums to ($31,000) [D], which represents a
liability. For the adjustable derivative loan com-
mitments, the aggregate fair value, adjusted for
the pull-through rate, is approximately ($2,000)
[E], which is also a liability. The fair value of
the floating derivative loan commitments
approximates zero.
ABC also estimates the fair value of its
forward loan-sales commitments outstanding at
the end of the month using a similar methodol- 48. The absolute value of the fair value of the forward
ogy as that described above. Based upon this loan-sales commitments is greater than the absolute value of
information, ABC determines that the estimated the fair value of the related derivative loan commitments
fair value of the forward loan-sales commit- because the forward loan-sales commitments also apply to,
and act as an economic hedge of, ABC’s warehouse loans.
ments related to its derivative loan commitments ABC accounts for its warehouse loans at the lower of cost or
and warehouse loans with above-market rates is fair value in accordance with FAS 65. In this example, ABC
approximately ($45,000) [F], which represents a does not apply hedge accounting to its warehouse loans.

Page 38
Table 3—Regulatory Reporting Implications for Derivative Loan Commitments

and Forward Loan-Sales Commitments
Amount Reference
Derivative loan commitments

Notional amount of ‘‘over-the-counter written options’’49 $12,000,000 [A]
Derivatives with a positive fair value held for purposes other than
trading (asset) $21,000 [C]
Derivatives with a negative fair value held for purposes other than
trading (liability) $33,000 [D + E]
Forward loan-sales commitments

Notional amount of ‘‘forward contracts’’ $20,000,000 [B]
Derivatives with a positive fair value held for purposes other than
trading (asset) $50,000 [G]
Derivatives with a negative fair value held for purposes other than
trading (liability) $45,000 [F]
Derivative loan commitments and forward loan-sales commitments

Total notional amount of derivative contracts held for purposes other
than trading $32,000,000 [A + B]
As illustrated in table 3, depending upon par- In addition, for regulatory reporting purposes,
ticular market circumstances, individual deriva- ABC consistently reports the periodic changes
tive loan commitments and forward loan-sales in the fair value of its derivative contracts in
commitments may have either positive or nega- ‘‘other noninterest expense’’ in its income state-
tive fair values, which ABC properly reports ment. Alternatively, ABC could have chosen to
gross as assets or liabilities on its balance sheet. consistently report these fair-value changes in
‘‘other noninterest income’’ in its regulatory
49. Because derivative loan commitments are in certain reports.
respects similar to options, they are reported with ‘‘over-the-
counter written options’’ for regulatory reporting purposes.

Page 39
1. To determine if policies, practices, proce- 9. To ascertain, to the extent possible, that the
dures, and internal controls for loan port- bank’s credit extensions did not include
folio management are adequate. impermissible tying arrangements.
2. To determine if bank officers are operat- 10. To determine that management has imple-
ing in conformance with the established mented satisfactory policies, procedures, and
guidelines. controls to address the risks inherent in
3. To determine the scope and adequacy of the mortgage banking activities.
audit and loan-review functions. 11. To find out if the bank accounted for and
4. To determine the overall quality of the loan reported the following transactions at their
portfolio and how that quality relates to the fair value: (1) its commitments to originate
soundness of the bank. mortgage loans that were held for resale
5. To be alert to indications of insufficiently (derivatives) and (2) its loan-sales agree-
rigorous risk assessment at banking institu- ments that are derivatives. If so, to ascertain
tions, particularly excessive reliance on if these transactions were accounted for and
strong economic conditions and robust reproted—
financial markets to support the capacity of a. in accordance with the instructions for
borrowers to service their debts, and inad- the bank Call Report; generally accepted
equate stress testing. accounting principles (GAAP); SR-05-10
6. To be attentive when reviewing an institu- and its attached May 3, 2005, Inter-
tion’s lending policies and its assessment agency Advisory on Accounting and
and monitoring of credit risk to ensure that Reporting for Commitments to Originate
undue reliance on favorable conditions does and Sell Mortgage Loans; and
not lead to the delayed recognition of emerg- b. based on reasonable and supportable
ing weaknesses in some loans. valuation techniques, as prescribed by
7. To ascertain whether there has been signifi- the above-mentioned guidance.
cant and undue reliance by the institution on 12. To determine if the banking organization’s
favorable assumptions about borrowers or loan-review activities or other internal con-
the economy and financial markets. If so, to trol and risk-management processes have
carefully consider downgrading, under the been weakened by staff turnover, failure to
applicable supervisory rating framework, an commit sufficient resources, inadequate
institution’s risk-management, management, training, and reduced-scope or less-thorough
or asset-quality ratings (or all three). If the internal loan reviews. To incorporate such
institution’s assumptions are deemed suffi- findings into the determination of supervi-
ciently significant, to consider downgrading sory ratings.
its capital adequacy rating. 13. To prepare, in a concise, reportable format,
8. To determine if the bank has adequate information on the bank’s lending function.
policies, procedures, internal controls, and 14. To determine compliance with laws and
internal or external audit reviews that ensure regulations, including sections 23A and 23B
its compliance (and its subsidiaries’ compli- of the Federal Reserve Act and the Board’s
ance) with section 106(b) of the Bank Regulation W.
Holding Company Act Amendments, 15. To initiate corrective action when policies,
the Board’s regulations and orders, and practices, procedures, or internal controls
the Board’s interpretations for tying are deficient or when violations of law or
arrangements. regulations have been noted.

Page 1
FIRST-DAY LETTER, another lending institution as a result of a

PRE-EXAMINATION ANALYSIS sale, participation, or asset swap
f. since the previous examination, loans
1. If selected for implementation, complete or acquired from another lending institution
update the loan portfolio management sec- as a result of a purchase, participation, or
tion of the internal control questionnaire. asset swap
2. Test for compliance with policies, practices, g. loans considered ‘‘problem loans’’ by man-
procedures, and internal controls in agement (This report may be either as of
conjunction with performing the remaining the examination date or as submitted to
procedures. the officer’s loan-review committee, loan
3. Request reports on the following from the and discount committee, or board of
bank, by department, as of the examination directors.)
date, unless otherwise specified: h. loan commitments and contingent
a. past-due loans covering— liabilities
• single-payment notes 30 days or more i. loans secured by stock of other banks and
past maturity; loans secured by rights, interests, or pow-
• single-payment notes with interest due ers of a savings and loan association
at specified intervals and demand notes j. extensions of credit (including outstand-
on which interest is due and unpaid for ing balances and any bank or personal
30 days or more; and charges on bank-owned or bank-issued
• consumer, mortgage, or term loans, pay- credit cards) that have been issued to
able in regular installments in which employees, officers, directors, and princi-
one installment is due and unpaid for pal shareholders and their interests, speci-
30 days or more. fying which officers are considered execu-
The following information should be in- tive officers
cluded: k. for correspondent banks, extensions of
• name of the obligor credit to executive officers, directors, and
• original amount of the loan principal shareholders and their interests
• outstanding amount of the loan l. a list of correspondent banks
• date the loan was made m. miscellaneous loan debit-and-credit sus-
• due date pense accounts
• terms of the loan n. current interest-rate structure
• number of payments the loan is o. officers’ current lending authority
delinquent p. the nature and extent of servicing activities,
• date of the borrower’s last payment including—
• interest billing cycle • the aggregate volume and types of ser-
• date up to which interest is paid viced loans,
For larger loans, the report should also • the dollar volume of loans originated
include the purpose of the loan and any from out of territory,
action being taken. • the number of originations and sales
b. loans in a nonaccrual status year-to-date compared with the same
c. loans on which interest is not being col- period in the previous year, and
lected in accordance with the terms of the • fee income from sales and servicing
loan year-to-date compared with the same
d. loans whose terms have been modified by period in the previous year.
a reduction of interest rate or principal q. extensions of credit in the form of over-
payment, by a deferral of interest or prin- night overdrafts resulting from wire trans-
cipal, or by other restructuring of repay- fer activities
ment terms 4. Obtain the following information:
e. since the previous examination, loans a. a copy of written policies covering all
transferred, either in whole or in part, to lending functions

Page 1
2040.3 Loan Portfolio Management: Examination Procedures
b. a statement of whether a standing com- thiness of any institution or customer on

mittee administers the lending function whose behalf the bank executes funds
c. copies of reports furnished to the board transfers
for meetings q. loan-pricing policies and practices indicat-
d. lists of directors, executive officers, and ing that the institution may be unduly
principal shareholders and their interests weighting the short-term benefit of
e. a summary of the officer’s borrowing retaining or attracting new customers
report (debts to own and other banks) through price concessions, while not giv-
5. Obtain a copy of the latest reports furnished ing sufficient consideration to potential
to the loan and discount committee. longer-term consequences
6. Review the lending policies and updates r. policies reflecting any indications of
thereto and determine, as loans and other insufficiently rigorous risk assessments,
extensions of credit are being reviewed, and, in particular, an excessive reliance on
whether the institution’s lending practices strong economic conditions and robust
adhere to the board-of-directors lending financial markets to support the capacity
policies and procedures and if they require of borrowers to service their debts, as well
continued compliance with sections 23A and as inadequate stress testing of the assump-
23B of the Federal Reserve Act and the tions underlying the risk assessment
Board’s Regulation W. s. policies involving the institution’s assess-
7. Abstract appropriate excerpts of the lending ments and monitoring of credit risk to
policies and updates on the following: ensure that an undue reliance on favorable
a. distribution of loans by category conditions does not lead the institution to
b. geographic limitations delay recognition of emerging weaknesses
c. industrial concentration limitations in some loans
d. allowable or desirable ratios of loans to
other balance-sheet accounts
e. lending authorities of committees and
officers LENDING POLICIES AND
f. any prohibited types of loans PROCEDURES, ASSET-LIABILITY
g. maximum maturities for various types of MANAGEMENT
loans
h. interest-rate structure 1. When more than one lending policy exists,
i. minimum downpayments for various types determine that policies are internally consis-
of loans tent by reviewing the guidelines previously
j. collateral-appraisal policies including— obtained.
• persons authorized to perform apprais- 2. Review minutes of the bank’s loan and
als and discount committee meetings to obtain—
• lending values of various types of a. present members and their attendance
property record,
k. financial information requirements by b. the scope of work performed, and
types of loans c. any information deemed useful in the
l. limitations and guidelines for purchasing examination of specific loan categories or
and selling loans either directly or through other areas of the bank.
participations or swaps 3. Compare reports furnished to the board and
m. guidelines for supplying complete and the loan and discount committee and those
regularly updated credit information to received from the bank in step 3 of the
purchasers of loans that the bank ‘‘First-Day Letter, Pre-examination Analy-
originated sis’’ section to determine any material differ-
n. guidelines for obtaining complete and ences and that they are transmitted to the
regularly updated credit information on board in a timely manner.
loans purchased from others 4. Perform the following steps for past-due
o. guidelines for loans to major stock- loans:
holders, directors, officers, or their a. Compare the following to determine any
interests material inconsistencies:
p. guidelines for determining the creditwor- • the past-due loan schedule received in

Page 2
Loan Portfolio Management: Examination Procedures 2040.3
step 3 of the ‘‘First-Day Letter, Pre-

examination Analysis’’ section
• delinquency reports submitted to the
board

Page 2.1
• list of loans considered ‘‘problem’’ loans on a recourse basis and that loans are
by management sold on a nonrecourse basis.
• delinquency lists submitted for regula- • Determine that the bank does not
tory purposes buy back or pay interest on defaulted
b. Scan the delinquency lists submitted to loans in contradiction of the underlying
the board to determine that reports are agreement.
sufficiently detailed to evaluate risk • Compare the volume of loans purchased
factors. and sold with the total portfolio.
c. Compile current aggregate totals of past- • Determine that the bank has sufficient
due paper including unplanned overdrafts expertise to properly evaluate the vol-
not paid in 30 days. ume of loans purchased and sold.
5. Perform the following using the loan com- • Determine if loans are sold primarily to
mitments and contingent liabilities schedule accommodate overline needs of custom-
obtained in step 3 of the ‘‘First-Day Letter, ers or to generate fee income.
Pre-examination Analysis’’ section: • Determine if loans are purchased or sold
a. Reconcile appropriate contingencies totals to affiliates or other companies in a
to memorandum ledger controls. chain banking organization; if so, deter-
b. R e v i e w r e c o n c i l i n g i t e m s f o r mine that the purchasing companies are
reasonableness. given sufficient information to properly
6. Consult with the examiner responsible for evaluate the credit. (Section 23A of the
the asset/liability management analysis to Federal Reserve Act prohibits transfers
determine the appropriate maturity break- of low-quality assets between affiliates.
down of loans needed for the analysis. If See section 4050.1, ‘‘Bank-Related
requested, have the examiners assigned to the Organizations.’’)
various loan areas compile the information • Investigate any situations in which assets
using bank records or other appropriate were transferred before the date of
sources. See ‘‘Instructions for the Report of examination to determine if any were
Examination,’’ section 6000.1, for consider- transferred to avoid possible criticism
ations to be taken into account when compil- during the examination.
ing maturity information for the gap analysis. • Determine whether any of the loans
transferred were nonperforming at the
time of transfer, classified at the previ-
LOAN PORTFOLIO REVIEW AND ous examination, or for any other reason
ANALYSIS considered to be of questionable quality.
• Review the bank’s policies and pro-
1. Review the information received and per- cedures to determine whether assets or
form the following procedures. participations purchased by the bank are
a. Loan participations, loan purchases or given an independent, complete, and
sales, loan swaps. The procedures are adequate credit evaluation. If the bank
designed to ensure that loan transfers is a holding company subsidiary or a
involving state member banks, bank hold- member of a chain banking organiza-
ing companies, and nonbank affiliates tion, review asset purchases or partici-
are carefully evaluated to determine if pations from affiliates or other known
they were carried out to avoid classifi- members of the chain to determine if the
cation and to determine the effect of the asset purchases are given an arm’s-
transfer on the condition of the insti-. length and independent credit evalua-
tution. In addition, the procedures are tion by the purchasing bank.
designed to ensure that the primary reg- • Determine that any assets purchased by
ulator of the other financial institution the bank are properly reflected on its
involved in the transfer is notified. books at fair market value (while fair
• Check participation certificates and market value may be difficult to deter-
records and determine that the parties mine, it should at a minimum reflect
share in the risks and contractual pay- both the rate of return being earned on
ments on a pro rata basis. such assets and an appropriate risk pre-
• Ascertain whether loans are purchased mium). Determine that appropriate write-

Page 3
offs are taken on any assets sold by the ciated with the sale of U.S.
bank at less than book value. government–guaranteed loans
• Determine that transactions involving should be recognized only as
transfers of low-quality assets to the earned and amortized to appro-
parent holding company or a nonbank priate income accounts over the
affiliate are properly reflected at fair life of the loan.
market value on the books of both the — Recommendations for purchasing
bank and the holding company institutions:
affiliate. (1) Purchasers of U.S. government–
• If poor-quality assets were transferred guaranteed loans should be
to or from another financial institution aware that the purchase premi-
for which the Federal Reserve is not the ums are not guaranteed and are
primary regulator, prepare a memo- not paid by the guaranteeing
randum to be submitted to the Reserve federal agency when the loans
Bank supervisory personnel. The Reserve are prepaid. Because payment
Bank will then inform the local office of of premiums that do not reason-
the primary federal regulator of the ably relate to the yield on the
other institution involved in the transfer. loan can distort published finan-
The memorandum should include the cial reports by overstating the
following information, as applicable: value of a financial institution’s
— name of originating and receiving assets, it will generally be viewed
institutions as an unsafe and unsound bank-
— type of assets involved and type of ing practice for a financial insti-
transfer (i.e., participation, purchase tution to pay purchase premi-
or sale, swap) ums that result in a significant
— date (or dates) of transfer overstatement in the value of
— total number and dollar amount of bank assets.
assets transferred (2) Many government-guaranteed
— status of the assets when transferred loans currently being originated
(e.g., nonperforming, classified, etc.) and sold are variable rate. These
— any other information that would be variable-rate loans normally
helpful to the other regulator should not trade at anything
• Review the sale and purchase of U.S. more than a modest premium or
government–guaranteed loans and sale discount from par. Examiners
premiums. should carefully review any
— Recommendations for originating loans being sold or purchased
and selling institutions: at significant premiums and
(1) Examiners should review the criticize any involvement with
extent and nature of activities in excessive premiums as an unsafe
connection with the sale of and unsound business practice.
government-guaranteed loans. Excessive purchase premiums
Lax or improper management will be classified loss. The loans
of the selling institution’s ser- will be required to be revalued
vicing responsibilities should to the market value at the time
be criticized. Out-of-trade-area of the acquisition and the exces-
lending for the purpose of sive premiums will be charged
resale of any portion of U.S. against current earnings.
government–guaranteed loans In addition, any unamortized
should be carefully reviewed loan premium on a government-
to ensure that the practice is guaranteed loan must be imme-
conducted in a safe and sound diately charged against income
manner. if the loan is prepaid, regardless
(2) All income, including servic- of whether payment is received
ing fees and premiums charged from the borrower or the guar-
in lieu of servicing fees, asso- anteeing agency.

Page 4
b. Loans serviced. b. Compare the various department results to

• Determine that the bank exercises simi- determine the extent of nonadherence and
lar controls and procedures over loans if it is systemwide.
serviced for others as it does for loans in c. Organize internal-guideline exceptions in
its own portfolio. order of their relative importance.
• Determine that the bank, as lead or d. Determine the aggregate amount of statu-
agent in a credit, exercises similar con- tory bad debts. (See section 4070.1,
trols and procedures over syndications ‘‘Dividends.’’)
and participations sold as it does for e. Organize and prepare a listing of viola-
loans in its own portfolio. tions of law and regulations.
• Ascertain whether the serviced loans are f. Review loan classifications and assets
subject to a repurchase agreement or are listed for special mention to determine—
backed by a standby letter of credit from • inclusion of all necessary information
the originating bank. and
• Compare the volume of serviced loans • substantiation of classification.
with the total portfolio.
g. Determine the aggregate amount of paper
• Determine if out-of-territory origina- criticized in each of the four levels of
tions are significant relative to loans criticism.
serviced.
h. Compile a listing of all loans not sup-
• Determine if the volume of loans origi- ported by current and satisfactory credit
nated, sold, and serviced is consistent information.
with the loan-servicing capabilities of
management. i. Compile a listing of all loans not
supported by complete collateral
• Ascertain that servicing fees and premi- documentation.
ums charged in lieu of fees are amor-
tized over the life of the loan. j. Determine the aggregate amount of out-
of-area paper.
2. Obtain the listing of Uniform Review
of Shared National Credits, and update k. Compile a listing of low-quality loans
the listing based on information obtained transferred to or from another lending
in step 3 of the ‘‘First-Day Letter, Pre- institution through purchases or sales
examination Analysis’’ section. or participations or swaps. Submit the
listing to Reserve Bank supervisory
3. Distribute the applicable schedules and other personnel.
information obtained in the preceding steps
to the examiners performing the loan l. Review the separate procedures in section
examination procedures. Request that the 2050.3 ‘‘Concentrations of Credit,’’ and
examiners test the accuracy of the informa- determine—
tion. Also, request that they perform the appro- • if all necessary data are included,
priate steps in section 2050.3, ‘‘Concentra- • if there is substantiation for including
tions of Credit.’’ specific items in the report of examina-
4. Determine the general distribution character- tion as a concentration, and
istics of the loan portfolio by— • if the concentration is undue or
a. determining the percentage of total loans unwarranted.
in specific classes and m. Compute the following ratios, and com-
b. comparing loan-category distributions with pare them with computations from prior
policy guidelines. examinations:
5. Obtain the results of the internal loan reviews • aggregate classified paper to primary
of the loan department, and perform the capital
following: • weighted classified paper to primary
a. Determine any nonadherence to internally capital
established policies, practices, procedures, • aggregate past-due paper to loans
and controls. outstanding

Page 5
TYING ARRANGEMENTS ance subsidiary maintains a consistently

high penetration rate on credits granted
1. Evaluate compliance with section 106(b) of by the bank or its bank subsidiaries,
the Bank Holding Company Act Amend- which could indicate the presence of
ments, the Board’s regulations (section 225.7 voluntary or involuntary tying arrange-
of Regulation Y (12 CFR 225.7), and the ments;
Board’s interpretations of the prohibitions • verify that the bank’s internal loan-
against tying arrangements. During the course review policies require a periodic review
of the bank’s examination, examiners should of actual transactions that involve tying
focus on the bank’s responsibility to oversee arrangements to ensure the permissibil-
and safeguard against potentially illegal tying ity of the tying arrangements under
arrangements by the bank and its subsidi- section 106(b), section 225.7 of the
aries. Examiners are to thoroughly review Board’s Regulation Y, the Board’s or-
and evaluate the following areas: ders, and the Board’s interpretations on
a. the bank’s monitoring and oversight of tying arrangements;
compliance with section 106(b) and the • evaluate the nature, terms, and condi-
Board’s regulations tions of all services provided to custom-
b. the bank’s establishment and monitoring ers; and
of internal controls and procedures that • review billing arrangements, the fre-
are intended to prevent illegal tie-ins by quency of billing, the method of com-
the bank and its subsidiaries (Determine if putation, and the basis for such fees.
management and its internal auditors have
2. During the examination review of borrowers’
periodically confirmed that there is full
loans, review those extensions of credit whose
compliance with such an internal policy.)
credit facilities or services may result in tying
c. the adequacy of the bank’s written poli- arrangements imposed by the bank or its
cies (including policy statements) and pro- subsidiaries that are impermissible or in vio-
cedures pertaining to prohibited tying lation of section 106(b) or the Board’s regu-
arrangements (Policies and procedures lations. (See ‘‘Prohibitions Against Tying
include statements that many tying Arrangements’’ in section 2040.1.)
arrangements are illegal, as well as spe-
cific examples of prohibited tie-in prac- 3. Review the adequacy of external and internal
tices that are relevant to particular current audits, including the audit’s workpapers and
product lines.) procedures, to determine if the auditors
adequately ensured compliance with the pro-
d. documentation for the training of manage-
hibitions on tying arrangements in section
ment and staff who are responsible for
106(b).
monitoring the bank and its subsidiaries
for compliance with anti-tying provisions 4. On the ‘‘Matters Requiring Board Atten-
(Also review the adequacy of training on tion,’’ the ‘‘Comments and Conclusions,’’
compliance with anti-tying requirements and the ‘‘Violations of Laws and Regula-
that is provided to the bank’s other tions’’ report pages (or their equivalent),
employees.) report any significant comments on observed
e. the adequacy of the bank’s internal loan noncompliance with the prohibitions against
reviews of pertinent bank extensions of tying arrangements. (Comments would also
credit to borrowers whose credit facilities be appropriate if controls to prevent tie-ins
or services may be susceptible to improp- had not been established.)
erly imposed tying arrangements in viola-
tion of section 106(b) or the Board’s
regulations (See ‘‘Prohibitions Against
Tying Arrangements’’ in section 2040.1 MORTGAGE BANKING
for the statutory and regulatory provisions ACTIVITIES
and their exceptions.) The internal loan
reviews should— 1. Review the mortgage banking policies, pro-
• include reviews of insurance applica- cedures, and management information
tions, particularly if the bank’s insur- systems.

Page 6
2. Determine whether the directors, managers, ‘‘other asset’’ or an ‘‘other liability,’’ based
and auditors are adequately evaluating, moni- on whether the individual commitment
toring, and maintaining internal controls over has a positive (asset) or negative (liability)
the valuation and modeling processes, hedg- fair value in accordance with the bank
ing activities, management information sys- Call Report instructions.
tems, and the internal audit function. b. Determine if the floating-rate derivative
3. Review the bank’s mortgage-servicing loan commitments and other derivative
operations, and determine if market-based loan commitments were reported at their
assumptions are used and if they are reason- entire gross notional amount in the bank
able and supportable for estimating the fair Call Report.
value of servicing assets. c. Find out if the balance sheet correctly
a. Ascertain whether management uses bulk, presents (accounts for, discloses, and
flow, and daily mortgage-servicing asset reports) all such transactions, including
(MSA) or loan-pricing activities observed the netting of contracts, the application of
in the market to evaluate the bank’s MSA hedge accounting to mortgage banking
valuation assumptions. activities, the valuation of derivatives, and
b. Determine if those assumptions are rea- any material or other accounting changes
sonable and consistent with the market for derivative loan commitments and loan-
activity for similar assets. sales agreements. Also determine if there
4. With respect to management, determine— is compliance with the May 3, 2005,
a. if detailed policies and procedures are in Interagency Advisory on Accounting and
place to monitor and control mortgage Reporting for Commitments to Originate
banking activities, including loan produc- and Sell Mortgage Loans and with gener-
tion, pipeline (unclosed loans) and ware- ally accepted accounting principles
house (closed loans) administration, (GAAP).
secondary-market transactions, servicing
operations, and management (including d. Ascertain if periodic changes in the fair
hedging) of mortgage-servicing assets, and value of derivative loan commitments and
b. if reports and limits focus on key risks, forward loan-sales commitments are
profitability, and proper accounting reported in current-period earnings in ei-
practices. ther ‘‘other noninterest income’’ or ‘‘non-
5. Determine whether the bank has written and interest expense,’’ as appropriate.
has consistently applied accounting policies 8. Report to the central point of contact (CPC)
to its commitments to originate mortgage or examiner-in-charge (EIC) any failure of
loans that are held for resale and its commit- bank management to follow (1) the bank’s
ments to sell mortgage loans under mandatory- accounting and valuation policies for its
delivery and best-efforts contracts. commitments to originate mortgage loans
6. Find out if the bank has developed and uses that are held for resale and its commitments
approved valuation methodologies and pro- to sell mortgage loans, (2) the instructions for
cedures to obtain formal approval for changes the bank Call Report, (3) the May 3, 2005,
to those methodologies. interagency advisory, or (4) GAAP.
a. Ascertain whether the valuation method- 9. When additional examination scrutiny is
ologies are reasonable, objectively sup- needed, based on the examination findings,
ported, and fully documented. the supervisory concerns discussed in section
b. Determine if the bank has internal con- 2040.1, the February 23, 2003, Interagency
trols, including an effective independent Advisory on Mortgage Banking (see SR-
review or audit, in place that give integrity 03-4 and its attachment), and the May 3,
to the valuation process. 2005, Interagency Advisory on Accounting
7. If the bank issues fixed-, adjustable-, and and Reporting for Commitments to Originate
floating-rate derivative loan commitments or and Sell Mortgage Loans (see SR-05-10 and
forward loan-sales commitments, review an its attachment), perform the comprehensive
adequate sample that evidences the full cov- mortgage banking examination procedures
erage of these types of transactions. found in the appendix section A.2040.3.
a. Ascertain if these transactions were prop- (Section A.2040.3 is located behind the
erly reported on the balance sheet as an ‘‘Appendix’’ tab in the back of the manual.)

Page 7
PROBLEM LOANS AND ate statutes (12 USC 375a and 375b, 12 USC
CLASSIFICATION 1972(2)), and the board of directors’ lending
and other policies. Civil money penalties
1. Forward the total loss and doubtful classifi- may be assessed for noncompliance. Specific
cations and the total of statutory bad debts matters that should be addressed are as fol-
(‘‘A’’ paper) to the examiner assigned to lows:
analyze the adequacy of capital. a. Reports of examination.
2. Compare management’s list of ‘‘problem’’ • Each report of examination on the lend-
loans from step 3 (under ‘‘First-Day Letter, ing activities of state member banks
Pre-examination Analysis’’) with the listing should contain information as to the
of classified loans to determine the extent of bank’s compliance with the lending
management’s knowledge of its own loan restrictions found at 12 USC 375a and
problems. 375b, 12 USC 1972(2), and Regulation
3. Through information previously generated, O. Violations should be reported, as
determine the causes of existing problems or appropriate, in the following report
weaknesses within the system that have the pages of the Commercial Bank Report
potential to be future problems. of Examination:
— Matters Requiring Board Attention
— Examination Conclusions and Com-
ALLOWANCE FOR LOAN AND ments
LEASE LOSSES (ALLL) — Violations of Law and Regulations
b. Schedule RC-M.
1. Forward the following information to the • The information from this schedule
examiner assigned to review the ALLL: should be reviewed to verify the accu-
a. a listing of loans considered ‘‘problem racy and completeness of the informa-
loans’’ by management tion reported in the Consolidated Report
b. a listing of classified loans of Condition and Income (Call Report).
Complete and accurate preparation of
this schedule is particularly important
because Schedule RC-M provides impor-
DISCUSSIONS WITH tant data on possible insider abuse. It
MANAGEMENT also contains information that will be
used to respond to public requests for
1. Discuss results of the examination of the information concerning loans to execu-
lending function with senior management of tive officers, directors, principal share-
the bank. holders, and to related interests of such
2. During discussions with senior management, persons.
structure inquiries to— • Examiners should verify that the bank
a. gain insight into the general management has established procedures for compli-
lending philosophy, and ance with the requirements of Regula-
b. elicit management responses for correction O for disclosing information on
tion of deficiencies. extensions of credit to its executive
officers, directors, principal sharehold-
ers, and to related interests of such
REGULATION O persons. The bank should maintain
records of all public requests for infor-
1. During the course of all examinations of the mation and the disposition of such
lending activities of state member banks, requests.
determine whether the bank and its executive • Records of requests for information and
officers, directors, principal shareholders, and the disposition of such requests may be
related interests of such persons have com- disposed of by banks after two years
plied with the substantive restrictions as well from the date of request.
as the reporting and disclosure requirements 2. The examination procedures for checking
of Regulation O (12 CFR 215), the appropri- compliance with the relevant law and regu-

Page 8
lation covering bank insider lending activi- ments associated with 12 USC 1972(2)
ties and reporting requirements are as fol- have been eliminated, the bank must still
lows (the examiner should refer to the comply with the existing substantive
appropriate sections of the statutes for spe- restrictions in 12 USC 1972(2). In doing
cific definitions, lending limitations, report- so, a bank may select any reasonably
ing requirements, and conditions indicating prudent method to ensure its compliance
preferential treatment): with the restrictions.
When reviewing the bank’s information 3. During the examinations of correspondent
on its loans to its insiders (that is, informa- banks, loans to executive officers, directors,
tion on all types of loans including loan principal shareholders, and to related inter-
participations, loans purchased and sold, and ests of such persons of respondent banks
loan swaps) perform the examination proce- should be reviewed for any evidence of
dures listed below: preferential lending. Such loans should be
• Test the accuracy and completeness of the reviewed to—
information on the bank’s extended loans • determine whether they were made on
by comparing it with the trial balance or substantially the same terms, including
loans sampled. interest rates and collateral, as those pre-
• Review credit files on insider loans to vailing at the time for comparable trans-
determine that required information is actions with other persons;
available. • involve more-than-normal risk of repay-
• Determine that loans to insiders do not ment; or
contain terms that are more favorable than • have other unfavorable features, such as
those afforded to other borrowers. not being supported by adequate credit
• Determine that loans to insiders do not information or being in violation of state
involve more-than-normal risk of repay- lending limitations.
ment or present other unfavorable features.
• Determine that loans to insiders, as defined Although Regulation O no longer contains
by the various sections of Regulation O, information related to the restrictions on
do not exceed the imposed lending limits. lending to the insiders of correspondent
• If prior approval by the bank’s board of banks, the statutory limitations still remain at
directors was required for a loan to an 12 USC 1972(2).2 Banks must still comply
insider, determine that such approval was with these substantive restrictions. In doing
obtained. so, a bank may select any reasonably prudent
• Determine that there is compliance with method to ensure compliance with the restric-
the various reporting requirements for tions.
insider loans. 4. Determine if the bank provides employees or
• Determine that the bank has made provi- other insiders with bank-owned or bank-
sions to comply with the public disclosure issued credit cards for use in conducting the
requirements of Regulation O. bank’s business.
• Determine that the bank maintains records a. Verify that the bank has a written policy
of such public requests and the disposition that forbids or discourages an employee or
of the requests for a period of two years other insider from using a bank-owned or
after the dates of the requests. bank-issued credit card for the insider’s
• Review the adequacy of the bank’s poli- personal purposes and that the policy
cies and procedures that it uses to ensure obligates the insider to promptly reim-
that loans to insiders of the bank and its burse the bank.
correspondent banks comply with 12 USC b. To ascertain the bank’s compliance with
1972(2), which prohibits extending loans Regulation O, verify that the bank moni-
with preferential terms.1 Although the tors the amount of personal charges out-
statutory and regulatory reporting require- standing on its bank-owned or bank-
issued credit cards that are held by insiders
1. Based on an interim rule, effective December 11, 2006,
Regulation O will no longer contain information related to 2. The statutory and regulatory reporting requirements
restrictions on lending to the insiders of correspondent banks. previously associated with 12 USC 1972 and Regulation O
(See 71 Fed. Reg. 71,472, December 11, 2006.) have been eliminated.

Page 9
so that the outstanding charges, when procedures, and controls over the lending
aggregated with all of an insider’s other function;
indebtedness owed to the bank, do not c. the general level of adherence to internal
exceed $15,000. policies, practices, procedures, and
c. To verify the bank’s compliance with the controls;
market-terms requirement of Regulation d. the scope and adequacy of the internal
O, determine if— loan-review system;
• the bank requires employees and other e. the quality of the entire loan portfolio;
insiders who use bank-owned or bank- f. the competency of management with
issued credit cards for personal pur- respect to the lending function;
poses to meet the bank’s normal credit g. causes of existing problems;
underwriting standards and h. expectations for continued sound lending
• the bank has verified that its bank- or correction of existing deficiencies;
owned or bank-issued credit cards do i. promises made by management for cor-
not have more preferential terms (for rection of deficiencies; and
example, a lower interest rate or a j. loans to insiders and their interests.
longer repayment period) than the 2. If appropriate and after careful consideration,
consumer credit cards offered by the recommend downgrading, under the appli-
bank. cable supervisory rating framework, the
institution’s risk-management, management,
or asset-quality ratings (or all three). Recom-
mend downgrading its capital adequacy rat-
ing (if assumptions are sufficiently signifi-
EXAMINATION REPORTING, cant) when there is significant and undue
RATINGS ASSIGNMENT, AND reliance on favorable assumptions about bor-
WORKPAPER RETENTION rowers, the economy, and financial markets,
or when that reliance has slowed the recog-
1. In the appropriate report format, write gen- nition of loan problems.
eral remarks, which may include— 3. Compile or prepare all information that pro-
a. the scope of the examination of the lend- vides substantiation for the general remarks.
ing function; 4. Update the workpapers with any information
b. the quality of internal policies, practices, that will facilitate future examinations.

Page 10
Review the bank’s internal controls, policies, tions 23A and 23B of the Federal Reserve
practices, and procedures for managing the Act and Regulation W.
bank’s loan portfolio. The bank’s system should 2. Are loan portfolio management policies and
be documented completely and concisely and objectives reviewed at least annually to
should include, where appropriate, narrative determine if they are compatible with chang-
descriptions, flow charts, copies of forms used, ing market conditions?
and other pertinent information. 3. Are the following reported to the board of
directors or its committees (indicate which)
at their regular meetings (at least monthly):
LENDING POLICIES AND a. past-due single-payment notes? (If so,
PROCEDURES indicate the minimum days past due for
them to be included .)
1. Has the board of directors, consistent with b. notes on which interest only is past due?
its duties and responsibilities, adopted writ- (If so, indicate the minimum days past
ten loan portfolio management policies and due for them to be included .)
objectives that— c. term loans on which one installment is
a. establish suggested guidelines for the past due? (If so, indicate the minimum
distribution of loans in the commercial, days due for them to be included
real estate, and installment categories? .)
b. establish geographic limits for loans? d. total outstanding loan commitments?
c. establish suggested guidelines for aggre- e. loans requiring special attention?
gate outstanding loans in relation to other f. new loans and loan renewals or restruc-
balance-sheet categories? tured loans?
d. establish the loan authority of commit- 4. Are reports to be submitted to the board or
tees and individual lending officers? its committees rechecked by a designated
e. define acceptable types of loans? individual for possible omissions before the
f. establish maximum maturities for vari- reports are submitted?
ous types of loans? 5. Are written applications required for all
g. establish loan pricing? loans?
h. establish an appraisal policy? 6. Does the bank maintain credit files for all
i. establish the minimum financial informa- borrowers?
tion required at the inception of credit? 7. Does the credit file contain information
j. establish limits and guidelines for pur- on—
chasing paper? a. the purpose of the loan?
k. establish guidelines for loans to bank b. the planned repayment schedule?
directors, officers, principal sharehold- c. the disposition of loan proceeds?
ers, and their related interests? 8. Does the bank require periodic submission
l. establish collection procedures? of financial statements by all borrowers
m. define the duties and responsibilities of whose loans are not fully secured by readily
loan officers and loan committees? marketable collateral?
n. outline loan portfolio management 9. Is a tickler file maintained to ensure that
objectives that acknowledge— current financial information is requested
• concentrations of credit within specific and received?
industries? 10. Does the bank require submission of
• the need to employ personnel with audited financial statements based on the
specialized knowledge and experience? dollar amount of the commitment? (If so,
• community service obligations? state the dollar minimum for requiring
• possible conflicts of interests? $ .)
o. ensure that all of the bank’s loan port- 11. Does the bank perform a credit investiga-
folios are monitored and reviewed to tion on proposed and existing borrowers for
ensure continued compliance with sec- new loan applications?

Page 1
2040.4 Loan Portfolio Management: Internal Control Questionnaire
12. Is it required that all loan commitments be of an officer’s withholding a loan from the
in writing? review process?
13. Are lines of credit reviewed and updated at 26. Is the bank’s problem-loan list periodically
least annually? updated by the lending officers?
14. Are borrowers’ outstanding liabilities 27. Does the bank maintain a list of loans
checked to appropriate lines of credit before reviewed, indicating the date of the review
granting the borrowers additional advances? and the credit rating?
15. Does the bank employ a procedure for 28. Does the loan-review section prepare sum-
disclosure of a loan or combination of loans mations to substantiate credit ratings, includ-
that are or will be secured by 25 percent of ing pass loans?
another insured financial institution’s stock? 29. Are loan-review summations maintained in
16. Does the bank employ procedures to ensure a central location or in appropriate credit
compliance with the requirements of the files?
Lost and Stolen Securities Program (17 30. Are follow-up procedures in effect for
CFR 240.17f-l)? (See Internal Control Ques- internally classified loans, including an
tionnaire questions 6–15 of section 4150.4 update memorandum to the appropriate
‘‘Review of Regulatory Reports.’’) credit file?
17. Is there an internal review system (it may be 31. Are officers and employees prohibited from
a function of the internal audit department) holding blank signed notes in anticipation
that covers each department, and does it— of future borrowings?
a. recheck interest, discount, and maturity- 32. Are paid and renewed notes cancelled and
date computations? promptly returned to customers?
b. reexamine notes for proper execution, 33. Are loan records retained in accordance
receipt of all required supporting papers, with the record-retention policy and legal
and proper disclosure forms? requirements?
c. determine that loan approvals are within 34. Are new notes microfilmed daily?
the limits of the bank’s lending
35. Is a systematic and progressively stronger
authorities?
follow-up-notice procedure used for
d. determine that notes bear the initial of
delinquent loans?
the loan officer?
36. Does the bank maintain loan interest-rate
e. ascertain that new loans are within the
schedules for various types of loans?
limitations set for the borrower by cor-
porate resolution? 37. Does the bank periodically update interest-
f. recheck the liability ledger to determine rate schedules? If so, state the normal fre-
that new loans have been accurately quency of updates .
posted? 38. Does the bank maintain records in sufficient
18. Does the bank have a loan-review section or detail to generate the following information
the equivalent? by type of advance:
19. Is the loan-review section independent of a. the cost of funds loaned?
the lending function? b. the cost of servicing loans, including
20. Are the initial results of the loan-review overhead?
process submitted to a person or committee c. the cost factor of probable losses?
that is also independent of the lending d. the programmed profit margin?
function? 39. Has the bank conducted industry studies for
21. Are all loans exceeding a certain dollar those industries in which it is a substantial
amount selected for review? lender?
22. Do lending officers recommend loans for 40. Are loan proceeds either credited to custom-
review? ers’ accounts or released through issuance
23. Is a method, other than those detailed in of official bank checks payable to the
steps 21 or 22, used to select loans for borrower?
review? (If so, provide details.) 41. Is a record of charged-off loans maintained
24. Are internal reviews conducted at least by a person other than the one who has
annually for all lending areas? custody of the notes or receives payment? Is
25. In an officer-identification system, are guide- this record checked against the notes at least
lines in effect that define the consequences annually?

Page 2
Loan Portfolio Management: Internal Control Questionnaire 2040.4
42. Are adequate procedures in effect with jected indicates the existence of an impair-
respect to recoveries? ment for which a direct write-down should
be recorded?
11. Does bank management evaluate MSAs for
impairment at least quarterly to ensure that
MORTGAGE BANKING amounts reported in the call report are
ACTIVITIES accurately stated?
12. Does bank management measure the actual
1. Are the assumptions used in the bank’s
performance of MSAs by analyzing gross
valuation models supported when these
monthly cash flows of servicing assets rela-
assumptions are not benchmarked to market
tive to the assumptions and projections used
participants’ assumptions and to the bank’s
in each quarterly valuation?
actual portfolio performance across each
product type? 13. Does bank management validate or update
models for new information?
2. Are there questionable, inappropriate, or
unsupported items in the valuation models 14. Does bank management periodically inven-
(for example, retention benefits, deferred tory and revalidate its MSA valuation mod-
tax benefits, captive reinsurance premiums, els, including an independent assessment of
or income from cross-selling activities). all key assumptions?
The inclusion of such items in the bank’s 15. Does the bank obtain periodic third-party
mortgage-servicing asset (MSA) valuation valuations by qualified market professionals
must be appropriate under generally accepted to support the fair values of its MSAs and to
accounting principles (GAAP) and must update its internal models?
also be consistent with what a willing buyer 16. Does the bank have comprehensive docu-
would pay for the mortgage-servicing mentation standards for all aspects of mort-
contract. gage banking, including mortgage-servicing
3. Does bank management use comparable assets?
market data as a means of supporting model 17. Does bank management and, where appro-
assumptions and the fair value of MSAs? priate, the board of directors, review and
4. Does bank management frequently change approve results and assumptions of the
the assumptions it uses in its MSA valua- bank’s MSA valuation models?
tion models from period to period for no 18. Does bank management compare models
compelling reason? used throughout the company, including
5. Are there inconsistencies in the MSA valu- valuation, hedging, pricing, and bulk acqui-
ation assumptions used in valuation, bid- sition, to identify inconsistencies? Are
ding, pricing, and hedging activities as well identified inconsistencies satisfactorily
as, where relevant, in mortgage-related supported?
activities in other aspects of the bank’s 19. Does the bank have systems to measure and
business? control interest-rate risk?
6. Is there satisfactory segregation of duties 20. Does bank management ensure that appro-
from an organizational perspective between priate systems and internal controls are in
the valuation, hedging, and accounting func- place to oversee hedging activities, includ-
tions for the bank’s mortgage banking ing monitoring the effectiveness of hedging
activities? strategies and reviewing concentrations of
7. Does bank management use appropriate hedge instruments and counterparties?
amortization practices for its MSAs? 21. Does bank management ensure that the
8. Does the bank properly stratify MSAs for bank’s hedge accounting methods are
impairment-testing purposes? adequately documented and consistent with
9. Do the bank’s MSA impairment ana- GAAP?
lyses use reasonable and supportable 22. Does the bank’s board receive information
assumptions? on hedged and unhedged positions, mark-
10. Does bank management use a valuation to-market analyses, warehouse aging, the
allowance for the impairment of a stratum valuation of MSAs, various rate shock sce-
of MSAs when repayment of the underlying narios and risk exposures, the creation of
loans at a rate faster than originally pro- economic value, and policy exceptions

Page 3
2040.4 Loan Portfolio Management: Internal Control Questionnaire
whenever material exposure to MSAs ward loan-sales commitments reported

exists? in current-period earnings in either ‘‘other
23. Does the bank have written and consistently noninterest income’’ or ‘‘noninterest
applied accounting policies for its commit- expense,’’ as appropriate?
ments to originate mortgage loans that are 26. Has the bank’s management failed to follow
held for resale and its commitments to sell the bank’s accounting and valuation poli-
mortgage loans under mandatory-delivery cies for its commitments to originate mort-
and best-efforts contracts? gage loans that are held for sale and its
24. Has the bank developed, and does it use, commitments to sell mortgage loans, accord-
approved valuation methodologies and pro- ing to the instructions in the bank Call
cedures to obtain formal approval for the Report, the May 3, 2005, interagency advi-
changes to those methodologies? sory, or GAAP?
a. Are the valuation methodologies reason- 27. Does the bank have satisfactory systems
able, objectively supported, and fully that track quality-control exceptions?
documented? 28. Does bank management analyze the bank’s
b. Does the bank have internal controls, quality-control reports to determine credit
including an effective independent review quality, loan characteristics and demograph-
or audit, in place that give integrity to the ics, trends, and sources of problems?
valuation process? 29. Does the bank have satisfactory systems
25. If the bank issues fixed-, adjustable-, and that track and collect required mortgage
floating-rate derivative loan commitments loan documents?
or forward loan-sales commitments, does it 30. Does bank management ensure that adequate
review an adequate sample that evidences control processes are in place for both
the full coverage of these types of front-end-closing and post-closing loan
transactions? documents?
a. Are these types of transactions properly 31. Does the bank have satisfactory systems
reported on the balance sheet as an that monitor and manage the risks associ-
‘‘other asset’’ or an ‘‘other liability’’ ated with third-party-originated loans?
according to whether the individual com- 32. Does bank management ensure prudent risk-
mitment has a positive (asset) or nega- management systems are in place for broker
tive (liability) fair value, in accordance and correspondent approvals and for ongo-
with the bank Call Report instructions? ing monitoring, including controls on the
b. Are floating-rate derivative loan commit- appraisal and credit-underwriting process of
ments and other derivative loan commit- third-party-originated loans?
ments reported at their entire gross 33. Is the bank’s internal audit coverage of its
notional amount in the bank Call Report? mortgage banking activities adequate?
c. Is the bank’s balance-sheet presentation
of all such transactions (including the
netting of contracts, the application of
hedge accounting to mortgage banking CONCLUSION
activities, the valuation of derivatives,
and any material or other accounting 1. Is the foregoing information considered an
changes for derivative loan commit- adequate basis for evaluating internal con-
ments and loan-sales agreements) trol; that is, there are no significant deficien-
accounted for and reported in accordance cies in areas not covered in this question-
with the May 3, 2005, Interagency naire that impair any controls? Explain
Advisory on Accounting and Reporting negative answers briefly and indicate any
for Commitments to Originate and Sell additional examination procedures deemed
Mortgage Loans and in accordance with necessary.
generally accepted accounting principles 2. Based on a composite evaluation as
(GAAP)? evidenced by answers to the foregoing
d. Are periodic changes in the fair value of questions, is internal control considered
derivative loan commitments and for- adequate?

Page 4
Nontraditional Mortgages—Associated Risks
The Federal Reserve and the other federal bank- Many of these nontraditional mortgage loans
ing and thrift regulatory agencies (the agencies)1 are underwritten with less stringent income and
issued the Interagency Guidance on Nontradi- asset verification requirements (reduced docu-
tional Mortgage Product Risks on September mentation) and are increasingly combined with
29, 2006. The guidance addresses both risk- simultaneous second-lien loans.4 Such risk lay-
management and consumer disclosure practices ering, combined with the broader marketing of
that institutions2 should employ to effectively nontraditional mortgage loans, exposes financial
manage the risks associated with closed-end institutions to increased risk relative to tradi-
residential mortgage products that allow borrow- tional mortgage loans.
ers to defer repayment of principal and, some- Given the potential for heightened risk levels,
times, interest (referred to as nontraditional management should carefully consider and ap-
mortgage loans). (See SR-06-15.) propriately mitigate exposures created by these
Residential mortgage lending has tradition- loans. To manage the risks associated with
ally been a conservatively managed business nontraditional mortgage loans, management
with low delinquencies and losses and reason- should—
ably stable underwriting standards. However,
during the past few years consumer demand has • ensure that loan terms and underwriting stan-
been growing, particularly in high-priced real dards are consistent with prudent lending
estate markets, for nontraditional mortgage loans. practices, including consideration of a borrow-
These mortgage products include such products er’s repayment capacity;
as ‘‘interest-only’’ mortgages, where a borrower • ensure that consumers have sufficient infor-
pays no loan principal for the first few years of mation to clearly understand loan terms and
the loan, and ‘‘payment-option’’ adjustable-rate associated risks prior to making a product
mortgages (ARMs), where a borrower has flex- choice; and
ible payment options with the potential for • recognize that many nontraditional mortgage
negative amortization.3 loans, particularly when they have risk-
While some institutions have offered nontra- layering features, are untested in a stressed
ditional mortgages for many years with appro- environment. As evidenced by experienced
priate risk management and sound portfolio institutions, these products warrant strong risk-
performance, the market for these products and management standards, capital levels commen-
the number of institutions offering them has surate with the risk, and an allowance for loan
expanded rapidly. Nontraditional mortgage loan and lease losses (ALLL) that reflects the
products are now offered by more lenders to a collectibility of the portfolio. The Federal
wider spectrum of borrowers; these borrowers Reserve expects institutions to effectively as-
may not otherwise qualify for more traditional sess and manage the risks associated with
mortgage loans and may not fully understand nontraditional mortgage loan products.5
the risks associated with nontraditional mort-
gage loans. Institutions should use the guidance to ensure
that risk-management practices adequately
address these risks. Risk-management pro-
1. The Board of Governors of the Federal Reserve System, cesses, policies, and procedures in this area will
the Office of the Comptroller of the Currency, the Federal be carefully scrutinized. Institutions that do not
Deposit Insurance Corporation, the Office of Thrift Supervi- adequately manage these risks will be asked to
sion, and the National Credit Union Administration.
2. The term institution(s) is used in the interagency guid- take remedial action.
ance. As used in this section, institutions applies to Federal This guidance focuses on the higher risk
Reserve-supervised state member banks and their subsidiaries, elements of certain nontraditional mortgage prod-
and bank holding companies and their nonbank subsidiaries. ucts, not the product type itself. Institutions with
3. Interest-only and payment-option ARMs are variations
of conventional ARMs, hybrid ARMs, and fixed-rate prod- sound underwriting, adequate risk management,
ucts. Refer to the appendix for additional information on
interest-only and payment-option ARM loans. This guidance
does not apply to reverse mortgages; home equity lines of 4. Refer to the appendix for additional information on
credit (HELOCs), other than as discussed in the Simultaneous reduced documentation and simultaneous second-lien loans.
Second-Lien Loans section; or fully amortizing residential 5. Refer to the Interagency Guidelines Establishing Stan-
mortgage loan products. dards for Safety and Soundness in 12 CFR 208, appendix D-1.

Page 1
2043.1 Nontraditional Mortgages—Associated Risks
and acceptable portfolio performance will not be velop a range of reasonable tolerances for each
subject to criticism merely for offering such factor. However, the criteria should be based
products. upon prudent and appropriate underwriting stan-
dards, considering both the borrower’s charac-
teristics and the product’s attributes.
NONTRADITIONAL MORTGAGE For all nontraditional mortgage loan products,
LOAN TERMS AND an institution’s analysis of a borrower’s repay-
UNDERWRITING STANDARDS ment capacity should include an evaluation of
the borrower’s ability to repay the debt by final
When an institution offers nontraditional mort- maturity at the fully indexed rate,7 assuming a
gage loan products, underwriting standards fully amortizing repayment schedule.8 In addi-
should address the effect of a substantial pay- tion, for products that permit negative amortiza-
ment increase on the borrower’s capacity to tion, the repayment analysis should be based
repay when loan amortization begins. Underwrit- upon the initial loan amount plus any balance
ing standards should also comply with the Fed- increase that may accrue from the negative
eral Reserve’s real estate lending standards and amortization provision.9
appraisal regulations and associated guidelines.6 Furthermore, the analysis of repayment capac-
Central to prudent lending is the internal ity should avoid overreliance on credit scores as
discipline to maintain sound loan terms and a substitute for income verification in the under-
underwriting standards despite competitive pres- writing process. The higher a loan’s credit risk,
sures. Institutions are strongly cautioned against either from loan features or borrower character-
ceding underwriting standards to third parties istics, the more important it is to verify
that have different business objectives, risk tol-
erances, and core competencies. Loan terms
7. The fully indexed rate equals the index rate prevailing at
should be based on a disciplined analysis of origination plus the margin that will apply after the expiration
potential exposures and compensating factors to of an introductory interest rate. The index rate is a published
ensure that risk levels remain manageable. interest rate to which the interest rate on an ARM is tied.
Some commonly used indices include the 1-Year Constant
Maturity Treasury Rate (CMT), the 6-Month London Inter-
bank Offered Rate (LIBOR), the 11th District Cost of Funds
Qualifying Borrowers for (COFI), and the Moving Treasury Average (MTA), a 12-
Nontraditional Loans month moving average of the monthly average yields of U.S.
Treasury securities adjusted to a constant maturity of one year.
The margin is the number of percentage points a lender adds
Payments on nontraditional loans can increase to the index value to calculate the ARM interest rate at each
significantly when the loans begin to amortize. adjustment period. In different interest-rate scenarios, the fully
Commonly referred to as payment shock, this indexed rate for an ARM loan based on a lagging index (for
increase is of particular concern for payment- example, the MTA rate) may be significantly different from
the rate on a comparable 30-year fixed-rate product. In these
option ARMs where the borrower makes mini- cases, a credible market rate should be used to qualify the
mum payments that may result in negative borrower and determine repayment capacity.
amortization. Some institutions manage the 8. The fully amortizing payment schedule should be based
potential for excessive negative amortization on the term of the loan. For example, the amortizing payment
for a loan with a 5-year interest-only period and a 30-year
and payment shock by structuring the initial term would be calculated based on a 30-year amortization
terms to limit the spread between the introduc- schedule. For balloon mortgages that contain a borrower
tory interest rate and the fully indexed rate. option for an extended amortization period, the fully amortiz-
Nevertheless, an institution’s qualifying stan- ing payment schedule can be based on the full term the
borrower may choose.
dards should recognize the potential impact of 9. The balance that may accrue from the negative amorti-
payment shock, especially for borrowers with zation provision does not necessarily equate to the full
high loan-to-value (LTV) ratios, high debt-to- negative amortization cap for a particular loan. The spread
income (DTI) ratios, and low credit scores. between the introductory or ‘‘teaser’’ rate and the accrual rate
will determine whether a loan balance has the potential to
Recognizing that an institution’s underwriting reach the negative amortization cap before the end of the
criteria are based on multiple factors, an insti- initial payment-option period (usually five years). For ex-
tution should consider these factors jointly in the ample, a loan with a 115 percent negative amortization cap but
qualification process and potentially it may de- only a small spread between the introductory rate and the
accrual rate may reach a 109 percent maximum loan balance
before the end of the initial payment-option period, even if
6. Refer to 12 CFR 208.51 subpart E and appendix C and only minimum payments are made. The borrower could be
12 CFR 225 subpart G. qualified based on this lower maximum loan balance.

Page 2
Nontraditional Mortgages—Associated Risks 2043.1
the borrower’s income, assets, and outstanding Clear policies should govern the use of
liabilities. reduced documentation. For example, stated
income should be accepted only if there are
mitigating factors that clearly minimize the need
Collateral-Dependent Loans for direct verification of repayment capacity. For
many borrowers, institutions generally should
Institutions should avoid the use of loan terms be able to readily document income using recent
and underwriting practices that may heighten W-2 statements, pay stubs, or tax returns.
the need for a borrower to rely on the sale or
refinancing of the property once amortization
begins. Loans to individuals who do not Simultaneous Second-Lien Loans
demonstrate the capacity to repay, as structured,
from sources other than the collateral pledged Simultaneous second-lien loans reduce owner
are generally considered unsafe and unsound.10 equity and increase credit risk. Historically, as
Institutions that originate collateral-dependent combined loan-to-value ratios rise, so do defaults.
mortgage loans may be subject to criticism, cor- A delinquent borrower with minimal or no
rective action, and higher capital requirements. equity in a property may have little incentive to
work with a lender to bring the loan current and
avoid foreclosure. In addition, second-lien HE-
Risk Layering LOCs typically increase borrower exposure to
increasing interest rates and monthly payment
Institutions that originate or purchase mortgage burdens. Loans with minimal or no owner equity
loans that combine nontraditional features, such generally should not have a payment structure
as interest-only loans with reduced documenta- that allows for delayed or negative amortization
tion or a simultaneous second-lien loan, face without other significant risk-mitigating factors.
increased risk. When features are layered, an
institution should demonstrate that mitigating
factors support the underwriting decision and
the borrower’s repayment capacity. Mitigating
Introductory Interest Rates
factors could include higher credit scores, lower
LTV and DTI ratios, significant liquid assets, As a marketing tool for payment-option ARM
mortgage insurance, and other credit enhance- products, many institutions offer introductory
ments. While higher pricing is often used to interest rates set well below the fully indexed
address elevated risk levels, it does not replace rate. When developing nontraditional mortgage
the need for sound underwriting. product terms, an institution should consider the
spread between the introductory rate and the
fully indexed rate. Since initial and subsequent
monthly payments are based on these low intro-
Reduced Documentation ductory rates, a wide initial spread means that
borrowers are more likely to experience nega-
Institutions increasingly rely on reduced docu- tive amortization, severe payment shock, and an
mentation, particularly unverified income, to earlier-than-scheduled recasting of monthly pay-
qualify borrowers for nontraditional mortgage ments. Institutions should minimize the likeli-
loans. Because these practices essentially sub- hood of disruptive early recastings and extraor-
stitute assumptions and unverified information dinary payment shock when setting introductory
for analysis of a borrower’s repayment capacity rates.
and general creditworthiness, they should be
used with caution. As the level of credit risk
increases, the Federal Reserve expects an insti-
tution to more diligently verify and document a Lending to Subprime Borrowers
borrower’s income and debt-reduction capacity.
Mortgage programs that target subprime borrow-
ers through tailored marketing, underwriting
10. A loan will not be determined to be ‘‘collateral- standards, and risk selection should follow the
dependent’’ solely through the use of reduced documentation. applicable interagency guidance on subprime

Page 3
lending.11 Among other things, the subprime and risk-management expectations;

guidance discusses circumstances under which • design enhanced performance measures and
subprime lending can become predatory or abu- management reporting that provide early warn-
sive. Institutions designing nontraditional mort- ing for increasing risk;
gage loans for subprime borrowers should pay • establish appropriate ALLL levels that con-
particular attention to this guidance. They should sider the credit quality of the portfolio and
also recognize that risk-layering features in conditions that affect collectibility; and
loans to subprime borrowers may significantly • maintain capital at levels that reflect portfolio
increase risks for the institution and the borrower. characteristics and the effect of stressed eco-
nomic conditions on collectibility. Institutions
should hold capital commensurate with the
Non-Owner-Occupied Investor Loans risk characteristics of their nontraditional mort-
gage loan portfolios.
Borrowers financing non-owner-occupied invest-
ment properties should qualify for loans based
on their ability to service the debt over the life of Nontraditional Mortgage Loan
the loan. Loan terms should reflect an appropri- Policies
ate combined LTV ratio that considers the
potential for negative amortization and main- An institution’s policies for nontraditional mort-
tains sufficient borrower equity over the life of gage lending activity should set acceptable lev-
the loan. Further, underwriting standards should els of risk through its operating practices, ac-
require evidence that the borrower has sufficient counting procedures, and policy exception
cash reserves to service the loan, considering the tolerances. Policies should reflect appropriate
possibility of extended periods of property limits on risk layering and should include risk-
vacancy and the variability of debt service management tools for risk-mitigation purposes.
requirements associated with nontraditional Further, an institution should set growth and
mortgage loan products. volume limits by loan type, with special atten-
tion for products and product combinations in
need of heightened attention due to easing terms
PORTFOLIO AND or rapid growth.
RISK-MANAGEMENT PRACTICES
Institutions should ensure that risk-management Concentrations in Nontraditional
practices keep pace with the growth and chang- Mortgage Products
ing risk profile of their nontraditional mortgage
loan portfolios and changes in the market. Active Institutions with concentrations in nontradi-
portfolio management is especially important tional mortgage products should have well-
for institutions that project or have already developed monitoring systems and risk-
experienced significant growth or concentration management practices. Monitoring systems
levels. Institutions that originate or invest in should keep track of concentrations in key
nontraditional mortgage loans should adopt more portfolio segments such as loan types, third-
robust risk-management practices and manage party originations, geographic area, and prop-
these exposures in a thoughtful, systematic man- erty occupancy status. Concentrations also
ner. To meet these expectations, institutions should be monitored by key portfolio character-
should— istics such as non-owner-occupied investor loans
and loans with (1) high combined LTV ratios,
• develop written policies that specify accept- (2) high DTI ratios, (3) the potential for negative
able product attributes, production and port- amortization, (4) credit scores of borrowers
folio limits, sales and securitization practices, below established thresholds, and (5) risk-
layered features. Further, institutions should con-
11. See SR-99-6, Subprime Lending and its attachment, sider the effect of employee incentive programs
Interagency Guidance on Subprime Lending, March 1, 1999,
and SR-01-4, Subprime Lending and its attachment, inter-
that could produce higher concentrations of
agency Expanded Guidance for Subprime Lending Programs, nontraditional mortgage loans. Concentrations
January 31, 2001. that are not effectively managed will be subject

Page 4
to elevated supervisory attention and potential defaults, incomplete documentation, and fraud.
examiner criticism to ensure timely remedial If problems involving appraisals, loan documen-
action. tation, credit, or consumer complaints are dis-
covered, the institution should take immediate
action. Remedial action could include more
thorough application reviews, more frequent
Controls re-underwriting, and even termination of the
third-party relationship.
An institution’s quality control, compliance, and
audit procedures should focus on mortgage
lending activities posing high risk. Controls to
monitor compliance with underwriting Risk Management of
standards and exceptions to those standards are Secondary-Market Activity
especially important for nontraditional loan
products. The quality control function should The sophistication of an institution’s secondary-
regularly review a sample of nontraditional market risk-management practices should be
mortgage loans from all origination channels commensurate with the nature and volume of
and a representative sample of underwriters to activity. Institutions with significant secondary-
confirm that policies are being followed. When market activities should have comprehensive,
control systems or operating practices are found formal strategies for managing risks.12 Contin-
deficient, business-line managers should be held gency planning should include how the institu-
accountable for correcting deficiencies in a tion will respond to reduced demand in the
timely manner. secondary market.
Since many nontraditional mortgage loans While third-party loan sales can transfer a
permit a borrower to defer principal and, in portion of the credit risk, an institution remains
some cases, interest payments for extended exposed to reputation risk when credit losses on
periods, institutions should have strong controls sold mortgage loans or securitization transac-
over accruals, customer service, and collections. tions exceed expectations. As a result, an insti-
Policy exceptions made by servicing and collec- tution may determine that it is necessary to
tions personnel should be carefully monitored to repurchase defaulted mortgages to protect its
confirm that practices such as re-aging, payment reputation and maintain access to the markets. In
deferrals, and loan modifications are not inad- the Federal Reserve’s view, the repurchase of
vertently increasing risk. Customer service and mortgage loans beyond the selling institution’s
collections personnel should receive product- contractual obligation is implicit recourse. Under
specific training on the features and potential the risk-based capital rules, a repurchasing
customer issues with these products. institution would be required to maintain risk-
based capital against the entire pool or securiti-
zation.13 Institutions should familiarize them-
selves with these guidelines before deciding to
Third-Party Originations support mortgage loan pools or buying back
loans in default.
Institutions often use third parties, such as
mortgage brokers or correspondents, to origi-
nate nontraditional mortgage loans. Institutions
should have strong systems and controls in place Management Information and
for establishing and maintaining relationships Reporting
with third parties, including procedures for per-
forming due diligence. Oversight of third parties Reporting systems should allow management to
should involve monitoring the quality of origi- detect changes in the risk profile of its nontra-
nations so that they reflect the institution’s ditional mortgage loan portfolio. The structure
lending standards and compliance with appli- and content should allow the isolation of key
cable laws and regulations.
Monitoring procedures should track the qual- 12. Refer to SR-02-16, dated May 23, 2002, Interagency
Questions and Answers on Capital Treatment of Recourse,
ity of loans by both origination source and key Direct Credit Substitutes, and Residual Interests in Asset
borrower characteristics. This will help institu- Securitizations and its attachment.
tions identify problems such as early payment 13. Refer to 12 CFR 208 and 225, appendix A, III.B.3.

Page 5
loan products, risk-layering loan features, and Capital and the Allowance for Loan
borrower characteristics. Reporting should also and Lease Losses
allow management to recognize deteriorating
performance in any of these areas before it has Institutions should establish an appropriate
progressed too far. At a minimum, information ALLL for the estimated credit losses inherent in
should be available by (1) loan type (for example, their nontraditional mortgage loan portfolios.
interest-only mortgage loans and payment- They should also consider the higher risk of loss
option ARMs); (2) risk-layering features (for posed by layered risks when establishing their
example, payment-option ARMs with stated ALLL.
income and interest-only mortgage loans with Moreover, institutions should recognize that
simultaneous second-lien mortgages); (3) under- their limited performance history with these
writing characteristics (for example, LTV, DTI, products, particularly in a stressed environment,
and credit score); and (4) borrower performance increases performance uncertainty. Capital lev-
(for example, payment patterns, delinquencies, els should be commensurate with the risk char-
interest accruals, and negative amortization). acteristics of the nontraditional mortgage loan
Portfolio volume and performance should be portfolios. Lax underwriting standards or poor
tracked against expectations, internal lending portfolio performance may warrant higher capi-
standards, and policy limits. Volume and tal levels.
performance expectations should be established When establishing an appropriate ALLL and
at the subportfolio and aggregate portfolio considering the adequacy of capital, institutions
levels. Variance analyses should be performed should segment their nontraditional mortgage
regularly to identify exceptions to policies and loan portfolios into pools with similar credit-risk
prescribed thresholds. Qualitative analysis characteristics. The basic segments typically
should occur when actual performance devi- include collateral and loan characteristics, geo-
ates from established policies and thresholds. graphic concentrations, and borrower qualifying
Variance analysis is critical to the monitoring of attributes. Segments could also differentiate loans
a portfolio’s risk characteristics and should be by payment and portfolio characteristics, such
an integral part of establishing and adjusting as loans on which borrowers usually make only
risk-tolerance levels. minimum payments, mortgages with existing
balances above original balances, and mort-
gages subject to sizable payment shock. The
objective is to identify credit quality indicators
Stress Testing that affect collectibility for ALLL measurement
purposes. In addition, understanding character-
Based on the size and complexity of their istics that influence expected performance also
lending operations, institutions should perform provides meaningful information about future
sensitivity analysis on key portfolio segments to loss exposure that would aid in determining
identify and quantify events that may increase adequate capital levels.
risks in a segment or the entire portfolio. The Institutions with material mortgage banking
scope of the analysis should generally include activities and mortgage servicing assets should
stress tests on key performance drivers such as apply sound practices in valuing the mortgage
interest rates, employment levels, economic servicing rights for nontraditional mortgages.
growth, housing value fluctuations, and other The valuation process should follow generally
factors beyond the institution’s immediate con- accepted accounting principles and use reason-
trol. Stress tests typically assume rapid deterio- able and supportable assumptions.14
ration in one or more factors and attempt to
estimate the potential influence on default rates
and loss severity. Stress testing should aid an
institution in identifying, monitoring, and man-
CONSUMER PROTECTION ISSUES
aging risk, as well as developing appropriate and
While nontraditional mortgage loans provide
cost-effective loss-mitigation strategies. The
flexibility for consumers, the Federal Reserve is
stress testing results should provide direct feed-
back in determining underwriting standards, 14. See SR-03-4, dated February 25, 2003, Interagency
product terms, portfolio concentration limits, Advisory on Mortgage Banking and its attachment, which has
and capital levels. the same title.

Page 6
concerned that consumers may enter into these provide consumers with useful information at
transactions without fully understanding the crucial decision-making points, such as when
product terms. Nontraditional mortgage prod- they are shopping for loans or deciding which
ucts have been advertised and promoted based monthly payment amount to make. Such com-
on their affordability in the near term; that is, munication should help minimize potential con-
their lower initial monthly payments compared sumer confusion and complaints, foster good
with traditional types of mortgages. In addition customer relations, and reduce legal and other
to apprising consumers of the benefits of non- risks to the institution.
traditional mortgage products, institutions should
take appropriate steps to alert consumers to the
risks of these products, including the likelihood Legal Risks
of increased future payment obligations. This
information should be provided in a timely Institutions that offer nontraditional mortgage
manner—before disclosures may be required products must ensure that they do so in a manner
under the Truth in Lending Act or other laws—to that complies with all applicable laws and regu-
assist the consumer in the product selection lations. With respect to the disclosures and other
process. information provided to consumers, applicable
laws and regulations include the following:
Concerns and Objectives • Truth in Lending Act (TILA) and its imple-
menting regulation, Regulation Z
More than traditional ARMs, mortgage products • Section 5 of the Federal Trade Commission
such as payment-option ARMs and interest-only Act (FTC Act)
mortgages can carry a significant risk of pay-
ment shock and negative amortization, neither TILA and Regulation Z contain rules governing
of which may be fully understood by consum- disclosures that institutions must provide for
ers. For example, consumer payment obligations closed-end mortgages (1) in advertisements,
may increase substantially at the end of an (2) with an application,15 (3) before loan con-
interest-only period or upon the ‘‘recast’’ of a summation, and (4) when interest rates change.
payment-option ARM. The magnitude of these Section 5 of the FTC Act prohibits unfair or
payment increases may be affected by factors deceptive acts or practices.16
such as the expiration of promotional interest Other federal laws, including the fair-lending
rates, increases in the interest-rate index, and laws and the Real Estate Settlement Procedures
negative amortization. Negative amortization Act (RESPA), also apply to these transactions.
also results in lower levels of home equity as Moreover, the Federal Reserve notes that the
compared with a traditional amortizing mort- sale or securitization of a loan may not affect an
gage product. When borrowers go to sell or institution’s potential liability for violations of
refinance the property, they may find that nega- TILA, RESPA, the FTC Act, or other laws in
tive amortization has substantially reduced or connection with its origination of the loan. State
eliminated their equity in the property—even laws, including laws regarding unfair or decep-
when the property has appreciated. The concern tive acts or practices, also may apply.
that consumers may not fully understand these
products is exacerbated by marketing and pro-
motional practices that emphasize potential ben- Recommended Practices
efits without also providing clear and balanced
information about material risks. Recommended practices for addressing the risks
In light of these considerations, communica-
tions with consumers, including advertisements,
15. These program disclosures apply to ARM products and
oral statements, promotional materials, and must be provided at the time an application is provided or
monthly statements, should provide clear and before the consumer pays a nonrefundable fee, whichever is
balanced information about the relative benefits earlier.
and risks of these products, including the risks 16. The Board of Governors enforces this provision under
the FTC Act and section 8 of the Federal Deposit Insurance
of payment shock and of negative amortization. Act. See the joint Board and FDIC guidance titled Unfair or
Clear, balanced, and timely communication to Deceptive Acts or Practices by State-Chartered Banks, March
consumers of the risks of these products will 11, 2004.

Page 7
raised by nontraditional mortgage products tion decisions, promotional materials and other
include the following:17 product descriptions should provide information
about the costs, terms, features, and risks of
nontraditional mortgages (including information
Communications with Consumers about the matters discussed below).
When promoting or describing nontraditional Payment Shock. Institutions should apprise

mortgage products, institutions should provide consumers of potential increases in payment
consumers with information that is designed to obligations for these products, including
help them make informed decisions when select- circumstances in which interest rates or nega-
ing and using these products. Meeting this tive amortization reach a contractual limit. For
objective requires appropriate attention to the example, product descriptions could state the
timing, content, and clarity of information pre- maximum monthly payment a consumer would
sented to consumers. Thus, institutions should be required to pay under a hypothetical loan
provide consumers with information at a time example once amortizing payments are required
that will help consumers select products and and the interest rate and negative amortization
choose among payment options. For example, caps have been reached.20 Such information
institutions should offer clear and balanced prod- also could describe when structural payment
uct descriptions when (1) a consumer is shop- changes will occur (for example, when
ping for a mortgages (such as when the con- introductory rates expire or when amortizing
sumer makes an inquiry to the institution about payments are required) and what the new pay-
a mortgage product and receives information ment amount would be or how it would be
about nontraditional mortgage products) or calculated. As applicable, these descriptions
(2) when marketing relating to nontraditional could indicate that a higher payment may be
mortgage products is provided by the institution required at other points in time due to factors
to the consumer. Clear and balanced information such as negative amortization or increases in the
should not be offered by the institution only interest-rate index.
upon the submission of an application or at
consummation.18 The provision of such infor- Negative Amortization. When negative amorti-
mation would serve as an important supplement zation is possible under the terms of a nontra-
to the disclosures currently required under TILA ditional mortgage product, consumers should be
and Regulation Z as well as other laws.19 apprised of the potential for increasing principal
balances and decreasing home equity, as well as
other potential adverse consequences of nega-
Promotional Materials and Product tive amortization. For example, product descrip-
Descriptions tions should disclose the effect of negative
amortization on loan balances and home equity,
To assist other consumers in their product selec- and could describe the potential consequences to
the consumer of making minimum payments
17. Institutions should review the recommendations relat- that cause the loan to negatively amortize. (One
ing to mortgage lending practices set forth in other supervi-
sory guidance from their respective primary regulators, as
possible consequence is that it could be more
applicable, including guidance on abusive lending practices. difficult to refinance the loan or to obtain cash
18. Institutions also should strive to (1) focus on informa- upon a sale of the home.)
tion important to consumer decision making; (2) highlight key
information to make it more prominent; (3) employ a user-
friendly and readily navigable format for presenting the
Prepayment Penalties. If the institution may
information; and (4) use plain language, with concrete and impose a penalty in the event that the consumer
realistic examples. Comparative tables and information de- prepays the mortgage, consumers should be
scribing key features of available loan products, including alerted to this fact and to the need to ask the
reduced documentation programs, also may be useful for
consumers who are considering the nontraditional mortgage
lender about the amount of any such penalty.
products and other loan features described in this guidance.
19. Institutions may not be able to incorporate all of the Cost of Reduced Documentation Loans. If an
practices recommended in this guidance when advertising institution offers both reduced and full documen-
nontraditional mortgages through certain forms of media, such
as radio, television, or billboards. Nevertheless, institutions
should provide clear and balanced information about the risks 20. Consumers also should be apprised of other material
of these products in all forms of advertising. changes in payment obligations, such as balloon payments.

Page 8
tation loan programs and there is a pricing or predictions about the future direction of
premium attached to the reduced documentation interest rates (and, consequently, the borrower’s
program, consumers should be alerted to this future obligations); (2) making one-sided repre-
fact. sentations about the cash savings or expanded
buying power to be realized from nontraditional
Monthly Statements on Payment-Option ARMs. mortgage products in comparison with amortiz-
Monthly statements that are provided to con- ing mortgages; (3) suggesting that initial mini-
sumers on payment-option ARMs should pro- mum payments in a payment-option ARM will
vide information that enables consumers to make cover accrued interest (or principal and interest)
informed payment choices, including an expla- charges; and (4) making misleading claims that
nation of each payment option available and the interest rates or payment obligations for these
impact of that choice on loan balances. For products are ‘‘fixed.’’
example, the monthly payment statement should
contain an explanation, as applicable, next to the
minimum payment amount that making this
payment would result in an increase to the Control Systems
consumer’s outstanding loan balance. Payment
statements also could provide the consumer’s Institutions should develop and use strong con-
current loan balance, what portion of the control systems to monitor whether actual practices
sumer’s previous payment was allocated to prin- are consistent with their policies and procedures
cipal and to interest, and, if applicable, the relating to nontraditional mortgage products.
amount by which the principal balance increased. Institutions should design control systems to
Institutions should avoid leading payment- address compliance and consumer information
option ARM borrowers to select a nonamortiz- concerns as well as the safety and soundness
ing or negatively amortizing payment (for ex- considerations discussed in this guidance. Lend-
ample, through the format or content of monthly ing personnel should be trained so that they are
statements). able to convey information to consumers about
product terms and risks in a timely, accurate,
Practices to Avoid. Institutions also should avoid and balanced manner. As products evolve and
practices that obscure significant risks to the new products are introduced, lending personnel
consumer. For example, if an institution adver- should receive additional training, as necessary.
tises or promotes a nontraditional mortgage by Lending personnel should be monitored to
emphasizing the comparatively lower initial pay- determine whether they are following these
ments permitted for these loans, the institution policies and procedures. Institutions should re-
also should provide clear and comparably promi- view consumer complaints to identify potential
nent information alerting the consumer to the compliance, reputation, and other risks. Atten-
risks. Such information should explain, as rel- tion should be paid to appropriate legal review
evant, that these payment amounts will increase, and to using compensation programs that do not
that a balloon payment may be due, and that the improperly encourage lending personnel to direct
loan balance will not decrease and may even consumers to particular products.
increase due to the deferral of interest or prin- With respect to nontraditional mortgage loans
cipal payments. Similarly, institutions should that an institution makes, purchases, or services
avoid promoting payment patterns that are struc- using a third party, such as a mortgage broker,
turally unlikely to occur.21 Such practices could correspondent, or other intermediary, the insti-
raise legal and other risks for institutions, as tution should take appropriate steps to mitigate
described more fully above. risks relating to compliance and consumer
Institutions also should avoid such practices information concerns discussed in this guidance.
as (1) giving consumers unwarranted assurances These steps would ordinarily include, among
other things, (1) conducting due diligence and
21. For example, marketing materials for payment-option establishing other criteria for entering into and
ARMs may promote low predictable payments until the recast maintaining relationships with such third par-
date. Such marketing should be avoided in circumstances in ties, (2) establishing criteria for third-party com-
which the minimum payments are so low that negative
amortization caps would be reached and higher payment
pensation designed to avoid providing incen-
obligations would be triggered before the scheduled recast, tives for originations inconsistent with this
even if interest rates remain constant. guidance, (3) setting requirements for agree-

Page 9
ments with such third parties, (4) establishing only payment option based on the fully indexed
procedures and systems to monitor compliance interest rate, or a fully amortizing principal and
with applicable agreements, bank policies, and interest payment option based on a 15- or 30-
laws, and (5) implementing appropriate correc- year loan term, plus any required escrow pay-
tive actions in the event that the third party fails ments. The minimum payment option can be
to comply with applicable agreements, bank less than the interest accruing on the loan, re-
policies, or laws. sulting in negative amortization. The interest-
only option avoids negative amortization but
does not provide for principal amortization. Af-
APPENDIX ter a specified number of years, or if the loan
reaches a certain negative amortization cap, the
(Terms Used in This Document) required monthly payment amount is recast to
Interest-Only Mortgage Loan. An interest-only require payments that will fully amortize the
mortgage loan refers to a nontraditional mort- outstanding balance over the remaining loan
gage in which, for a specified number of years term.
(for example, three or five years), the borrower
is required to pay only the interest due on the Reduced Documentation. Reduced documenta-
loan, during which time the rate may fluctuate or tion is a loan feature that is commonly referred
may be fixed. After the interest-only period, the to as ‘‘low doc/no doc,’’ ‘‘no income/no asset,’’
rate may be fixed or it may fluctuate based on ‘‘stated income,’’ or ‘‘stated assets.’’ For mort-
the prescribed index and payments, including gage loans with this feature, an institution sets
both principal and interest. reduced or minimal documentation standards to
substantiate the borrower’s income and assets.
Payment-Option ARM. A payment-option
ARM is a nontraditional adjustable-rate mort- Simultaneous Second-Lien Loan. A simulta-
gage that allows the borrower to choose from a neous second-lien loan is a lending arrangement
number of different payment options. For where either a closed-end second lien or a home
example, each month, the borrower may equity line of credit is originated simultaneously
choose a minimum payment option based on a with the first-lien mortgage loan, typically in
‘‘start’’ or introductory interest rate, an interest- lieu of a higher down payment.

Page 10
1. To ascertain if the bank has adequate risk- tices, including consideration of a borrow-
management processes, policies, and proce- er’s repayment capacity;
dures to address the risk associated with its b. its nontraditional mortgage loan products
nontraditional mortgage loans. have strong risk-management standards,
2. To evaluate whether the bank’s nontradi- capital levels commensurate with the risk,
tional mortgage loan terms are supported by and an allowance for loan and lease losses
a disciplined analysis of its potential expo- that reflects the collectibility of the port-
sures versus the mitigating factors that ensure folio; and
that risk levels are adequately managed. c. its consumers have sufficient information
3. To determine if the underwriting standards to clearly understand the loan terms and
for nontraditional mortgage loans comply associated risks prior to making a
with the Federal Reserve’s real estate lending nontraditional mortgage loan product
standards and appraisal regulations and asso- choice.
ciated guidelines. 5. To determine if the bank has borrower quali-
4. To evaluate whether the bank’s management fication criteria that include an evaluation of
carefully considers and appropriately assesses a borrower’s repayment capacity and ability
and mitigates the risk exposures created by to repay the debt—the full amount of the
the nontraditional mortgage loans by ensur- credit extended, including any balance
ing that— increase that may accrue from negative
a. its loan terms and underwriting standards amortization—by the final maturity date at
are consistent with prudent lending prac- the fully indexed rate.

Page 1
RISK MITIGATION as a substitute for income verification or a

reliance on the sale or refinancing of the
1. Assess the bank’s management procedures to property (pledged as collateral) when
mitigate the risk created by nontraditional amortization begins.
mortgage products. Determine that— 4. Determine whether originated or purchased
a. underwriting standards and terms are con- mortgage loans that combine nontraditional
sistent with prudent lending practices, features (such as interest-only loans with
including consideration of each borrow- reduced documentation and second-lien loans)
er’s repayment capacity; have mitigating factors (that is, higher credit
b. products are supported by strong risk- scores, lower LTVs and DTI repayment ratios,
management standards, capital levels that significant liquid assets, mortgage insurance,
are commensurate with their risk, and an or other credit enhancements) that support
allowance for loan and lease losses that the underwriting decisions and the borrow-
reflects the collectiblity of the portfolio; er’s repayment capacities.
and 5. Verify that the bank has clear loan underwrit-
c. borrowers have sufficient information to ing policies governing the use of—
clearly understand the terms of their loans a. reduced documentation of the borrower’s
and their associates risks. financial capacity (for example, non- veri-
fication of reported income when the bor-
rower’s income can be documented based
on recent W-2 statements, pay stubs, or
UNDERWRITING STANDARDS tax returns);
b. minimal or no owner’s equity for second-
1. Determine if the bank’s underwriting
lien home equity lines of credit (such
standards—
loans generally should not have a payment
a. address the effect of a substantial payment structure allowing for delayed or negative
increase on the borrower’s capacity to amortization without other significant risk-
repay when loan amortization begins, mitigating factors);
b. comply with the Federal Reserve’s real c. introductory interest rates (banks should
estate lending standards and appraisal minimize the likelihood of disruptive early
regulations and associated guidelines, and recastings and extraordinary payment
c. require that loan terms are based on a shock when setting introductory rates);
disciplined analysis of potential exposures d. subprime lending (adherence to the inter-
and mitigating factors, which will ensure agency guidance on subprime lending);1
that risk levels remain manageable. and
2. Verify that the bank’s nontraditional mort- e. non-owner-occupied investor loans (quali-
gage loan qualification standards recognize fications should be based on the borrow-
the potential impact of payment shock (par- er’s ability to service the debt over the life
ticularly for borrowers with high loan-to- of the loan, which would include a com-
value (LTV) ratios, high debt-to-income (DTI) bined LTV ratio that considers negative
ratios, and low credit scores). amortization and sufficient borrower equity,
3. Ascertain that the analysis of a borrower’s and continuing cash reserves).
repayment capacity includes—
a. an evaluation of the borrower’s ability to
repay the debt by final maturity at the
fully indexed rate, assuming a fully PORTFOLIO AND
amortizing repayment schedule, RISK-MANAGEMENT PRACTICES
b. a repayment schedule that is based on the
initial loan amount plus any balance 1. If the bank originates or invests in nontradi-
increase that may accrue from a negative tional mortgage loans, determine if more
amortization provision, and
c. avoiding an overreliance on credit scores 1. See SR-01-4 and SR-99-6.

Page 1
robust risk-management practices have been modifications are not inadvertently increas-
adopted to manage the exposures. ing risk.
a. Verify that there are appropriate written c. Find out if the quality control function
lending policies that have been adopted regularly reviews (1) a sample of nontra-
and are being used and monitored, speci- ditional mortgage loans from all origina-
fying acceptable product attributes, pro- tion channels and (2) a representative
duction and portfolio limits (growth and sample of underwriters confirming that
volume limits by loan type), sales and underwriting policies are followed.
securitization practices, and risk- 4. Bank oversight of third-party originators—
management expectations (acceptable lev- a. determine if the bank has strong systems
els of risk). and controls in place for establishing and
b. Determine if enhanced performance mea- maintaining relationships with third-party
sures have been designed and if there is nontraditional mortgage loan originators,
management reporting that provides an including procedures for due diligence,
early warning for increasing risk. and
c. Find out if the appropriate levels for the b. find out if the oversight of third- party
allowance for loan and lease losses mortgage loan origination lending prac-
(ALLL) have been established that con- tices includes monitoring the quality of
sider the credit quality of the portfolio and originations (that is, the quality of origi-
the conditions that affect collectibility. nation sources, key borrower characteris-
d. Evaluate whether adequate capital is main- tics, appraisals, loan documentations, and
tained at levels that reflect portfolio char- credit repayment histories) so that they are
acteristics and the effect of stressed eco- reflective of the bank’s lending standards
nomic conditions on collectibility. and in compliance with applicable laws
e. Determine if capital is held commensurate and regulations.
with the risk characteristics of the bank’s 5. Determine if the bank’s risk-management
nontraditional mortgage loan portfolios. practices are commensurate with the nature,
2. If the bank has concentrations in nontradi- volume, and risk of its secondary-market
tional mortgage products, determine if there activities.
are— a. Find out if there are comprehensive for-
a. well-developed monitoring systems and mal strategies for managing the risks aris-
risk-management practices that monitor ing from significant secondary-market
and keep track of concentrations in key activities.
portfolio segments, such as by loan type,
b. Ascertain if contingency planning includes
third-party originations, geographic area,
how the bank will respond to a decline in
and property occupancy status, and
loan demand in the secondary market.
b. systems that also monitor key portfolio
characteristics: non-owner-occupied inves- c. Determine if there were any repurchases
tor loans and loans with (1) high com- of defaulted mortgages and if the bank
bined LTV ratios, (2) high DTI ratios, complies with its risk-based capital
(3) the potential for negative amortization, guidelines.
(4) credit scores of borrowers that are 6. Evaluate the appropriateness of management
below established thresholds, and (5) risk- information and reporting systems for the
layered features. level and nature of the bank’s mortgage
3. Determine if the bank has adequate quality lending activity.
controls as well as compliance and audit a. Verify that the reporting allows manage-
procedures that focus on mortgage lending ment to detect changes in the risk profile,
activities posing high risk. or deteriorating performance, of its non-
a. Determine if the bank has strong internal traditional mortgage loan portfolio.
controls over accruals, customer service, b. Determine if management information is
and collections. reported and available by loan type, risk-
b. Verify that policy exceptions made by layering features, underwriting character-
servicing and collections personnel are istics, and borrower performance.
carefully monitored and that practices such c. Find out if—
as re-aging, payment deferrals, and loan 1) portfolio volume and performance are

Page 2
tracked against expectations, internal vide direct feedback for determining

lending standards, and policy limits; underwriting standards, product terms,
2) volume and performance expectations portfolio concentration limits, and capital
are established at the subportfolio and levels.
aggregate portfolio levels; g. Determine if the bank has established an
3) variance analyses are regularly per- appropriate ALLL for the estimated credit
formed to identify exceptions to poli- losses and commensurate capital levels
cies and prescribed thresholds; and for the risk inherent in its nontraditional
4) qualitative analyses are performed mortgage loan portfolios (considering the
when actual performance deviates from higher risk of loss posed by the layered
established policies and thresholds. risks).
d. Determine if the bank, based on the size
h. If the bank has material mortgage banking
and complexity of its lending operations,
activities and mortgage servicing assets—
performs sensitivity analysis on its key
portfolio segments to identify and quan- a. evaluate whether sound practices were
tify events that may increase its risks in a applied in valuing the mortgage servic-
segment or the entire portfolio. ing rights for its nontraditional mort-
e. Verify that the scope of the sensitivity gages and
analysis includes stress tests on key per- b. ascertain if the valuation process fol-
formance drivers such as interest rates, lowed the nontraditional mortgage and
employment levels, economic growth, other interagency guidance and gener-
housing value fluctuations, and other fac- ally accepted accounting principles, and
tors beyond the bank’s immediate control. whether reasonable and supportable
f. Find out if the stress testing results pro- assumptions were used.

Page 3
Review the bank’s internal controls, policies, UNDERWRITING STANDARDS

procedures, and practices for making and ser-
vicing nontraditional mortgage loans. The bank’s 1. Do the bank’s underwriting standards—
internal control system should be documented in a. appropriately address and assess the effect
a complete and concise manner and should of a substantial payment increase in the
include, where appropriate, narrative descrip- borrower’s capacity to repay when loan
tions, flowcharts, copies of forms used, and amortization begins?
other pertinent information. b. establish practices consistent with the
Federal Reserve’s real estate lending
standards and appraisal regulations and
RISK MANAGEMENT AND RISK associated guidelines?
MITIGATION c. require that loan terms be based on a
disciplined analysis of potential expo-
1. Are there procedures established to control, sures and mitigating factors, which will
limit, and monitor the authorization of non- ensure that risk levels will remain
traditional mortgage loan transactions and manageable?
to establish the appropriate supervision and 2. Does the bank’s nontraditional mortgage
preliminary review of nontraditional mort- loan qualification standards recognize the
gage loan decisions? potential impact of payment shock, particu-
2. For nontraditional mortgage loans, is there larly for borrowers with high loan-to-value
an appropriate separation of the employees’ (LTV) ratios, high debt-to-income (DTI)
duties involving (1) the authorizing, execut- ratios, and low credit scores?
ing, recording, and adjusting of loans, 3. Does the analysis of a borrower’s repay-
(2) receiving payments, (3) reconciling the ment capacity include—
accounts, and (4) maintaining clear title to, a. an evaluation of the borrower’s ability to
and custody of, pledged collateral—all to repay the debt by final maturity at the
safeguard against the possible misappropria- fully indexed rate, assuming a fully amor-
tion of the bank’s funds? tizing repayment schedule?
3. Has the bank’s management developed risk- b. a repayment schedule that is based on the
mitigation procedures for nontraditional initial loan amount plus any balance
mortgage products? If so, do the risk- increase that may accrue from a negative
mitigation procedures— amortization provision?
a. set forth underwriting standards and terms c. an avoidance of overreliance on credit
that are consistent with prudent lending scores as a substitute for income verifi-
practices, including the consideration of cation or reliance on the sale or refinanc-
each borrower’s repayment capacity, ing of the property when amortization
third-party credit reports, pledged collat- begins?
eral valuations, and regularly timed 4. Do originated or purchased mortgage loans
follow-up reviews thereon? that combine nontraditional features (such
b. require that nontraditional mortgage prod- as interest-only loans with reduced docu-
ucts be supported by appropriate super- mentation and second-lien loans) have miti-
visory oversight and review, strong risk- gating factors (that is, higher credit scores,
management standards, capital levels that lower LTVs and DTI repayment ratios,
are commensurate with their risk, and an significant liquid assets, mortgage insur-
adequate allowance for loan and lease ance, or other credit enhancements) that
losses (ALLL) that reflects the collect- support the underwriting decisions and the
ibility of the portfolio? borrower’s repayment capacities?
c. require that borrowers be provided with 5. Are there clear bank loan underwriting
sufficient information so they can clearly policies governing the use of—
understand the terms of their loans and a. reduced documentation of the borrow-
their associated risks? er’s financial capacity (for example, non-

Page 1
verification of reported income when the lished that consider the credit quality of
borrower’s income can be documented the portfolio and the conditions that affect
based on recent W-2 statements, pay collectibility?
stubs, or tax returns)? e. is the bank’s capital maintained at a level
b. minimal or no owner’s equity for second- that is adequate and commensurate with
lien home equity lines of credit (such the characteristics of its nontraditional
loans generally should not have a pay- mortgage loan portfolio, including the
ment structure allowing for delayed or effect of stressed economic conditions on
negative amortization without other sig- the collectibility of such loans?
nificant risk-mitigating factors)? 2. If the bank has concentrations in nontradi-
c. introductory interest rates (banks should tional mortgage products, are there—
minimize the likelihood of disruptive a. well-developed monitoring systems and
early recastings and extraordinary pay- risk-management practices that monitor
ment shock when setting introductory and keep track of concentrations in key
rates)? portfolio segments, such as by loan type,
d. subprime lending (including underwrit- third-party originations, geographic area,
ing policies that are consistent with the and property occupancy status?
interagency guidance on subprime b. systems that also monitor key portfolio
lending)1? characteristics: non-owner-occupied
e. non-owner-occupied investor loans (the investor loans and loans with (1) high
qualifications should be based on the combined LTV ratios, (2) high DTI ratios,
borrower’s ability to service the debt (3) the potential for negative amortiza-
over the life of the loan, which would tion, (4) credit scores of borrowers that
include a combined LTV ratio that would are below established thresholds, and
consider negative amortization and suf- (5) risk-layered features?
ficient borrower equity, and continuing 3. Does the bank have adequate quality con-
cash reserves)? trols, including an independent internal loan
review staff, that will consider and review
loan documentation and other compliance
PORTFOLIO AND and audit procedures that focus on mort-
gage lending activities posing high risk?
RISK-MANAGEMENT PRACTICES Are there—
1. If the bank originates or invests in nontra- a. strong internal controls over accruals,
ditional mortgage loans— customer service, and collections?
a. has the bank adopted risk-management b. reviews of policy exceptions, conducted
practices to keep pace with the growth by servicing and collections personnel,
and changing risk profile of its nontradi- which are carefully monitored, and are
tional loan portfolio? practices such as re-aging, payment defer-
b. are there appropriate bank-adopted (and rals, and loan modifications regularly
monitored) written lending policies in reviewed to ensure that they are not
use that specify— inadvertently increasing risk?
• acceptable product attributes? c. regular reviews conducted by the quality
• production and portfolio limits (growth control function that focus on (1) a
and volume limits by loan type)? sample of nontraditional mortgage loans
• sales and securitization practices? from all origination channels and (2) a
• risk-management expectations (accept- representative sample of underwriters to
able levels of risk)? confirm that underwriting policies are
c. have enhanced performance measures followed?
been designed and is there management 4. Bank oversight of third-party originators—
reporting that will provide an early warn- a. Does the bank have strong internal sys-
ing of increasing risk? tems and controls in place for establish-
d. are there appropriate ALLL levels estab- ing and maintaining relationships with
third-party nontraditional mortgage loan
originators, including procedures for due
1. See SR-01-4 and SR-99-6. diligence?

Page 2
b. Are there staff designated to provide d. qualitative analyses performed when

bank oversight of third-party mortgage actual performance deviates from estab-
loan origination lending practices, which lished policies and thresholds?
include the monitoring of the quality of 5. Does the bank’s MIS provide reports con-
originations (that is, the quality of origi- sisting of a trial balance of the borrower’s
nation sources, key borrower character- loan balances, and an aged trial balance
istics, appraisals, loan documentations, (based on the borrower’s loan repayment
and credit repayment histories) to ensure terms), for the entire loan portfolio (the
that the originations (1) reflect adher- totals of which agree with the bank’s respec-
ence to the bank’s lending standards and tive general ledger balance[s]), but with
(2) compliance with applicable laws and nontraditional mortgage loan balances seg-
regulations? regated and subtotaled (or totaled)?
5. Are the bank’s risk-management practices 6. Does the bank, based on the size and
for nontraditional mortgage loans commen- complexity of its lending operations, per-
surate with the nature, volume, and risk of form sensitivity analysis on its key portfolio
its secondary-market activities? If so, are segments to identify and quantify events
there— that may increase its risks in a segment or
a. comprehensive formal strategies for man- the entire portfolio?
aging the risks arising from significant 7. Does the scope of the sensitivity analysis
secondary-market activities? include stress tests on key performance
b. bank contingency plans that include how drivers such as interest rates, employment
the bank will respond to a decline in loan levels, economic growth, housing value fluc-
demand in the secondary market? tuations, and other factors beyond the bank’s
c. repurchases of defaulted mortgages and, immediate control?
if so, is the bank in compliance with its 8. Do the stress testing results provide direct
riskbased capital guidelines? feedback for determining underwriting stan-
dards, product terms, portfolio concentra-
tion limits, and capital levels?
MANAGEMENT INFORMATION 9. Has the bank established and maintained an
SYSTEM appropriate ALLL for the estimated credit
losses on nontraditional mortgage loans?
1. Are the bank’s management information
system (MIS) and reports appropriate for 10. Do designated supervisory personnel peri-
the level and nature of the bank’s nontradi- odically review adjustments to, and of, past
tional mortgage lending activity? due and charged-off nontraditional mort-
2. Do the systems and reports allow manage- gage loans to confirm that appropriate
ment to detect changes in the risk profile of, actions have been taken, including collec-
or deteriorating performance in, its nontra- tions and recoveries?
ditional mortgage loan portfolio? 11. Does the bank have commensurate capital
3. For the bank’s nontraditional loan portfolio, levels for the risk inherent in its nontradi-
is management information reported and tional mortgage loan portfolios (considering
available by loan type, risk-layering fea- the higher risk of loss posed by the layered
tures, underwriting characteristics, and bor- risks)?
rower performance? 12. If the bank has material mortgage banking
4. Is the bank’s nontraditional mortgage activities and mortgage servicing assets—
portfolio’s— a. has it evaluated whether sound practices
a. volume and performance tracked against were applied in valuing the mortgage
expectations, internal lending standards, servicing rights for its nontraditional
and policy limits? mortgages?
b. volume and performance expectations b. does the bank’s valuation process follow
established at the sub portfolio and aggre- the nontraditional mortgage and other
gate portfolio levels? interagency guidance and generally
c. variance analyses regularly performed to accepted accounting principles, and have
identify exceptions to policies and pre- reasonable and supportable assumptions
scribed thresholds? been used?

Page 3
CONCLUSION mation and communication system, effi-

ciency and effectiveness of operations, com-
1. With respect to the bank’s management of pliance with laws and regulations, and
its nontraditional mortgage loan portfolio, is monitoring of internal control performance?
there adequate separation of duties, proper 3. Are there any internal control deficiencies
authorization of transactions and activities, in areas that are not covered within this
adequate documents and records, physical questionnaire that impair any controls?
control over assets and records, and inde- Explain any additional examination proce-
pendent checks on performance? dures that are, or would be, necessary to
2. Have any responses to the forgoing infor- draw conclusions about the adequacy of the
mation revealed any significant deficiencies internal controls over the bank’s nontradi-
and weaknesses in the bank management’s tional mortgage loans.
system of internal controls over its nontra- 4. Based on an overall evaluation, as evi-
ditional mortgage loan portfolio— denced by your answers to the foregoing
weaknesses that effect controls over risk questions, are internal controls over the
management and assessment, the reliability bank’s nontraditional mortgage loans
of financial reporting, the accounting infor- adequate or inadequate?

Page 4
Concentrations of Credit
INTRODUCTION afforded by a debt or equity issue of a corpo-

ration. Regardless of whether the issuing entity
A concentration of credit generally consists of is a listed concern or a closely held enterprise,
direct or indirect (1) extensions of credit and a concentration may exist in the underlying
(2) contingent obligations that, when aggre- collateral.
gated, exceed 25 percent of the bank’s capital • Loans that are dependent on a particular
structure (tier 1 capital plus the allowance for agricultural crop or livestock herd. Banking
loan and lease losses). A concentration exists institutions located in farming, dairying, or
when the extensions of credit or other obliga- livestock areas may grant substantially all
tions possess similar risk characteristics. Typi- their loans to individuals or concerns engaged
cally, loans to related groups of borrowers, loans in and dependent on the agricultural industry.
collateralized by a single security or securities Concentrations of this type are commonplace
with common characteristics, and loans to bor- and may be necessary if these banks are to
rowers with common characteristics within an adequately serve the needs of their
industry have been included in homogeneous communities.
risk groupings when assessing asset concentra- • The aggregate amount of interim construction
tions. Furthermore, a concentration may include loans that do not have firm, permanent take-
the aggregate of all types of credit to or invest- out commitments. In the event that permanent
ment in a particular homogeneous risk grouping. financing is not obtainable, the bank will have
Limitations imposed by the various state and to continue financing the projects. This longer
federal legal lending limits were intended to term financing subjects the bank to additional
prevent an individual or a relatively small group liquidity and possibly interest-rate risks, as
from borrowing an undue amount of the bank’s well as to risks associated with the real estate
resources and to safeguard the bank’s depositors itself.
by spreading the loans among a relatively large • Loans to groups of borrowers who handle a
number of persons engaged in different busi- product from the same industry. Although the
nesses. However, lending limits alone are not borrowers may appear to be independent from
sufficient to prevent and control concentrations one another, their financial conditions may be
of credit. Policy guidance for risk diversification affected similarly if a slowdown occurs in
should be formulated in conformity with both their economic sector.
legal and prudent investment restrictions. Before
bank management can limit the bank’s involve- Concentrations may also occur in banks
ment or perform the necessary review, it must located in towns that are economically domi-
recognize the various types of concentrations nated by one or only a few business enterprises.
and implement systems to retrieve the informa- In these situations, banks may extend a substan-
tion necessary to monitor and report concentra- tial amount of credit to these companies and to
tions. The Federal Reserve expects management a large percentage of the companies’ employees.
to identify, measure, monitor, and control If economic or other events cause the enter-
concentrations. prise’s operations to slow down or stop, heavy
unemployment may result—with other job
opportunities in the area limited or nonexistent.
TYPES OF CREDIT In identifying asset concentrations, commer-
CONCENTRATIONS cial and residential real estate loans can be
viewed separately when their performance is not
There are numerous possibilities for determin- subject to similar economic or financial risks. In
ing concentrations within a loan portfolio. In the same vein, commercial real estate develop-
evaluating a potential concentration, it is impor- ment loans need not be grouped with residential
tant to determine the key factors germane to the real estate development loans, especially when
credits. Concentrations that are commonly iden- the residential developer has firm, reliable pur-
tified in a loan portfolio include the following: chase contracts for the sale of the homes upon
their completion. Even within the commercial
• Loans to a group of borrowers, perhaps unre- development and construction sector, distinc-
lated, predicated on the collateral support tions for concentration purposes may be made,

Page 1
2050.1 Concentrations of Credit
when appropriate, between those loans that have realistic, prudent, and achievable in view of
firm take-out commitments and those that do their particular circumstances and market
not. Groups or classes of real estate loans conditions.
should, of course, be combined and viewed as The purpose of an institution’s policies should
concentrations when they do share significant be to improve the overall quality of its portfolio.
common characteristics and are similarly affected Institutions that have effective internal controls
by adverse economic, financial, or business to manage and reduce excessive concentrations
developments. over a reasonable period of time need not
automatically refuse credit to sound borrowers
IDENTIFYING LOAN because of their particular industry or geo-
graphic location. Furthermore, a bank may be
CONCENTRATIONS able to reduce the risks associated with concen-
The examiner should understand and evaluate trations through the strengthening of individual
the effectiveness of the internal policies, sys- credits. For example, the bank may be able to
tems, and controls that an institution uses to obtain additional collateral or guarantees. In the
monitor and manage the risk associated with event of deterioration, the bank’s position would
asset concentrations. Every institution should be improved because the additional collateral or
maintain adequate records that may be used to guarantees provide a cushion against losses.
identify asset concentrations. The degree of When concentration levels have been built up
sophistication of the reporting records will vary over an extended period, it may take time, in
by the size of institution. For example, larger some cases several years, to achieve a more
institutions may have the automated capability balanced and diversified portfolio mix. Given
to segregate loans by Standard Industrial Clas- the institution’s trade area, lack of economic
sification (SIC) codes, while smaller institutions diversity, or geographic location, reducing the
may generate asset concentration listings existing concentration in the near term may be
manually. impossible. If a concentration does exist, the
Regardless of the identification system used banking organization should have adequate sys-
by the institution, the accuracy of listed concen- tems and controls for reducing undue or exces-
trations, as well as the appropriateness of con- sive concentrations in accordance with a prudent
centrations, should be verified during the exami- plan. Strong credit policies and loan administra-
nation. All new and any existing asset tion standards should provide adequate control
concentrations should be reported monthly to for the risks associated with new loans. The
the institution’s board of directors or other institution should also maintain adequate capital
appropriate committee for review. to protect the institution while its portfolio is
being restructured. For identified asset concen-
trations, bank management should be aware of
RISK MANAGEMENT OF ASSET not only the particular company’s or industry’s
CONCENTRATIONS recent trends, but also of its future prospects.
Institutions with asset concentrations are expected

to have in place effective policies, systems, and Alternatives for Reducing
internal controls to monitor and manage this Concentrations
risk. The bank’s board of directors is responsible
for establishing appropriate risk parameters and Some alternatives for institutions whose asset
for monitoring exposure, as well as for evaluat- concentrations are not likely to be reduced in the
ing the methods used by management to manage near term are described below.
and control concentration risk. Furthermore, the
Board’s Regulation F addresses exposure that Increased Holdings of Capital
may arise from a bank’s relationship with its
correspondents. Concentrations that involve To compensate for the additional risk that may
excessive or undue risks require close scrutiny be associated with an asset concentration, a bank
by the bank and should be reduced over a may elect to maintain a higher capital ratio than
reasonable period of time. Banking organiza- would be required under the risk-based capital
tions with a need to reduce asset concentrations guidelines. This additional capital would pro-
are normally expected to develop a plan that is vide support in the event the concentration

Page 2
Concentrations of Credit 2050.1
adversely affects the organization’s financial may be possible to sell a portion of the loan
position. portfolio in the secondary market to reduce its
dependency on an asset group. If the institution
is not large enough to participate in the second-
Increased Allowance for Loan and Lease ary market, an alternative might be to sell loans,
Losses without recourse, to a correspondent bank that is
also attempting to diversify its loan portfolio.
The banking organization may choose to factor
a cushion for loan concentrations into its deter-
mination of an adequate allowance for loan and
lease losses a basis-point cushion for loan con- Government Guarantee Programs
centrations in determining the minimum level.
Another possible solution to reduce the risk
This cushion would be available to absorb some
associated with a loan concentration is to seek
deterioration in loan concentrations.
government guarantees of originated loans. In
some cases, a government agency may be will-
Loan Participations ing to guarantee (or insure) a portion of agricul-
tural or small-business loans, thereby reducing
If a banking institution has a concentration, it the risk to the originating bank.

Page 3
1. To determine if the policies, practices, pro- represent a hazard to the soundness of the
cedures, and internal controls regarding con- bank.
centrations of credit are adequate. 5. To determine that concentrations of credit do
2. To determine if bank officers are operating in not violate applicable banking statutes.
3. To determine the existence of any concentra- practices, procedures, or internal controls are
tions of credit. deficient.
4. To determine if any concentrations of credit

Page 1
Examiners should obtain or prepare the infor- ments and money market instruments that
mation necessary to perform the appropriate exceed 10 percent of the bank’s capital
procedural steps. structure.
9. Combine the schedules obtained in steps
1. If selected for implementation, complete or 4 through 8 and determine concentrations
update the Concentrations of Credits sec- that equal or exceed 25 percent of the
tion of the Internal Control Questionnaire. bank’s capital structure. The remaining pro-
2. Based on the evaluation of internal controls, cedures apply only to these concentrations.
determine the scope of the examination. 10. From the schedule of loans collateraled by a
3. Test for compliance with policies, practices, common security, eliminate all borrowers
procedures, and internal controls in conjunc- for whom the common security can be
tion with performing the remaining exami- considered excess collateral, then review—
nation procedures. a. the trend in market prices and
4. Request the bank’s schedules of concentra- b. current financial information, if
tions that are reported to the board of appropriate.
directors and/or senior management at regu- 11. For loans dependent upon a particular crop
lar intervals and— or herd—
a. if schedules are not current, update and/or a. review the bank’s files for information
have bank personnel update them as of on market conditions, future markets,
the examination date and and estimated prices and
b. request that other examiners review the
b. determine any adverse trends that might
schedules for reasonableness relative to
affect payment of the concentrations.
information developed in performing the
examination procedures for the various 12. For loans dependent upon major employers—
departments. a. review financial and other available
5. If schedules of concentrations are not main- information on the company and evalu-
tained or if the listing is incomplete, prepare ate its ability to continue as an ongoing
or obtain the following schedules of obliga- entity,
tions that exceed 25 percent of the bank’s b. review excerpts from trade papers or
capital structure— periodicals in bank files to determine that
a. loans collateralized by a common security bank management is adequately informed
b. loans, contingent liabilities, and/or other on the business activity of the company,
obligations to one borrower or a related and
group of borrowers c. note any adverse trends that might affect
c. loans dependent upon a particular crop the collectibility of the loans in the
or herd concentrations.
d. aggregate loans to major employers in 13. For loans within industry groups—
the service area, their employees, and a. review financial and other available
their major suppliers information on each industry and evalu-
e. loans within industry groups ate its ability to continue as a viable
f. out-of-normal territory loans industry,
g. all construction or development loans b. review the bank’s files to determine that
without firm takeout commitments. management is adequately informed on
6. If the schedules were prepared by others, the activities of the industry, and
review them for reasonableness relative to c. determine any adverse trends that might
information developed in performing the affect the collectibility of the loans
examination procedures for the various loan included in the concentrations.
areas. 14. For due from bank accounts, inquire as to
7. Obtain a listing of due from bank accounts. the reasonableness of the account relative to
8. Obtain from the examiner assigned ‘‘Invest- the activity and services provided.
ment Securities’’ the schedule of invest- 15. Discuss with management—

Page 1
2050.3 Concentrations of Credit: Examination Procedures
a. the adequacy of written policies regard- should be made regarding each concentra-
ing concentrations of credit, tion, particularly regarding the percentage
b. the manner in which the bank’s officers of the bank’s capital accounts (total capital)
are operating in conformance with estab- that the total of each concentration repre-
lished policies, sents. Examiners should avoid direct
c. concentrations that will appear in the requests for reduction in the concentration
report of examination, and unless facts are included that would support
d. any matter requiring immediate attention. this action.
16. Prepare, in appropriate form, all informa- 17. Update the workpapers with any informa-
tion regarding concentrations for inclusion tion that will facilitate future examinations.
in the report of examination. A comment

Page 2
Review the bank’s internal controls, policies, 5. Are the periodic reports checked for accu-
practices, and procedures relating to concentra- racy by someone other than the preparer
tions of credit. The bank’s system should be before being submitted to the board or its
documented in a complete and concise manner committee?
and should include, where appropriate, narrative 6. When concentrations exist predicated upon a
descriptions, flow charts, copies of forms used, particular crop or herd of livestock, does the
and other pertinent information. bank attempt to diversify the inherent poten-
tial risk by means of—
a. participations or
POLICIES b. arrangements with governmental agencies
such as—
1. Has a policy been adopted that specifically • guarantees or
addresses concentrations of credits? • lending arrangements?
2. Does the policy include deposits and other 7. When concentrations exist predicated upon a
financial transactions with financial particular industry, does the bank make a
institutions? periodic review of industry trends?
3. Have controls been instituted to monitor the
following types of concentrations:
a. loans and other obligations of one borrower CONCLUSION
b. loans predicated on the collateral support
afforded by a debt or equity issue of a 8. Is the foregoing information an adequate
corporation basis for evaluating internal control in that
c. loans to a company dominant in the local there are no significant deficiencies in areas
economy, its employees, and major not covered in this questionnaire that impair
suppliers any controls? Explain negative answers
d. loans dependent upon one crop or herd briefly and indicate any additional examina-
e. loans dependent upon one industry group tion procedures deemed necessary.
f. loans considered out of normal territory 9. Based on a composite evaluation, as evi-
4. Are periodic reports of concentrations required denced by answers to the foregoing
to be submitted to the board or its committee questions, internal control is considered
for review (if so, state frequency )? (adequate/inadequate).

Page 1
Classification of Credits
Effective date June 2004 Section 2060.1
The criteria used to assign quality ratings to reliance on secondary sources of repayment
extensions of credit that exhibit potential prob- should be questioned, and the bank’s policy
lems or well-defined weaknesses are primarily about permitting such a practice should be
based upon the degree of risk and the likelihood reviewed.)
of orderly repayment, and their effect on a
bank’s safety and soundness. Extensions of The longer the tenure of the borrower’s exten-
credit that exhibit potential weaknesses are cat- sion of credit or contractual right to obtain
egorized as ‘‘special mention,’’ while those that funds, the greater the risk of some adverse
exhibit well-defined weaknesses and a distinct development in the borrower’s ability to repay
possibility of loss are assigned to the more the funds. This is because confidence in the
general category of ‘‘classified.’’ The term ‘‘clas- borrower’s repayment ability is based upon the
sified’’ is subdivided into more specific subcat- borrower’s past financial performance as well as
egories ranging from least to most severe: ‘‘sub- projections of future performance. Failure of the
standard,’’ ‘‘doubtful,’’ and ‘‘loss.’’ The amount borrower to meet its financial projections is a
of classified extensions of credit as a percent of credit weakness, but does not necessarily mean
capital represents the standard measure of the extension of credit should be considered as
expressing the overall quality of a bank’s loan special mention or be classified. On the other
portfolio. hand, the inability to generate sufficient cash
These classification guidelines are only applied flow to service the debt is a well-defined weak-
to individual credits, even if entire portions or ness that jeopardizes the repayment of the debt
segments of the industry to which the borrower and, in most cases, merits classification. When
belongs are experiencing financial difficulties. determining which credit-quality rating category
The evaluation of each extension of credit should is appropriate, the examiner should consider the
be based upon the fundamental characteristics extent of the shortfall in the operating figures,
affecting the collectibility of that particular credit. the support provided by any pledged collateral,
The problems broadly associated with some and/or the support provided by cosigners,
sectors or segments of an industry, such as endorsers, or guarantors.
certain commercial real estate markets, should
not lead to overly pessimistic assessments of
particular credits in the same industry that are
not affected by the problems of the troubled Delinquent Extensions of Credit
sector(s).
One of the key indicators of a problem credit is
a borrower’s inability to meet the contractual
repayment terms of an extension of credit. When
ASSESSMENT OF CREDIT this occurs, the extension of credit is identified
QUALITY as past due or delinquent. Examiners divide
delinquent credits into two main categories for
The evaluation of each credit should be based the purpose of a bank examination: ‘‘A’’ delin-
upon the fundamentals of the particular credit, quent extensions of credit and ‘‘B’’ delinquent
including, at a minimum— extensions of credit. Extensions of credit are
also referred to as ‘‘paper’’ because the legal
• the overall financial condition and resources obligation, for example the note, loan, or credit
of the borrower, including the current and agreement, is typically recorded on a paper
stabilized cash flow (capacity); form. The designation of ‘‘A’’ paper is given to
• the credit history of the borrower; any extension of credit that is considered to be a
• the borrower’s or principal’s character; statutory bad debt. Statutory bad debts are
• the purpose of the credit relative to the source defined in section 5204 of the Revised Statutes
of repayment; and (12 USC 56) as all debts due to a bank on which
• the types of secondary sources of repayment interest is past due and unpaid for a period of six
available, such as guarantor support and the months, unless the extension of credit is well
collateral’s value and cash flow, when they secured and in the process of collection. Delin-
are not a primary source of repayment. (Undue quent credits that are not covered under the

Page 1
2060.1 Classification of Credits
definition of statutory bad debt are designated as sions of credit that contain risks usually associ-
‘‘B’’ paper. In either case, special mention or ated with that particular type of lending. Any
classified extensions of credit are often found to extension of credit involves certain risks, regard-
be delinquent. An extension of credit that is not less of the collateral or the borrower’s capacity
delinquent also may be identified as special and willingness to repay the debt.
mention or classified. Nondelinquent extensions For example, an extension of credit secured
of credit (also referred to as ‘‘performing’’ or by accounts receivable has a certain degree of
‘‘current’’) should be classified when well- risk, but the risk must have increased beyond
defined weaknesses exist that jeopardize repay- that which existed at origination to categorize
ment. Examples of well-defined weaknesses the credit as special mention. Other characteris-
include the lack of credible support for full tics of accounts receivable warranting identifi-
repayment from reliable sources, or a significant cation as special mention include a rapid increase
departure from the intended source of repay- in receivables without bank knowledge of the
ment. This latter weakness warrants concern causative factors, concentrations in receivables
because a delinquent credit may have been lacking proper credit support, or lack of on-site
brought current through loan or credit modifica- audits of the bank’s borrower.
tions, refinancing, or additional advances.
CLASSIFICATION CATEGORIES
SPECIAL MENTION CATEGORY
Split Classifications
A special mention extension of credit is defined
as having potential weaknesses that deserve When classifying a particular credit, it may not
management’s close attention. If left uncor- be appropriate to list the entire balance under
rected, these potential weaknesses may, at some one credit-quality category. This situation is
future date, result in the deterioration of the commonly referred to as a ‘‘split classification’’
repayment prospects for the credit or the insti- and may be appropriate in certain instances,
tution’s credit position. Special mention credits especially when there is more certainty regard-
are not considered as part of the classified ing the collectibility of one portion of an exten-
extensions of credit category and do not expose sion of credit than another. Split classifications
an institution to sufficient risk to warrant may also involve special mention as well as
classification. ‘‘pass’’ credits, those that are neither special
Extensions of credit that might be detailed in mention nor classified. Extensions of credit that
this category include those in which— exhibit well-defined credit weaknesses may war-
rant classification based on the description of the
• the lending officer may be unable to properly following three classification categories.1
supervise the credit because of an inadequate
loan or credit agreement;
• questions exist regarding the condition of
and/or control over collateral; Substandard Extensions of Credit
• economic or market conditions may unfavor-
A ‘‘substandard’’ extension of credit is inad-
ably affect the obligor in the future;
equately protected by the current sound worth
• a declining trend in the obligor’s operations or
and paying capacity of the obligor or of the
an imbalanced position in the balance sheet
collateral pledged, if any. Extensions of credit so
exists, but not to the point that repayment is
classified must have a well-defined weakness or
jeopardized; and
• other deviations from prudent lending prac-
tices are present.
The special mention category should not be used

to identify an extension of credit that has as its 1. Guidelines for the uniform classification of consumer-
installment extensions of credit and credit card plans, as well
sole weakness credit-data or documentation as classification guidelines for troubled commercial real estate
exceptions not material to the repayment of the credits, are discussed in detail in sections 2130.1 and 2090.1,
credit. It should also not be used to list exten- respectively.

Page 2
Classification of Credits 2060.1
weaknesses that jeopardize the liquidation2 of continuation of the doubtful classification is

the debt. They are characterized by the distinct warranted. However, the examiner should avoid
possibility that the bank will sustain some loss if undue continuation if repeatedly, over the course
the deficiencies are not corrected. Loss poten- of time, pending events do not occur and repay-
tial, while existing in the aggregate amount ment is again deferred awaiting new
of substandard credits, does not have to exist developments.
in individual extensions of credit classified
substandard.
Loss Extensions of Credit
Doubtful Extensions of Credit Extensions of credit classified ‘‘loss’’ are
considered uncollectible and of such little value
An extension of credit classified ‘‘doubtful’’ has that their continuance as bankable assets is not
all the weaknesses inherent in one classified warranted. This classification does not mean
substandard, with the added characteristic that that the credit has absolutely no recovery or
the weaknesses make collection or liquidation in salvage value, but rather that it is not practical
full, on the basis of currently existing facts, or desirable to defer writing off this basically
conditions, and values, highly questionable and worthless asset even though partial recovery
improbable. The possibility of loss is extremely may be effected in the future. Amounts classi-
high, but because of certain important and fied loss should be promptly charged off. (See
reasonably specific pending factors that may SR-04-9 and its attachment.)
work to the advantage of and strengthen the Banks should not be allowed to attempt long-
credit, its classification as an estimated loss is term recoveries while the credit remains on the
deferred until its more exact status may be bank’s books. Losses should be taken in the
determined. Pending factors may include a pro- period in which they surface as uncollectible.
posed merger or acquisition, liquidation proceed- In some cases, examiners should determine a
ings, capital injection, perfecting liens on addi- reasonable carrying value for a distressed exten-
tional collateral, or refinancing plans. sion of credit and require a write-down through
Examiners should avoid classifying an entire a charge to the allowance for loan and lease
credit as doubtful when collection of a specific losses, or to other operating expenses in the case
portion appears highly probable. An example of of an ‘‘other asset.’’ Such a determination should
proper use of the doubtful category is the case of be based on tangible facts recorded in the bank’s
a company being liquidated, with the trustee-in- credit file and contained in reports on problem
bankruptcy indicating a minimum disbursement credits submitted to the board of directors or its
of 40 percent and a maximum of 65 percent to committee, and not solely on verbal assurances
unsecured creditors, including the bank. In this from a bank officer.
situation, estimates are based on liquidation-
value appraisals with actual values yet to be
realized. By definition, the only portion of the
credit that is doubtful is the 25 percent differ- SITUATIONS NOT REQUIRING
ence between 40 and 65 percent. A proper CLASSIFICATION
classification of such a credit would show 40 per-
cent substandard, 25 percent doubtful, and It is generally not necessary to classify exten-
35 percent loss. sions of credit and contingent liabilities that are
Examiners should generally avoid repeating adequately protected by the current sound worth
a doubtful classification at subsequent examina- and debt-service capacity of the borrower, guar-
tions, as the time between examinations should antor, or the underlying collateral. Further, a
be sufficient to resolve pending factors. This is performing extension of credit should not auto-
not to say that situations do not occur when matically be identified as special mention, clas-
sified, or charged off solely because the value
of the underlying collateral has declined to an
2. This terminology is used in the original classification amount that is less than the balance outstanding.
definitions as set forth in the 1938 accord and its amendments.
The term ‘‘liquidation’’ refers to the orderly repayment of the
Extensions of credit to sound borrowers that are
debt and not to a forced sale of the loan or its underlying refinanced or renewed in accordance with pru-
collateral. dent underwriting standards should not be cat-

Page 3
egorized as special mention unless a potential Formally Restructured

weakness exists, or classified unless a well- Extensions of Credit
defined weakness exists that jeopardizes repay-
ment. The existence of special mention or clas- Restructured troubled debt should be identified
sified extensions of credit should not be identified in the institution’s internal credit-review system
as an imprudent banking practice, as long as the and closely monitored by management. When
institution has a well-conceived and effective analyzing a formally restructured extension of
workout plan for such borrowers, and effective credit, the examiner should focus on the ability
internal controls to manage the level of these of the borrower to repay the credit in accordance
extensions of credit. with its modified terms.4 With formally restruc-
tured credits, it is frequently necessary to charge
off a portion of the principal, due to the borrow-
Partially Charged-Off er’s difficulties in meeting the contractual pay-
Extensions of Credit ments. In these circumstances, the same credit-
risk assessment given to nonrestructured credits
When an institution has charged off a portion of with partial charge-offs (see the previous sub-
a credit and the remaining recorded balance of section) would also generally be appropriate for
the credit (1) is being serviced (based upon a formally restructured credit. This includes not
reliable sources) and (2) is reasonably assured identifying the remaining recorded balance as
of collection, categorization of the remaining special mention or classified if unwarranted.
recorded balance as special mention or classified The assignment of special mention status to a
may not be appropriate.3 For example, when the formally restructured credit would be appropri-
remaining recorded balance of an extension of ate, if, after the restructuring, potential weak-
credit is secured by readily marketable collat- nesses remained. It would also be appropriate to
eral, the portion that is secured by this collateral classify a formally restructured extension of
would generally not be identified as special credit when well-defined weaknesses exist that
mention or classified. This would be appropri- jeopardize the orderly repayment of the credit,
ate, however, if potential or well-defined weak- based upon its reasonable modified terms. For a
nesses, respectively, continue to be present in further discussion of troubled debt restructur-
the remaining recorded balance. In such cases, ings, see the glossary section of the Instructions
the remaining recorded balance would generally for the Consolidated Reports of Condition and
receive a credit rating no more severe than Income and ‘‘Loan Portfolio Management,’’ sec-
substandard. tion 2040.1.
A more severe credit rating than substandard
for the remaining recorded balance would be
appropriate if the loss exposure cannot be rea- ROLE OF GUARANTEES
sonably determined, for example, when signifi-
cant risk exposures are perceived, such as might The primary focus of a review of an extension of
be the case in bankruptcy or for credits collat- credit’s quality is the original source of repay-
eralized by properties subject to environmental ment and the borrower’s ability and intent to
hazards. In addition, classification of the remain- fulfill the obligation without reliance on guaran-
ing recorded balance would be appropriate when tors.5 In situations involving troubled credits,
sources of repayment are considered unreliable. however, the assessment of credit quality should
also be based upon the support provided by
guarantees. As a result, the lending institution
4. An example of a restructured commercial real estate

credit that does not have reasonable modified terms would be
a mortgage that requires interest payments only, but no
3. The accrual/nonaccrual status of the credit must con- principal payments, despite the fact that the underlying
tinue to be determined in accordance with the glossary section collateral generates sufficient cash flow to pay both.
of the Instructions for the Consolidated Reports of Condition 5. Some credits are originated based primarily upon the
and Income (Call Report). Thus, while these partially charged- financial strength of the guarantor, who is, in substance, the
off credits may qualify for nonaccrual treatment, cash-basis primary source of repayment. In such circumstances, exam-
recognition of income will be appropriate when the criteria iners generally assess the collectibility of the credit based
specified in the Call Report guidance are met. upon the guarantor’s ability to repay the credit.

Page 4
must have sufficient information concerning the cross-collateralized or otherwise inter-

guarantor’s financial condition, income, liquid- twined with the credit; or
ity, cash flow, contingent liabilities, and other — guarantees collateralized by readily mar-
relevant factors (including credit ratings, when ketable assets that are under the control of
available) to demonstrate the guarantor’s finan- a third party.
cial capacity to fulfill the obligation. • The extent to which guarantees are legally
enforceable, although in general this is the
only type of guarantee that should be relied
upon.
Examiner Treatment of Guarantees
— Collection of funds under a guarantee
should not be subject to significant delays
A guarantee should provide support for repay-
or undue complexities or uncertainties
ment of indebtedness, in whole or in part, and be
that might render legal enforceability
legally enforceable. It is predicated upon both
questionable.
the guarantor’s financial capacity and willing-
ness to provide support for a credit. — Although the bank may have a legally
To assess the financial capacity of a guarantor enforceable guarantee, it may decide not
and determine whether the guarantor can honor to enforce it. The examiner’s judgment
its contingent liabilities in the event required, should be favorably affected by previous
examiners normally rely on their own analysis extensions of credit evidencing the timely
of a guarantor’s financial strength. This includes enforcement and successful collection of
an evaluation of the financial statements and the guarantees.
number and amount of guarantees currently • The type of the guarantee. Some guarantees
committed to. for real estate projects are limited in that they
A guarantor’s willingness to perform is only pertain to the development and construc-
assumed, unless there is evidence to the con- tion phases of a project. As such, these limited
trary. Since a guarantee is obtained with the guarantees cannot be relied upon to support a
intent of improving the repayment prospects of a troubled credit after the completion of these
credit, a guarantor may add sufficient strength to phases.
preclude or reduce the severity of the risk
assessment.
Examiners should consider and analyze the
following guarantee-related factors during the OFF-BALANCE-SHEET ITEMS
course of their review of extensions of credit:
The principal off-balance-sheet credit-related
• The degree to which the guarantors have transactions likely to be encountered during loan
demonstrated their ability and willingness to reviews are loan commitments, commercial let-
fulfill previous guarantees. ters of credit, and standby letters of credit. When
• Whether previously required performance evaluating off-balance-sheet credit transactions
under guarantees was voluntary or was the for the purpose of assigning a credit-quality
result of legal or other actions by the lender. rating, the examiner should carefully consider
Examiners should give limited credence, if whether the bank is irrevocably committed to
any, to guarantees from obligors who have advance additional funds under the credit agree-
reneged on obligations in the past, unless ment. If the bank must continue to fund the
there is clear evidence that the guarantor has commitment and a potential weakness exists
the ability and intent to honor the specific that, if left uncorrected, may at some future date
guarantee under review. result in the deterioration of repayment pros-
pects or the bank’s credit position, the amount of
• The economic incentives for performance by
the commitment may be categorized as special
guarantors. This includes—
mention. If there is a well-defined weakness that
— guarantors who have already partially per- jeopardizes repayment of a commitment, classi-
formed under the guarantee; fication may be warranted. If an amount is
— guarantors who have other significant classified, it should be separated into two com-
investments in the project; ponents: the direct amount (the amount that has
— guarantors whose other sound projects are already been advanced) and the indirect amount

Page 5
(the amount that must be advanced in the Standby Letters of Credit

future).
Most standby letters of credit (SLCs) are unse-
cured and involve substituting the bank’s credit
Loan Commitments standing for that of the bank’s customer on
behalf of a beneficiary. This occurs when the
beneficiary needs to ensure that the bank’s
Loan commitments are defined as legally bind- customer is able to honor its commitment to
ing obligations to extend credit (other than in the deliver the goods or services by the agreed-upon
form of retail credit cards, check credit, and time and with the agreed-upon quality. For
related plans) for which a fee or other compen- credit-analysis purposes, SLCs are to be treated
sation is typically received. Different types of like loans and represent just one type of exten-
loan commitments vary based upon the nature of sion of credit relative to the overall exposure
the credit granted. Loan-commitment credit risk extended by the bank to the borrower. SLCs can
stems from the possibility that the creditworthi- be divided into two main groups: ‘‘financial
ness of the customer will deteriorate between SLCs’’ and ‘‘nonfinancial SLCs.’’ Financial
the time the commitment is made and the funds SLCs essentially guarantee repayment of finan-
are advanced. (See ‘‘Contingent Claims from cial instruments and are commonly used to
Off-Balance-Sheet Activities,’’ section 4110.1.) ‘‘guarantee’’ payment on behalf of customers,
issuers of commercial paper, or municipalities
(relative to tax-exempt securities). Nonfinancial
Commercial Letters of Credit SLCs are essentially used as bid and perfor-
mance bonds to ‘‘guarantee’’ completion of
projects, such as building or road construction,
Commercial letters of credit involve a buyer of
or to guarantee penalty payment in case a
goods and a seller of goods and are instruments
supplier is unable to deliver goods or services
issued by a bank serving as an intermediary
under a contract.
between the two for the resultant payment for
the goods. Commercial letters of credit are
customarily used to facilitate international trade
due to the distances involved, as well as differ-
ences in legal, political, and business practices. REQUIRED LOAN WRITE-UPS
Additionally, there may be a lack of familiarity
between the buyer and seller. As a result, the A full loan write-up (see criteria below) is
bank substitutes its credit in place of the buyer’s required for all significant or material classified
credit and promises on behalf of its customer to or specially mentioned assets if (1) management
pay predetermined amounts of money to the disagrees with the disposition accorded by the
seller against the delivery of documents indicat- examiner, or (2) the institution will be rated
ing shipment of goods and representing title to composite 3, 4, or 5. The write-ups will be used
those goods. If the shipping documents are in to support the classifications to management
order, the bank is obligated to pay the seller and, in the case of problem banks, to support
through the issuance of a sight or time draft. The any necessary follow-up supervisory actions.
bank is then reimbursed by its customer for the An abbreviated write-up may be appropriate
amount of the shipment plus a fee for conduct- for other loans to illustrate a credit-administration
ing the transaction. weakness or to formalize certain decisions, docu-
Given the nature of the bank’s commitment to ment agreements, and clarify action plans for
pay for the goods on behalf of its customer, a management. For example, bank management
commercial letter of credit is typically irrevo- may have agreed to either collect or charge off a
cable. This means that it cannot be cancelled or loan classified doubtful by the next call report
revoked without the consent of all parties con- date or to reverse interest accruals and place the
cerned. As a result, there is added credit risk for loan on nonaccrual status. These agreements
the issuing bank since it cannot cancel its may be expressed in the report through a brief
commitment in the event the credit standing of comment under the classification write-up.
its customer deteriorates, even if the deteriora- The examiner may find it beneficial to list
tion occurs before the shipment of the goods. extensions of credit alphabetically by depart-

Page 6
ment and/or branch. When more than one Before a write-up is prepared, the examiner
borrower is relevant to a single write-up, the should recheck central information files or other
alphabetization of the prime borrower or the sources in the bank to determine that all of the
parent corporation should determine the credit’s obligor’s debt, including related debt,6 has been
position in the list. All other parties to the credit, noted and included. The examiner should con-
including cosigners, endorsers, and guaran- sider identifying accrued interest receivable as
tors, should be indicated directly under the special mention or classified, especially when
maker of the notes or embodied within the the cumulative effect on classified percentages is
write-up. significant or the accrued interest is appropri-
Although classifications and items listed for ately classified loss.
special mention may be listed alphabetically on Even though the length of a write-up may be
the report page, examiners may elect to format limited, the information and observations con-
the listing or write-ups in other ways to illustrate tained in the write-up must substantiate the
examination findings or conclusions. For exam- credit’s treatment as a special mention or clas-
ple, examiners may wish to group classifications sified credit. To prepare a write-up that brings
into categories of weakness and to use these out pertinent and fundamental facts, an exam-
listings to support loan-administration com- iner needs to have a thorough understanding of
ments without providing a write-up for each all the factors relative to the extension of credit.
classified item. An ineffective presentation of the facts weakens
Notwithstanding this guidance, examiners a write-up and frequently casts doubt on the
have the flexibility of writing up more than the accuracy of the risk assessment. The examiner
criticized assets, including any special mention might consider emphasizing deviations from
credits, if deemed necessary. The decision to prudent banking practices as well as loan policy
increase the number of write-ups should be and procedure deficiencies that are pertinent to
based on factors such as the overall financial the credit’s problems. When portions of a bor-
condition of the bank, quality of the loan rower’s indebtedness are assigned to different
portfolio, or adequacy of loan portfolio risk categories, including portions identified as
administration. ‘‘pass,’’ the examiner’s comments should clearly
It is important that a sufficient number of set forth the reason for the split-rating treatment.
write-ups with appropriate content be provided A full write-up on items adversely classified or
to support the examiner’s assessment of the listed as special mention must provide sufficient
bank’s problem loans, leases, and other exten- detail to support the examiner’s judgment con-
sions of credit. The write-ups should also sup- cerning the rating assigned. To ensure that the
port any comments pertaining to credit- write-ups provide a clear, concise, and logical
administration policies and practices as they discussion of material credit weaknesses, the
relate to this component of the bank’s loan following minimum categories of information
portfolio. should be presented, preferably in the order
listed (see SR-99-24):
1. A general description of the obligation.

General Guidelines for Write-Ups • Amount of exposure (both outstanding and
of Special Mention and Classified contingent or undrawn) as follows:
Extensions of Credit — Summarize total related and contingent
borrowings, including amounts previ-
Extension of credit write-ups may be in a ously charged off and recovered.
narrative or bullet format, similar to the write- — List the borrower’s total related liabili-
ups of shared national credits, where appropri- ties outstanding. Amounts making up
ate. When the special mention or classified this total refer to credits in which the
credit consists of numerous extensions of credit borrower may have a related interest
to one borrower, or when multiple borrowers are and is directly or indirectly obligated to
discussed in one write-up, the write-up should repay, such as partnerships and joint
be structured to clearly identify the credit facili- ventures. The rule for determining what
ties being discussed. For example, each exten-
sion of credit could be numbered when multiple 6. The term ‘‘related’’ refers to direct and indirect
credits are involved. obligations.

Page 7
is included in related debt (aggregating assuming that a borrower is necessarily in

debt), which ultimately has to do with the same line of business indicated by the
ascertaining compliance with legal borrower’s business name. In the preced-
lending limits, is governed by state ing example, if the borrower is primarily a
law. wholesale grocery or sporting goods sup-
— List and identify the obligor’s contin- plier, or if it radically deviates from the
gent liabilities to the bank under type of business indicated in its business
examination. Contingent liabilities name, the situation should be clarified. It is
include items such as unadvanced por- important to state the borrower’s position
tions of a line of credit or extension of in the marketing process—manufacturer,
credit (commitments), guarantees or wholesaler, or retailer—and to indicate the
endorsements, and commercial and types of goods or services.
standby letters of credit. Although con- • Description and value of collateral. The
tingent liabilities to other lenders rep- type of lien, collateral description and its
resent an important component of the condition and marketability, as well as the
financial analysis of the obligor, they collateral’s current value, date of valua-
should not be listed in the write-up tion, and basis for the valuation, should be
unless they are particularly relevant to included. If values are estimated, the
the situation, or are portions of both write-up should indicate the source of the
related and contingent liabilities that valuation, such as the obligor’s recent
represent participations purchased from financial statement, an independent
and sold to other lenders. The latter appraisal, or an internal management report.
example should be listed even though If valuations are not available, a statement
the entire relationship may not have to that effect should be included. A bank’s
been identified as special mention or failure to obtain collateral valuations, when
classified. Additionally, only the clas- available, is cause for criticism. Also
sified portion of extensions of credit or include any other pertinent information
contingent liabilities of the bank under that might impede or facilitate the possible
examination should be listed in the sale of the collateral to repay the extension
appropriate column(s) of the classified of credit.
asset page. When problem borrowers are involved,
• The obligor and the obligor’s location and the sale of the collateral often becomes the
type of business or occupation. For the sole or primary source of repayment. As a
type of business or occupation of the obli- result, the valuation of the collateral
gor, indicate whether the business is a becomes especially important when
proprietorship, partnership, joint venture, describing the credit, as described in the
or corporation. This information can be specific examples below.
used to compare the purpose of the credit If real estate is pledged to secure the
with the source(s) of repayment, and to credit, the write-up should provide a
compare the credit’s structure with the description of the property, the lien status,
obligor’s repayment ability. The general the amount of any prior lien, and the
identification of occupation, such as pro- appraised value. If multiple parcels are
fessional or wage earner, may not be securing the credit, appraised values should
definitive enough, so it may be necessary be listed for each parcel, including the date
to indicate that, for example, the extension of the appraisal and the basis for the value.
of credit is to a medical doctor. When bank staff or examiners’ challenges
Types of businesses may be clearly indi- to appraisal assumptions are supported, the
cated in the borrower’s business name and resulting adjustment in value for credit-
may not require additional comment. For analysis purposes should be indicated. If
example, Apex Supermarket and Ajax the property held as collateral has tenants,
Sporting Goods Store imply a retail super- its cash flow should be noted and the
market and a retail sporting goods store. financial strength of the major lessees com-
However, examiners should not be misled mented upon, if appropriate.
in their analysis of the credit; likewise, the If the collateral represents shares of or
write-up reviewer should not be misled by an interest in a closely held company, the

Page 8
shares or ownership interest held should be • Amounts previously classified.

indicated in relation to the total shares • Repayment terms and historical perfor-
outstanding, and the financial condition of mance, including prior charge-offs, and
the closely held company should be sum- current delinquency status (with notation if
marized in the write-up. Additionally, the the credit is currently on nonaccrual sta-
approximate value of the closely held com- tus). Any changes to the original repay-
pany, as indicated by its financial statement terms, whether initiated by bank
ments, should be compared for consistency management or the obligor, should be
with the value of the company as indicated detailed with an appropriate analysis of the
on the principal’s or partner’s personal changes included in the write-up. Renew-
financial statement. The values often do als, extensions, and rewritten notes that
not correlate to the extent they should, deviate from the stated purpose and repay-
which typically indicates overvaluation of ment expectations, as approved by manage-
the asset on the balance sheet of the entity ment, should be discussed in light of their
owning the shares or ownership interest. effect on the quality of the credit. Restruc-
If a blanket lien on assets, such as turings should be discussed in terms of
receivables, inventory, or equipment, is their reasonable objectives, focusing on the
pledged as collateral, the current estimated prospects for full repayment in accordance
value of each asset type should be shown with the modified terms.
separately. The basis for these values can It may be prudent to state the purpose of
come from various sources, which should the credit. The purpose can be compared
be indicated: with the intended source of repayment for
— If receivables are pledged as collateral appropriateness. For example, a working
for an asset-based extension of credit, a capital extension of credit generally should
current aging report and an assessment not depend on the sale of real estate for
of the appropriateness of the advance repayment. Additionally, the obligor’s prior
ratio is usually necessary to determine business experience should correlate to the
their collectibility and value. credit’s purpose.
— If inventory is pledged as collateral for 2. A summary listing of weaknesses resulting in
an asset-based extension of credit, an classification or special mention treatment.
assessment of the appropriateness of 3. A reference to any identified deficiencies in
the advance ratio is necessary. Addi- the item that will support loan-administration
tionally, the value varies with the con- or violation comments elsewhere in the report.
dition and marketability of the inventory. This information may consist of deficien-
— If listed securities or commodities are cies in credit and collateral documentation
pledged as collateral, the market value or violations of law that have a material
and date of valuation should be noted. impact on credit quality. Loan-portfolio-
• Notation if borrower is an insider or a administration performance includes, but is
related interest of an insider. not limited to—
• Guarantors and a brief description of their • changes in asset quality since the last
ability to act as a source of repayment. If examination;
the financial strength of guarantors has • the appropriateness of loan-underwriting
changed significantly since the initial guar- standards;
antee of the credit facility, this should be • the adequacy of—
noted. The relationship of the guarantors to
— loan documentation;
the borrower should be identified, includ-
ing a brief description of the guarantors’ — management information systems;
ability (financial strength) to serve as a — internal control systems; and
source of repayment independent of the — loan-loss reserves;
borrower. Any collateral supporting the • the accuracy of internal loan-rating systems;
guarantees should also be stated. See the • the ability and experience of lending offi-
previous subsection, ‘‘Role of Guaran- cers, as well as other personnel managing
tees,’’ and SR-91-24 for further guidance the lending function; and
on considering guarantees for credit- • changes in lending policies or procedures
analysis purposes. since the last examination.

Page 9
4. If management disagrees with the classifica- Optional Information for Write-ups

tion, a statement to that effect along with
management’s rationale. Information could At the examiner’s discretion, other information
include selected data from the most recent may be included in loan write-ups. For example
fiscal and interim financial statements (dis- the examiner may want to include current finan-
cussion of items such as leverage, liquidity, cial information on the borrower, cosigners, and
and cash flow) when the primary reason for guarantors. The additional information may con-
the write-up relates to the borrower’s finan- sist of discussions regarding current balance
cial condition or operating performance. Cost sheets and operating statements. If discussed,
of goods sold, nonrecurring expenses, divi- the examiner should indicate whether the finan-
dends, or other items indicating deterioration cial statements have been audited, reviewed,
in the credit quality may also be highlighted. compiled, or prepared by the borrower, and
Any stated value of the borrower’s encum- whether they are fiscal or interim statements. If
bered assets should be set off against specific the statements are audited, the examiner should
debt to arrive at the unprotected balance, if indicate the type of opinion expressed—
applicable. In addition, the examiner should unqualified, qualified, disclaimer, or adverse—
identify encumbered assets that are pledged and whether the auditor is a certified public
elsewhere. accountant. If the opinion is qualified, note the
5. A concise description of any management reason(s) given by the auditor.
action taken or planned to address the weak-
ness in the asset. The action plan should When the examiner includes comments
focus on a concise description of manage- regarding the borrower’s financial condition, the
ment’s workout or action plan to improve the comments should always highlight credit weak-
credit’s collectibility or to liquidate the debt. nesses in a manner that supports the risk assess-
Review of the bank’s documented workout ment. It is important that sufficient detail is
plan should give an examiner a clear idea of provided to identify unfavorable factors. A trend
past efforts to improve the prospect of col- analysis or details of balance-sheet, income-
lectibility and management’s current efforts statement, or cash-flow items can be included.
and future strategy. The plan should clearly The examiner may also include comments when
state the bank’s goals and corresponding special mention or classified credits may exhibit
timetable as they appear at that point, includ- favorable as well as unfavorable financial char-
ing items such as the degree of repayment acteristics. Both types of pertinent factors may
envisioned and the proceeds anticipated from be included in the write-up as long as they are
the sale of the collateral. Based on this placed in the proper perspective to demonstrate
information, the examiner should succinctly the credit’s inherent weaknesses.
summarize in the write-up the bank’s collec-
tion efforts to date and its ongoing plans to
address the situation.

Page 10
Allowance for Loan and Lease Losses
The allowance for loan and lease losses (ALLL) credit losses as of the end of the fourth quarter.
is presented on the balance sheet as a contra- Therefore, in the fourth quarter of year 1, Bank
asset account that reduces the amount of the A should record a provision for $250,000, deb-
loan portfolio reported on the balance sheet. The iting this expense and crediting the ALLL for
purpose of the ALLL is to reflect estimated this amount to bring the ALLL to the appropri-
credit losses within a bank’s portfolio of loans ate level of $1.5 million. Assume further that
and leases. Estimated credit losses are estimates during the first quarter of year 2, Bank A
of the current amount of loans that are probable identifies $750,000 in uncollectible loans. It
that the bank will be unable to collect given the must charge off this amount against the ALLL
facts and circumstances since the evaluation by debiting the ALLL and crediting the indi-
date (generally the balance sheet date). That is, vidual loans for a total of $750,000. Also
estimated credit losses represent net charge-offs assume that in the same first quarter of year 2,
that are likely to be realized for a loan or group Bank A receives $100,000 in cash recoveries on
of loans as of the evaluation date. previously charged-off loans. These recoveries
All federally insured depository institutions must be credited to the ALLL in that quarter.
must maintain an ALLL, except for federally Thus, in the first quarter of year 2, Bank A’s
insured branches and agencies of foreign banks. ALLL, which began the year at $1.5 million,
A bank determines the appropriate balance or will have been reduced $850,000 ($1,500,000 −
level of the ALLL at least each quarter by $750,000 + $100,000 = $850,000). However,
evaluating the collectibility of its loan and lease management’s ALLL analysis for the first quar-
portfolio, including any accrued and unpaid ter of year 2 indicates that an ALLL of $1.2 mil-
interest. Increases or decreases to the ALLL are lion is appropriate. To bring the recorded ALLL
to be made through charges (debits) or credits to to this level, Bank A must make a debit to the
the ‘‘provision for loan and lease losses’’ (pro- provision for loan and lease losses of $350,000
vision), an expense account on the bank’s Con- ($850,000 + $350,000 = $1.2 million).
solidated Report of Income or income state- While the overall responsibility for maintain-
ment, and not through transfers from retained ing the ALLL at an appropriate level rests with
earnings or any segregation of retained earnings the bank’s senior management and board of
or other components of equity capital. directors, the appropriateness of the ALLL and
When there is information available to con- management’s analysis of it are subject to exam-
firm that specific loans, or portions thereof, are iner review. The examiner should make every
uncollectible, these amounts should be promptly effort to fully understand a bank’s methods for
charged off against the ALLL. Under no circum- determining the needed balance of its ALLL.
stances can loan or lease losses be charged During the process of conducting the examina-
directly to ‘‘retained earnings’’ and capital. Any tion, the examiner should take these methods
subsequent recoveries on loans or leases previ- into account when making a final determination
ously charged off must be credited to the ALLL, on the appropriateness (adequacy) of the bal-
provided, however, that the total amount cred- ance of the ALLL. The examiner may confer
ited to the allowance as recoveries of an indi- with bank management and any outside accoun-
vidual loan (which may include amounts repre- tant or auditor that has advised management on
senting principal, interest, and fees) is limited to its ALLL-review policies or practices.
the amount previously charged off against the If the examiner concludes that the reported
ALLL on that loan. Any amounts collected in ALLL level is not appropriate or determines that
excess of this limit should be recognized as the ALLL evaluation process is based on the
income. results of an unreliable loan review system or is
To illustrate these concepts, assume that Bank otherwise deficient, recommendations for cor-
A has a loan and lease portfolio totaling recting these deficiencies, including any exam-
$100 million at the end of year 1 and an ALLL iner concerns regarding an appropriate level for
of $1.25 million; thus, its net carrying amount the ALLL, should be noted in the report of
for the loan portfolio on the balance sheet is examination. The examiner’s comments should
$98.75 million. Based on its most recent analy- cite any departures from generally accepted
sis, Bank A has determined that an ALLL of accounting principles (GAAP) and any contra-
$1.5 million is necessary to cover its estimated ventions of the following 2006 Interagency

Page 1
2070.1 Allowance for Loan and Lease Losses
Policy Statement on the Allowance for Loan and agencies and the SEC agreed on the following
Lease Losses as well as the 2001 policy state- important aspects of loan loss allowance
ment (see section 2072.1). Additional supervi- practices:
sory action may also be taken based on the
magnitude of the observed shortcomings in the • Arriving at an appropriate allowance involves
ALLL process, including the materiality of any a high degree of management judgment and
error in the reported amount of the ALLL. results in a range of estimated losses.
• Prudent, conservative—but not excessive—
loan loss allowances that fall within an accept-
INTERAGENCY POLICY able range of estimated losses are appropriate.
STATEMENT ON THE In accordance with GAAP, an institution
should record its best estimate within the
ALLOWANCE FOR LOAN AND range of credit losses, including when man-
LEASE LOSSES agement’s best estimate is at the high end of
the range.
This 2006 policy statement1 revises and replaces • Determining the allowance for loan losses is
the 1993 policy statement on the ALLL. It inevitably imprecise, and an appropriate
reiterates key concepts and requirements included allowance falls within a range of estimated
in generally accepted accounting principles losses.
(GAAP) and existing ALLL supervisory guid-
• An ‘‘unallocated’’ loan loss allowance is
ance.2 The principal sources of guidance on
appropriate when it reflects an estimate of
accounting for impairment in a loan portfolio
probable losses, determined in accordance
under GAAP are Statement of Financial
with GAAP, and is properly supported.
Accounting Standards No. 5, ‘‘Accounting for
• Allowance estimates should be based on a
Contingencies’’ (FAS 5), and Statement of Finan-
comprehensive, well-documented, and consis-
cial Accounting Standards No. 114, ‘‘Accounting
tently applied analysis of the loan portfolio.
by Creditors for Impairment of a Loan’’ (FAS
• The loan loss allowance should take into
114). In addition, the Financial Accounting
consideration all available information exist-
Standards Board Viewpoints article that is
ing as of the financial statement date, includ-
included in Emerging Issues Task Force Topic
ing environmental factors such as industry,
D-80 (EITF D-80), ‘‘Application of FASB State-
geographical, economic, and political factors.
ments No. 5 and No. 114 to a Loan Portfolio,’’
presents questions and answers that provide
In July 2001, the banking agencies issued the
specific guidance on the interaction between
Policy Statement on Allowance for Loan and
these two FASB statements and may be helpful
Lease Losses Methodologies and Documenta-
in applying them.
tion for Banks and Savings Institutions (2001
In July 1999, the banking agencies and the
Policy Statement). The policy statement is
Securities and Exchange Commission (SEC)
designed to assist institutions in establishing a
issued a Joint Interagency Letter to Financial
sound process for determining an appropriate
Institutions. The letter stated that the banking
ALLL and documenting that process in accor-
dance with GAAP.3 (See section 2072.1.)
1. This policy statement was adopted on December 13, In March 2004, the agencies also issued the
2006, by, and applies to, all depository institutions (institu- Update on Accounting for Loan and Lease
tions), except U.S. branches and agencies of foreign banks,
that are supervised by the Board of Governors of the Federal
Losses. This guidance provided reminders of
Reserve System, the Office of the Comptroller of the Cur- longstanding supervisory guidance as well as a
rency, the Federal Deposit Insurance Corporation, the Office listing of the existing allowance guidance that
of Thrift Supervision (the banking agencies) and to institu- institutions should continue to apply.
tions insured and supervised by the National Credit Union
Administration (NCUA) (collectively, the agencies). U.S.
branches and agencies of foreign banks continue to be subject
to any separate guidance that has been issued by their primary 3. See section 2072.1 for the 2001 Policy Statement. The
supervisory agency. SEC staff issued parallel guidance in July 2001, which is
2. As discussed more fully below in the ‘‘Nature and found in Staff Accounting Bulletin No. 102, ‘‘Selected Loan
Purpose of the ALLL’’ section, this policy statement and the Loss Allowance Methodology and Documentation Issues’’
ALLL generally do not address loans carried at fair value or (SAB 102), which has been codified as Topic 6.L. in the
loans held for sale. In addition, this policy statement provides SEC’s Codification of Staff Accounting Bulletins. Both SAB
only limited guidance on ‘‘purchased impaired loans.’’ 102 and the codification are available on the SEC’s web site.

Page 2
Allowance for Loan and Lease Losses 2070.1
Nature and Purpose of the ALLL facts and circumstances since the evaluation
date. Thus, estimated credit losses represent net
The ALLL represents one of the most significant charge-offs that are likely to be realized for a
estimates in an institution’s financial statements loan or group of loans. These estimated credit
and regulatory reports. Because of its signifi- losses should meet the criteria for accrual of a
cance, each institution has a responsibility for loss contingency (that is, through a provision to
developing, maintaining, and documenting a the ALLL) set forth in GAAP.7 When available
comprehensive, systematic, and consistently information confirms that specific loans, or por-
applied process for determining the amounts of tions thereof, are uncollectible, these amounts
the ALLL and the provision for loan and lease should be promptly charged off against the
losses (PLLL). To fulfill this responsibility, each ALLL. For ‘‘purchased impaired loans,’’8 GAAP
institution should ensure controls are in place to prohibits ‘‘carrying over’’ or creating an ALLL
consistently determine the ALLL in accordance in the initial recording of these loans. However,
with GAAP, the institution’s stated policies and if, upon evaluation subsequent to acquisition, it
procedures, management’s best judgment, and is probable that the institution will be unable to
relevant supervisory guidance. As of the end of collect all cash flows expected at acquisition on
each quarter, or more frequently if warranted, a purchased impaired loan (an estimate that
each institution must analyze the collectibility of considers both timing and amount), the loan
its loans and leases held for investment4 (here- should be considered impaired for purposes of
after referred to as ‘‘loans’’) and maintain an applying the measurement and other provisions
ALLL at a level that is appropriate and deter- of FAS 5 or, if applicable, FAS 114.
mined in accordance with GAAP. An appropri- Estimates of credit losses should reflect con-
ate ALLL covers estimated credit losses on sideration of all significant factors that affect the
individually evaluated loans that are determined collectibility of the portfolio as of the evaluation
to be impaired as well as estimated credit losses date. For loans within the scope of FAS 114 that
inherent in the remainder of the loan and lease
portfolio. The ALLL does not apply, however, 7. FAS 5 requires the accrual of a loss contingency when
to loans carried at fair value, loans held for sale,5 information available prior to the issuance of the financial
statements indicates it is probable that an asset has been
off-balance-sheet credit exposures6 (for example, impaired at the date of the financial statements and the amount
financial instruments such as off-balance-sheet of loss can be reasonably estimated. These conditions may be
loan commitments, standby letters of credit, and considered in relation to individual loans or in relation to
guarantees), or general or unspecified business groups of similar types of loans. If the conditions are met,
accrual should be made even though the particular loans that
risks. are uncollectible may not be identifiable. Under FAS 114, an
For purposes of this policy statement, the individual loan is impaired when, based on current informa-
term estimated credit losses means an estimate tion and events, it is probable that a creditor will be unable to
of the current amount of loans that it is probable collect all amounts due according to the contractual terms of
the loan agreement. It is implicit in these conditions that it
the institution will be unable to collect given must be probable that one or more future events will occur
confirming the fact of the loss. Thus, under GAAP, the
4. Consistent with the American Institute of Certified purpose of the ALLL is not to absorb all of the risk in the loan
Public Accountants’ (AICPA) Statement of Position 01-6, portfolio, but to cover probable credit losses that have already
‘‘Accounting by Certain Entities (Including Entities With been incurred.
Trade Receivables) That Lend to or Finance the Activities of 8. A purchased impaired loan is defined as a loan that an
Others,’’ loans and leases held for investment are those loans institution has purchased, including a loan acquired in a
and leases that the institution has the intent and ability to hold purchase business combination, that has evidence of deterio-
for the foreseeable future or until maturity or payoff. ration of credit quality since its origination and for which it is
5. See ‘‘Interagency Guidance on Certain Loans Held for probable, at the purchase date, that the institution will be
Sale’’ (March 26, 2001) for the appropriate accounting and unable to collect all contractually required payments. When
reporting treatment for certain loans that are sold directly from reviewing the appropriateness of the reported ALLL of an
the loan portfolio or transferred to a held-for-sale account. institution with purchased impaired loans, examiners should
Loans held for sale are reported at the lower of cost or fair consider the credit losses factored into the initial investment in
value. Declines in value occurring after the transfer of a loan these loans when determining whether further deterioration—
to the held-for-sale portfolio are accounted for as adjustments for example, decreases in cash flows expected to be collected—
to a valuation allowance for held-for-sale loans and not as has occurred since the loans were purchased. The bank’s
adjustments to the ALLL. consolidated reports of condition and income and the disclo-
6. Credit losses on off-balance-sheet credit exposures should sures in the bank’s financial statements may provide useful
be estimated in accordance with FAS 5. Any allowance for information for examiners in reviewing these loans. Refer to
credit losses on off-balance-sheet exposures should be reported the AICPA’s Statement of Position 03-3, ‘‘Accounting for
on the balance sheet as an ‘‘other liability,’’ and not as part of Certain Loans or Debt Securities Acquired in a Transfer,’’ for
the ALLL. further guidance on the appropriate accounting.

Page 3
are individually evaluated and determined to be loans. When estimating credit losses on each
impaired,9 these estimates should reflect con- group of loans with similar risk characteristics,
sideration of one of the standard’s three impair- an institution should consider its historical loss
ment measurement methods as of the evaluation experience on the group, adjusted for changes in
date: (1) the present value of expected future trends, conditions, and other relevant factors
cash flows discounted at the loan’s effective that affect repayment of the loans as of the
interest rate,10 (2) the loan’s observable market evaluation date.
price, or (3) the fair value of the collateral if the For analytical purposes, an institution should
loan is collateral dependent. attribute portions of the ALLL to loans that it
An institution may choose the appropriate evaluates and determines to be impaired under
FAS 114 measurement method on a loan-by- FAS 114 and to groups of loans that it evaluates
loan basis for an individually impaired loan, collectively under FAS 5. However, the ALLL is
except for an impaired collateral-dependent loan. available to cover all charge-offs that arise from
The agencies require impairment of a collateral- the loan portfolio.
dependent loan to be measured using the fair
value of collateral method. As defined in FAS
114, a loan is collateral dependent if repayment
of the loan is expected to be provided solely by Responsibilities of the Board of
the underlying collateral. In general, any portion Directors and Management
of the recorded investment in a collateral-
dependent loan (including any capitalized accrued Appropriate ALLL Level
interest, net deferred loan fees or costs, and
unamortized premium or discount) in excess of Each institution’s management is responsible
the fair value of the collateral that can be for maintaining the ALLL at an appropriate
identified as uncollectible, and is therefore level and for documenting its analysis according
deemed a confirmed loss, should be promptly to the standards set forth in the 2001 policy
charged off against the ALLL.11 statement. Thus, management should evaluate
All other loans, including individually evalu- the ALLL reported on the balance sheet as of the
ated loans determined not to be impaired under end of each quarter or more frequently if war-
FAS 114, should be included in a group of loans ranted, and charge or credit the PLLL to bring
that is evaluated for impairment under FAS 5.12 the ALLL to an appropriate level as of each
While an institution may segment its loan port- evaluation date. The determination of the
folio into groups of loans based on a variety of amounts of the ALLL and the PLLL should be
factors, the loans within each group should have based on management’s current judgments about
similar risk characteristics. For example, a loan the credit quality of the loan portfolio, and
that is fully collateralized with risk-free assets should consider all known relevant internal and
should not be grouped with uncollateralized external factors that affect loan collectibility as
of the evaluation date. Management’s evalua-
9. FAS 114 does not specify how an institution should tion is subject to review by examiners. An
identify loans that are to be evaluated for collectibility nor institution’s failure to analyze the collectibility
does it specify how an institution should determine that a loan of the loan portfolio and maintain and support
is impaired. An institution should apply its normal loan review
procedures in making those judgments. Refer to the ALLL
an appropriate ALLL in accordance with GAAP
interpretations for further guidance. and supervisory guidance is generally an unsafe
10. The ‘‘effective interest rate’’ on a loan is the rate of and unsound practice.
return implicit in the loan (that is, the contractual interest rate
adjusted for any net deferred loan fees or costs and any
In carrying out its responsibility for maintain-
premium or discount existing at the origination or acquisition ing an appropriate ALLL, management is
of the loan). expected to adopt and adhere to written policies
11. For further information, refer to the illustration in and procedures that are appropriate to the size of
Appendix B of the 2001 Policy Statement (the appendix in
section 2072.1).
the institution and the nature, scope, and risk of
12. An individually evaluated loan that is determined not to its lending activities. At a minimum, these
be impaired under FAS 114 should be evaluated under FAS 5 policies and procedures should ensure that—
when specific characteristics of the loan indicate that it is
probable there would be estimated credit losses in a group of
loans with those characteristics. For further guidance, refer to
• the institution’s process for determining an
the frequently asked questions (FAQs) that were distributed appropriate level for the ALLL is based on a
with this policy statement. comprehensive, well-documented, and consis-

Page 4
tently applied analysis of its loan portfolio.13 is independent of these processes could be the
The analysis should consider all significant internal audit staff, a risk management unit of
factors that affect the collectibility of the the institution, an external auditor (subject to
portfolio and should support the credit losses applicable auditor independence standards),
estimated by this process. or another contracted third party from outside
• the institution has an effective loan review the institution. One party need not perform the
system and controls (including an effective entire analysis as the validation can be divided
loan classification or credit grading system) among various independent parties.
that identify, monitor, and address asset qual-
ity problems in an accurate and timely man- The board of directors is responsible for over-
ner.14 To be effective, the institution’s loan seeing management’s significant judgments and
review system and controls must be estimates pertaining to the determination of an
responsive to changes in internal and external appropriate ALLL. This oversight should include
factors affecting the level of credit risk in the but is not limited to—
portfolio.
• the institution has adequate data capture and • reviewing and approving the institution’s writ-
reporting systems to supply the information ten ALLL policies and procedures at least
necessary to support and document its esti- annually;
mate of an appropriate ALLL. • reviewing management’s assessment and jus-
• the institution evaluates any loss estimation tification that the loan review system is sound
models before they are employed and modi- and appropriate for the size and complexity of
fies the models’ assumptions, as needed, to the institution;
ensure that the resulting loss estimates are • reviewing management’s assessment and jus-
consistent with GAAP. To demonstrate this tification for the amounts estimated and
consistency, the institution should document reported each period for the PLLL and the
its evaluations and conclusions regarding the ALLL; and
appropriateness of estimating credit losses • requiring management to periodically validate
with the models or other estimation tools. The and, when appropriate, revise the ALLL
institution should also document and support methodology.
any adjustments made to the models or to the
output of the models in determining the esti- For purposes of the Consolidated Reports of
mated credit losses. Condition and Income for a Bank (Call Report),
• the institution promptly charges off loans, or an appropriate ALLL (after deducting all loans
portions of loans, that available information and portions of loans confirmed loss) should
confirms to be uncollectible. consist only of the following components (as
• the institution periodically validates the ALLL applicable),15 the amounts of which take into
methodology. This validation process should account all relevant facts and circumstances as
include procedures for a review, by a party of the evaluation date:
who is independent of the institution’s credit
approval and ALLL estimation processes, of • For loans within the scope of FAS 114 that are
the ALLL methodology and its application in individually evaluated and found to be
order to confirm its effectiveness. A party who impaired, the associated ALLL should be
based upon one of the three impairment mea-
13. As noted in the 2001 Policy Statement, an institution surement methods specified in FAS 114.16
with less complex lending activities and products may find it
more efficient to combine a number of procedures while
• For all other loans, including individually
continuing to ensure that the institution has a consistent and evaluated loans determined not to be impaired
appropriate ALLL methodology. Thus, much of the support- under FAS 114,17 the associated ALLL should
ing documentation required for an institution with more
complex products or portfolios may be combined into fewer
supporting documents in an institution with less complex 15. A component of the ALLL that is labeled ‘‘unallo-
products or portfolios. cated’’ is appropriate when it reflects estimated credit losses
14. Loan review and loan classification or credit grading determined in accordance with GAAP and is properly sup-
systems are discussed in attachment 1 of this policy statement. ported and documented.
In addition, state member banks should refer to the asset 16. As previously noted, the use of the fair value of
quality standards in the Interagency Guidelines Establishing collateral method is required for an individually evaluated
Standards for Safety and Soundness, which were adopted by loan that is impaired if the loan is collateral dependent.
the Federal Reserve Board (see Appendix D-1, 12 CFR 208). 17. See footnote 12.

Page 5
be measured under FAS 5 and should provide particular, for banks with cross-border lending
for all estimated credit losses that have been exposure, management should determine that
incurred on groups of loans with similar risk the ALLL is appropriate to cover estimated
characteristics. losses from transfer risk associated with this
• For estimated credit losses from transfer risk exposure over and above any minimum amount
on cross-border loans, the impact to the ALLL that the Interagency Country Exposure Review
should be evaluated individually for impaired Committee requires to be provided in the Allo-
loans under FAS 114 or evaluated on a group cated Transfer Risk Reserve (or charged off
basis under FAS 5. See. . .this policy against the ALLL). These estimated losses
statement’s. . .attachment 2 for further guid- should meet the criteria for accrual of a loss
ance on considerations of transfer risk on contingency set forth in GAAP. (See attachment
cross-border loans. 2 for factors to consider.)
• For estimated credit losses on accrued interest
and fees on loans that have been reported as
part of the respective loan balances on the Factors to Consider in the Estimation of
institution’s balance sheet, the associated Credit Losses
ALLL should be evaluated under FAS 114 or
FAS 5 as appropriate, if not already included Estimated credit losses should reflect consider-
in one of the preceding components. ation of all significant factors that affect the
collectibility of the portfolio as of the evaluation
Because deposit accounts that are overdrawn date. Normally, an institution should determine
(that is, overdrafts) must be reclassified as loans the historical loss rate for each group of loans
on the balance sheet, overdrawn accounts should with similar risk characteristics in its portfolio
be included in one of the first two components based on its own loss experience for loans in
above, as appropriate, and evaluated for esti- that group. While historical loss experience
mated credit losses. provides a reasonable starting point for the
Determining the appropriate level for the institution’s analysis, historical losses—or even
ALLL is inevitably imprecise and requires a recent trends in losses—do not by themselves
high degree of management judgment. Manage- form a sufficient basis to determine the appro-
ment’s analysis should reflect a prudent, conser- priate level for the ALLL. Management also
vative, but not excessive ALLL that falls within should consider those qualitative or environmen-
an acceptable range of estimated credit losses. tal factors that are likely to cause estimated
When a range of losses is determined, institu- credit losses associated with the institution’s
tions should maintain appropriate documenta- existing portfolio to differ from historical loss
tion to support the identified range and the experience, including but not limited to—
rationale used for determining the best estimate
from within the range of loan losses. • changes in lending policies and procedures,
As discussed more fully in attachment 1 of including changes in underwriting standards
this policy statement, it is essential that institu- and collection, charge-off, and recovery prac-
tions maintain effective loan review systems. An tices not considered elsewhere in estimating
effective loan review system should work to credit losses;
ensure the accuracy of internal credit classifica- • changes in international, national, regional,
tion or grading systems and, thus, the quality of and local economic and business conditions
the information used to assess the appropriate- and developments that affect the collectibility
ness of the ALLL. The complexity and scope of of the portfolio, including the condition of
an institution’s ALLL evaluation process, loan various market segments;18
review system, and other relevant controls should • changes in the nature and volume of the
be appropriate for the size of the institution and portfolio and in the terms of loans;
the nature of its lending activities. The evalua- • changes in the experience, ability, and depth
tion process should also provide for sufficient
flexibility to respond to changes in the factors
that affect the collectibility of the portfolio. 18. Credit loss and recovery experience may vary signifi-
cantly depending upon the stage of the business cycle. For
Credit losses that arise from the transfer risk example, an over reliance on credit loss experience during a
associated with an institution’s cross-border lend- period of economic growth will not result in realistic estimates
ing activities require special consideration. In of credit losses during a period of economic downturn.

Page 6
of lending management and other relevant nation of the range of, an institution’s annual net
staff; charge-off experience to more complex tech-
• changes in the volume and severity of past due niques, such as migration analysis and models
loans, the volume of nonaccrual loans, and the that estimate credit losses.20 Generally, institu-
volume and severity of adversely classified or tions should use at least an ‘‘annualized’’ or
graded loans;19 twelve-month average net charge-off rate that
• changes in the quality of the institution’s loan will be applied to the groups of loans when
review system; estimating credit losses. However, this rate could
• changes in the value of underlying collateral vary. For example, loans with effective lives
for collateral-dependent loans; longer than twelve months often have workout
• the existence and effect of any concentrations periods over an extended period of time, which
of credit, and changes in the level of such may indicate that the estimated credit losses
concentrations; and should be greater than that calculated based
• the effect of other external factors such as solely on the annualized net charge-off rate for
competition and legal and regulatory require- such loans. These groups may include certain
ments on the level of estimated credit losses in commercial loans as well as groups of adversely
the institution’s existing portfolio. classified loans. Other groups of loans may have
effective lives shorter than twelve months, which
In addition, changes in the level of the ALLL may indicate that the estimated credit losses
should be directionally consistent with changes should be less than that calculated based on the
in the factors, taken as a whole, that evidence annualized net charge-off rate.
credit losses, keeping in mind the characteristics Regardless of the method used, institutions
of an institution’s loan portfolio. For example, if should maintain supporting documentation for
declining credit quality trends relevant to the the techniques used to develop the historical loss
types of loans in an institution’s portfolio are rate for each group of loans. If a range of
evident, the ALLL level as a percentage of the historical loss rates is developed instead for a
portfolio should generally increase, barring group of loans, institutions should maintain
unusual charge-off activity. Similarly, if improv- documentation to support the identified range
ing credit quality trends are evident, the ALLL and the rationale for determining which rate is
level as a percentage of the portfolio should the best estimate within the range of loss rates.
generally decrease. The rationale should be based on management’s
assessment of which rate is most reflective of
the estimated credit losses in the current loan
Measurement of Estimated Credit Losses portfolio.
After determining the appropriate historical
FAS 5. When measuring estimated credit losses loss rate for each group of loans with similar
on groups of loans with similar risk character- risk characteristics, management should
istics in accordance with FAS 5, a widely used consider those current qualitative or
method is based on each group’s historical net
charge-off rate adjusted for the effects of the 20. Annual charge-off rates are calculated over a specified
time period (for example, three years or five years), which can
qualitative or environmental factors discussed vary based on a number of factors including the relevance of
previously. As the first step in applying this past periods’ experience to the current period or point in the
method, management generally bases the histori- credit cycle. Also, some institutions remove loans that become
cal net charge-off rates on the ‘‘annualized’’ adversely classified or graded from a group of nonclassified or
nongraded loans with similar risk characteristics in order to
historical gross loan charge-offs, less recoveries, evaluate the removed loans individually under FAS 114 (if
recorded by the institution on loans in each deemed impaired) or collectively in a group of adversely
group. classified or graded loans with similar risk characteristics
Methodologies for determining the historical under FAS 5. In this situation, the net charge-off experience
on the adversely classified or graded loans that have been
net charge-off rate on a group of loans with removed from the group of nonclassified or nongraded loans
similar risk characteristics under FAS 5 can should be included in the historical loss rates for that group of
range from the simple average of, or a determi- loans. Even though the net charge-off experience on adversely
classified or graded loans is included in the estimation of the
historical loss rates that will be applied to the group of
19. For banks, adversely classified or graded loans are nonclassified or nongraded loans, the adversely classified or
loans rated ‘‘Substandard’’ (or its equivalent) or worse under graded loans themselves are no longer included in that group
its loan classification system. for purposes of estimating credit losses on the group.

Page 7
environmental factors that are likely to cause graphic area, economic reports and data, and
estimated credit losses as of the evaluation date notes from discussions with borrowers.
to differ from the group’s historical loss experi- There may be times when an institution does
ence. Institutions typically reflect the overall not have its own historical loss experience upon
effect of these factors on a loan group as an which to base its estimate of the credit losses in
adjustment that, as appropriate, increases or a group of loans with similar risk characteristics.
decreases the historical loss rate applied to the This may occur when an institution offers a new
loan group. Alternatively, the effect of these loan product or when it is a newly established
factors may be reflected through separate (that is, de novo) institution. If an institution has
standalone adjustments within the FAS 5 no experience of its own for a loan group,
component of the ALLL.21 Both methods are reference to the experience of other enterprises
consistent with GAAP, provided the adjust- in the same lending business may be appropri-
ments for qualitative or environmental factors ate, provided the institution demonstrates that
are reasonably and consistently determined, are the attributes of the group of loans in its port-
adequately documented, and represent estimated folio are similar to those of the loan group in the
credit losses. For each group of loans, an portfolio providing the loss experience. An insti-
institution should apply its adjusted historical tution should only use another enterprise’s expe-
loss rate, or its historical loss rate and separate rience on a short-term basis until it has devel-
standalone adjustments, to the recorded invest- oped its own loss experience for a particular
ment in the group when determining its group of loans.
estimated credit losses.
Management must exercise significant judg- FAS 114. When determining the FAS 114 com-
ment when evaluating the effect of qualitative ponent of the ALLL for an individually impaired
factors on the amount of the ALLL because data loan,22 an institution should consider estimated
may not be reasonably available or directly costs to sell the loan’s collateral, if any, on a
applicable for management to determine the discounted basis, in the measurement of impair-
precise impact of a factor on the collectibility of ment if those costs are expected to reduce the
the institution’s loan portfolio as of the evalua- cash flows available to repay or otherwise sat-
tion date. Accordingly, institutions should sup- isfy the loan. If the institution bases its measure
port adjustments to historical loss rates and of loan impairment on the present value of
explain how the adjustments reflect current infor- expected future cash flows discounted at the
mation, events, circumstances, and conditions in loan’s effective interest rate, the estimates of
the loss measurements. Management should these cash flows should be the institution’s best
maintain reasonable documentation to support estimate based on reasonable and supportable
which factors affected the analysis and the assumptions and projections. All available evi-
impact of those factors on the loss measurement. dence should be considered in developing the
Support and documentation includes descrip- estimate of expected future cash flows. The
tions of each factor, management’s analysis of weight given to the evidence should be com-
how each factor has changed over time, which mensurate with the extent to which the evidence
loan groups’ loss rates have been adjusted, the can be verified objectively. The likelihood of the
amount by which loss estimates have been possible outcomes should be considered in deter-
adjusted for changes in conditions, an explana- mining the best estimate of expected future cash
tion of how management estimated the impact, flows.
and other available data that supports the rea-
sonableness of the adjustments. Examples of
underlying supporting evidence could include,
but are not limited to, relevant articles from
newspapers and other publications that describe 22. As noted in FAS 114, some individually impaired loans
have risk characteristics that are unique to an individual
economic events affecting a particular geo- borrower and the institution will apply the measurement
methods on a loan-by-loan basis. However, some impaired
21. An overall adjustment to a portion of the ALLL that is loans may have risk characteristics in common with other
not attributed to specific segments of the loan portfolio is impaired loans. An institution may aggregate those loans and
often labeled ‘‘unallocated.’’ Regardless of what a component may use historical statistics, such as average recovery period
of the ALLL is labeled, it is appropriate when it reflects and average amount recovered, along with a composite
estimated credit losses determined in accordance with GAAP effective interest rate as a means of measuring impairment of
and is properly supported. those loans.

Page 8
Analyzing the Overall Measurement of the Estimated Credit Losses in Credit Related
ALLL Accounts
Institutions also are encouraged to use ratio Typically, institutions evaluate and estimate
analysis as a supplemental tool for evaluating the credit losses for off-balance-sheet credit expo-
overall reasonableness of the ALLL. Ratio sures at the same time that they estimate credit
analysis can be useful in identifying divergent losses for loans. While a similar process should
trends (compared with an institution’s peer group be followed to support loss estimates related to
and its own historical experience) in the off-balance-sheet exposures, these estimated
relationship of the ALLL to adversely classified credit losses are not recorded as part of the
or graded loans, past due and nonaccrual loans, ALLL. When the conditions for accrual of a loss
total loans, and historical gross and net charge- under FAS 5 are met, an institution should
offs. Based on such analysis, an institution may maintain and report as a separate liability
identify additional issues or factors that previ- account, an allowance that is appropriate to
ously had not been considered in the ALLL cover estimated credit losses on off-balance-
estimation process, which may warrant adjust- sheet loan commitments, standby letters of credit,
ments to estimated credit losses. Such adjust- and guarantees. In addition, recourse liability
ments should be appropriately supported and accounts (that arise from recourse obligations on
documented. any transfers of loans that are reported as sales
While ratio analysis, when used prudently, can in accordance with GAAP) should be reported
be helpful as a supplemental check on the in regulatory reports as liabilities that are sepa-
reasonableness of management’s assumptions rate and distinct from both the ALLL and the
and analyses, it is not a sufficient basis for allowance for credit losses on off-balance-sheet
determining the appropriate amount for the credit exposures.
ALLL. In particular, because an appropriate When accrued interest and fees are reported
ALLL is an institution-specific amount, such separately on an institution’s balance sheet from
comparisons do not obviate the need for a the related loan balances (that is, as other
comprehensive analysis of the loan portfolio and assets), the institution should maintain an appro-
the factors affecting its collectibility. Further- priate valuation allowance, determined in accor-
more, it is inappropriate for the board of directors dance with GAAP, for amounts that are not
or management to make adjustments to the likely to be collected unless management has
ALLL when it has been properly computed and placed the underlying loans in nonaccrual status
supported under the institution’s methodology and reversed previously accrued interest and
for the sole purpose of reporting an ALLL that fees.24
corresponds to the peer group median, a target
ratio, or a budgeted amount. Institutions that have
high levels of risk in the loan portfolio or are Responsibilities of Examiners
uncertain about the effect of possible future
events on the collectibility of the portfolio should Examiners should assess the credit quality of an
address these concerns by maintaining higher institution’s loan portfolio, the appropriateness
equity capital and not by arbitrarily increasing of its ALLL methodology and documentation,
the ALLL in excess of amounts supported under and the appropriateness of the reported ALLL in
GAAP.23 the institution’s regulatory reports. In their
review and classification or grading of the loan
23. It is inappropriate to use a ‘‘standard percentage’’ as the portfolio, examiners should consider all signifi-
sole determinant for the amount to be reported as the ALLL on cant factors that affect the collectibility of the
the balance sheet. Moreover, an institution should not simply portfolio, including the value of any collateral.
default to a peer ratio or a ‘‘standard percentage’’ after
determining an appropriate level of ALLL under its method- In reviewing the appropriateness of the ALLL,
ology. However, there may be circumstances when an insti- examiners should do the following:
tution’s ALLL methodology and credit risk identification
systems are not reliable. Absent reliable data of its own, • Consider the effectiveness of board oversight
management may seek data that could be used as a short-term
proxy for the unavailable information (for example, an indus-
try average loss rate for loans with similar risk characteris- within its loan portfolio.
tics). This is only appropriate as a short-term remedy until the 24. See the Call Report instructions for further guidance on
institution creates a viable system for estimating credit losses placing a loan in nonaccrual status.

Page 9
as well as the quality of the institution’s loan collectibility of loans at the institution and its
review system and management in identify- current environment.
ing, monitoring, and addressing asset quality • Review the ALLL amount reported in the
problems. This will include a review of the institution’s regulatory reports and financial
institution’s loan review function and credit statements and ensure these amounts reconcile
grading system. Typically, this will involve to its ALLL analyses. There should be no
testing a sample of the institution’s loans. The material differences between the consolidated
sample size generally varies and will depend loss estimate, as determined by the ALLL
on the nature or purpose of the examination.25 methodology, and the final ALLL balance
• Evaluate the institution’s ALLL policies and reported in the financial statements. Inquire
procedures and assess the methodology that about reasons for any material differences
management uses to arrive at an overall esti- between the results of the institution’s ALLL
mate of the ALLL, including whether man- analyses and the institution’s reported ALLL
agement’s assumptions, valuations, and judg- to determine whether the differences can be
ments appear reasonable and are properly satisfactorily explained.
supported. If a range of credit losses has been • Review the adequacy of the documentation
estimated by management, evaluate the rea- and controls maintained by management to
sonableness of the range and management’s support the appropriateness of the ALLL.
best estimate within the range. In making • Review the interest and fee income accounts
these evaluations, examiners should ensure associated with the lending process to ensure
that the institution’s historical loss experience that the institution’s net income is not mate-
and all significant qualitative or environmen- rially misstated.26
tal factors that affect the collectibility of the
portfolio (including changes in the quality of As noted in the ‘‘Responsibilities of the
the institution’s loan review function and the Board of Directors and Management’’ section of
other factors previously discussed) have been this policy statement, when assessing the appro-
appropriately considered and that manage- priateness of the ALLL, it is important to
ment has appropriately applied GAAP, includ- recognize that the related process, methodology,
ing FAS 114 and FAS 5. and underlying assumptions require a substan-
• Review management’s use of loss estimation tial degree of management judgment. Even when
models or other loss estimation tools to ensure an institution maintains sound loan administra-
that the resulting estimated credit losses are in tion and collection procedures and an effective
conformity with GAAP. loan review system and controls, its estimate of
• Review the appropriateness and reasonable- credit losses is not a single precise amount due
ness of the overall level of the ALLL. In to the wide range of qualitative or environmen-
some instances this may include a quantita- tal factors that must be considered.
tive analysis (for example, using the types of An institution’s ability to estimate credit losses
ratio analysis previously discussed) as a pre- on specific loans and groups of loans should
liminary check on the reasonableness of the improve over time as substantive information
ALLL. This quantitative analysis should accumulates regarding the factors affecting
demonstrate whether changes in the key repayment prospects. Therefore, examiners
ratios from prior periods are reasonable should generally accept management’s esti-
based on the examiner’s knowledge of the mates when assessing the appropriateness of the
institution’s reported ALLL, and not seek adjust-
25. In an examiner’s review of an institution’s loan review
ments to the ALLL, when management has—
system, the examiner’s loan classifications or credit grades
may differ from those of the institution’s loan review system. • maintained effective loan review systems and
If the examiner’s evaluation of these differences indicates controls for identifying, monitoring, and
problems with the loan review system, especially when the
loan classification or credit grades assigned by the institution
are more liberal than those assigned by the examiner, the 26. As noted previously, accrued interest and fees on loans
institution would be expected to make appropriate adjust- that have been reported as part of the respective loan balances
ments to the assignment of its loan classifications or credit on the institution’s balance sheet should be evaluated for
grades to the loan portfolio and to its estimated credit losses. estimated credit losses. The accrual of the interest and fee
Furthermore, the institution would be expected to improve its income should also be considered. Refer to GAAP and the
loan review system. (This policy statement’s attachment 1 Call Report instructions for further guidance on income
discusses effective loan review systems.) recognition.

Page 10
addressing asset quality problems in a timely Attachment 1 to Policy

manner; Statement—Loan Review Systems
• analyzed all significant qualitative or environ-
mental factors that affect the collectibility of The nature of loan review systems may vary
the portfolio as of the evaluation date in a based on an institution’s size, complexity, loan
reasonable manner; types, and management practices.27 For example,
• established an acceptable ALLL evaluation a loan review system may include components
process for both individual loans and groups of a traditional loan review function that is
of loans that meets the GAAP requirements independent of the lending function, or it may
for an appropriate ALLL; and place some reliance on loan officers. In addition,
• incorporated reasonable and properly sup- the use of the term ‘‘loan review system’’ can
ported assumptions, valuations, and judg- refer to various responsibilities assigned to credit
ments into the evaluation process. administration, loan administration, a problem
loan workout group, or other areas of an insti-
If the examiner concludes that the reported tution. These responsibilities may range from
ALLL level is not appropriate or determines that administering the internal problem loan report-
the ALLL evaluation process is based on the ing process to maintaining the integrity of the
results of an unreliable loan review system or is loan classification or credit grading process (for
otherwise deficient, recommendations for cor- example, ensuring that timely and appropriate
recting these deficiencies, including any exam- changes are made to the loan classifications or
iner concerns regarding an appropriate level for credit grades assigned to loans) and coordinat-
the ALLL, should be noted in the report of ing the gathering of the information necessary to
examination. The examiner’s comments should assess the appropriateness of the ALLL. Addi-
cite any departures from GAAP and any contra- tionally, some or all of this function may be
ventions of this policy statement and the 2001 outsourced to a qualified external loan reviewer.
policy statement, as applicable. Additional super- Regardless of the structure of the loan review
visory action may also be taken based on the system in an institution, an effective loan review
magnitude of the observed shortcomings in the system should have, at a minimum, the follow-
ALLL process, including the materiality of any ing objectives:
error in the reported amount of the ALLL.
• to promptly identify loans with potential credit
weaknesses;
ALLL Level Reflected in Regulatory • appropriately grade or adversely classify loans,
Reports especially those with well-defined credit weak-
nesses that jeopardize repayment, so that
The agencies believe that an ALLL established timely action can be taken and credit losses
in accordance with this policy statement and the can be minimized;
2001 policy statement, as applicable, falls within • identify relevant trends that affect the collect-
the range of acceptable estimates determined in ibility of the portfolio and isolate segments of
accordance with GAAP. When the reported the portfolio that are potential problem areas;
amount of an institution’s ALLL is not appro- • assess the adequacy of and adherence to
priate, the institution will be required to adjust
27. The loan review function is not intended to be per-
its ALLL by an amount sufficient to bring the formed by an institution’s internal audit function. However, as
ALLL reported on its Call Report to an appro- discussed in the banking agencies’ March 2003 Interagency
priate level as of the evaluation date. This Policy Statement on the Internal Audit Function and Its
adjustment should be reflected in the current Outsourcing, some institutions seek to coordinate the internal
audit function with several risk monitoring functions such as
period provision or through the restatement of loan review. The policy statement notes that coordination of
prior period provisions, as appropriate in the loan review with the internal audit function can facilitate the
circumstances. reporting of material risk and control issues to the audit
committee, increase the overall effectiveness of these moni-
toring functions, better utilize available resources, and enhance
the institution’s ability to comprehensively manage risk.
However, the internal audit function should maintain the
ability to independently audit other risk monitoring functions,
including loan review, without impairing its independence
with respect to these other functions.

Page 11
internal credit policies and loan administra- system in which loan classifications or credit
tion procedures and to monitor compliance grades reflect the risk of default and credit
with relevant laws and regulations; losses and for which a written description is
• evaluate the activities of lending personnel maintained, including a discussion of the fac-
including their compliance with lending poli- tors used to assign appropriate classifications
cies and the quality of their loan approval, or credit grades to loans;28
monitoring, and risk assessment; • an identification or grouping of loans that
• provide senior management and the board of warrant the special attention of management29
directors with an objective and timely assess- or other designated ‘‘watch lists’’ of loans that
ment of the overall quality of the loan portfo- management is more closely monitoring;
lio; and • documentation supporting the reasons why
• provide management with accurate and timely particular loans merit special attention or
credit quality information for financial and received a specific adverse classification or
regulatory reporting purposes, including the credit grade and management’s adherence to
determination of an appropriate ALLL. approved workout plans;
• a mechanism for direct, periodic, and timely
reporting to senior management and the board
Loan Classification or Credit-Grading of directors on the status of loans identified as
Systems meriting special attention or adversely classi-
fied or graded and the actions taken by man-
The foundation for any loan review system is agement; and
accurate and timely loan classification or credit • appropriate documentation of the institution’s
grading, which involves an assessment of credit historical loss experience for each of the
quality and leads to the identification of problem groups of loans with similar risk characteris-
loans. An effective loan classification or credit tics into which it has segmented its loan
grading system provides important information portfolio.30
on the collectibility of the portfolio for use in the
determination of an appropriate level for the
ALLL. Elements of Loan Reviews
Regardless of the type of loan review system
employed, an effective loan classification or Each institution should have a written policy
credit grading framework generally places pri- that is reviewed and approved at least annually
mary reliance on the institution’s lending staff to by the board of directors to evidence its support
identify emerging loan problems. However, of and commitment to maintaining an effective
given the importance and subjective nature of loan review system. The loan review policy
loan classification or credit grading, the judg- should address the following elements that are
ment of an institution’s lending staff regarding described in more detail below: the qualifica-
the assignment of particular classification or tions and independence of loan review person-
grades to loans should be subject to review by:
(1) peers, superiors, or loan committee(s); (2) an 28. A bank may have a loan classification or credit grading
system that differs from the framework used by the banking
independent, qualified part-time or full-time agencies. However, each institution that maintains a loan
employee(s); (3) an internal department staffed classification or credit grading system that differs from the
with credit review specialists; or (4) qualified banking agencies’ framework should maintain documentation
outside credit review consultants. A loan classi- that translates its system into the framework used by the
banking agencies. This documentation should be sufficient to
fication or credit grading review that is indepen- enable examiners to reconcile the totals for the various loan
dent of the lending function is preferred because classifications or credit grades under the institution’s system
it typically provides a more objective assess- to the banking agencies’ categories.
ment of credit quality. Because accurate and 29. For banks, loans that have potential weaknesses that
deserve management’s close attention are designated ‘‘special
timely loan classification or credit grading is a mention’’ loans.
critical component of an effective loan review 30. In particular, institutions with large and complex loan
system, each institution should ensure that its portfolios are encouraged to maintain records of their histori-
loan review system includes the following cal loss experience for credits in each of the categories in their
loan classification or credit grading framework. For banks,
attributes: these categories should either be those used by, or should be
categories that can be translated into those used by, the
• a formal loan classification or credit grading banking agencies.

Page 12
nel; the frequency, scope, and depth of reviews; institution personnel who are independent of the
the review of findings and follow-up; and work- lending function should assess control risks,
paper and report distribution. develop the credit review plan, and ensure
appropriate follow-up of findings. Furthermore,
Qualifications of loan review personnel. Persons the institution should be mindful of special
involved in the loan review or credit grading requirements concerning independence should it
function should be qualified based on their level consider outsourcing the credit review function
of education, experience, and extent of formal to its external auditor.
credit training. They should be knowledgeable
in both sound lending practices and the Frequency of reviews. Loan review personnel
institution’s lending guidelines for the types of should review significant credits31 at least annu-
loans offered by the institution. In addition, they ally, upon renewal, or more frequently when
should be knowledgeable of relevant laws and internal or external factors indicate a potential
regulations affecting lending activities. for deteriorating credit quality in a particular
loan, loan product, or group of loans. Optimally,
Independence of loan review personnel. An the loan review function can be used to provide
effective loan review system uses both the ini- useful continual feedback on the effectiveness
tial identification of emerging problem loans by of the lending process in order to identify any
loan officers and other line staff, and the credit emerging problems. A system of ongoing or
review of loans by individuals independent of periodic portfolio reviews is particularly
the credit approval process. An important important to the ALLL determination process
requirement for an effective system is to place because this process is dependent on the
responsibility on loan officers and line staff for accurate and timely identification of problem
continuous portfolio analysis and prompt iden- loans.
tification and reporting of problem loans.
Because of frequent contact with borrowers, Scope of reviews. Reviews by loan review per-
loan officers and line staff can usually identify sonnel should cover all loans that are significant
potential problems before they become appar- and other loans that meet certain criteria. Man-
ent to others. However, institutions should be agement should document the scope of its
careful to avoid overreliance upon loan officers reviews and ensure that the percentage of the
and line staff for identification of problem portfolio selected for review provides reason-
loans. Institutions should ensure that loans are able assurance that the results of the review have
also reviewed by individuals who do not have identified any credit quality deterioration and
control over the loans they review and who are other unfavorable trends in the portfolio and
not part of, and are not influenced by anyone reflect its quality as a whole. Management
associated with, the loan approval process. should also consider industry standards for loan
While larger institutions typically establish a review coverage consistent with the size and
separate department staffed with credit review complexity of its loan portfolio and lending
specialists, cost and volume considerations may operations to verify that the scope of its reviews
not justify such a system in smaller institutions. is appropriate. The institution’s board of direc-
In some smaller institutions, an independent tors should approve the scope of loan reviews on
committee of outside directors may fill this role. an annual basis or when any significant interim
Whether or not the institution has an indepen- changes to the scope of reviews are made.
dent loan review department, the loan review Reviews typically include—
function should report directly to the board of
directors or a committee thereof (although senior • loans over a predetermined size;
management may be responsible for appropriate • a sufficient sample of smaller loans;
administrative functions so long as they do not • past due, nonaccrual, renewed, and restruc-
compromise the independence of the loan review tured loans;
function). • loans previously adversely classified or graded
Some institutions may choose to outsource and loans designated as warranting the special
the credit review function to an independent
outside party. However, the responsibility for
maintaining a sound loan review process cannot 31. Significant credits in this context may or may not be
be delegated to an outside party. Therefore, loans individually evaluated for impairment under FAS 114.

Page 13
attention of management32 by the institution that a borrower is less creditworthy than is

or its examiners; perceived by the institution, the lower credit
• insider loans; and quality classification or grade should prevail
• loans constituting concentrations of credit risk unless internal parties identify additional infor-
and other loans affected by common repay- mation sufficient to obtain the concurrence of
ment factors. the outside reviewer or arbiter on the higher
credit quality classification or grade.
Depth of reviews. Reviews should analyze a
number of important aspects of the loans selected Workpaper and report distribution. The loan
for review, including— review function should prepare a list of all loans
reviewed (including the date of the review) and
• credit quality, including underwriting and bor- documentation (including a summary analysis)
rower performance; that substantiates the grades or classifications
• sufficiency of credit and collateral documen- assigned to the loans reviewed. A report that
tation; summarizes the results of the loan review should
• proper lien perfection; be submitted to the board of directors at least
• proper approval by the loan officer and loan quarterly.33 In addition to reporting current credit
committee(s); quality findings, comparative trends can be pre-
• adherence to any loan agreement covenants; sented to the board of directors that identify
• compliance with internal policies and proce- significant changes in the overall quality of the
dures (such as aging, nonaccrual, and classi- portfolio. Findings should also address the
fication or grading policies) and laws and adequacy of and adherence to internal policies
regulations; and and procedures, as well as compliance with laws
• appropriate identification of individually and regulations, in order to facilitate timely
impaired loans, measurement of estimated correction of any noted deficiencies.
loan impairment, and timeliness of charge-
offs.
Attachment 2 to the Policy
Furthermore, these reviews should consider the
appropriateness and timeliness of the identifica-
Statement—International Transfer
tion of problem loans by loan officers. Risk Considerations
With respect to international transfer risk, an
Review of findings and follow-up. Loan review
institution with cross-border exposures should
personnel should discuss all noted deficiencies
support its determination of the appropriateness
and identified weaknesses and any existing or
of its ALLL by performing an analysis of the
planned corrective actions, including time frames
transfer risk, commensurate with the size and
for correction, with appropriate loan officers and
composition of the institution’s exposure to each
department managers. Loan review personnel
country. Such analyses should take into consid-
should then review these findings and corrective
eration the following factors, as appropriate:
actions with members of senior management.
All noted deficiencies and identified weaknesses
• the institution’s loan portfolio mix for each
that remain unresolved beyond the scheduled
country (for example, types of borrowers, loan
time frames for correction should be promptly
maturities, collateral, guarantees, special credit
reported to senior management and the board of
facilities, and other distinguishing factors);
directors.
• the institution’s business strategy and its debt
Credit classification or grading differences
management plans for each country;
between loan officers and loan review personnel
• each country’s balance of payments position;
should be resolved according to a prearranged
• each country’s level of international reserves;
process. That process may include formal appeals
• each country’s established payment perfor-
procedures and arbitration by an independent
mance record and its future debt servicing
party or may require default to the assigned
prospects;
classification or grade that indicates lower credit
quality. If an outsourced credit review concludes 33. The board of directors should be informed more
frequently than quarterly when material adverse trends are
32. See footnote 29. noted.

Page 14
• each country’s socio-political situation and its • the status of each country’s relationships with
effect on the adoption or implementation of other creditors, including institutions; and
economic reforms, in particular those affect- • the most recent evaluations distributed by the
ing debt servicing capacity; banking agencies’ Interagency Country Expo-
• each country’s current standing with multilat- sure Review Committee.
eral and official creditors;

Page 15
cedures and internal controls regarding loan regulations.
and lease losses and the allowance for loan 5. To initiate corrective action when policies,
and lease losses are adequate. practices, procedures, or internal controls are
2. To determine if bank officers and employees deficient or when violations of laws or regu-
are operating in conformance with the estab- lations have been noted.
lished guidelines.
audit function.

Page 1
1. If selected for implementation, complete or have occurred since the allowance was last
update the Allowance for Loan and Lease adjusted, suggest that management adjust
Losses section of the Internal Control the allowance through examination date.
Questionnaire. To do so, obtain a descrip- 9. Evaluate management’s determination of
tion of the methods and procedures em- the amount necessary to adequately provide
ployed by management to determine the for estimated loan losses as of the examina-
adequacy of the bank’s allowance for loan tion date by considering the following:
and lease losses and the supporting records a. known probable losses as determined by
maintained. a review of the lists of loans obtained
2. Based on the evaluation of internal controls in steps 5 and 6 and other pertinent
and the work performed by internal/ information
external auditors, determine the scope of the b. information included in the Uniform
examination. Bank Performance Report including—
3. Test for compliance with policies, practices, • historical losses as a percentage of
procedures and internal controls in conjunc- loans outstanding and other relevant
tion with performing the remaining exami- factors; and
nation procedures and obtain a listing of • comparison of the allowance ratios of
any audit deficiencies noted in the latest banks of similar loan portfolio size and
review done by internal/external auditors composition
from the examiner assigned ‘‘Internal Con- c. other procedures necessary in the
trol,’’ and determine if appropriate correc- circumstances
tions have been made. 10. Review the following items with appropri-
4. Obtain or prepare an analysis of the allow- ate management personnel, or prepare a
ance for loan and lease losses (valuation memo to other examining personnel, for
reserve) and the related deferred tax and their use in reviewing with management:
capital accounts (in prior years referred to
a. internal control exceptions and deficien-
as the deferred tax and contingency portions
cies in or noncompliance with written
of the reserve) for the period from the last
policies, practices, and procedures
examination date to the current one. Agree
b. uncorrected audit deficiencies
beginning and ending balances to the gen-
eral ledger and review the appropriateness c. inadequate allowance for possible loan
of changes in those accounts. and lease losses, if any
5. Obtain from the appropriate examiner a list 11. Request that management make appropriate
of problem loans as of the examination date, adjustments to the allowance for loan and
that is, loans which are or may become less lease losses.
than 100 percent collectible, possess more a. Determine the materiality of the change
than the normal degree of credit risk, are and the need to file amended financial
past due, or require more than normal man- reports.
agement supervision. b. Provide information to the examiner
6. Obtain from the appropriate examiner a reviewing regulatory reports, if
detailed list of classified loans identified in appropriate.
the various loan departments. 12. Prepare comments for the examination
7. Determine whether the reserve for possible report regarding the allowance for loan and
loan losses has been adjusted through the lease losses, and include any deficiencies
most recent quarter and, if not, suggest that reviewed with management and any reme-
management make such adjustment. dial actions recommended.
8. If, in the opinion of management, signifi- 13. Update the workpapers with any informa-
cant changes in the collectibility of loans tion that will facilitate future examinations.

Page 1
Review the bank’s internal controls, policies, 7. Are adequate procedures in effect relative
practices and procedures relating to the allow- to recoveries?
ance for loan and lease losses (valuation reserve)
and the determination of its adequacy. The
bank’s system should be documented in a com-
plete and concise manner and should include,
OTHER
where appropriate, narrative descriptions, flow- *8. Does management review the adequacy of
charts, copies of forms used and other pertinent the valuation portion of the allowance and
information. Items marked with an asterisk make necessary adjustments prior to pre-
require substantiation by observation or testing. paring public financial statements (at a
minimum, on a quarterly basis)?
9. Does management’s review encompass and
POLICIES give adequate consideration to:
a. Past loan loss experience and other
1. Has the board of directors, consistent with pertinent historical data?
its duties and responsibilities, adopted writ- b. Assessment of the effectiveness of lend-
ten policies which: ing policies and procedures?
a. Establish criteria for determining when c. Identification, on an individual loan
a loan is to be charged-off? basis, of significant potential weak-
b. Establish procedures for charging off nesses within the current loan portfolio
loans? and an estimate of related amount of
c. Establish procedures for periodically loss?
reviewing and documenting the ade- d. Changes in the character of the loan
quacy of the valuation portion of the portfolio?
allowance? e. Current economic conditions?
d. Define collection efforts to be under- f. Amount of past-due loans on which
taken after a loan is charged-off? interest is not being collected in accor-
dance with the terms of the loans, and
loans whose terms have been modified
by reducing interest rates or deferring
LOAN CHARGE-OFFS interest?
g. Other information appropriate to the
*2. Is the preparation and posting of any circumstances (if so, explain briefly)?
subsidiary records of loans charged-off 10. Does management retain documentation
performed or reviewed by persons who do of their review?
not also: 11. Is accrued interest on loans charged-off
a. Issue official checks and drafts? also charged-off against the allowance
b. Handle cash? account or reversed against interest income,
*3. Are all loans charged-off reviewed and as appropriate?
approved by the board of directors as
evidenced by the minutes of board
meetings? CONCLUSION
*4. Are notes for loans charged-off maintained
under dual custody? 12. Is the foregoing information considered an
5. Are collection efforts continued for loans adequate basis for evaluating internal con-
charged-off until the potential for recovery trol in that there are no significant defi-
is exhausted? ciencies in areas not covered in this ques-
6. Are periodic progress reports prepared and tionnaire that impair any controls? Explain
reviewed by appropriate management per- negative answers briefly, and indicate any
sonnel for all loans charged-off for which additional examination procedures deemed
collection efforts are continuing? necessary.

Page 1
2070.4 Allowance for Loan and Lease Losses: Internal Control Questionnaire
13. Based on a composite evaluation, as questions, internal control is considered

evidenced by answers to the foregoing (adequate/inadequate).

Page 2
ALLL Methodologies and Documentation
OVERVIEW The policy statement is consistent with the

Federal Reserve’s long-standing policy to pro-
A supplemental interagency Policy Statement mote strong internal controls over an institu-
on Allowance for Loan and Lease Losses Meth- tion’s ALLL process. In this regard, the new
odologies and Documentation for Banks and policy statement recognizes that determining an
Savings Institutions1 was issued by the Federal appropriate allowance involves a high degree of
Financial Institutions Examination Council management judgment and is inevitably impre-
(FFIEC) on July 2, 2001.2 The policy statement cise. Accordingly, an institution may determine
clarifies the agencies’ expectations for documen- that the amount of loss falls within a range. In
tation that supports the ALLL methodology. accordance with GAAP, an institution should
Additionally, the statement emphasizes the need record its best estimate within the range of credit
for appropriate ALLL policies and procedures, losses.
which should include an effective loan-review The policy statement is provided below. Some
system. The guidance also provides examples of wording has been slightly modified for this
appropriate supporting documentation, as well manual, as indicated by asterisks or text enclosed
as illustrations on how to implement this guid- in brackets. Some footnotes have also been
ance. The policy statement, by its terms, applies renumbered.
only to depository institutions insured by the
Federal Deposit Insurance Corporation. Exam-
iners should apply the policy during the exami- 2001 POLICY STATEMENT ON
nation of state member banks and their subsid- ALLL METHODOLOGIES
iaries. (See SR-01-17.)
AND DOCUMENTATION
The guidance requires that a financial institu-
tion’s ALLL methodology be in accordance Boards of directors of banks * * * are respon-
with generally accepted accounting principles sible for ensuring that their institutions have
(GAAP) and all outstanding supervisory guid- controls in place to consistently determine the
ance. An ALLL methodology should be system- allowance for loan and lease losses (ALLL) in
atic, consistently applied, and auditable. The accordance with the institutions’ stated policies
methodology should be validated periodically and procedures, generally accepted accounting
and modified to incorporate new events or principles (GAAP), and ALLL supervisory guid-
findings, as needed. The guidance specifies that ance.3 To fulfill this responsibility, boards of
management, under the direction of the board of directors instruct management to develop and
directors, should implement appropriate proce- maintain an appropriate, systematic, and consis-
dures and controls to ensure compliance with tently applied process to determine the amounts
the institution’s ALLL policies and procedures. of the ALLL and provisions for loan losses.
Institution management should (1) segment the Management should create and implement suit-
portfolio to evaluate credit risks; (2) select loss able policies and procedures to communicate the
rates that best reflect the probable loss; and ALLL process internally to all applicable per-
(3) be responsive to changes in the organization, sonnel. Regardless of who develops and imple-
the economy, or the lending environment by ments these policies, procedures, and underlying
changing the methodology, when appropriate. controls, the board of directors should assure
Furthermore, supporting information should be themselves that the policies specifically address
included on summary schedules, whenever fea- the institution’s unique goals, systems, risk pro-
sible. Under this policy, institutions with less file, personnel, and other resources before
complex loan products or portfolios, such as approving them. Additionally, by creating an
community banks, may use a more streamlined environment that encourages personnel to fol-
approach to implement this guidance.
3. The actual policy statement includes a bibliography that

lists applicable ALLL GAAP guidance, interagency state-
1. See 66 Fed. Reg. 35629–35639 (July 6, 2001). ments, and other reference materials that may assist in
2. The guidance was developed in consultation with Secu- understanding and implementing an ALLL in accordance with
rities and Exchange Commission staff, who are issuing paral- GAAP. See the appendix for additional information on apply-
lel guidance in the form of Staff Accounting Bulletin No. 102. ing GAAP to determine the ALLL.

Page 1
2072.1 ALLL Methodologies and Documentation
low these policies and procedures, management in accordance with GAAP. GAAP requires that
improves procedural discipline and compliance. allowances be well documented, with clear
The determination of the amounts of the explanations of the supporting analyses and
ALLL and provisions for loan and lease losses rationale.8 This [2001] policy statement describes
should be based on management’s current judg- but does not increase the documentation require-
ments about the credit quality of the loan port- ments already existing within GAAP. Failure to
folio, and should consider all known relevant maintain, analyze, or support an adequate ALLL
internal and external factors that affect loan in accordance with GAAP and supervisory guid-
collectibility as of the reporting date. The ance is generally an unsafe and unsound bank-
amounts reported each period for the provision ing practice.9
for loan and lease losses and the ALLL should This guidance [the 2001 policy statement]
be reviewed and approved by the board of applies equally to all institutions, regardless of
directors. To ensure the methodology remains the size. However, institutions with less com-
appropriate for the institution, the board of plex lending activities and products may find it
directors should have the methodology periodi- more efficient to combine a number of proce-
cally validated and, if appropriate, revised. Fur- dures (e.g., information gathering, documenta-
ther, the audit committee4 should oversee and tion, and internal-approval processes) while con-
monitor the internal controls over the ALLL- tinuing to ensure the institution has a consistent
determination process.5 and appropriate methodology. Thus, much of the
The [Federal Reserve and other] banking supporting documentation required for an insti-
agencies6 have long-standing examination poli- tution with more complex products or portfolios
cies that call for examiners to review an institu- may be combined into fewer supporting docu-
tion’s lending and loan-review functions and ments in an institution with less complex prod-
recommend improvements, if needed. Addition- ucts or portfolios. For example, simplified docu-
ally, in 1995 and 1996, the banking agencies mentation can include spreadsheets, checklists,
adopted interagency guidelines establishing stan- and other summary documents that many insti-
dards for safety and soundness, pursuant to tutions currently use. Illustrations A and C
section 39 of the Federal Deposit Insurance Act provide specific examples of how less complex
(FDI Act).7 The interagency asset-quality guide- institutions may determine and document por-
lines and [this guidance will assist] an institution tions of their loan-loss allowance.
in estimating and establishing a sufficient ALLL
supported by adequate documentation, as required
under the FDI Act. Additionally, the guidelines Documentation Standards
require operational and managerial standards
that are appropriate for an institution’s size and
the nature and scope of its activities. Appropriate written supporting documentation
for the loan-loss provision and allowance facili-
For financial-reporting purposes, including
regulatory reporting, the provision for loan and
lease losses and the ALLL must be determined
8. The documentation guidance within this [2001] policy
statement is predominantly based upon the GAAP guidance
4. All institutions are encouraged to establish audit com- from Financial Accounting Standards Board (FASB) State-
mittees; however, at small institutions without audit commitment No. 5 and No. 114 (FAS 5 and FAS 114, respectively);
tees, the board of directors retains this responsibility. Emerging Issues Task Force Topic No. D-80 (EITF Topic
5. Institutions and their auditors should refer to Statement D-80 and attachments), ‘‘Application of FASB Statements No.
on Auditing Standards No. 61, ‘‘Communication with Audit 5 and No. 114 to a Loan Portfolio’’ (which includes the
Committees’’ (as amended by Statement on Auditing Stan- Viewpoints article—an article issued in 1999 by FASB staff
dards No. 90, ‘‘Audit Committee Communications’’), which providing guidance on certain issues regarding the ALLL,
requires certain discussions between the auditor and the audit particularly on the application of FAS 5 and FAS 114 and how
committee. These discussions should include items, such as these statements interrelate); Chapter 7, ‘‘Credit Losses,’’ the
accounting policies and estimates, judgments, and uncertain- American Institute of Certified Public Accountants’ (AICPA)
ties that have a significant impact on the accounting informa- Audit and Accounting Guide, Banks and Savings Institutions,
tion included in the financial statements. 2000 edition (AICPA Audit Guide); and the Securities and
6. The [other] banking agencies are the Federal Deposit Exchange Commission’s (SEC) Financial Reporting Release
Insurance Corporation, the Office of the Comptroller of the No. 28 (FRR 28).
Currency, and the Office of Thrift Supervision. 9. Failure to maintain adequate supporting documentation
7. Institutions should refer to the guidelines *** for state does not relieve an institution of its obligation to record an
member banks, appendix D to part 208***. appropriate ALLL.

Page 2
ALLL Methodologies and Documentation 2072.1
tates review of the ALLL process and reported policies for charge-offs and recoveries and for
amounts, builds discipline and consistency into estimating the fair value of collateral, where
the ALLL-determination process, and improves applicable;
the process for estimating loan and lease losses • the description of the institution’s systematic
by helping to ensure that all relevant factors are methodology, which should be consistent with
appropriately considered in the ALLL analysis. the institution’s accounting policies for deter-
An institution should document the relationship mining its ALLL;11 and
between the findings of its detailed review of the • the system of internal controls used to ensure
loan portfolio and the amount of the ALLL and that the ALLL process is maintained in accor-
the provision for loan and lease losses reported dance with GAAP and supervisory guidance.
in each period.10
At a minimum, institutions should maintain An internal-control system for the ALLL-
written supporting documentation for the follow- estimation process should—
ing decisions, strategies, and processes:
• include measures to provide assurance regard-
• policies and procedures— ing the reliability and integrity of information
— over the systems and controls that main- and compliance with laws, regulations, and
tain an appropriate ALLL and internal policies and procedures;
— over the ALLL methodology • reasonably assure that the institution’s finan-
• loan-grading system or process cial statements (including regulatory reports)
• summary or consolidation of the ALLL are prepared in accordance with GAAP and
balance ALLL supervisory guidance;12 and
• validation of the ALLL methodology • include a well-defined loan-review process
• periodic adjustments to the ALLL process containing—
— an effective loan-grading system that is
consistently applied, identifies differing
Policies and Procedures risk characteristics and loan-quality prob-
lems accurately and in a timely manner,
Financial institutions utilize a wide range of and prompts appropriate administrative
policies, procedures, and control systems in actions;
their ALLL process. Sound policies should be — sufficient internal controls to ensure that
appropriately tailored to the size and complexity all relevant loan-review information is
of the institution and its loan portfolio. appropriately considered in estimating
In order for an institution’s ALLL methodol- losses. This includes maintaining appro-
ogy to be effective, the institution’s written priate reports, details of reviews per-
policies and procedures for the systems and formed, and identification of personnel
controls that maintain an appropriate ALLL involved; and
should address but not be limited to— — clear formal communication and coordina-
tion between an institution’s credit-
• the roles and responsibilities of the institu- administration function, financial-reporting
tion’s departments and personnel (including group, management, board of directors,
the lending function, credit review, financial
reporting, internal audit, senior management, 11. Further explanation is presented in the ‘‘Methodology’’
audit committee, board of directors, and oth- section that appears below.
ers, as applicable) who determine, or review, 12. In addition to the supporting documentation require-
ments for financial institutions, as described in interagency
as applicable, the ALLL to be reported in the asset-quality guidelines, public companies are required to
financial statements; comply with the books and records provisions of the Securi-
• the institution’s accounting policies for loans, ties Exchange Act of 1934 (Exchange Act). Under sections
[leases, and their loan losses], including the 13(b)(2)–(7) of the Exchange Act, registrants must make and
keep books, records, and accounts, which, in reasonable
detail, accurately and fairly reflect the transactions and dispo-
10. This position is fully described in the SEC’s FRR 28, in sitions of assets of the registrant. Registrants also must
which the SEC indicates that the books and records of public maintain internal accounting controls that are sufficient to
companies engaged in lending activities should include docu- provide reasonable assurances that, among other things, trans-
mentation of the rationale supporting each period’s determi- actions are recorded as necessary to permit the preparation of
nation that the ALLL and provision amounts reported were financial statements in conformity with GAAP. See also SEC
adequate. Staff Accounting Bulletin No. 99, Materiality.

Page 3
and others who are involved in the ALLL- • for determining and measuring impairment
determination or -review process, as appli- under FAS 114:
cable (e.g., written policies and proce- — the methods used to identify loans to be
dures, management reports, audit programs, analyzed individually;
and committee minutes). — for individually reviewed loans that are
impaired, how the amount of any impair-
ment is determined and measured,
Methodology including—
• procedures describing the impairment-
An ALLL methodology is a system that an measurement techniques available and
institution designs and implements to reason- • steps performed to determine which tech-
ably estimate loan and lease losses as of the nique is most appropriate in a given
financial statement date. It is critical that ALLL situation.
methodologies incorporate management’s cur- — the methods used to determine whether
rent judgments about the credit quality of the and how loans individually evaluated under
loan portfolio through a disciplined and consis- FAS 114, but not considered to be indi-
tently applied process. vidually impaired, should be grouped with
An institution’s ALLL methodology is influ- other loans that share common character-
enced by institution-specific factors, such as an istics for impairment evaluation under
institution’s size, organizational structure, busi- FAS 5.
ness environment and strategy, management • for determining and measuring impairment
style, loan-portfolio characteristics, loan- under FAS 5—
administration procedures, and management — how loans with similar characteristics are
information systems. However, there are certain grouped to be evaluated for loan collect-
common elements an institution should incorpo- ibility (such as loan type, past-due status,
rate in its ALLL methodology. A summary and risk);
of common elements is provided in [the — how loss rates are determined (e.g., his-
appendix].13 torical loss rates adjusted for environmen-
tal factors or migration analysis) and what
Documentation of ALLL Methodology in factors are considered when establishing
Written Policies and Procedures appropriate time frames over which to
evaluate loss experience; and
An institution’s written policies and procedures — descriptions of qualitative factors (e.g.,
should describe the primary elements of the industry, geographical, economic, and
institution’s ALLL methodology, including port- political factors) that may affect loss rates
folio segmentation and impairment measure- or other loss measurements.
ment. In order for an institution’s ALLL meth-
odology to be effective, the institution’s written The supporting documents for the ALLL may be
policies and procedures should describe the integrated in an institution’s credit files, loan-
methodology— review reports or worksheets, board of directors’
and committee meeting minutes, computer
• for segmenting the portfolio: reports, or other appropriate documents and
— how the segmentation process is per- files.
formed (i.e., by loan type, industry, risk
rates, etc.),
— when a loan-grading system is used to ALLL Under FAS 114
segment the portfolio:
• the definitions of each loan grade, An institution’s ALLL methodology related to
• a reconciliation of the internal loan FAS 114 loans begins with the use of its normal
grades to supervisory loan grades, and loan-review procedures to identify whether a
• the delineation of responsibilities for the loan is impaired as defined by the accounting
loan-grading system. standard. Institutions should document—
13. Also, refer to paragraph 7.05 of the AICPA Audit • the method and process for identifying loans
Guide. to be evaluated under FAS 114 and

Page 4
• the analysis that resulted in an impairment — appraisal quality, and the expertise and
decision for each loan and the determination independence of the appraiser.
of the impairment-measurement method to be • When using the observable-market-price-of-a-
used (i.e., present value of expected future loan method—
cash flows, fair value of collateral less costs to — the amount, source, and date of the
sell, or the loan’s observable market price). observable market price.
Once an institution has determined which of Illustration A describes a practice used by a

the three available measurement methods to use small financial institution to document its FAS
for an impaired loan under FAS 114, it should 114 measurement of impairment using a com-
maintain supporting documentation as follows: prehensive worksheet.14 [Examples 1 and 2
provide examples of applying and documenting
• When using the present-value-of-expected- impairment-measurement methods under FAS
future-cash-flows method— 114. Some loans that are evauluated individu-
— the amount and timing of cash flows, ally for impairment under FAS 114 may be fully
— the effective interest rate used to discount collateralized and therefore require no ALLL.
the cash flows, and Example 3 presents an institution whose loan
— the basis for the determination of cash portfolio includes fully collateralized loans. It
flows, including consideration of current describes the documentation maintained by that
environmental factors and other informa- institution to support its conclusion that no
tion reflecting past events and current ALLL was needed for those loans.]
conditions.
• When using the fair-value-of-collateral
method— 14. The [referenced] illustrations are presented to assist
institutions in evaluating how to implement the guidance
— how fair value was determined, including provided in this document. The methods described in the
the use of appraisals, valuation assump- illustrations may not be suitable for all institutions and are not
tions, and calculations, considered required processes or actions. For additional
— the supporting rationale for adjustments to descriptions of key aspects of ALLL guidance, a series of
[numbered examples is provided. These examples were
appraised values, if any, included in appendix A of the policy statement as questions
— the determination of costs to sell, if appli- and answers. The wording of the examples has been slightly
cable, and modified for this format.]
Illustration A Example 1: ALLL Under FAS 114—

Measuring and Documenting Impairment
Documenting an ALLL Under
FAS 114 Facts. Approximately one-third of Institution
A’s commercial loan portfolio consists of large-
Comprehensive worksheet for the impairment- balance, nonhomogeneous loans. Due to their
measurement process large individual balances, these loans meet the
criteria under Institution A’s policies and proce-
A small institution utilizes a comprehensive dures for individual review for impairment under
worksheet for each loan being reviewed indi- FAS 114. Upon review of the large-balance
vidually under FAS 114. Each worksheet loans, Institution A determines that certain of
includes a description of why the loan was the loans are impaired as defined by FAS 114.
selected for individual review, the impairment-
measurement technique used, the measurement Analysis. For the commercial loans reviewed
calculation, a comparison to the current loan under FAS 114 that are individually impaired,
balance, and the amount of the ALLL for that Institution A should measure and document the
loan. The rationale for the impairment- impairment on those loans. For those loans that
measurement technique used (e.g., present value are reviewed individually under FAS 114 and
of expected future cash flows, observable mar- considered individually impaired, Institution A
ket price of the loan, fair value of the collateral) must use one of the methods for measuring
is also described on the worksheet. impairment that is specified by FAS 114 (that is,
the present value of expected future cash flows,

Page 5
the loan’s observable market price, or the fair Company X is impaired, as defined by FAS 114.
value of collateral). Because the loan is collateral dependent, Insti-
An impairment-measurement method other tution B measures impairment of the loan based
than the methods allowed by FAS 114 cannot be on the fair value of the collateral. Institution B
used. For the loans considered individually determines that the most recent valuation of the
impaired under FAS 114, under the circum- collateral was performed by an appraiser 18
stances described above, it would not be appro- months ago and, at that time, the estimated value
priate for Institution A to choose a measurement of the collateral (fair value less costs to sell) was
method not prescribed by FAS 114. For exam- $12 million.
ple, it would not be appropriate to measure loan Institution B believes that certain of the
impairment by applying a loss rate to each loan assumptions that were used to value the collat-
based on the average historical loss percentage eral 18 months ago do not reflect current market
for all of its commercial loans for the past five conditions and, therefore, the appraiser’s valua-
years. tion does not approximate current fair value of
Institution A should maintain, as sufficient, the collateral. Several buildings, which are com-
objective evidence, written documentation to parable to the real estate collateral, were recently
support its measurement of loan impairment completed in the area, increasing vacancy rates,
under FAS 114. If it uses the present value of decreasing lease rates, and attracting several
expected future cash flows to measure impair- tenants away from the borrower. Accordingly,
ment of a loan, it should document (1) the credit-review personnel at Institution B adjust
amount and timing of cash flows, (2) the effec- certain of the valuation assumptions to better
tive interest rate used to discount the cash flows, reflect the current market conditions as they
and (3) the basis for the determination of cash relate to the loan’s collateral.16 After adjusting
flows, including consideration of current envi- the collateral-valuation assumptions, the credit-
ronmental factors15 and other information review department determines that the current
reflecting past events and current conditions. If estimated fair value of the collateral, less costs
Institution A uses the fair value of collateral to to sell, is $8 million. Given that the recorded
measure impairment, it should document (1) how investment in the loan is $10 million, Institution
it determined the fair value, including the use of B concludes that the loan is impaired by $2 mil-
appraisals, valuation assumptions and calcula- lion and records an allowance for loan losses of
tions; (2) the supporting rationale for adjust- $2 million.
ments to appraised values, if any, and the
determination of costs to sell, if applicable; Analysis. Institution B should maintain docu-
(3) appraisal quality; and (4) the expertise and mentation to support its determination of the
independence of the appraiser. Similarly, Insti- allowance for loan losses of $2 million for the
tution A should document the amount, source, loan to Company X. It should document that it
and date of the observable market price of a measured impairment of the loan to Company X
loan, if that method of measuring loan impair- by using the fair value of the loan’s collateral,
ment is used. less costs to sell, which it estimated to be
$8 million. This documentation should include
(1) the institution’s rationale and basis for the
Example 2: ALLL Under FAS 114—
$8 million valuation, including the revised valu-
Measuring Impairment for a
ation assumptions it used; (2) the valuation
Collateral-Dependent Loan
calculation; and (3) the determination of costs to
Facts. Institution B has a $10 million loan sell, if applicable. Because Institution B arrived
outstanding to Company X that is secured by at the valuation of $8 million by modifying an
real estate, which Institution B individually earlier appraisal, it should document its ratio-
evaluates under FAS 114 due to the loan’s size. nale and basis for the changes it made to the
Company X is delinquent in its loan payments valuation assumptions that resulted in the col-
under the terms of the loan agreement. Accord- lateral value declining from $12 million 18
ingly, Institution B determines that its loan to 16. When reviewing collateral-dependent loans, Institution
B may often find it more appropriate to obtain an updated
15. Question 16 in Exhibit D-80A of EITF Topic D-80 and appraisal to estimate the effect of current market conditions on
[its] attachments indicates that environmental factors include the appraised value instead of internally estimating an
existing industry, geographical, economic, and political factors. adjustment.

Page 6
months ago to $8 million in the current period.17 tion that no allowance is needed for this group
of loans, Institution C must maintain the follow-
ing documentation:
Example 3: ALLL Under FAS 114—Fully
Collateralized Loans • The management summary of the ALLL must
include documentation indicating that, in
Facts. Institution C has $10 million in loans that accordance with the institution’s ALLL pol-
are fully collateralized by highly rated debt icy, (1) Institution C has verified the collateral
securities with readily determinable market val- protection on these loans, (2) no probable loss
ues. The loan agreement for each of these loans has been incurred, and (3) no ALLL is
requires the borrower to provide qualifying necessary.
collateral sufficient to maintain a loan-to-value • The documentation in Institution C’s loan files
ratio with sufficient margin to absorb volatility must include (1) the two independent market
in the securities’ market prices. Institution C’s quotes obtained each quarter for each loan’s
collateral department has physical control of the collateral amount, (2) the documents evidenc-
debt securities through safekeeping arrange- ing the perfection of the security interest in the
ments. In addition, Institution C perfected its collateral and other relevant supporting docu-
security interest in the collateral when the funds ments, and (3) Institution C’s ALLL policy,
were originally distributed. On a quarterly basis, including guidance for determining when a
Institution C’s credit-administration function loan is considered ‘‘fully collateralized,’’ which
determines the market value of the collateral for would not require an ALLL. Institution C’s
each loan using two independent market quotes policy should require the following factors to
and compares the collateral value to the loan be considered and fully documented:
carrying value. If there are any collateral defi- — volatility of the market value of the
ciencies, Institution C notifies the borrower and collateral
requests that the borrower immediately remedy — recency and reliability of the appraisal or
the deficiency. Due in part to its efficient opera- other valuation
tion, Institution C has historically not incurred — recency of the institution’s or third party’s
any material losses on these loans. Institution C inspection of the collateral
believes these loans are fully collateralized and — historical losses on similar loans
therefore does not maintain any ALLL balance — confidence in the institution’s lien or
for these loans. security position including appropriate—
• type of security perfection (e.g., physi-
Analysis. To adequately support its determina- cal possession of collateral or secured
17. In accordance with the FFIEC’s Federal Register
filing);
notice, Implementation Issues Arising from FASB No. 114, • filing of security perfection (i.e., correct
‘‘Accounting by Creditors for Impairment of a Loan,’’ pub- documents and with the appropriate
lished February 10, 1995 (60 Fed. Reg. 7966, February 10, officials);
1995), impaired, collateral-dependent loans must be reported
at the fair value of collateral, less costs to sell, in regulatory
• relationship to other liens; and
reports. This treatment is to be applied to all collateral- • other factors as appropriate for the loan
dependent loans, regardless of type of collateral. type.
ALLL Under FAS 5 that are involved in less complex activities often
segment the portfolio into broad loan categories.
Segmenting the Portfolio This method of segmenting the portfolio is
likely to be appropriate in only small institutions
For loans evaluated on a group basis under FAS offering a narrow range of loan products. Larger
5, management should segment the loan port- institutions typically offer a more diverse and
folio by identifying risk characteristics that are complex mix of loan products. Such institutions
common to groups of loans. Institutions typi- may start by segmenting the portfolio into major
cally decide how to segment their loan port- loan types but typically have more detailed
folios based on many factors, which vary with information available that allows them to further
their business strategies as well as their infor- segregate the portfolio into product-line seg-
mation system capabilities. Smaller institutions ments based on the risk characteristics of each

Page 7
portfolio segment. Regardless of the segmenta- strategies, which may result in adjustments to
tion method used, an institution should maintain the way in which they segment their loan
documentation to support its conclusion that the portfolio for purposes of estimating loan losses.
loans in each segment have similar attributes or Illustration B presents an example in which an
characteristics. institution refined its segmentation method to
As economic and other business conditions more effectively consider risk factors and main-
change, institutions often modify their business tains documentation to support this change.
Illustration B institution decided to evaluate loss rates on an

individual-product basis (e.g., auto loans, unse-
Documenting Segmenting Practices cured loans, or home equity loans). This analy-
sis disclosed significant differences in the loss
Documenting a refinement in a segmentation rates on different products. With this additional
method information, the methodology was amended in
the current period to segment the portfolio by
An institution with a significant portfolio of product, resulting in a better estimation of the
consumer loans performed a review of its ALLL loan losses associated with the portfolio. To
methodology. The institution had determined its support this change in segmentation practice,
ALLL based upon historical loss rates in the the credit-review committee records contain the
overall consumer portfolio. The ALLL method- analysis that was used as a basis for the change
ology was validated by comparing actual loss and the written report describing the need for the
rates (charge-offs) for the past two years to the change.
estimated loss rates. During this process, the
Institutions use a variety of documents to should follow a systematic and consistently

support the segmentation of their portfolios. applied approach to select the most appropriate
Some of these documents include— loss-measurement methods and support its con-
clusions and rationale with written documenta-
• loan trial balances by categories and types of tion. Regardless of the methods used to measure
loans, losses, an institution should demonstrate and
• management reports about the mix of loans in document that the loss-measurement methods
the portfolio, used to estimate the ALLL for each segment are
• delinquency and nonaccrual reports, and determined in accordance with GAAP as of the
• a summary presentation of the results of an financial statement date.19
internal or external loan-grading review. One method of estimating loan losses for
groups of loans is through the application of loss
Reports generated to assess the profitability of a rates to the groups’ aggregate loan balances.
loan-product line may be useful in identifying Such loss rates typically reflect the institution’s
areas in which to further segment the portfolio. historical loan-loss experience for each group of
loans, adjusted for relevant environmental fac-
tors (e.g., industry, geographical, economic, and
Estimating Loss on Groups of Loans political factors) over a defined period of time. If
an institution does not have loss experience of
Based on the segmentation of the loan portfolio,
its own, it may be appropriate to reference the
an institution should estimate the FAS 5 portion
loss experience of other institutions, provided
of its ALLL. For those segments that require an
that the institution demonstrates that the attributes
ALLL, 18 the institution should estimate the loan
of the loans in its portfolio segment are similar
and lease losses, on at least a quarterly basis,
to those of the loans included in the portfolio of
based upon its ongoing loan-review process and
the institution providing the loss experience.20
analysis of loan performance. The institution
Institutions should maintain supporting docu-
18. An example of a loan segment that does not generally
require an ALLL is loans that are fully secured by deposits 19. Refer to paragraph 8(b) of FAS 5***.
maintained at the lending institution. 20. Refer to paragraph 23 of FAS 5.

Page 8
mentation for the technique used to develop • levels of and trends in charge-offs and
their loss rates, including the period of time over recoveries
which the losses were incurred. If a range of loss • trends in volume and terms of loans
is determined, institutions should maintain docu- • effects of any changes in risk-selection and
mentation to support the identified range and the underwriting standards, and other changes in
rationale used for determining which estimate is lending policies, procedures, and practices
the best estimate within the range of loan losses. • experience, ability, and depth of lending man-
An example of how a small institution performs agement and other relevant staff
a comprehensive historical loss analysis is pro- • national and local economic trends and
vided as the first item in Illustration C. conditions
Before employing a loss-estimation model, an • industry conditions
institution should evaluate and modify, as • effects of changes in credit concentrations
needed, the model’s assumptions to ensure that
the resulting loss estimate is consistent with For any adjustment of loss measurements
GAAP. In order to demonstrate consistency with for environmental factors, the institution should
GAAP, institutions that use loss-estimation mod- maintain sufficient, objective evidence to
els typically document the evaluation, the con- support the amount of the adjustment and to
clusions regarding the appropriateness of explain why the adjustment is necessary to
estimating loan losses with a model or other reflect current information, events, circum-
loss-estimation tool, and the support for adjust- stances, and conditions in the loss measurements.
ments to the model or its results. The second item in illustration C provides an
In developing loss measurements, institutions example of how an institution adjusts its com-
should consider the impact of current environ- mercial real estate historical loss rates for
mental factors and then document which factors changes in local economic conditions. Example
were used in the analysis and how those factors 4 provides an example of maintaining support-
affected the loss measurements. Factors that ing documentation for adjustments to portfolio-
should be considered in developing loss mea- segment loss rates for an environmental factor
surements include the following:21 related to an economic downturn in the bor-
rower’s primary industry. Example 5 describes
• levels of and trends in delinquencies and one institution’s process for determining and
impaired loans documenting an ALLL for loans that are not
individually impaired but have character-
istics indicating there are loan losses on a group
21. Refer to paragraph 7.13 in the AICPA Audit Guide. basis.
Illustration C analysis, including historical losses by type of

loan, originating branch office, and loan grade
Documenting the Setting of Loss for the three-year period.
Rates
Adjustment of loss rates for changes in local
Comprehensive loss analysis in a small economic conditions
institution
An institution develops a factor to adjust loss
A small institution determines its loss rates rates for its assessment of the impact of changes
based on loss rates over a three-year historical in the local economy. For example, when ana-
period. The analysis is conducted by type of lyzing the loss rate on commercial real estate
loan and is further segmented by originating loans, the assessment identifies changes in recent
branch office. The analysis considers charge- commercial building occupancy rates. The insti-
offs and recoveries in determining the loss rate. tution generally finds the occupancy statistics to
The institution also considers the loss rates for be a good indicator of probable losses on these
each loan grade and compares them to historical types of loans. The institution maintains docu-
losses on similarly rated loans in arriving at the mentation that summarizes the relationship
historical loss factor. The institution maintains between current occupancy rates and its loss
supporting documentation for its loss-factor experience.

Page 9
Example 4: ALLL Under FAS 5— analysis, including relevant newspaper articles,

Adjusting Loss Rates economic reports, economic data, and notes
from discussions with individual borrowers.
Facts. Institution D’s lending area includes a Since Institution D has had similar situations
metropolitan area that is financially dependent in the past, its supporting documentation should
upon the profitability of a number of manufac- also include an analysis of how the current
turing businesses. These businesses use highly conditions compare to its previous loss experi-
specialized equipment and significant quantities ences in similar circumstances. As part of its
of rare metals in the manufacturing process. Due effective ALLL methodology, a summary should
to increased low-cost foreign competition, sev- be created of the amount and rationale for the
eral of the parts suppliers servicing these manu- adjustment factor, which management presents
facturing firms declared bankruptcy. The foreign to the audit committee and board for their
suppliers have subsequently increased prices, review and approval prior to the issuance of the
and the manufacturing firms have suffered from financial statements.
increased equipment maintenance costs and
smaller profit margins. Additionally, the cost of
the rare metals used in the manufacturing pro- Example 5: ALLL Under FAS 5—
cess increased and has now stabilized at double Estimating Losses on Loans Individually
last year’s price. Due to these events, the manu- Reviewed for Impairment but Not
facturing businesses are experiencing financial Considered Individually Impaired
difficulties and have recently announced down-
sizing plans. Facts. Institution E has outstanding loans of
Although Institution D has yet to confirm an $2 million to Company Y and $1 million to
increase in its loss experience as a result of these Company Z, both of which are paying as agreed
events, management knows that it lends to a upon in the loan documents. The institution’s
significant number of businesses and individuals ALLL policy specifies that all loans greater than
whose repayment ability depends upon the long- $750,000 must be individually reviewed for
term viability of the manufacturing businesses. impairment under FAS 114. Company Y’s finan-
Institution D’s management has identified par- cial statements reflect a strong net worth, good
ticular segments of its commercial and con- profits, and ongoing ability to meet debt-service
sumer customer bases that include borrowers requirements. In contrast, recent information
highly dependent upon sales or salary from the indicates Company Z’s profitability is declining
manufacturing businesses. Institution D’s man- and its cash flow is tight. Accordingly, this loan
agement performs an analysis of the affected is rated substandard under the institution’s loan-
portfolio segments to adjust its historical loss grading system. Despite its concern, manage-
rates used to determine the ALLL. In this ment believes Company Z will resolve its prob-
particular case, Institution D has experienced lems and determines that neither loan is
similar business and lending conditions in the individually impaired as defined by FAS 114.
past that it can compare to current conditions. Institution E segments its loan portfolio to
estimate loan losses under FAS 5. Two of its
Analysis. Institution D should document its loan portfolio segments are Segment 1 and
support for the loss-rate adjustments that result Segment 2. The loan to Company Y has risk
from considering these manufacturing firms’ characteristics similar to the loans included in
financial downturns. It should document its Segment 1, and the loan to Company Z has risk
identification of the particular segments of its characteristics similar to the loans included in
commercial and consumer loan portfolio for Segment 2.22
which it is probable that the manufacturing In its determination of the ALLL under FAS
business’ financial downturn has resulted in loan 5, Institution E includes its loans to Company Y
losses. In addition, it should document its analy-
sis that resulted in the adjustments to the loss
rates for the affected portfolio segments. As part 22. These groups of loans do not include any loans that
of its documentation, Institution D should main- have been individually reviewed for impairment under FAS
tain copies of the documents supporting the 114 and determined to be impaired as defined by FAS 114.

Page 10
and Company Z in the groups of loans with are not considered individually impaired. As
similar characteristics (i.e., Segment 1 for Com- part of its effective ALLL methodology, Institu-
pany Y’s loan and Segment 2 for Company Z’s tion E documents the decision to include its
loan). Management’s analyses of Segment 1 and loans to Company Y and Company Z in its
Segment 2 indicate that it is probable that each determination of its ALLL under FAS 5. It
segment includes some losses, even though the should also document the specific characteristics
losses cannot be identified to one or more of the loans that were the basis for grouping
specific loans. Management estimates that the these loans with other loans in Segment 1 and
use of its historical loss rates for these two Segment 2, respectively. Institution E maintains
segments, with adjustments for changes in documentation to support its method of estimat-
environmental factors, provides a reasonable ing loan losses for Segment 1 and Segment 2,
estimate of the institution’s probable loan losses including the average loss rate used, the analysis
in these segments. of historical losses by loan type and by internal
risk rating, and support for any adjustments to
Analysis. Institution E should adequately docu- its historical loss rates. The institution also
ment an ALLL under FAS 5 for these loans that maintains copies of the economic and other
were individually reviewed for impairment but reports that provided source data.
Consolidating the Loss Estimates Illustration D describes how an institution docu-

ments its estimated ALLL by adding compre-
To verify that ALLL balances are presented hensive explanations to its summary schedule.
fairly in accordance with GAAP and are audit- Generally, an institution’s review and approval
able, management should prepare a document process for the ALLL relies upon the data
that summarizes the amount to be reported in the provided in these consolidated summaries. There
financial statements for the ALLL. The board may be instances in which individuals or com-
of directors should review and approve this mittees that review the ALLL methodology and
summary. resulting allowance balance identify adjust-
Common elements in such summaries ments that need to be made to the loss estimates
include— to provide a better estimate of loan losses. These
changes may be due to information not known at
• the estimate of the probable loss or range of the time of the initial loss estimate (e.g., infor-
loss incurred for each category evaluated (e.g., mation that surfaces after determining and
individually evaluated impaired loans, homo- adjusting, as necessary, historical loss rates, or
geneous pools, and other groups of loans that a recent decline in the marketability of property
are collectively evaluated for impairment); after conducting a FAS 114 valuation based
• the aggregate probable loss estimated using upon the fair value of collateral). It is impor-
the institution’s methodology; tant that these adjustments are consistent with
• a summary of the current ALLL balance; GAAP and are reviewed and approved by
• the amount, if any, by which the ALLL is to appropriate personnel. Additionally, the sum-
be adjusted;23 and mary should provide each subsequent reviewer
• depending on the level of detail that supports with an understanding of the support behind
the ALLL analysis, detailed subschedules of these adjustments. Therefore, management
loss estimates that reconcile to the summary should document the nature of any adjustments
schedule. and the underlying rationale for making the
changes. This documentation should be pro-
vided to those making the final determination
23. Subsequent to adjustments, there should be no material of the ALLL amount. Example 6 addresses
differences between the consolidated loss estimate, as deter-
mined by the methodology, and the final ALLL balance the documentation of the final amount of the
reported in the financial statements. ALLL.

Page 11
Illustration D estimates. As a result of the adjustments made

by senior management, the total amount of the
Summarizing Loss Estimates ALLL changes. However, senior management
Descriptive comments added to the consolidated (or its designee) does not update the ALLL
ALLL summary schedule summary schedule to reflect the adjustments or
reasons for the adjustments. When performing
To simplify the supporting documentation pro- their audit of the financial statements, the inde-
cess and to eliminate redundancy, an institution pendent accountants are provided with the origi-
adds detailed supporting information to its sum- nal ALLL summary schedule that was reviewed
mary schedule. For example, this institution’s by senior management and the credit committee,
board of directors receives, within the body of as well as a verbal explanation of the changes
the ALLL summary schedule, a brief descrip- made by senior management and the credit
tion of the institution’s policy for selecting loans committee when they met to discuss the loan-
for evaluation under FAS 114. Additionally, the loss allowance.
institution identifies which FAS 114 impairment-
measurement method was used for each indi- Analysis. Institution F’s documentation prac-
vidually reviewed impaired loan. Other items on tices supporting the balance of its loan-loss
the schedule include a brief description of the allowance, as reported in its financial state-
loss factors for each segment of the loan port- ments, are not in compliance with existing
folio, the basis for adjustments to loss rates, and documentation guidance. An institution must
explanations of changes in ALLL amounts from maintain supporting documentation for the loan-
period to period, including cross-references to loss allowance amount reported in its financial
more detailed supporting documents. statements. As illustrated above, there may be
instances in which ALLL reviewers identify
adjustments that need to be made to the loan-
Example 6: Consolidating the Loss loss estimates. The nature of the adjustments,
Estimates—Documenting the Reported how they were measured or determined, and the
ALLL underlying rationale for making the changes to
the ALLL balance should be documented.
Facts. Institution F determines its ALLL using Appropriate documentation of the adjustments
an established systematic process. At the end of should be provided to the board of directors (or
each period, the accounting department prepares its designee) for review of the final ALLL
a summary schedule that includes the amount of amount to be reported in the financial state-
each of the components of the ALLL, as well as ments. For institutions subject to external audit,
the total ALLL amount, for review by senior this documentation should also be made avail-
management, the credit committee, and, ulti- able to the independent accountants. If changes
mately, the board of directors. Members of frequently occur during management or credit
senior management and the credit committee committee reviews of the ALLL, management
meet to discuss the ALLL. During these discus- may find it appropriate to analyze the reasons
sions, they identify changes that are required by for the frequent changes and to reassess the
GAAP to be made to certain of the ALLL methodology the institution uses.
Validating the ALLL Methodology ance, an institution’s directors should establish

internal-control policies, appropriate for the size
An institution’s ALLL methodology is consid- of the institution and the type and complexity of
ered valid when it accurately estimates the its loan products. These policies should include
amount of loss contained in the portfolio. Thus, procedures for a review, by a party who is
the institution’s methodology should include independent of the ALLL-estimation process, of
procedures that adjust loss-estimation methods the ALLL methodology and its application in
to reduce differences between estimated losses order to confirm its effectiveness.
and actual subsequent charge-offs, as necessary. In practice, financial institutions employ
To verify that the ALLL methodology is valid numerous procedures when validating the rea-
and conforms to GAAP and supervisory guid- sonableness of their ALLL methodology and

Page 12
determining whether there may be deficiencies A creditor should record an ALLL when the
in their overall methodology or loan-grading criteria for accrual of a loss contingency as set
process. Examples are— forth in GAAP have been met. Estimating the
amount of an ALLL involves a high degree of
• a review of trends in loan volume, delinquen- management judgment and is inevitably impre-
cies, restructurings, and concentrations; cise. Accordingly, an institution may determine
• a review of previous charge-off and recovery that the amount of loss falls within a range. An
history, including an evaluation of the timeli- institution should record its best estimate within
ness of the entries to record both the charge- the range of loan losses.25
offs and the recoveries; Under GAAP, Statement of Financial Account-
• a review by a party that is independent of the ing Standards No. 5, ‘‘Accounting for Contin-
ALLL-estimation process (this often involves gencies’’ (FAS 5), provides the basic guidance
the independent party reviewing, on a test for recognition of a loss contingency, such as the
basis, source documents and underlying collectibility of loans (receivables), when it is
assumptions to determine that the established probable that a loss has been incurred and the
methodology develops reasonable loss amount can be reasonably estimated. Statement
estimates); and of Financial Accounting Standards No. 114,
• an evaluation of the appraisal process of the ‘‘Accounting by Creditors for Impairment of a
underlying collateral. (This may be accom- Loan’’ (FAS 114) provides more specific guid-
plished by periodically comparing the appraised ance about the measurement and disclosure of
value to the actual sales price on selected impairment for certain types of loans.26 Specifi-
properties sold.) cally, FAS 114 applies to loans that are identi-
fied for evaluation on an individual basis. Loans
are considered impaired when, based on current
Supporting Documentation for the information and events, it is probable that the
Validation Process creditor will be unable to collect all interest and
principal payments due according to the contrac-
Management usually supports the validation tual terms of the loan agreement.
process with the workpapers from the ALLL- For individually impaired loans, FAS 114
review function. Additional documentation often provides guidance on the acceptable methods to
includes the summary findings of the indepen- measure impairment. Specifically, FAS 114 states
dent reviewer. The institution’s board of direc- that when a loan is impaired, a creditor should
tors, or its designee, reviews the findings and measure impairment based on the present value
acknowledges its review in its meeting minutes. of expected future principal and interest cash
If the methodology is changed based upon the flows discounted at the loan’s effective interest
findings of the validation process, documenta- rate, except that as a practical expedient, a
tion that describes and supports the changes creditor may measure impairment based on a
should be maintained. loan’s observable market price or the fair value
of collateral, if the loan is collateral dependent.
When developing the estimate of expected future
Appendix—Application of GAAP cash flows for a loan, an institution should
[This appendix was designated appendix B in

the policy statement.] An ALLL recorded pur- Banks and Savings Institutions, 2000 edition (AICPA Audit
suant to GAAP is an institution’s best estimate Guide). Additionally, this appendix does not address allow-
ances or accounting for assets or portions of assets sold with
of the probable amount of loans and lease- recourse, which is described in Statement of Financial
financing receivables that it will be unable to Accounting Standards No. 140, ‘‘Accounting for Transfers
collect based on current information and events.24 and Servicing of Financial Assets and Extinguishments of
Liabilities—a Replacement of FASB Statement No. 125’’
(FAS 140).
24. This appendix provides guidance on the ALLL and 25. Refer to FASB Interpretation No. 14, ‘‘Reasonable
does not address allowances for credit losses for off-balance- Estimation of the Amount of a Loss,’’ and Emerging Issues
sheet instruments (e.g., loan commitments, guarantees, and Task Force Topic No. D-80, ‘‘Application of FASB Statements
standby letters of credit). Institutions should record liabilities No. 5 and No. 114 to a Loan Portfolio’’ (EITF Topic D-80).
for these exposures in accordance with GAAP. Further guid- 26. EITF Topic D-80 includes additional guidance on the
ance on this topic is presented in the American Institute of requirements of FAS 5 and FAS 114 and how they relate to
Certified Public Accountants’ Audit and Accounting Guide, each other.***

Page 13
consider all available information reflecting past following illustration provides an example of an
events and current conditions, including the institution estimating a loan’s impairment when
effect of existing environmental factors. The the loan has been partially charged off.
Illustration of the recorded investment deemed to be the

confirmed loss and classified the remaining
Interaction of FAS 114 with an recorded investment as ‘‘Substandard.’’ For this
Adversely Classified Loan, Partial loan, the amount classified ‘‘Loss’’ was less than
Charge-Off, and the Overall ALLL the impairment amount (as determined under
FAS 114). The institution charged off the ‘‘Loss’’
An institution determined that a collateral- portion of the loan. After the charge-off, the
dependent loan, which it identified for evalua- portion of the ALLL related to this ‘‘Substan-
tion, was impaired. In accordance with FAS dard’’ loan (1) reflects an appropriate measure of
114, the institution established an ALLL for the impairment under FAS 114, and (2) is included
amount that the recorded investment in the loan in the aggregate FAS 114 ALLL for all loans
exceeded the fair value of the underlying collat- that were identified for evaluation and individu-
eral, less costs to sell. ally considered impaired. The aggregate FAS
Consistent with relevant regulatory guidance, 114 ALLL is included in the institution’s overall
the institution classified as ‘‘Loss,’’ the portion ALLL.
Large groups of smaller-balance homoge- While different institutions may use different
neous loans that are collectively evaluated for methods, there are certain common elements
impairment are not included in the scope of FAS that should be included in any loan-loss allow-
114.27 Such groups of loans may include, but are ance methodology. Generally, an institution’s
not limited to, credit card, residential mortgage, methodology should—
and consumer installment loans. FAS 5 addresses
the accounting for impairment of these loans. • include a detailed analysis of the loan port-
Also, FAS 5 provides the accounting guidance folio, performed on a regular basis;
for impairment of loans that are not identified • consider all loans (whether on an individual or
for evaluation on an individual basis and loans group basis);
that are individually evaluated but are not indi- • identify loans to be evaluated for impairment
vidually considered impaired. Institutions should on an individual basis under FAS 114 and
ensure that they do not layer their loan-loss segment the remainder of the portfolio into
allowances. Layering is the inappropriate prac- groups of loans with similar risk characteris-
tice of recording in the ALLL more than one tics for evaluation and analysis under FAS 5;
amount for the same probable loan loss. Layer- • consider all known relevant internal and
ing can happen when an institution includes a external factors that may affect loan
loan in one segment, determines its best esti- collectibility;
mate of loss for that loan either individually or • be applied consistently but, when appropriate,
on a group basis (after taking into account all be modified for new factors affecting
appropriate environmental factors, conditions, collectibility;
and events), and then includes the loan in • consider the particular risks inherent in differ-
another group, which receives an additional ent kinds of lending;
ALLL amount.28 • consider current collateral values (less costs to
sell), where applicable;
• require that analyses, estimates, reviews, and
27. In addition, FAS 114 does not apply to loans measured
at fair value or at the lower of cost or fair value, leases, or debt
other ALLL methodology functions be
securities. performed by competent and well-trained
28. According to the Federal Financial Institutions Exami- personnel;
nation Council’s Federal Register notice, Implementation • be based on current and reliable data;
Issues Arising from FASB Statement No. 114, ‘‘Accounting
by Creditors for Impairment of a Loan,’’ published February
10, 1995, institution-specific issues should be reviewed when conducted as part of the evaluation of each individual loan
estimating loan losses under FAS 114. This analysis should be reviewed under FAS 114 to avoid potential ALLL layering.

Page 14
• be well documented, in writing, with clear designed and implemented should result in an
explanations of the supporting analyses and institution’s best estimate of the ALLL. Accord-
rationale; and ingly, institutions should adjust their ALLL
• include a systematic and logical method to balance, either upward or downward, in each
consolidate the loss estimates and ensure the period for differences between the results of the
ALLL balance is recorded in accordance with systematic determination process and the unad-
GAAP.29 justed ALLL balance in the general ledger.30
A systematic methodology that is properly

30. Institutions should refer to the guidance on materiality
29. Refer to paragraph 7.05 of the AICPA Audit Guide. in SEC Staff Accounting Bulletin No. 99, Materiality.

Page 15
1. To evaluate internal controls over the loan- 5. To determine if the bank has adequately
loss estimation process by evaluating the developed a range of loss and a margin for
ALLL written policy and the process used to imprecision.
create and maintain the policy, loan-grading 6. To determine that the ALLL reflects esti-
systems, and other associated internal con- mated credit losses for specifically identified
trols over credit risk. loans (or groups of loans) and any estimated
2. To determine the existence of an ALLL probable credit losses inherent in the remain-
balance and review the summary schedule der of the loan portfolio at the balance-sheet
supporting it. date.
3. To analyze and review the evaluation for 7. To analyze and review the ALLL-
Statement of Financial Accounting Standards documentation support.
No. 114 (FAS 114) (for individually listed 8. To determine the adequacy of the bank’s
loans). process to evaluate the ALLL methodology
4. To analyze and review the evaluation for and to adjust the methodology, as needed.
Statement of Financial Accounting Standards
No. 5 (FAS 5) (for groups of loans).

Page 1
1. Determine if the board of directors has overseeing and monitoring the internal con-
developed and maintained an appropriate, trols over the ALLL-documentation process.
systematic, and consistently applied process 6. Ascertain that the bank maintains adequate
to determine the amounts of the ALLL and written documentation of its ALLL, includ-
provision for loan losses, or if it has instructed ing clear explanations of the supporting analy-
management to do so. Determine if the ALLL ses and rationale. The documentation should
policies specifically address the bank’s goals, consist of—
risk profile, personnel, and other resources. • policies and procedures over the systems
2. Determine if the board of directors has and controls that maintain an appropriate
approved the written ALLL policy. ALLL and over the ALLL methodology,
3. Determine if the bank’s loan-loss estimate, in • the loan-grading system or process,
accordance with its methodology, is consis-
• a summary or consolidation (including
tent with generally accepted accounting prin-
losses) of the ALLL balance,
ciples and supervisory guidance. Addition-
ally, ensure that the bank’s loan-loss estimate • a validation of the ALLL methodology,
is materially consistent with the reported and
balance of the bank’s ALLL account. • periodic adjustments to the ALLL process.
4. Determine if the ALLL methodology is peri- 7. Determine if the amount reported for the
odically validated by an independent party ALLL for each period and the provisions for
and, if appropriate, revised. loan and leases losses are reviewed and
5. Ascertain whether the audit committee is approved by the board of directors.

Page 1
Commercial and Industrial Loans
INTRODUCTION tory, receivables, the purchase of supplies, or

other operating needs during the business cycle.
The term ‘‘commercial and industrial loan’’ is These types of loans are often appropriate for
commonly used to designate loans to a corpo- businesses that experience seasonal or short-
ration, commercial enterprise, or joint venture term peaks in current assets and current liabili-
that are not ordinarily maintained in either the ties, such as a retailer who relies heavily on a
real estate or consumer installment loan port- holiday season for sales or a manufacturing
folios. Generally, commercial loans are the larg- company that specializes in summer clothing.
est asset concentration of a state member bank, These types of loans are often structured in the
offer the most complexity, and require the great- form of an advised line of credit or a revolving
est commitment from bank management to moni- credit. An advised revocable line of credit is a
tor and control risks. Proper management of revocable commitment by the bank to lend
these assets requires a clearly articulated credit- funds up to a specified period of time, usually
policy that imposes discipline and sound loan one year. Lines of credit are generally reviewed
administration. Since lenders are subject to pres- annually by the bank, do not have a fixed
sures related to productivity and competition, repayment schedule, and may not require fees or
they may be tempted to relax prudent credit- compensating balances. In the case of unadvised
underwriting standards to remain competitive in lines of credit, the bank has more control over
the marketplace, thus increasing the potential advances and may terminate the facility at any
for risk. Examiners need to understand the time, depending on state law or legal precedents.
unique characteristics of the varying types of A revolving credit is valid for a stated period of
commercial and industrial loans, as well as how time and does not have a fixed repayment
to properly analyze their quality. schedule, but usually it has a required fee. The
Commercial loans are extended on a secured lender has less control over a revolving credit
or unsecured basis with a wide range of pur- since there is an embedded guarantee to make
poses, terms, and maturities. While the types of advances within the prescribed limits of the loan
commercial and industrial loans can vary widely agreement. The borrower may receive periodic
depending on the purpose of loans made and advances under the line of credit or the revolv-
market characteristics where the bank operates, ing credit. Repayment of the loans is generally
most commercial and industrial loans will pri- accomplished through conversion or turnover of
marily be made in the form of a seasonal or short-term assets. Interest payments on seasonal
working-capital loan, term business loan, or loans are usually paid throughout the term of the
loan to an individual for a business purpose. loan, such as monthly or quarterly.
This section will provide examiners with a Seasonal or working-capital loans are intended
fundamental understanding of secured and to be repaid through the cash flow derived from
unsecured transactions, loan evaluation and cov- converting the financed assets to cash. The
erage techniques, the key principles for assess- structure of the loans can vary, but they should
ing credit quality, minimum documentation stan- be closely tied to the timing of the conversion
dards for loan line sheets, and basic bankruptcy of the financed assets. In most cases, seasonal
law, as well as an overview of sections 23A and or working-capital facilities are renewable at
23B of the Federal Reserve Act and tie-in maturity, are for a one-year term, and include
arrangements. Other sections of this manual a clean-up requirement for a period sometime
discuss more specific types of lending. during the low point or contraction phase of the
business cycle. The clean-up period is a speci-
fied period (usually 30 days) during the term of
PRIMARY TYPES OF the loan in which the borrower is required to pay
COMMERCIAL AND off the loan. While this requirement is becoming
INDUSTRIAL LOANS less common, it provides the bank with proof
that the borrower is not dependent on the lender
Seasonal or Working-Capital Loans for permanent financing. It is important to note,
however, that an expanding business may not be
Seasonal or working-capital loans provide a able to clean up its facility since it may be
business with short-term financing for inven- increasing its current assets.

Page 1
2080.1 Commercial and Industrial Loans
Analysis of Seasonal and Working-Capital Normally, a bank is secured by a perfected

Loans blanket security interest on accounts receivable,
inventory, and equipment and on the pro-
The analysis of a seasonal loan is best accom- ceeds from the turnover of these assets.
plished by a monthly or quarterly review of a Well-capitalized companies with a good history
company’s balance sheet and income statements of seasonal payout or cleanup may be excep-
to identify the peak and contraction phases of tions. An annual lien search, however, would be
the business cycle. The lender should know prudent under this type of lending relationship
when the peak and contraction phases are, and to detect any purchase-money security interest
the loan should be structured accordingly. The that may have occurred during the business
lender’s primary objective is to determine cycle.
whether the advances are being used for the The following are potential problems associ-
intended purposes (inventories or payables) and ated with working-capital and seasonal loans:
not for the acquisition of fixed assets or pay-
ments on other debts. Repayments on the facil- • Working-capital advances used for funding
ity should also be consistent with the conversion losses. A business uses advances from a
of assets. If the borrower has other loan facilities revolving line of credit to fund business losses,
at the bank, all credit facilities should be including the funding of wages, business
reviewed at the same time to ensure that the expenses, debt service, or any other cost not
activity with the seasonal or working-capital specifically associated with the intended pur-
facility is not linked to other loans in the bank. pose of the facility.
Projections of sources and uses of funds are also • Working-capital advances funding long-term
a valuable tool for reviewing a seasonal or assets. A business will use working-capital
working-capital line of credit and determining funds to purchase capital assets that are nor-
the sales cycle. mally associated with term business loans.
Quarterly balance-sheet and income state- • Trade creditors not paid out at end of business
ments are very helpful when a comparison is cycle. While the bank may be paid out, some
made with the original projections. Other help- trade creditors may not get full repayment.
ful information can be obtained from a review This can cause a strained relationship as
of an aging of accounts receivable for delin- unpaid trade creditors may be less willing to
quencies and concentrations, a current list of provide financing or offer favorable credit
inventory, an accounts-payable aging, and terms in the future. In turn, the business will
accruals made during the quarter. This infor- become more reliant on the bank to support
mation can be compared with the outstanding funding needs that were previously financed
balance of the facility to ensure that the loan by trade creditors.
is not overextended and that the collateral • Overextension of collateral. The business
margins are consistent with borrowing-base does not have the collateral to support the
parameters. A borrowing base is the amount extension of credit, causing an out-of-
the lender is willing to advance against a dol- borrowing-base situation. Examiners should
lar value of pledged collateral; for example, a review borrowing-base certificates to verify
bank will only lend up to a predetermined that coverage meets the prescribed limitations
specified percentage of total outstanding receiv- established by the bank’s credit policy for the
ables less all past-due accounts more than a specific asset being financed.
certain number of days delinquent. A borrowing- • Value of inventory declines. If a business
base certificate should be compiled at least does not pay back the bank after inventory is
monthly or more often during peak activity in converted to cash or accounts receivable, the
the facility. When reviewing seasonal loans, value of the inventory declines. Other causes
examiners should remember that a bank relies of inventory devaluation include obsoles-
heavily on inventory as collateral in the begin- cence; a general economic downturn; or, in
ning of a company’s business cycle and on the case of a commodity, market volatility.
receivables toward the end of the business cycle. Declines in inventory value will commonly
However, in traditional working-capital loans, put a working-capital facility in an out-of-
greater emphasis is usually placed on accounts borrowing-base situation and require the
receivable as collateral throughout the loan’s excess debt to be amortized and repaid through
tenure. future profits of the business.

Page 2
Commercial and Industrial Loans 2080.1
• Collectibility of accounts receivable declines. loans are often secured. Loan interest may be
The increasingly past-due status of accounts payable monthly, quarterly, semiannually, or
receivable or deteriorating credit quality of annually.
account customers both result in the noncol- In most cases, the terms of these loans are
lection of receivables. This can also cause an detailed in formal loan agreements with affirma-
out-of-borrowing-base situation for the lend- tive and negative covenants that place certain
ing institution. conditions on the borrower throughout the term
• Working-capital advances used to fund long- of the loan. Generally, loan agreements substan-
term capital. Funds may be inappropriately tially enhance a borrower/banker relationship
used to repurchase company stock, pay off because they encourage and promote more fre-
subordinated debt holders, or even pay divi- quent communication between the parties. In
dends on capital stock. affirmative covenants, the borrower pledges to
fulfill certain requirements, such as maintain
These situations may cause a loan balance to adequate insurance coverage, make timely loan
be remaining at the end of the business cycle. If repayments, or ensure the financial stability of
this should occur, the bank generally has one of the business. Negative or restrictive covenants
three options: (1) Require the unpaid balance to prohibit or require the borrower to refrain from
be amortized. This option is, however, depen- certain practices, such as selling or transferring
dent on the ability of the business to repay the assets, defaulting, falling below a minimum debt
debt through future profits. (2) Request the coverage ratio, exceeding a maximum debt-to-
borrower to find another lender or require an equity ratio, or taking any action that may
infusion of capital by the borrower. This is not diminish the value of collateral or impair the
always a feasible option because of the probable collectibility of the loan. Covenants should not
weakened financial condition of the business be written so restrictively that the borrower is
and ownership under these circumstances. (3) Liq- constantly in default over trivial issues; how-
uidate the collateral. Foreclosing on the collat- ever, violations should be dealt with immedi-
eral should only be executed when it becomes ately to give credibility to the agreement. Vio-
obvious that the business can no longer function lations of these covenants can often result in
as a going concern. The problem with this acceleration of the debt maturity. A formal loan
option is that once the bank discovers that the agreement is most often associated with longer-
business is no longer a viable concern, realizing term loans. If a formal agreement does not exist,
the full value of the collateral is in jeopardy. The the term loans should be written with shorter
need to resort to any of these options may maturities and balloon payments to allow more
prompt criticism of the credit. frequent review by bank management.
Analysis of Term Business Loans

Term Business Loans
While a seasonal or working-capital loan analy-
Term business loans are generally granted at a sis emphasizes the balance sheet, the analysis of
fixed or variable rate of interest, have a maturity term loans will focus on both the balance sheet
in excess of one year, and are intended to and the income statement. Because a term loan
provide an organization with the funds needed is repaid from excess cash flow, the long-term
to acquire long-term assets, such as physical viability of the business is critical in determin-
plants and equipment, or finance the residual ing the overall quality of the credit. In evaluat-
balance on lines of credit or long-term working ing long-term earnings, the examiner must de-
capital. Term loans are repaid through the busi- velop a fundamental understanding of the
ness’s cash flow, according to a fixed- company’s industry and competitive position in
amortization schedule, which can vary based on the marketplace. Most of the analysis will be
the cash-flow expectations of the underlying conducted based on the historical performance
asset financed or the anticipated profitability or of the business and its history of making pay-
cash flow of the business. Term business loans ments on its debt. Any historical record of
involve greater risk than short-term advances inconsistencies or inability to perform on exist-
because of the length of time the credit is ing debt should prompt an in-depth review to
extended. As a result of this greater risk, term determine the ability of the borrower to meet the

Page 3
loan’s contractual agreements. One of the most national credits (SNCs). An SNC is defined as
critical determinations that should be made when any loan or commitment in an original amount
evaluating term debt is whether the term of the of $20 million or more that is (1) shared at its
debt exceeds the useful life of the underlying inception by two or more supervised institutions
asset being financed. under a formal loan agreement and (2) sold in
While cash flow of the business is the primary part to one or more supervised institutions with
source of repayment for a term loan, a secondary the purchasing bank assuming its pro rata share
source would be the sale of the underlying of the credit risk. Loans sold to affiliate banks of
collateral. Often, if circumstances warrant a the same holding company are not part of the
collateral sale, the bank may face steep dis- SNC program. If the outstanding balance or
counts and significant expenses related to the commitment of an SNC credit falls below
sale. Examiners should carefully consider these $20 million after its inception, and it is not
issues when evaluating the underlying value of criticized, the credit will not be reviewed at the
collateral under a liquidation scenario. next review date. Therefore, the examiner should
The following are potential problems associ- conduct an individual review of the credit at the
ated with term business loans: bank under examination. However, if the former
SNC facility fell below the threshold through a
• The term of the loan is not consistent with the charge-off, and was classified or specially men-
useful life of collateral. tioned at the most recent SNC review, the credit
• Cash flow from operations does not allow for relationship would continue to be reviewed
adequate debt amortization, a fundamental under the SNC program until such time that the
problem that can only be solved by improved balance falls below $10 million. The Federal
performance. Deposit Insurance Corporation (FDIC), the state
• The gross margin of the business is narrow- agencies, and the Office of the Comptroller of
ing, which requires the business to sell more the Currency (OCC) also participate in this
product to produce the same gross profit. program. The Federal Reserve carries out the
Higher sales volume could require more cash examination of SNCs at the lead or agent banks
for expansion of current assets, leaving less that are state member banks, state-chartered
cash for debt amortization. This situation is a foreign branches, and credit-extending nonbank
common by-product of increased competition. subsidiaries of domestic and foreign organiza-
• Sales are lower than expected. In the face of tions. The FDIC is primarily responsible for any
lower sales, management is unable or unwill- SNC credits at state nonmember banks, and the
ing to cut overhead expenses, straining cash OCC supervises the review of those SNCs in
flow and resulting in diminished debt-servicing which the lead bank is a national bank or an
ability. OCC-chartered foreign branch.
• Fixed assets that are financed by term loans SNCs should not be analyzed or reviewed
become obsolete before the loans are retired, during the examination of the individual partici-
likely causing the value of underlying collat- pating bank. If the examiner is uncertain whether
eral to deteriorate. the credit was reviewed under the SNC program,
• The business’s excess cash is spent on higher the respective Reserve Bank coordinator should
salaries or other unnecessary expenses. be contacted. If credits eligible for the program
• The payments on term debt have put a strain are found but have not been reviewed (other
on cash flow, and the business is unable to than new SNCs since the time of the last SNC
adequately operate or allow natural expansion. program review), the examiner should submit a
• The balance sheet of the business is weaken- memorandum detailing those credits to the
ing. The overall financial condition of the respective Reserve Bank coordinator to be for-
business is deteriorating because of poor per- warded to the SNC coordinator at the Federal
formance or unforeseen occurrences in the Reserve Bank of New York.
industry.
SECURED AND UNSECURED

Shared National Credits TRANSACTIONS
The Federal Reserve System participates in a This subsection is intended to be a general
program for the uniform review of shared reference for an examiner’s review of a credit

Page 4
file to determine whether the bank’s collateral 9-203(1). Once the following requirements are
position is properly documented. Examiners met, the security interest attaches:
should be aware that secured transactions
encompass an extensive body of law that is • The collateral is in the possession of the
rather technical in nature. The following discus- secured party pursuant to agreement, or the
sion contains general information for examiners debtor has signed a security agreement that
on the basic laws that govern a bank’s security contains a description of the collateral and,
interest in property and on the documentation when the security interest covers crops now
that needs to be in a loan file to properly growing or to be grown or timber to be cut, a
document a perfected security interest in a description of the land concerned.
borrower’s assets. • Value has been given to the debtor.
• The debtor has rights in the collateral.
Secured Transactions Thus, unless the collateral is in the possession

of the secured party, there must be a written
Most secured transactions in personal property security agreement that describes the collateral.
and fixtures are governed by article 9 of the The description does not have to be very specific
Uniform Commercial Code (UCC). The UCC or detailed—‘‘any description of personal prop-
has been adopted by all 50 states, the District of erty . . . is sufficient whether or not it is specific
Columbia, and the Virgin Islands. Timing dif- if it reasonably identifies what is described’’
ferences as well as filing locations differ from (see section 9-110). The agreement must also be
state to state. Failure to file a financing statement signed by the debtor. The creditor may sign it,
in a timely manner or in the proper location will but its failure to do so does not affect the
compromise a lender’s security interest in the agreement’s enforceability against the debtor.
collateral. ‘‘Giving value’’ is any consideration that
Article 9 of the UCC applies to any trans- supports a contract. Value can be given by a
action that is intended to create a security direct loan, a commitment to grant a loan in the
interest in personal property. Mortgage trans- future, the release of an existing security inter-
actions are not covered, marine mortgages are est, or the sale of goods on contract.
filed with the Coast Guard, and aircraft liens are While the debtor must have ‘‘rights’’ in the
filed with the Federal Aviation Administration. collateral, he or she does not necessarily have to
A ‘‘security interest’’ is defined in the UCC as have title to the property. For example, the
‘‘an interest in personal property or fixtures debtor may be the beneficiary of a trust (the
which secures payment or performance of an trustee has title of trust assets) or may lease the
obligation.’’ A secured transaction requires that collateral. The debtor, in such cases, has rights
there be an agreement between the parties indi- in the collateral, but does not hold the title to the
cating the parties’ intention to create a security collateral. The secured party, however, only
interest for the benefit of the creditor or secured obtains the debtor’s limited interest in the col-
party. This agreement is commonly referred to lateral on default if the debtor does not have full
as a security agreement. title to the collateral.
Article 9 of the UCC refers to two different
concepts related to security interests: attachment
and perfection. Attachment is the point in time Perfection of Security Interest in Property
at which the security interest is created and
becomes enforceable against the debtor. Perfec- Perfection represents the legal process by which
tion refers to the steps that must be taken in a bank secures an interest in property. Perfection
order for the security interest to be enforceable provides the bank assurance that it has an
against third parties who have claims against interest in the collateral. The category of collat-
collateral. eral will dictate the method of perfection to be
used. The most common methods of perfection
are (1) automatic perfection when the security
Attachment of Security Interest interest attaches (such as in the case of purchase-
money security interests applicable to consumer
The three requirements for the creation of a goods other than vehicles); (2) perfection by
security interest are stated in UCC section possession; (3) the filing of a financing state-

Page 5
ment in one or more public filing offices (The determines where the financing statement must
financing statement is good for five years, and be filed.
the lender must file for a continuation within the
six-month period before expiration of the origi-
nal statement.) and (4) compliance with a state Evaluation of Security Interest in
certificate of title law or central filing under a Property
state statute other than the UCC, such as regis-
tration of vehicles. Key items to look for in evaluating a security
The most common method of perfecting a interest in property include the following:
security interest is public filing. Public filing
serves as a constructive notice to the rest of the • Security agreement. There should be a proper
world that the bank claims a security interest in security agreement, signed and dated by the
certain property of the debtor described in both borrower, that identifies the appropriate col-
the security agreement and the financing state- lateral to be secured. It should include a
ment. Public filing is accomplished by filing a description of the collateral and its location in
financing statement (UCC-1) in a public office, sufficient detail so the lender can identify it,
usually the county recorder or secretary of state. and should assign to the lender the right to sell
The system of filing required by the UCC or dispose of the collateral if the borrower is
provides for a notice filing whereby potential unable to pay the obligation.
creditors can determine the existence of any • Collateral possession. If the institution has
outstanding liens against the debtor’s property. taken possession of the collateral to perfect its
The form of the financing statement and security interest, management of the institu-
where to file it varies from state to state. While tion should have an adequate record-keeping
the filing of a nonstandard form will generally system and proper dual control over the
be accepted, the failure to file in the proper property.
public office can jeopardize the priority of the • Financing statement. If the institution has
lender’s security interest. The UCC provides filed a financing statement with the state or
three alternative filing systems: local authority to perfect its security interest in
the collateral, in general, it should contain the
• Alternative System One. Liens on minerals, following information:
timber to be cut, and fixtures are filed in the —names of the secured party and debtor
county land records. All other liens are filed in —the debtor’s signature
the office of the secretary of state. —the debtor’s mailing address
• Alternative System Two. The majority of —the address of the secured party from which
states have adopted this version. It is the same information about the security interest may
as system one, except liens on consumer be obtained
goods, farm equipment, and farm products are —the types of the collateral and description
filed in the county where the debtor resides or of the collateral (Substantial compliance
in the county where the collateral is located if with the requirements of UCC section 9-402
it is owned by a nonresident. is sufficient if errors are only minor and not
seriously misleading. Some states require
• Alternative System Three. In a minority of
the debtor’s tax ID number on the financing
states, filings made with the secretary of state
statement.)
must also be filed in the county of the bor-
rower’s business (or residence if there is no • Amendments. Not all amendments require the
place of business in that state). Otherwise, the borrower’s signature, and banks may file an
requirement in these states is the same as amendment for the following reasons:
system two. —borrower’s change of address
—creditor’s change of address
As each state may select any of the above —borrower’s name change
three alternatives or a modified version of them, —creditor’s name change
it is important that the examiner ascertain the —correction of an inaccurate collateral
filing requirements of the state(s) where the description
bank’s customer operates. Most importantly, it —addition of a trade name for the borrower
is the location of the borrower, not the bank, that that was subsequently adopted

Page 6
• Where to file a financing statement. In general, ing the mortgage. Make sure that the form of
financing statements filed in good faith or the acknowledgment used is in accordance
financing statements not filed in all of the with the type of individual or entity executing
required places are effective with respect to the mortgage.
any collateral covered by the financing state- • If a corporation is the mortgagor, its articles of
ment against any person with knowledge of incorporation or bylaws often will specifically
the statement’s contents. If a local filing is state which officers have authority to sign an
required, the office of the recorder in the instrument affecting real estate. In these
county of the debtor’s residence is the place to instances, the designated officer should be
file. If state filing is required, the office of the required to sign. If the corporation has a seal,
secretary of state is the place to file. that also must be affixed. If the corporation
• Duration of effectiveness of a financing does not have a seal, this fact must be shown
statement. Generally, effectiveness lapses five in the acknowledgment.
years after filing date. If a continuation state- • As soon as possible after the mortgage is
ment is filed within six months before the executed, it should be recorded in the office of
lapse, effectiveness is extended five years the recorder for each county in which the
after the last date on which the filing was property described in the mortgage is located.
effective. Succeeding continuation statements In most cases, the borrower signs an affidavit
may be filed to further extend the period of that indicates, in part, that he or she will not
effectiveness. attempt to encumber the property while the
lender is waiting for the mortgage to be
recorded. In smaller community banks, com-
Perfection of Security Interest in Real mon practice may be not to advance any of the
Estate money under the loan until the mortgage has
been recorded and the later search completed.
As previously mentioned, real estate is expressly In larger banks or cities, however, this practice
excluded from coverage under the UCC. A is often not practical.
separate body of state law covers such interests. • If the mortgagor is married, the spouse must
However, for a real estate mortgage to be join in the execution of the mortgage to
enforceable, the mortgage must be recorded in subject his or her interest to the lien of the
the county where the real estate covered by the mortgage. If the mortgagor is single, the
mortgage is located. mortgage should indicate that no spouse exists
who might have a dower interest or homestead
Real estate mortgage or deed of trust. When interest in the property.
obtaining a valid lien on real estate, only one • If the mortgagor is a partnership, it must be
document is used, the mortgage or deed of trust. determined whether the title is in the name of
The difference between a mortgage and a deed the partnership or in the names of the indi-
of trust varies from state to state; however, the vidual partners. If the title is in the names of
primary difference relates to the process of the individual partners, their spouses should
foreclosure. A mortgage generally requires a join in executing the mortgage. If the title is in
judicial foreclosure, whereas, in some states, a the name of the partnership, those partners
foreclosure on a deed of trust may not. Nearly who are required to sign under the partnership
all matters affecting the title to the real estate, agreement should sign.
including the ownership thereof, are recorded in
the recorder’s office.
When determining the enforceability of a real
estate mortgage or deed of trust, the examiner Unsecured Transactions
should be aware of the following requirements:
Unsecured transactions are granted based on the
• The mortgage must be in writing. borrower’s financial capacity, credit history,
• To be recordable, the mortgage must be earnings potential, and liquidity. Assignment of
acknowledged. There are different forms of the borrower’s collateral is not required, and
acknowledgments for various situations repayment is based on the terms and conditions
depending on whether individuals, corpora- of the loan agreement. While unsecured loans
tions, partnerships, or other entities are execut- often represent the bank’s strongest borrowers,

Page 7
the unsecured loan portfolio can represent its and credit standards, and evaluating the adequacy
most significant risk. One of the primary con- of the allowance for loan and lease losses. Credit
cerns related to unsecured credit is that if the reviews also help the examiner to ascertain a
borrower’s financial condition deteriorates, the bank’s compliance with applicable laws and
lender’s options to work out of the lending regulations, judge the safety and soundness of
relationship deteriorate as well. In general, if a the bank’s lending and credit-administration
credit is unsecured, the file should contain functions, and, most important, evaluate directly
reliable and current financial information that is the quality of the bank’s loan portfolio. Since
sufficient to indicate that the borrower has the examiners need to make the most efficient use of
capacity and can be reasonably expected to their time during their on-site review of the loan
repay the debt. portfolio, it is not practical to review every loan
in the bank’s loan portfolio. Instead, examiners
must select for review a sample of loans1 that is
Problem Loans sufficient in size and scope to enable them to
reach reliable conclusions about the bank’s over-
The following are key signals of an emerging all lending function. At a minimum, examiners
problem loan: should include in their sample a group of loans
referred to as the ‘‘core group,’’2 as described
• Outdated or inaccurate financial information below.
on the borrower. The borrower is unwilling to SR-02-19 describes an alternative to the tra-
provide the financial institution with a current, ditional statistical sampling procedures (see SR-
complete, and accurate financial statement at 94-13) found in this section. (See also section
least annually. Management should also be 2082.1.) The alternative statistical sampling pro-
requesting a personal tax return (and all related cedures of SR-02-19 may only be used for
schedules) on the borrower. While borrowers reviewing loans at certain community banks—
will usually present their personal financial those rated CAMELS composite and asset qual-
statements in the most favorable light, their ity 1 or 2 with assets of less than $1 billion. The
income tax return provides a more conserva- statistical sampling approach is not recom-
tive picture. mended for use at de novo banks and other
• The crisis borrower. The borrower needed the banks with unusually high or low capital ratios.
money yesterday, so the bank advanced unse- If the statistical sampling procedures of SR-
cured credit. 02-19 are not used, the minimum loan-review
• No specific terms for repayment. The unse- coverage is still 40 percent of the core group of
cured loan has no structure for repayment, and loans.
it is commonly renewed or extended at
maturity.
• Undefined source of repayment. These types Core Group
of loans are often repaid through excess cash
flow of the borrower, sale of an asset(s), or Commercial and industrial loans and commer-
loan proceeds from another financial institu- cial real estate loans subject to examiner review
tion. These repayment sources are often not should include the following:
identified and are unpredictable.
• All problem loans, including loans that have
been previously classified or specially men-
tioned by the respective Reserve Bank or state
LOAN-SAMPLING AND banking department during the most recent
COVERAGE REQUIREMENTS
1. For the purposes of this section, the term ‘‘loans’’
A thorough review of a bank’s commercial loan includes all sources of credit exposure arising from loans and
portfolio is one of the most important elements leases. This exposure includes guarantees, letters of credit,
of a bank examination. Credit reviews are an and other loan commitments.
examiner’s primary means for evaluating the 2. If the examiner decides it is practical, the requirements
and fundamental guidance set forth in this section can be
effectiveness of internal loan-review and credit- applied to all types of commercial and industrial loans, as well
grading systems, determining that credit is being as to commercial real estate loans or any other type of loan
extended in compliance with internal policies made by the bank.

Page 8
examinations, loans that are past due as of the

date of examination, loans that are on non-
accrual status, loans that have been designated
as impaired according to the guidelines set
forth in Statement No. 114 of the Financial
Accounting Standards Board, loans that are
considered renegotiated or restructured debt,
and loans that are included on the bank’s most
recent internal watch list.
• All large loans, defined as loans or aggrega-
tions of loans to the same or related borrowers
that exceed a dollar cutoff level established by
the examiner-in-charge. This cutoff will typi-
cally be equal to about 1 percent of a bank’s

Page 8.1
equity capital, but a higher or lower percent- • is well-managed, and

age may be warranted depending on the cir- • has effective internal risk controls and under-
cumstances of the bank being examined. writing standards.
• Insider loans, as defined by the Board’s Regu-
lation O (12 CFR 215). Furthermore, the examiner should not have
identified any other matters of significant con-
This core group of loans (problem loans, cern during the examination. In other words,
special-mention loans, insider loans, and large coverage of the core group of loans could be
loans) should represent a substantial portion of 40 percent only for a bank that received a
the dollar volume of a bank’s total commercial composite CAMELS rating of 1 or 2 and an
and industrial loans and commercial real estate asset-quality rating of 1 on its last examination,
loans. Nevertheless, in the majority of cases, the provided the findings of the current review of
examiner should select additional loans from the the core group of loans appears consistent with
remaining portfolio to be reasonably assured of these ratings. For banks that have high overall
making an accurate and comprehensive assess- ratings (CAMELS 1 and 2) but a coverage ratio
ment of the condition of the bank’s overall loan for its core group of loans that is significantly
portfolio and lending activities.3 below 40 percent, additional loans should be
In determining the size and nature of addi- selected to bring the coverage ratio for all loans
tional loans to be reviewed, the examiner should reviewed to a minimum 40 percent.
consider the coverage ratio of the core group of Banking organizations with less than satisfac-
loans.4 If the core group of loans reviewed tory composite supervisory ratings or other sig-
constitutes a substantial portion of the total nificant areas of supervisory concern should
dollar volume of loans (at least 40 to 50 per- have loan coverage ratios of at least 55 to
cent), then sufficient additional loans should be 60 percent to fully determine the financial con-
reviewed to raise the coverage ratio another dition of the organization. Any divergence from
10 percent. If, on the other hand, the coverage these guidelines should be fully documented in
ratio of the core group of loans reviewed is the confidential section of the examination report.
lower, primarily because the bank has fewer The examiner should use his or her conclu-
large loans, then a greater number and higher sions from the review of the core group of loans
dollar volume of loans outside the core group to determine the extent to which additional loans
should be reviewed. For example, if the cover- should be selected for review, as these loans
age of the core group of loans amounts to only will provide the most up-to-date indications of
20 to 30 percent, then the loans reviewed in the the general condition of the bank’s loan port-
remaining portfolio should raise the coverage folio and the adequacy of the bank’s credit-
ratio to a minimum of 40 to 50 percent. Loan administration practices. For example, if the
coverage at the lower end of this range (40 per- review of the core group of loans reveals that an
cent) would be appropriate only if the bank— undue proportion of a bank’s problem assets are
concentrated in a particular type of loan or if a
• is in satisfactory condition, portion of the portfolio is growing rapidly, the
• has strong asset quality, additional loans to be reviewed should be
selected from that group.
In determining the extent of additional loans
to be reviewed, the effectiveness of the bank’s
3. One approach to selecting the additional sample of loans internal credit-review and -grading system
to be reviewed is to lower the cutoff level of larger loans
subject to review. Alternatively, other methods (including
should also be considered. If, for example, the
random sampling or selecting recent loans or specific loan examiner’s review of the core group of loans
types) may be used to select the sample when these methods provides essentially the same results as those
appear more suited to the bank’s circumstances. from these systems, then the number and dollar
4. A loan-review-coverage ratio should be calculated by
dividing the dollar volume of commercial and industrial loans
size of the remaining sample reviewed can
and commercial real estate loans reviewed during the exami- be kept relatively low (unless the review of
nation by a bank’s total dollar volume of such credits. For the the remaining sample raises questions about the
purposes of this calculation, loans are defined as all sources of integrity of the system with respect to the
credit exposure arising from loans and leases, including
guarantees, letters of credit, and other loan commitments.
remaining portfolio).
Credit exposures arising from trading and derivatives activi- In addition to the coverage ratio of the core
ties are not generally included in this coverage ratio. group of loans, an examiner should take into

Page 9
account other factors, including the overall con- In statistical sampling, the examiner uses the
dition of the bank at its last examination and, concepts of probability to apply sampling tech-
most importantly, that examination’s findings on niques to the design, selection, and evaluation of
the quality of the loan portfolio and the ade- loan samples. Statistical sampling eliminates (or
quacy of loan-administration activities (that is, at least minimizes) potential selection biases
the accuracy of internal loan-rating systems, the because each item in the sample-loan population
appropriateness of underwriting standards, the must have an equal or otherwise determinable
adequacy of documentation in files, the ade- probability of being included in the examined
quacy of management information and internal portion. This probability provides the examiner
control systems, and the adequacy of loan-loss with a quantitative, controllable measure of risk.
reserves). Other important factors are the ability Generally, statistical sampling techniques may
and experience of the lending officers and per- be implemented only in those banks (1) that
sonnel managing the lending function, any were found to be in financially sound condition,
changes in asset quality or lending policies since (2) that were without any undue loan port-
the last examination, and significant concentra- folio problems at the latest examination, and
tions identified in the preliminary review of the (3) where it was determined that the systems
loan portfolio. Regardless of the total coverage and controls were appropriate for implementing
of the core-group review and the additional such techniques. Moreover, if during an exami-
sample of loans, the examiner must select a nation, the examiner determines that the statis-
sufficient number, volume, and variety of loans tical sampling results are unsatisfactory, the
to accurately judge the condition of the bank’s traditional judgmental sampling technique should
entire loan and lease portfolio and the effective- be implemented.
ness of its credit-administration policies and The two recommended statistical sampling
practices. techniques are described below:
• Attributes Sampling. The objective of attributes

Commercial Loan Sampling sampling is to determine from a sample,
Techniques within specified reliability limits, the validity
of the bank’s internal loan-review program.
Sampling techniques are a valid and efficient The reliability limits are determined by the
method for reviewing the commercial loan port- examiner, who formulates a hypothesis about
folios at banks during on-site examinations. the bank’s loan-review program when evalu-
Sampling enables the examiner to draw conclu- ating its policies, practices, and procedures for
sions regarding the condition of the entire loan loan extensions. The population to be sampled
portfolio by reviewing only a selected portion. consists of all loans between certain dollar
These techniques make more efficient use of parameters, except for loans reviewed under
examination resources and allow examiners to the shared national credit program and loans
devote more of their time and efforts to other to identified problem industries (the latter are
areas of the examination. reviewed separately during the examination).
Generally, a judgmental sampling technique The lower dollar parameter is an amount that
is used for reviewing commercial loans. This the examiner deems sufficient to achieve the
technique enables examiners to evaluate the desired coverage of the loan portfolio and is
portfolio by reviewing a desired percentage of selected in much the same manner as a cutoff
all the loans over a preselected cutoff amount. In line is chosen in judgmental sampling. The
addition to the judgmental sampling approach, upper dollar parameter is an amount over
statistical sampling techniques can also be valid which all loans must be reviewed because of
methods for evaluating loan portfolios. Two the significant effect each could have on the
statistical sampling techniques that may be bank’s capital. Loans are selected from the
selectively implemented during on-site exami- sample population by using a random digit
nations are attributes sampling and proportional table.
sampling. Attributes sampling is especially well- When the selected loans are reviewed, the
suited for large banks that have formal loan examiner compares his or her grading with
review programs; proportional sampling may be those of the bank’s loan-review program. An
better suited for smaller or regional banks with- ‘‘error’’ generally exists if the examiner’s
out internal loan-review programs. grading of a particular loan is significantly

Page 10
more severe than the bank’s grading. If the REVIEWING CREDIT QUALITY
error rate in the sample is beyond the pre-
established reliability limits the examiner is Importance of Cash Flow
able to accept, all loans over the cutoff amount
should be reviewed. If the examiner is satis-
fied with the sample results, the bank’s inter- Evaluating cash flow is the single most impor-
nal grading will be accepted for all criticized tant element in determining whether a business
loans that have not been independently has the ability to repay debt. Two principal
reviewed within the sample population. Even methods of calculating the cash flow available in
when the bank’s internal grading is deemed a business to service debt are presented in this
acceptable by the examiner, any loans reviewed subsection. The results of these methods should
and found to be in error will be appropriately be used to determine the adequacy of cash flow
classified in the report. in each credit evaluated at an institution. The
accrual conversion method is the preferred
• Proportional Sampling. The procedures for method because it is the most reliable. The
proportional sampling are similar to those second and less reliable method is the supple-
followed for attributes sampling. The objec- mental or traditional cash-flow analysis; how-
tive of this sampling technique is to determine ever, the information needed for this analysis is
whether bank management can identify all the usually more obtainable and easier to calculate.
criticizable loans in the portfolio. The exam- The traditional method can be used when cir-
iner formulates a hypothesis about the quality cumstances warrant, for example, when the
of the examined bank’s loan administration, borrower’s financial statements are not suffi-
based on an analysis of loan policies, prac- ciently detailed for the information requested in
tices, and procedures for loan extensions. In the accrual conversion analysis or when histori-
proportional sampling, every loan in the cal information is inadequate.
sample population is given an equal chance of
selection in proportion to its size, so the larger
the loan, the more likely it will be selected for Analysis and Limitations of Cash Flow
review. Examiners grade the loans in the
sample and compare these gradings with the Cash-flow analysis uses the income statement
bank’s problem-loan list. and balance sheet to determine a borrower’s
As in attributes sampling, the examiner operational cash flow. Careful analysis of all
specifies the desired precision of the sample, investment and financing (borrowing) activities
that is, that the true error rate in the bank’s must be made for an accurate assessment of cash
problem-loan list should be within a certain flow. In reality, examiners face time constraints
range of values. A statistical error occurs that often prevent them from performing the
whenever the examiner criticizes a loan that is complex mathematical calculations involved in
not criticized by the bank. If the error rate is sophisticated cash-flow analysis. Therefore, the
higher than expected, the examiner will review cash-flow methods presented below were
all loans over a cutoff line, which is deter- designed to be reasonable and practical for
mined using the same criteria as line selection examiner use. However, examiners should be
in judgmental sampling. If the sample results careful of conclusions reached using the tradi-
indicate an error rate within expectations, then tional cash-flow analysis, without consideration
the examiner will accept the bank’s problem- to balance-sheet changes or other activities that
loan list as a reliable list of the nonpass loans affect cash flow. The traditional cash-flow analy-
in the population from which the sample was sis does not recognize growth in accounts
taken. The examiner will then review and receivable or inventory, a slow-down in accounts
grade each loan on the problem-loan list over payable, capital expenditures, or additional bor-
the cutoff amount. rowings. If the credit file contains a CPA-
prepared statement of cash flow or a statement
For detailed procedures on how to implement prepared using the accrual conversion method,
both attributes and proportional sampling, the examiner should concentrate efforts on
examiners should contact either Reserve Bank reviewing and analyzing these statements rather
supervision staff or Federal Reserve Board than on preparing a traditional cash-flow
supervision staff. statement.

Page 11
One critical issue to remember is that deficit Excess

cash flow does not always mean that the bor- (Deficit)
rower is encountering serious financial difficul- Cash Flow: Represents cash available before
ties. In some cases, deficit cash flow is caused debt service.
by a business’s experiencing significant growth,
and there is a pronounced need for external
financing to accommodate this growth and elimi- Calculation of Supplemental/Traditional
nate the deficit cash-flow position. In this case, Cash Flow
an adequate working-capital facility may not be
in place to accommodate the need for additional Net Income: Amount of net income reported
inventory. A comprehensive analysis of changes on most recent annual income
in the balance sheet from period to period statement before taxes.
should be made before the loan is criticized.5
Interest
Expense: Add the total amount of interest
Components of the Accrual Conversion expense for the period.
Method of Cash Flow Depreciation/
Amortization: Add all noncash depreciation
Category Basis for Amount
and principal amortization on
Sales: Dollar amount of sales in period outstanding debt.
+/−change in Cash Flow
A/R, INV., before
A/P: Represents the absolute differ- Debt Service: Indicates net Earnings Before
ence of the current period from Interest, Taxes, Depreciation,
the corresponding period of the and Amortization (EBITDA).
previous year in accounts Amortization should include
receivable, inventory, and both principal and interest pay-
accounts payable. ments required on debt.
Formula: (a) An increase in any current Debt Service: Subtract scheduled principal
asset is a use of cash and is and interest payments.
subtracted from the calculation.
Capital
Conversely, a decrease in any
Expenditures: Subtract all capital expendi-
current asset is a source of cash
tures for the period.
and is added to the calculation.
EQUALS—
(b) An increase in any current
Excess (Deficit)
liability is a source of cash and
Cash Flow: Total amount of excess or defi-
is added to the calculation. Con-
cit cash flow for the period after
versely, a decrease in any cur-
debt service.
rent liability is a use of cash
and is subtracted from the Coverage
calculation. Ratio: Cash flow before debt service
divided by debt service (princi-
SGA: Subtract selling, general, and
pal and interest).
administrative expenses.
Interest
Expense: Add interest expense to the cal-
culation if SGA ‘‘expense’’
Importance of Financial Analysis
includes interest expense.
While cash-flow analysis is critical in reviewing
whether a borrower has the ability to repay
5. Examiners should make sure that they are using financial individual debt, a review of the borrower’s other
data from consistent periods, that is, year-to-date financial
information. Mixing annual financial data with interim finan-
financial statements can offer information about
cial information can cause misinterpretation of cash flow for a other sources of repayment, as well as the
given business cycle or annual period. borrower’s overall financial condition and future

Page 12
prospects. The availability of historical balance- debt capacity and ability to meet obligations.
sheet and income information, which allow These ratios may include debt to assets, debt
declining trends to be identified, is critical. Also, to net worth, debt to tangible net worth, and
it may be appropriate to compare the borrower’s interest coverage.
financial ratios with the average for the industry • Liquidity ratios. Include ratios such as the
overall. Much of the financial information that current ratio and quick ratio, which measure
examiners will review will not be audited; the borrower’s ability to meet current
therefore, considerable understanding of general obligations.
accounting principles is necessary to compe-
tently review an unaudited financial statement.
The bank should obtain at least annual financial
statements from a borrower. Common ‘‘Red Flags’’
When reviewing a credit file of a borrowing
customer of a bank, the following financial The symptoms listed below are included to
information should be available for review: provide an understanding of the common prob-
income statement, balance sheet, reconciliation lems or weaknesses examiners encounter in
of equity, cash-flow statements, and applicable their review of financial information. While one
notes to financial statements. The components symptom may not justify criticizing a loan,
for a financial review can be segregated into when symptoms are considered in the aggregate,
three areas: operations management, asset man- they may help the examiner detect near-term
agement, and liability management. Operations trouble. This list is only a sampling of ‘‘red
management is derived from the income state- flags’’ that should prompt further review; exam-
ment and can be used to assess company sales, iners should also be able to identify issues that
cost control, and profitability. Asset manage- may require further investigation from their
ment involves the analysis of the quality and cursory review of a borrower’s financial
liquidity of assets, as well as the asset mix. statement.
Liability management covers the analysis of the
company’s record of matching liabilities to the • A slowdown in the receivables collection
asset conversion cycle, such as long-term assets period. This symptom often reveals that the
being funded by long-term liabilities. borrower has become more liberal in estab-
In studying the above forms of management, lishing credit policies, has softened collection
various ratios will help the examiner form an practices, or is encountering an increase in
informed and educated conclusion about the uncollected accounts.
quality of the credit being reviewed. The ratios • Noticeably rising inventory levels in both
can be divided into four main categories: dollar amount and percentage of total assets.
Increases in inventory levels are usually sup-
• Profitability ratios. These ratios measure man- ported by trade suppliers, and financing these
agement’s efficiency in achieving a given increases can be extremely risky, particularly
level of sales revenue and profits, as well as if turnover ratios are declining. The increase
management’s ability to control expenses and in inventory levels or lower turnover ratios
generate return on investment. Examples of may also be related to the borrower’s natural
these ratios include gross margin, operating reluctance to liquidate excessive or obsolete
profit margin, net profit margin, profit to sales goods at a reduced price. Many businesses are
ratio, profit to total assets ratio, and direct willing to sacrifice liquidity to maintain profit
cost and expense ratios. margins.
• Efficiency ratios. These ratios, which measure • Slowdown in inventory turnover. This symp-
management’s ability to manage and control tom may indicate overbuying or some other
assets, include sales to assets, inventory days imbalance in the company’s purchasing poli-
on hand, accounts receivable days on hand, cies, and it may indicate that inventory is
accounts payable days on hand, sales to net slow-moving. If the inventory is undervalued,
fixed assets, return on assets, and return on the actual turnover is even slower than the
equity. calculated results.
• Leverage ratios. These ratios compare the • Existence of heavy liens on assets. Evidence
funds supplied by business owners with the of second and third mortgage holders is a sign
financing supplied by creditors, and measure of greater-than-average risk. The cost of junior

Page 13
money is high. Most borrowers are reluctant review systems. However, the disposition of the
to use this source of funds unless conventional loan and the reasons for that disposition are the
sources are unavailable. most crucial entries on the line ticket. Examiners
• Concentrations of noncurrent assets other must document their entries and decide how
than fixed assets. A company may put funds much of the documentation is required to sup-
into affiliates or subsidiaries for which the port the loan-review decision. That decision and
bank may not have a ready source of infor- a summary of the reasons a loan is passed, listed
mation on operations. for special mention, or adversely classified
• High levels of intangible assets. Intangible should be provided (preferably in bullet form)
assets, which shrink or vanish much more on the loan line ticket. Beyond that, the docu-
quickly than hard assets, usually have very mentation will vary depending on the complex-
uncertain values in the marketplace. In some ity and profile of the credit. The examiner may
cases, however, intangible assets such as pat- provide more detailed information on the collat-
ents or trademarks have significant value and eral, cash flow, and repayment history. This
should be given considerable credit. additional information is not mandatory if the
• Substantial increases in long-term debt. This rationale for the disposition of the credit is
symptom causes increasing dependence on otherwise clear.
cash flow and long-term profits to support The extension of credit line sheets and work-
debt repayment. papers should document loan discussion com-
• A major gap between gross and net sales. This ments, identify the examiner who reviewed the
gap represents a rising level of returns and credit, and identify the officer(s) with whom the
allowances, which could indicate lower qual- credit was discussed. Line sheets should also
ity or inferior product lines. Customer dissat- include the examiner’s conclusion on the spe-
isfaction can seriously affect future profitability. cific credit and the reasons for that conclusion.
• Rising cost percentages. These percentages As part of a review of examination and
can indicate the business’s inability or unwill- supervisory policies and procedures and to pro-
ingness to pass higher costs to the customer or mote consistency, the items described below
its inability to control overhead expenses. have been implemented as required minimum
• A rising level of total assets in relation to documentation standards for loan line sheets.
sales. If a company does more business, it will These standards recognize a transactional
take more current assets in the form of inven- approach in examinations and reflect the effi-
tory, receivables, and fixed assets. Examiners ciencies inherent in a risk-focused approach to
should be concerned when assets are increas- examinations. The amount of information that
ing faster than sales growth. should be documented or included as part of a
• Significant changes in the balance-sheet struc- line sheet may vary depending on the type,
ture. These changes may not be the customary complexity, and materiality of the credit. How-
changes mentioned previously, but they are ever, all line sheets should include the following
represented by marked changes spread across information to satisfy the required minimum
many balance-sheet items and may not be documentation standards, as set forth by SR-
consistent with changes in the marketplace, 99-25 (‘‘Minimum Documentation Standards
profits or sales, product lines, or the general for Loan Line Sheets,’’ September 29, 1999).
nature of the business. The first seven items are frequently provided
through computer-based loan-review systems.
• Name and location of borrower. Document the

REQUIRED MINIMUM name of the individual or company respon-
DOCUMENTATION STANDARDS sible for repayment of the debt.
FOR LOAN LINE SHEETS • Notation if the borrower is an insider or a
related interest of an insider. If the borrower is
Certain minimum documentation must appear an insider or a related interest of the insider as
on all line examination sheets to leave an defined by Regulation O, reflect this associa-
acceptable audit trail and to support the classi- tion on the line sheet.
fication of designated loans. Currently, much of • Business or occupation. Briefly describe the
this information is often placed on the line ticket legal entity and the type of business in which
automatically by using computer-based loan- the company is engaged, according to the

Page 14
following definitions: type of document, such as a recent financial

— Corporation. A business organization that statement, formal appraisal, management
is owned by shareholders who have no estimate, or any publication that maintains a
inherent right to manage the business. The current market value of collateral. At a mini-
organization is generally managed by a mum, the collateral assessment should include
board of directors that is elected by the the following information:
shareholders. The file should contain the — collateral value
borrowing resolution indicating which — basis for valuation
officers from the corporation are autho- — date of valuation
rized to sign on its behalf. Indicate if the — control of collateral
corporation is closely held. — current lien status
— Partnership. A business organization, spe- • Loan officer assigned to the credit and the
cifically, an association of two or more internal rating of the credit. Note the name of
persons to carry on as co-owners of a the loan officer responsible for the loan. Also
business for profit. Indicate if it is a document the bank’s internal risk-rating. The
general partnership (GP) or limited part- date of the most recent update of the rating
nership (LP). If GP, each partner is fully should also be noted. Particular attention
liable for the firm’s debts and actions. If should be given to the consistency between
LP, at least one general partner is fully the loan classification at the current examina-
liable, but there will also be a number of tion and the assessment provided by the bank’s
partners whose liability is limited to that internal loan-review department. Significant
enumerated by the partnership agreement. disparities should be noted in the asset-quality
Indicate each partner’s proportionate inter- assessment.
est (such as 25 or 50 percent). • Total commitment and total outstanding bal-
— Proprietorship. A form of business orga- ances. Indicate the total amount of the bank’s
nization that is owned and operated by an legal commitment or line of credit available to
individual. If the borrower is an indi- the borrower. Note the total outstanding debt
vidual, include his or her primary occu- to the borrower as of the date of examination.
pation. • Examination date. Indicate the as-of date of
• Loan terms. Include the following loan infor- the examination.
mation6: • Past-due or nonaccrual status. Indicate the
— date of origination (note subsequent past-due status (current, nonaccrual, and days
renewals and/or extensions) past due).
— repayment terms (for example, maturity, • Amounts previously classified. Note the loan
periodic payments, revolving) amount and how the loan was previously
— maturity (restructured loans should be classified at the most recent examination (Fed-
noted as such) eral Reserve Bank or state).
— interest rate (fixed or variable) (If vari- • Loan disposition (pass, special mention, or
able, state the basis (index) upon which adverse classification). Note the credit amount
the interest rate is determined.) and how the credit is being classified, such as
— originated amount of the loan pass, special mention, substandard, doubtful,
• Purpose of loan. Note the purpose of each or loss.
credit facility. • Rationale for examiner’s conclusions (prefer-
• Repayment source. Indicate the primary and ably in bullet form). Indicate the reasons for
secondary sources of repayment for each credit passing the credit or extending it for criticism,
facility. which should be consistent with the classifi-
• Collateral summary and value. Describe col- cation descriptions noted in ‘‘Classification
lateral and assess the value of the collateral in of Credits,’’ section 2060.1.
which the bank maintains a perfected security • Name or initials of the examiner reviewing the
interest. Values should be supported by some credit. Indicate the name or initials of the
examiner who reviewed and assigned the
classification to the credit.
6. If the loan is a shared national credit (SNC), this should
be noted on the line sheet. A copy of the SNC write-up should
• Any significant comments by, or commitments
be attached to the line sheet, and it is not necessary to provide from, management. Clearly and specifically
any additional data. indicate relevant comments (including man-

Page 15
agement’s disagreement with the disposition • Guarantor(s). If a guarantor exists, the name,
of the loan, if applicable) that may be consid- amount of the guaranty, and date the guaranty
ered when determining whether or not to was signed can be noted. A summary and an
criticize the credit. Comments can include assessment of data supporting a guaranty may
officer’s comments noted in the credit file, also be included, along with current financial
information derived from discussions with information from the guarantor(s) which the
management, questions the examiner may have bank should obtain at least annually. Tax
about the borrower, or any other item deemed returns and supporting schedules, income state-
appropriate. If management plans to get out of ments, and other pertinent information on the
the credit relationship, a workout strategy guarantor(s) may be appropriate under certain
should be included in this section. Comments circumstances. If a troubled credit, indicate
should be included as to why management whether the guarantor has exhibited any will-
disagrees with any loan classification or how ingness to financially support the credit.
any loan was classified. • Summary of financial data. The following
• Any noted documentation exceptions or loan- information may be appropriate, based on the
administration policy or procedural weak- type and complexity of the loan:
nesses, and any contravention of law, regula- — key balance-sheet information (current
tion, or policy. Indicate any documentation ratio, D/E ratio)
exception or violation of law, regulation, or — key income items (EBITDA—earnings
policy that would be appropriate to include as before income taxes, depreciation, and
part of the report of examination. The exam- amortization; net income; profit margin)
iner may include any technical exception — cash-flow coverage (debt-service cover-
noted from the credit file that would inhibit age, interest coverage)
the ability of the loan officer or the examiner — source of financial data (company-
to make an informed and/or competent judg- prepared balance sheet, audited financial
ment about the quality of the credit relationship. statement)
• Dates and amounts of previous charge-offs.
When needed, loan line sheets should briefly • Specific reserves. The examiner may indicate
note that information is not available or that whether an amount (allocated reserve) was
certain information is not reliable due to defi- specifically set aside to absorb any loss from
cient loan-administration systems and pro- the credit. When evaluating the overall
cesses, particularly with respect to loan and adequacy of the loan-loss reserve, subtract the
collateral documentation and collateral values. aggregate of allocated reserves from the total
If such deficiencies are material, a listing of the reserve balance, and subtract the aggregate
exceptions should be noted in the examination amount of loans for which allocated reserves
report. In addition, the effect of these loan- exist from the total loan balance.
administration weaknesses should be discussed • The name of the loan officer who may have
and factored into the risk-management rating. offered the most pertinent discussion items
that affected the classification decision.
Optional Information for Loan Line BANKRUPTCY LAW AND

Sheets COMMERCIAL LOANS
In addition to the above information, additional This section provides examiners with an over-
items should be listed when needed to describe view of the United States Bankruptcy Code (the
the terms of the credit and/or the disposition code) chapters that affect commercial and indus-
accorded to it by the examiners, for example, trial loans. Bankruptcy law is a significant body
guarantors, amount of any specific reserve, or of law; it would be difficult in this manual to
amounts previously charged off, as described discuss all the issues necessary for comprehen-
below: sive understanding of the code. This subsection
• Related debt/tie-ins. The name, total debt will focus on basic issues that an examiner
outstanding, and type of borrowings (such as needs to be familiar with relative to three
real estate, commercial, installment debt) of principal sections of the code: chapters 7, 11,
the related party might be indicated. and 13.

Page 16
Creditors of a Bankrupt Business to a bankruptcy trustee. The trustee liquidates all

assets and distributes the net proceeds on a pro
A creditor in bankruptcy is anyone with a claim rata basis against the allowed claims of unse-
against a bankrupt business, even if a formal cured creditors. Secured creditor claims are
claim is not filed in the bankruptcy case. In generally satisfied by possession or sale of the
bankruptcy court, a claim is defined very broadly. debtor’s assets. Depending on the circum-
A claim may include a right to payment from a stances, a secured creditor may receive the
bankrupt business, a promise to perform work, collateral, the proceeds from the sale of the
or a right to a disputed payment from the debtor collateral, or a reaffirmation of the debt from
that is contingent on some other event. The two the debtor. The reaffirmed debts are generally
basic types of creditors are secured and unse- secured by property that the debtor can exempt
cured. Secured creditors are those with perfected from the bankruptcy estate, such as a home or
security interest in specific property, such as vehicle. The amount of the reaffirmation is
equipment, accounts receivable, or any other limited to the value of the asset at the time of the
asset pledged as collateral on a loan. Unsecured bankruptcy filing. Some characteristics of a
creditors are generally trade creditors and others chapter 7 bankruptcy are described below:
who have not taken a specific interest in prop-
erty supplied to the bankrupt debtor. • A trustee is appointed in all chapter 7 bank-
ruptcies and acts as an administrator of the
bankruptcy estate. The bankruptcy estate that
Voluntary Versus Involuntary

Bankruptcy
When a debtor files a bankruptcy petition, it is
described as a voluntary bankruptcy filing. The
individual or organization does not have to be
insolvent to file a voluntary case. Creditors may
also file a bankruptcy petition, in which case the
proceeding is known as an involuntary bank-
ruptcy. This form of petition can occur in
chapters 7 and 11 bankruptcy cases, and the
debtor generally must be insolvent. To be deemed
insolvent, the debtor must be unable to pay debts
as they mature. However, the code does limit
who an involuntary action can be sought against.
Chapter 7—Liquidation Bankruptcy

A chapter 7 action may be filed by virtually any
person or business organization that is eligible
to file bankruptcy. Chapter 7 bankruptcy can be
filed by a sole proprietorship, partnership, cor-
poration, joint stock company, or any other
business organization. Restrictions apply to only
a few highly regulated businesses, such as
railroads, insurance companies, banks, munici-
palities, and other financial institutions. This
chapter is often referred to as ‘‘straight liquida-
tion,’’ or the orderly liquidation of all assets of
the entity. Generally, a debtor in a chapter 7
bankruptcy case is released from obligations to
pay all dischargeable prebankruptcy debts in
exchange for surrendering all nonexempt assets

Page 16.1
is established when the petition is filed and equity interest into classes and provide for
becomes the legal owner of the property. The equal treatment of such class members. A plan
trustee acts to protect the interest of all parties must also identify those classes with impaired
affected by the bankruptcy. claims and their proposed treatment. Finally, a
• The trustee has control of all nonexempt method of implementation must be provided.
assets of the bankrupt debtor. Although plans do not have to be filed by a
• The trustee is required to liquidate the estate deadline, the bankruptcy judge will generally
quickly without jeopardizing the interests of place a deadline on the debtor or creditor autho-
the affected parties. rized to prepare the plan.
• The proceeds from the sale pay trustee’s fees Some characteristics of a chapter 11 bank-
and other creditors. Trustee fees are deter- ruptcy are described below.
mined according to the amount disbursed to
the creditors and are a priority claim. • The bankrupt debtor usually controls the busi-
• A chapter 7 bankruptcy is typically completed ness during the bankruptcy proceedings. This
in 90 days, depending on the time needed to arrangement is referred to as ‘‘debtor in
liquidate collateral. Some chapter 7 bankrupt- possession.’’
cies take years to complete. • The business continues to operate while in
• The court may allow the trustee to continue to bankruptcy.
operate a business, if this is consistent with • The debtor is charged with the duty of devel-
the orderly liquidation of the estate. oping a reorganization plan within the first
120 days of the filing. After this period
expires, the court may grant this authority to a
Chapter 11—Reorganization creditors’ committee.
• Once the plan is approved by the bankruptcy
Most major or large businesses filing bank- court, the debtor’s payment of debts is gener-
ruptcy file a chapter 11 reorganization. As in ally limited to the schedule and amounts that
chapter 7, virtually any business can file a are detailed in the reorganization plan.
chapter 11 reorganization. There are specialized • A chapter 11 proceeding can be complex and
chapter 11 reorganization procedures for certain lengthy, depending on the number of credi-
businesses such as railroads, and chapter 11 is tors, amount of the debts, amount of the
not available to stockbrokers, commodity bro- assets, and other factors that complicate the
kers, or a municipality. The basic concept behind proceedings.
chapter 11 is that a business gets temporary
relief or a reprieve from paying all debts owed
to creditors. This temporary relief gives the Chapter 13—Wage-Earner Bankruptcy
business time to reorganize, reschedule its debts
(at least partially), and successfully emerge from
A chapter 13 bankruptcy is available to any
bankruptcy as a viable business. The basic
individual whose income is sufficiently stable
assumption underlying a chapter 11 bankruptcy
and regular to enable him or her to make
is that the value of the enterprise as a going
payments under the plan. As long as the indi-
concern will usually exceed the liquidation value
vidual has regular wages or takes a regular draw
of its assets.
from his or her business, the individual may
qualify under chapter 13 of the code. Under
Reorganization Plan chapter 13, an individual or married couple can
pay their debts over time without selling their
Generally, the debtor has an exclusive 120-day property. As a protection to creditors, the money
period to prepare and file a reorganization plan. paid to a creditor must equal or exceed the
If the debtor’s plan has not been confirmed amount that the creditor would get in a liquida-
within 180 days of the bankruptcy filing, a tion or chapter 7 bankruptcy. Chapter 13 may be
creditor may file a plan. A plan can provide for used for a business bankruptcy, but only if the
any treatment of creditor claims and equity business is a proprietorship. In most cases, the
interest, as long as it meets the requirements set business needs to be fairly small to qualify.
out in the code. For example, a plan must Some characteristics of a chapter 13 bank-
designate substantially similar creditor claims ruptcy are described below:

Page 17
• In most cases, only an individual can file a Section 23A

chapter 13 bankruptcy.
• Secured debt may not exceed $350,000.
Section 23A of the Federal Reserve Act was
• Unsecured debt may not exceed $100,000.
designed to prevent misuse of a bank’s resources
• The debtor must propose a good-faith plan to
stemming from non-arm’s-length transactions
repay as many debts as possible from avail-
with affiliates. Examiners will first need to
able income.
determine if the institution and counterparty
• A debtor makes regular payments to a trustee, involved in a transaction are affiliates. Once this
who disburses the funds to creditors under the relationship is determined, the examiner will
terms of the plan. need to decide if the transaction is included in
• The trustee does not control the debtor’s the statute as a ‘‘covered transaction.’’ Gener-
assets. ally, covered transactions within the lending
• A chapter 13 bankruptcy may include the function of the institution would include any
debts of a sole proprietorship. The business loan or extension of credit to an affiliate as
may continue to operate during the bankruptcy. defined by section 23A. Any transaction by a
• After all payments are made under the plan, bank with any person is deemed to be a trans-
general discharge is granted. action with an affiliate to the extent that the
affiliate benefited from the transaction. A key
element of section 23A is that covered trans-
SECTIONS 23A AND 23B OF THE actions between a bank and its affiliate must be
on terms and conditions consistent with safe and
FEDERAL RESERVE ACT sound banking practices.
As a result of the Financial Institutions Reform, Once the examiner has determined that the
Recovery, and Enforcement Act of 1989 counterparty is an affiliate and that the trans-
(FIRREA), the application of sections 23A and action is a covered transaction, there are quan-
23B of the Federal Reserve Act was expanded to titative limitations that apply. Section 23A limits
all federally insured commercial and thrift the covered transaction between a bank and its
depository institutions. The passage of the Fed- affiliate to no more than 10 percent of the bank’s
eral Deposit Insurance Corporation Improve- capital and surplus (defined as capital stock,
ment Act of 1991 (FDICIA) affected section surplus, retained earnings, and reserves for loan
23A by allowing the appropriate federal regula- losses). In addition, an institution and its sub-
tor to revoke the ‘‘sister bank’’ exemption for all sidiaries may only engage in a covered trans-
financial institutions that are ‘‘significantly action with an affiliate if, in the case of all
undercapitalized’’ or those that are ‘‘undercapi- affiliates, the aggregate amount of the covered
talized’’ and fail to submit and implement transactions of the institution and its subsidiaries
capital-restoration plans. In addition, FDICIA will not exceed 20 percent of the capital stock
prohibits critically undercapitalized banks from and surplus of the institution.
engaging in covered transactions that are defined When the transaction involves an extension of
in section 23A without prior written approval credit to a defined affiliate, certain collateral
from the FDIC. Section 23B was added to the requirements must also be met. Generally,
Federal Reserve Act on August 10, 1987, through extensions of credit require certain collateral
the Competitive Equality Banking Act of 1987. margins that are tied to the type of collateral. For
This new section essentially codified additional example, extensions of credit that are secured
limitations regarding transactions banks have by U.S. Treasury securities or its agencies require
with their nonbank affiliates. Previously, these a collateral margin of 100 percent of the trans-
transactions had been governed only by Federal action amount, whereas collateral consisting of
Reserve policy or interpretation. The intent of stock, leases, or other real or personal property
this subsection is to provide examiners with requires a margin of 130 percent. Some collat-
general guidance on how to identify potential eral, such as the obligations of an affiliate, is not
violations of these sections of the Federal eligible. Certain exemptions to collateral require-
Reserve Act as it pertains to the commercial- ments were included to permit transactions that
lending function. (Specific guidance and defini- posed little risk to the bank and to prevent undue
tions can be obtained from part 1 of the Federal hardship among the affiliated organizations in
Reserve Regulatory Service.) carrying out customary transactions with related

Page 18
entities. These exemptions include various trans- Act Amendments of 1970 prohibits banks from
actions that are related to sister-bank relation- directly tying products or services offered by the
ships, correspondent relationships, uncollected bank or any of its affiliates. In the typical tie-in
items, or loans to affiliates secured by riskless arrangement, whether or not credit is extended
collateral. or a service is provided (or the amount charged
for the credit or service) depends upon the
customer’s obtaining some additional product or
Section 23B service from the bank or its affiliate or providing
some additional product or service to the bank
With respect to affiliates, section 23B defines
or its affiliate. The intent of section 106(b) was
affiliates in the same manner as section 23A,
to affirm the principles of fair competition by
except that all banks are excluded from section
eliminating the use of tie-in arrangements that
23B as affiliates. The principal requirements of
suppress competition. Specifically, the section
section 23B state that any transaction between a
prevents banks from using their marketing power
bank and a defined affiliate under the act must be
over certain products, specifically credit, to gain
(1) on terms and under circumstances, including
an unfair competitive advantage. There are two
credit standards, that are substantially the same,
exceptions to the anti-tying restrictions. The
or at least as favorable to the bank or its
bank may vary the consideration charged for a
subsidiary, as those prevailing at the time for
traditional bank product on the condition or
comparable transactions with or involving other
requirement that a customer also obtain a tradi-
nonaffiliated companies, or (2) in the absence
tional bank product from an affiliate. This ex-
of comparable transactions, on terms and under
ception is a limited extension of the traditional
circumstances, including credit standards, that
bank product exception provided in section 106.
in good faith would be offered or would apply to
The second exception applies to securities
nonaffiliated companies. In short, the terms and
brokerage services (only those activities autho-
conditions of an extension of credit to an affili-
rized under section 225.28(b)(7) of Regula-
ate under section 23B should be no more favor-
tion Y). A bank may vary the consideration
able than those that would be extended to any
charged for securities brokerage services on the
other borrowing customer of the bank. For
condition that a customer also obtain a tradi-
covered transactions, all transactions that are
tional bank product from that bank or its affiliate.
covered under section 23A are covered under
section 23B; however, section 23B expanded the On April 19, 1995, the Board issued a final
list to include other transactions such as the sale rule on the anti-tying provisions of section 106
of securities or the receipt of money or services of the 1970 Bank Holding Company Act
from an affiliate. Amendments. The rule establishes a ‘‘combined-
balance discount’’ safe harbor for a banking
The focus of section 23B is different from that
organization offering varieties of services to its
of section 23A. Section 23A contains quantita-
customers and wishing to offer them discounts
tive and collateral restrictions to protect the
based on the customers’ overall relationship
bank; section 23B focuses on whether transac-
with the bank or its holding company and
tions with nonbank affiliates are arm’s length
subsidiaries. The amendment, effective May 26,
and not injurious to the bank. Occasionally, an
1995, provides that a bank holding company or
extension of credit, by definition, is granted to
any bank or nonbank subsidiary thereof may
an affiliate of a federally insured bank or thrift
weight products as it sees fit in connection with
institution, so examiners are reminded that it is
its evaluation of combined-balance discount ar-
likely that sections 23A and 23B will be impli-
rangements, so long as deposits receive an equal
cated. Essentially, examiners need to keep one
or higher weight than other products. The new
basic principal in mind: If money flows from the
rule expanded the Board’s recent exemption to a
bank to an affiliate other than through a divi-
large regional banking organization to all bank-
dend, the transaction is probably a covered
ing organizations tying traditional services, such
transaction and would be enforceable under
as checking accounts and nontraditional banking
sections 23A and 23B.
products like brokerage services. It permits
banks to market products more efficiently and
TIE-IN ARRANGEMENTS compete more effectively with their nonbanking
competitors who currently offer combined-
Section 106(b) of the Bank Holding Company balance discount arrangements.

Page 19
Examiners should be aware that the principal to the organization’s staff; (3) pertinent exten-
motive of section 106(b) is to eliminate any sions of credit to borrowers whose credit facili-
potential for ‘‘arm twisting’’ customers into ties or services may be susceptible to improper
buying some other product to get the product tie-in arrangements imposed by the bank or
they desire. Examiners should focus on poten- company in violation of section 106(b) or the
tially illegal tie-in arrangements by reviewing Board’s regulations; and (4) where applicable,
(1) the banking organization’s internal controls the firewalls that have been established between
and procedures and its written policies and banks and their holding companies and nonbank
procedures in this area; (2) the training provided affiliates, including section 20 subsidiaries.

Page 20
1. To determine if lending policies, practices, 4. To determine the scope and adequacy of the
procedures, and internal controls for commer- audit function.
cial and industrial loans are adequate. 5. To determine compliance with applicable
2. To determine if bank officers are operating in laws and regulations.
3. To evaluate the portfolio for credit quality, practices, procedures, objectives, or internal
performance, collectibility, and collateral controls are deficient or when violations of
sufficiency. laws or regulations have been noted.

Page 1
1. If selected for implementation, complete or i. extensions of credit to employees, offi-

update the commercial loan section of the cers, directors, and principal sharehold-
internal control questionnaire. ers and their interests, specifying which
2. On the basis of the evaluation of internal officers are considered executive officers
controls and the work performed by internal j. extensions of credit to executive officers,
or external auditors, determine the scope of directors, and principal shareholders and
the examination. their interests of correspondent banks
3. Test for compliance with policies, practices, k. a list of correspondent banks
procedures, and internal controls in conjunc- l. miscellaneous loan-debit and credit-
tion with performing the remaining exami- suspense accounts
nation procedures. Also obtain a listing of m. Shared National Credits
any deficiencies noted in the latest review n. loans considered ‘‘problem loans’’ by
done by internal or external auditors, and management
determine if corrections have been o. specific guidelines in the lending policy
accomplished. p. each officer’s current lending authority
4. Obtain a trial balance of the customer lia- q. any useful information resulting from the
bility records. review of the minutes of the loan
a. Agree or reconcile balances to depart- and discount committee or any similar
ment controls and the general ledger. committee
b. Review reconciling items for reasonable- r. reports furnished to the loan and
ness. discount committee or any similar
5. Using an appropriate technique, select bor- committee
rowers for examination. Prepare credit line s. reports furnished to the board of directors
cards. t. loans classified during the previous
6. Obtain the following information from the examination
bank or other examination areas, if u. the extent and nature of loans serviced
applicable: 7. Review the information received, and per-
a. past-due loans form the following procedures.
b. loans in a nonaccrual status a. Loans transferred, either in whole or in
c. loans on which interest is not being part, to or from another lending institu-
collected in accordance with the terms of tion as a result of a participation, sale or
the loan (Particular attention should be purchase, or asset swap.
given to loans that have been renewed • Participations only:
with interest being rolled into principal.) — Test participation certificates and
d. loans whose terms have been modified records, and determine that the par-
by a reduction of interest-rate or princi- ties share in the risks and contrac-
pal payment, by a deferral of interest or tual payments on a pro rata basis.
principal, or by other restructuring of — Determine that the bank exercises
repayment terms similar controls and procedures
e. loans transferred, either in whole or in over loans serviced for others as
part, to another lending institution as a for loans in its own portfolio.
result of a sale, participation, or asset — Determine that the bank, as lead or
swap since the previous examination agent in a credit, exercises similar
f. loans acquired from another lending controls and procedures over syn-
institution as a result of a purchase, dications and participations sold as
participation, or asset swap since the for loans in its own portfolio.
previous examination • Procedures pertaining to all transfers:
g. loan commitments and other contingent — Investigate any situations in which
liabilities loans were transferred immedi-
h. loans secured by stock of other deposi- ately before the date of examina-
tory institutions tion to determine if any were trans-

Page 1
2080.3 Commercial and Industrial Loans: Examination Procedures
ferred to avoid possible criticism b. Miscellaneous loan-debit and credit-

during the examination. suspense accounts.
— Determine whether any of the loans • Discuss with management any large or
transferred were either nonperform- old items.
ing at the time of transfer or clas- • Perform additional procedures as
sified at the previous examination. deemed appropriate.
— Determine that the consideration c. Loan commitments and other contingent
received for low-quality loans trans- liabilities. Analyze the commitment or
ferred from the bank to an affiliate contingent liability if the borrower has
is properly reflected on the bank’s been advised of the commitment and the
books and is equal to the fair combined amount of the current loan
market value of the transferred balance (if any) and the commitment or
loans. (While fair market value other contingent liability exceeds the
may be difficult to determine, it cutoff.
should at a minimum reflect both d. Loans classified during the previous
the rate of return being earned on examination.
such loans as well as an appropri- • current balance and payment status, or
ate risk premium.) Section 23A of • date the loan was repaid and the source
the Federal Reserve Act generally of payment
prohibits a state member bank from Investigate any situations in which all or
purchasing a low-quality asset. part of the funds for the repayment came
— Determine that low-quality loans from the proceeds of another loan at the
transferred to the parent holding bank, or as a result of a participation,
company or a nonbank affiliate are sale, or swap with another lending insti-
properly reflected at fair market tution. If repayment was a result of a
value on the books of both the participation, sale, or swap, refer to step
bank and its affiliate. 7a of this section for the appropriate
— If low-quality loans were trans- examination procedures.
ferred to or from another lending e. Review of leveraged buyouts.
institution for which the Federal • In evaluating individual loans and
Reserve is not the primary regula- credit files, pay particular attention to
tor, prepare a memorandum to be the reasonableness of interest-rate
submitted to Reserve Bank super- assumptions and earnings projections
visory personnel. The Reserve Bank relied on by the bank in extending the
will then inform the local office of loan; the trend of the borrowing com-
the primary federal regulator of the pany’s and the industry’s performance
other institution involved in the over time and the history and stability
transfer. The memorandum should of the company’s earnings and cash
include the following information, flow, particularly over the most recent
as applicable: business cycle; the relationship between
(1) name of originating institution the company’s cash-flow and debt-
(2) name of receiving institution service requirements and the resulting
(3) type of transfer (i.e., participa- margin of debt-service coverage; and
tion, purchase or sale, swap) the reliability and stability of collateral
(4) date of transfer values and the adequacy of collateral
(5) total number of loans trans- coverage.
ferred • In reviewing the performance of indi-
(6) total dollar amount of loans vidual credits, attempt to determine if
transferred debt-service requirements are being
(7) status of the loans when trans- covered by cash flow generated by the
ferred (e.g., nonperforming, company’s operations or whether the
classified, etc.) debt-service requirements are being
(8) any other information that met out of the proceeds of additional
would be helpful to the other or ancillary loans from the bank
regulator designed to cover interest changes.

Page 2
Commercial and Industrial Loans: Examination Procedures 2080.3
• Review policies and procedures per- 10. Prepare commercial line cards for any loan
taining to leveraged buyout financing not in the sample that, based on information
to ensure that they incorporate prudent derived from the above schedules, requires
and reasonable limits on the total in-depth review.
amount and type (by industry) of 11. Obtain liability and other information
exposure that the bank can assume on common borrowers from examiners
through these financing arrangements. assigned to cash items, overdrafts, lease
• Review the bank’s pricing, credit poli- financing, and other loan areas, and together
cies, and approval procedures to en- decide who will review the borrowing
sure that rates are reasonable in light of relationship.
the risks involved and that credit stan- 12. Add collateral data to line cards selected in
dards are not compromised in order to the preceding steps.
increase market share. Credit stan- 13. Obtain credit files for all borrowers for
dards and internal review and approval whom commercial line cards were pre-
standards should reflect the degree of pared, and complete line cards. To analyze
risk and leverage inherent in these the loans, perform the following proce-
transactions. dures:
• Total loans to finance leveraged buy- a. Analyze balance-sheet and profit-and-
outs should be treated as a potential loss items as reflected in current and
concentration of credit. If, in the aggre- preceding financial statements, and deter-
gate, these loans are sufficiently large mine the existence of any favorable or
in relation to capital, the loans should adverse trends.
be listed on the concentrations page in b. Review components of the balance sheet
the examination report. as reflected in the current financial state-
• Discuss significant deficiencies or risks ments, and determine the reasonableness
regarding a bank’s leveraged buyout of each item as it relates to the total
financing on page 1 of the examination financial structure.
report, and bring them to the attention c. Review supporting information for the
of the board of directors. major balance-sheet items and the
f. Uniform review of Shared National techniques used in consolidation, if
Credits. applicable, and determine the primary
• Compare the schedule of commercial sources of repayment and evaluate their
credits included in the uniform review adequacy.
of the Shared National Credit Program
d. Ascertain compliance with provisions of
with the loans being reviewed to deter-
loan agreements.
mine which loans are portions of
Shared National Credits. e. Review digests of officers’ memoranda,
• For each loan so identified, transcribe mercantile reports, credit checks, and
appropriate information from the sched- correspondence to determine the exist-
ule to line cards. (No further examina- ence of any problems that might deter
tion procedures are necessary for these the contractual liquidation program.
credits.) f. Relate collateral values to outstanding
8. Consult with the examiner responsible for debt.
the asset/liability management analysis to g. Compare interest rates charged with the
determine the appropriate maturity break- interest-rate schedule, and determine
down of loans needed for the analysis. If that the terms are within established
requested, compile the information using guidelines.
bank records or other appropriate sources. h. Compare the original amount of loan
See ‘‘Instructions for the Report of Exami- with the lending officer’s authority.
nation,’’ section 6000.1, for considerations i. Analyze secondary support afforded by
to be taken into account when compiling guarantors and endorsers.
maturity information for the gap analysis. j. Ascertain compliance with the bank’s
9. Transcribe or compare information from the established commercial loan policy.
schedules to commercial line cards, where k. Determine whether public officials are
appropriate. receiving preferential treatment and

Page 3
whether there is any correlation between terms requirement of section 23B and
loans to public officials and deposits they Regulation W.
may control or influence. c. 18 USC 215, Receipt of Commission or
14. For selected loans, check the central liabil- Gift for Procuring Loans.
ity file on borrowers indebted above the • While examining the commercial loan
cutoff or borrowers displaying credit weak- area, determine the existence of any
ness or suspected of having additional lia- possible cases in which a bank officer,
bility in other loan areas. director, employee, agent, or attorney
15. Transcribe significant liability and other may have received anything of value
information on officers, principals, and for procuring or endeavoring to pro-
affiliations of appropriate borrowers con- cure any extension of credit.
tained in the sample. Cross-reference line • Investigate any such suspected
cards to borrowers, where appropriate. situation.
16. Prepare ‘‘Report of Loans Supported by d. Federal Election Campaign Act (2 USC
Bank Stock,’’ if appropriate. Determine if a 441b), Political Contributions.
concentration of any bank’s stock has been
• While examining the commercial loan
pledged.
area, determine the existence of any
17. Determine compliance with laws, rulings,
loans in connection with any politi-
and regulations pertaining to commercial
cal campaigns.
lending by performing the following steps.
a. Lending limits. • Review each such credit to determine
• Determine the bank’s lending limits as whether it is made in accordance with
prescribed by state law. applicable banking laws and in the
• Determine advances or combinations ordinary course of business.
of advances with aggregate balances e. 12 USC 1972, Tie-In Provisions. While
above the limit, if any. reviewing credit and collateral files (espe-
b. Section 23A, Relations with Affiliates (12 cially loan agreements), determine
USC 371c), and section 23B, Restric- whether any extension of credit is con-
tions on Transactions with Affiliates (12 ditioned upon—
USC 371c-1), of the Federal Reserve • obtaining or providing an additional
Act, and Regulation W. credit, property, or service to or from
• Obtain a listing of loans to affiliates. the bank or its holding company (or a
• Test-check the listing against the bank’s subsidiary of its holding company),
customer liability records to determine other than a loan, discount, deposit, or
its accuracy and completeness. trust service;
• Obtain a listing of other covered trans- • the customer not obtaining a credit,
actions with affiliates (i.e., purchase of property, or service from a competitor
loans from affiliates or acceptance of of the bank or its holding company (or
affiliates’ securities as collateral for a subsidiary of its holding company),
loan to any person). other than a reasonable condition to
• Ensure that covered transactions with ensure the soundness of the credit.
affiliates do not exceed the limits of (See ‘‘Tie-In Considerations of the
section 23A and Regulation W. BHC Act,’’ section 3500.0 of the Bank
• Ensure that covered transactions with Holding Company Supervision
affiliates meet the appropriate collat- Manual.)
eral requirements of section 23A and f. Insider lending activities. The examina-
Regulation W. tion procedures for checking compliance
• Determine that low-quality loans have with the relevant law and regulation
not been purchased from an affiliate. covering insider lending activities and
• Determine that all covered transactions reporting requirements are as follows
with affiliates are on terms and condi- (the examiner should refer to the appro-
tions that are consistent with safe and priate sections of the statutes for specific
sound banking practices. definitions, lending limitations, reporting
• Determine that all transactions with requirements, and conditions indicating
affiliates comply with the market- preferential treatment):

Page 4
Commercial and Industrial Loans: Examination Procedures 2080.3
• Regulation O (12 CFR 215), Loans to ascertain the profitability of those

Executive Officers, Directors, and Prin- relationships.
cipal Shareholders and Their Related — Determine that loans to insiders of
Interests. While reviewing information correspondent banks are not made
relating to insiders that is received on preferential terms and that no
from the bank or appropriate examiner conflict of interest appears to exist.
(including loan participations, loans g. 12 USC 1828(v), Loans Secured by Bank
purchased and sold, and loan swaps)— Stock.
— test the accuracy and completeness • While examining the commercial loan
of information about commercial area, determine the existence of any
loans by comparing it with the trial loans or discounts that are secured by
balance or loans sampled; the insured financial institution’s own
— review credit files on insider loans stock.
to determine that required informa- • In each case, determine that the chief
tion is available; executive officer has promptly reported
— determine that loans to insiders such fact to the proper regulatory
do not contain terms more favor- authority.
able than those afforded other h. 12 USC 83 (Rev. Stat. 5201), made
borrowers; applicable to state member banks by
— determine that loans to insiders do section 9, para. 6, of the Federal Reserve
not involve more than normal risk Act (12 USC 324), Loans Secured by
of repayment or present other Own Stock (see also 3-1505 in the Fed-
unfavorable features; eral Reserve Regulatory Service).
— determine that loans to insiders, as • While examining the commercial loan
defined by the various sections of area, determine the existence of any
Regulation O, do not exceed the loans secured by the bank’s own shares
lending limits imposed by those or capital notes and debentures.
sections; • Confer with the examiner assigned to
— if prior approval by the bank’s investment securities to determine
board was required for a loan to an whether the bank owns any of its own
insider, determine that such shares or its own notes and debentures.
approval was obtained; • In each case in which such collateral or
— determine compliance with the vari- ownership exists, determine whether
ous reporting requirements for the collateral or ownership was taken
insider loans; to prevent loss on a debt previously
— determine that the bank has made contracted (DPC) transaction.
provisions to comply with the pub- i. Regulation U (12 CFR 221). While
lic disclosure requirements of Regu- reviewing credit files, check the follow-
lation O; and ing for all loans that are secured directly
— determine that the bank maintains or indirectly by margin stock and that
records of such public requests and were extended for the purpose of buying
the disposition of the requests for a or carrying margin stock:
period of two years after the dates • Except for credits specifically exempted
of the requests. under Regulation U, determine that the
• Title VIII of the Financial Institutions required Form FR U-1 has been
Regulatory and Interest Rate Control executed for each credit by the cus-
Act of 1978 (FIRA) (12 USC 1972(2)), tomer and that it has been signed and
Loans to Executive Officers, Directors, accepted by a duly authorized officer
and Principal Shareholders of Corre- of the bank acting in good faith.
spondent Banks. • Determine that the bank has not
— Obtain from or request that the extended more than the maximum loan
examiners reviewing due from value of the collateral securing such
banks and deposit accounts verify credits, as set by section 221.7 of
a list of correspondent banks pro- Regulation U, and that the margin
vided by bank management, and requirements are being maintained.

Page 5
j. Financial Recordkeeping and Reporting j. extensions of credit to principal share-

of Currency and Foreign Transactions holders, employees, officers, directors,
(31 CFR 103), Retention of Credit Files. and related interests
• Determine compliance with other spe- k. other matters regarding the condition of
cific exceptions and restrictions of the the department
regulation as they relate to the credits 21. Inform the Reserve Bank of all criticized
reviewed. participation loans that are not covered by
• Review the operating procedures and the Shared National Credit Program. Include
credit file documentation, and deter- the names and addresses of all participating
mine if the bank retains records of state member banks and copies of loan
each extension of credit over $10,000, classification comments. (This step deals
specifying the name and address of the with loans that deteriorated subsequent to
borrower, the amount of credit, the participation and does not duplicate step 7a,
nature and purpose of the loan, and the which deals with transfers of loans that
date thereof. (See 31 CFR 103.33.) were of low quality when transferred).
(Loans secured by an interest in real 22. Inform the Reserve Bank of those loans
property are exempt.) eligible for the Shared National Credit Pro-
18. Determine whether the consumer compli- gram that were not previously reviewed.
ance examination uncovered any violations Include the names and addresses of all
of law or regulation in this department. If participants and the amounts of their credit.
violations were noted, determine whether (This step applies only to credits for which
corrective action was taken. Test for subse- the bank under examination is the lead
quent compliance with any law or regula- bank.)
tion so noted. 23. Evaluate the function for—
19. Perform the appropriate procedural steps in a. the adequacy of written policies relating
‘‘Concentration of Credits,’’ section 2050.3. to commercial loans,
20. Discuss with appropriate officers, and pre- b. the manner in which bank officers are
pare summaries in appropriate report form operating in conformance with estab-
of— lished policy,
a. delinquent loans
c. adverse trends within the commercial
b. violations of laws and regulations
loan department,
c. loans not supported by current and com-
plete financial information d. the accuracy and completeness of the
d. loans on which collateral documentation schedules obtained from the bank,
is deficient e. internal control deficiencies or exceptions,
e. concentrations of credits f. recommended corrective action when
f. criticized loans policies, practices, or procedures are
g. inadequately collateralized loans deficient,
h. Small Business Administration or other g. the competency of departmental manage-
government-guaranteed delinquent or ment, and
criticized loans h. other matters of significance.
i. transfers of low-quality loans to or from 24. Update the workpapers with any informa-
another lending institution tion that will facilitate future examinations.

Page 6
Review the bank’s internal controls, policies, and investigated by persons who do not
practices, and procedures for making and ser- also handle cash?
vicing commercial loans. The bank’s system *7. Are documents supporting recorded credit
should be documented in a complete and con- adjustments checked or tested subsequently
cise manner and should include, where appro- by persons who do not also handle cash (if
priate, narrative descriptions, flow charts, copies so, explain briefly)?
of forms used, and other pertinent information. 8. Is a daily record maintained summarizing
Items marked with an asterisk require substan- note transaction details, i.e., loans made,
tiation by observation or testing. payments received, and interest collected,
to support applicable general ledger account
entries?
9. Are frequent note and liability ledger trial
POLICIES balances prepared and reconciled with con-
trolling accounts by employees who do not
1. Has the board of directors, consistent with process or record loan transactions?
its duties and responsibilities, adopted writ- 10. Is an overdue account report generated
ten commercial loan policies that: frequently (if so, how often )?
a. Establish procedures for reviewing com- 11. Are subsidiary payment records and files
mercial loan applications? pertaining to serviced loans segregated
b. Define qualified borrowers? and identifiable?
c. Establish minimum standards for 12. Do loan records provide satisfactory audit
documentation? trails which permit the tracing of transac-
2. Are commercial loan policies reviewed at tions from initiation to final disposition?
least annually to determine if they are
compatible with changing market
conditions?
LOAN INTEREST
*13. Is the preparation and posting of interest
RECORDS records performed or reviewed by persons
who do not also:
*3. Is the preparation and posting of subsidi- a. Issue official checks or drafts?
ary commercial loan records performed or b. Handle cash?
reviewed by persons who do not also: 14. Are any independent interest computations
a. Issue official checks or drafts? made and compared or tested to initial
b. Handle cash? interest record by persons who do not also:
c. Approve loans? a. Issue official checks or drafts?
d. Reconcile subsidiary records to the gen- b. Handle cash?
eral ledger?
*4. Are the subsidiary commercial loan records
reconciled daily with the appropriate gen- COLLATERAL
eral ledger accounts, and are reconciling
items investigated by persons who do not 15. Are multicopy, prenumbered records main-
also handle cash? tained that:
5. Are delinquent account collection requests a. Detail the complete description of col-
and past-due notices checked to the trial lateral pledged?
balances that are used in reconciling com- b. Are typed or completed in ink?
mercial loan subsidiary records with gen- c. Are signed by the customer?
eral ledger accounts, and are they handled d. Are designed so that a copy goes to the
only by persons who do not also handle customer?
cash? *16. Are the functions of receiving and releasing
6. Are inquiries about loan balances received collateral to borrowers and of making

Page 1
2080.4 Commercial and Industrial Loans: Internal Control Questionnaire
entries in the collateral register performed 32. Are all loan rebates approved by an officer
by different employees? and made only by official check?
17. Is negotiable collateral held under joint 33. Does the bank have an internal review
custody? system that:
18. Are receipts signed by the customer a. Re-examines collateral items for nego-
obtained and filed for released collateral? tiability and proper assignment?
*19. Are securities and commodities valued b. Checks values assigned to collateral
and margin requirements reviewed at least when the loan is made and at frequent
monthly? intervals thereafter?
20. When the support rests on the cash surren- c. Determines that items out on temporary
der value of insurance policies, is a peri- vault-out tickets are authorized and have
odic accounting received from the insur- not been outstanding for an unreason-
ance company and maintained with the able length of time?
policy? d. Determines that loan payments are
21. Is a record maintained of entry to the promptly posted?
collateral vault? 34. Are all notes assigned consecutive num-
22. Are stock powers filed separately to bar bers and recorded on a note register or
negotiability and to deter abstraction of similar record? Do numbers on notes agree
both the security and the negotiating to those recorded on the register?
instrument? 35. Are collection notices handled by some-
23. Are securities out for transfer, exchange, one not connected with loan processing?
etc., controlled by prenumbered temporary 36. Are payment notices prepared and mailed
vault-out tickets? by someone other than the loan teller?
24. Has the bank instituted a system which: 37. Does the bank prohibit the holding of
a. Ensures that security agreements are debtor’s checks for payment of loans at
filed? maturity?
b. Ensures that collateral mortgages are *38. Concerning livestock loans:
properly recorded? a. Are inspections made at the inception
c. Ensures that title searches and property of credit?
appraisals are performed in connection b. Are inspections properly dated and
with collateral mortgages? signed?
d. Ensures that insurance coverage (includ- c. Is there a breakdown by sex, breed, and
ing loss payee clause) is in effect number of animals in each category?
on property covered by collateral d. Is the condition of the animals noted?
mortgages? e. Are inspections required at least
25. Are coupon tickler cards set up covering annually?
all coupon bonds held as collateral? *39. Concerning crop loans:
26. Are written instructions obtained and held a. Are inspections of growing crops made
on file covering the cutting of coupons? as loans are advanced?
27. Are coupon cards under the control of b. Are disbursements closely monitored to
persons other than those assigned to cou- ensure that the proceeds are properly
pon cutting? channeled into the farmer’s operation?
28. Are pledged deposit accounts properly c. Is crop insurance encouraged?
coded to negate unauthorized withdrawal 40. In mortgage warehouse financing, does the
of funds? bank hold the original mortgage note, trust
29. Are acknowledgments received for pledged deed, or other critical document, releasing
deposits held at other banks? only against payment?
30. Is an officer’s approval necessary before 41. Concerning commodity lending:
collateral can be released or substituted? a. Is control for the collateral satisfactory,
i.e., stored in the bank’s vault, another
bank, or a bonded warehouse?
OTHER b. If collateral is not stored within the
bank, are procedures in effect to ascer-
31. Are notes safeguarded during banking tain the authenticity of the collateral?
hours and locked in the vault overnight? c. Does the bank have a documented

Page 2
Commercial and Industrial Loans: Internal Control Questionnaire 2080.4
security interest in the proceeds of the financed by bank loans remain fully
future sale or disposition of the com- hedged?
modity as well as the existing collateral
position?
d. Do credit files document that the
financed positions are and remain fully
hedged? CONCLUSION
42. Concerning loans to commodity brokers
and dealers:
a. Does the bank maintain a list of the
trol in that there are no significant defi-
major customer accounts on the brokers
ciencies in areas not covered in this ques-
or dealers to whom it lends? If so, is the
tionnaire that impair any controls? Explain
list updated on a periodic basis?
negative answers briefly, and indicate any
b. Is the bank aware of the broker-dealer’s
additional examination procedures deemed
policy on margin requirements and the
necessary.
basis for valuing contracts for margin
purposes (i.e., pricing spot vs. future)? 44. Based on a composite evaluation, as evi-
c. Does the bank attempt to ascertain denced by answers to the foregoing
whether the positions of the broker- questions, internal control is considered
dealer’s clients that are indirectly (adequate/inadequate).

Page 3
Loan-Sampling Program for Certain Community Banks
A statistically based sampling approach to loan CONCEPT AND STRUCTURE OF

reviews can serve as an alternative to the tradi- THE SAMPLING TECHNIQUE
tional ‘‘top-down’’ loan-coverage approach when
scoping certain bank examinations. In some The sampling approach builds on procedures
cases, sampling requires fewer loans1 to be examiners currently use to evaluate loan port-
reviewed than would be required using the folios, which require coverage of a similar
minimum-coverage approach, while in other ‘‘core’’ group of exposures. The principal dif-
cases it requires more. The results depend heavily ference relates to the manner in which loans
on the number of commercial and industrial outside the core group are selected for review.
loans (C&I) and commercial real estate (CRE) Under the traditional approach, the largest
loans and the structure of the loan portfolio. remaining loans are selected until a desired
Asset size and the level of tier 1 capital also coverage ratio is achieved. Using sampling, the
affect the sample size. Additionally, sampling remaining noncore loans are grouped into sev-
may require fewer loans to be reviewed than eral strata, or buckets, based on the size of the
under the traditional method in well-managed borrowing relationship. Loans are randomly
institutions whose portfolios are not dominated selected from each of these buckets proportion-
by a small number of relatively large exposures. ate to the dollar value of each bucket relative to
Significantly, sampling may provide examin- the total noncore portfolio. The total number of
ers with a broader perspective on the accuracy sampled loans required is determined by the
of the bank’s classification process than is typi- number and size distribution of loans in the
cally provided by the traditional minimum- bank’s portfolio.
coverage target approach. At present, the sam- The sampling approach is an effective means
pling approach should be directed towards banks to determine if the examiner can rely on the
currently having a CAMELS composite and bank’s classification process or whether the
asset-quality rating of 1 or 2 and also assets of examiner must determine the level of classifica-
less than $1 billion. At present, the sampling tions by traditional means. Although sampling
approach should be directed towards banks cur- may, in some cases, require examiners to review
rently having a CAMELS composite and asset- more loans than required by the traditional
quality rating of 1 or 2 and also assets of less loan-coverage approach, sampling is more likely
than $1 billion. The statistical sampling approach to detect problems among smaller loans and will
is not recommended, however, for use at de provide a broader perspective of the bank’s
novo banks or other banks with unusually high classifications across the entire portfolio.
or low capital ratios. Reserve Banks wishing to In most cases, examiners should expect to
experiment with the sampling program at orga- find very few misclassifications within the
nizations with CAMELS or asset-quality ratings sampled buckets, since those segments would
of 3 or above or at larger organizations should exclude any credits that the bank’s internal
contact Board staff so that the examiner’s expe- procedures have identified as weak and those
rience that is gained in this area may be used to that the examiner has otherwise identified for
develop alternative sampling procedures for specific review (the ‘‘core’’ loans). When the
these other types of institutions. (See SR-02-19.) examiner’s classifications agree with the bank’s
internal loan classifications, then internal clas-
sification totals can be relied upon in calculating
the total and weighted asset-classification ratios.
However, if misclassifications are found within
1. The term ‘‘loans’’ encompasses all sources of credit the sample, internal classifications may under-
exposure arising from loans and leases, including guarantees, estimate the true extent of problem loans, and
letters of credit, and other loan commitments. The sampling the examiner must make adjustments to estimate
methods described in this section select ‘‘loans’’ for review by the actual extent of problems. To make that
obligor or related group of obligors (where identifiable). Thus,
in the sampling procedures, the term ‘‘loan’’ refers to total estimate, the rate of misclassification is applied
credit exposure to an individual obligor or related group of to the remaining loans in the sampled bucket to
obligors. As this implies, loan amounts referred to in this derive an estimate of other problems that the
section should be determined on an exposure basis, including examiners would likely find if all the loans were
all outstanding notes and commitments.

Page 1
2082.1 Loan-Sampling Program for Certain Community Banks
read. This extrapolated amount of problem loans folio. Thus, if loans in a particular category
is then added to the total of specifically identi- represent 30 percent of the bank’s total noncore
fied problems to evaluate the significance of exposures, then approximately 30 percent of the
credit weaknesses at the institution. Depending number of sampled credits will be drawn from
on the severity of misclassifications and the that category. A ‘‘custom’’ group—bucket 4—is
magnitude of problems specifically identified, available for examiners to target specific bor-
expansion of the examination scope will prob- rowers meeting a variety of selection criteria.
ably be necessary to better assess the accuracy Buckets 5 through 8 represent all remaining
of loan grading. loans in the commercial loan portfolio, segre-
gated by size relative to the bank’s tier 1 capital
and loan-loss reserve. The results of examiners’
findings for these sampled buckets would be
Specific Procedures extrapolated to the entire group of borrowers not
reviewed.
Using electronic loan files provided by the bank
(for example, those loan files available in the
Automated Loan Examination Review Tool Determination of Reliance on a Bank’s
(ALERT) format) and the System’s loan- Internal Classifications
sampling software, examiners are able to con-
struct a variety of core and noncore borrower Once the commercial loans have been selected
groups. (See table 1.) The ‘‘core’’ group— for review, examiners are expected to use exist-
bucket 1—consists of several categories of loans ing credit-analysis techniques as described in
that examiners have traditionally reviewed and this manual to evaluate the borrower’s credit-
would continue to review using sampling. These worthiness, determine the level of adverse clas-
core borrowers include, for instance, the largest sifications, and identify any discrepancies with
exposures and certain large problem or insider the bank’s internal classifications.
loans. The sampling program also permits In performing their analysis of the accuracy
examiners to select any additional borrower (or of classified credits, examiners should start with
borrowers) for review based on the examiner’s the assets internally classified by the bank’s
experience and judgment. These individually rating system and add any pass credits that were
selected loans would be placed in the ‘‘examiner- misclassified by the bank and downgraded to a
selected’’ group—bucket 2. All loans contained classified status during the examiner’s credit
in buckets 1 and 2 would be individually review. These classified assets are the key com-
reviewed, not sampled, and examiners would ponent for a ‘‘base’’ weighted asset-classification
not extrapolate their findings to other loans. All ratio.
remaining internally identified problem borrow- Under the sampling program, the ‘‘base’’
ers are included in a separate ‘‘problem’’ group— weighted asset-classification ratio must be
bucket 3—designated as ‘‘discuss only’’; these adjusted upward (extrapolated) to the extent
borrowers are not incorporated into the misclassifications were uncovered within the
commercial-loan-coverage ratio nor are their randomly sampled loan buckets. The resulting
findings extrapolated to other loans within the extrapolated weighted asset-classification ratio
same bucket. However, any borrower in the is necessary to account for the likelihood that
‘‘problem’’ group—bucket 3—may be individu- misclassifications uncovered from the sampled
ally selected for review by the examiner. Addi- loans represent only a small portion of the total
tionally, if the number of ‘‘discuss-only’’ bor- misclassified loans throughout the rest of the
rowers in the ‘‘problem’’ group—bucket 3—is portfolio that was not reviewed. The extrapo-
large, the examiner may select a number of lated value provides examiners with a more
borrowers to be randomly sampled. comprehensive picture of the magnitude of the
The remaining noncore categories represent institution’s credit problems.
‘‘pass’’ or creditworthy loans, grouped by the In many cases, there will be no disagreements
size of the borrowing relationship. Buckets 4 between the examiner’s credit analysis and the
through 8 are composed of loans to be randomly bank’s internal classifications. Consequently,
sampled. The number of loans selected from there will be no difference between the weighted
buckets 4 through 8 is proportional to its total asset-classification ratio and the extrapolated
dollar value relative to the total noncore port- ratio. Generally, no additional sampling would

Page 2
Loan-Sampling Program for Certain Community Banks 2082.1
Table 1—Groups of Loans Available for Review

Bucket Description
Nonsampled buckets
Bucket 1 1A: 10 largest non-insider non-problem-borrower exposures

Core
1B: 5 largest non-insider non-problem-borrower exposures underwritten in
the previous 12 months
1C: 10 largest non-insider problem-borrower exposures
1D: 5 largest insider borrower exposures
Bucket 2 Examiner optional core group. Examiners may manually select any borrower
Examiner- to review.
selected
Bucket 3 Problem loans (watch list, >59 days past due, internal ratings, and previously
Problem classified). Discuss-only borrowers.
Sampled buckets
Bucket 4 Examiners may select to target specific borrowers meeting a variety of criteria.
Custom
Bucket 5 Remaining borrower exposures greater than 3 percent of tier 1 capital plus
>3% T1 the ALLL.
Bucket 6 Remaining borrower exposures between 2 percent and 3 percent of tier 1

2%–3% T1 capital plus the ALLL.
Bucket 7 Remaining borrower exposures between 1 percent and 2 percent of tier 1

1%–2% T1 capital plus the ALLL.
Bucket 8 Remaining borrower exposures between 0.1 percent and 1 percent of tier 1
0.1%–1% T1 capital plus the ALLL.
Bucket 9 Remaining borrower exposures less than 0.1 percent of tier 1 capital plus
<0.1% T1 the ALLL. These loans are not included in the sample.
Bucket 10 All noncommercial borrowers. Examiners may scope into bucket 2.

Noncommercial
be necessary. However, other types of credit- the sampled loans, examiners should be aware
administration weaknesses may be discovered that those seemingly minor disagreements may
that warrant additional review and, as a result, translate into fairly large differences between
an additional sample of loans may be selected. the base and extrapolated problem-loan figures.
In this case, the number of loans selected is left When those differences are significant enough
to the examiner’s judgment. that they would alter an examiner’s overall
In other cases, either minor or significant conclusion regarding the accuracy of the bank’s
disagreements will require examiners to more loan-grading system, follow-up work is required.
fully investigate the reliance that can be placed In particular, significant differences between the
on the internal classifications. When there are ‘‘base’’ and extrapolated weighted classification
only a minor number of disagreements within ratios should raise concerns as to whether the

Page 3
2082.1 Loan-Sampling Program for Certain Community Banks
institution is systematically misreporting credit found one new misclassification, then the
problems. extrapolated ratio would be 15 percent. In these
For example, a disagreement may arise cases, it is highly unlikely that the misclassifi-
between an examiner’s analysis and the bank’s cations were caused by chance, and it is prob-
internal classification of a single credit that was able that a systematic problem exists in the
drawn from the sample buckets. Assuming a ability of bank management to correctly risk-
‘‘base’’ weighted asset-classification ratio of rate their commercial loans. Consequently,
4 percent, the disagreed-upon sample loan, when examiners should closely review the misclassi-
extrapolated, could increase the weighted asset- fications and determine if any pattern exists,
classification ratio to 7 percent. When the dif- such as loans generated from a specific originat-
ference between the ‘‘base’’ and extrapolated ing office or loan officer, or by type of credit
ratios is not material, it would not be necessary extension. In these cases, internal classifications
to select additional loans if the ratio difference should be deemed unreliable and further credit
would not alter the examiner’s conclusions review should be performed to evaluate the full
regarding the condition of the loan portfolio. extent of problem assets. That expanded review
In another situation, there may be disagree- should be consistent with the minimum loan
ment between the examiner’s analysis and the coverage of 55 percent to 65 percent or more, as
bank’s internal rating on two small-dollar loans required for banks posing supervisory concerns.
sampled from bucket 8 (borrower exposures (See SR-94-13.)
between 0.1 percent and 1 percent of tier 1
capital plus the allowance for loan and lease
losses (ALLL)). In this example, the bank’s Factoring Sampling Results into
‘‘base’’ weighted asset-classification ratio is cal-
culated to be 3 percent. Individually, these loans
Examination Findings
do not play a significant role in the level of the
An evaluation of a bank’s asset-quality rating
‘‘base’’ ratio. However, when these same
within CAMELS should take into account both
disagreed-upon classifications are extrapolated,
financial and managerial factors as detailed in
the result is a significant difference between the
SR-96-38. When using the sampling approach,
‘‘base’’ ratio and the extrapolated classification
the extrapolated weighted classification ratio is
ratio of 18.5 percent. This can occur when there
to be used as a tool for assessing the extent to
are only four loans that are sampled from bucket
which examiners may rely on the bank’s internal
8, and the two loans in disagreement account for
classifications. To the extent loan sampling indi-
40 percent of the dollar volume of the sampled
cates that the bank’s internal classifications are
loans. Through extrapolation, 40 percent of the
not reliable, the severity of that fundamental
remaining bucket 8 loans would be considered
risk-management weakness should be factored
classified, thereby increasing the extrapolated
into the asset-quality rating as well as the
ratio to a level that may cause an examiner to
management and the risk-management rating.
question the reliability of the bank’s classifica-
Results of the statistical loan sampling should be
tion system.
documented in the examination report. (See the
In the preceding example, to rule out the
examination procedures, section 2082.3, for a
possibility that misclassifications were identified
detailed description of the required information.)
as a matter of chance, examiners should expand
their loan coverage by pulling an additional
sample from the bucket in which the misclassi-
fications were identified. If the examiner selected Discussions with Management
four additional borrowers from bucket 8 to Regarding the Sampling Procedures
review and no new misclassifications were found,
the extrapolated ratio would decline to 11 per- The sampling procedure produces an extrapo-
cent. As the base and extrapolated ratios move lated estimate of weighted classified assets. The
much closer together, the examiner may have principal use of extrapolation is to provide an
greater confidence in the bank’s internal loan- estimate of what the weighted asset-classification
rating system and place greater reliance on ratio would be for the entire loan portfolio. The
bank-identified problems in evaluating the bank’s extrapolated ratio will differ significantly from
asset quality. However, when reviewing the the traditional weighted asset-classification ratio
additional four back-up loans, if the examiner when errors in the bank’s internal classification

Page 4
Loan-Sampling Program for Certain Community Banks 2082.1
system are detected through random sampling. of sampling (that resulted from rating errors)
Examiners may want to discuss (1) how the should be discussed with management and
errors led to a widening of the loan-review included in the examination report, along with
scope and (2) the degree of errors found in the any necessary follow-up work required to gain
loans pulled beyond the initial sample. Any more certainty. Those discussions may center on
uncertainties regarding the integrity of the insti- the number of errors uncovered in sampled and
tution’s classification system or the extent of its core loans.
asset-quality problems uncovered from the use

Page 5
1. To evaluate and improve, using statistical a bank’s internal credit-review process and
sampling, the comprehensiveness and effec- also the effectiveness of its credit risk-
tiveness of the examination’s credit review management practices.
of a bank’s loan portfolio. 3. To assess the accuracy of the bank’s internal
2. To better evaluate, using statistical sampling, credit classifications.

Page 1
1. Using the Federal Reserve System’s loan- 4. When it is determined that the bank’s inter-
sampling software and the electronic files nal classifications are unreliable, factor the
provided by the bank under examination (for severity of this risk-management weakness
example, those in the Automated Loan into the asset-quality, management, and risk-
Examination Review Tool (ALERT) format), management ratings.
develop the bank’s core and sampled bor- 5. Include the following information in the
rower groups. (See table 1 in section 2082.1.) examination report (for instance, the infor-
Follow the ‘‘Specific Procedures’’ of section mation illustrated below):
2082.1 for selecting loans for review, includ-
a. Report the traditional weighted asset-
ing those that are to be randomly sampled.
classification ratio in the open section of
2. Use the bank examination credit-analysis
the examination report.
techniques in this manual to—
a. evaluate the borrower’s creditworthiness, b. Report the extrapolated weighted asset-
b. determine the level of adverse classifica- classification ratio, the traditional asset-
tions, and classification ratio, and the number of
c. identify any discrepancies within the errors found in the sampled buckets in the
bank’s internal classifications. confidential section of the report.
3. Continue to follow the ‘‘Specific Proce- c. If an expanded sample was undertaken
dures.’’ because of misclassification errors, report
a. Be especially alert when reviewing loan in the confidential section the number of
misclassifications to detect patterns of additional loans selected, any errors from
misclassifications (for example, whether the expanded sample, and the adjusted
the misclassified loans were generated by weighted and extrapolated asset-
a specific originating office or loan officer). classification ratios.
b. When misclassifications are identified, be
prepared to expand the scope of the loan The illustration below is a sample table format
review. that may be used to highlight the sampling
c. Ascertain whether the bank is systemati- findings within the indicated sections of the
cally misreporting credit problems. examination report.
Loan-Sampling Results—Items to Be Reported in the Examination Report
Open section
Traditional weighted asset-classification ratio %
Confidential section
Extrapolated weighted asset-classification ratio %
Number of borrowers sampled
Number of errors in sampled buckets
Expanded-sample information
Number of sampled borrowers in expanded review
Number of errors in expanded review
Adjusted weighted asset-classification ratio %
Adjusted extrapolated weighted asset-classification ratio %

Page 1
Real Estate Loans
Real estate lending is a major function of most As mandated by the Federal Deposit Insur-
banks. However, the composition of banks’ real ance Corporation Improvement Act of 1991
estate loan portfolios will vary because of dif- (FDICIA) (12 USC 1828(c)), the Federal Reserve
ferences in the banks’ asset size, investment Board, along with the other banking agencies,
objectives, lending experience, market competi- adopted in December 1992 uniform regulations
tion, and location. Additionally, state member prescribing standards for real estate lending.
banks’ lending activity is subject to supervision FDICIA defines real estate lending as extensions
by state banking regulatory agencies, which of credit secured by liens on or interests in real
may impose limitations, including restrictions estate or made for the purpose of financing the
on lending territory, types of lending, percentage construction of a building or other improve-
of assets in real estate loans, loan limits, loan- ments to real estate, regardless of whether a lien
to-value ratios, and loan terms. has been taken on the property.
Because of the differences in state banking
laws, this section of the manual is only an The Federal Reserve’s Regulation H requires
overview of the Federal Reserve’s supervisory an institution to adopt real estate lending poli-
and regulatory requirements for a safe and cies that are—
sound real estate lending program. For spe-
cific information on lending limitations and • consistent with safe and sound banking
restrictions, refer to the applicable state banking practices,
laws. In addition, information related to real • appropriate to the size of the institution and
estate construction lending is discussed in sec- the nature and scope of its operations, and
tion 2100.1 of this manual. • reviewed and approved by the bank’s board of
directors at least annually.
These lending policies must establish—

REAL ESTATE LENDING
POLICY MANDATED BY • loan portfolio diversification standards;
FDICIA • prudent underwriting standards that are clear
and measurable, including loan-to-value
A bank’s real estate lending policy is a broad limits;
statement of its standards, guidelines, and limi- • loan-administration procedures for the institu-
tations that senior bank management and lend- tion’s real estate portfolio; and
ing officers are expected to adhere to when • documentation, approval, and reporting
making a real estate loan. The maintenance of requirements to monitor compliance with the
prudent written lending policies, effective interbank’s real estate lending policies.
nal systems and controls, and thorough loan
documentation is essential to the bank’s man- Furthermore, the bank is expected to monitor
agement of the lending function. conditions in the real estate market in its lending
The policies governing a bank’s real estate area to ensure that its policies continue to be
lending activities must include prudent under- appropriate for current market conditions.
writing standards that are clearly communicated
to the institution’s management and lending
staff. The bank should also have credit-risk
control procedures that include, for example, an GUIDELINES ESTABLISHED
effective credit-review and -classification pro- PURSUANT TO FDICIA
cess and a methodology for ensuring that the
allowance for loan and lease losses is main- The criteria and specific factors that a bank
tained at an adequate level. As part of the should consider in establishing its real estate
analysis of a bank’s real estate loan portfolio, lending policies are set forth in the Interagency
examiners should review lending policies, loan- Guidelines for Real Estate Lending Policies
administration procedures, and credit-risk con- (Regulation H, part 208, appendix C (12 CFR
trol procedures, as well as the bank’s compli- 208, appendix C)). These guidelines apply to
ance with its own policies. transactions (including legally binding, but

Page 1
2090.1 Real Estate Loans
unfunded, lending commitments) originated on should also consider the need to avoid undue
or after March 19, 1993. concentrations of risk and compliance with all
real estate–related laws and regulations (such as
the Community Reinvestment Act, the Truth in
Lending Act, the Real Estate Settlement Proce-
dures Act, and antidiscrimination laws).
Loan Portfolio Management The bank should monitor the conditions in the
real estate markets in its lending area so that it
The bank’s lending policies should contain a can react quickly to changes in market condi-
general outline of its market area; a targeted tions that are relevant to the lending decision.
loan portfolio distribution; and the manner in This should include monitoring market supply-
which real estate loans are made, serviced, and and-demand factors, such as employment trends;
collected. Lending policies should include— economic indicators; current and projected
vacancy, construction, and absorption rates; and
• identification of the geographic areas in which current and projected lease terms, rental rates,
the bank will consider lending; and sales prices.
• establishment of a loan portfolio diversifica-
tion policy and limits for real estate loans by
type and geographic market (for example,
limits on higher-risk loans); Underwriting Standards
• identification of the appropriate terms and
conditions, by type of real estate loan; The bank’s lending policies should reflect the
level of risk that is acceptable to its board of
• establishment of loan-origination and -approval directors and should provide clear and measur-
procedures, both generally and by size and able underwriting standards that enable the
type of loan; bank’s lending staff to evaluate all relevant
• establishment of prudent underwriting stan- credit factors. These factors include—
dards, including loan-to-value (LTV) limits,
that are clear and measurable and consistent • the capacity of the borrower or income from
with the supervisory LTV limits contained in the underlying property to adequately service
the interagency guidelines; the debt;
• establishment of review and approval proce- • the market value of the underlying real estate
dures for exception loans, including loans collateral;
with LTV ratios in excess of the interagency • the overall creditworthiness of the borrower,
guidelines’ supervisory limits; • the level of the borrower’s equity invested in
the property;
• establishment of loan-administration proce- • any secondary sources of repayment; and
dures, including documentation, disburse- • any additional collateral or credit enhance-
ment, collateral inspection, collection, and ments, such as guarantees, mortgage insur-
loan review; ance, or takeout commitments.
• establishment of real estate appraisal and
evaluation programs consistent with the While there is no one lending policy appropriate
Federal Reserve’s appraisal regulation and for all banks, there are certain standards that a
guidelines; and bank should address in its policies, such as—
• a requirement that management monitor the
• the maximum loan amount by type of
loan portfolio and provide timely and adequate
reports to the bank’s board of directors. property,
• the maximum loan maturities by type of
The complexity and scope of these policies property,
and procedures should be appropriate for the • amortization schedules,
market, size, and financial condition of the • the pricing structure for each type of real
institution and should reflect the expertise and estate loan, and
size of the lending staff. The bank’s policies • loan-to-value limits by type of property.

Page 2
Real Estate Loans 2090.1
For development and construction projects eral and readily marketable collateral securing
and completed commercial properties, the bank’s the credit.
policy should also establish appropriate stan- In accordance with the Federal Reserve’s
dards for the unique risks associated with these appraisal regulation and guidelines, the value of
types of real estate loans by addressing the size, the real estate collateral should be set forth in an
type, and complexity of the project. Such stan- appraisal or evaluation (whichever is appropri-
dards should include the acceptability of and ate) and should be expressed in terms of market
limits for nonamortizing loans and interest value. However, for loans to purchase an exist-
reserves; requirements for pre-leasing and pre- ing property, the term ‘‘value’’ means the lesser
sale; limits on partial recourse or nonrecourse of the actual acquisition cost to the borrower or
loans; requirements for guarantor support; the estimate of value as presented in the
requirements for takeout commitments; and min- appraisal or evaluation. See ‘‘Real Estate
imum covenants for loan agreements. Further- Appraisals and Evaluations,’’ section 4140.1 of
more, the bank’s policy should set minimum this manual for further discussion of the Federal
requirements for initial investment by the bor- Reserve’s appraisal regulation and guidelines.
rower; maintenance of hard equity throughout ‘‘Other acceptable collateral’’ refers to any
the life of the project; and net worth, cash flow, collateral in which the lender has a perfected
and debt-service coverage of the borrower or security interest, that has a quantifiable value,
underlying property. and that is accepted by the lender in accordance
with safe and sound lending practices. This
includes inventory, accounts receivables, equip-
ment, and unconditional irrevocable standby
Exceptions to Underwriting Standards
letters of credit.
The bank should have procedures for handling Readily marketable collateral means insured
loan requests from creditworthy borrowers deposits, financial instruments, and bullion in
whose credit needs do not conform with the which the lender has a perfected interest. Finan-
bank’s general lending policy. As a part of the cial instruments and bullion must be readily
permanent loan file, the bank should document salable under ordinary circumstances at a mar-
justification for approving such loans. More- ket value determined by quotations based on
over, in the course of monitoring compliance actual transactions, on an auction, or similarly
with its own real estate lending policy, bank available daily bid and asking price.
management should report to its board of direc- Other acceptable collateral and readily mar-
tors loans of a significant size that are excep- ketable collateral should be appropriately dis-
tions to bank policy. An excessive volume of counted by the lender consistent with the bank’s
exceptions to the institution’s own policies may usual practices for making loans secured by
signal weaknesses in its underwriting practices such collateral. The lender may not consider the
or a need to revise its policy. general net worth of the borrower, which might
be a determining factor for an unsecured loan, as
equivalent to other acceptable collateral for
determining the LTV on a secured real estate
loan. Furthermore, if an institution attempts to
Supervisory Loan-to-Value Limits circumvent the supervisory LTV limits by lend-
ing a portion of the funds on a secured basis and
The bank should establish its own internal a portion on an unsecured basis, examiners are
loan-to-value (LTV) limits for each type of real instructed to consider the two loans as one if
estate loan that is permitted by its loan policy. certain similarities are found. These similarities
The LTV ratio is derived at the time of loan are based upon facts such as common origina-
origination by dividing the extension of credit, tion dates or loan purposes, and should be used
including the amount of all senior liens on, or to determine compliance with the supervisory
other senior interests in, the property, by the LTV limits. The bank’s policy should reflect the
total value of the property or properties securing supervisory limits set forth in the Interagency
or being improved by the extension of credit, Guidelines for Real Estate Lending Policies,
plus the amount of any other acceptable collat- which are shown in the following table.

Page 3
Table 1—Supervisory Loan-to-Value extension of credit for a property containing

Limits fewer than five individual dwelling units, includ-
ing manufactured homes permanently affixed to
the underlying property.
Loan Category Loan-to-Value Limit
Multifamily construction loan means an exten-
Raw land 65% sion of credit for a residential property contain-
Land development, including ing five or more individual units, including
improved land loans 75% condominiums and cooperatives.
Construction: Improved property loan refers to (1) farmland,

Commercial, multifamily, ranchland, or timberland committed to ongoing
and other nonresidential 80% management and agricultural production;
One- to four-family residential 85% (2) one- to four-family residential property that
is not owner-occupied; (3) residential property
Improved property 85%
containing five or more individual dwelling
Owner-occupied one- to units; (4) completed commercial property; or
four-family and home equity ** (5) other income-producing property that has
been completed and is available for occupancy
** A loan-to-value limit has not been established for and use, except income-producing owner-
permanent mortgage or home equity loans on owner-occupied occupied one- to four-family residential
one- to four-family residential property. However, for any
such loan with a loan-to-value ratio that equals or exceeds
property.
90 percent at origination, an institution should require appro-
priate credit enhancement in the form of either mortgage Owner-occupied one- to four-family residential
insurance or readily marketable collateral. property means that the owner of the underlying
real property occupies at least one unit of the
For purposes of these supervisory limits, the real property as a principal residence.
loan categories are defined as follows:
For loans that fund multiple phases of the same
Raw land loan means an extension of credit in real estate project, the appropriate LTV limit is
which the funds are used to acquire and/or hold the supervisory LTV limit applicable to the final
raw land. phase of the project. For example, when the loan
is for the acquisition and development of land
Land development loan means an extension of and the construction of an office building in
credit for the purpose of improving unimproved continuous phases of development, the appro-
real property before the erection of any struc- priate supervisory LTV limit for the project loan
tures. Such improvements include the laying or would be 80 percent (the supervisory LTV limit
placement of sewers, water pipes, utility cables, for commercial construction). However, this
streets, and other infrastructure necessary for does not imply that the lender can finance the
future development. This loan category also total acquisition cost of the land at the time the
includes an extension of credit for the acquisi- raw land is acquired by assuming that this
tion of improved land, such as residential lots in financing would be less than 80 percent of the
an established development. If there are mini- project’s final value. The lender is expected to
mal improvements to the land, and the time- fund the loan according to prudent disbursement
frame for construction of the dwelling or build- procedures that set appropriate levels for the
ing has not been scheduled to commence in the borrower’s hard equity contributions throughout
foreseeable future, the loan generally should be the disbursement period and term of the loan. As
considered a raw land loan. a general guideline, the funding of the initial
acquisition of the raw land should not exceed
Construction loan means an extension of credit the 65 percent supervisory LTV limit; likewise,
for the purpose of erecting or rehabilitating the project cost to fund the land development
buildings or other structures, including any phase of the project should not exceed the
infrastructure necessary for development. 75 percent supervisory LTV limit.
For a multiple-phase one- to four-family resi-
One- to four-family residential loan means an dential loan in which the lender is funding both

Page 4
the construction of the house and the permanent of a bank as its level of loans in excess of
mortgage to a borrower who will be the owner- supervisory LTV limits approaches the capital
occupant, there is no supervisory LTV limit. limitations. Nevertheless, a nonconforming loan
However, if the LTV ratio equals or exceeds should not be criticized solely because it does
90 percent, the bank should require an appropri- not adhere to supervisory limits.
ate credit enhancement in the form of either The aggregate amount of nonconforming loans
mortgage insurance or readily marketable may not exceed 100 percent of a bank’s total
collateral. risk-based capital (referred to as the noncon-
When a loan is fully cross-collateralized by forming basket). Within this limit, the aggregate
two or more properties, the maximum loan amount of non–one- to four-family residential
amount is determined by first multiplying each loans (for example, raw land, commercial, mul-
property’s collateral value by the LTV ratio tifamily, and agricultural loans) that do not
appropriate to that property and then deducting conform to supervisory LTV limits may not
from that product any existing senior liens on exceed 30 percent of total risk-based capital.
that property. The resulting sum is the maximum The remaining portion of the nonconforming
loan amount that may be extended under cross- basket includes the aggregate amount of one- to
collateralization. To ensure that collateral mar- four-family residential development and con-
gins remain within the supervisory limits, the struction loans, non-owner-occupied one- to
bank should redetermine conformity whenever four-family residential loans with an LTV ratio
collateral substitutions are made to the collateral greater than 85 percent, and owner-occupied
pool. one- to four-family residential loans with an
LTV ratio equal to or exceeding 90 percent
without mortgage insurance or readily market-
Loans in Excess of Supervisory able collateral.
LTV Limits For the purpose of determining the loans
subject to the 100 percent of risk-based capital
The Federal Reserve believes that it may be limitation, and for the purposes of determining
appropriate for a bank, in certain circumstances, the aggregate amount of such loans, institutions
to originate or purchase loans with LTV ratios in should include loans that are secured by the
excess of supervisory limits, based on the sup- same property, when the combined loan amount
port provided by other credit factors that the equals or exceeds 90 percent LTV and there is
bank documented in its permanent credit files. no additional credit support. In addition, insti-
While high LTV lending poses higher risk for tutions should include the recourse obligation of
lenders than traditional mortgage lending, high any such loan sold with recourse. If there is a
LTV lending can be profitable when these risks reduction in principal or senior liens or if the
are effectively managed and loans are priced borrower contributes additional collateral or
based on risk. Therefore, institutions involved in equity that brings the LTV ratio into supervisory
high LTV lending should implement risk- compliance, the loan is no longer considered
management programs that identify, measure, nonconforming and may be deleted from the
monitor, and control the inherent risks (see quarterly nonconforming loan report to the
SR-99-26 and the attached ‘‘Interagency Guid- directors.
ance on High LTV Residential Real Estate The following guidance is provided for cal-
Lending,’’ October 8, 1998). The primary credit culating the LTV when multiple loans and more
risks associated with this type of lending are than one lender are involved. The institution
increased default risk and losses, inadequate should include its loan and all senior liens on or
collateral, longer term and thus longer exposure, interests in the property in the total loan amount
and limited default remedies. when calculating the LTV ratio. The following
examples are provided:
Capital limits. A bank’s nonconforming loans—
those in excess of the supervisory LTV limits— • Bank A holds a first-lien mortgage on a
should be identified in bank records, and the property and subsequently grants the borrower
aggregate amount, along with the performace a home equity loan secured by the same
experience of the portfolio, should be reported at property. In this case, the bank would combine
least quarterly to the bank’s board of directors. both loans to determine if the total amount
There should be increased supervisory scrutiny outstanding equaled or exceeded 90 percent of

Page 5
the property’s market value. If the LTV ratio excluding such transactions from the application
equals or exceeds 90 percent and there is no of the supervisory LTV and capital limits. This
other appropriate credit support, the entire includes loans—
amount of both loans is an exception to the
supervisory LTV limits and is included in the • guaranteed or insured by the U.S. government
aggregate capital limitation. or its agencies, provided the amount of the
guaranty or insurance is at least equal to the
• Bank A grants a borrower a home equity loan portion of the loan that exceeds the supervi-
secured by a second lien. Bank B holds a sory LTV limit.
first-lien mortgage for the same borrower and • backed by the full faith and credit of a state
on the same property. Bank A would combine government, provided the amount of the guar-
the committed amount of its home equity loan anty or insurance is at least equal to the
with the amount outstanding on Bank B’s portion of the loan that exceeds the supervi-
first-lien mortgage to determine if the LTV sory LTV limit.
ratio equaled or exceeded 90 percent of the • guaranteed or insured by a state, municipal, or
property’s market value. If the LTV ratio local government or agency, provided the
equals or exceeds 90 percent and there is no amount of the guaranty or insurance is at least
other appropriate credit support, Bank A’s equal to the portion of the loan that exceeds
entire home equity loan is an exception to the the supervisory LTV limit and that the guar-
supervisory LTV limits and is included in the antor or insurer has the financial capacity and
aggregate capital limitation. Bank A does not willingness to perform.
report Bank B’s first-lien mortgage loan as an • sold promptly (within 90 days) after origina-
exception, but must use it to calculate the LTV tion. A supervisory determination may be
ratio. made that this exclusion is not available for an
institution that has consistently demonstrated
When a loan’s LTV ratio is reduced below significant weaknesses in its mortgage bank-
90 percent by amortization or additional credit ing operations. (If a loan is sold with recourse
support, it is no longer an exception to the and the LTV is in excess of supervisory limits,
guidelines and may be excluded from the insti- the recourse portion of the loan counts toward
tution’s 100 percent of capital limitation. the bank’s limit for nonconforming loans.)
Institutions will come under increased super- • renewed, refinanced, or restructured—
visory scrutiny as the total of all loans in excess — without the advancement of new monies
of the supervisory LTV limits, including high (except reasonable closing costs); or
LTV residential real estate loan exceptions, — in conjunction with a clearly defined and
approaches 100 percent of total capital. If an documented workout, either with or with-
institution exceeds the 100 percent of capital out the advancement of new funds.
limit, a supervisory assessment may be needed • facilitating the sale of real estate acquired by
to determine whether there is any concern that the lender in the course of collecting a debt
warrants taking appropriate supervisory action. previously contracted in good faith.
Such action may include directing the institution • in which a lien on real property is taken
(1) to reduce its loans in excess of the supervi- through an abundance of caution; for exam-
sory LTV limits to an appropriate level, (2) to ple, the value of the real estate collateral is
raise additional capital, or (3) to submit a plan to relatively low compared with the aggregate
achieve compliance. The institution’s capital value of other collateral, or a blanket lien is
level and overall risk profile, and the adequacy taken on all or substantially all of the borrow-
of its controls and operations, as well as other er’s assets.1
factors will be the basis for determining whether • for working-capital purposes in which the
such actions are necessary. lender does not rely principally on real estate
as security. The proceeds of the loan are not
Transactions Excluded from Supervisory
LTV Limits
1. Any residential mortgage or home equity loan with an
LTV ratio that equals or exceeds 90 percent and that does not
There are a number of lending situations in have the additional credit support should be considered an
which other factors significantly outweigh the exception to the guidelines and included in the calculation of
need to apply supervisory LTV limits, thereby loans subject to the 100 percent of capital limit.

Page 6
used to acquire, develop, or construct real of pipeline and warehoused loans, and alternate
property. funding sources should be identified.
• financing permanent improvements to real Institutions should refer to the Financial
property, but in which no security interest is Accounting Standards Board’s Statement of
taken or required by prudent underwriting Financial Accounting Standards No. 140 (FAS
standards. For example, a manufacturing com- 140), ‘‘Accounting for Transfers and Servicing
pany obtains a loan to build an addition to its of Financial Assets and Extinguishments of
plant. The bank does not take a lien on the Liabilities (a replacement of FASB statement
plant because the bank is relying on the 125),’’ for guidance on accounting for these
company’s operating income and financial types of transactions. If a securitization transac-
strength to repay the debt. tion meets FAS 140 sale or servicing criteria, the
seller must recognize any gain or loss on the sale
of the pool immediately and carry any retained
Risk Management for Supervisory interests in the assets sold (including servicing
Loan-to-Value Limits rights or obligations and interest-only strips) at
fair value. Management should ensure that the
Loan review and monitoring. Institutions should key assumptions used to value these retained
perform periodic quality analyses through loan interests are reasonable and well supported, both
review and portfolio monitoring. These periodic for the initial valuation and for subsequent
reviews should include an evaluation of various quarterly revaluations.
risk factors, such as credit scores, debt-to-
income ratios, loan types, location, and concen- Compliance risk. Institutions that originate or
trations. At a minimum, the high-LTV loan purchase high-LTV real estate loans must take
portfolios should be segmented by their vintage special care to avoid violating fair lending and
(that is, age) and the performance of the portfo- consumer protection laws and regulations. Higher
lios should be analyzed for profitability, growth, fees and interest rates combined with compen-
delinquencies, classifications and losses, and the sation incentives can foster predatory pricing or
adequacy of the allowance for loan and lease discriminatory ‘‘steering’’ of borrowers to high-
losses based on the various risk factors. The LTV products for reasons other than the borrow-
ongoing performance of the high-LTV loans er’s creditworthiness. An adequate compliance-
should be monitored by a periodic re-scoring of management program must identify, monitor,
the accounts, or by periodically obtaining and control the compliance risks associated with
updated credit bureau reports or financial infor- high-LTV real estate lending.
mation on borrowers. In addition, institutions
involved in high-LTV lending should adopt, as
part of their loan-review program, the standards REAL ESTATE LENDING
in the FFIEC’s Uniform Retail-Credit Classifi- ACTIVITY AND RISKS
cation and Account-Management Policy. (See
section 2130.1.) Real estate lending falls into two broad catego-
ries: short-term financing (primarily construc-
Sales of high-LTV loans. When institutions tion loans) and permanent financing (for example,
securitize and sell high-LTV loans, all the risks a 30-year residential mortgage or a 10-year
inherent in such lending may not be transferred mortgage loan with payments based on a
to the purchasers. Institutions that actively 25-year amortization schedule and a balloon
securitize and sell high-LTV loans must imple- payment due at the end of the 10 years on an
ment procedures to control the risks inherent in existing commercial office building). Each type
that activity. Only written counterparty agree- of lending carries with it unique underwriting
ments that specify the duties and responsibilities risks as well as common risks associated with
of each party and that include a regular schedule any type of lending. In all cases, the bank should
for loan sales should be entered into. A contin- understand the credit risks and structure of the
gency plan should be developed that designates proposed transaction, even if it is not the origi-
backup purchasers and servicers in the event nating bank. This includes, at a minimum,
that either party is unable to meet its contractual understanding the borrower’s ability to repay
obligations. To manage liquidity risk, commit- the debt and the value of the underlying real
ment limits should be established for the amount estate collateral.

Page 7
Permanent financing, as the name implies, is manage its real estate loan portfolio risk. An
long term and presents a funding risk since a indication of improper management of a bank’s
bank’s source of funds is generally of a shorter portfolio is an excessive concentration in loans
maturity. Accordingly, bank management should to one borrower or related borrowers, in one
be aware of the source for funding this lending type of real estate loan, or in a geographic
activity. While matching the maturity structures location outside the bank’s designated trade
of assets to liabilities is particularly important area.
for a bank’s overall loan portfolio management, In identifying loan concentrations, commer-
the importance of this task is even more evident cial real estate loans and residential real estate
in real estate lending activity. Many banks loans should be viewed separately when their
reduce their funding risk by entering into loan performance is not subject to similar economic
participations and sales with other institutions as or financial risks. However, groups or classes of
well as asset securitization transactions.2 For a real estate loans should be viewed as concentra-
detailed discussion on short-term financing, see tions when there are significant common char-
section 2100.1, ‘‘Real Estate Construction acteristics and the loans are affected by similar
Loans.’’ adverse economic, financial, or business
developments. Banks with asset concentrations
should have in place effective internal policies,
Unsound Lending Practices systems, and controls to monitor and manage
this risk.
Some banks have adversely affected their finan- Concentrations that involve excessive or
cial condition and performance by granting undue risks require close scrutiny by the bank
loans based on ill-conceived real estate projects. and should be reduced over a reasonable period
Apart from losses due to unforeseen economic of time. To reduce this risk, the bank should
downturns, these losses have generally been the develop a prudent plan and institute strong
result of poor or lax underwriting standards and underwriting standards and loan administration
improper management of the bank’s overall real to control the risks associated with new loans.
estate loan portfolio. At the same time, the bank should maintain
A principal indication of an unsound lending adequate capital to protect it from the excessive
practice is an improper relationship between the risk while restructuring its portfolio.
loan amount and the market value of the prop-
erty; for example, a high loan-to-value ratio in
relationship to normal lending practice for a
similar type of property. Another indication of Loan Administration and Servicing
unsound lending practices is the failure of the
bank to examine the borrower’s debt-service Real estate loan administration is responsible for
ability. For a commercial real estate loan, sound certain aspects of loan monitoring. While the
underwriting practices are critical to the detec- administration may be segregated by property
tion of problems in the project’s plans, such as type, such as residential or commercial real
unrealistic income assumptions, substandard estate loans, the functions of the servicing
project design, potential construction problems, department may be divided into the following
and a poor marketing plan, that will affect the categories (although the organization will vary
feasibility of the project. among institutions):
• Loan closing and disbursement—preparing

Real Estate Loan Portfolio the legal documents verifying the transaction,
Concentration Risk recording the appropriate documents in the
public land records, and disbursing funds in
A bank should have in place effective internal accordance with the loan agreement.
policies, systems, and controls to monitor and • Payment processing—collecting and applying
the loan payments.
• Escrow administration—collecting insurance
2. See section 4030.1, ‘‘Asset Securitization,’’ for addi-
tional information, including information on mortgage-backed
premiums and property taxes from the bor-
securities (MBSs), collateralized mortgage obligations (CMOs), rower and remitting the funds to the insurance
and real estate mortgage investment conduits (REMICs). company and taxing authority.

Page 8
• Collateral administration—maintaining docu- BANK ASSESSMENT OF THE

ments to reflect the status of the bank’s lien on BORROWER
the collateral (i.e., mortgage/deed of trust and
title policy/attorney’s opinion), the value of Although the value of the real estate collateral is
the collateral (i.e., real estate appraisal or an important component of the loan-approval
evaluation and verification of senior lien, if in process, the bank should not place undue reli-
existence), and the protection of the collateral ance on the collateral value in lieu of an ade-
(i.e., hazard/liability insurance and tax pay- quate assessment of the borrower’s ability to
ments). repay the loan. These assessment factors differ
• Loan payoffs—determining the pay-off amount, depending upon the purpose of the loan, such as
preparing the borrower release or assumption single-family residential loans as compared with
documents, confirming the receipt of funds, income-producing commercial property loans
and recording the appropriate lien-release and commercial or residential development loans
documents in the public land records. (referred to as ‘‘commercial real estate lend-
• Collections and foreclosure—monitoring the ing’’). The loan documentation must adequately
payment performance of the borrower and support the bank’s assessment of the borrower
pursuing collection of past-due amounts in and contain the appropriate legal documentation
accordance with bank policy on delinquen- to protect the bank’s interests.
cies.
• Claims processing—seeking recoveries on
defaulted loans that are covered by a govern-
ment guarantee or insurance program or a Single-Family Residential Loans
private mortgage insurance company.
For single-family residential loans, the bank
should evaluate the loan applicant’s creditwor-
The bank should have adequate procedures to
thiness and whether the individual has the abil-
ensure segregation of duties for disbursal and
ity to meet monthly mortgage payments as well
receipt of funds control purposes. Additionally,
as all other obligations and expenses associated
the procedures should address the need for
with home ownership. This includes an assess-
document control because of the importance of
ment of the borrower’s income, liquid assets,
the timely recording of the bank’s security
employment history, credit history, and existing
interests in the public land records.
obligations.3 The bank should also consider the
Some institutions provide various levels of
availability of private mortgage insurance; a
loan services for other institutions, which may
government guarantee; or a government insur-
range from solely the distribution of payments
ance program, such as loans through the FHA-
received to the ultimate collection of the debt
insured or VA-guaranteed programs, in assess-
through foreclosure. In such cases, the bank will
ing the credit risk of a loan applicant.
have the additional responsibility of remitting
If a bank delegates the loan-origination func-
funds on a timely basis to the other institutions
tion to a third party, the bank should have
in accordance with a servicing agreement. The
adequate controls to ensure that its loan policies
servicing agreement sets forth the servicer’s
and procedures are being followed. The controls
duties, reporting requirements, timeframe for
should include a review of the third party’s
remitting funds, and fee structure. If a bank
qualifications; a written agreement between the
relies on another institution for servicing, the
bank and the third-party originator to set forth
bank should have adequate control and audit
the responsibilities of the third party as an agent
procedures to verify the performance of the
for the bank; a periodic review of the third
servicer (also see section 4030.1, ‘‘Asset Secu-
party’s operations to ensure that the bank’s
ritization’’). For residential loans sold into the
secondary mortgage market for which the bank
has retained servicing, Fannie Mae, Freddie 3. There are restrictions on the information a bank can
Mac, and the Government National Mortgage request. The Federal Reserve’s Regulation B, Equal Credit
Corporation (Ginnie Mae) have specific stan- Opportunity (12 CFR 202), details the information that may
dards the bank (that is, seller/servicer) must and may not be requested on a loan application and provides
a model form for a residential mortgage transaction. The
adhere to. Failure to meet these standards can Federal Reserve’s Regulation Z, Truth in Lending (12 CFR
result in the termination of the servicing 226), describes the bank-disclosure requirements to the po-
agreement. tential borrower on the cost of financing.

Page 9
policies and procedures are being adhered to; extent of commercial real estate lending activity
and development of quality controls to ensure should be contingent upon the lender’s expertise
that loans originated by the third party meet the and the bank’s experience. In considering an
bank’s lending standards, as well as those of the application for a commercial real estate loan, a
secondary mortgage market if the bank expects bank should understand the relationship of the
to sell the mortgages. actual borrower to the project being financed.
The form of business ownership varies for
commercial real estate projects and can affect
Secondary Residential Mortgage the management, financial resources available
for the completion of the project, and repayment
Market of the loan.
In the secondary market, a bank (the primary Information on past and current projects con-
mortgage originator) sells all or a portion of its structed, rented, or managed by the potential
interest in residential mortgages to other finan- borrower can help the bank assess the borrow-
cial institutions (investors). Thus, the secondary er’s experience and the likelihood of the pro-
mortgage market provides an avenue for a bank posed project’s success. For development and
to liquidate a long-term asset as the need for construction projects, the bank should closely
funds arises. The majority of the secondary review the project’s feasibility study. The study
mortgage market activity is supported by three should provide sensitivity and risk analyses of
government-related or -controlled institutions: the potential impact of changes in key economic
Fannie Mae,4 Freddie Mac,5 and Ginnie Mae.6 variables, such as interest rates, vacancy rates,
These entities were created or sponsored by the or operating expenses. The bank should also
federal government to encourage the financing conduct credit checks of the borrower and of all
and construction of residential housing. Fannie principals involved in the transaction to verify
Mae, Freddie Mac, and Ginnie Mae have spe- relationships with contractors, suppliers, and
cific underwriting standards and loan- business associates.
documentation requirements for mortgages pur- Finally, the bank should assess the borrower’s
chased or guaranteed by them. Generally, financial strength to determine if the principals
financial institutions enter into either a manda- of the project have the necessary working capi-
tory or a standby commitment agreement with tal and financial resources to support the project
these entities wherein the financial institution until it reaches stabilization. As with any type of
agrees to sell loans according to certain delivery lending on income-producing properties,7 the
schedules, terms, and performance penalties. bank should quantify the degree of protection
from the borrower’s (or collateral’s) cash flow,
the value of the underlying collateral, and any
Commercial Real Estate Loans guarantees or other collateral that may be avail-
able as a source of loan repayment.
As with other types of lending activities, the
4. Although Fannie Mae was originally created in 1938 as

an organization within the federal government, it became a
federally chartered, stockholder corporation in 1968 when BANK ASSESSMENT OF REAL
some of its functions were placed under the newly created
Ginnie Mae. Financial institutions can either sell mortgages
ESTATE COLLATERAL
directly to Fannie Mae or pool mortgages for placement in a
Fannie Mae–guaranteed mortgage-backed security. Banks should obtain an appraisal or evaluation,
5. Freddie Mac was sponsored by the Federal Home Loan as appropriate, for all real estate–related finan-
Bank Board and its members in 1970. Its primary purpose is
to provide a secondary market for conventional mortgages
cial transactions before making the final credit
originated by thrifts. or other decision. The Federal Reserve’s appraisal
6. Ginnie Mae, a government agency under the Department regulation requires institutions to obtain apprais-
of Housing and Urban Development (HUD), was created in als when certain criteria are met. See ‘‘Real
1968 when Fannie Mae became a private corporation. It has
several functions to assist in government housing programs,
such as managing and liquidating loans acquired by the
government. In the secondary market, Ginnie Mae acts as a 7. Income-producing commercial properties include rental
guarantor of mortgage-backed securities for pools of loans apartments, retail properties, office buildings, warehouses, and
originated and securitized by financial institutions. hotels.

Page 10
Estate Appraisals and Evaluations’’ section Loans qualifying for sale to any U.S. govern-
4140.1, for a description of the related requirement agency or government-sponsored agency
ments a bank must follow for real estate–related or conforming to the appraisal standards of
financial transactions. The appraisal section Fannie Mae and Freddie Mac are also exempt
explains the standards for appraisals, indicates from the Federal Reserve’s appraisal regulation.
which transactions require an appraisal or an Fannie Mae and Freddie Mac jointly developed
evaluation, states qualifications for an and adopted the Uniform Residential Appraisal
appraiser and evaluator, provides guidance on Report (URAR) as the standard form for resi-
evaluations, and describes the three appraisal dential loans sold to them. As a result, a prop-
approaches. erly completed URAR form is considered the
Management is responsible for reviewing the industry standard for appraising one- to four-
reasonableness of the appraisal’s or evaluation’s family residential properties.
assumptions and conclusions. Also, manage-
ment’s rationale for accepting and relying upon
the appraisal or evaluation should be docu- Commercial Real Estate Loans
mented in writing. In assessing the underwrit-
ing risks, management should reconsider any Due to the variety of uses and the complexity of
assumptions used by an appraiser that reflect most commercial projects, there is not a uni-
overly optimistic or pessimistic values. If man- formly accepted format for valuing commercial
agement, after its review of the appraisal or properties like there is for valuing one- to
evaluation, determines that there are unsubstan- four-family residential properties. A bank relies
tiated assumptions, the bank may request the on outside appraisers, or in some instances
appraiser or evaluator to provide a more detailed in-house expertise, to prepare appraisals. For the
justification of the assumptions or obtain a new most part, appraisals on commercial real estate
appraisal or evaluation. projects are presented in a narrative format with
supporting schedules. As the complexity of a
commercial project increases, the detail of the
appraisal report or evaluation should also
increase to fully support the analysis.
Single-Family Residential Loans When estimating the value of income-
producing real estate, the appraiser generally
The assessment of a residential property’s mar- relies to a greater degree on the income approach
ket value is critical to the bank’s estimate of to valuation than on the comparable-sales
loan-to-value ratio. This assessment provides approach or the cost approach. The income
the bank with an estimate of the borrower’s approach converts all expected future net oper-
equity in the property and the bank’s potential ating income into present-value terms, using
credit risk if the borrower should default on the different analytical methods. One method, known
loan. For mortgages over $250,000, a bank is as the direct capitalization method, estimates the
required to obtain an appraisal in conformance present value of a property by discounting its
with the Federal Reserve’s appraisal regulation. stabilized net operating income at an appropriate
As of January 1, 1993, the appraisal must be capitalization rate (commonly referred to as a
performed by a state-certified or -licensed cap rate). Stabilized net operating income is the
appraiser, as specified in the regulation. While net cash flow derived from a property when
transactions under $250,000 do not require an market conditions are stable and no unusual
appraisal, a bank is expected to perform an patterns of future rents and occupancy are
appropriate evaluation of the underlying real expected. To approximate stabilized net operat-
estate collateral. Loans that are wholly or paring income, the appraiser or bank may need to
tially insured or guaranteed by a U.S. govern- adjust the current net operating income of a
ment agency or government-sponsored agency property either up or down to reflect current
are exempt from the Federal Reserve’s appraisal market conditions. The direct capitalization
regulation, so long as the loan meets the under- method is appropriate only for use in valuing
writing requirements of the federal insurer or stabilized properties.
guarantor. Additionally, state laws for appraisals Another method, known as the discounted
may differ from the Federal Reserve’s cash-flow method, requires the discounting of
requirements. expected future cash flows at an appropriate

Page 11
discount rate to ascertain the net present value of EARLY INDICATIONS OF

a property. This method is appropriate for use in TROUBLED COMMERCIAL
estimating the values of new properties that REAL ESTATE LOANS
have not yet stabilized, or for troubled properties
that are experiencing fluctuations in income.
The discount rates and cap rates, used in Market-Related
estimating property values, should reflect rea-
sonable expectations about the rate of return that To evaluate the collectibility of their commer-
investors and lenders require under normal, cial real estate portfolio, banks should be alert
orderly, and sustainable market conditions. The for economic indicators of weakness in their real
appraiser’s analysis and assumptions should sup- estate markets as well as for indicators of actual
port the discount and cap rates used in the or potential problems in the individual commer-
appraisal. The appraiser should not use exagger- cial real estate projects. Available indicators
ated, imprudent, or unsustainably high or low useful in evaluating the condition of the local
discount rates, cap rates, or income projections. real estate market include permits for and the
In assessing the reasonableness of the facts value of new construction, absorption rates,
and assumptions associated with the valuation employment trends, vacancy rates, and tenant
of commercial real estate, the bank should lease incentives. Weaknesses disclosed by these
consider— types of statistics may signify that a real estate
market is experiencing difficulties that may
• current and projected vacancy and absorption cause cash-flow problems for individual real
rates; estate projects, declining real estate values, and
• lease-renewal trends and anticipated rents; ultimately, troubled real estate loans.
• volume and trends in past-due leases;
• the project’s feasibility study and market sur-
vey to determine support for the assumptions Project-Related
concerning future supply-and-demand factors;
• effective rental rates or sale prices (taking into Characteristics of potential or actual difficulties
account all concessions); in commercial real estate projects may include—
• net operating income of the property as com-
pared with budget projections; and • an excess supply of similar projects under
• discount rates and direct capitalization rates. construction in the same trade area.
• the lack of a sound feasibility study or analy-
Because the income approach is generally sis that reflects current and reasonably antici-
relied on to a greater degree than the other pated market conditions.
methods, with specific emphasis on arriving at • changes in concept or plan (for example, a
stabilized values, the bank must use judgment in condominium project converted to an apart-
determining the time it will take for a property ment project because of unfavorable market
to achieve stabilized occupancy and rental rates. conditions).
The analysis of collateral values should not be • rent concessions or sales discounts, resulting
based on a simple projection of current levels of in cash flow below the level projected
net operating income if markets are depressed or in the original feasibility study, appraisal, or
reflect speculative pressures but can be expected evaluation.
over a reasonable period of time to return to • concessions on finishing tenant space, moving
normal (stabilized) conditions. expenses, and lease buyouts.
The capacity of a property to generate cash • slow leasing or lack of sustained sales activity
flow to service a loan is evaluated on the basis of and increasing sales cancellations that may
rents (or sales), expenses, and rates of occu- reduce the project’s income potential, result-
pancy that are reasonably estimated to be ing in protracted repayment or default on the
achieved over time. The determination of the loan.
level of stabilized occupancy, rental rates, and • delinquent lease payments from major
net operating income should be based on an tenants.
analysis of current and reasonably expected • land values that assume future rezoning.
market conditions, taking into consideration his- • tax arrearages.
torical levels when appropriate. • environmental hazards and liability for cleanup.

Page 12
As the problems associated with a commer- the borrower’s character, overall financial con-
cial real estate loan become more pronounced, dition and resources, and payment history; the
the borrower/guarantor may experience a reduc- prospects for support from any financially
tion in cash flow to service-related debts, which responsible guarantors; and the nature and
could result in delinquent interest and principal degree of protection provided by the cash flow
payments. and value of the underlying collateral.9 As the
While some real estate loans become troubled borrower’s and guarantor’s ability to repay a
because of a general downturn in the market, troubled real estate loan decreases, the impor-
others become troubled because the loans were tance of the collateral value of the loan increases
originated on an unsound or a liberal basis. commensurately.
Common examples of unsound loans include—
• loans with no or minimal borrower equity Examiner Review

• loans on speculative undeveloped property in of the Real Estate Collateral
which the borrower’s only source of repay-
ment is the sale of the property An examiner’s analysis of the collateral value is
• loans based on land values that have been based on the bank’s most recent appraisal or
driven up by rapid turnover of ownership, but evaluation and includes a review of the major
without any corresponding improvements to facts, assumptions, and approaches used by
the property or supportable income projec- the appraiser or person performing the evalua-
tions to justify an increase in value tion (including any comments made by manage-
• additional advances to service an existing loan ment relative to the reasonableness of the
without evidence that the loan will be repaid appraisal or evaluation assumptions and conclu-
in full sions). While the examiner may make adjust-
• loans to borrowers with no development plans ments to the assessment of value, these adjust-
or noncurrent development plans ments should be made solely for purposes of an
• renewals, extensions, and refinancings that examiner’s analysis and assessment of credit
lack credible support for full repayment from quality and should not involve an adjustment to
reliable sources and that do not have a reason- the actual appraisal or evaluation.
able repayment schedule8 Furthermore, examiners should not make
adjustments to appraisal or evaluation assump-
tions for credit-analysis purposes based on worst-
EXAMINER REVIEW case scenarios that are unlikely to occur. For
OF COMMERCIAL example, an examiner should not necessarily
assume that a building will become vacant just
REAL ESTATE LOANS because an existing tenant who is renting at a
The focus of an examiner’s review of a real rate above today’s market rate may vacate the
estate loan is on the ability of the loan to be property when the current lease expires. On the
repaid. The principal factors that bear on this other hand, an adjustment to value may be
review are the income-producing potential of appropriate for credit-analysis purposes when
the underlying collateral and the borrower’s the valuation assumes renewal at the above-
willingness and ability to repay the loan from market rate, unless that rate is a reasonable
other resources, if necessary, and according to estimate of the expected market rate at the time
existing loan terms. In evaluating the overall of renewal.
risk associated with a real estate loan, examiners Assumptions, when recently made by quali-
should consider a number of factors, including fied appraisers or persons performing the evalu-
9. The primary basis for the review and classification of the

8. As discussed more fully in the section on classification loan should be the original source of repayment and the
guidelines, the refinancing or renewing of loans to sound borrower’s intent and ability to fulfill the obligation without
borrowers would not result in a supervisory classification or relying on third-party guarantees. However, the examiner
criticism unless well-defined weaknesses exist that jeopardize should also consider the support provided by any guarantees
repayment of the loans. As consistent with sound banking when determining the appropriate classification treatment for
practices, institutions should work appropriately and construc- a troubled loan. The treatment of guarantees in the classifica-
tively with borrowers who may be experiencing temporary tion process is discussed in ‘‘Classification of Credits,’’
difficulties. section 2060.1.

Page 13
ation and when consistent with the discussion defined weaknesses exist that jeopardize repay-
above, should be given a reasonable amount of ment. An institution should not be criticized for
deference. Examiners should not challenge the working with borrowers whose loans are classi-
underlying assumptions, including discount fied or categorized as special mention as long as
rates and cap rates used in appraisals or evalu- the institution has a well-conceived and effec-
ations, that differ only in a limited way from tive workout plan for such borrowers, along
norms that would generally be associated with with effective internal controls to manage the
the property under review. However, the esti- level of these loans.
mated value of the underlying collateral may be In evaluating real estate credits for special-
adjusted for credit-analysis purposes when the mention categorization or classification, exam-
examiner can establish that underlying facts or iners should apply the standard definitions as set
assumptions are inappropriate and can support forth in ‘‘Classification of Credits,’’ section
alternative assumptions. 2060.1. In assessing credit quality, examiners
should consider all important information regard-
ing repayment prospects, including information
CLASSIFICATION GUIDELINES on the borrower’s creditworthiness, the value of
and cash flow provided by all collateral support-
As with other types of loans, real estate loans ing the loan, and any support provided by
that are adequately protected by the current financially responsible guarantors.
sound worth and debt-service capacity of the These guidelines apply to individual credits,
borrower, guarantor, or the underlying collateral even if portions or segments of the industry to
generally are not classified. The examiner should which the borrower belongs are experiencing
focus on the ability of the borrower, guarantor, financial difficulties. The evaluation of each
or the collateral to provide the necessary cash credit should be based upon the fundamental
flow to adequately service the loan. The loan’s characteristics affecting the collectibility of the
record of performance is also important and particular credit. The problems broadly associ-
must be taken into consideration. As a general ated with some sectors or segments of an indus-
principle, a performing real estate loan should try, such as certain commercial real estate mar-
not be automatically classified or charged off kets, should not lead to overly pessimistic
solely because the value of the underlying col- assessments of particular credits in the same
lateral has declined to an amount that is less than industry that are not affected by the problems of
the loan balance. Conversely, the fact that the the troubled sectors.
underlying collateral value equals or exceeds the
current loan balance, or that the loan is perform-
ing, does not preclude the loan from classifica-
tion if well-defined weaknesses jeopardize the
Troubled Project-Dependent
repayment ability of the borrower, such as the Commercial Real Estate Loans
lack of credible financial support for full repay-
The following guidelines for classifying a
ment from reliable sources.10
troubled commercial real estate loan apply when
Similarly, loans to sound borrowers that are
the repayment of the debt will be provided
refinanced or renewed according to prudent
solely by the underlying real estate collateral,
underwriting standards, including loans to
and there are no other available and reliable
creditworthy commercial or residential real
sources of repayment. As a general principle, for
estate developers, should not be categorized as
a troubled project-dependent commercial real
special mention unless potential weaknesses
estate loan, any portion of the loan balance that
exist or should not be classified unless well-
exceeds the amount that is adequately secured
by the value of the collateral, and that can be
clearly identified as uncollectible, should be
10. Another issue that arises in the review of a commercial
real estate loan is its accrual or nonaccrual treatment for
classified loss. The portion of the loan balance
reporting purposes. The federal banking agencies, under the that is adequately secured by the value of the
auspices of the FFIEC, have provided guidance on nonaccrual collateral should generally be classified no worse
status in the instructions for the Reports of Condition and than substandard. The amount of the loan bal-
Income (call reports) and in related supervisory guidance of
the agencies. This guidance is summarized in ‘‘Loan Portfolio
ance in excess of the value of the collateral, or
Management,’’ section 2040.1. portions thereof, should be classified doubtful

Page 14
when the potential for full loss may be mitigated nesses exist that jeopardize the orderly repay-
by the outcome of certain pending events, or ment of the loan in accordance with reasonable
when loss is expected but the amount of the loss modified terms.11 Troubled commercial real
cannot be reasonably determined. If warranted estate loans whose terms have been restructured
by the underlying circumstances, an examiner should be identified in the institution’s internal
may use a doubtful classification on the entire credit-review system and closely monitored by
loan balance. However, such a classification management.
should occur infrequently.
Home Equity Loans

Partially Charged-Off Loans
Home equity loans (HELs) are defined as loans
An evaluation based upon consideration of all that are usually collateralized by a second mort-
relevant factors may indicate that a credit has gage or deed of trust on the borrower’s principal
well-defined weaknesses that jeopardize collec- residence or second residence; however, the
tion in full, although a portion of the loan may collateral may be a first mortgage or deed of
be reasonably assured of collection. When a trust. The borrower’s equity in the residence,
charge-off has been taken in an amount suffi- pledged as collateral, provides protection for the
cient to ensure that the remaining recorded loan and determines the maximum amount of
balance of the loan (1) is being serviced (based credit that may be advanced. Traditionally, HELs
upon reliable sources) and (2) is reasonably were used to fund home improvements or to
assured of collection, classification of the consolidate debt, and they were usually amor-
remaining recorded balance may not be appro- tized without a revolving feature. Because of
priate. Classification would be appropriate these characteristics, home equity loans were
when well-defined weaknesses continue to be commonly maintained and administered in a
present in the remaining recorded balance. In bank’s consumer or installment loan department
such cases, the remaining recorded balance and were monitored based on delinquency status.
would generally be classified no more severely However, since enactment of the Tax Reform
than substandard. Act of 1986, which allows the deduction of
A more severe classification than substandard home equity loan interest on debt of up to
for the remaining recorded balance would be $100,000, the popularity and usage of HELs
appropriate, however, if the loss exposure can- have expanded considerably. The proceeds of
not be reasonably determined—for example, home equity loans are now used for increasingly
when significant risk exposures are perceived, diverse purposes, such as to make consumer
such as in the case of bankruptcy or loans purchases or personal investments, to provide
collateralized by properties subject to working capital for small businesses, and to
environmental hazards. In addition, classifying supplement personal income.
the remaining recorded balance more severly The structure and repayment terms of home
than substandard would be appropriate when equity loans have become more varied. Amor-
sources of repayment are considered unreliable. tization periods may be as long as 15 years, with
possible balloon maturities of three to five years.
In some instances, the payment requirement is
only interest due for an initial period. Revolving
Formally Restructured Loans lines of credit have also gained popularity as a
way to accommodate the many different uses of
The classification treatment previously dis- loan proceeds. Lines of credit to individuals
cussed for a partially charged-off loan would with high incomes or high net worths may
also generally be appropriate for a formally substantially exceed $100,000. These loans are
restructured loan when partial charge-offs have often housed in the bank’s private-banking
been taken. For a formally restructured loan, the
focus of the examiner’s analysis is on the ability
of the borrower to repay the loan in accordance 11. An example of a restructured commercial real estate
loan that does not have reasonable modified terms would be a
with its modified terms. Classification of a cash-flow mortgage, which requires interest payments only
formally restructured loan would be appropriate when the underlying collateral generates cash flow but pro-
if, after the restructuring, well-defined weak- vides no substantive benefits to the lending institution.

Page 15
division or within the commercial loan port- ketability of residential real estate. Moreover,
folio, rather than in the consumer loan department. most HELs are collateralized by junior lien
In addition to the increasingly varied pur- positions. Therefore, if the bank forecloses, it
poses of HELs, there has also been an upsurge in must pay off or service the senior mortgage
loans in which the combined first and second lender, further increasing its exposure. Foreclo-
mortgages result in very high LTV ratios. To sure proceedings may entail lengthy and costly
remain competitive with other residential lend- litigation, and real estate law commonly protects
ers, some banks have relaxed their underwriting the home owner.
standards by permitting higher LTV ratios. In Examiners should ensure that banks have
addition, some banks may have offset declines proper controls to manage HEL exposure, par-
in residential mortgage refinancing during periods ticularly those banks that have a high concen-
of higher interest rates by competing more tration of home equity loans with excessively
aggressively for home equity loan business. high combined LTV ratios. (See the following
Consumer demand for HELs may also increase subsection for interagency guidance on credit-
during periods of higher interest rates because risk management in home equity lending.) Banks
they provide an alternative source of financing with concentrations that lack proper controls
for consumer purchases. and monitoring procedures should be criticized
Examiners must ensure that a bank’s policies for these credit deficiencies. If the examiner
for originating and acquiring HELs comply with judges the deficiencies to be severe, the bank
the real estate lending standards and guidelines should be cited for unsafe and unsound banking
stipulated in the Board’s Regulation H, sub- practices.
part E. (See Regulation H, subpart E, 12 CFR
208.50–51.) While the guidelines permit banks
to make residential real estate loans with LTV Interagency Credit-Risk Management
ratios in excess of 90 percent without the appro-
priate credit enhancements, these loans are
Guidance for Home Equity Lending
treated as exceptions to the guidelines and are The Federal Reserve and the other federal
subject to the aggregate limitation of 100 per- financial institutions regulatory agencies12 col-
cent of the bank’s total capital. lectively issued this interagency guidance on
For all types of lending, banks should have May 16, 2005. The guidance is intended to
strong underwriting standards for HELs. In promote sound credit-risk management prac-
assessing these standards, the examiner should tices at financial institutionsthat have home
determine whether the bank primarily empha- equity lending programs, including open-end
sizes the borrower’s ability and willingness to home equity lines of credit (HELOCs) and
repay the loan from income or cash flow versus closed-end home equity loans (HELs). Home
the amount of equity in the real estate. Extended equity lending can be an attractive product for
repayment terms and liberal loan structures can many homeowners and lenders. The quality of
increase the risk of default on HELs. Normally, these portfolios, however, is subject to increased
longer repayment terms increase the likelihood risk if interest rates rise and home values decline.
of events that could jeopardize the borrower’s Sound underwriting practices and effective risk-
ability to repay, for example, the loss of a job, a management systems are essential to mitigate
change in marital status, a prolonged spike in this risk. Therefore, financial institutions’ credit-
prevailing interest rates, or a deflationary eco- risk management practices for home equity
nomic environment. Additionally, the examiner lending need to keep pace with any rapid growth
should review the bank’s policy (or practice) for in home equity lending and should emphasize
obtaining appraisals or evaluations to determine compliance with sound underwriting standards
the lendable equity in the borrower’s residence. and practices.
The examiner should determine that the bank
has not relaxed its appraisal and evaluation 12. The Board of Governors of the Federal Reserve Sys-
requirements to accommodate the growth of its tem, the Office of the Comptroller of the Currency, the Federal
HEL portfolio. Deposit Insurance Corporation, the Office of Thrift Supervi-
Economic periods of increasing unemploy- sion, and the National Credit Union Administration. Also, the
interagency guidance frequently uses the term financial insti-
ment, rising interest rates, or other recessionary tutions. As used in this section, financial institutions means
factors can negatively affect the repayment abil- commercial banks and any of their various credit-extending
ity of borrowers and erode the value and mar- nonbanking subsidiaries.

Page 16
The risk factors listed below, combined with ment should have a review and approval process
an inherent vulnerability to rising interest rates, that is sufficiently broad to ensure compliance
suggest that financial institutions need to fully with the financial institution’s internal policies
recognize the risk embedded in their home and applicable laws and regulations13 and to
equity portfolios. Following are the specific evaluate the credit, interest-rate, operational,
product, risk-management, and underwriting risk compliance, reputation, and legal risks. In par-
factors and trends that deserve scrutiny: ticular, risk-management personnel should be
involved in product development, including an
• interest-only features that require no amorti- evaluation of the targeted population and the
zation of principal for a protracted period product(s) being offered. For example, material
• limited or no documentation of a borrower’s changes in the targeted market, origination
assets, employment, and income (known as source, or pricing could have a significant impact
‘‘low doc’’ or ‘‘no doc’’ lending) on credit quality and should receive senior
• higher loan-to-value (LTV) and debt-to-income management approval.
(DTI) ratios When HELOCs or HELs are marketed or
• lower credit-risk scores for underwriting home closed by a third party, financial institutions
equity loans should have standards that provide assurance
• greater use of automated valuation models that the third party also complies with applicable
(AVMs) and other collateral-evaluation tools laws and regulations, including those on mar-
for the development of appraisals and evalu- keting materials, loan documentation, and clos-
ations ing procedures. (For further details on agent
• an increase in the number of transactions relationships, see ‘‘Third-Party Originations.’’)
generated through a loan broker or other third Finally, management should have appropriate
party monitoring tools and management information
systems (MIS) to measure the performance of
Home equity lending can be conducted in a various marketing initiatives, including offers to
safe and sound manner if pursued with the increase a line, extend the interest-only period,
appropriate risk-management structure, includ- or adjust the interest rate or term.
ing adequate allowances for loan and lease
losses and appropriate capital levels. Sound
practices call for fully articulated policies that Origination and Underwriting
address marketing, underwriting standards,
collateral-valuation management, individual- All relevant risk factors should be considered
account and portfolio management, and servicing. when establishing product offerings and under-
Financial institutions should ensure that risk- writing guidelines. Generally, these factors
management practices keep pace with the growth should include a borrower’s income and debt
and changing risk profile of home equity port- levels, credit score (if obtained), and credit
folios. Management should actively assess a history, as well as the loan size, collateral value
portfolio’s vulnerability to changes in consum- (including valuation methodology), lien posi-
ers’ ability to pay and the potential for declines tion, and property type and location.
in home values. Active portfolio management is Consistent with the Federal Reserve’s regula-
especially important for financial institutions tions on real estate lending standards,14 pru-
that project or have already experienced signifi- dently underwritten home equity loans should
cant growth or concentrations, particularly in include an evaluation of a borrower’s capacity
higher-risk products such as high-LTV, ‘‘low
doc’’ or ‘‘no doc,’’ interest-only, or third-party-
generated loans. (See SR-05-11.) 13. Applicable laws include the Federal Trade Commission
Act; the Equal Credit Opportunity Act (ECOA); the Truth in
Lending Act (TILA), including the Home Ownership and
Equity Protection Act (HOEPA); the Fair Housing Act; the
Credit-Risk Management Systems Real Estate Settlement Procedures Act (RESPA); and the
Home Mortgage Disclosure Act (HMDA), as well as applica-
Product Development and Marketing ble state consumer protection laws.
14. On December 23, 1992, the Federal Reserve announced
the adoption of uniform rules on real estate lending standards
In the development of any new product offering, and issued the Interagency Guidelines for Real Estate Lending
product change, or marketing initiative, manage- Policies. See 12 CFR 208.51 and 12 CFR 208, appendix C.

Page 17
to adequately service the debt.15 Given the home perform any underwriting will depend on the
equity products’ long-term nature and the large relationship between the financial institution and
credit amount typically extended to a consumer, the broker. For control purposes, the financial
an evaluation of repayment capacity should institution should retain appropriate oversight of
consider a borrower’s income and debt levels all critical loan-processing activities, such as
and not just a credit score.16 Credit scores are verification of income and employment and
based upon a borrower’s historical financial independence in the appraisal and evaluation
performance. While past performance is a good function.
indicator of future performance, a significant
change in a borrower’s income or debt levels Correspondents are financial companies that
can adversely alter the borrower’s ability to pay. usually close and fund loans in their own name
How much verification these underwriting fac- and subsequently sell them to a lender. Financial
tors require will depend upon the individual institutions commonly obtain loans through cor-
loan’s credit risk. respondents and, in some cases, delegate the
HELOCs generally do not have interest-rate underwriting function to the correspondent. In
caps that limit rate increases.17 Rising interest delegated underwriting relationships, a financial
rates could subject a borrower to significant institution grants approval to a correspondent
payment increases, particularly in a low-interest- financial company to process, underwrite, and
rate environment. Therefore, underwriting stan- close loans according to the delegator’s process-
dards for interest-only and variable-rate HELOCs ing and underwriting requirements and is com-
should include an assessment of the borrower’s mitted to purchase those loans. The delegating
ability to amortize the fully drawn line over the financial institution should have systems and
loan term and to absorb potential increases in controls to provide assurance that the correspon-
interest rates. dent is appropriately managed, is financially
sound, and provides mortgages that meet the
financial institution’s prescribed underwriting
Third-Party Originations guidelines and that comply with applicable con-
sumer protection laws and regulations. A quality-
Financial institutions often use third parties, control unit or function in the delegating finan-
such as mortgage brokers or correspondents, to cial institution should closely monitor the quality
originate loans. When doing so, institutions of loans that the correspondent underwrites.
should have strong control systems to ensure the Monitoring activities should include post-
quality of originations and compliance with all purchase underwriting reviews and ongoing
applicable laws and regulations, and to help portfolio-performance-management activities.
prevent fraud. Both brokers and correspondents are compen-
sated based upon mortgage-origination volume
Brokers are firms or individuals, acting on and, accordingly, have an incentive to produce
behalf of either the financial institution or the and close as many loans as possible. Therefore,
borrower, who match the borrower’s needs with financial institutions should perform comprehen-
institutions’ mortgage-origination programs. sive due diligence on third-party originators
Brokers take applications from consumers. prior to entering a relationship. In addition, once
Although they sometimes process the applica- a relationship is established, the financial insti-
tion and underwrite the loan to qualify the tution should have adequate audit procedures
application for a particular lender, they gener- and controls to verify that the third parties are
ally do not use their own funds to close loans. not being paid to generate incomplete or fraudu-
Whether brokers are allowed to process and lent mortgage applications or are not otherwise
receiving referral or unearned income or fees
15. See also section 226.34(a)(4) of Regulation Z, Truth in contrary to RESPA prohibitions.18 Monitoring
Lending (12 CFR 226.34(a)(4)).
16. The Interagency Guidelines Establishing Standards for
Safety and Soundness also call for documenting the source of 18. In addition, a financial institution that purchases loans
repayment and assessing the ability of the borrower to repay subject to TILA’s rules for HELs with high rates or high
the debt in a timely manner. See 12 CFR 208, appendix D-1. closing costs (loans covered by HOEPA) can incur assignee
17. While there may be periodic rate increases, the lender liability unless the financial institution can reasonably show
must state in the consumer credit contract the maximum that it could not determine the transaction was a loan covered
interest rate that may be imposed during the term of the by HOEPA. Also, the nature of its relationship with brokers
obligation. See 12 CFR 226.30(b). and correspondents may have implications for liability under

Page 18
the quality of loans by origination source, and tools or AVMs are used for the same property,
uncovering such problems as early payment the financial institution should adhere to a
defaults and incomplete packages, enables man- policy for selecting the most reliable method,
agement to know if third-party originators are rather than the highest value.)
producing quality loans. If ongoing credit or • require sufficient documentation to support
documentation problems are discovered, the the collateral valuation in the appraisal or
financial institution should take appropriate evaluation
action against the third party, which could
include terminating its relationship with the
third party. AVMs
When AVMs are used to support evaluations or
Collateral-Valuation Management appraisals, the financial institution should vali-
date the models on a periodic basis to mitigate
Competition, cost pressures, and advancements the potential valuation uncertainty in the model.
in technology have prompted financial institu- As part of the validation process, the financial
tions to streamline their appraisal and evaluation institution should document the validation’s
processes. These changes, coupled with finan- analysis, assumptions, and conclusions. The vali-
cial institutions underwriting to higher LTVs, dation process includes back-testing a represen-
have heightened the importance of strong tative sample of the valuations against market
collateral-valuation management policies, pro- data on actual sales (where sufficient informa-
cedures, and processes. tion is available). The validation process should
Financial institutions should have appropriate cover properties representative of the geo-
collateral-valuation policies and procedures that graphic area and property type for which the
ensure compliance with the Federal Reserve’s tool is used.
appraisal regulations19 and the Interagency Many AVM vendors, when providing a value,
Appraisal and Evaluation Guidelines (the guide- will also provide a ‘‘confidence score,’’ which
lines).20 In addition, the financial institution usually relates to the accuracy of the value
should— provided. Confidence scores, however, come in
many different formats and are calculated based
• establish criteria for determining the appropri- on differing scoring systems. Financial institu-
ate valuation methodology for a particular tions that use AVMs should have an understand-
transaction, based on the risk in the transac- ing of how the model works as well as what the
tion and loan portfolio (For example, higher- confidence scores mean. Institutions should also
risk transactions or nonhomogeneous property establish the confidence levels that are appropri-
types should be supported by more-thorough ate for the risk in a given transaction or group of
valuations. The financial institution should transactions.
also set criteria for determining the extent to When tax-assessment valuations are used as a
which an inspection of the collateral is basis for the collateral valuation, the financial
necessary.) institution should be able to demonstrate and
• ensure that an expected or estimated value of document the correlation between the assess-
the property is not communicated to an ment value of the taxing authority and the
appraiser or individual performing an property’s market value as part of the validation
evaluation process.
• implement policies and controls to preclude
‘‘value shopping’’ (Use of several valuation
tools may return different values for the same Account Management
property. These differences can result in sys-
tematic overvaluation of properties if the valu- Since HELOCs often have long-term, interest-
ation choice becomes driven by the highest only payment features, financial institutions
property value. If several different valuation should have risk-management techniques that
identify higher-risk accounts and adverse changes
ECOA, and for reporting responsibilities under HMDA.
in account risk profiles, thereby enabling man-
19. 12 CFR 208, subpart E, and 12 CFR 225, subpart G. agement to implement timely preventive action
20. See SR-94-55, dated October 27, 1994. (e.g., freezing or reducing lines). Further, a

Page 19
financial institution should have risk-management deterioration in the borrower’s financial circum-
procedures to evaluate and approve additional stances.22 In order to freeze or reduce credit
credit on an existing line or extending the lines due to deterioration in a borrower’s finan-
interest-only period. Account-management prac- cial circumstances, two conditions must be met:
tices should be appropriate for the size of the (1) there must be a ‘‘material’’ change in the
portfolio and the risks associated with the types borrower’s financial circumstances and (2) as a
of home equity lending. result of this change, the financial institution
Effective account-management practices for must have a reasonable belief that the borrower
large portfolios or portfolios with high-risk char- will be unable to fulfill the plan’s payment
acteristics include— obligations.
Account-management practices that do not
• periodically refreshing credit-risk scores on adequately control authorizations and provide
all customers; for timely repayment of over-limit amounts may
• using behavioral scoring and analysis of indi- significantly increase a portfolio’s credit risk.
vidual borrower characteristics to identify Authorizations of over-limit home equity lines
potential problem accounts; of credit should be restricted and subject to
• periodically assessing utilization rates; appropriate policies and controls. A financial
• periodically assessing payment patterns, includ- institution’s practices should require over-limit
ing borrowers who make only minimum pay- borrowers to repay in a timely manner the
ments over a period of time or those who rely amount that exceeds established credit limits.
on the line to keep payments current; Management information systems should be
• monitoring home values by geographic area; sufficient to enable management to identify,
and measure, monitor, and control the unique risks
• obtaining updated information on the collat- associated with over-limit accounts.
eral’s value when significant market factors
indicate a potential decline in home values, or
when the borrower’s payment performance Portfolio Management
deteriorates and greater reliance is placed on
the collateral. Financial institutions should implement an
effective portfolio credit-risk management pro-
The frequency of these actions should be cess for their home equity portfolios that includes
commensurate with the risk in the portfolio. the following.
Financial institutions should conduct annual
credit reviews of HELOC accounts to determine Policies. The Federal Reserve’s real estate
whether the line of credit should be continued, lending standards regulations require that a finan-
based on the borrower’s current financial cial institution’s real estate lending policies be
condition.21 consistent with safe and sound banking practices
When appropriate, financial institutions should and that the financial institution’s board of
refuse to extend additional credit or reduce the directors review and approve these policies at
credit limit of a HELOC, bearing in mind that least annually. Before implementing any changes
under Regulation Z such steps can be taken only to policies or underwriting standards, manage-
in limited circumstances. These include, for ment should assess the potential effect on the
example, when the value of the collateral financial institution’s overall risk profile, which
declines significantly below the appraised value would include the effect on concentrations, prof-
for purposes of the HELOC, default of a mate- itability, and delinquency and loss rates. The
rial obligation under the loan agreement, or accuracy of these estimates should be tested by
comparing them with actual experience.
21. Under the Federal Reserve’s risk-based capital guide- Portfolio objectives and risk diversification.
lines, an unused HELOC commitment with an original matu- Effective portfolio management should clearly
rity of one year or more may be allocated a zero percent communicate portfolio objectives such as growth
conversion factor if the institution conducts at least an annual
credit review and is able to unconditionally cancel the targets, utilization, rate-of-return hurdles, and
commitment (i.e., prohibit additional extensions of credit,
reduce the credit line, and terminate the line) to the full extent 22. Regulation Z does not permit these actions to be taken
permitted by relevant federal law. See 12 CFR 208, appendix in circumstances other than those specified in the regulation.
A, III.D.4. See 12 CFR 226.5b(f)(3)(vi)(A)–(F).

Page 20
default and loss expectations. For financial Policy- and underwriting-exception systems.
institutions with significant concentrations of Financial institutions should have a process for
HELs or HELOCs, limits should be established identifying, approving, tracking, and analyzing
and monitored for key portfolio segments, such underwriting exceptions. Reporting systems that
as geographic area, loan type, and higher-risk capture and track information on exceptions,
products. When appropriate, consideration should both by transaction and by relevant portfolio
be given to the use of risk mitigants, such as segments, facilitate the management of a port-
private mortgage insurance, pool insurance, or folio’s credit risk. The aggregate data is useful
securitization. As the portfolio approaches con- to management in assessing portfolio risk pro-
centration limits, the financial institution should files and monitoring the level of adherence to
analyze the situation sufficiently to enable the policy and underwriting standards by various
financial institution’s board of directors and origination channels. Analysis of the informa-
senior management to make a well-informed tion may also be helpful in identifying correla-
decision to either raise concentration limits or tions between certain types of exceptions and
pursue a different course of action. delinquencies and losses.
Effective portfolio management requires an
understanding of the various risk characteristics High-LTV monitoring. To clarify the real
of the home equity portfolio. To gain this estate lending standards regulations and inter-
understanding, a financial institution should ana- agency guidelines, the agencies issued Guidance
lyze the portfolio by segment, using criteria such on High Loan-To-Value LTV Residential Real
as product type, credit-risk score, DTI, LTV, Estate Lending (the HLTV guidance) in October
property type, geographic area, collateral- 1999. The HLTV guidance clarified the Inter-
valuation method, lien position, size of credit agency Real Estate Lending Guidelines and the
relative to prior liens, and documentation type supervisory loan-to-value limits for loans on
(such as ‘‘no doc’’ or ‘‘low doc’’). one- to four-family residential properties. Finan-
cial institutions are expected to ensure compli-
Management information systems. By main- ance with the supervisory loan-to-value limits of
taining adequate credit MIS, a financial institu- the Interagency Real Estate Lending Guidelines.
tion can segment loan portfolios and accurately The HLTV guidance places emphasis on certain
assess key risk characteristics. The MIS should controls that financial institutions should have in
also provide management with sufficient infor- place when engaging in HLTV lending. Finan-
mation to identify, monitor, measure, and con- cial institutions should accurately track the vol-
trol home equity concentrations. Financial insti- ume of HLTV loans, including HLTV home
tutions should periodically assess the adequacy equity and residential mortgages, and report the
of their MIS in light of growth and changes in aggregate of such loans to the financial institu-
their appetite for risk. For institutions with tion’s board of directors. Specifically, financial
significant concentrations of HELs or HELOCs, institutions are reminded that:
MIS should include, at a minimum, reports and
analysis of the following: • Loans in excess of the supervisory LTV limits
should be identified in the financial institu-
• production and portfolio trends by product, tion’s records. The aggregate of high-LTV
loan structure, originator channel, credit score, one- to four-family residential loans should
LTV, DTI, lien position, documentation type, not exceed 100 percent of the financial insti-
market, and property type tution’s total capital.23 Within that limit, high-
• delinquency and loss-distribution trends by
product and originator channel with some 23. For purposes of the Interagency Real Estate Lending
accompanying analysis of significant under- Standards Guidelines, high-LTV one- to four-family residen-
writing characteristics (such as credit score, tial property loans include (1) a loan for raw land zoned for
one- to four-family residential use with an LTV ratio greater
LTV, DTI) than 65 percent; (2) a residential land development loan or
• vintage tracking improved lot loan with an LTV greater than 75 percent; (3) a
• the performance of third-party originators (bro- residential construction loan with an LTV ratio greater than
kers and correspondents) 85 percent; (4) a loan on non-owner occupied one- to
four-family residential property with an LTV greater than
• market trends by geographic area and property 85 percent; and (5) a permanent mortgage or home equity loan
type to identify areas of rapidly appreciating on an owner-occupied residential property with an LTV equal
or depreciating housing values to or exceeding 90 percent without mortgage insurance,

Page 21
LTV loans for properties other than one- to periodically analyze markets in key geographic
four-family residential properties should not areas, including identified ‘‘soft’’ markets. Man-
exceed 30 percent of capital. agement should consider developing contin-
• In calculating the LTV and determining com- gency strategies for scenarios and outcomes that
pliance with the supervisory LTVs, the finan- extend credit risk beyond internally established
cial institution should consider all senior liens. risk tolerances. These contingency plans might
All loans secured by the property and held by include increased monitoring, tightening under-
the financial institution are reported as an writing, limiting growth, and selling loans or
exception if the combined LTV of a loan and portfolio segments.
all senior liens on an owner-occupied one- to
four-family residential property equals or
exceeds 90 percent and if there is no addi- Operations, Servicing, and Collections
tional credit enhancement in the form of either
mortgage insurance or readily marketable Effective procedures and controls should be
collateral. maintained for such support functions as per-
• For the LTV calculation, the loan amount is fecting liens, collecting outstanding loan docu-
the legally binding commitment (that is, the ments, obtaining insurance coverage (including
entire amount that the financial institution is flood insurance), and paying property taxes.
legally committed to lend over the life of the Credit-risk management should oversee these
loan). support functions to ensure that operational risks
• All real estate secured loans in excess of are properly controlled.
supervisory LTV limits should be aggregated
and included in a quarterly report for the Lien recording. Financial institutions should
financial institution’s board of directors. take appropriate measures to safeguard their lien
position. They should verify the amount and
Certain insurance products have been devel- priority of any senior liens prior to closing the
oped to help financial institutions mitigate the loan. This information is necessary to determine
credit risks of HLTV residential loans. Insurance the loan’s LTV ratio and to assess the credit
policies that cover a ‘‘pool’’ of loans can be an support of the collateral. Senior liens include
efficient and effective credit-risk management first mortgages, outstanding liens for unpaid
tool. But if a policy has a coverage limit, the taxes, outstanding mechanic’s liens, and recorded
coverage may be exhausted before all loans in judgments on the borrower.
the pool mature or pay off. The Federal Reserve
will consider pool insurance to be a sufficient Problem-loan workouts and loss-mitigation
credit enhancement to remove the HLTV desig- strategies. Financial institutions should have
nation in the following circumstances: (1) the established policies and procedures for problem-
policy is issued by an acceptable mortgage loan workouts and loss-mitigation strategies.
insurance company, (2) it reduces the LTV for Policies should be in accordance with the re-
each loan to less than 90 percent, and (3) it is quirements of the FFIEC’s Uniform Retail Credit
effective over the life of each loan in the pool. Classification and Account Management Policy,
issued June 2000 (see SR-00-8 and the appendix
Stress testing for portfolios. Financial institu- to section 2130.1) and should, at a minimum,
tions with home equity concentrations as well as address the following:
higher-risk portfolios are encouraged to perform
sensitivity analyses on key portfolio segments. • circumstances and qualifying requirements for
This type of analysis identifies possible events various workout programs including exten-
that could increase risk within a portfolio seg- sions, re-ages, modifications, and re-writes
ment or for the portfolio as a whole. Institutions (Qualifying criteria should include an analysis
should consider stress tests that incorporate of a borrower’s financial capacity to service
interest-rate increases and declines in home the debt under the new terms.)
values. Since these events often occur simulta- • circumstances and qualifying criteria for loss-
neously, the testing should be performed for mitigating strategies, including foreclosure
these events together. Institutions should also • appropriate MIS to track and monitor the
effectiveness of workout programs, including
readily marketable collateral, or other acceptable collateral. tracking the performance of all categories of

Page 22
workout loans (For large portfolios, vintage revolving period could affect the loss curves for
delinquency and loss tracking also should be its HELOC portfolio. Those institutions engag-
included.) ing in programmatic subprime home equity
lending or institutions that have higher-risk
While financial institutions are encouraged to products are expected to recognize the elevated
work with borrowers on a case-by-case basis, a risk of the activity when assessing capital and
financial institution should not use workout ALLL adequacy.25
strategies to defer losses. Financial institutions
should ensure that credits in workout programs
are evaluated separately for the allowance for
loan and lease losses (ALLL), because such ALLOWANCE FOR LOAN AND
credits tend to have higher loss rates than other LEASE LOSSES
portfolio segments.
A bank bases the adequacy of its allowance for
loan and lease losses (ALLL), including amounts
Secondary-Market Activities resulting from an analysis of the real estate
portfolio, on a careful, well-documented, and
More financial institutions are issuing HELOC consistently applied analysis of its loan and
mortgage-backed securities (i.e., securitizing lease portfolio.26 Guidance related to the ALLL
HELOCs). Although such secondary-market is primarily addressed in section 2070.1. The
activities can enhance credit availability and a following discussion summarizes general prin-
financial institution’s profitability, they also pose ciples for assessing the adequacy of the ALLL.
certain risk-management challenges. An institu- Examiners should evaluate the methodology,
tion’s risk-management systems should address documentation, and process that management
the risks of HELOC securitizations.24 has followed in arriving at an overall estimate of
the ALLL to ensure that all of the relevant
factors affecting the collectibility of the port-
Portfolio Classifications, Allowance for folio have been appropriately considered. In
Loan and Lease Losses, and Capital addition, the examiner should review the reason-
ableness of management’s overall estimate of
The FFIEC’s Uniform Retail Credit Classifica- the ALLL, as well as the range of possible credit
tion and Account Management Policy governs losses, by taking into account these factors. The
the classification of consumer loans and estab- examiner’s analysis should also consider the
lishes general classification thresholds that are quality of the bank’s systems and management’s
based on delinquency. Financial institutions and ability to identify, monitor, and address asset-
the Federal Reserve’s examiners have the dis- quality problems.
cretion to classify entire retail portfolios, or As discussed in the earlier subsection on
segments thereof, when underwriting weak- classification guidelines, examiners should con-
nesses or delinquencies are pervasive and present sider the value of the collateral when reviewing
an excessive level of credit risk. Portfolios of and classifying a loan. For a performing com-
high-LTV loans to borrowers who exhibit inad- mercial real estate loan, however, the supervisory
equate capacity to repay the debt within a policy does not require automatic increases to
reasonable time may be subject to classification.
Financial institutions should establish appro-
25. Section 2133.1 incorporates the January 2001 Inter-
priate ALLL and hold capital commensurate agency Expanded Guidance for Subprime Lending Programs.
with the riskiness of their portfolios. In deter- That guidance sets forth the supervisory expectations regard-
mining the ALLL adequacy, a financial institu- ing risk-management processes, the ALLL, and capital
tion should consider how the interest-only and adequacy for institutions engaging in subprime-lending
programs.
draw features of HELOCs during the lines’ 26. The estimation process described in this section per-
mits a more accurate estimate of anticipated losses than could
24. See SR-02,16, ‘‘Interagency Questions and Answers on be achieved by assessing the loan portfolio solely on an
Capital Treatment of Recourse, Direct Credit Substitutes, and aggregate basis. However, it is only an estimation process and
Residual Interests in Asset Securitizations,’’ (see also section does not imply that any part of the ALLL is segregated for, or
3020.1) and the risk management and capital adequacy of allocated to, any particular asset or group of assets. The ALLL
exposures arising from secondary-market credit activities is available to absorb all credit losses originating from the
discussion in SR-97-21. loan and lease portfolio.

Page 23
the ALLL solely because the value of the states that a bank is prohibited from fixing or
collateral has declined to an amount that is less varying the consideration for extending credit,
than the loan balance. leasing or selling property of any kind, or
In assessing the ALLL during examinations, furnishing any product or service on the condi-
it is important that the examiner recognize that tion or requirement that a customer—
management’s process, methodology, and under-
lying assumptions require a substantial degree • obtain additional credit, property, or service
of judgment. Even when an institution maintains from the bank, other than a loan, discount,
sound loan-administration and collection proce- deposit, or trust service (a ‘‘traditional bank
dures and effective internal systems and con- product’’);
trols, the estimation of anticipated losses may • obtain additional credit, property, or service
not be precise because of the wide range of from the bank’s parent holding company or
factors that must be considered. Furthermore, the parent’s other subsidiaries;
the ability to estimate anticipated losses on • provide additional credit, property, or service
specific loans and categories of loans improves to the bank, other than those related to and
over time as substantive information accumu- usually provided in connection with a loan,
lates regarding the factors affecting repayment discount, deposit, or trust service;
prospects. The examiner should give consider- • provide additional credit, property, or service
able weight to management’s estimates in to the bank’s parent holding company or any
assessing the adequacy of the ALLL when of the parent’s other subsidiaries; or
management has (1) maintained effective sys- • not obtain other credit, property, or service
tems and controls for identifying, monitoring, from the competitors of the bank, the bank’s
and addressing asset-quality problems and parent holding company, or the parent’s other
(2) analyzed all significant factors affecting the subsidiaries, except that the lending bank may
collectibility of the portfolio. impose conditions and requirements in a credit
transaction to ensure the soundness of the
credit.
REGULATORY COMPLIANCE
See the statutory exceptions in section 106(b)
Banks are expected to comply with laws, of the Bank Holding Company Act Amend-
regulations, and Federal Reserve policy in all ments and the exceptions in the Federal Reserve’s
aspects of their real estate lending programs. Regulation Y (12 CFR 225.7).
Moreover, banks should establish adequate
internal controls to detect deficiencies or
Insider lending activities. Loans to insiders
exceptions to their lending policy that result
should not contain more-favorable terms than
in unsafe and unsound lending practices. In
those afforded to other borrowers nor should
regard to lending limits, the examiner should
these loans pose a more-than-normal risk of
review the bank’s lending practices in accor-
repayment. The bank is expected to maintain
dance with the applicable state laws in the
adequate loan documentation of insider loans
following areas, which prescribe limits on aggre-
showing that proper approval for the loan was
gate advances to a single borrower and related
obtained. Such loans should comply with the
borrowers:
Federal Reserve’s Regulation O, Loans to
Executive Officers, Directors, and Principal
Transactions with affiliates. All transactions with
Shareholders of Member Banks (12 CFR 215,
affiliates should be on terms and conditions that
subpart A).
are consistent with safe and sound banking
practices. The bank is expected to comply with
Loans to executives, officers, directors, and
the limits and collateral requirements of sections
principal shareholders of correspondent banks.
23A and 23B of the Federal Reserve Act
There should be no preferential treatment on
(12 USC 371c and 371c-1) and Regulation W
loans to insiders of correspondent banks nor
(12 CFR 223).
should there be the appearance of a conflict of
interest. The bank should comply with title VIII
Tie-in provisions. Section 106 of the Bank of the Financial Institutions Regulatory and
Holding Company Act Amendments of 1970 Interest Rate Control Act of 1978 (FIRA)

Page 24
(12 USC 1972(2)). (See also 12 CFR 215, ation requirements are separately discussed in
subpart B.) section 4140.1, ‘‘Real Estate Appraisals and
Evaluations.’’
Appraisals and evaluations. Banks should
obtain an appraisal or evaluation for all real Consumer compliance. The bank’s residential
estate–related financial transactions before mak- lending program should ensure that the loan
ing the final credit decision in conformance with applicant is adequately informed of the annual
title XI of the Financial Institutions interest rate, finance charges, amount financed,
Reform, Recovery, and Enforcement Act of total payments, and repayment schedule as man-
1989 (FIRREA) (12 USC 3310, 3331–3351) dated in the Federal Reserve’s Regulation Z,
and the Federal Reserve’s Regulation H, Mem- Truth in Lending (12 CFR 226). The bank’s
bership of State Banking Institutions in the process for taking, evaluating, and accepting or
Federal Reserve System (12 CFR 208), as set rejecting a credit application is subject to the
forth in subpart G of Regulation Y (12 CFR Federal Reserve’s Regulation B, Equal Credit
225). The Federal Reserve’s appraisal and evalu- Opportunity (12 CFR 202).

Page 25
Real Estate Loans
1. To determine if policies, practices, proce- and regulations that are applicable to the
dures, and internal controls for real estate organization.
loans are adequate to identify and manage the 3. To determine if the financial institution has
risks the bank is exposed to. given full recognition to the risks embedded
2. To ascertain if the institution has imple- in its home equity lending.
mented risk-management programs that iden- 4. To determine whether the financial institu-
tify, measure, monitor, and control the inher- tion’s risk-management practices have kept
ent risks involved in real estate lending. pace with the growth and changing risk
3. To determine if bank officers and staff are profile of its home equity portfolios and
operating in conformance with the bank’s whether underwriting standards have eased.
established guidelines. 5. To determine whether the financial institu-
4. To evaluate the portfolio for collateral suffi- tion’s loan policy—
ciency, performance, credit quality, and a. ensures prudent underwriting standards
collectibility. for home equity lending, including stan-
5. To determine compliance with applicable dards to ensure that a thorough evaluation
laws and regulations. of a borrower’s capacity to service the
6. To initiate corrective action when policies, debt is conducted (that is, the institution is
practices, procedures, objectives, or internal not relying solely on the borrower’s credit
controls are deficient or when violations of score);
laws or regulations have been noted. b. provides risk-management safeguards for
potential declines in home values;
c. ensures that the standards for interest-only
Home Equity Lending and variable-rate home equity lines of
credit (HELOCs) include an assessment
1. To determine if the financial institution has of a borrower’s ability to (1) amortize the
an appropriate review and approval process fully drawn line of credit over the loan
for new product offerings, product changes, term and (2) absorb potential increases in
and marketing initiatives. interest rates; and
2. To ascertain whether the financial institution d. provides appropriate collateral-valuation
has appropriate control procedures for third policies and procedures and provides for
parties that generate loans on its behalf and if the use and validation of automated valu-
the control procedures comply with the laws ation models.

Page 1
Real Estate Loans
1. Determine the scope of the examination, including whether the bank is adequately
based on the evaluation of internal controls documenting exceptions to supervisory
and the work performed by internal or loan-to-value (LTV) limits, whether the
external auditors. volume of nonconforming loans
2. Review the board of directors minutes to exceeds the capital limitations, and
ensure that real estate loan policies are whether risk-management programs have
reviewed and approved at least annually. been established and maintained to iden-
3. Test real estate loans for compliance with tify, measure, monitor, and control the
policies, practices, and procedures by per- inherent risks associated with high-LTV
forming the remaining examination proce- lending;
dures in this section. Obtain a listing of any i. compliance with the Interagency Credit-
deficiencies noted in the latest internal or Risk Management Guidance for Home
external audit report, and determine if Equity Lending; and
appropriate corrections have been made. j. other matters of significance, including
Additionally, obtain a list of personnel mortgage servicing, warehousing
changes. Determine if these changes are operations, and the loan-origination/
significant enough to influence the scope of resale process.
the examination. 6. Select loans for examination, using an
4. Obtain a trial balance and delinquency list- appropriate sampling technique drawn from
ing for all real estate loans. judgmental (cutoff-amount approach) or sta-
a. Reconcile the real estate department’s tistical sampling. Analyze the performance
trial balance totals to the bank’s general of the loans selected for review by transcrib-
ledger accounts. ing the appropriate information from the
b. Review reconciling items for reason- following list onto the real estate loan line
ableness. cards, when applicable:
c. Obtain information (for example, paid-to a. collateral records and credit files
dates, last date paid, and date of nonac- b. loan agreements relative to any pur-
crual status) on past-due loans and loans chases, transfers, participations, or sales
on nonaccrual status. that have been entered into since the last
5. Evaluate the bank with respect to— examination
a. the adequacy of written policies and c. loan commitments and other contingent
procedures relating to real estate loans; liabilities
b. the operating compliance with estab- d. loan-modification agreements or restruc-
lished bank policy; turing terms to identify a reduction in
c. favorable or adverse trends in the overall interest rate or principal payments,
real estate lending activity; deferral of interest or principal pay-
d. the accuracy and completeness of the ments, or other restructurings of terms
bank’s records; e. past-due/nonaccrual-related information
e. the adequacy of internal controls; f. loan-specific internal information from
f. adherence to lending policies, proce- problem credit analyses
dures, and authority by all appropriate g. escrow-analysis reports, including the
personnel; status of property tax payments and
g. compliance with laws, regulations, and escrow advances by the bank to cover
Federal Reserve policy on real estate delinquent property taxes
lending activity, including lending limits h. the status of mortgage insurance claims
and restrictions; loans to officers, direc- either for government insurance or guar-
tors, and shareholders; appraisal and antee programs or for private mortgage
evaluation of real estate collateral; and insurance, including procedures for
lending practices; ensuring coverage and reporting proce-
h. compliance with the Interagency Guide- dures for filing claims and contested
lines for Real Estate Lending Policies, claims, if any

Page 1
2090.3 Real Estate Loans: Examination Procedures
i. loans to insiders and their interests tractual terms are being adhered to;
7. In analyzing the selected real estate loans, b. loan documentation to see if it meets the
consider the following procedures, taking bank’s underwriting procedures (that is,
appropriate action if necessary: the documentation for loan participations
a. Determine the primary source of repay- should meet the same standards as the
ment and evaluate its adequacy. documentation for loans the bank
b. Assess the quality of any secondary col- originates);
lateral afforded by the loan guarantors or c. the transfer of loans immediately before
partners. the date of the examination to determine
c. Compare collateral values with outstand- if the loan was either nonperforming or
ing debt. Determine whether the loan’s classified and if the transfer was made to
LTV ratio is in excess of the supervisory avoid possible criticism during the cur-
LTV limits. If so, ascertain whether the rent examination; and
loan has been properly reported as a d. losses to determine if such losses are
nonconforming loan. shared on a pro rata basis.
d. Assess the adequacy of the appraisal or 9. For participations between an institution
evaluation. that has a different primary regulator and
e. Ascertain whether the loan complies with loans in the Shared National Credit
established bank policy. program—
f. Identify any deficiencies in the loan’s a. identify loans to be included in the Shared
documentation in the credit files, the National Credit review;
collateral records, or both. b. inform the Reserve Bank of any criti-
g. Identify whether the loan is to an officer, cized participation loans that were not
a director, or a shareholder of the bank or covered by the Shared National Credit
to a correspondent bank. Determine program and in which the participant(s)
whether an officer, a director, or a share- had a different primary regulator; and
holder of the bank is a guarantor on the c. inform the Reserve Bank of those loans
loan. eligible for the Shared National Credit
h. Review the borrower’s compliance with program that were not previously
provisions of the loan agreement. Review reviewed.
the borrower’s payment performance, 10. In connection with the examination of other
indicating whether the loan is past due. lending activity in the bank—
i. Determine if there are any problems that a. check the central liability file on the
may jeopardize the repayment of the real borrower(s) and determine whether the
estate loan. total indebtedness of the borrower
j. Determine whether the loan was classi- exceeds the lending limit to a single
fied during the preceding examination, borrower; and
and, if the loan has been paid off, whether b. obtain information and related perfor-
all or part of the funds for repayment mance status on common borrowers and
came from another loan at the bank, from their interests from examiners assigned
a participation or sale with another insti- to other examination areas (such as non–
tution, or from the repossession of the real estate loans, leasing, overdrafts, and
property. cash items). Determine the total
k. Identify whether the loan is to a firm or indebtedness of these borrowers to the
to individuals who are principals of a bank. Additionally, one examiner should
firm that provided professional services be assigned to review the borrower’s
to the bank, including attorneys, accoun- overall borrowing relationship with the
tants, and appraisers. If so, determine bank.
if the loan has received preferential 11. Consult with the examiner responsible for
treatment. the asset-liability management analysis por-
8. For loan participations, either in whole or in tion of the examination to determine the
part, to or with another lending institution, appropriate maturity breakdown of real
review, if applicable— estate loans needed for the analysis. Prepare
a. participation certificates and agreements, the necessary schedules.
on a test basis, to determine if the con- 12. Summarize the findings of the real estate

Page 2
Real Estate Loans: Examination Procedures 2090.3
loan portfolio review and address the the borrower’s ability to (1) amortize the
following: fully drawn line of credit over the loan
a. the scope of the examination term and (2) absorb potential increases in
b. the quality of the policies, procedures, interest rates for interest-only and
and controls variable-rate home equity lines of credit
c. the general level of adherence to policies (HELOCs).
and procedures 3. Assess the reasonableness and adequacy of
d. the competency of management and loan the analyses and methodologies underlying
officers, including the identification of the financial institution’s evaluation of bor-
individuals with an excessively high level rowers.
of problem loans or documentation 4. If the financial institution uses third parties
exceptions to originate home equity loans, find out—
e. the quality of the loan portfolio a. if the institution delegates the underwrit-
f. loans not supported by current and coming function to a broker or correspon-
plete financial information dent;
g. loans with incomplete documentation, b. if the institution’s internal controls for
addressing deficiencies related to items delegated underwriting are adequate;
such as appraisals or evaluations, title c. whether the institution retains appropri-
policy, proof of insurance, deeds of trust, ate oversight of all critical loan-
and mortgage notes processing activities, such as verification
h. loans to officers, directors, shareholders, of income and employment and the in-
or their interests dependence of the appraisal and evalua-
i. causes of existing problems tion function;
j. delinquent loans and the aggregate amount d. if there are adequate systems and con-
of statutory bad debts. (See section trols to ensure that a third-party origina-
2060.1, ‘‘Classification of Credits.’’) tor is appropriately managed, is finan-
k. concentrations of credits cially sound, provides mortgages that
l. classified loans meet the institution’s prescribed under-
m. violations of laws, regulations, and Fed- writing guidelines, and adheres to appli-
eral Reserve policy cable consumer protection laws and
n. action taken by management to correct regulations;
previously noted deficiencies, and cor- e. if the institution has a quality-control
rective actions recommended to manage- unit or function that closely monitors
ment at this examination, with the bank’s (monitoring activities should include
response to them post-purchase underwriting reviews
and ongoing portfolio-performance-
management activities) the quality of
Home Equity Lending loans that the third party underwrites;
and
1. Review the credit policies for home equity f. whether the institution has adequate audit
lending to determine if the underwriting procedures and controls to verify that
standards address all relevant risk factors third parties are not being paid to gener-
(that is, an analysis of a borrower’s income ate incomplete or fraudulent mortgage
and debt levels, credit score, and credit applications or are not otherwise receiv-
history versus the loan’s size, the collateral ing referral or unearned income or fees
value (including valuation methodology), contrary to RESPA prohibitions.
the lien position, and the property type and 5. Evaluate the adequacy of the financial insti-
location). tution’s collateral-valuation policies and pro-
2. Determine whether the financial institu- cedures. Ascertain whether the institution—
tion’s underwriting standards include— a. establishes criteria for determining the
a. a properly documented evaluation of the appropriate valuation methodology for a
borrower’s financial capacity to particular transaction (based on the risk
adequately service the debt; in the transaction and loan portfolio);
b. an adequately documented evaluation of b. sets criteria for determining when a physi-

Page 3
2090.3 Real Estate Loans: Examination Procedures
cal inspection of the collateral is time or those who rely on the credit line
necessary; to keep payments current;
c. ensures that an expected or estimated e. monitors home values by geographic
value of the property is not communi- area; and
cated to an appraiser or individual per- f. obtains updated information on the col-
forming an evaluation; lateral’s value when significant market
d. implements policies and controls to pre- factors indicate a potential decline in
clude ‘‘value shopping’’; and home values, or when the borrower’s
e. requires sufficient documentation to sup- payment performance deteriorates and
port the collateral valuation in the ap- greater reliance is placed on the collateral.
praisal or evaluation. Determine if the frequency of the above
6. If the financial institution uses automated actions is commensurate with the risk in the
valuation models (AVMs) to support evalu- portfolio.
ations or appraisals, find out if the
10. Verify that annual credit reviews of HELOC
institution—
accounts are conducted. Verify if the reviews
a. implements policies and controls to pre-
of HELOC accounts determine whether the
clude ‘‘value shopping’’ in its use of
line of credit should be continued, based on
AVMs;
the borrower’s current financial condition.
b. periodically validates the models, to miti-
gate the potential valuation uncertainty 11. Determine that authorizations of over-limit
in the model; home equity lines of credit are restricted
c. adequately documents the validation’s and subject to appropriate policies and
analysis, assumptions, and conclusions; controls.
d. back-tests a representative sample of a. Verify that the financial institution requires
evaluations and appraisals supporting over-limit borrowers to repay, in a timely
loans outstanding; and manner, the amount that exceeds estab-
e. evaluates the reasonableness and lished credit limits.
adequacy of its procedures for validating b. Evaluate the sufficiency of management
AVMs. information systems (MIS) that enable
7. If tax-assessment valuations are used as a management to identify, measure, moni-
basis for collateral valuation, ascertain tor, and control the risks associated with
whether the financial institution is able to over-limit accounts.
demonstrate and document the correlation 12. Verify that the financial institution’s real
between the assessment value of the taxing estate lending policies are consistent with
authority and the property’s market value, safe and sound banking practices and that
as part of the validation process. its board of directors reviews and approves
8. Review the risk- and account-management the policies at least annually.
procedures. Verify that the procedures are 13. Determine whether the MIS—
appropriate for the size of the financial a. allows for the segmentation of the loan
institution’s loan portfolio, as well as for the portfolios;
risks associated with the types of home b. accurately assesses key risk characteris-
equity lending conducted by the institution. tics; and
9. If the financial institution has large home
equity loan portfolios or portfolios with c. provides management with sufficient in-
high-risk characteristics, determine if the formation to identify, monitor, measure,
institution— and control home equity concentrations.
a. periodically refreshes credit-risk scores 14. Determine whether management periodi-
on all customers; cally assesses the adequacy of its MIS, in
b. uses behavioral scoring and analysis of light of growth and changes in the financial
individual borrower characteristics to institution’s risk appetite.
identify potential problem accounts; 15. If the financial institution has significant
c. periodically assesses utilization rates; concentrations of HELs or HELOCs, deter-
d. periodically assesses payment patterns, mine if the MIS includes, at a minimum,
including borrowers who make only reports and analysis of the following:
minimum payments over a period of a. production and portfolio trends by prod-

Page 4
Real Estate Loans: Examination Procedures 2090.3
uct, loan structure, originator channel, records. Determine whether the institution
credit score, loan to value (LTV), debt to reports, on a quarterly basis, the dollar value
income (DTI), lien position, documenta- of such loans to its board of directors.
tion type, market, and property type 18. Find out whether the financial institution
b. the delinquency and loss-distribution has purchased insurance products to help
trends by product and originator channel, mitigate the credit risks of its HLTV resi-
with some accompanying analysis of dential loans. If a policy has a coverage
significant underwriting characteristics limit, determine whether the coverage may
(such as credit score, LTV, DTI) be exhausted before all loans in the pool
c. vintage tracking mature or pay off.
d. the performance of third-party origina- 19. Determine whether the financial institu-
tors (brokers and correspondents) tion’s credit risk-management function over-
e. market trends by geographic area and sees the support function(s). Evaluate the
property type, to identify areas of rapidly effectiveness of controls and procedures
appreciating or depreciating housing over staff who are responsible for perfecting
values. liens, collecting outstanding loan docu-
16. Determine whether the financial institution ments, obtaining insurance coverage (includ-
accurately tracks the volume of high-LTV ing flood insurance), and paying property
(HLTV) loans, including HLTV home equity taxes.
and residential mortgages, and if the finan- 20. Determine whether policies and procedures
cial institution reports the aggregate of these have been established for home equity
loans to its board of directors. problem-loan workouts and loss-mitigation
17. Determine whether loans in excess of the strategies.
supervisory LTV limits are identified as 21. Summarize the findings of the home equity
high-LTV loans in the financial institution’s loan portfolio review.

Page 5
Real Estate Loans
Review the bank’s internal controls, policies, type of financial information required
practices, and procedures for making and ser- for each category of real estate loan?
vicing real estate loans. The bank’s system j. LTV limits that are consistent with
should be documented completely and concisely regulatory supervisory limits?
and should include, where appropriate, narrative k. real estate appraisal and evaluation pro-
descriptions, flow charts, copies of forms used, grams consistent with the Federal
and other pertinent information. Negative Reserve’s appraisal regulation, guide-
responses to the questions in this section should lines, and the October 27, 2003, inter-
be explained, and additional procedures deemed agency statement on Independent
necessary should be discussed with the examiner- Appraisal and Evaluation Functions (see
in-charge. Items marked with an asterisk require SR-03-18)?
substantiation by observation or testing. l. reporting requirements to the board of
directors relative to loan portfolio moni-
toring, including items such as compli-
ance with lending policies and proce-
LOAN POLICIES dures, delinquency trends, and problem
loans?
1. Has the board of directors and manage- 2. Are real estate policies and objectives
ment, consistent with their duties and appropriate to the size and sophistication
responsibilities, adopted and, at least annu- of the bank, and are they compatible with
ally, reviewed and approved written real changing market conditions?
estate loan policies that define—
a. the institution’s target market?
b. loan portfolio diversification standards? LOAN RECORDS
c. acceptable collateral types?
d. prudent, clear, and measurable under- *1. Are the preparation and posting of subsid-
writing standards, including relevant iary real estate loan records performed or
credit factors such as— adequately reviewed by persons who do
• maximum loan amount by type of not also—
property? a. issue official checks and drafts?
• maximum loan maturity by type of b. handle cash receipts?
property? c. reconcile subsidiary records to general
• repayment terms? ledger controls?
• pricing structure for each type of real *2. Are the subsidiary real estate loan records
estate loan? reconciled at least monthly to the appro-
• loan-to-value (LTV) limits by type of priate general ledger accounts? Are recon-
property? ciling items adequately investigated by
persons who do not also handle cash or
e. procedures for reviewing real estate
prepare/post subsidiary controls?
loan applications?
3. Are loans in excess of supervisory LTV
f. loan-origination and -approval proce- limits identified in the bank’s records, and
dures (including loan-authority limits) are the aggregate amounts of such loans
by size and type of loan? reported at least quarterly to the board of
g. review and approval procedures for directors, along with the experience of the
exception loans? high-LTV loan portfolio?
h. loan-administration procedures that 4. Are loan statements, delinquent-account-
include documentation, disbursement, collection requests, and past-due notices
collateral inspection, collection, and reconciled to the real estate loan subsidi-
loan review? ary records? Are the notices and reconcili-
i. minimum loan-documentation stan- ations handled by persons who do not also
dards, such as minimum frequency and handle cash?

Page 1
2090.4 Real Estate Loans: Internal Control Questionnaire
5. Are inquiries about loan balances received b. Does the bank use a check sheet to
and investigated by persons who do not ensure that required documents are
also handle cash? received and on file?
*6. Are documents supporting recorded credit c. Are safeguards in effect to protect notes
adjustments subsequently checked or tested and other documents?
by persons who do not also handle cash? d. Does the bank obtain a signed applica-
7. Does the bank maintain a daily record tion form for all real estate mortgage
summarizing note-transaction details (loans loan requests?
made, payments received, and interest e. Are separate credit files maintained?
collected) to support applicable general f. Is there a program of systematic
ledger account entries? follow-up to determine that all required
8. Are note and liability trial balances fre- documents are received after the loan
quently reconciled to the general ledger by closing and from public recording
employees who do not process or record offices?
loan transactions? g. Does a designated employee conduct a
9. Are subsidiary payment records and files review after loan closing to determine if
pertaining to serviced loans segregated all documents are properly drawn, exe-
and identifiable? cuted, recorded, and filed within the
10. Are past-due-loan reports generated daily? loan files?
h. Are all notes and other instruments
pertaining to paid-off loans returned
promptly to the borrower, canceled, and
LOAN INTEREST AND marked paid, where appropriate?
i. Are charged-off notes and related files
COMMITMENT FEES segregated and adequately controlled?
*1. Are the preparation and posting of loan
interest and fee records performed or ade-
quately reviewed by persons who do not LOAN ORIGINATION
also—
a. issue official checks or drafts? 1. Does the bank have a written schedule of
b. handle cash? fees, rates, terms, and types of collateral
2. Are any independent interest and fee com- for all new loans?
putations made and compared with or 2. Does the bank have a mortgage errors and
adequately tested to loan interest records omission policy?
by persons who do not also— 3. Are procedures in effect to ensure compli-
a. issue official checks or drafts? ance with the requirements of governmen-
b. handle cash? tal agencies that insure or guarantee loans
or with the requirements of private mort-
gage insurance companies?
PROCESSING AND DOCUMENT

CONTROL ESCROW PROCESSING
*1. Are all real estate loan commitments issued 1. Regarding insurance and property taxes
in written form? coverage—
2. Are loan officers prohibited from process- a. Is there a procedure for determining
ing loan payments? that private mortgage insurance premi-
*3. Are loan payments received by mail re- ums are current on insured loans?
corded upon receipt independently before b. Is there a procedure for determining
being sent to and processed by a note that property and hazard insurance pre-
teller? miums are current on properties secur-
*4. Regarding mortgage documents— ing loans?
a. Has the responsibility for the document c. Does the bank require that the hazard
files been established? insurance policies include a loss-payable

Page 2
Real Estate Loans: Internal Control Questionnaire 2090.4
clause to the bank? HOME EQUITY LENDING

d. Are escrow accounts reviewed at
least annually to determine if monthly Policies
deposits will cover anticipated
disbursements? 1. Do the credit policies for home equity
lending address the underwriting standards
e. Are disbursements for taxes and
for all relevant risk factors, such as—
insurance supported by records show-
a. an analysis of a borrower’s income and
ing the nature and purpose of the
debt levels?
disbursement?
b. an analysis of a borrower’s credit score
f. If advance deposits for taxes and insur- and credit history versus the loan’s
ance are not required, does the bank size?
have a system to determine that taxes c, the collateral value (including valuation
and insurance are being paid? methodology)?
d. the lien position?
e. the property type and location?
2. Are the financial institution’s risk-and
LOAN ADMINISTRATION account-management procedures appropri-
ate for the size of the institution’s loan
*1. Are approvals of real estate advances portfolio, as well as for the risks associated
reviewed, before disbursement, to deter- with the types of home equity lending
mine that such advances do not increase conducted by the institution?
the borrower’s total liability to an amount 3. Does the financial institution have reason-
in excess of the bank’s legal lending limit? able and adequate policies and procedures
2. Are detailed statements of account bal- for home equity problem-loan workouts
ances and activity mailed to mortgagors at and loss-mitigation strategies?
least annually?
Underwriting
COLLECTIONS AND 4. Has the financial institution purchased
FORECLOSURES insurance products to mitigate the credit
risks of its high-LTV (HLTV) residential
1. Does the bank have adequate collection
loans?
procedures to monitor delinquencies and,
a. If so, do any of those insurance policies
as necessary, have procedures to pursue
have a coverage limit?
foreclosure?
b. Has the institution conducted reason-
2. Are properties under foreclosure proceed- able and adequate analyses to deter-
ings segregated? mine whether the coverage may be
3. Are properties to which the bank has exhausted before all loans in the pool
obtained title appropriately transferred to covered by the insurance product ma-
other real estate owned (OREO)? See ture or pay off?
‘‘Other Real Estate Owned,’’ section 2200.1, 5. Does the financial institution’s credit-risk
for requirements. management function oversee the support
4. Does the bank have an adequate manage- function(s) for its real estate lending? Does
ment and sales disposition program for the institution have effective controls and
timely liquidation of OREO? Does the procedures over staff who are responsible
program take into account the maximum for perfecting liens, collecting outstanding
retention period for OREO allowed under loan documents, obtaining insurance cov-
state law? erage (including flood insurance), and pay-
5. Does the bank have adequate procedures ing property taxes?
for filing and monitoring its mortgage 6. Do the financial institution’s underwriting
insurance claims for government-insured standards include—
or -secured programs and for private mort- a. a properly documented evaluation of
gage insurance? the borrower’s financial capacity to

Page 3
2090.4 Real Estate Loans: Internal Control Questionnaire
adequately service the debt? appropriate valuation methodology for

b. an adequately documented evaluation a particular transaction (based on the
of the borrower’s ability to— risk in the transaction and loan port-
• amortize the fully drawn line of credit folio)?
over the loan term? b. set criteria for determining when a
• absorb potential increases in interest physical inspection of the collateral is
rates for interest-only and variable- necessary?
rate home equity lines of credit c. ensure that an expected or estimated
(HELOCs)? value of the property is not communi-
7. Are the analyses and methodologies under- cated to an appraiser or individual per-
lying the institution’s evaluation of bor- forming an evaluation?
rowers reasonable and adequate? d implement controls to preclude ‘‘value
8. Does the financial institution use third shopping?’’
parties to originate home equity loans? If e. require sufficient documentation to sup-
so, does the institution— port the collateral valuation in the
a. delegate the underwriting function to a appraisal or evaluation?
broker or correspondent? 10. Does the financial institution use auto-
b. have adequate internal controls for its mated valuation models (AVMs) to sup-
delegated underwriting? port evaluations or appraisals? If so, does
c. retain appropriate oversight of all criti- the institution—
cal loan-processing activities, such as a. periodically validate the models, to miti-
verification of income and employment gate the potential valuation uncertainty
and the independence of the appraisal in the model?
and evaluation function? b. adequately document the validation’s
d. have adequate systems and controls to analysis, assumptions, and conclusions?
ensure that a third-party originator is c. implement controls to preclude ‘‘value
appropriately managed, is financially shopping’’ in its use of AVMs?
sound, provides mortgages that meet d. back-test a representative sample of
the institution’s prescribed underwrit- evaluations and appraisals supporting
ing guidelines, and adheres to applica- loans outstanding?
ble consumer protection laws and e. evaluate the reasonableness and
regulations? adequacy of its procedures for validat-
e. have a quality-control unit or function ing AVMs?
that closely monitors (monitoring 11. Are tax-assessment valuations used as a
activities should include post-purchase basis for collateral valuation? If so, is the
underwriting reviews and ongo- financial institution able to demonstrate
ing portfolio-performance-management and document the correlation between the
activities) the quality of loans that the assessment value of the taxing authority
third party underwrites? and the property’s market value, as part of
f. have adequate audit procedures and the validation process?
controls to verify that third parties are
not being paid to generate incomplete
or fraudulent mortgage applications and Risk Concentrations
are not otherwise receiving referral or
unearned income or fees contrary to 12. Does the financial institution have large
RESPA prohibitions? home equity loan portfolios or portfolios
with high-risk characteristics? If so, does
the institution—
Collateral Valuation a. periodically refresh credit-risk scores
on all customers?
9. Does the financial institution have adequate b. use behavioral scoring and analysis of
collateral-valuation policies and proce- individual borrower characteristics to
dures that— identify potential problem accounts?
a. establish criteria for determining the c. periodically assess utilization rates?

Page 4
Real Estate Loans: Internal Control Questionnaire 2090.4
d. periodically assess payment patterns, tics (such as credit score, LTV, or DTI)?
including borrowers who make only c. vintage tracking?
minimum payments over a period of d. the performance of third-party origina-
time or those who rely on the credit line tors (brokers and correspondents)?
to keep payments current? e. market trends by geographic area and
e. monitor home values by geographic property type, to identify areas of rap-
area? idly appreciating or depreciating hous-
f. obtain updated information on the col- ing values?
lateral’s value when significant market 17. Do the financial institution’s records iden-
factors indicate a potential decline in tify loans in excess of the supervisory LTV
home values, or when the borrower’s limits as high-LTV (HLTV) loans? Is the
payment performance deteriorates and aggregate dollar value of such loans re-
greater reliance is placed on the ported quarterly to the instution’s board of
collateral? directors? Does the volume of HLTV loans
Are the frequency of these actions com- exceed 100 percent of the institution’s
mensurate with the risk in the portfolio? capital?
Management Information Systems Internal Loan Review

13. Are the financial institution’s real estate 18. Does the financial institution conduct annual
lending policies consistent with safe and credit reviews of HELOC accounts? Does
sound banking practices, and does its board the review of HELOC accounts determine
of directors review and approve the poli- whether the line of credit should be contin-
cies at least annually? ued, based on the borrower’s current finan-
14. Do the financial institution’s management cial condition?
information systems (MIS) for real estate 19. Are the financial institution’s authoriza-
lending— tions of over-limit home equity lines of
a. allow for the segmentation of the loan credit restricted? Are they subject to
portfolios? appropriate policies and controls?
b. accurately assess key risk characteris- a. Does the institution require over-limit
tics? borrowers to repay, in a timely manner,
c. provide management with sufficient the amount that exceeds established
information to identify, monitor, mea- credit limits?
sure, and control home equity b. Is MIS sufficient to enable management
concentrations? to identify, measure, monitor, and con-
15. Does the financial institution’s manage- trol the risks associated with over-limit
ment periodically assess the adequacy of accounts?
its MIS, in light of growth and changes in
the institution’s risk appetite?
16. Does the financial institution have signifi-
cant concentrations of HELs or HELOCs? CONCLUSION
If so, does the MIS include, at a minimum,
reports and analysis of— 1. Does the foregoing information provide an
a. production and portfolio trends by prod- adequate basis for evaluating internal con-
uct, loan structure, originator channel, trol in that deficiencies in areas not cov-
credit score, loan to value (LTV), debt ered by this questionnaire do not signifi-
to income (DTI), lien position, docu- cantly impair any controls? Explain
mentation type, market, and property negative answers briefly, and indicate any
type? additional examination procedures deemed
b. the delinquency and loss-distribution necessary.
trends, by product and originator chan- 2. On the basis of a composite evaluation, are
nel, with some accompanying analysis internal controls adequate, as evidenced by
of significant underwriting characteris- answers to the foregoing questions?

Page 5
Real Estate Construction Loans
A construction loan is used to finance the Lending Limits

construction of a particular project within a
specified period of time and is funded by super- A bank should have established and well-
vised disbursements of a predetermined amount controlled construction lending limits that are
over the construction period. When properly within the acceptable standards of state banking
controlled, a bank can promote commercial or regulations. State banking statutes governing
residential development through its construction construction lending may contain minimum stan-
lending as well as receive significant profits over dards of prudence without specifying actual loan
a relatively short time frame. However, the terms.
higher rate of return demanded by construc- The bank’s internal limits should not exceed
tion lenders is indicative of the higher risks the supervisory loan-to-value (LTV) limits set
assumed. forth in the Interagency Guidelines for Real
Inasmuch as construction lending is a form of Estate Lending Policies, as required by the
interim financing, loan repayment is contingent Federal Deposit Insurance Corporation Improve-
on whether the borrower either obtains perma- ment Act of 1991 (12 USC 1828(c)) and included
nent financing or finds a buyer with sufficient as appendix C of the Federal Reserve’s Regula-
funds to purchase the completed project. Because tion H. These guidelines and the accompanying
many borrowers anticipate retaining ownership LTV limits are discussed in ‘‘Real Estate Loans,’’
after construction, the cost and availability of section 2090.1. Generally, the LTV ratio should
funds from permanent financing is a primary not exceed the following supervisory limits:
factor to be considered by the bank in assessing
the risk of a construction loan. • 65 percent for raw-land loans
A construction loan is generally secured by a • 75 percent for land-development and
first mortgage or deed of trust on the land and improved-land loans
improvements, which is often backed by a • 80 percent for commercial, multifamily, and
purchase agreement from a financially sound other nonresidential construction loans
investor or by a takeout financing agreement • 85 percent for one- to four-family residential
from a responsible permanent lender. A long- construction loans
term mortgage loan (permanent financing) is
typically obtained before or simultaneously with For loans that fund multiple phases of the same
the construction loan and is made to refinance real estate project, the appropriate LTV limit is
the short-term construction loan. Additionally, the supervisory LTV limit applicable to the final
the bank may require a borrower to provide phase of the project.
secondary collateral in the form of a junior
interest in another real estate project or a per-
sonal guarantee.
Lending Risks
Construction loans are vulnerable to a wide

BANK LENDING POLICY variety of risks. Critical to the evaluation of any
construction loan is the analysis of the project’s
Banks can limit the risk inherent in construction feasibility study to ascertain the developer’s
lending by establishing policies that specify the risk, which affects the lender’s risk. The major
type and extent of bank involvement. The bank’s portion of the risk is attributable to the need to
lending policies should reflect prudent lending complete a project within specified cost and
standards and set forth pricing guidelines, limits time limits. Examples of difficulties that may
on loan-to-value ratios and debt-coverage ratios, arise include—
and yield requirements. Such policies should
also address procedures relative to controlling • completion of a project after takeout
disbursements in a manner that is commensurate dates, which voids permanent funding
with the progress of construction. commitments;

Page 1
2100.1 Real Estate Construction Loans
• cost overruns, which may exceed takeout unsecured advances to creditworthy borrowers.
commitments or sale prices; A development loan involves the purchase of
• the possibility that the completed project will land and lot development in anticipation of
be an economic failure; further construction or sale of the property. In
• the diversion of progress payments, result- addition to funding the acquisition of the land, a
ing in nonpayment of material bills or development loan may be used to fund the
subcontractors; preparation of the land for future construction,
• a financial collapse or the failure of the including the grading of land, installation of
contractors, subcontractors, or suppliers to utilities, and construction of streets.
perform before the completion date; Effective administration of a land-development
• increased material or labor costs; loan begins with a plan defining each step of the
• the destruction of improvements from unex- development. The development plan should
pected natural causes; and incorporate cost budgets, including legal expenses
• an improper or lax monitoring of funds for building and zoning permits, environmental
advanced by the bank. impact statements, costs of installing utilities,
and all other projected costs of the development.
Bank management’s review of the plan and
TYPES OF CONSTRUCTION related cost breakdowns should provide the
LOANS basis for determining the size, terms, and restric-
tions for the development loan. Refer to the
The basic types of construction lending are subsection below on the assessment of real
unsecured front-money, land-development, resi- estate collateral for further discussion.
dential construction, and commercial construc- The LTV ratio should provide for sufficient
tion loans. It is not uncommon for a bank to margin to protect the bank from unforeseen
provide the acquisition, development, and con- events (such as unplanned expenses) that would
struction loans for a particular project. otherwise jeopardize the bank’s collateral posi-
tion or repayment prospects. If the loan involves
the periodic development and sale of portions of
Unsecured Front-Money Loans the property under lien, each separately identi-
fiable section of the project should be inde-
Front-money loans are considered very risky pendently appraised, and any collateral should
and should not be undertaken unless the bank be released in a manner that maintains a reason-
has the expertise to evaluate the credit risk. able margin. The repayment program should be
These loans may represent working-capital structured to follow the sales or development
advances to a borrower who may be engaged in program. Control over development loans can
a new and unproven venture. The funds may be be best established when the bank finances both
used to acquire or develop a building site, the development and the construction or sale
eliminate title impediments, pay architect or phases of the project.
standby fees, and meet minimum working- In the case of an unsecured land-development
capital requirements established by construction loan, it is essential to analyze the borrower’s
lenders. Because repayment often comes from financial statements to determine the source of
the first draw against construction financing, loan repayment. In establishing the repayment
many construction loan agreements prohibit the program, the bank should review sales projec-
use of the first advance to repay nonconstruction tions to ensure that they are not overly optimis-
costs. Unsecured front-money loans used as a tic. Additionally, banks should avoid granting
developer’s equity investment in a project or to loans to illiquid borrowers or guarantors who
cover initial cost overruns are symptomatic of provide the primary support for a borrower
an undercapitalized or possibly an inexperi- (project).
enced or inept builder.
Land-Development Loans Residential Construction Loans

Land-development or off-site-improvement loans Residential construction loans are made either
are intended to be secured-purchase loans or on a speculative basis, where homes are built to

Page 2
Real Estate Construction Loans 2100.1
be sold later in the general market, or for a dential construction projects are usually negoti-
specific buyer with prearranged permanent ated with prearranged permanent financing as
financing. Loans financing residential projects part of the construction loan.
that do not have prearranged homebuyer financ-
ing are usually limited to a predetermined num-
ber of speculative homes, which are permitted to
get the project started. However, smaller banks Commercial Construction Loans
are often engaged in this type of financing, and
the aggregate total of individual speculative A bank’s commercial construction lending
construction loans may equal a significant por- activity can encompass a wide range of projects—
tion of their capital funds. It is important to apartments, condominiums, office buildings,
ensure that the homebuyer has arranged perma- shopping centers, and hotels—with each requir-
nent financing before the bank finances the ing a special set of skills and expertise to
construction; otherwise, the bank may find itself successfully manage, construct, and market.
without a source of repayment. Construction Commercial construction loan agreements
loans without takeout commitments generally should normally require the borrower to have a
should be aggregated to determine whether a precommitted extended-term loan to ‘‘take out’’
concentration of credit exists, that is, in those the construction lender. Takeout-financing agree-
situations when the amount exceeds 25 percent ments, however, are usually voidable if construc-
of the bank’s capital structure (tier 1 capital plus tion is not completed by the final funding date,
loan loss reserves). if the project does not receive occupancy per-
Proposals to finance speculative construction mits, or if the preleasing or occupancy rate does
should be evaluated according to predetermined not meet an agreed-upon level. A bank can also
policies that are compatible with the institu- enter into an open-end construction loan where
tion’s size, the technical competence of its there is no precommitted source to repay the
management, and the housing needs of its ser- construction loan. Such loans pose an added risk
vice area. The prospective borrower’s reputa- because the bank may be forced into providing
tion, experience, and financial condition should permanent financing, oftentimes in distressed
also be reviewed to assess the likelihood of situations. In evaluating this risk, the bank
completing the proposed project. Until the should consider whether the completed project
project is completed, the actual value of the real will be able to attract extended-term financing,
estate is questionable. Thus, the marketability of supportable by the projected net operating
the project should be substantiated in a feasibil- income.
ity study, reflecting a realistic assessment of The risk of commercial construction requires
current favorable and unfavorable local housing a complete assessment of the real estate collat-
market conditions. As in any real estate loan, the eral, borrower’s financial resources, source of
bank must also obtain an appraisal or evaluation the extended-term financing, and construction
for the project. The appraisal or evaluation and plans. As it does any real estate loan, the bank
the feasibility study are important tools to be must obtain an appraisal or evaluation of the real
used by lenders in evaluating project risks. For estate in accordance with the Federal Reserve’s
projects located out of area, the lender may lack appraisal regulation. Additionally, the borrower
market expertise, which makes evaluating the should provide a feasibility study for the project
reasonableness of the marketing plan and feasi- that details the project’s marketing plan, as well
bility study more difficult, and therefore makes as an analysis of the supply-and-demand factors
the loan inherently riskier. affecting the projected absorption rate. For an
A bank dealing with speculative builders open-end construction loan, the feasibility study
should have control procedures tailored to the is particularly important to the bank’s assess-
individual project. A predetermined limit on the ment of the credit because the repayment of the
number of unsold units to be financed at any one loan becomes increasingly dependent on the
time should be included in the loan agreement to sales program or leasing of the project.
avoid overextending the builder’s capacity. The The bank also needs to assess the borrower’s
construction lender should receive current in- development expertise, that is, whether the bor-
spection reports indicating the project’s progress. rower can complete the project within budget
In some instances, the construction lender is also and according to the construction plans. The
the permanent mortgagor. Loans on larger resi- financial risk of the project is contingent on the

Page 3
borrower’s development expertise because the history, expertise, and financial statements (pref-
source of the extended-term loan may be predi- erably audited) for the most recent fiscal years.
cated upon a set date for project completion. Background information regarding a borrower’s
Until the project is completed, the actual value and partner’s/guarantor’s character and credit
of the real estate is questionable. history is based upon their work experience and
A bank may reduce its financial risk by previous repayment practices, both relative to
funding the construction loan after the borrower trade creditors and financial institutions. The
has funded its share of the project equity (for documentation files should indicate whether the
example, by paying for the feasibility study and borrower has demonstrated it can successfully
land-acquisition and -development costs). An complete the type of project to be undertaken.
alternative approach would require the borrower The financial statements should be analyzed to
to inject its own funds into the project at ensure that the loan can be repaid in the event
agreed-upon intervals during the project’s man- that a takeout does not occur.
agement, construction, and marketing phases to The degree of analysis depends on whether
coincide with the construction lender’s contri- the borrower is in reality a single-asset entity or
butions. In larger projects, equity injections can a multi-asset entity. A loan to a single-asset
be provided by equity partners or joint ventures. entity is often predicated upon the strength of
These can take the form of equity syndications,1 the partners/guarantors. Accordingly, understand-
whose contributions are injected in the project in ing their financial strength, which frequently is
phases. A bank should assess the likelihood of made up of various partnership interests, is key
the syndication being able to raise the necessary to assessing the project’s strength. In this exam-
equity. ple, it would be necessary to obtain financial
information on the partner’s/guarantor’s other
projects, even those not financed by the bank, to
BANK ASSESSMENT OF THE understand their overall financial condition. This
is necessary because other unsuccessful projects
BORROWER may cause financial trouble for the partner/
The term borrower can refer to different types of guarantor, despite a successful sales program by
entities. These forms can range from an entity the bank’s borrower. Issues to be considered, in
whose sole asset is the project being financed to addition to those raised in the preceding para-
an entity that has other assets available to graph, include the vacancy rates of the various
support the debt in addition to the project being projects, break-even points, and rent rolls.
financed (a multi-asset entity). A loan to a multi-asset entity has similar
Although the value of the real estate collateral characteristics to those found in the single-asset
is an important component of the loan approval entity, in that it is necessary to evaluate all of the
process, the bank should not place undue reli- assets contained therein to ascertain the actual
ance on the collateral value in lieu of an ad- financial strength. In both cases, assessment of
equate analysis of the borrower’s ability to the project under construction would include
repay the loan. The analytical factors differ pre-leasing requirements. For a loan with a
depending on the purpose of the loan, such as takeout commitment, the financial strength and
residential construction versus the various types reputation of the permanent lender should be
of commercial construction loans. analyzed. For a loan without a takeout commit-
The bank’s analysis is contained in its document, or one in which the construction lender
mentation files, which should include back- provides the permanent financing for its con-
ground information on the borrower and partner/ struction loan, the long-term risks also need to
guarantor concerning their character and credit be evaluated. See the ‘‘Real Estate Loans’’
section in this manual, on the bank’s assessment
of the borrower, for additional factors to be
1. Syndication generally refers to the act of bringing
together a group of individuals or entities to invest in a real
considered.
estate project and does not refer to any particular legal form of In instances where approval for the loan is
ownership. The legal form varies depending on the investors’ predicated upon the strength of entities other
investment objectives, division of tax benefits, responsibility than the borrower (partner/guarantor), the bank
for project management, and desire to limit personal liability.
The investment vehicle may be a general partnership, limited
should obtain information on their financial
partnership, joint venture, tenancy in common, corporation, condition, income, liquidity, cash flow, contin-
real estate investment trust, or common law trust. gent liabilities, and any other relevant factors

Page 4
that exist to demonstrate their financial capacity mum, the ‘‘as is’’ market value of the property.2
to fulfill the obligation in the event that the Additionally, the bank will normally request the
borrower defaults. appraiser to report the ‘‘as completed’’ value.3
Partners/guarantors generally have invest- Projections should be accompanied by a feasi-
ments in other projects included as assets on bility study explaining the effect of projected
their financial statements. The value of these property improvements on the market value of
investments frequently represents the partner’s/ the land. The feasibility study may be a separate
guarantor’s own estimate of the investment’s report or incorporated into the appraisal report.
worth, as opposed to a value based upon the If the appraiser uses the feasibility study, the
investment’s financial statements. As a result, it appraiser’s acceptance or rejection of the study
is necessary to obtain detailed financial statements and its effect on the value should be fully
for each investment to understand the partner’s/ explained in the appraisal. An institution’s board
guarantor’s complete financial picture and of directors is responsible for reviewing and
capacity to support the loan. The statements adopting policies and procedures that establish
should include detailed current and accurate and maintain an effective, independent real estate
cash-flow information since cash flow is often appraisal and evaluation program (the program)
the source of repayment. for all of its lending functions. The real estate
It is also important to consider the number lending functions include commercial real estate
and amount of the guarantees currently extended mortgage departments, capital-market groups,
by a partner/guarantor to determine if they have and asset-securitization and -sales units. Con-
the financial capacity to fulfill the contingent cerns about the independence of real estate
claims that exist. Furthermore, the bank should appraisal and evaluation programs include the
review the prior performance of the partner/ risk that improperly prepared appraisals and
guarantor to voluntarily honor the guarantee as evaluations may undermine the integrity of
well as the marketability of the assets collater- credit-underwriting processes. More broadly, an
alizing the guarantee. Since the guarantee can be institution’s lending functions should not have
limited to development and construction phases undue influence that might compromise the
of a project, the bank should closely monitor the program’s independence. See the October 27,
project before issuing a release to the partner/ 2003, interagency statement on Independent
guarantor. Appraisal and Evaluation Functions (SR-03-18).
Management is responsible for reviewing the
reasonableness of the appraisal’s or evaluation’s
assumptions and conclusions. Also, manage-
BANK ASSESSMENT OF REAL ment’s rationale in accepting and relying upon
ESTATE COLLATERAL the appraisal or evaluation should be in writing
and made a part of loan documentation. In
Banks should obtain an appraisal or evaluation, assessing the underwriting risks, management
as appropriate, for all real estate–related finan- should reconsider any assumptions used by an
cial transactions before making the final credit appraiser that reflect overly optimistic or pessi-
or other decision. See ‘‘Real Estate Appraisals mistic values. If management, after its review of
and Evaluations,’’ section 4140.1, for a descrip- the appraisal or evaluation, determines that there
tion of the related requirements a bank must
follow for real estate–related financial transac- 2. The ‘‘as is’’ value is the value of the property in its
tions. The appraisal section explains the stan- current physical condition and subject to the zoning in effect
dards for appraisals, indicates which transac- as of the date of appraisal.
3. The ‘‘as completed’’ value reflects the value of the land
tions require an appraisal or an evaluation, states and the projected improvements. A bank may also request a
qualifications for an appraiser and evaluator, value based on stabilized occupancy or a value based on the
provides guidance on evaluations, and describes sum of retail sales. However, the sum of retail sales for a
the three appraisal approaches. proposed development is not the market value of the devel-
opment. For proposed residential developments that involve
The appraisal or evaluation techniques used the sale of individual houses, units, or lots, the appraisal
to value a proposed construction project are should reflect deductions and discounts for holding costs,
essentially the same as those used for other marketing costs, and entrepreneurial profit. For proposed and
rehabilitated income-producing properties, the appraisal should
types of real estate. The aggregate principal reflect appropriate deductions and discounts for leasing com-
amount of the loan should be based on an missions, rent losses, and tenant improvements from the
appraisal or evaluation that provides, at a mini- estimated value based on stabilized occupancy.

Page 5
are unsubstantiated assumptions, the bank may equity contributions. A detailed cost break-
request the appraiser or evaluator to provide a down of land, ‘‘hard’’ construction costs, and
more detailed justification of the assumptions or indirect or ‘‘soft’’ construction costs (such as
a new appraisal or evaluation. The approval of construction loan interest; organizational and
the loan is based upon the value of the project administration costs; and architectural, engi-
after the construction is completed. Insofar as neering, and legal fees) should be included.
the value component of the loan-to-value ratio is • Property surveys, easements, an environmen-
concerned, it is important for the bank to closely tal impact report, and soil reports that indicate
monitor the project’s progress (value) during the construction is feasible on the selected devel-
construction period. See ‘‘Real Estate Loans,’’ opment site. The bank should also obtain the
section 2090.1, for additional information rela- architect’s certification of the plan’s compli-
tive to the real estate collateral assessment. ance with all applicable building codes and
zoning, environmental protection, and other
government regulations, as well as the engi-
neer’s report on compliance with building
LOAN DOCUMENTATION codes and standards. If internal expertise is
not available, a bank may need to retain an
The loan documentation should provide infor-
independent construction expert to review
mation on the essential details of the loan
these documents to assess the reasonableness
transaction, the security interest in the real estate
and appropriateness of the construction plans
collateral, and the takeout loan commitment, if
and costs.
any. The necessary documentation before the
start of construction generally includes: • The takeout commitment from the permanent
lender, if applicable, and the terms of the loan.
• Financial and background information on the The bank should verify the financial strength
borrower to substantiate the borrower’s exper- of the permanent lender to fund the takeout
tise and financial strength to complete the commitment.
project. • A completion or performance bond signed by
• The construction loan agreement, which sets the borrower that guarantees the borrower will
forth the rights and obligations of the lender apply the loan proceeds to the project being
and borrower, conditions for advancing funds, financed.
and events of default. In some states, the • An owners’ affidavit or a borrowing resolution
agreement must be cited in either the deed of empowering the borrower or its representative
trust or the mortgage. to enter into the loan agreement.
• A recorded mortgage or deed of trust, which • Evidence that property taxes have been paid to
can be used to foreclose and obtain title to the date.
collateral.
These documents furnish evidence that the lend-
• A title insurance binder or policy, usually
ing officer is obtaining the information neces-
issued by a recognized title insurance com-
sary for processing and servicing the loan and
pany or, in some states, an attorney’s opinion.
protect the bank in the event of default.
The title should be updated with each advance
of funds to provide additional collateral
protection.
• Insurance policies and proof of payment as Documentation for Residential
evidence that the builder has adequate and Construction Loans on Subdivisions
enforceable coverage for liability, fire and
other hazards, and vandalism and malicious The documents mentioned above are usually
mischief losses. available for residential construction loans on
• An appropriate appraisal or evaluation show- subdivisions (tracts). Documentation of tract
ing the value of the land and improvements to loans frequently includes a master note in the
date or, possibly, a master appraisal based on gross amount of the entire project, and a master
specifications for a multiphase development. deed of trust covering all of the land involved in
• Project plans, a feasibility study, and a con- the project. In addition to an appraisal or evalu-
struction budget showing the development ation for each type of house to be constructed,
plans, project costs, marketing plans, and the bank should also obtain a master appraisal

Page 6
including a feasibility study for the entire devel-

opment. The feasibility study compares the
projected demand for housing against the antici-
pated supply of housing in the market area of the
proposed tract development. This analysis should
indicate whether there will be sufficient demand
for the developer’s homes given the project’s
location, type of homes, and unit sales price.
Documentation for the Takeout

Commitment
Most construction lenders require the developer

to have an arrangement for permanent financing
for each house to be constructed. Exceptions
include model homes, typically one for each
style of home offered, and a limited number

Page 6.1
of housing starts ahead of sales (speculative the takeout lender. Construction changes can
houses). The starts ahead of sales, however, result in increased costs, which may not neces-
contain additional risk. If the bank finances too sarily increase the sale value of the completed
many houses without purchase contracts, and project. On the other hand, a decrease in costs
housing sales decline rapidly, it may have to may not indicate a savings but may suggest the
foreclose on the unsold houses and sell them for use of lesser quality materials or workmanship,
less than their loan value. A takeout of this type which could affect the marketability of the
is usually an arrangement between the developer project.
and a permanent mortgage lender, but construc-
tion lenders may also finance the permanent
mortgages.
The essential information required for a com- Disbursement of Loan Funds
mercial real estate takeout to proceed includes
the floor and ceiling rental rates and minimum Loan funds are generally disbursed through
occupancy requirements; details of the project either a stage payment plan or a progress pay-
being financed; expiration date; standby fee ment plan. Regardless of the method of disburse-
requirement; assignment of rents; and, gener- ment, the amount of each construction draw
ally, a requirement that the construction loan be should be commensurate with the improvements
fully disbursed and not in any way in default at made to date. Funds should not be advanced
the time settlement occurs. unless they are used in the project being
The commitment agreement, referred to as the financed and as stipulated in the draw request.
buy/sell contract or the tri-party agreement, is Therefore, the construction lender must monitor
signed by the borrower, the construction lender, the funds being disbursed and must be assured,
and the permanent lender. The purpose of this at every stage of construction, that sufficient
agreement is to permit the permanent lender to funds are available to complete the project.
buy the loan directly from the construction
lender upon completion of the construction,
with the stipulation that all contingencies have Stage Payment Plan
been satisfied. Examples of contingencies include
project completion by the required date, clear The stage payment plan, which is normally
title to the property, and minimum lease-up applied to residential and smaller commercial
requirements. A commitment agreement also construction loans, uses a preestablished sched-
protects the construction lender against unfore- ule for fixed disbursements to the borrower at
seen possibilities, such as the death of a princi- the end of each specified stage of construction.
pal, before the permanent loan documents are The amount of the draw is usually based upon
signed. the stage of development because residential
housing projects normally consist of houses in
various stages of construction. Nevertheless,
ADMINISTERING THE LOAN loan agreements involving tract financing
typically restrict further advances in the event of
The bank and the borrower4 must effectively an accumulation of completed and unsold houses.
cooperate as partners if controls relative to Disbursements are made when construction has
construction progress are to be maintained. The reached the agreed-upon stages, verified by an
loan agreement specifies the performance of actual inspection of the property. These typi-
each party during the entire course of construc- cally include advances at the conclusion of
tion. Any changes in construction plans should various stages of construction, such as the foun-
be approved by both the construction lender and dation, exterior framing, the roof, interior fin-
ishing, and completion of the house. The final
4. The borrower may not be the entity responsible for the
payment is made after the legally stipulated lien
actual construction of the project. Depending on the size, type, period for mechanic’s liens has lapsed.
and complexity of the project, the borrower may strictly be a Disbursement programs of this type are usu-
developer who assembles the land, designs the project, and ally required for each house constructed within a
contracts with a construction company to handle the actual
construction of the building. If this is the case, the bank should
tract development. As each house is completed
obtain financial and project history information on the builder/ and sold, the bank makes a partial release
contractor. relative to that particular house covered by its

Page 7
master deed of trust. The amount of the release pleted for which payment has been received.
is set forth in the loan agreement, which speci- Upon review of the draw request and indepen-
fies the agreed-upon release price for each house dent confirmation on the progress of work, the
sold with any excess over the net sales proceeds bank will disburse funds for construction costs
remitted to the borrower. incurred, less the hold back. The percentage of
the loan funds retained are released when a
notice of the project’s completion has been filed,
Progress Payment Plan and after the stipulated period has elapsed under
which subcontractors or suppliers can file a lien.
The progress payment plan is normally used for
commercial projects.5 Under a progress pay-
ment system, funds are released as the borrower
completes certain phases of construction as Monitoring Progress of Construction
agreed upon in the loan agreement. Normally, and Loan Draws
the bank retains a percentage of the funds as a
hold back (or retainage) to cover project cost It is critical that a bank has appropriate proce-
overruns or outstanding bills from suppliers or dures and an adequate tracking system to moni-
subcontractors. Hold backs occur when a tor payments to ensure that the funds requested
developer/contractor uses a number of subcon- are appropriate for the given stage of develop-
tractors and maintains possession of a portion of ment. The monitoring occurs through physical
the amounts owed to the subcontractors during inspections of the project once it has started. The
the construction period. This is done to ensure results of the inspections are then documented in
that the subcontractors finish their work before the inspection reports, which are kept in the
receiving the final amount owed. Accordingly, appropriate file. Depending on the complexity
the construction lender holds back the same of the project, the inspection reports can be
funds from the developer/contractor to avert the completed either by the lender or by an
risk of their misapplication or misappropriation. independent construction consulting firm, the
The borrower presents a request for payment latter generally staffed by architects and engi-
from the bank in the form of a ‘‘construction neers. The reports address both the quantity and
draw’’ request or ‘‘certification for payment,’’ the quality of the work for which funds are
which sets forth the funding request by construc- being requested. They also verify that the plans
tion phase and cost category for work that has are being followed and that the construction is
been completed. This request should be accom- proceeding on schedule and within budget.
panied by receipts for the completed work The bank must be accurately informed of the
(material and labor) for which payment is being progress to date in order to monitor the loan. It
requested. The borrower also certifies that the is also important that the bank ascertain whether
conditions of the loan agreement have been draws are being taken in accordance with the
met—that all requested funds have been used in predetermined disbursement schedule. Before
the subject project and that suppliers and sub- any draw amount is disbursed, however, the
contractors have been paid. Additionally, the bank must obtain verification of continued title
subcontractors and suppliers should provide the insurance. Generally, this means verifying that
bank with lien waivers covering the work com- no liens have been filed against the title of the
project since the previous draw. The title insur-
ance insuring the construction lender’s mort-
gage or lien is then increased to include the new
5. Other methods for disbursing commercial construction draw, which results in an increase in the title
loans include the voucher system and the monthly draw insurance commensurate with the disbursement
method. The voucher system is similar to the progress system of funds. The lender frequently examines title to
except that borrower prepares a voucher of all invoices to be
paid with signatures of the subcontractors attesting to the
the property securing the construction loan to
invoiced amount. The bank then issues checks directly to the also be certain that the borrower is not pledging
subcontractors or suppliers. The monthly draw method is used it for other borrowings and to be sure that
in long-term projects wherein the borrower makes a draw mechanic’s liens are not being filed for unpaid
request each month for the previous month’s work. In turn, the
bank determines the amount of work completed to date and
bills. When the project is not proceeding as
releases funds based on the value of work completed versus anticipated, that fact should be reflected in the
the value of the work remaining. inspection reports.

Page 8
Another important component in the process loan should be in a condition to be converted to

is the ongoing monitoring of general economic a permanent loan. Usually the final draw
factors that will affect the marketing and selling includes payment of the hold back stipulated in
of the residential or commercial properties and the loan agreement and is used to pay all
affect their success upon completion of the remaining bills. The bank should obtain full
project. waivers of liens (releases) from all contractors,
subcontractors, and suppliers before the loan is
released and the hold back is disbursed. The
Monitoring Residential Projects bank should also obtain a final inspection report
to confirm the project is completed and meets
An inventory list is maintained for each tract or
the building specifications, including confirma-
phase of the project. The inventory list should
tion of the certificate of occupancy from the
show each lot number, the style of house, the
governing building authority.
release price, the sale price, and the loan bal-
ance. The list should be posted daily with Sources of permanent funding for commercial
advances and payments indicating the balance projects vary greatly, depending upon the type
advanced for each house, date completed, date of project. For condominium projects, the con-
sold, and date paid, and should age the builder’s struction lender may also be providing the
inventory by listing the older houses completed funding for marketing the individual units and
and unsold. would be releasing the loan on a unit-by-unit
basis similar to a residential development con-
Inspections (usually monthly) during the
struction loan. If there is a precommitted takeout
course of construction of each house should be
lender, the new lender could purchase the con-
documented in progress reports. The progress
struction loan documents and assume the security
report should indicate the project’s activity dur-
interest from the construction lender. If the
ing the previous month, reflecting the number of
project is being purchased for cash, the bank
homes under construction, the number com-
would release its lien and cancel the note.
pleted, and the number sold. The monthly report
should indicate whether advances are being Additionally, as the commercial project is
made in compliance with the loan agreement. leased, the lender should ensure that the bank’s
position is protected in the event that extended-
term funding is not obtained. The bank may
Monitoring Commercial Projects require tenants to enter into subordination,
attornment, and nondisturbance agreements,
To have an effective control over its commercial which protect the bank’s interests in the lease by
construction loan program, the bank must have providing for the assumption of the landlord’s
an established loan administration process that position by the bank in the event the borrower
continually monitors each project. The process declares bankruptcy. Furthermore, to ensure that
should include monthly reporting on the work the bank has full knowledge of all provisions of
completed, the cost to date, the cost to complete, the lease agreements, tenants should be required
construction deadlines, and loan funds remain- to sign an estoppel certification.
ing. Any changes in construction plans should In some cases, the takeout lender may only
be documented and reviewed by the construc- pay off a portion of the construction loan be-
tion consulting firm and should be approved by cause a conditional requirement for full funding
the bank and takeout lender. A significant num- has not been met, such as the project not
ber of change orders may indicate poor planning attaining a certain level of occupancy. The
or project design, or problems in construction, construction lender would then have a second
and should be tracked and reflected in the mortgage on the remaining balance of the con-
project’s budget. Soft costs such as advertising struction loan. When the conditions of the take-
and promotional expenses normally are not out loan are met, the construction lender is
funded until the marketing of the project has repaid in full and the lien is released.
started.
Interest Reserves
Final Repayment
A construction loan is generally an interest-only
Before the final draw is made, the construction loan because of the fact that cash flow is not

Page 9
available from most projects until they are Signs of Problems

completed. The borrower’s interest expense is
therefore borrowed from the construction lender To detect signs of a borrower’s financial prob-
as part of the construction loan for the purpose lems, the bank should review the borrower’s
of ‘‘paying’’ the lender interest on the ‘‘portion’’ financial statements on a periodic (quarterly)
of the loan used for actual construction. The basis, assessing the liquidity, debt level, and
funds advanced to pay the interest are included cash flow. The degree of information the finan-
as part of the typical monthly draw. As a result, cial statements provide the bank, insofar as
the balance due to the lender increases with each understanding the borrower’s financial condi-
draw by the full amount of construction costs, tion is concerned, depends primarily on whether
plus the interest that is borrowed. the borrower is a single-asset entity or a multi-
The borrower’s interest cost is determined by asset entity.
the amount of credit extended and the length of The financial statements of a single-asset
time needed to complete the project. This inter- entity only reflect the project being constructed;
est cost is referred to as an interest reserve. This therefore, they are of a more limited use than
period of time should be evaluated for reason- statements of multi-asset entities. Nevertheless,
ableness relative to the project being financed. one issue that is of importance to financial
In larger projects cash flow may be generated statements of both entities relates to monitoring
prior to the project’s completion. In such cases, changes in accounts and trade payables. Moni-
toring these payables in a detailed manner helps
any income from the project should be applied
the bank to determine if trade payables are paid
to debt service before there is a draw on the
late or if there are any unpaid bills. In the event
interest reserve. The lender should closely moni- of problems, a bank might choose to either
tor the lease-up of the project to ensure that the contact the payables directly or request an addi-
project’s net income is being applied to debt tional credit check on the borrower. Another
service and not diverted to the borrower as a source of information indicating borrower prob-
return of the developer’s capital or for use in the lems is local publications that list lawsuits or
developer’s other projects. judgments that have been filed or entered against
the borrower. Additionally, the bank should also
verify that the borrower is making its tax pay-
ments on time.
Loan Default
In a multi-asset entity, on the other hand,
The inherent exposure in construction financing more potential problems could arise due to the
is that the full value of the collateral is not greater number of assets (projects/properties)
that make up the borrower. As a result, it is
realized until the project is completed. In default
necessary to obtain detailed financial statements
situations the bank must consider the alterna-
of each of the assets (projects/properties) and
tives available to recover its advances. For the consolidating financial statements, as well as
uncompleted projects, the bank must decide the consolidated financial statements. This is
whether it is more advantageous to complete the important because each kind of statement can
project or to sell on an ‘‘as is’’ basis. The various provide significant insight into problems that
mechanic’s and materialmen’s liens, tax liens, could adversely affect the borrower’s overall
and other judgments that arise in such cases are financial condition.
distressing to even the most seasoned lender. Assessing the financial condition of the multi-
Due to these factors, the construction lender asset entity includes evaluating the major sources
may not be in the preferred position indicated by of cash and determining whether cash flow is
documents in the file. Therefore, the lender dependent on income generated from completed
should take every precaution to minimize any projects, the sale of real estate, or infusion of
third-party claim on the collateral. Because laws outside capital. Additionally, the bank should
regarding the priority of certain liens may vary also review the borrower’s account receivables
among states, the bank should take the necessary for the appropriateness of intercompany trans-
steps to ensure that its lien is recorded prior to actions and to guard against diversion of funds.
the commencement of work or the delivery of Depending upon the structure of the loan, it
materials and supplies. may also be desirable to obtain a partner’s/

Page 10
guarantor’s financial statements on a periodic interest to allow the borrower to complete the
basis. In such cases it is important to obtain project.
detailed current and accurate financial state-
ments that include cash flow information on a
project-by-project basis.
Slow unit sales, or excessive inventory rela- SUPERVISORY POLICY
tive to sales, indicate the borrower may have
difficulty repaying the loan. Although some- As a result of competitive pressures, many
times there are mitigating factors beyond the banks in the early 1980s made construction
control of the borrower, such as delays in loans on an open-end basis, wherein the bor-
obtaining materials and supplies, adverse weather rower did not have a commitment for longer-
conditions, or unanticipated site work, the bor- term or takeout financing before construction
rower may be unable to overcome these prob- was started. Although there was sufficient
lems. Such delays usually increase project costs demand for commercial real estate space when
and could hamper the loan’s repayment. this practice commenced, the supply of space
The construction lender should be aware of began to exceed demand. One symptom of the
funds being misused—for example, rebuilding excess supply was an increase in vacancy rates,
to meet specification changes not previously which led to declining rental income caused by
disclosed, starting a new project, or possibly the ever greater need for rent concessions. The
paying subcontractors for work performed else- commensurate declining cash flow from income-
where. The practice of ‘‘front loading,’’ whereby producing properties, and the uncertainty regard-
a builder deliberately overstates the cost of the ing future income, reduced the market value of
work to be completed in the early stages of many properties to levels considered undesir-
construction, is not uncommon and, if not de- able by permanent mortgage lenders. As a result
tected early on, will almost certainly result in of the subsequent void created by the permanent
insufficient loan funds with which to complete lenders, banks in the mid- and late 1980s began
construction in the event of a default. to extend medium-term loans with maturities for
up to seven years (also referred to as mini-
perms). These mini-perms were granted with the
Loan Workouts expectation by banks that as the excess supply
of space declined, the return on investment
Sound workout programs begin with a full would improve, and permanent lenders would
disclosure of all relevant information based on a return.
realistic evaluation of the borrower’s ability to As these loans mature in the 1990s, borrowers
manage the business entity (business, technical, may continue to find it difficult to obtain ad-
and financial capabilities), and the bank’s ability equate sources of long-term credit. In some
to assist the borrower in developing and moni- cases, banks may determine that the most desir-
toring a feasible workout/repayment plan. Man- able and prudent course is to roll over or renew
agement should then decide on a course of loans to those borrowers who have demon-
action to resolve the problems with the terms of strated an ability to pay interest on their debts,
the workout in writing and formally agreed to by but who presently may not be in a position to
the borrower. If additional collateral is accepted obtain long-term financing for the loan balance.
or substituted, the bank should ensure that the The act of refinancing or renewing loans to
necessary legal documents are filed to protect sound borrowers, including creditworthy com-
the bank’s collateral position. mercial or residential real estate developers,
In those cases where the borrower is permit- generally should not be subject to supervisory
ted to finish the project, additional extensions of criticism in the absence of well-defined weak-
credit for completing the project, due to cost nesses that jeopardize repayment of the loans.
overruns or an insufficient interest reserve, may Refinancings or renewals should be structured in
represent the best alternative for a workout plan. a manner that is consistent with sound banking,
At the same time, the bank should evaluate the supervisory, and accounting practices, and that
cause of the problem(s), such as mismanage- protects the bank and improves its prospects for
ment, and determine whether it is in its best collecting or recovering on the asset.

Page 11
1. To determine if policies, practices, proce- 4. To determine compliance with applicable

dures, and internal controls regarding real laws and regulations.
estate construction loans are adequate. 5. To initiate corrective action when policies,
2. To determine if bank officers are operating in practices, procedures, or internal controls are
conformance with the bank’s established deficient or when violations of law or regu-
guidelines. lations have been noted.
3. To evaluate the portfolio for collateral suffi-
ciency, performance, credit quality, and
collectibility.

Page 1
1. Refer to the Real Estate Loan Examination appropriate sampling technique drawn from
Procedures section of this manual for exam- judgmental (cut-off line) or statistical sam-
ination procedures related to all types of pling. Analyze the performance of the loans
real estate lending activity, and incorporate selected for examination by transcribing the
into this checklist those procedures applica- following kinds of information onto the real
ble to the review of the real estate construc- estate construction loan line cards, when
tion loans. The procedures in this checklist applicable:
are unique to the review of a bank’s con- a. Collateral records and credit files, includ-
struction lending activity. ing the borrower’s financial statements,
2. Determine the scope of the examination review of related projects, credit report
based on the evaluation of internal controls of the borrower and guarantors, appraisal
and the work performed by internal/external or evaluation of collateral, feasibility
auditors. studies, economic impact studies, and
3. Test real estate construction loans for com- loan agreement and terms.
pliance with policies, practices, procedures, b. Loan modification or restructuring agree-
and internal controls by performing the ments to identify loans where interest or
remaining examination procedures in this principal is not being collected according
section. Also, obtain a listing of any defi- to the terms of the original loan. Exam-
ciencies noted in the latest internal/external ples include reduction of interest rate or
audit reviews and determine if appropriate principal payments, deferral of interest
corrections have been made. or principal payments, or renewal of a
4. Review management reports on the status loan with accrued interest rolled into the
of construction lending activity, economic principal.
developments in the market, and problem c. The commitment agreement—a buy/sell
loan reports. contract or the tri-party agreement—
5. Evaluate the bank with respect to— from the extended-term or permanent
a. the adequacy of written policies and lender for the takeout loan.
procedures relating to construction d. Cash-flow projections and any revisions
lending. to projections based on cost estimates
b. operating compliance with established from change orders.
bank policy. e. Estimates of the time and cost to com-
c. favorable or adverse trends in construc- plete construction.
tion lending activity. f. Inspection reports and evaluations of the
d. the accuracy and completeness of the cost to complete, construction deadlines,
bank’s records. and quality of construction.
e. the adequacy of internal controls, includ- g. Construction draw schedules and audits
ing control of construction draws. for compliance with the schedules.
f. the adherence of lending staff to lending h. Documentation on payment of insurance
policies, procedures, and authority as and property taxes.
well as the bank’s adherence to the i. Terms of a completion or performance
holding company’s loan limits, if bond.
applicable. j. Past-due/nonaccrual–related information.
g. compliance with laws, regulations, and k. Loan-specific internal problem credit
Federal Reserve policy on construction analyses information.
lending activity, including supervisory l. Loans to insiders and their interests.
loan-to-value (LTV) limits and restric- m. Loans classified during the preceding
tions; loans to officers, directors, and examination.
shareholders; appraisal and evaluation of 7. In analyzing the selected construction loans,
real estate collateral; and prudent lending the examiner should consider the following
practices. procedures, taking appropriate action if
6. Select loans for examination, using an necessary:

Page 1
2100.3 Real Estate Construction Loans: Examination Procedures
a. Determine the primary source of repay- j. Determine whether the loan was classi-
ment and evaluate its adequacy, includ- fied during the preceding examination,
ing whether— and, if the loan has been paid off, whether
• the permanent lender has the financial all or part of the funds for repayment
resources to meet its commitment. came from another loan at the bank or
• the amount of the construction loan from the repossession of the property.
and its estimated completion date cor- 8. In connection with the examination of other
respond to the amount and expiration lending activity in the bank, the examiner
date of the takeout commitment and/or should—
completion bond. a. check the central liability file on the
• the permanent lender and/or the bond- borrower(s) and determine whether the
ing company have approved any mod- total construction lending activity
ifications to the original agreement. exceeds the lending limit to a single
• properties securing construction loans borrower.
that are not supported by a takeout b. obtain information and related perfor-
commitment will be marketable upon mance status on common borrowers and
completion. their interests from examiners assigned
b. Analyze secondary support afforded by to other examination areas (such as non–
guarantors and partners. real estate loans, leasing, overdrafts, and
c. Relate collateral values to outstanding cash items) and determine the total in-
debt by— debtedness of the borrower to the bank.
assessing the adequacy of the appraisal Additionally, one examiner should be
and evaluation. assigned to review the borrower’s over-
• ascertaining whether inspection re- all borrowing relationship with the bank.
ports support disbursements to date. c. perform appropriate procedural steps as
• determining whether the amount of outlined in the Concentration of Credits
undisbursed loan funds is sufficient to section of this manual. Interim construc-
complete the project. tion loans that do not have firm perma-
• establishing whether title records nent takeout commitments are to be
assure the primacy of the bank’s liens. treated as concentrations of credit.
• determining if adequate hazard, build- 9. Consult with the examiner responsible for
er’s risks, and worker’s compensation the asset/liability management analysis por-
insurance is maintained. tion of the examination to determine the
d. Determine whether the loan’s loan-to- appropriate maturity breakdown of construc-
value (LTV) ratio is in excess of the tion loans needed for the analysis and pre-
supervisory LTV limits. If so, ascertain pare the necessary schedules.
whether the loan has been properly 10. Summarize the findings of the construction
reported as a nonconforming loan. loan portfolio review and address—
e. Ascertain whether the loan complies with
a. the scope of the examination.
established bank policy.
f. Identify any deficiencies in the loan’s b. the quality of the policies, procedures,
documentation in both the credit files and controls.
and the collateral records. c. the general level of adherence to policies
g. Identify whether the loan is to an officer, and procedures.
director, or shareholder of the bank or a d. the competency of management.
correspondent bank and whether an offi- e. the quality of the loan portfolio.
cer, director, or shareholder of the bank f. loans not supported by current and com-
is a guarantor on the loan. plete financial information.
h. Review the borrower’s compliance with g. loans with incomplete documentation,
the provisions of the loan agreement, addressing deficiencies related to items
indicating whether the loan is in default such as appraisals or evaluations, feasi-
or in past-due status. bility studies, the environmental impact
i. Determine if there are any problems that study, takeout commitment, title policy,
may jeopardize the repayment of the construction plans, inspection reports,
construction loan. change orders, proof of payment for

Page 2
Real Estate Construction Loans: Examination Procedures 2100.3
insurance and taxes, deeds of trust, and l. concentrations of credits.

mortgage notes. m. classified loans.
h. the adequacy of control over construc- n. violations of laws, regulations, and Fed-
tion draws and advances. eral Reserve policy.
i. loans to officers, directors, shareholders, o. action taken by management to correct
or their interests. previously noted deficiencies and correc-
j. causes of existing problems. tive actions recommended to manage-
k. delinquent loans and the aggregate amount ment at this examination, with the bank’s
of statutory bad debts. Refer to the man- response to such recommendations.
ual section on classification of credits for
a discussion on statutory bad debts or A
Paper.

Page 3
Review the bank’s internal controls, policies, l. require agreements by borrowers for
practices, and procedures for making and ser- completion of improvements according
vicing real estate construction loans. The bank’s to approved construction specifications,
system should be documented completely and and cost and time limitations?
concisely and should include, where appropriate, 2. Are construction lending policies and
narrative descriptions, flow charts, copies of objectives appropriate to the size and
forms used, and other pertinent information. sophistication of the bank, and are they
Negative responses to the questions in this compatible with changing market conditions?
section should be explained, and additional 3. Has the board of directors adopted, and
procedures deemed necessary should be dis- does it periodically review, policies and
cussed with the examiner-in-charge. Items procedures that establish and maintain an
marked with an asterisk require substantiation effective, independent real estate appraisal
by observation or testing. and evaluation program for the entire bank’s
lending functions? (The real estate lending
functions include commercial real estate
mortgage departments, capital-market
POLICIES AND OBJECTIVES groups, and asset-securitization and -sales
units.)
*1. Has the board of directors and management,
consistent with their duties and
responsibilities, adopted and, at least
annually, reviewed and approved written
construction lending policies that— REVIEWING LOAN
a. outline construction lending objectives APPLICATIONS
regarding—
• the aggregate limit for construction 1. Does bank policy require a personal guar-
loans? antee from the borrower on construction
• concentrations of credit in particular loans?
types of construction projects? 2. Does bank policy require personal comple-
b. establish minimum standards for tion guarantees by the property owner
documentation? and/or the contractor?
c. define qualified collateral and minimum 3. Does the bank require a construction bor-
margin requirements? rower to contribute equity to a proposed
d. define the minimum equity requirement project in the form of money or real estate?
for a project? If so, indicate which form of equity.
e. define loan-to-value (LTV) limits that are 4. Does the project budget include the amount
consistent with supervisory LTV limits? and source of the builder’s and/or owner’s
f. require an appraisal or evaluation that equity contribution?
complies with the Federal Reserve 5. Does the bank require—
real estate appraisal regulation and a. background information on the bor-
guidelines? rower’s, contractor’s, and major subcon-
g. d e l i n e a t e s t a n d a r d s f o r t a k e o u t tractors’ development and construction
commitments? experience, as well as other projects
h. i n d i c a t e c o m p l e t i o n b o n d i n g currently under construction?
requirements? b. payment-history information from sup-
i. establish procedures for reviewing con- pliers and trade creditors on the afore-
struction loan applications? mentioned’s previous projects?
j. detail methods for disbursing loan c. credit reports?
proceeds? d. detailed current and historical financial
k. detail project-inspection requirements and statements, including cash flow–related
progress-reporting procedures? information?

Page 1
2100.4 Real Estate Construction Loans: Internal Control Questionnaire
6. Do the borrower’s project-cost estimates 5. Does the construction loan agreement

include— require that—
a. land and construction costs? a. the contractor not start work until autho-
b. off-site improvement expenses? rized to do so by the bank?
c. soft costs, such as organizational and b. on-site inspections be permitted by the
administrative costs, and architectural, lending officer or an agent of the bank
engineering, and legal fees? without prior notice?
d. interest, taxes, and insurance expenses? c. disbursement of funds be made as work
7. Does the bank require an estimated cost progresses, supported by documenta-
breakdown for each stage of construction? tion that the subcontractors are receiv-
8. Does the bank require that cost estimates of ing payment and that the appropriate
more complicated projects be reviewed by liens are being released?
qualified personnel: experienced in-house d. the bank be allowed to withhold dis-
staff, an architect, a construction engineer, bursements if work is not performed
or an independent estimator? according to approved specifications?
9. Are commitment fees required on approved e. a percentage of the loan proceeds be
construction loans? retained pending satisfactory comple-
tion of the construction?
f. the lender be allowed to assume prompt
and complete control of the project in
CONSTRUCTION LOAN the event of default? If a commercial
AGREEMENTS project, are the leases assignable to the
bank?
1. Is the construction loan agreement signed g. the contractor carry builder’s risk and
before an actual loan disbursement is made? workers’ compensation insurance? If
*2. Is the construction loan agreement reviewed so, has the bank been named as mort-
by counsel and other experts to determine gagee or loss payee on the builder’s risk
that improvement specifications conform policy?
to— h. periodic increases in the project’s value
a. building codes? be reported to the builder’s risk and title
b. subdivision regulations? insurance companies?
c. zoning and ordinances? 6. Does the construction loan agreement
d. title and/or ground lease restrictions? for residential tract construction loans
e. health and handicap access regulations? require—
f. known or projected environmental pro- a. bank authorization for individual tract-
tection considerations? housing starts?
g. specifications required under the b. that periodic sales reports be submitted
National Flood Insurance Program? to the bank?
h. provisions in tenant leases? c. that periodic reports on tract houses
i. specifications approved by the perma- occupied under a rental, lease, or
nent lender? purchase-option agreement be submit-
j. specifications required by the completed to the bank?
tion or performance bonding company d. limitations on the number of specula-
and/or guarantors? tive houses and the completion of one
*3. Does the bank require all change orders to tract before beginning another?
be approved in writing by the—
a. bank?
b. bank’s counsel? COLLATERAL
c. permanent lender?
d. architect or supervising engineer? 1. Are liens filed on non–real estate construc-
e. prime tenants bound by firm leases or tion improvements, i.e., personal property
letters of intent to lease? that is movable from the project?
f. completion bonding company? 2. When entering into construction loans, does
4. Does the construction loan agreement set a the bank, consistent with supervisory loan-
date for project completion? to-value limits—

Page 2
Real Estate Construction Loans: Internal Control Questionnaire 2100.4
a. limit the loan amount to a reasonable c. authorized in writing by the contractor,

percentage of the appraised value of the borrower, inspector, subcontractors,
project when there is no prearranged and/or lending officer?
permanent financing? d. reviewed by a bank employee who had
b. limit the loan amount to a percentage of no part in granting the loan?
the appraised value of the completed e. compared with original cost estimates?
project when subject to the bank’s own f. checked against previous disburse-
takeout commitment? ments?
c. limit the loan amount to the floor of a g. made directly to subcontractors and
takeout commitment that is based upon suppliers?
achieving a certain level of rents or h. supported by invoices describing the
lease occupancy? work performed and the materials
3. Are unsecured credit lines to contractors or furnished?
developers, who are also being financed by 2. Does the bank obtain waivers of subcon-
secured construction loans, supervised by tractor’s and mechanic’s liens as work is
the construction loan department or the completed and disbursements are made?
officer supervising the construction loan? 3. Does the bank obtain sworn and notarized
4. Does the bank have adequate procedures to releases of mechanic’s liens from the gen-
determine whether construction appraisal or eral contractor at the time construction is
evaluation policies and procedures are con- completed and before final disbursement is
sistently being followed in conformance made?
with regulatory requirements, and that the 4. Does the bank periodically review undis-
appraisal or evaluation documentation sup- bursed loan proceeds to determine their
ports the value indicated in the conclusions? adequacy to complete the projects?
5. Are the borrower’s undisbursed loan pro-
ceeds and contingency or escrow accounts
independently verified at least monthly by
INSPECTIONS someone other than the individuals respon-
1. Are inspection authorities noted in the— sible for loan disbursements?
a. construction loan commitment?
b. construction loan agreement?
c. tri-party buy-and-sell agreement? TAKEOUT COMMITMENTS
d. takeout commitment?
1. Does counsel review takeout agreements
2. Are inspections conducted on an irregular
for acceptability?
basis?
2. Does the bank obtain and review the per-
3. Are inspection reports sufficiently detailed
manent lender’s financial statements
to support disbursements?
to determine the adequacy of its finan-
4. Are inspectors rotated from project to cial resources to fulfill the takeout
project? commitment?
5. Are spot checks made of the inspectors’ 3. Is a tri-party buy-and-sell agreement signed
work? before the construction loan is closed?
6. Do inspectors determine compliance with 4. Does the bank require takeout agreements
plans and specifications as well as the to include a force majeure—an act-of-God
progress of the work? If so, are the inspec- clause—that provides for an automatic
tors competent to make the determination? extension of the completion date in the
event that construction delays occur for
reasons beyond the builder’s control?
DISBURSEMENTS
*1. Are disbursements— COMPLETION BONDING
a. advanced on a prearranged disburse- REQUIREMENTS
ment plan?
b. made only after reviewing written 1. Does the bank require completion insurance
inspection reports? for all construction loans?

Page 3
2100.4 Real Estate Construction Loans: Internal Control Questionnaire
2. Has the bank established minimum finan- 3. Does the bank employ standardized check-
cial standards for borrowers who are not lists to control documentation for individual
required to obtain completion bonding? Are files, and does it perform audit reviews for
these standards observed in all cases? adequacy?
3. Does counsel review completion insurance 4. Does the documentation file indicate all of
bonds for acceptability? the borrower’s other loans and deposit
account relationships with the bank, and
include a summary of other construction
DOCUMENTATION projects being financed by other banks?
Does the bank analyze the status of these
1. Does the bank require and maintain docu- projects and the potential effect on the
mentary evidence of— borrower’s financial position?
a. the contractor’s payment of— 5. Does the bank use tickler files that—
• employee withholding taxes? a. control scheduling of inspections and
• builder’s risk insurance? disbursements?
• workers’ compensation insurance? b. ensure prompt administrative follow-up
• public liability insurance? on items sent for—
• completion insurance? • recording?
b. the property owner’s payment of real • an attorney’s opinion?
estate taxes? • an expert review?
2. Does the bank require that documentation 6. Does the bank maintain tickler files that
files include— provide advance notice (such as 30 days’
a. loan applications? prior notice) to staff of the expiration dates
b. financial statements for the— for—
• borrower? a. the takeout commitment?
• builder? b. hazard insurance?
• proposed prime tenant? c. workers’ compensation insurance?
• takeout lender? d. public liability insurance?
• guarantors/partners?
c. credit and trade checks on the—
• borrower? LOAN RECORDS
• builder?
• major subcontractor? *1. Are the preparation, addition, and posting
• proposed tenants? of subsidiary real estate construction loan
d. a copy of plans and specifications? records performed or adequately reviewed
e. a copy of the building permit? by persons who do not also—
f. a survey of the property? a. issue official checks or drafts?
g. the construction loan agreement? b. handle cash?
h. an appraisal or evaluation and feasibil- c. reconcile subsidiary records to general
ity study? ledger controls?
i. an up-to-date title search? *2. Are the subsidiary real estate construction
j. the mortgage? loan records reconciled at least monthly to
k. ground leases? the appropriate general ledger accounts?
l. assigned tenant leases or letters of Are reconciling items adequately investi-
intent to lease? gated by persons who do not also handle
m. a copy of the takeout commitment? cash or prepare/post subsidiary controls?
n. a copy of the borrower’s application to *3. Are loan statements, delinquent account-
the takeout lender? collection requests, and past-due notices
o. the tri-party buy-and-sell agreement? reconciled to the real estate construction
p. inspection reports? loan subsidiary records? Are the reconcili-
q. disbursement authorizations? ations handled by a person who does not
r. undisbursed loan proceeds and con- also handle cash?
tingency or escrow account 4. Are inquiries about construction loan bal-
reconcilements? ances received and investigated by persons
s. insurance policies? who do not also handle cash?

Page 4
Real Estate Construction Loans: Internal Control Questionnaire 2100.4
*5. Are documents supporting recorded credit adequately reviewed by persons who do not
adjustments subsequently checked or tested also—
by persons who do not also handle cash? a. issue official checks or drafts?
6. Is a delinquent-accounts report generated b. handle cash?
daily? 2. Are any independent interest and fee com-
7. Are loans in excess of supervisory LTV putations made and compared with or
limits identified in the bank’s records, and adequately tested to loan interest by persons
are the aggregate amounts of such loans who do not also—
reported at least quarterly to the board of a. issue official checks or drafts?
directors? b. handle cash?
8. Does the bank maintain a daily record
summarizing note transaction details (loans
made, payments received, and interest CONCLUSION
collected) to support applicable general led-
ger account entries? 1. Does the foregoing information provide an
9. Are note and liability trial balances fre- adequate basis for evaluating internal con-
quently reconciled to the general ledger by trol in that deficiencies in areas not covered
employees who do not process or record by this questionnaire do not significantly
loan transactions? impair any controls? Explain negative
answers briefly, and indicate any additional
examination procedures deemed necessary.
LOAN INTEREST AND 2. On the basis of a composite evaluation, are
COMMITMENT FEES internal controls adequate as evidenced by
answers to the foregoing questions?
*1. Are the preparation and posting of loan
interest and fee records performed or

Page 5
Concentrations in Commercial Real Estate Lending, Sound
Risk-Management Practices
This interagency supervisory guidance was the sale, refinancing, or permanent financing of
developed to reinforce sound risk-management the property. Loans to real estate investment
practices for institutions with high and increas- trusts and unsecured loans to developers also
ing concentrations of commercial real estate should be considered CRE loans for purposes of
loans on their balance sheets. The guidance, this guidance if their performance is closely
Concentrations in Commercial Real Estate linked to performance of the CRE markets. The
(CRE) Lending, Sound Risk-Management Prac- scope of the guidance does not include loans
tices (the guidance), was issued on December 6, secured by nonfarm nonresidential properties
2006 (effective on December 12, 2006).1 How- where the primary source of repayment is the
ever, institutions needing to improve their risk- cash flow from the ongoing operations and
management processes may have been provided activities conducted by the party, or affiliate of
the opportunity for some flexibility on the time the party, who owns the property. Rather than
frame for complying with the guidance. This defining a CRE concentration, the guidance’s
time frame will be commensurate with the level ‘‘Supervisory Oversight’’ section describes the
and nature of CRE concentration risk, the qual- criteria that the Federal Reserve will use as
ity of the institution’s existing risk-management high-level indicators to identify banks
practices, and its levels of capital. (See 71 Fed. potentially exposed to CRE concentration risk.
Reg. 74,580 [December 12, 2006], the Federal
Reserve Board’s press release dated December
6, 2006, and SR-07-01 and its attachments.)
CRE CONCENTRATION
ASSESSMENTS
SCOPE OF THE CRE
CONCENTRATION GUIDANCE Banks that are actively involved in CRE lending
should perform ongoing risk assessments to
The guidance focuses on those CRE loans for identify CRE concentrations. The risk assess-
which the cash flow from the real estate is the ment should identify potential concentrations by
primary source of repayment rather than loans stratifying the CRE portfolio into segments that
to a borrower for which real estate collateral is have common risk characteristics or sensitivities
taken as a secondary source of repayment or to economic, financial, or business develop-
through an abundance of caution. For the ments. A bank’s CRE portfolio stratification
purposes of this guidance, CRE loans include should be reasonable and supportable. The CRE
those loans with risk profiles sensitive to the portfolio should not be divided into multiple
condition of the general CRE market (for segments simply to avoid the appearance of
example, market demand, changes in capitaliza- concentration risk.
tion rates, vacancy rates, or rents). CRE loans The Federal Reserve recognizes that risk
are land development and construction loans characteristics vary among CRE loans secured
(including one- to four-family residential and by different property types. A manageable level
commercial construction loans) and other land of CRE concentration risk will vary by bank
loans. CRE loans also include loans secured by depending on the portfolio risk characteristics,
multifamily property, and nonfarm the quality of risk-management processes, and
nonresidential property where the primary capital levels. Therefore, the guidance does not
source of repayment is derived from rental establish a CRE concentration limit that applies
income associated with the property (that is, to all banks. Rather, banks are encouraged to
loans for which 50 percent or more of the identify and monitor credit concentrations and
source of repayment comes from third-party, to establish internal concentration limits, and all
nonaffiliated, rental income) or the proceeds of concentrations should be reported to senior man-
agement and the board of directors on a periodic
1. The guidance was jointly adopted by the Board of
Governors of the Federal Reserve System, the Office of the
basis. Depending on the results of the risk
Comptroller of the Currency, and the Federal Deposit Insur- assessment, the bank may need to enhance its
ance Corporation. risk-management systems.

Page 1
2103.1 Concentrations in Commercial Real Estate Lending, Sound Risk-Management Practices
CRE RISK MANAGEMENT 4. periodically review and approve CRE risk

exposure limits and appropriate sublimits
The sophistication of a bank’s CRE risk- (for example, by nature of concentration) to
management processes should be appropriate to conform to any changes in the bank’s strat-
the size of the portfolio, as well as the level and egies and to respond to changes in market
nature of concentrations and the associated risk conditions.
to the bank. Banks should address the following
key elements in establishing a risk-management
framework that effectively identifies, monitors, CRE Portfolio Management
and controls CRE concentration risk:
Banks with CRE concentrations should manage
1. board and management oversight not only the risk of individual loans but also
2. portfolio management portfolio risk. Even when individual CRE loans
3. management information systems are prudently underwritten, concentrations of
4. market analysis loans that are similarly affected by cyclical
5. credit underwriting standards changes in the CRE market can expose a bank to
6. portfolio stress testing and sensitivity analysis an unacceptable level of risk if not properly
7. credit risk review function managed. Management regularly should evalu-
ate the degree of correlation between related real
estate sectors and establish internal lending
guidelines and concentration limits that control
Board and Management Oversight of the bank’s overall risk exposure.
CRE Concentration Risk Management should develop appropriate strat-
egies for managing CRE concentration levels,
A bank’s board of directors has ultimate respon- including a contingency plan to reduce or miti-
sibility for the level of risk assumed by the bank. gate concentrations in the event of adverse CRE
If the bank has significant CRE concentration market conditions. Loan participations, whole
risk, its strategic plan should address the ratio- loan sales, and securitizations are a few examples
nale for its CRE levels in relation to its overall of strategies for actively managing concentra-
growth objectives, financial targets, and capital tion levels without curtailing new originations.
plan. In addition, the Federal Reserve’s real If the contingency plan includes selling or secu-
estate lending regulations require that each bank ritizing CRE loans, management should assess
adopt and maintain a written policy that estab- periodically the marketability of the portfolio.
lishes appropriate limits and standards for all This should include an evaluation of the bank’s
extensions of credit that are secured by liens on ability to access the secondary market and a
or interests in real estate, including CRE loans. comparison of its underwriting standards with
Therefore, the board of directors or a designated those that exist in the secondary market.
committee thereof should—
1. establish policy guidelines and approve an CRE Management Information

overall CRE lending strategy regarding the Systems
level and nature of CRE exposures accept-
able to the bank, including any specific A strong management information system (MIS)
commitments to particular borrowers or prop- is key to effective portfolio management. The
erty types, such as multifamily housing; sophistication of the MIS will necessarily vary
2. ensure that management implements proce- with the size and complexity of the CRE port-
dures and controls to effectively adhere to folio and level and nature of concentration risk.
and monitor compliance with the bank’s The MIS should provide management with suf-
lending policies and strategies; ficient information to identify, measure, moni-
3. review information that identifies and quan- tor, and manage CRE concentration risk. This
tifies the nature and level of risk presented by includes meaningful information on CRE port-
CRE concentrations, including reports that folio characteristics that is relevant to the bank’s
describe changes in CRE market conditions lending strategy, underwriting standards, and
in which the bank lends; and risk tolerances. A bank should assess periodi-

Page 2
Concentrations in Commercial Real Estate Lending, Sound Risk-Management Practices 2103.1
cally the adequacy of the MIS in light of growth access to fewer sources of detailed market data
in CRE loans and changes in the CRE portfo- than a bank operating in large, metropolitan
lio’s size, risk profile, and complexity. markets, a bank should be able to demonstrate
Banks are encouraged to stratify the CRE that it has an understanding of the economic and
portfolio by property type, geographic market, business factors influencing its lending markets.
tenant concentrations, tenant industries, devel-
oper concentrations, and risk rating. Other use-
ful stratifications may include loan structure (for Credit Underwriting Standards
example, fixed-rate or adjustable), loan purpose
(for example, construction, short-term, or per- A bank’s lending policies should reflect the
manent), loan-to-value (LTV) limits, debt ser- level of risk that is acceptable to its board of
vice coverage, policy exceptions on newly under- directors and should provide clear and measur-
written credit facilities, and affiliated loans (for able underwriting standards that enable the
example, loans to tenants). A bank should also bank’s lending staff to evaluate all relevant
be able to identify and aggregate exposures to a credit factors. When a bank has a CRE concen-
borrower, including its credit exposure relating tration, the establishment of sound lending poli-
to derivatives. cies becomes even more critical. In establishing
Management reporting should be timely and its policies, a bank should consider both internal
in a format that clearly indicates changes in the and external factors, such as its market position,
portfolio’s risk profile, including risk-rating historical experience, present and prospective
migrations. In addition, management reporting trade area, probable future loan and funding
should include a well-defined process through trends, staff capabilities, and technology
which management reviews and evaluates con- resources. Consistent with the Federal Reserve’s
centration and risk-management reports, as well real estate lending guidelines, CRE lending
as special ad hoc analyses in response to poten- policies should address the following underwrit-
tial market events that could affect the CRE loan ing standards:
portfolio.
1. maximum loan amount by type of property
2. loan terms
3. pricing structures
Market Analysis 4. collateral valuation2
5. LTV limits by property type
Market analysis should provide the bank’s man-
6. requirements for feasibility studies and sen-
agement and board of directors with information
sitivity analysis or stress testing
to assess whether its CRE lending strategy and
7. minimum requirements for initial investment
policies continue to be appropriate in light of
and maintenance of hard equity by the
changes in CRE market conditions. A bank
borrower
should perform periodic market analyses for the
8. minimum standards for borrower net worth,
various property types and geographic markets
property cash flow, and debt service cover-
represented in its portfolio.
age for the property
Market analysis is particularly important as a
bank considers decisions about entering new A bank’s lending policies should permit
markets, pursuing new lending activities, or exceptions to underwriting standards only on a
expanding in existing markets. Market informa- limited basis. When a bank does permit an
tion also may be useful for developing sensitiv- exception, it should document how the transac-
ity analysis or stress tests to assess portfolio risk. tion does not conform to the bank’s policy or
Sources of market information may include underwriting standards, obtain appropriate man-
published research data, real estate appraisers agement approvals, and provide reports to the
and agents, information maintained by the prop- board of directors or designated committee
erty taxing authority, local contractors, builders, detailing the number, nature, justifications, and
investors, and community development groups. trends for exceptions. Exceptions to both the
The sophistication of a bank’s analysis will vary bank’s internal lending standards and the Fed-
by its market share and exposure, as well as the
availability of market data. While a bank oper- 2. Refer to the Federal Reserve’s appraisal regulations: 12
ating in nonmetropolitan markets may have CFR 208 subpart E and 12 CFR 225, subpart G.

Page 3
2103.1 Concentrations in Commercial Real Estate Lending, Sound Risk-Management Practices
eral Reserve’s supervisory LTV limits3 should Credit Risk Review Function
be monitored and reported on a regular basis.
Further, banks would analyze trends in excep- A strong credit risk review function is critical
tions to ensure that risk remains within the for a bank’s self-assessment of emerging risks.
bank’s established risk tolerance limits. An effective, accurate, and timely risk-rating
Credit analysis should reflect both the borrow- system provides a foundation for the bank’s
er’s overall creditworthiness and project-specific credit risk review function to assess credit
considerations as appropriate. In addition, for quality and, ultimately, to identify problem
development and construction loans, the bank loans. Risk ratings should be risk sensitive,
should have policies and procedures governing objective, and appropriate for the types of CRE
loan disbursements to ensure that the bank’s loans underwritten by the bank. Further, risk
minimum borrower equity requirements are ratings should be reviewed regularly for
maintained throughout the development and con- appropriateness.
struction periods. Prudent controls should include
an inspection process, documentation on con-
struction progress, tracking pre-sold units, pre-
leasing activity, and exception monitoring and
SUPERVISORY OVERSIGHT OF
reporting. CRE CONCENTRATION RISK
As part of its ongoing supervisory monitoring
processes, the Federal Reserve will use certain
CRE Portfolio Stress Testing and criteria to identify banks that are potentially
Sensitivity Analysis exposed to significant CRE concentration risk.
A bank that has experienced rapid growth in
A bank with CRE concentrations should per- CRE lending, has notable exposure to a specific
form portfolio-level stress tests or sensitivity type of CRE, or is approaching or exceeds the
analysis to quantify the impact of changing following supervisory criteria may be identified
economic conditions on asset quality, earnings, for further supervisory analysis of the level and
and capital. Further, a bank should consider the nature of its CRE concentration risk:
sensitivity of portfolio segments with common
risk characteristics to potential market condi- 1. total reported loans for construction, land
tions. The sophistication of stress testing prac- development, and other land4 represent
tices and sensitivity analysis should be consis- 100 percent or more of the bank’s total
tent with the size, complexity, and risk capital5 or
characteristics of the CRE loan portfolio. For 2. total commercial real estate loans as defined
example, well-margined and seasoned perform- in this guidance6 represent 300 percent or
ing loans on multifamily housing normally would more of the bank’s total capital, and the
require significantly less robust stress testing outstanding balance of the bank’s commer-
than most acquisition, development, and con- cial real estate loan portfolio has increased by
struction loans. 50 percent or more during the prior 36 months.
Portfolio stress testing and sensitivity analysis
may not necessarily require the use of a sophis- The Federal Reserve will use the criteria as a
ticated portfolio model. Depending on the risk preliminary step to identify banks that may
characteristics of the CRE portfolio, stress test- have CRE concentration risk. Because regula-
ing may be as simple as analyzing the potential tory reports capture a broad range of CRE
effect of stressed loss rates on the CRE portfo- loans with varying risk characteristics, the
lio, capital, and earnings. The analysis should
focus on the more vulnerable segments of a
bank’s CRE portfolio, taking into consideration 4. For commercial banks as reported in the Call Report
the prevailing market environment and the FFIEC 031 and 041, schedule RC-C, item 1a.
bank’s business strategy. 5. For purposes of this guidance, the term total capital
means the total risk-based capital as reported for commercial
banks in the Call Report FFIEC 031 and 041 schedule RC-
3. The Interagency Guidelines for Real Estate Lending R—Regulatory Capital, line 21.
state that loans exceeding the supervisory LTV guidelines 6. For commercial banks as reported in the Call Report
should be recorded in the bank’s records and reported to the FFIEC 031 and 041 schedule RC-C, items 1a, 1d, 1e, and
board at least quarterly. memorandum item 3.

Page 4
Concentrations in Commercial Real Estate Lending, Sound Risk-Management Practices 2103.1
supervisory monitoring criteria do not consti- 5. portfolio liquidity (ability to sell or securitize
tute limits on a bank’s lending activity but exposures on the secondary market)
rather serve as high-level indicators to identify
banks potentially exposed to CRE concentra- While consideration of these factors should
tion risk. Nor do the criteria constitute a ‘‘safe not change the method of identifying a credit
harbor’’ for banks if other risk indicators are concentration, these factors may mitigate the
present, regardless of their measurements under risk posed by the concentration.
(1) and (2).
Evaluation of CRE Concentrations Assessment of Capital Adequacy for

CRE Concentration Risk
The effectiveness of a bank’s risk-management
practices will be a key component of the super- The Federal Reserve’s existing capital adequacy
visory evaluation of the bank’s CRE concentra- guidelines note that a bank should hold capital
tions. Examiners will engage in a dialogue with commensurate with the level and nature of the
the bank’s management to assess CRE exposure risks to which it is exposed. Accordingly, banks
levels and risk-management practices. Banks with CRE concentrations are reminded that their
that have experienced recent, significant growth capital levels should be commensurate with the
in CRE lending will receive closer supervisory risk profile of their CRE portfolios. In assessing
review than those that have demonstrated a the adequacy of a bank’s capital, the Federal
successful track record of managing the risks in Reserve will consider the level and nature of
CRE concentrations. inherent risk in the CRE portfolio as well as
In evaluating CRE concentrations, the Fed- management expertise, historical performance,
eral Reserve will consider the bank’s own analy- underwriting standards, risk-management prac-
sis of its CRE portfolio, including consideration tices, market conditions, and any loan loss
of factors such as— reserves allocated for CRE concentration risk. A
bank with inadequate capital to serve as a buffer
1. portfolio diversification across property types against unexpected losses from a CRE concen-
2. geographic dispersion of CRE loans tration should develop a plan for reducing its
3. underwriting standards CRE concentrations or for maintaining capital
4. level of pre-sold units or other types of appropriate to the level and nature of its CRE
take-out commitments on construction loans concentration risk.

Page 5
Concentrations in Commercial Real Estate Lending,
Sound Risk-Management Practices
When a bank has significant commercial real used to identify, measure, and manage the
estate (CRE) credit concentrations, the inspec- bank’s CRE concentration risk.
tion objectives are as follows: d. To verify whether the bank’s market analy-
ses provide the bank’s management and
1. To determine if the bank’s risk-management board of directors with sufficient informa-
practices and capital levels are commensu- tion to assess whether the bank’s CRE
rate with the level and nature of its CRE lending strategy and policies continue to
concentration risk. be appropriate in light of its changing
2. To ascertain if the bank performs ongoing CRE market conditions.
risk assessments to identify its CRE 4. To determine if the bank’s CRE lending
concentrations. policies reflect the level of credit risk that is
3. To evaluate whether the bank’s CRE risk- acceptable to its board of directors.
management processes are appropriate for a. To evaluate whether the lending policies
the size of its CRE loan portfolio, as well as provide clear and measurable underwrit-
for the level and nature of its concentrations ing standards.
and their associated risks to the bank. b. To assess whether the bank’s lending
a. To determine whether the bank’s strategic policies enable the bank’s lending staff to
plan addresses the rationale for its CRE evaluate all relevant credit factors.
credit concentration levels in relation to 5. To find out if the bank performs portfolio-
its overall growth objectives, financial level stress tests or sensitivity analyses in
targets, and capital plan. order to quantify the impact of changing
b. To evaluate whether the bank manages not economic conditions on asset quality, earn-
only the risk of individual loans but also ings, and capital.
its loan portfolio risks. 6. To determine if the bank has a strong credit-
c. To find out if the bank’s management review function that includes a self-
information system provides management assessment of its emerging credit and other
with sufficient information that can be risks.

Page 1
RISK MANAGEMENT outstanding balance of the bank’s CRE

loan portfolio has increased by 50 per-
Board and Senior Management cent or more during the prior 36 months.
Oversight
1. Determine if the board of directors or its Portfolio Management
designated committee has—
a. established policy guidelines and 4. Ascertain whether the bank manages not
approved an overall commercial real only the risk from individual loans but also
estate (CRE) lending strategy on the portfolio risk. Find out if management—
level and nature of the bank’s CRE a. regularly (1) evaluates the degree of
exposures, including any specific com- correlation between related real estate
mitments to particular borrowers or prop- sectors and (2) establishes internal lend-
erty types, such as multifamily housing; ing guidelines and concentration limits
b. ensured that management implements that control the bank’s overall risk expo-
procedures and controls to effectively sure; and
adhere to and monitor compliance with b. develops appropriate strategies for man-
the bank’s lending policies and strate- aging CRE concentration levels, includ-
gies; ing the development of a contingency
c. reviewed information that identifies and plan to reduce or mitigate concentrations
quantifies the nature and level of risk during adverse CRE market conditions
presented by CRE concentrations, includ- (such a plan may include strategies
ing a review of reports that describe involving loan participations, whole loan
changes in the CRE market conditions in sales, and securitizations).
which the bank lends; and • Find out if the bank’s contingency plan
d. periodically reviewed and approved CRE includes selling or securitizing CRE
risk exposure limits and appropriate sub- loans.
limits (for example, by nature of concen- • Ascertain if management periodically
tration) to ensure they conform to any assesses the marketability of the CRE
changes in the bank’s strategies and portfolio and evaluates the bank’s abil-
respond to changes in market conditions. ity to access the secondary market.
• Verify whether the bank compares its
underwriting standards with those that
Supervisory Oversight exist in the secondary market.
2. Determine if the bank is (or is potentially)

exposed to significant CRE credit concen- Management Information Systems
tration risk.
3. If the bank has experienced rapid growth in 5. Evaluate whether management information
CRE lending or has notable exposure to a systems (MIS) provide sufficient informa-
specific type of CRE, or if the bank is tion to identify, measure, monitor, and man-
approaching or exceeds one or both of the age CRE concentration risk (MIS should
following criteria, perform a preliminary include information on CRE portfolio char-
analysis of the bank’s CRE concentration acteristics that are consistent with and rel-
risk: evant to the bank’s lending strategy, under-
a. Total loans for construction, land devel- writing standards, and risk tolerances).
opment, and other land represent 100 per- 6. Verify that management reporting is timely
cent or more of the bank’s total capital. and in a format that clearly indicates changes
b. Total CRE loans represent 300 percent or in the portfolio’s risk profile, including
more of the bank’s total capital, and the risk-rating migrations.

Page 1
2103.3 Concentrations in Commercial Real Estate Lending: Examination Procedures
Market Analysis 11. Verify that exceptions to both the bank’s

internal lending standards and the Federal
7. Determine if management reporting includes Reserve’s supervisory LTV limits are moni-
a well-defined process through which man- tored and reported on a regular basis.
agement reviews and evaluates concentra- 12. Find out if the bank analyzes trends in its
tion and risk-management reports, as well CRE lending exceptions in order to ensure
as special ad hoc analyses that are prepared that credit-underwriting risk remains within
in response to potential market events that its established risk-tolerance limits.
could affect the CRE loan portfolio. 13. Evaluate whether the bank’s credit analyses
8. Find out if the bank’s market analysis reflect both the borrowers’ overall credit-
provides management and the board of worthiness and project-specific consider-
directors with sufficient information to assess ations, as appropriate.
(1) the bank’s CRE lending strategy and 14. For the bank’s development and construc-
policies and (2) whether they continue to be tion loans, determine if—
appropriate in light of changes in CRE
a. the bank has policies and procedures
market conditions.
governing loan disbursements in order to
ensure that the bank’s requirements for
minimum borrower equity are main-
Credit-Underwriting Standards tained throughout the development and
9. Determine if CRE lending policies include construction periods; and
the following underwriting standards: b. prudent controls, including the follow-
a. maximum loan amount by type of ing, are in place:
property • an inspection process
b. loan terms • documentation of construction progress
c. pricing structures • tracking of pre-sold units
d. collateral valuation • pre-leasing activity
e. loan-to-value (LTV) limits by property
• exception monitoring and reporting
type
f. requirements for feasibility studies and
sensitivity analyses or stress testing
g. minimum requirements for initial invest- Portfolio Stress Testing and
ment and maintenance of hard equity by Sensitivity Analysis
the borrower
h. minimum standards for borrower net
worth, property cash flow, and debt- 15. When the bank has CRE concentrations,
service coverage for the property determine if it performs portfolio-level
10. Review the bank’s permitted exceptions to stress tests or sensitivity analyses in order
its underwriting standards. Ascertain if the to quantify the impact of changing
exceptions— economic conditions on asset quality, earn-
a. have been granted on a limited basis ings, and capital.
only; and a. Ascertain if the bank considers the sen-
b. are supported by documentation and sitivity of portfolio segments with com-
reports to management and the board of mon risk characteristics to potential mar-
directors or a designated committee. The ket conditions.
documentation and reports should b. Determine whether the sophistication of
indicate— the bank’s stress-testing practices and
• how the transactions did not conform sensitivity analyses are consistent with
to the bank’s policy or underwriting the size, complexity, and risk character-
standards; istics of its CRE loan portfolio.
• whether appropriate management c. Evaluate whether the bank’s sensitivity
approvals were obtained; and analyses focus on the more vulnerable
• the details of the number and nature of segments of its CRE portfolio, consider-
and the justifications and trends for the ing its prevailing market environment
exceptions. and business strategy.

Page 2
Concentrations in Commercial Real Estate Lending: Examination Procedures 2103.3
Credit-Review Function d. the level of pre-sold units or other types

of take-out commitments on construction
16. Find out if the bank has a credit-review loans
function, and if it is supported by a credit- e. portfolio liquidity (the ability to sell or
risk rating system that is used to assess securitize exposures on the secondary
credit quality and identify problem loans. market)
17. Determine if (1) the bank’s risk ratings are
risk-sensitive, objective, and appropriate for
the types of CRE loans underwritten and Assessment of Capital Adequacy
(2) the risk ratings are regularly reviewed.
2. Evaluate whether the bank’s holds capital
commensurate with the risk profile of its
EVALUATION OF CRE portfolios. Consider the level and
CRE CONCENTRATIONS nature of inherent risk in the bank’s CRE
portfolio, as well as management expertise,
1. Engage in a dialogue with bank manage- historical performance, underwriting stan-
ment in order to assess the bank’s CRE dards, risk-management practices, market
exposure levels and risk-management prac- conditions, and any loan-loss reserves allo-
tices. If the bank has experienced recent, cated for CRE concentration risk.
significant growth in CRE lending, perform 3. If a bank has inadequate capital to serve as
an expanded review of the bank’s risk in a buffer against unexpected losses from its
CRE concentrations, including a review of CRE concentration, reach agreement with
the bank’s analysis of its CRE concentra- the bank’s senior management and board of
tions. Consider factors such as— directors on the development of a plan to
a. portfolio diversification across property reduce the bank’s CRE concentrations or to
types maintain capital that is appropriate and
b. the geographic dispersion of CRE loans commensurate with the level and nature of
c. underwriting standards the bank’s CRE concentration risk.

Page 3
CRE CONCENTRATION mitments to particular borrowers or

ASSESSMENTS property types, such as multifamily
housing?
1. Are ongoing risk assessments performed to b. ensured that the bank’s management
identify commercial real estate (CRE) implements procedures and controls to
concentrations? effectively adhere to and monitor com-
2. Are CRE concentration limits established pliance with the bank’s lending policies
and monitored? and strategies?
3. Is the CRE portfolio stratified into reason- c. reviewed information that identifies and
able and supportable segments that have quantifies the nature and level of risk
common risk characteristics or sensitivities presented by CRE concentrations, includ-
to economic, financial, or business ing a review of reports that describe
developments? changes in the conditions of the CRE
4. Are all CRE concentrations reported to market in which the bank lends?
senior management and the board of direc- d. periodically reviewed and approved
tors on a periodic basis? CRE risk exposure limits and appropri-
ate sublimits (for example, by nature of
concentration) in order to conform to
any changes in the bank’s strategies and
RISK MANAGEMENT respond to changes in market
conditions?
1. Has a risk-management framework been
established that effectively identifies, moni-
tors, and controls CRE concentration risk?
If such a framework has been established, Portfolio Management
does it address—
a. board and management oversight? 4. Does the bank’s management regularly per-
form an analysis of its CRE portfolio, con-
b. portfolio management?
sidering factors such as—
c. management information systems?
a. portfolio diversification across property
d. market analysis?
types?
e. credit-underwriting standards?
b. the geographic dispersion of CRE loans?
f. portfolio stress testing and sensitivity
c. underwriting standards?
analysis?
d. the level of pre-sold units or other types
g. the credit-risk review function?
of take-out commitments on construction
loans?
e. portfolio liquidity (the ability to sell or
Board and Management Oversight securitize exposures on the secondary
market)?
2. If the bank has significant CRE concentra- 5. Has the bank’s board of directors and senior
tion risk, does it have a strategic plan that management—
addresses the rationale for its CRE concen- a. (1) regularly evaluated the degree of
tration levels in relation to the bank’s over- correlation between related real estate
all growth objectives, financial targets, and sectors and (2) established internal lend-
capital plan? ing guidelines?
3. Has the board of directors or its designated b. established internal lending guidelines
committee— and concentration limits in order to con-
a. established policy guidelines and trol the bank’s overall risk exposure?
approved an overall CRE lending c. developed appropriate strategies to man-
strategy for the level and nature of CRE age CRE concentration levels?
exposures, including any specific com- 6. Has the bank’s management developed a

Page 1
2103.4 Concentrations in Commercial Real Estate Lending: Internal Control Questionnaire
contingency plan to reduce or mitigate CRE ment and maintenance of hard equity by
loan concentrations during adverse market the borrower?
conditions? If the bank’s contingency plan h. minimum standards for borrower net
includes selling or securitizing CRE loans, worth, property cash flow, and debt-
has management periodically assessed the service coverage for the property?
marketability of the portfolio? 14. Do the bank’s lending policies permit excep-
tions to its underwriting standards for CRE
concentrations on a limited basis only?
Management Information System 15. Are permitted exceptions documented; that
is, do the documented exceptions describe
7. Does the bank’s management information how the loan transaction does not conform
system (MIS) provide sufficient information to the bank’s lending policy or underwriting
to identify, monitor, and manage CRE con- standards?
centration risk? 16. Does management analyze trends in excep-
8. Is the bank’s CRE portfolio stratified by tions to ensure that the bank’s CRE concen-
property type, geographic market, tenant tration risk remains within established risk-
concentrations, tenant industries, developer tolerance limits?
concentrations, and risk rating? 17. Does the bank have policies and procedures
9. Does the bank’s MIS identify and aggregate governing loan disbursements in order to
exposures to a borrower, including its credit ensure that its minimum requirements for
exposure relating to derivatives? borrower equity are maintained throughout
10. Are the bank’s management reports timely development and construction periods?
and in a format that clearly indicates changes 18. Do the bank’s internal controls consist of an
in the portfolio’s risk profile? inspection process, documentation on con-
11. Does the bank’s management reporting struction progress, tracking of pre-sold units,
include a well-defined process whereby tracking of pre-leasing activity, and excep-
management reviews and evaluates CRE tion monitoring and reporting?
concentrations, risk-management reports,
and special ad hoc analyses prepared in
response to potential market events that
could affect the concentration risk in the
Portfolio Stress Testing and
bank’s CRE portfolio? Sensitivity Analysis
19. Are portfolio stress tests or sensitivity analy-
ses performed in order to quantify the
Credit-Underwriting Standards impact of changing economic conditions on
asset quality, earnings, and capital?
12. Are underwriting standards clear and mea- 20. If performed, are portfolio stress tests or
surable, and do they enable the bank’s sensitivity analyses required to focus on the
lending staff to evaluate relevant credit more vulnerable segments of the bank’s
factors? CRE portfolio? Do they take into consider-
13. Do the bank’s CRE lending policies address ation the prevailing market environment
the following underwriting standards— and the bank’s business strategy?
a. maximum loan amount by type of
property?
b. loan terms?
c. pricing structures? Credit-Review Function
d. collateral valuation?
e. loan-to-value (LTV) limits by property 21. Does the bank have an effective, accurate,
type? and timely risk-rating system that supports
f. requirements for feasibility studies and its credit-review function?
sensitivity analyses or stress testing? 22. Are credit-risk ratings reviewed regularly
g. minimum requirements for initial invest- for appropriateness?

Page 2
Floor-Plan Loans
INTRODUCTION thoroughly enough to ensure compliance with

the floor-plan agreement. Inspections should be
Floor-plan lending is a form of dealer-inventory conducted on a surprise basis. Floor-plan inspec-
financing in which each loan advance, which tion reports should be reviewed and retained by
may be as much as 100 percent of the dealer’s the bank. Where practical, inspection duties
invoiced cost, is collateralized by a specific should be rotated among the bank’s staff. Banks
piece of inventory. As each unit of inventory is should verify the floor-planned inventory by
sold by the dealer, the loan advance against that comparing serial numbers with manufacturers’
unit of inventory is repaid. Floor-planned items certificates of origin or titles and to the bank’s
typically have broad consumer demand. Items records, and the inspection reports should reflect
commonly subject to floor-plan debt are auto- whether the floor-planned inventory is available
mobiles, large home appliances, furniture, tele- for sale. Any missing inventory or other excep-
visions and stereo equipment, boats, mobile tions revealed by the inspection, and the dealer’s
homes, and other types of merchandise usually explanation, should be noted in the inspection
sold under a sales-finance contract. Floor-plan report.
financing involves all the basic risks inherent in
any form of inventory financing. However,
because of the high loan-to-value ratios typical SECURITY INTEREST
of floor-plan financing, the exposure to loss is
generally greater than in other types of inven- In most banks, the security interest to floor-
tory financing. planned inventory is evidenced by a trust
receipt.2 Generally, trust receipts are created
by two methods. First, the bank may enter into
COLLATERAL a drafting agreement with the manufacturer,
which is similar to a letter of credit. In this
As with all inventory financing, collateral value situation, the bank agrees to pay documentary
is of prime importance. Control over collateral drafts covering shipments of merchandise to the
value requires the bank to determine the value at dealer. The drafts are payable at the time the
the time the loan is placed on the books, to merchandise is received by the dealer or, if the
periodically inspect the collateral to determine manufacturer permits, after a grace period, which
its condition and location, and to determine allows the dealer to prepare the inventory for
whether any curtailment payments1 are needed sale. The drafting agreement usually limits the
to keep the loan balance in line with depreciat- number of units, the per-unit cost, and the
ing collateral values. As a general rule, curtail- aggregate cost that can be shipped at one time.
ment payments are not required for new auto- Drafting agreements are frequently used in con-
mobile models until the model year is junction with repurchase agreements when the
approximately one-half over. Periodic curtail- manufacturer agrees to repurchase inventory
ment payments are then expected to commence that remains unsold after a specified period of
at some predetermined percentage of the amount time. The inventory and related title documents
financed. remain with the dealer until they are sold and are
evidenced by a trust receipt. Banks should
physically inspect all the documents during the
Collateral Inspections floor-plan inspection to prevent dual financing.
The examiner should determine whether the Second, trust receipts are also created when
bank is inspecting the collateral frequently and merchandise is shipped under an invoice sys-
1. Curtailment payments are payments made by the dealer

to the floor-plan lender when an item of floor-planned
inventory is not sold during the anticipated time frame. The 2. A trust receipt is a document issued to the floor-plan
implicit assumption is that if the floor-planned inventory is not lender by the dealer receiving the floor-plan financing. The
sold as anticipated, the inventory value depreciates over time. trust receipt provides evidence that the dealer possesses the
Unless a curtailment payment is made, the bank’s loan-to- floor-planned inventory. It establishes the bank’s rights to the
value ratio would increase and place the bank in a riskier inventory collateral and its proceeds or refers to other docu-
position than desired. ments that set forth the rights of the bank.

Page 1
2110.1 Floor-Plan Loans
tem. The dealer receives the inventory accom- cial information. Annual and interim financial
panied by invoices and titles, where appropriate. statements are necessary to monitor the dealer’s
The dealer presents the documents to the bank condition. Interim financial statements are often
and the bank pays the invoice, attaching dupli- in the form of monthly financial reports to the
cates of the documents to a trust receipt that is dealer’s franchiser. In analyzing the data, the
signed by the borrower. Depending on the type bank should review the number of units sold and
of inventory and the dealer, the title may remain the profitability of those sales, as well as com-
in the bank or be released. For example, used car pare the number of units sold with the number
inventories are usually financed with trust financed to determine that inventory levels are
receipts listing each item of the inventory and its reasonable.
loan value. Inventory will invariably be a dealer’s pri-
The method of perfecting a security interest mary asset, and its acquisition will normally
varies from state to state, and there can be create the dealer’s major liability. The dealer’s
divergences from the Uniform Commercial financial statement should show an inventory
Code. The examiner should determine that the figure at least equal to the related flooring
security interest has been properly perfected. liability. Unless the difference is represented by
For a detailed discussion of the UCC require- short-term sales receivables, including contracts
ments regarding secured transactions, refer to in transit, a floor-plan liability that is greater
section 2080.1, ‘‘Commercial and Industrial than the amount of inventory is an indication
Loans.’’ that the dealer has sold inventory and has not
made the appropriate loan payment. To assess
credit quality, it is essential that the examiner
BANK/DEALER RELATIONSHIP closely evaluate the level of floor-plan debt
relative to inventory.
Two important facets of the bank’s relationship
with a dealer are (1) the quality of the paper
generated and (2) the deposit account main- IDENTIFYING PROBLEMS
tained. The income derived from a floor-plan
loan may not be sufficient to justify the credit Missing inventory, reportedly sold and unpaid,
risk. However, additional income derived from should be verified to related contracts-in-process.
quality loans to purchasers of the dealer’s inven- Time to collect on contracts-in-process should
tory may justify the credit risk. If the bank is not be reasonable and conform to the floor-plan
receiving an adequate portion of loans generated agreement. Floor-planned inventory sold and
by the dealer or if the paper is of inferior quality, not in the process of payment is termed ‘‘sold
the relationship is of questionable value to the out of trust’’ and represents a breach of trust by
bank. The dealer’s deposit relationship repre- the dealer—and a significant exposure to the
sents both a compensating balance and a tool by bank.
which the loan officer can monitor customer During floor-plan inspections, recurring out-
activity. A review of the flow of funds into and of-trust positions that are not cleared in a rea-
out of the dealer’s account may suggest that sonable time frame (three to five days) should be
inventory has been sold without debt reduction, a red flag. If a bank discovers that a dealer is
that the dealer is incurring abnormal expenses, deliberately withholding funds or diverting funds
or that unreported diversification, expansion, or received from the sale of pledged inventory,
other financial activity has occurred that might bank officials should meet with the borrower to
warrant a reconsideration of the credit arrange- discuss this situation and, if appropriate, con-
ment. Token or overdrawn balances should also sider terminating the lending relationship. Banks
trigger increased attention to the value of the should avoid complicated situations in which
relationship. they finance only part of the dealer’s floor-plan
debt that originates from one particular manu-
facturer or distributor. Other warning signs
DEALER FINANCIAL ANALYSIS banks should be aware of include interest or
curtailment payment delinquencies, extended
Many dealers have minimal liquidity and capital maturities beyond reasonable expectations, slow-
relative to total debt. Therefore, the bank should moving inventory, and the absence of interim
closely and frequently review the dealer’s finan- financial statements.

Page 2
Floor-Plan Loans 2110.1
LOAN POLICY for detailed tri-party (manufacturer, dealer, and

banker) floor-plan agreements, loan-to-value
The bank’s loan policy should establish sound requirements, the percentage amount and timing
standards to control the credit and operational of curtailment payments, inspection standards,
risks associated with floor-plan lending. At a and the frequency for obtaining and evaluating
minimum, the policy should address the need financial statements.

Page 3
Floor-Plan Loans
1. To determine if policies, practices, proce- 5. To determine compliance with applicable

dures, and internal controls for floor-plan laws and regulations.
loans are adequate. 6. To initiate corrective action when policies,
2. To determine if bank officers are conforming practices, procedures, or internal controls are
to established guidelines. deficient or when violations of laws or regu-
3. To evaluate the quality of the loan portfolio lations have been noted.
and the sufficiency of its collateral.
4. To determine the scope and effectiveness of
the audit function.

Page 1
Floor-Plan Loans
1. If selected for implementation, complete or a. past-due loans

update the floor-plan loans section of the b. loans in a nonaccrual status
internal control questionnaire. c. loans on which interest is not being
2. On the basis of the evaluation of internal collected in accordance with the terms of
controls and the work performed by internal the loan (Particular attention should be
or external auditors, determine the scope of given to loans that have been renewed
the examination. with interest being rolled into principal.)
3. Test for compliance with policies, practices, d. loans whose terms have been modified
procedures, and internal controls in conjunc- by a reduction on interest rate or princi-
tion with performing the remaining exami- pal payment, by a deferral of interest or
nation procedures. Also, obtain a listing of principal, or by other restructuring of
any deficiencies noted in the latest review repayment terms
done by internal or external auditors from e. loans transferred, either in whole or in
the examiner assigned to internal control, part, to another lending institution as a
and determine if corrections have been result of a sale, participation, or asset
accomplished. swap since the previous examination
4. Request that the bank supply the following: f. loans acquired from another lending
a. schedule of curtailment requirements for institution as a result of a purchase,
each dealer participation, or asset swap since the
b. schedule of approved floor-plan lines previous examination
for each dealer, including outstanding g. loan commitments and other contingent
balances liabilities
c. delinquent curtailment billing report h. extensions of credit to employees, offi-
d. drafting agreements and amount of out- cers, directors, and principal sharehold-
standing drafts ers and their interests specifying which
e. delinquent interest billings, date billed, officers are considered executive officers
and amount of past-due interest i. extensions of credit to executive officers,
5. Obtain a trial balance of all floor-plan directors, and principal shareholders and
accounts. their interests of correspondent banks
a. Agree balances to department controls j. a list of correspondent banks
and general ledger. k. miscellaneous loan-debit and credit-
b. Review reconciling items for reason- suspense accounts
ableness. l. loans considered ‘‘problem loans’’ by
6. Using an appropriate technique, select bor- management
rowers for examination. m. specific guidelines in the lending policy
7. Using the trial balance, transcribe the fol- n. each officer’s current lending authority
lowing information for each borrower o. current interest-rate structure
selected onto the credit line cards: p. any useful information obtained from the
a. total outstanding liability review of the minutes of the loan
b. number of items and discount committee or any similar
c. status of any outstanding interest or cur- committee
tailment billings q. reports furnished to the loan and
d. amount of approved floor-plan line discount committee or any similar
8. Obtain liability and other information on committee
common borrowers from examiners assigned r. reports furnished to the board of directors
to overdrafts, lease financing, and other s. loans classified during the previous
loan areas, and together decide who will examination
review the borrowing relationship. 10. Review the information received, and per-
9. Obtain from the bank or appropriate exam- form the following procedures.
iner the following schedules, if applicable a. Loans transferred, either in whole or in
to this area: part, to or from another lending institu-

Page 1
2110.3 Floor-Plan Loans: Examination Procedures
tion as a result of a participation, sale or applicable:

purchase, or asset swap. (1) name of originating institution
• Participations only: (2) name of receiving institution
— Test participation certificates and (3) type of transfer (i.e., participa-
records, and determine that the par- tion, purchase or sale, swap)
ties share in the risks and contrac- (4) date of transfer
tual payments on pro rata basis. (5) total number of loans trans-
— Determine that the bank, as lead or ferred
agent in a credit, exercises similar (6) total dollar amount of loans
controls and procedures over syn- transferred
dications and participations sold as (7) status of the loans when trans-
for loans in its own portfolio. ferred (e.g., nonperforming,
• Procedures pertaining to all transfers: classified, etc.)
— Investigate any situations in which (8) any other information that
loans were transferred immediately would be helpful to the other
before the date of examination to regulator
determine if any were transferred b. Miscellaneous loan-debit and credit-
to avoid possible criticism during suspense accounts.
the examination.
• Discuss with management any large or
— Determine whether any of the loans
old items.
transferred were either nonperform-
• Perform additional procedures as
ing at the time of transfer or clas-
deemed appropriate.
sified at the previous examination.
— Determine that low-quality loans c. Loans classified during the previous
transferred to (but not purchased) examination. Determine the disposition
or from the bank are properly of loans so classified by reviewing—
reflected on its books at fair market • current balances and payment status,
value (while fair market value may • date loan was repaid and sources of
be difficult to determine, it should payment, and
at a minimum reflect both the rate • any situations in which all or part of
of return being earned on such the funds for the repayment came from
loans as well as an appropriate risk the proceeds of another loan at the
premium). Section 23A of the Fed- bank, or as a result of a participation,
eral Reserve Act prohibits a state sale, or swap with another lending
member bank from purchasing low- institution. If repayment was a result
quality assets. of a participation, sale or swap, refer to
— Determine that low-quality loans step 10a of this section for the appro-
transferred to the parent holding priate examination procedures.
company or a nonbank affiliate are d. Loan commitments and other contingent
properly reflected at fair market liabilities. Analyze whether—
value on the books of both the • the borrower has been advised of the
bank and its affiliate. contingent liability, and
— If low-quality loans were trans- • the combined amounts of the current
ferred to or from another lending loan balance and the commitment or
institution for which the Federal contingent liability exceeds the cutoff.
Reserve is not the primary regula- e. Select loans that require in-depth review
tor, prepare a memorandum to be on the basis of the information derived
submitted to the Reserve Bank from the above schedules.
supervisory personnel. The Reserve 11. Consult with the examiner responsible for
Bank will then inform the local the asset/liability management analysis to
office of the primary federal regu- determine the appropriate maturity break-
lator of the other institution down of loans needed for the analysis. If
involved in the transfer. The requested, compile the information using
memorandum should include bank records or other appropriate sources.
the following information, as See‘‘ Instructions for the Report of Exami-

Page 2
Floor-Plan Loans: Examination Procedures 2110.3
nation,’’ section 6000.1, for considerations c. 12 USC 1972, Tie-In Provisions. While
to be taken into account when compiling reviewing credit and collateral files (espe-
maturity information for the gap analysis. cially loan agreements), determine
12. For those loans selected in step 6 and for whether any extension of credit is con-
any other loans selected while performing ditioned upon—
the above steps— • obtaining or providing an additional
a. transcribe the following information from credit, property, or service to or from
the bank’s collateral record onto the the bank or its holding company (or a
credit line card: subsidiary of its holding company),
• a list of items floored, including date other than a loan, discount, deposit, or
of entry, description of property, amount trust service, or
advanced, and curtailment, if any • the customer not obtaining a credit,
(Similar items and model year should property, or service from a competitor
be shown in aggregate, and entry dates of the bank or its holding company (or
should be shown as a range, except on a subsidiary of its holding company),
stale or not properly curtailed items.) other than a reasonable condition to
• a summary of the wholesale agreement ensure the soundness of the credit.
between the bank and the dealer
• a summary of the agreement between d. Insider lending activities. The examina-
the manufacturer and the bank tion procedures for checking compliance
• a summary of any repurchase with the relevant law and regulation
agreement covering insider lending activities and
• evidence that security interest has been reporting requirements are as follows
perfected (the examiner should refer to the appro-
• details of any guarantees that may be priate sections of the statutes for specific
held definitions, lending limitations, reporting
• details of any other collateral held requirements, and conditions indicating
b. review the two most recent floor-plan preferential treatment):
inspection reports and determine— • Regulation O (12 CFR 215), Loans to
• if any items were sold out of trust, Executive Officers, Directors, and Prin-
• that where trust receipts were used, all cipal Shareholders and Their Interests.
title documents were physically While reviewing information relating
inspected, and to insiders that is received from the
• that appropriate follow-up was made bank or appropriate examiner (includ-
on all missing items. ing loan participations, loans pur-
13. Determine compliance with laws and regu- chased and sold, and loan swaps)—
lations pertaining to floor-plan loans by — test the accuracy and complete-
performing the following steps. ness of information about
a. Lending limits. floor-plan loans by comparing it
• Determine the bank’s lending limits as with the trial balance or loans
prescribed by state law. sampled;
• Determine advances or combinations — review credit files on insider loans
of advances with aggregate balances to determine that required informa-
above the limit, if any. tion is available;
b. 18 USC 215, Commission or Gift for
Procuring Loan. — determine that loans to insiders do
• While examining the floor-plan loan not contain terms more favorable
area, determine the existence of any than those afforded other borrowers;
possible cases in which a bank officer, — determine that loans to insiders do
director, employee, agent, or attorney not involve more than normal risk
may have received anything of value of repayment or present other
for procuring or endeavoring to pro- unfavorable features;
cure any extension of credit. — determine that loans to insiders, as
• Investigate any such suspected defined by the various sections of
situation. Regulation O, do not exceed the

Page 3
2110.3 Floor-Plan Loans: Examination Procedures
lending limits imposed by those correspondent banks are not made

sections; on preferential terms and that no
— if prior approval by the bank’s conflict of interest appears to exist.
board was required for a loan to an 14. Perform the appropriate procedural steps in
insider, determine that such ‘‘Concentrations of Credit,’’ section 2050.3.
approval was obtained; 15. Discuss with appropriate officers, and pre-
— determine compliance with the vari- pare summaries in appropriate report form
ous reporting requirements for for—
insider loans; a. delinquent loans;
— determine that the bank has made b. extensions of credit to employees, offi-
provisions to comply with the pub- cers, directors, and/or their interests;
lic disclosure requirements for c. loans on which collateral documentation
insider loans; and is deficient;
— determine that the bank maintains d. transfers of low-quality loans to or from
records of public disclosure requests another lending institution;
and the disposition of the requests
e. the adequacy of written policies relating
for a period of two years after the
to floor-plan loans;
date of the requests.
f. the manner in which bank officers are
• Title VIII of the Financial Institutions
conforming with established policy;
Regulatory and Interest Rate Control
Act of 1978 (FIRA) (12 USC g. schedules applicable to the department
1972(2)), Loans to Executive Officers, that were discovered to be incorrect or
Directors, and Principal Shareholders incomplete;
of Correspondent Banks. h. the performance of departmental
— Obtain from or request that the management;
examiners reviewing due from i. internal control deficiencies or exceptions;
banks and deposit accounts verify j. recommended corrective action when
a list of correspondent banks pro- policies, practices, or procedures are
vided by bank management, and deficient; and
ascertain the profitability of those k. other matters of significance.
relationships. 16. Update the workpapers with any informa-
— Determine that loans to insiders of tion that will facilitate future examinations.

Page 4
Floor Plan Loans
Review the bank’s internal controls, policies, *7. Are documents supporting recorded credit
practices and procedures for making and servic- adjustments checked or tested subsequently
ing floor plan loans. The bank’s system should by persons who do not also handle cash (if
be documented in a complete and concise man- so, explain briefly)?
ner and should include, where appropriate, nar- 8. Is a daily record maintained summarizing
rative descriptions, flowcharts, copies of forms note transaction details, i.e., loans made,
used and other pertinent information. Items payments received and interest collected,
marked with an asterisk require substantiation to support applicable general ledger account
by observation or testing. entries?
9. Are frequent note and liability ledger trial
balances prepared and reconciled with con-
POLICIES trolling accounts by employees who do not
process or record loan transactions?
1. Has the board of directors, consistent with 10. Is an overdue account report generated
its duties and responsibilities, adopted writ- frequently (if so, state frequency )?
ten floor plan loan policies that:
a. Establish procedures for reviewing floor
plan applications?
b. Define qualified borrowers, overall lim- LOAN INTEREST
its, and types of merchandise to be floor
planned? *11. Is the preparation and posting of interest
c. Establish minimum standards for records performed or reviewed by persons
documentation? who do not also:
d. Establish curtailment amounts and time a. Issue official checks or drafts singly?
limits? b. Handle cash?
2. Are floor plan loan policies reviewed at 12. Are any independent interest computations
least annually to determine if they are made and compared or adequately tested
compatible with changing market to initial interest records by persons who
conditions? do not also:
a. Issue official checks or drafts singly?
b. Handle cash?
RECORDS
*3. Is the preparation and posting of subsidi-
ary floor plan loan records performed or COLLATERAL
reviewed by persons who do not also:
a. Issue official checks or drafts? 13. Are floor plan checks, physical invento-
b. Handle cash? ries, conducted at least monthly and on a
4. Are the subsidiary floor plan loan records surprise basis (if so, state frequency
reconciled daily with the appropriate gen- )?
eral ledger accounts, and are reconciling 14. Are more frequent floor plan checks
items investigated by persons who do not required if the dealer is experiencing finan-
also handle cash? cial difficulties?
*5. Are delinquent account collection requests 15. Are individuals performing floor plan
and past-due notices checked to the trial checks rotated?
balances used in reconciling floor plan 16. Are floor plan inspector(s) required to
subsidiary records with general ledger determine or verify the following and
accounts, and are they handled only by indicate their findings on the floor plan
persons who do not also handle cash? check sheet:
*6. Are inquiries about loan balances received a. Serial number of item?
and investigated by persons who do not b. Odometer reading of vehicles?
also handle cash? c. Condition of item?

Page 1
2110.4 Floor Plan Loans: Internal Control Questionnaire
d. Location of item, if other than normal b. Serial number of each item?

place of business? c. Loan amount for each item?
e. Existence of any fire or theft hazards? d. Interest rate?
17. Does the floor plan inspector include on e. Date?
the check sheet: f. Authorized signature of dealer or per-
a. Date inspection was performed? son holding power-of-attorney to exe-
b. Date any item located elsewhere was cute the trust receipt?
checked? 31. If the bank and dealer permit a bank
c. His or her signature? employee to execute trust receipts using
d. Summary of his or her report, if the dealer’s power-of-attorney:
appropriate? a. Are proper documents on file granting
18. Are all demonstrators checked? the power-of-attorney?
19. Are floor plan reports reviewed by an b. Does the bank maintain a numbered
officer? register for trust receipt notes?
20. Are follow-up inspections made of items c. Are trust receipt notes under dual
not seen during the regular inspection? control?
21. Are items reported by the dealer as being
sold, required to be paid off immediately?
22. Does the floor plan inspector determine
the date that item(s) reported as sold were OTHER
sold from that on the dealer’s copy of the
sales agreement? 32. Are all floor plan loans granted under an
23. Are dealer sales patterns reviewed to de- established line?
termine that the number of units reported 33. Are line approvals structured to permit the
sold at the time of floor plan inspection is bank to cancel or suspend shipments of
not excessive and does not indicate a float? unwanted merchandise?
24. Are payments-in-process reported by the 34. Are dealer floor plan line limits strictly
dealer during floor plan inspection verified adhered to?
by bank personnel? 35. Is a trial balance of each dealer’s trust
25. When a dealer trade or ‘‘swap’’ occurs, receipts/security agreements prepared at
does the bank: least monthly?
a. Obtain the manufacturer’s invoice from 36. Are dealer trial balances reconciled to
the selling dealer on the new unit department and general ledger controls?
acquired? 37. Are floor plan interest charges systemati-
b. Obtain the invoice from the borrowing cally computed and regularly billed?
dealer for the new unit? 38. Are notices of past due interest payments
c. Have a trust receipt executed on the sent promptly?
new unit? 39. Are all interest, curtailment and unit pay
26. Does the bank have a procedure to check off payments from dealers posted promptly?
all indirect paper received from a dealer 40. Are disbursements for floor plan loans on
against the trust receipts of items floored new units made only against the original
for that dealer to determine that there is copy of the manufacturer’s invoices?
no duplication of loans against the same 41. Are the original invoices retained in the
security? bank’s files?
27. Does the bank have floor plan property 42. Are loan proceeds on new units paid
damage insurance or require that the dealer directly to the manufacturer rather than to
maintain such coverage with the bank the dealer?
named as loss payee? 43. Are accounting records established so that
28. Is the insurance coverage periodically re- the bank has records of all floored items
viewed for adequacy? with adequate individual identification?
29. Are all trust receipts required to be sup- 44. Are limits on loan advance versus invoice
ported by invoices or other evidence that price (current wholesale value, if used)
title to the security is vested in the bank? clearly established?
30. Are trust receipts required to include: 45. Are wholesale values determined indepen-
a. Description of each item? dently of dealer appraisals?

Page 2
Floor Plan Loans: Internal Control Questionnaire 2110.4
46. Are wholesale values that are assigned by 59. Do such agreements with the manufacturer
floor plan department personnel periodi- stipulate under what conditions the bank
cally reviewed by someone independent of will accept items to be floored?
the department? 60. Are checks made periodically to determine
47. Is amount of loan advance prohibited from that only those individuals granted power-
exceeding 100 percent of the invoice price of-attorney are signing the trust receipts?
of a new item or of the wholesale value of 61. Are dealers required to submit financial
a used item? and operating statements on a continuing
48. Has a curtailment policy been established basis?
and is it being followed? 62. Are all dealers who prepare internal finan-
49. Does the policy provide proper incentives cial and operating statements more fre-
to the dealer to turn over inventory on a quently than annually required to submit
timely basis? copies of those statements to the bank?
50. Is the loan written so that the floored items 63. Are all financial statements received from
never depreciate faster than the loan bal- dealers reviewed promptly?
ance is reduced?
51. If a manufacturer of floored items has 64. Do financial statement reviews include a
entered into a repurchase agreement, are determination that floor plan loans, deposit
curtailments structured to keep the loan accounts and other information agree with
balance in line with any declining repur- the bank’s records?
chase amount? 65. Are periodic reviews made of deposit
52. Are records maintained on curtailment accounts to detect any possible out-of-trust
billings so that delinquency is easily sales?
determinable? 66. Are periodic reviews made of the retail
53. Are notices of past due curtailment pay- paper being generated to determine if the
ments sent promptly? bank is receiving an adequate portion?
54. If assignment of rebates has been made,
have procedures been established to en-
sure that factory rebate checks payable at
the end of the model year are promptly CONCLUSION
forwarded to the bank?
55. If demonstrators are floored, are they sub- 67. Does the foregoing information constitute
ject to separate curtailment requirements an adequate basis for evaluating internal
which keep the loan balance in line with control in that there are no significant
their liquidation value? deficiencies in areas not covered in this
56. Are floor plan agreements required for all questionnaire that impair any controls?
dealers? Explain negative answers briefly, and indi-
57. Must agreements be accompanied by bor- cate any additional examination proce-
rowing resolutions? dures deemed necessary.
58. Is a written agreement between the manu- 68. Based on a composite evaluation as evi-
facturer and the bank required on any denced by answers to the foregoing
flooring line which includes drafting questions, internal control is considered
arrangements with the manufacturer? (adequate/inadequate).

Page 3
Leveraged Financing
Leveraged financing is an important financing INTERAGENCY STATEMENT ON

vehicle for mergers and acquisitions, business LEVERAGED FINANCING
recapitalizations, and business expansions. Lever-
aged transactions are characterized by a degree
of financial leverage that significantly exceeds * * * * *
industry norms, as measured by ratios such as
debt-to-assets, debt-to-equity, cash flow-to-total Institutions participate in leveraged financing on
debt, or other ratios and standards unique to a number of levels. In addition to providing
particular industry norms for leverage. Lever- senior secured financing, they extend credit on a
aged borrowers typically have a diminished subordinated basis (mezzanine financing). Insti-
ability to respond to changing economic condi- tutions and their affiliates also may take equity
tions or unexpected events, creating significant positions in leveraged companies with direct
implications for an institution’s overall credit- investments through affiliated securities firms,
risk exposure and challenges for bank risk- small business investment companies (SBICs),
management systems. and venture capital companies or take equity
Leveraged-finance activities can be con- interests via warrants and other equity ‘‘kick-
ducted in a safe and sound manner if a risk- ers’’ received as part of a financing package.
management structure provides appropriate Institutions also may invest in leveraged loan
underwriting, pricing, monitoring, and controls. funds managed by investment banking compa-
Comprehensive credit-analysis processes, fre- nies or other third parties. Although leveraged
quent monitoring, and detailed portfolio reports financing is far more prevalent in large institu-
are needed to better understand and manage tions, this type of lending can be found in
the inherent risk in these leveraged-finance institutions of all sizes * * * The extent to which
portfolios. institutions should apply these sound practices
Many leveraged transactions are underwritten will depend on the size and risk profile of their
with reliance on the imputed value of a business leveraged exposures relative to assets, earnings,
(enterprise value), which is often highly volatile. and capital; and the nature of their leveraged-
Sound valuation methodologies must be used financing activities (i.e., origination and distri-
for these types of transactions, in addition to bution, participant, equity investor, etc.) * * *
ongoing stress testing and monitoring of enter-
prise values.
On April 9, 2001, the Federal Reserve, along Risk-Management Guidelines
with the Office of the Comptroller of the Cur-
rency, the Federal Deposit Insurance Corpora- [Institutions substantively engaged in leveraged
tion, and the Office of Thrift Supervision, issued financing are expected to] adequately risk-rate,
the following guidance concerning sound risk- track, and monitor these transactions and to
management practices for institutions engaged maintain policies specifying conditions that
in leveraged financing.1 The statement also pro- would require a change in risk rating, accrual
vides guidance about risk-rating for leveraged- status, loss recognition, or reserves. In general,
finance loans and how enterprise value should the risk-management framework for leveraged
be evaluated in the risk-rating process. (See finance is no different from that which should be
SR-01-9.) (The introductory paragraphs and applied to all lending activities. However,
some other material have been omitted from the because of the potential higher level of risk, the
policy statement here, as indicated by a line of degree of oversight should be more intensive.
asterisks. Other wording has been slightly
altered, as indicated by brackets.)
Loan Policy
1. This guidance augments previously issued supervisory
statements on sound credit-risk management. See SR-99-23, The loan policy should specifically address the
‘‘Recent Trends in Bank Lending Standards for Commercial institutions’ leveraged-lending activities by
Loans,’’ and SR-98-18, ‘‘Lending Standards for Commercial
Loans.’’ (See also sections 2040.1, ‘‘Loan Portfolio Manage-
including—
ment,’’ and 2040.3, ‘‘Examination Procedures—Loan Port-
folio Management.’’) • a definition of leveraged lending;

Page 1
2115.1 Leveraged Financing
• an approval policy that requires sufficient istics of the borrower, by the institution’s
senior-level oversight; internal-risk grade, by particular industry or
• pricing policies that ensure a prudent tradeoff other factors that the institution determines are
between risk and return; and correlated with an above-average default prob-
• a requirement for action plans whenever cash ability. In addition, sublimits may be appropriate
flow, asset-sale proceeds, or collateral values by collateral type, loan purpose, industry, sec-
decline significantly from projections. Action ondary sources of repayment, and sponsor rela-
plans should include remedial initiatives and tionships. Institutions should also establish lim-
triggers for rating downgrades, changes to its for the aggregate number of policy exceptions.
accrual status, and loss recognition.
Credit Analysis
Underwriting Standards
Effective management of leveraged-financing
Either the loan policy or separate underwriting risk is highly dependent on the quality of analy-
guidelines should prescribe specific underwrit- sis during the approval process and after the
ing criteria for leveraged financing. The stan- loan is advanced. At a minimum, analysis of
dards should avoid compromising sound bank- leveraged-financing transactions should ensure
ing practices in an effort to broaden market that—
share or realize substantial fees. The policy
should— • cash-flow analyses do not rely on overly
optimistic or unsubstantiated projections of
• describe appropriate leveraged loan struc- sales, margins, and merger and acquisition
tures; synergies;
• require reasonable amortization of term loans • projections provide an adequate margin for
(i.e., allow a moderate time period to realize unanticipated merger-related integration costs;
the benefit of synergies or augment revenues
• projections are stress-tested for one or two
and institute meaningful repayment);
downside scenarios;
• specify collateral policies including accept-
• transactions are reviewed quarterly to deter-
able types of collateral, loan-to-value limits,
mine variance from financial plans, the risk
collateral margins, and proper valuation
implications thereof, and the accuracy of risk
methodologies;
ratings and accrual status;
• establish covenant requirements, particularly
• collateral valuations are derived with a proper
minimum interest and fixed-charge coverage
degree of independence and consider potential
and maximum leverage ratios;
value erosion;
• describe how enterprise values and other
• collateral-liquidation and asset-sale estimates
intangible business values may be used; and
are conservative;
• establish minimum documentation require-
ments for appraisals and valuations, including • potential collateral shortfalls are identified and
enterprise values and other intangibles. factored into risk-rating and accrual decisions;
• contingency plans anticipate changing condi-
tions in debt or equity markets when expo-
sures rely on refinancing or recapitalization;
Limits and
Leveraged-finance and other loan portfolios with • the borrower is adequately protected from
above-average default probabilities tend to interest-rate and foreign-exchange risk.
behave similarly during an economic or sectoral
downturn. Consequently, institutions should take
steps to avoid undue concentrations by setting Enterprise Value
limits consistent with their appetite for risk and
their financial capacity. Institutions should ensure Enterprise value is often relied upon in the
that they monitor and control as separate risk underwriting of leveraged loans to evaluate the
concentrations those loan segments most vulner- feasibility of a loan request, determine the
able to default. Institutions may wish to identify debt-reduction potential of planned asset sales,
such concentrations by the leveraged character- assess a borrower’s ability to access the capital

Page 2
Leveraged Financing 2115.1
markets, and to provide a secondary source of appear to be of a lasting nature and it is probable
repayment. Consideration of enterprise value is that a lender will be unable to collect all
appropriate in the credit-underwriting process. principal and interest owed, the loan should be
However, enterprise value and other intangible placed on nonaccrual and will likely have a
values can be difficult to determine, are fre- doubtful component. Such loans should be
quently based on projections, and may be sub- reviewed for impairment in accordance with
ject to considerable change. Consequently, reli- FAS 114, ‘‘Accounting by Creditors for Impair-
ance upon them as a secondary source of ment of a Loan.’’
repayment can be problematic. If the primary source of repayment is inad-
Because enterprise value is commonly derived equate and a loan is considered collateral-
from the cash flows of a business, it is closely dependent, it is generally inappropriate to con-
correlated with the primary source of repay- sider enterprise value unless the value is well
ment. This interdependent relationship between supported. Well-supported enterprise values may
primary and secondary repayment sources be evidenced by a binding purchase and sale
increases the risk in leveraged financing, espe- agreement with a qualified third party or through
cially when credit weaknesses develop. Events valuations that fully consider the effect of the
or changes in business conditions that nega- borrower’s distressed circumstances and poten-
tively affect a company’s cash flow will also tial changes in business and market conditions.
negatively affect the value of the business, For such borrowers, where a portion of the loan
simultaneously eroding both the lender’s pri- is not protected by pledged assets or a well-
mary and secondary source of repayment. Con- supported enterprise value, examiners will gen-
sequently, lenders that place undue reliance erally classify the unprotected portion of the
upon enterprise value as a secondary source of loan doubtful or loss.
repayment or that utilize unrealistic assumptions In addition, institutions need to ensure that
to determine enterprise value are likely to the risks in leveraged-lending activities are fully
approve unsound loans at origination or experi- incorporated in the allowance-for-loan-and-lease-
ence outsize losses upon default. loss and capital-adequacy analysis. For allow-
It is essential that institutions establish sound ance purposes, leverage exposures should be
valuation methodologies for enterprise value, taken into account either through analysis of the
apply appropriate margins to protect against expected losses from the discrete portfolio or as
potential changes in value, and conduct ongoing part of an overall analysis of the portfolio
stress testing and monitoring. utilizing the institution’s internal risk grades or
other factors. At the transaction level, exposures
heavily reliant on enterprise value as a second-
Rating Leveraged-Finance Loans ary source of repayment should be scrutinized to
determine the need for and adequacy of specific
Institutions need thoroughly articulated policies allocations.
that specify requirements and criteria for risk-
rating transactions, identifying loan impairment,
and recognizing losses. Such specificity is criti- Problem-Loan Management
cal for maintaining the integrity of an institu-
tion’s risk-management system. Institutions’ For adversely rated borrowers and other high-
internal rating systems should incorporate both risk borrowers who significantly depart from
the probability of default and loss given default planned cash flows, asset sales, collateral val-
in their ratings to ensure that the risk of the ues, or other important targets, institutions should
borrower and the risk of the transaction structure formulate individual action plans with critical
itself are clearly evaluated. This is particularly objectives and time frames. Actions may include
germane to leverage-finance-transactions struc- working with the borrower for an orderly reso-
tures, which in many recent cases have resulted lution while preserving the institution’s inter-
in large losses upon default. ests, sale in the secondary market, and liquida-
In cases where a borrower’s condition or tion. Regardless of the action, examiners and
future prospects have significantly weakened, bankers need to ensure such credits are reviewed
leveraged-finance loans will likely merit a sub- regularly for risk-rating accuracy, accrual status,
standard classification based on the existence of recognition of impairment through specific allo-
well-defined weaknesses. If such weaknesses cations, and charge-offs.

Page 3
Portfolio Analysis risk characteristics of the leveraged portfolio,

such as high reliance on enterprise value, con-
Higher-risk credits, including leveraged-finance centrations, adverse risk-rating trends or port-
transactions, require frequent monitoring by folio performance, will dictate more frequent
banking organizations. At least quarterly, man- reviews.
agement and the board of directors should
receive comprehensive reports about the charac-
teristics and trends in such exposures. These
reports at a minimum should include— Distributions
• total exposure and segment exposures, includ- Asset sales, participations, syndication, and other
ing subordinated debt and equity holdings, means of distribution are critical elements in the
compared to established limits; rapid growth of leveraged financing. [Lead and
• risk-rating distribution and migration data; purchasing institutions are expected] to adopt
• portfolio performance—noncompliance with formal policies and procedures addressing the
covenants, restructured loans, delinquencies, distribution and acquisition of leveraged-
nonperforming assets, and impaired loans; financing transactions. The policies should
and include—
• compliance with internal procedures and the • procedures for defining, managing, and
aggregate level of exceptions to policy and accounting for distribution fails;
underwriting standards. • identification of any sales made with recourse
and procedures for fully reflecting the risk of
Institutions with significant exposure levels to any such sales;
higher-risk credits should consider additional • a process to ensure that purchasers are pro-
reports covering— vided with timely, current financial informa-
tion;
• collateral composition of the portfolio, e.g., • a process to determine the portion of a trans-
percentages supported by working assets, fixed action to be held in the portfolio and the
assets, intangibles, blanket liens, and stock of portion to be held for sale;
borrower’s operating subsidiaries; • limits on the length of time transactions can be
• unsecured or partially secured exposures, held in the held-for-sale account and policies
including potential collateral shortfalls caused for handling items that exceed those limits;
by defaults that trigger pari passu [equable] • prompt recognition of losses in market value
collateral treatment for all lender classes; for loans classified as held-for-sale; and
• absolute amount and percentage of the port- • procedural safeguards to prevent conflicts of
folio dependent on refinancing, recapitaliza- interest for both bank and affiliated securities
tion, asset sales, and enterprise value; firms.
• absolute amounts and percentages of sched-
uled and actual annual portfolio amortiza-
tions; and
• secondary-market pricing data and trading Participations Purchased
volume for loans in the portfolio.
Institutions purchasing participations and assign-
ments in leveraged finance must make a thor-
Internal Controls ough, independent evaluation of the transaction
and the risks involved before committing any
Institutions engaged in leveraged finance need funds. They should apply the same standards of
to ensure their internal-review function is appro- prudence, credit assessment and approval crite-
priately staffed to provide timely, independent ria, and ‘‘in-house’’ limits that would be
assessments of leveraged credits. Reviews should employed if the purchasing organization were
evaluate risk-rating integrity, valuation method- originating the loan. At a minimum, policies
ologies, and the quality of risk management. should include requirements for—
Because of the volatile nature of these credits,
portfolio reviews should be conducted on at • obtaining and independently analyzing full
least an annual basis. For many institutions, the credit information both before the participa-

Page 4
Leveraged Financing 2115.1
tion is purchased and on a timely basis should also establish procedures to restrict the
thereafter; internal dissemination of material nonpublic
• obtaining from the lead lender copies of all information about leveraged-finance transac-
executed and proposed loan documents, legal tions.
opinions, title insurance policies, UCC
searches, and other relevant documents;
• carefully monitoring the borrower’s perfor- Compliance Function
mance throughout the life of the loan; and
• establishing appropriate risk-management The legal and regulatory issues raised by lever-
guidelines as described in this [statement.] aged transactions are numerous and complex.
To ensure that potential conflicts are avoided
and laws and regulations are adhered to, an
Process To Identify Potential Conflicts independent compliance function should review
all leveraged-financing activity.
Examiners should determine whether an institu-
tion’s board of directors and management have * * * * *
established policies for leveraged finance that
minimize the risks posed by potential legal EXAMINATION RISK-RATING
issues and conflicts of interest. GUIDANCE FOR LEVERAGED
FINANCING
Conflicts of Interest When evaluating individual borrowers, examin-
ers should pay particular attention to—
When a banking company plays multiple roles
in leveraged finance, the interests of different • the overall performance and profitability of a
customers or the divisions of the institution borrower and its industry over time, including
may conflict. For example, a lender may be periods of economic or financial adversity;
reluctant to employ an aggressive collection • the history and stability of a borrower’s mar-
strategy with a problem borrower because of the ket share, earnings, and cash flow, particularly
potential impact on the value of the organiza- over the most recent business cycle and last
tion’s equity interest. A lender may also be economic downturn; and
pressured to provide financial or other privi- • the relationship between a borrowing compa-
leged client information that could benefit an ny’s projected cash flow and debt-service
affiliated equity investor. Institutions should requirements and the resulting margin of debt-
develop appropriate policies to address potential service coverage.
conflicts of interest. Institutions should also
track aggregate totals for borrowers and spon-
sors to which it has both a lending and equity
relationship. Appropriate limits should be estab- Cash Flow/Debt-Service Coverage
lished for such relationships.
Particular attention should be paid to the
adequacy of the borrower’s cash flow and the
reasonableness of projections. Before entering
Securities Laws into a leveraged-financing transaction, bankers
should conduct an independent, realistic assess-
Equity interests and certain debt instruments
ment of the borrower’s ability to achieve the
used in leveraged lending may constitute
projected cash flow under varying economic and
‘‘securities’’ for the purposes of federal securi-
interest-rate scenarios. This assessment should
ties laws. When securities are involved, institu-
take into account the potential effects of an
tions should ensure compliance with applicable
economic downturn or other adverse business
securities law requirements, including disclo-
sure and regulatory requirements.2 Institutions
Company Act and the Federal Reserve Act. Institutions need
2. Institutions should also ensure that their acquired equity to take special care to aggregate all the equity positions held
positions are consistent with equity ownership restrictions throughout the entire organization, including those held in all
imposed by federal and state laws, such as the Bank Holding banking and nonbanking subsidiaries. [footnote added]

Page 5
conditions on the borrower’s cash flow and ing business conditions more adverse than the
collateral values. Normally bankers and exam- base-case scenario. Stress testing of enterprise
iners should adversely rate a credit if material values and their underlying assumptions should
questions exist as to the borrower’s ability to be conducted upon origination of the loan and
achieve the projected necessary cash flows, or if periodically thereafter incorporating the actual
orderly repayment of the debt is in doubt. performance of the borrower and any adjust-
Credits with only minimal cash flow for debt ments to projections. The bank should in all
service are usually subject to an adverse rating. cases perform its own discounted-cash-flow
analysis to validate ‘‘enterprise value’’ implied
by proxy measures such as multiples of cash
Enterprise Value flow, earnings or sales.
Finally, it must be recognized that valuations
Many leveraged-financing transactions rely on derived with even the most rigorous valuation
‘‘enterprise value’’ as a secondary source of procedures are imprecise and may not be real-
repayment. Most commonly, enterprise value is ized when needed by an institution. Therefore,
based on a ‘‘going concern’’ assumption and institutions relying on enterprise value or illiq-
derived from some multiple of the expected uid and hard-to-value collateral must have lend-
income or cash flow of the firm. The methodol- ing policies that provide for appropriate loan-to-
ogy and assumptions underlying the valuation value ratios, discount rates and collateral margins.
should be clearly disclosed, well supported, and
understood by appropriate decision makers and
risk-oversight units. Examiners should ensure
that the valuation approach is appropriate for the Deal Sponsors
company’s industry and condition.
Enterprise value is often viewed as a second- Deal sponsors can be an important source of
ary source of repayment and as such would be financial support for a borrower that fails to
relied upon under stressful conditions. In such achieve cash-flow projections. However, sup-
cases the assumptions used for key variables port from this source should only be considered
such as cash flow, earnings, and sale multiples positively in a risk-rating decision when the
should reflect those adverse conditions. These sponsor has a history of demonstrated support as
variables can have a high degree of uncertainty— well as the economic incentive, capacity, and
sales and cash-flow projections may not be stated intent to continue to support the transac-
achieved; comparable sales may not be avail- tion. Even with capacity and a history of sup-
able; changes can occur in a firm’s competitive port, a sponsor’s potential contributions should
position, industry outlook, or the economic not mitigate criticism unless there is clear reason
environment. Because of these uncertainties, to believe it is in the best interests of the sponsor
changes in the value of a firm’s assets need to be to continue that support or unless there is a
tested under a range of stress scenarios, includ- formal guarantee.

Page 6
Leveraged Financing
1. To obtain assurances that the institution main- prepared and used to better understand and
tains sound lending standards. manage the inherent risk in leveraged-
2. To ensure that the institution’s risk- finance portfolios.
management structure provides for appro- 4. To ensure the institution uses sound valua-
priate underwriting, pricing, monitoring, tion methodologies, conducts ongoing stress
and controls over leveraged-financing testing, and monitors enterprise values for
transactions. leveraged-financing transactions.
3. To assess whether the institution uses com- 5. To determine whether the institution’s
prehensive credit-analysis processes, whether leveraged-financed loans are risk-rated and
frequent and continuous monitoring exists, how enterprise values are evaluated in the
and whether detailed portfolio reports are risk-rating process.

Page 1
Leveraged Financing
1. Ascertain that the institution has established gin of debt-service coverage, and actual
procedures for determining which credits performance.
should be regarded as constituting ‘‘lever- 5. Determine if the institution’s leveraged-
aged financing.’’ finance rating systems incorporate both the
2. Determine that the institution regularly probability of default and a realistic assess-
reviews its leveraged-financing credits for ment of likely loss amounts in a troubled
their risk-rating accuracy, accrual status, rec- situation.
ognition of impairment through specific allo- 6. When a borrower’s condition or future pros-
cations, and charge-offs. pects have significantly weakened, consider
3. Ascertain whether an institution’s board of whether the leveraged-finance loans will
directors and management have established likely merit an adverse rating based on the
policies for leveraged financing that mini- existence of well-defined weaknesses. If such
mize the risks of potential legal issues and weaknesses appear to be of a lasting nature
conflicts of interest. and it is probable that a lender will be unable
4. When reviewing leveraged-financing credits, to collect all principal and interest owed, the
give particular attention to— loan should be placed on nonaccrual.1
• the overall performance and profitability of 7. Determine whether the valuation approach
a borrower and its industry over time, used for the leverage financing is appropriate
including periods of economic or financial for the company’s industry and condition.
adversity; 8. When reviewing leveraged loans that are
• the history and stability of a borrower’s collateral-dependent, determine whether the
market share, earnings, and cash flow, loans are well protected by pledged assets or
particularly over the most recent business whether enterprise values are well supported.
cycle and last economic downturn; and
• the relationship between a borrowing 1. These loans should also be reviewed for impairment in
company’s projected cash flow and debt- accordance with Financial Accounting Standard No. 114 (FAS
service requirements, the resulting mar- 114), ‘‘Accounting by Creditors for Impairment of a Loan.’’

Page 1
Direct Financing Leases
INTRODUCTION ria provide useful guidelines for reviewing the

appropriateness and prudence of bank leasing
Leasing is a recognized form of financing for activities. Any substantial departure from these
fixed assets that provides a lessee (the customer) criteria must be judged in light of safety-and-
the right to use depreciable assets without tying soundness implications.
up working capital. Leasing frequently offers A BHC can act as an agent, broker, or adviser
the lessee greater flexibility than traditional in leasing such property only if—
bank term-loan financing. Leasing also provides
the lessor (the owner of the asset) with a • the lease is on a nonoperating basis1 and
generally higher rate of return than lending, but • the initial term of the lease is at least 90 days.
this is in exchange for assuming greater risk or
investing more resources in marketing and deal For leases involving real property—
structuring. The higher risk inherent in a typical
lease transaction is due to the higher advance to • the effect of the transaction at the inception of
collateral value; a longer payment period; and, the initial lease must be to yield a return that
in some cases, the lessor’s dependence on the will compensate the lessor for not less than the
sale of the leased property to recover a portion lessor’s full investment in the property plus
of the initial investment. In most instances, the estimated total cost of financing the prop-
some or all of the higher rate of return for the erty over the term of the lease, such return to
lessor is derived from the tax benefits of equip- be derived from rental payments, estimated
ment ownership. tax benefits, and the estimated residual value
While leases differ from loans in some of the property at the expiration of the initial
respects, they are similar from a credit view- lease; and
point because the basic considerations are cash • the estimated residual value cannot exceed 25
flow, repayment capacity, credit history, man- percent of the acquisition cost of the property
agement, and projections of future operations. to the lessor.
Additional considerations are the type of prop-
erty being leased and its marketability in the Examiners should ensure that the bank’s poli-
event of default or termination of the lease. cies and procedures appropriately govern its
However, these latter considerations do not direct-lease-financing activities and that bank
radically alter how an examiner evaluates col- management adheres to established policies and
lateral for a lease. The assumption is that the procedures. Examiners should also ensure that
lessee/borrower will generate sufficient funds to the bank’s audit and loan-review functions
liquidate the lease/debt. Leases are generally adequately encompass the leasing activity.
structured so that the bank recovers the full cost
of the equipment plus an interest factor over the
course of the lease term. Sale of the leased
property/collateral remains a secondary source
of repayment and, except for the estimated
residual value at the expiration of the lease, will
not, in most cases, become a factor in liquidat-
ing the advance. 1. With respect to the ‘‘nonoperating basis’’ requirement, a
BHC may not, directly or indirectly, engage in operating,
In general, leasing activities of state member servicing, maintaining, or repairing leased property during the
banks are governed by federal tax law and, in term of the lease. For automobile leasing, this requirement
some instances, applicable state law. The leas- means that a BHC may not, directly or indirectly, (1) provide
ing of personal or real property or acting as servicing, repair, or maintenance of the leased vehicle during
the lease term; (2) purchase parts and accessories in bulk or
agent, broker, or adviser in leasing such property for an individual vehicle after the lessee has taken delivery of
is considered a ‘‘closely related nonbanking the vehicle; (3) provide the loan of an automobile during
activity’’ and is therefore permitted under sec- servicing of the leased vehicle; (4) purchase insurance for the
tion 225.28(b)(3) of Regulation Y by a bank lessee; or (5) provide for the renewal of the vehicle’s license
merely as a service to the lessee when the lessee could renew
holding company (BHC) or subsidiary thereof, the license without authorization from the lessor. The BHC
in accordance with certain requirements. While can arrange for a third party to provide these services or
not specifically applicable to banks, these crite- products.

Page 1
2120.1 Direct Financing Leases
ACCOUNTING FOR LEASES Cost $120,000

Since leasing activity became prominent within Unearned income 34,080
the last few decades, lessors have employed a Rentals receivable (96 × $1,605) 154,080
number of different methods to account for their Est. residual value 24,000
investments in leases. Financial Accounting Gross investment 178,080
Standards Board (FASB) Statement No. 13,
‘‘Accounting for Leases,’’ effective January 1, Less:
1977, was intended to bring uniformity to lease Unearned income 34,080
accounting.2 Pursuant to the guidance, a lease is Unearned income (ERV) 24,000
generally structured as a direct financing lease
Net investment 120,000
and reported as such on the institution’s account-
ing records. A direct financing lease is a type of
capital lease 3 that transfers substantially all the
benefits and risks inherent in the ownership of
the leased property to the lessee. In addition, Rentals Receivable
collection of the minimum lease payments must
be reasonably predictable, and no important This account is established in the amount of
uncertainties may exist regarding costs to be total rental payments to be received from the
incurred by the lessor under the terms of the lessee. The amount by which the rentals receiv-
lease. Although minor variations in accounting able ($154,080) exceeds the cost of the property
methods are still found, most investment-in- ($120,000) is the functional equivalent of inter-
leases accounts will be equal to— est and represents a portion of the income to be
recognized over the life of the lease. In the
• the sum of the minimum lease payments to be example below, the cost of the property is
received from the lessee, plus temporarily charged to a fixed-asset account,
• the unguaranteed residual value (estimated then transferred to rentals receivable.
fair market value) of the property at the end of
the lease term, reduced by
• the amount of unearned and deferred income
to be recognized over the life of the lease.
For the purpose of illustration, assume that

property costing $120,000 is leased for a period
of 96 months at $1,605 per month, and the
estimated residual value (ERV) of the property
is $24,000. In this example, income is recog-
nized monthly according to the sum of the
months’ digits method. The investment in this
lease is calculated below, followed by an expla-
nation of each component of the net investment.
2. Other Financial Accounting Standards Board releases

dealing with leasing are FASB Statements 22, 23, 27, 28, 29,
76, 77, 91, 94, 98, and 109; FASB Interpretations 19, 21, 23,
24, 26, and 27; and FASB Technical Bulletins 79-10, 79-12,
79-13, 79-14, 79-15, 79-16, 85-3, 86-2, and 88-1.
3. FASB Statement No. 13, paragraph 7, outlines in detail
certain criteria that a lease must meet for it to be classified as
a capital lease. (See also the call report instructions.)

Page 2
Direct Financing Leases 2120.1
recorded residual value, the difference will be

Fixed assets $120,000 recognized as either a gain or loss, whichever is
Cash 120,000 appropriate.
To record purchase
or property
for lease Est. residual value $24,000
Rentals receivable 154,080 Unearned income 24,000
Fixed assets 120,000 To record ERV of
Unearned income 34,080 leased property
To record amount Cash 26,000
due from lessee Est. residual value 24,000
Gain on sale 2,000
Throughout the lease term, the rentals- To record sale of
receivable account is periodically reduced by property
the full amount of each rental payment received.
Any portion of the ERV guaranteed by a party

unrelated to the lessor would be deducted
Cash $1,605
from the ERV account and added to rentals
Rentals receivable 1,605 receivable.
To record receipt of
monthly payment
Unearned Income
Estimated Residual Value This liability account has a credit balance and is
netted against the total of rentals receivable and
The estimated residual value represents the pro- the ERV for balance-sheet presentation. Its com-
ceeds the lessor expects to realize at the end of ponent parts are the ‘‘interest’’ income equal to
the lease term from the sale or re-leasing of the the excess of rentals receivable over the cost of
property. Exactly as its title states, this account the property and the income to be realized from
represents only an estimate of future value and disposition of the property at the end of the lease
does not represent current market value or term. Each of these components is recognized as
depreciated book value. The residual value at income throughout the life of the lease by
the end of the lease term is considered to be periodic transfers to earned income. Unearned
income, and the corresponding credit for this income is amortized to income over the lease
asset account is posted to unearned income. term to produce a constant periodic rate of
The balance of the ERV account does not return on the net investment in the lease. Any
normally change significantly during the lease other method, such as the sum-of-the-months’-
term. The unguaranteed residual value should be digits method, may be used if the results obtained
reviewed at least annually to determine whether are not materially different from those that
a decline, other than a temporary one, has would result from the interest method described
occurred in its estimated value. If a decline is in the preceding sentence and if the resulting
not temporary, the accounting for the lease impact does not overstate income during the
transaction should be revised using the new current period. Loan-origination fees and initial
estimate, and the resulting loss should be recog- direct costs, such as commissions and fees that
nized in the period that the change is made. are incurred by the lessor in negotiating and
Upward adjustments or increases in the residual consummating the lease, are offset against each
value are not recognized. other, and the resulting net amount is deferred
After the end of the term, the residual value and recognized over the lease term. The practice
account is eliminated from the books upon sale, of recognizing a portion of the unearned income
re-lease, or other disposition of the property. If at the inception of the lease to offset initial direct
the amount of proceeds received differs from the costs is no longer acceptable.

Page 3
Depreciation Classification
For certain leases, the lessor is entitled to claim If it is deemed appropriate to classify a lease, the
depreciation for tax purposes. However, for amount at which the lease would be classified is
financial statement purposes, no depreciation for the net investment. For example, assume that 94
leased property will appear on the income state- of the 96 payments have been received on the
ment and no accumulated depreciation will above lease, that income has been recognized
appear on the balance sheet. If the lessor is monthly according to the sum-of-the-months’-
entitled to the benefits of depreciation, then, for digits method, and that the lease is now consid-
tax purposes only, depreciation will be calcu- ered a loss. Its balance on the books is $27,173,
lated and will reduce the lessor’s tax liability. as follows:
The lessor’s entitlement to depreciation tax
benefits is a function of the type of lease
arrangement negotiated. When the lessor retains
title to the asset and owns the asset at the Rentals receivable $ 3,210
expiration of the lease, the lessor may take Est. residual value 24,000
depreciation into account for tax purposes. These Gross investment 27,210
characteristics are typical of a ‘‘true," ‘‘net,’’ or Less:
‘‘capital’’ lease, terms often used interchange-
ably in the industry. In a ‘‘financing’’ lease, the Unearned income 22
lessee rather than the lessor acquires title to the Unearned income (ERV) 15
property at the expiration of the lease and is Net investment 27,173
entitled to depreciation tax benefits. Accord-
ingly, the lessor will charge the lessee a higher
periodic lease payment (for a higher ‘‘rate of Classification of the $27,173 balance of this
return’’) to offset its loss of depreciation tax lease involves classifying $3,188 of the unre-
benefits. covered portion of the cost of the property
($3,210 less $22 unearned income) plus $23,985
of income that has already been recognized in
Balance-Sheet Presentation anticipation of receiving the ERV ($24,000 less
$15 not yet recognized). In short, the calculation
Lease receivables are to be reported on the is $3,188 + $23,985 = $27,173.
balance sheet as the single amount ‘‘net invest- Charging off the ERV included in the net
ment’’ (see below). If the lessor has established investment treats the lease as if the underlying
an allowance for possible lease losses, this property has no value and, in effect, reverses the
amount is included in the total allowance for unearned income that has been recognized in
loan and lease losses and represents a deduction anticipation of selling the leased property at its
from the net investment. Footnotes to the bal- recorded ERV. Accordingly, if the property does
ance sheet should disclose the components of have value, the $27,173 classified should be
the net investment, as follows: reduced by the net amount that the lessor could
realize by selling the property.
Rentals receivable $154,080

Est. residual value 24,000 Delinquency
Gross investment 178,080
It is appropriate for the examination report to
Less: state the percentage of delinquency in the lease
Unearned income 58,080 portfolio. The percentage is calculated by divid-
Net investment $120,000 ing the aggregate rentals receivable on delin-
quent leases (less the ‘‘interest’’ components of
their unearned income accounts) by the total of
For call report purposes, lease financing rentals receivable on all leases (less the ‘‘inter-
receivables are reported net of unearned income est’’ components of their unearned income
as part of an institution’s total loans. accounts). ERVs would not be included in the

Page 4
Direct Financing Leases 2120.1
delinquent amounts since they do not represent of a leveraged lease permits multiple tax bene-
obligations of the lessees. fits and maximum investment return. The lessor
If the lease obligation in the previously is in search of a tax shelter to offset income
described classification example was the only generated from other sources, while the lessee
delinquent obligation in a portfolio of leases bargains for lower rental charges in exchange
with component accounts as shown below, the for the tax advantage the lessor receives. The
rate of delinquency in the portfolio would be result of this trade-off ideally produces an
3.4 percent. attractive rate of return on the lessor’s invested
dollars, while the lessee conserves working
capital and obtains financing at a cost substan-
Rentals receivable $ 94,411 tially below the lessee’s usual borrowing rate.
In a leveraged lease, the lessor purchases and
Est. residual value 705,882 becomes owner of the equipment by providing
Gross investment 800,293 only a percentage (usually 20 to 40 percent) of
Less: the capital needed. The rest of the purchase price
Unearned income 647 is borrowed by the lessor from long-term lenders
on a nonrecourse basis. The borrowings are
Unearned income (ERV) 441 secured by a first lien on the equipment, an
Net investment $799,205 assignment of the lease, and an assignment of
the lease payments.
$3,210 − 22 If the purchase price of the equipment is
= 3.4% large, there may be several equity owners and
$94,411 − 647 debtholders involved. In this case, an owner
trustee may be named to hold title to the
equipment and to represent the equity owners.
An indenture trustee may be named to hold the
Termination of a Lease mortgage on the property for the benefit of the
debtholders.
The termination of a lease is recognized in the The lessor (equity holder), as the owner, is
income of the period in which the termination allowed to take accelerated depreciation based
occurs by eliminating the remaining net invest- on the total cost of the equipment. The lessor
ment from the lessor’s account. The lease prop- might also receive a small portion of the rental
erty is then recorded as an asset using the lower payments, but the desired yield is obtained from
of the original cost, present fair value, or present the timing of depreciation. The effect gives the
carrying amount. lessor a return through the small rentals and
allows the lessor to retain the residual value
rights to the equipment at the end of the lease
LEVERAGED LEASES period.
The bank should consider its present and
Leveraged leasing is a specialized form of anticipated future tax position, its future money
financing and should only be pursued by banks rates, and the residual value of the property. The
with the appropriate expertise. Part of the exam- return on the bank’s investment in leveraged
iner’s duty is to determine that the personnel leases depends largely on these factors. A slight
who structure and follow leveraged leases are change can precipitate significant changes in the
highly qualified in that area and have a current bank’s position. Anticipated proceeds from the
working knowledge of applicable tax laws and sale or re-leasing of the property at the conclu-
regulations. sion of the lease term (the residual value) is an
A leveraged lease transaction is complex in important element of the return and should be
terms of size, the number of parties involved, estimated carefully. It will, in most cases, exceed
legal involvement, and, of course, the unique 25 percent of the purchase price because of
advantages to all parties. Legal expenses and certain tax requirements. The bank should con-
administrative costs associated with leveraged tinually evaluate the property for misuse, obso-
leasing limit its use to financing large capital- lescence, or market decline, all of which can
equipment projects. By tailoring the tax effects rapidly deteriorate the value of the property
to the needs of the parties involved, the structure before the lease term expires. In these cases, the

Page 5
lessee may default, often with expensive conse- in a position to foreclose and leave the bank
quences for the lessors. without a way to recapture the carrying value of
The examiner should remember that a portion its investment. Therefore, the general rule is that
of the bank’s recapture of its investment in a bank should not enter into a leveraged lease
leased property is often predicated on the inher- transaction with any party to which it would not
ent tax benefits. Accordingly, a decline in the normally extend unsecured credit.
bank’s ability to use these tax benefits could The lessor’s net investment in a leveraged
reduce or eliminate the profitability of the lease shall be recorded in a manner similar to
venture. that for a direct financing lease, but net of the
The complexity of leveraged leasing should principal and interest on the nonrecourse debt.
motivate the examiner to carefully scrutinize The components of the net investment, includ-
each indenture and all parties concerned before ing related deferred taxes, should be fully dis-
any analysis begins. The examiner should closed in the footnotes to the lessor’s financial
approach each lease from the standpoint of the statements when leveraged leasing is a signifi-
creditworthiness of the lessee and the continu- cant part of a bank’s business activities. (See
ous assessment of the value of the leased prop- appendix E of FASB 13 for an example of how
erty. If the lessee defaults, the loan participant is to account for a leveraged lease.)

Page 6
1. To determine if lease policies, practices, 4. To determine the scope and adequacy of the
procedures, objectives, and internal controls audit function.
are adequate. 5. To determine compliance with applicable
2. To determine if bank officers are operating laws and regulations.
in conformance with the established 6. To initiate corrective action when policies,
guidelines. practices, procedures, objectives, or internal
3. To evaluate the adequacy of collateral, credit controls are deficient or when violations of
quality, and collectibility. laws or regulations have been noted.

Page 1
1. If selected for implementation, complete or to the lessor or for which financial infor-
update the Direct Financing Leases section mation was not adequate to make such a
of the Internal Control Questionnaire. determination, transcribe the following
2. Based on the evaluation of internal controls information to line cards:
and the work performed by internal/ a. name and line of business of lessee
external auditors, determine the scope of the b. name of guarantor(s)
examination. c. original date of the lease contract
3. Test for compliance with policies, practices, d. original amount of the rentals receivable
procedures, and internal controls in conjunc- e. ERV of the property
tion with performing the remaining exami- f. amount of ITC to be realized
nation procedures. Also, obtain a listing of g. book value of the investment in the lease
any deficiencies noted in the latest review as of the examination date
done by internal/external auditors from h. cost of the property
the examiner assigned ‘‘Internal Control’’ i. description and location of the property
and determine if corrections have been j. a m o u n t a n d f r e q u e n c y o f r e n t a l
accomplished. payments
4. The following information should be avail- k. original amount, term, rate, and schedule
able at the start of the examination: of amortization of any nonrecourse debt
a. trial balance of all leases and outstanding associated with the lease
credits l. lessor’s percentage of equity participa-
b. listing of accounts on which payments tion in the lease obligation, if applicable
are delinquent 30 days or more or on m. summary financial data indicating the
which payments are otherwise not being creditworthiness of the lessee and guar-
made according to schedule antors, if applicable
c. listing of available lines of credit 9. Before the conclusion of the examination,
d. minutes of board and executive meet- discuss with management all classified
ings since the date of the previous leases. Inadequate or negative cash flow and
examination unfavorable trends reflected in financial
5. Using an appropriate sampling technique, statements of the lessee are usually indica-
select leases for review. tive of a substandard lease. Leases classified
6. Obtain liability and other information on doubtful typically include those on which
common borrowers from examiners as- payments are delinquent for an extended
signed cash items, overdrafts, and other period and those on which the lessor’s
loan areas and together decide who will recovery of investment is dependent upon
review the borrowing relationship. an event of unknown probability, such as a
7. For leases selected for review, analyze the pending lawsuit or insurance claim. A loss
creditworthiness of the lessees. Consider- classification results from the lessee’s
ation is given to the figures derived from the inability or refusal to continue making
lessee’s financial statements, as well as to payments.
cash flow, trends and projections of growth 10. Prepare write-ups to support the classifica-
in sales and income, and the qualifications tions. The write-up should include the
of management. Delinquency on a lease lessee’s type of business, present financial
obligation is potentially more serious status, circumstances that led to the classi-
than delinquency on a conventional loan fication, the probability that the terms of the
because, if the property under lease is nec- lease can be met, and the amount of protec-
essary for the lessee’s continued production tion afforded by sale or release of the
of income, as is frequently the case, the underlying property.
lessee’s financial condition will be seriously 11. Review a sample of the lessor’s computa-
deteriorated before the lessee is willing to tions of lease yields to determine whether
risk losing the property by default. the lessor will recover the cost of purchas-
8. For those leases which might result in loss ing and the after-tax cost of financing the

Page 1
2120.3 Direct Financing Leases: Examination Procedures
property during the initial term of the lease After deducting the $120,000 cost of the
or 40 years, whichever is less. property from the net cash flow provided by
the lease, after-tax funds of $98,563 are
Shown below are the amounts which may available to cover the cost of financing the
be applied against the purchase and financ- property. Dividing this amount by the
ing costs in calculating recovery. assumed marginal tax rate of 46 percent
indicates that the equivalent amount in pre-
a. Total of lease payments and ERV, reduced tax funds is $214,267. If this $214,267 were
by the estimated taxes to be paid on paid as interest over a 96-month period to
unearned income. The amount of the finance the acquisition of property costing
ERV used in this calculation may not $120,000, the annual rate of interest (inter-
exceed 20 percent of acquisition cost, nal rate of return) would be 32.0 percent
though it is permissible for the ERV to (see compound interest chart). No further
be carried on the books in an amount calculation need be made since this high
exceeding 20 percent of cost. percentage based on funds available to cover
b. ITC to be realized by the lessor. finance costs would exceed by far the les-
c. Tax benefits resulting from depreciation sor’s likely approximate pre-tax cost of
charges, equal to total allowable depre- funds. However, in those instances in which
ciation times the lessor’s marginal tax the percentage calculated is believed to
rate. Depreciation for tax purposes is closely approximate the cost of funds, the
calculated on the basis of total original lessor should be asked to explain the man-
cost ignoring ERV. However, over time, ner by which its recovery of cost is assured.
accumulated depreciation may not If this example were a personal property
exceed original cost less ERV. lease with a term of seven years or less, any
d. For personal property leases of seven qualified guarantee up to 60 percent of
years or less, any additional amount acquisition cost could have been considered
provided by an unconditional guarantee as an addition to the funds available to
of the lessor’s full recovery of invest- provide the lessor with full payout.
ment plus financing cost. The guarantee As mentioned in the introduction to this
can be made by a lessee, an indepen- section, an exception to the full-payout
dent third party, or manufacturer deemed requirement is made for leases to those
creditworthy by the lessor. In determin- governmental entities that are prohibited
ing full-payout compliance, the guaran- from entering into leases for periods exceed-
tee may only account for up to 60 per- ing one year. In the case of leases to
cent of the acquisition cost of the government entities, the lessor should dem-
property. onstrate that the lease is expected to be
The following example of a payout cal- continually renewed until the cost is fully
culation assumes a marginal tax rate of recovered.
46 percent and depreciation of the full cost 12. Review records to determine that the lease
of the property for tax purposes: transaction constitutes a valid lease for tax
purposes. If the agreement is ruled by the
IRS to be a ‘‘conditional sale,’’ the lessor
Total lease payments $154,080 would not be entitled to depreciation charges
ERV 24,000 or the ITC, and the lessee would be required
ITC (tax benefit) 12,000 to deduct depreciation charges rather than
Depreciation—tax benefit lease payments from taxable income. It is
(46% × 120,000) 55,200 preferable that the lessor obtain a private
Subtotal $245,280 ruling from the IRS to make certain that it
qualifies as the original user of the property
Less taxes on unearned income: and is therefore entitled to the previously
(‘‘interest’’) $34,080 mentioned tax benefits. Circumstances
(ERV) 24,000 that the IRS considers as evidence of a
46% × $58,080 26,717 conditional sale rather than a lease are as
$218,563 follows:
a. portions of the rental payments are made

Page 2
Direct Financing Leases: Examination Procedures 2120.3
applicable to an equity interest of the will be sold or re-leased within the required
lessee in the property two-year period.
b. the lessee acquires title to the property 18. Investigate the lessor’s procedures for peri-
after making a specified number of odic review of the reasonableness of the
payments estimated residual value. The estimate
c. the payments made by the lessee for a should be reviewed at least annually and
short period of use constitute an unusu- reduced in amount on the books if the value
ally large percentage of the purchase has declined on a presumably permanent
price of the property basis.
d. the total rental payments to be received 19. Review past operations of the lessee com-
exceed the current fair rental value of the pany to determine if projections of income
property, indicating that the payments and ERV have been realistic in light of
include an element other than rent actual experience.
e. the lessee has an option to purchase the 20. Review the minutes of the meetings of the
property at a price that is nominal in board and executive committees to deter-
relation to the value of the property or to mine whether purchases of property and
the total amount of rental payments delinquent leases are reported to the board.
f. a portion of each rental payment is readily 21. Determine if the bank has entered into
identifiable as the equivalent of interest leases with companies owned or controlled
13. Ascertain whether title to the property rests by any director or officer. Compare the rates
with the lessor and that the lessor has taken and terms on such leases to the rates and
steps to protect its ownership rights. Evi- terms offered on leases to companies of
dence of filing under the Uniform Commer- similar credit standing.
cial Code, where appropriate, should be 22. Check for lease concentrations to any one
found in the documentation file. Aircraft lessee or industry and prepare a comment
should be registered with the FAA, inter- for the examination report if any concentra-
state vehicles with the ICC, and ships with tion is considered unwarranted.
the Coast Guard. 23. Determine whether the bank has established
14. Check for cancellation or other provisions limits for the maximum amount of ‘‘credit’’
in the contract that could jeopardize the to be extended to a single lessee. If these
full-payout status of the lease. There is no limits have been established, investigate
need to take exception to a cancellation whether the bank adheres to them. If they
provision that provides for payment by the have not been established, inquire as to the
lessee of an amount that allows the lessor to bank’s policy on this matter.
fully recover its investment in the property. 24. Check for action taken on matters criticized
15. Check that insurance coverage on leased in the most recent audit reports and the
property is provided by the lessee in com- previous examination report. Determine if
pliance with all insurance provisions of the leases classified ‘‘loss’’ were removed from
contract in an amount sufficient to protect the books.
against loss from property damage. Public 25. Discuss with appropriate officer(s) and pre-
liability insurance should also be provided pare summaries in appropriate report form
to protect against loss from lawsuits that of—
could arise from situations such as the crash
a. delinquent leases, including those con-
of leased aircraft.
sidered ‘‘A’’ paper;
16. Review the lessee’s duties under the con-
tract with respect to repairs and taxes. b. violations of laws and regulations;
Determine whether the lessor has instituted c. leases not supported by current and com-
procedures to check that the lessee’s plete financial information;
required duties are being performed. d. leases on which documentation is
17. Review the status of all property acquired deficient;
for lease purposes but which is not now e. equipment deficiencies revealed in
under lease. Determine the reason for the inspection reports;
‘‘off-lease’’ status of the property, ascertain f. off-lease equipment;
the realizable value of the property, and g. concentrations of leases;
investigate whether the off-lease property h. classified leases; and

Page 3
2120.3 Direct Financing Leases: Examination Procedures
i. leases to major shareholders, employees, 26. Update workpapers with any information
officers, directors, and/or their interests. that will facilitate future examinations.

Page 4
Review the bank’s internal controls, policies, adjustments checked or tested subsequently
practices, and procedures for making and ser- by persons who do not also handle cash or
vicing direct lease financing. The bank’s system initiate transactions (if so, explain briefly)?
should be documented in a complete and con-
cise manner and should include, where appro-
priate, narrative descriptions, flow charts, copies INTEREST AND/OR RENT
of forms used, and other pertinent information.
Items marked with an asterisk require substan- *8. Is the preparation and posting of interest
tiation by observation or testing. and/or rent records performed or reviewed
by persons who do not also—
a. issue official checks and drafts or
POLICIES AND OBJECTIVES b. handle cash?
1. Has the board of directors, consistent with

its duties and responsibilities, adopted writ- DEPRECIATION (OPERATING
ten direct lease financing policies that— LEASES)
a. establish procedures for reviewing direct
lease financing applications, 9. Is the preparation and posting of periodic
b. define qualified property, and depreciation records performed or re-
c. establish minimum standards for viewed by persons who do not also have
documentation? sole custody of property?
2. Are direct lease financing policies reviewed 10. Do the bank’s procedures require that
at least annually to determine if they depreciation expense be charged at least
are compatible with changing market quarterly?
conditions? *11. Are the subsidiary depreciation records
balanced, at least quarterly, to the appro-
priate general ledger controls by persons
RECORDS who do not also have sole custody of
property?
*3. Is the preparation and posting of subsidi-
ary direct lease financing records per-
formed or reviewed by persons who do not OTHER
also—
a. issue official checks and drafts or *12. Are periodic property inventory reports
b. handle cash? prepared by the lessee or trustee?
*4. Are the subsidiary direct lease financing 13. Do reports clearly indicate the condition
records reconciled, at least monthly, with and location of the leased property?
the appropriate general ledger accounts, 14. When inspection of the equipment leased
and are reconciling items investigated by is either infrequent or not feasible, has the
persons who do not also handle cash? bank taken measures to protect its equip-
5. Are delinquent account collection requests ment and prevent its misuse?
and past-due notices checked to the trial 15. At lease termination, are outside appraisals
balances that are used in reconciling sub- made of property before bids are accepted?
sidiary records of direct lease receivables 16. Are review procedures in effect to main-
to general ledger accounts, and are they tain the necessary insurance coverage on
handled only by persons who do not also all leased assets regardless of whether the
handle cash? cost of this insurance is to be borne by the
6. Are inquiries about lease balances received bank or the lessee?
and investigated by persons who do not 17. Does the bank have insurance coverage
also handle cash or pass adjustments? against its potential public liability risk as
*7. Are documents supporting recorded credit owner/lessor of the property?

Page 1
2120.4 Direct Financing Leases: Internal Control Questionnaire
18. Are safeguards in effect to prevent the 24. Is residual value substantiated by periodic
possibility of conflict of interest or self- appraisals?
dealing in selecting the seller, servicer, 25. Are reports listing past-due leases and/or
insurer, or purchaser for the equipment those receiving special attention submitted
leased? to the board for review at their regular
19. Are separate files maintained for each meetings?
lease transaction?
20. Does each file supporting the acquisition
and disposal of assets reflect the review CONCLUSION
and written approval of an officer other
than the person who actually controlled 26. Is the foregoing information considered an
the disbursement and receipt of funds? adequate basis for evaluating internal con-
21. Are all leases required to be supported by trol in that there are no significant defi-
current credit information? ciencies in areas not covered in this ques-
22. Do modifications of terms require the tionnaire that impair any controls? Explain
approval of the board or committee that negative answers briefly and indicate any
initially approved the lease? additional examination procedures deemed
23. If commitments are issued contingent upon necessary.
receipt of certain satisfactory information, 27. Based on a composite evaluation, as evi-
has authority to reject or accept such denced by answers to the foregoing
information been vested in someone other questions, internal control is considered
than the account officer? (adequate/inadequate).

Page 2
Consumer Credit
This section applies to most types of loans found as in an automobile loan, or by money in a bank
in a consumer loan department. Consumer credit, account.
also referred to as retail credit, is defined as A bank’s installment loan portfolio usually
credit extended to individuals for household, consists of a large number of small loans, each
family, and other personal expenditures, rather scheduled to be amortized over a specific period.
than credit extended for use in a business or for Most installment loans are made for consumer
home purchases. Consumer credit loans are purchases; however, amortizing commercial
loans not ordinarily maintained by either the loans are sometimes placed in the installment
commercial or real estate loan departments. loan portfolio to facilitate their servicing. In
Consumer loans frequently make up the largest addition, the installment loan portfolio can con-
number of loans originated and serviced by the sist of both loans made by the bank and loans
bank, but their dollar volume may be signifi- purchased from retail merchants who originated
cantly less than for other types of loans. Con- the loans to finance the sale of goods to their
sumer credit loans may be secured or unsecured customers.
and are usually structured with short- or medium-
term maturities. Broadly defined, consumer
credit includes all forms of closed-end credit Indirect Installment Loans
(installment credit) and open-end credit (revolv-
ing credit), such as check credit and credit card Indirect installment loans are also known as
plans. Consumer credit also includes loans dealer loans, sales-finance contracts, or dealer
secured by an individual’s personal residence, paper. In this type of consumer credit, the bank
such as home equity and home-improvement purchases, sometimes at a discount, loans origi-
loans. Home equity loans are discussed in ‘‘Real nated by retailers of consumer goods, such as a
Estate Loans,’’ section 2090.1. car dealer. This type of lending is called indirect
The examiner should determine the adequacy lending because the dealer’s customer indirectly
of the consumer credit department’s overall becomes a customer of the bank.
policies, procedures, and credit quality. The The sales-finance contracts purchased from
examiner’s goal should not be limited to identi- dealers of consumer goods are generally closed-
fying current portfolio problems but should also end installment loans with a fixed rate of inter-
include identifying potential problems that may est. These loans are purchased in one of three
result from liberal lending policies, unfavorable ways depending on the dealer and the circum-
trends, potentially imprudent concentrations, or stances of purchase:
nonadherence to established policies. Banks lack-
ing written policies, or failing to implement or • Without recourse. The bank is responsible for
follow established policies effectively, should be collecting the account, curing the delinquency,
criticized in the report of examination. or applying the deficiency against dealer
reserves or holdback accounts. The majority
of sales-finance contracts with dealers are
without recourse.
TYPES OF CONSUMER CREDIT • Limited recourse. The dealer will repurchase
the loan, cure the default, or replace the loan
Installment Loans only under certain circumstances in accordance
with the terms of the agreement between the
Many traditional forms of installment credit bank and the dealer.
have standard monthly payments and fixed • With recourse. The dealer is required to repur-
repayment schedules of one to five years. These chase the loan from the bank on demand,
loans are made with either fixed or variable typically within 90 to 120 days of default.
interest rates that are based on specific indices.
Installment loans fill a variety of needs, such as In the case of recourse and limited-recourse
financing the purchase of an automobile or loans, legal lending limitations need to be
household appliance, financing home improve- considered.
ment, or consolidating debt. These loans may be Sales-finance contracts purchased without
unsecured or secured by an assignment of title, recourse from dealers should be based on the

Page 1
2130.1 Consumer Credit
individual’s creditworthiness, not on the finan- cally, ad hoc programs involve insured deposi-
cial strength of the dealership itself. The con- tory institutions’ providing discretionary cover-
tracts purchased should comply with the bank’s age of customers’ overdrafts on a case-by-case
loan policy for similar consumer loans. Excep- basis. Automated overdraft-protection programs,
tions to the bank’s policies and procedures also referred to as bounced-check protection or
should be documented in the credit file and have overdraft protection, are credit programs increas-
the appropriate level of approval. For sales- ingly offered by institutions to transaction-
finance contracts purchased with recourse that account (typically deposit-account) customers
do not meet the bank’s normal credit criteria and as an alternative to traditional check-credit and
are purchased on the basis of the added strength ad hoc programs for covering overdrafts.
of the dealer, the bank should document the Under both the ad hoc and automated pro-
minimum criteria for such loans and the specific grams, regardless of whether an overdraft is
bank-approved financial covenants with which paid, institutions typically impose a fee when an
the dealer must comply. overdraft occurs. This fee is referred to as a
nonsufficient-funds, or NSF, fee. Unlike the
discretionary ad hoc accommodation typically
Check Credit and provided to those lacking a line of credit or other
Overdraft Protection type of overdraft service (such as linked
accounts), automated programs are often mar-
Check credit is defined, for the purpose of this keted to consumers and may give consumers the
manual, as the granting of unsecured, interest- impression that the service is a guaranteed short-
bearing revolving lines of credit to individuals term credit facility. These marketed programs
or businesses. Such extensions of credit are typically provide consumers with an express
subject to the disclosure requirements of the overdraft ‘‘limit’’ that applies to their account.
Truth in Lending Act (TILA). Banks provide Neither the ad hoc nor the automated over-
check-credit services through overdraft protec- draft programs are subject to the annual percent-
tion, cash reserves, and special drafts. age rate (APR) disclosure requirements of TILA.
The most common product is overdraft line- These programs are, however, subject to the
of-credit protection, whereby a transfer is made disclosure requirements of the Truth in Savings
from a preestablished line of credit to a custom- Act (TISA) and Regulation DD.
er’s deposit account when a check is presented The specific details of institutions’ overdraft-
that would cause the account to be overdrawn. protection programs have varied over time. The
Transfers normally are made in specific incre- programs currently offered by institutions incor-
ments, up to a maximum line of credit approved porate some or all of the following characteristics:
by the bank. • Institutions inform consumers that overdraft
In a cash reserve system, the customer must protection is a feature of their accounts and
request that the bank transfer funds from a promote consumers’ use of the service. Insti-
preestablished line of credit to his or her deposit tutions may also inform consumers of their
account. To avoid overdrawing the account, the aggregate dollar limit under the overdraft-
customer must request the transfer before nego- protection program.
tiating a check against the account.
• Coverage is automatic for consumers who
In a special draft system, the customer nego-
meet the institution’s criteria (for example,
tiates a special check drawn directly against a
the account has been open a certain number
preestablished line of credit. In this method,
of days, and deposits are made regularly).
deposit accounts are not affected.
Typically, the institution performs no credit
In all three systems, the bank periodically underwriting.
provides its check-credit customers with a state-
ment of account activity. Required minimum • Overdrafts generally are paid up to the aggre-
payments are computed as a fraction of the gate limit set by the institution for the specific
balance in the account on the cycle date and may class of accounts. Limits are typically $100 to
be made by automatic charges to the deposit $500.
account. • Many program disclosures state that payment
Banks also provide credit through ad hoc and of an overdraft is discretionary on the part of
automated overdraft-protection programs. Typi- the institution and may disclaim any legal

Page 2
Consumer Credit 2130.1
obligation of the institution to pay any Safety-and-Soundness Considerations

overdraft.
• The service may extend to check transactions When overdrafts are paid, credit is extended to
as well as other transactions, such as with- an institution’s customers. To the extent overdraft-
drawals at automated teller machines (ATMs), protection programs lack individual account
transactions using debit cards, preauthorized underwriting, these programs may expose an
automatic debits from a consumer’s account, institution to more credit risk (higher delinquen-
telephone-initiated funds transfers, and online cies and losses) than overdraft lines of credit and
banking transactions. other traditional overdraft-protection options.
• A flat fee is charged each time the service is Institutions providing overdraft-protection pro-
triggered and an overdraft item is paid. Com- grams should adopt written policies and proce-
monly, a fee in the same amount would be dures adequate to address the credit, operational,
charged even if the overdraft item was not and other risks associated with these types of
paid for nonsufficient funds. A daily fee may programs. Prudent risk-management practices
also apply for each day the account remains include the establishment of express account-
overdrawn. eligibility standards and well-defined and prop-
• Some institutions offer closed-end loans to erly documented dollar-limit decision criteria.
consumers who do not bring their accounts to Institutions should also monitor these accounts
a positive balance within a specified time on an ongoing basis and be able to identify
period. These repayment plans allow consum- consumers who may represent an undue credit
ers to repay their overdrafts and fees in risk to the institution. Overdraft-protection pro-
installments. grams should be administered and adjusted, as
needed, to ensure that credit risk remains in line
To assist insured depository institutions in with expectations. Program adjustments may
the responsible disclosure and administration of include, as appropriate, disqualification of a
overdraft-protection services, particularly those consumer from future overdraft protection. Man-
that are marketed to consumers (a depository agement should regularly receive reports suffi-
institution’s customers), the federal banking and cient to enable it to identify, measure, and
thrift agencies issued Joint Guidance on Over- manage overdraft volume, profitability, and credit
draft Protection Programs. The interagency guid- performance.
ance, issued on February 18, 2005, addresses the Institutions are also expected to incorporate
agencies’ concerns about the potentially mis- prudent risk-management practices related to
leading implementation, marketing, disclosure, account repayment and suspension of overdraft-
and operation of these programs. (See the ‘‘Best protection services. These practices include the
Practices’’ section of the guidance.) The guid- establishment of specific time frames for when
ance also discusses the agencies’ safety-and- consumers must pay off their overdraft balances.
soundness considerations and the legal risks of For example, procedures should be established
such programs. Institutions are encouraged to for the suspension of overdraft services when
carefully review their programs to ensure that an account holder no longer meets the eligibility
their marketing and other communications con- criteria (such as when the account holder
cerning the programs (1) do not mislead con- has declared bankruptcy or defaulted on another
sumers into believing that their programs are loan at the bank) as well as for when an account
traditional lines of credit (when they are not) or holder does not repay an overdraft. In addition,
that payment of overdrafts is guaranteed, (2) do overdraft balances should generally be charged
not mislead consumers about their account bal- off when considered uncollectible, but no later
ance or the costs and scope of the overdraft than 60 days from the date first overdrawn. In
protection offered, and (3) do not encourage some cases, an institution may allow a consumer
irresponsible consumer financial behavior that to cover an overdraft through an extended re-
may potentially increase the institution’s risk. payment plan when the consumer is unable to
See SR-05-3 and the attached interagency bring the account to a positive balance within
guidance for detailed discussions of the agen- the required time frames. The existence of the
cies’ concerns and best practices (for marketing repayment plan, however, would not extend the
and communication with consumers and pro- charge-off determination period beyond 60 days
gram features and operation). See also section (or a shorter period if applicable), as measured
3000.1. from the date of the overdraft. Any payments

Page 3
received after the account is charged off (up to Risk-Based Capital Treatment of
the amount charged off against the allowance for Overdraft Balances
loan and lease losses) should be reported as a
recovery. Banks are expected to provide proper risk-based
Some overdrafts are rewritten as loan obliga- capital treatment of outstanding overdrawn
tions in accordance with an institution’s loan balances and unused commitments. Overdraft
policy and are supported by a documented balances should be risk-weighted according to
assessment of that consumer’s ability to repay. the obligor. Under the risk-based capital guide-
In those instances, the institution should use the lines, the capital charge on the unused portion
charge-off time frames described in the Federal of commitments is generally based on an off-
Financial Institutions Examination Council’s balance-sheet credit-conversion factor and the
Uniform Retail Credit Classification and Account risk weight appropriate to the obligor. (See
Management Policy (revised June 6, 2000; ef- section 3020.1.) In general, the capital guide-
fective December 31, 2000). (See SR-00-8.) lines provide that the unused portion of a com-
Institutions should follow generally accepted mitment is subject to a zero percent credit-
accounting principles and the instructions for conversion factor if the commitment has an
the Reports of Condition and Income (Call original maturity of one year or less, or to a
Reports) to report income and loss recognition 50 percent credit-conversion factor if the com-
on overdraft-protection programs. Overdraft mitment has an original maturity over one year.
balances should be reported on the Report of Under the guidelines, a zero percent conversion
Condition of the bank Call Report as loans. factor also applies to the unused portion of a
Accordingly, overdraft losses should be charged ‘‘retail credit card line’’ or ‘‘related plan’’ if it is
off against the allowance for loan and lease unconditionally cancelable by the institution in
losses. All institutions are expected to adopt accordance with applicable law. (See 12 CFR
rigorous loss-estimation processes to ensure that 208, appendix A, section III.D.5.) The phrase
overdraft-fee income is accurately measured. ‘‘related plans’’ in the guidelines includes over-
Such methods may include providing loss allow- draft checking plans. The overdraft-protection
ances for uncollectible fees or, alternatively, programs discussed in the agencies’ February
only recognizing that portion of earned fees 18, 2005, guidance fall within the meaning of
estimated to be collectible.1 The procedures for ‘‘related plans’’ as a type of ‘‘overdraft checking
estimating an adequate allowance should be plan’’ for the purposes of the federal banking
documented in accordance with the July 2, agencies’ risk-based capital guidelines. Conse-
2001, interagency Policy Statement on the Allow- quently, overdraft-protection programs that are
ance for Loan and Lease Losses Methodologies unconditionally cancelable by the institution in
and Documentation for Banks and Savings accordance with applicable law would qualify
Institutions.2 (See SR-01-17.) for a zero percent credit-conversion factor.
If an institution advises account holders of the Institutions entering into overdraft-protection
available amount of overdraft protection, for contracts with third-party vendors must conduct
example, when accounts are opened or on thorough due-diligence reviews before signing a
depositors’ account statements or automated contract. The November 30, 2000, interagency
teller machine (ATM) receipts, the institution guidance Risk Management of Outsourced Tech-
should report the available amount of overdraft nology Services outlines the agencies’ expecta-
protection with its other legally binding com- tions for prudent practices in this area. (See
mitments, for Call Report purposes. These avail- section 4060.1 and SR-00-17.)
able amounts, therefore, should be reported as
‘‘unused commitments.’’
Legal Risks
1. Uncollected overdraft fees may be charged off against
the allowance for loan and lease losses if such fees are
Overdraft-protection programs must comply with
recorded with overdraft balances as loans and if estimated all applicable federal laws and regulations,
credit losses on the fees are provided for in the allowance for including the Federal Trade Commission Act (as
loan and lease losses. outlined below). State laws may also be appli-
2. The interagency policy statement was issued by the
Board of Governors of the Federal Reserve System, the Office
cable, including usury and criminal laws, as well
of the Comptroller of the Currency, the Federal Deposit as laws on unfair or deceptive acts or practices.
Insurance Corporation, and the Office of Thrift Supervision. Before implementing an overdraft-protection

Page 4
program, institutions should have their program on this account or other loans) by drawing on
reviewed by counsel for compliance with all reserves
applicable laws. Further, although the agencies’ • accounts with steady usage
guidance outlines the applicable federal laws
and regulations as of February 2005, such laws Many banks offer check-credit plans to small
and regulations are subject to amendment. businesses; these plans may have a higher-than-
Accordingly, institutions should monitor appli- normal degree of risk unless they are offered
cable laws and regulations for revisions and under very stringent controls. In these situations,
ensure that their overdraft-protection programs the examiner’s review should be based on the
are fully compliant. same factors and criteria used for the review of
unsecured commercial loans.
Federal Trade Commission Act. Section 5 of the
Federal Trade Commission Act (the FTC Act)
prohibits unfair or deceptive acts or practices
(15 USC 45). The banking agencies enforce this Credit Card Plans
section pursuant to their authority in section 8
of the Federal Deposit Insurance Act (12 USC Most bank credit card plans are similar. The
1818).3 An act or practice is unfair if it causes or bank solicits retail merchants, service organiza-
is likely to cause substantial injury to consumers tions, and others who agree to accept a credit
that is not reasonably avoidable by consumers card in lieu of cash for sales or services per-
themselves and not outweighed by countervail- formed. The bank assumes the credit risk and
ing benefits to consumers or to competition. An charges the nonrecourse sales draft to the indi-
act or practice is deceptive if, in general, it is a vidual customer’s credit card account. The bank
representation, omission, or practice that is likely sends monthly statements to the customer, who
to mislead a consumer acting reasonably under may elect to pay the entire amount or to pay in
the circumstances and if the representation, monthly installments, with an additional percent-
omission, or practice is material. age charge on the outstanding balance each
Overdraft-protection programs may raise month. A cardholder may also obtain cash
issues under the FTC Act, depending on how the advances, which accrue interest from the trans-
programs are marketed and implemented. Insti- action date, from the bank or automated teller
tutions should closely review all aspects of their machines.
overdraft-protection programs, especially any
materials that inform consumers about the pro- A bank can be involved in a credit card plan
grams, to avoid engaging in deceptive, inaccu- in various ways. Also, the terminology used to
rate, misrepresentative, or unfair practices. describe the manner in which a bank is involved
in a credit card plan may vary. The examiner
first needs to determine the type of credit card
plan that the bank has and then ascertain the
Examiner’s Review of Delinquencies
degree of risk that the plan poses to the bank.
Involving Check-Credit
(Overdraft-Protection) Plans Both the bank’s customers and the bank itself
can generate potential risk in the credit card
Delinquencies are often experienced when an department. On the customer side, the risk is
account is at or near the customer’s maximum generally divided into two categories: the mis-
credit line. Examiners should verify that the use of credit and the misuse of the credit card.
following reports are generated for and reviewed The potential for credit misuse is reduced by
by bank management, and examiners should careful screening of cardholders before cards are
also analyze them as part of the examination issued and by monitoring individual accounts
process: for abuse. Credit card misuse may be reduced by
establishing controls to prevent the following
• aging of delinquent accounts abuses:
• accounts on which payments are made (either
• employees or others from intercepting the
3. See the March 2002 OCC Advisory Letter 2002-3 and card before delivery to the cardholder
the March 11, 2004, joint Federal Reserve Board and FDIC
interagency guidance Unfair or Deceptive Acts or Practices by
• merchants from obtaining control of cards
State-Chartered Banks. • fraudulent use of lost or stolen cards

Page 4.1
Because credit cards may be easily misused by affinity-relationship cards, without considering
the cardholders and others who may obtain the their entire relationship with a customer. In
cards, strict adherence to appropriate internal extreme cases, some banks may grant additional
controls and operating procedures is essential in cards to borrowers who are already experiencing
any credit card department. The examiner should payment problems on their existing cards. Banks
determine if adequate controls and procedures that offer multiple credit lines should have
exist. sufficient internal controls and management
information systems (MIS) to aggregate related
exposures and analyze performance before they
Account Management, Risk Management, offer additional credit lines to customers.
and the Allowance for Loan and Lease
Losses Over-limit practices. Account-management prac-
tices that do not adequately control authoriza-
Credit card lending programs can generate risk tion and provide for timely repayment of over-
through inappropriate account-management, risk- limit amounts may significantly increase the
management, and loss-allowance practices. Banks credit-risk profile of a bank’s portfolio. While
should have and follow prudent policies for prudent over-limit practices are important for all
credit-line management, over-limit practices, credit card accounts, such practices are espe-
minimum payments, negative amortization, cially important for subprime accounts. Liberal
workout and forbearance practices, and recovery over-limit tolerances and inadequate repayment
practices. In addition, banks should follow gen- requirements in subprime accounts can magnify
erally accepted accounting principles (GAAP), the high risk exposure of the lending bank, and
existing interagency policies, and Call Report deficient reporting and loss-allowance method-
instructions for income-recognition and loss- ologies can understate the credit risk.
allowance practices. In arriving at an overall All banks should carefully manage their over-
assessment of the adequacy of a bank’s account- limit practices and focus on reasonable control
management practices for its credit card lending and timely repayment of amounts that exceed
business, examiners should incorporate the risk established credit limits. A bank’s MIS should
profile of the bank, the quality of management be sufficient to enable its management to iden-
reporting, and the adequacy of the bank’s charge- tify, measure, manage, and control the unique
off policies and its allowance for loan and lease risks associated with over-limit accounts. Over-
losses methodologies and documentation prac- limit authorization on open-end accounts, par-
tices. (See SR-03-01 and the FFIEC January 8, ticularly those that are subprime, should be
2003, interagency guidance on credit card restricted and subject to appropriate policies and
lending.) controls. The bank’s objective should be to
ensure that the borrower remains within prudent
Credit-line management. Banks should carefully established credit limits that increase the likeli-
consider the repayment capacity of borrowers hood of responsible credit management.
when assigning initial credit lines or signifi-
cantly increasing borrowers’ existing credit lines. Minimum payment and negative amortization.
When a bank inadequately analyzes the repay- Competitive pressures and a desire to preserve
ment capacity of a borrower, practices such as outstanding balances can lead to a bank’s easing
liberal line-increase programs and multiple card of minimum-payment requirements, which in
strategies can increase the risk profile of a turn can increase credit risk and mask portfolio
borrower quickly and result in rapid and signifi- quality. These problems are exacerbated when
cant portfolio deterioration. minimum payments consistently fall short of
Credit-line assignments should be managed covering all finance charges and fees assessed
conservatively using proven credit criteria. Sup- during the billing cycle and when the outstand-
port for credit-line management should include ing balance continues to build (known as ‘‘nega-
documentation and analysis of decision factors tive amortization’’). In these cases, the lending
such as a borrower’s repayment history, risk bank is recording uncollected income by capi-
scores, behavior scores, or other relevant criteria. talizing the unpaid finance charges and fees into
Banks can significantly increase their credit the account balance the customer owes. The
exposure by offering customers additional cards, pitfalls of negative amortization are magnified
including store-specific private-label cards and when subprime accounts are involved—and are

Page 4.2
even more damaging when the condition is dence that less conservative terms and condi-
prolonged by programmatic, recurring over- tions are warranted. To meet the appropriate
limit fees and other charges that are primarily time frames, banks may need to substantially
intended to increase recorded income for the reduce or eliminate interest rates and fees on
lending bank rather than enhance the borrowers’ credit card debt so that more of the payment is
performance or their access to credit. applied to reducing the principal.
The Federal Reserve expects lending banks to In lieu of workout programs, banks some-
require minimum payments that will amortize times negotiate settlement agreements with
the current balance over a reasonable period of borrowers who are unable to service their unse-
time, consistent with the unsecured, consumer- cured open-end credit. In a settlement arrange-
oriented nature of the underlying debt and the ment, the bank forgives a portion of the amount
borrower’s documented creditworthiness. Exam- owed. In exchange, the borrower agrees to pay
iners should criticize prolonged practices involv- the remaining balance either in a lump-sum
ing negative amortization and inappropriate fees, payment or by amortizing the balance over
as well as other practices that inordinately com- several months.
pound or protract consumer debt and disguise
portfolio performance and quality, all of which Income-recognition and ALLL methodologies
raise safety-and-soundness concerns. and practices. Most banks use historical net
charge-off rates, which are based on a migration
Workout and forbearance practices. Banks analysis of the roll rates 3b to charge-off, as the
should properly manage workout programs. 3a starting point for determining appropriate loss
Areas of concern involve liberal repayment allowances. Banks then typically adjust the
terms with extended amortizations, high charge- historical charge-offs to reflect current trends
off rates, moving accounts from one workout and conditions and other factors.
program to another, multiple re-agings, and poor Banks should evaluate the collectibility of
MIS to monitor program performance. Examin- accrued interest and fees on credit card accounts
ers should criticize management and require because a portion of accrued interest and fees is
appropriate corrective action when workout pro- generally not collectible. 3c Although regulatory
grams are not managed properly. Such actions reporting instructions do not require consumer
may include adversely classifying entire seg- credit card loans to be placed on nonaccrual on
ments of portfolios, placing loans on nonac- the basis of their delinquency status, all banks
crual, increasing loss allowances to adequate should employ appropriate methods to ensure
levels, and accelerating charge-offs to appropri- that income is accurately measured. Such meth-
ate time frames. ods may include providing loss allowances for
Workout programs should be designed to uncollectible fees and finance charges or placing
maximize principal reduction and should gener- delinquent and impaired receivables on non-
ally strive to have borrowers repay credit card accrual status. Banks must account for the
debt within 60 months. Repayment terms for owned portion of accrued interest and fees,
workout programs should be consistent with including related estimated losses, separately
these time frames; exceptions should be clearly from the retained interest in accrued interest and
documented and supported by compelling evi- fees from credit card receivables that have been
securitized.
3a. A workout is a former open-end credit card account in A bank’s allowance for loan and lease losses
which credit availability has been closed and the balance should be adequate to absorb credit losses
owed has been placed on a fixed (dollar or percentage) that are probable and estimable on all loans.
repayment schedule in accordance with modified, concession-
ary terms and conditions. Generally, the repayment terms
While some banks provide for an ALLL on all
require amortization or liquidation of the balance owed over a loans, others may only provide for an
defined payment period. Such arrangements are typically used
when a customer is either unwilling or unable to repay the
open-end credit card account in accordance with the original
terms but shows the willingness and ability to repay the loan 3b. Roll rate is the percentage of balances or accounts that
in accordance with modified terms and conditions. move from one delinquency stage to the next delinquency
Workout programs generally do not include temporary- stage.
hardship programs that help borrowers overcome temporary 3c. AICPA Statement of Position 01-6, Accounting by
financial difficulties. However, temporary-hardship programs Certain Entities (Including Entities with Trade Receivables)
longer than 12 months, including renewals, should be consid- That Lend to or Finance the Activities of Others, provides
ered workout programs. guidance on accounting for delinquency fees.

Page 4.3
ALLL on loans that are delinquent. This last settlement payment, banks should charge off
practice may result in an inadequate ALLL. deficiency balances within 30 days.
Banks should ensure that their loan-impairment
analysis and ALLL methodology, including the Recovery practices. After a credit card loan is
analysis of roll rates, consider the losses inher- charged off, banks must properly report any
ent in both delinquent and nondelinquent loans. subsequent collections on the loan.5 Typically,
A bank’s allowance methodologies should banks report some or all of such collections on
always fully recognize the losses inherent in charged-off credit card loans as recoveries to the
over-limit portfolio segments. For example, if a ALLL. If the total amount a bank credits to the
bank requires borrowers to pay monthly over- ALLL as the recovery on an individual credit
limit and other fees in addition to the minimum card loan (which may include principal, interest,
monthly payment amount, roll rates and esti- and fees) exceeds the amount previously charged
mated losses may be higher than indicated in the off against the ALLL on that loan (which may
overall portfolio migration analysis. Accord- have been limited to principal), then the bank’s
ingly, banks should ensure that their allowance net charge-off experience—an important indica-
methodology addresses the incremental losses tor of the credit quality and performance of its
that may be inherent in over-limit accounts. portfolio—will be understated. Banks must
A bank’s allowances should appropriately ensure that the total amount credited to the
provide for the inherent probable loss in work- ALLL as recoveries on a loan (which may
out programs, particularly when a program has include amounts representing principal, interest,
liberal repayment periods with little progress in and fees) is limited to the amount previously
reducing principal. Accounts in workout pro- charged off against the ALLL on that loan. Any
grams should be segregated for performance- amounts collected in excess of this limit should
measurement, impairment-analysis, and moni- be recognized as income.
toring purposes. When multiple workout
programs with different performance character- Re-aging of credit card receivables. The exam-
istics exist, a bank should track each program iner should review the bank’s credit card receiv-
separately and establish and maintain adequate ables to determine if re-aging occurs. Re-aging
allowances for each program. Generally, the refers to the removal of a delinquent account
allowance allocation should equal the estimated from normal collection activity after the bor-
loss in each program based on historical expe- rower has demonstrated over time that he or she
rience as adjusted for current conditions and is capable of fulfilling contractual obligations
trends. These adjustments should take into without the intervention of the bank’s collection
account changes in economic conditions, the department. The bank may use re-aging when a
volume and mix of loans in each program, the customer makes regular and consecutive pay-
terms and conditions of each program, and loan ments over a period of time that maintain the
collection activities. account at a consistent delinquency level or
Banks should ensure that they establish and reduce the delinquency level with minimal col-
maintain adequate loss allowances for credit lection effort. Re-aging, in effect, changes the
card accounts that are subject to settlement delinquency-payment status of a credit card
arrangements. In addition, the FFIEC Uniform receivable from a past-due to a current status.
Retail Credit Classification and Account Man- The examiner should determine if the bank
agement Policy states that ‘‘actual credit losses re-ages its accounts on an exception basis or as
on individual retail loans should be recorded a regular practice. The bank should document
when the bank becomes aware of the loss.’’ In those accounts that have been re-aged, obtain
general, the amount of debt forgiven in a settle- appropriate approval, and ensure that re-aging is
ment arrangement should be classified as loss done in conformance with internal policies and
and charged off immediately. Immediate charge- procedures. (See ‘‘Bank Classification and
off, in some circumstances, however, may be Charge-Off Policy’’ later in this section and
impractical. In such cases, banks may treat SR-00-8 for further guidance.)
amounts forgiven in settlement arrangements as
specific allowances.4 Upon receipt of the final
RI-B of the call report.
4. For regulatory reporting purposes, banks should report 5. AICPA Statement of Position 01-6 provides recognition
the creation of a specific allowance as a charge-off in Schedule guidance for recoveries of previously charged-off loans.

Page 5
Exceptions to examiner guidance. From time to credit-evaluation process, with the following
time, banks with well-managed programs may specific goals:
authorize, and provide a basis for granting, — establish minimum and maximum loan
limited exceptions to the FFIEC Uniform Retail maturities
Credit Classification and Account Management — establish minimum levels of creditworthi-
Policy. The basis for granting exceptions to the ness
policy should be identified and described in the — create consistency within the bank’s under-
bank’s policies and procedures. Such policies writing process
and procedures should address the types of — ensure uniformity in how the bank’s con-
exceptions allowed and the circumstances for sumer credit products are offered to
permitting them. The volume of accounts granted borrowers
exceptions should be small and well controlled, • provide a degree of flexibility, which allows
and the performance of these accounts should be credit officers and management to use their
closely monitored. Examiners will evaluate knowledge, skills, and experience
whether a bank uses its exceptions prudently. • provide specific guidelines for determining
Examiners should criticize management and the creditworthiness of applicants; these guide-
require corrective action when exceptions are lines might include the following:
not used prudently, are not well managed, result — minimum income levels
in improper reporting, or mask delinquencies — maximum debt-to-income ratios
and losses. — job or income stability
— payment history on previous obligations
— the type and value of collateral
— maximum loan-to-value ratios on various
LOAN POLICY types of collateral
— a minimum score on a credit scoring
A written consumer credit policy provides bank system
management with the framework to underwrite • provide guidelines for the level and type of
and administer the risk inherent in lending documentation to be maintained, including—
money while establishing a mechanism for the — a signed application
board of directors or senior management to — the identity of the borrower and his or her
monitor compliance. The policy should estab- occupation
lish the authority, rules, and guidelines to oper- — documentation of the borrower’s financial
ate and administer the bank’s consumer loan capacity
portfolio effectively; that is, the policy should — a credit bureau report
help manage risk while ensuring profitability. — the purpose of all loans granted to the
The policy should set basic standards and pro- borrower, the sources of repayment, and
cedures clearly and concisely. The policy’s the repayment programs
guidelines should be derived from a careful — documentation of the collateral, its value,
review of internal and external factors that affect and the source of the valuation
the bank. To avoid any discriminatory policies — documents perfecting the lien on the
or practices, the policy should include guide- collateral
lines on the various consumer credit laws and — verification worksheets and supporting
regulations. documentation
The composition of the loan portfolio will — a credit scoring worksheet, if applicable
differ considerably among banks because lend- — the sales contract and related security
ing activities are influenced by many factors, agreements, if applicable
including the type of institution, management’s — evidence of insurance coverage, if appli-
objectives and philosophies on diversification cable
and risk, the availability of funds, and credit — any other documentation received or pre-
demand. An effective lending policy and compared in conjunction with the credit request
mensurate procedures are integral components • define procedures for handling delinquent con-
of the lending process. The bank’s consumer sumer credit loans and the subsequent charge-
credit policy should accomplish the following: off and possible re-aging of those loans
• define standards, rules, and guidelines for the The consumer credit policy should also provide

Page 6
guidelines for granting loans that do not con- ence to policies and procedures and (2) the
form to the bank’s written lending policy or operational controls over recordkeeping, pay-
procedures. The policy should require that the ments, and collateral records to ensure that risks
reason for the exception be detailed in writing, are controlled properly. (See ‘‘Loan Portfolio
submitted for approval to a designated authority, Management,’’ section 2040.1, for an overview
and documented in the loan file. Credit excep- of the various types of risk that the bank should
tions should be reviewed by the appropriate be aware of and the controls it should implement
bank committee. The frequency of exceptions to effectively manage risk.) Risks that are inher-
granted may indicate a lessening of underwrit- ent to the consumer credit function and that
ing standards or a need to adjust the policy to require internal controls include, but are not
allow flexibility within safe and sound param- limited to, the following:
eters. The examiner should assess the excep-
tions and make recommendations accordingly. • Insurance. All insurance policies on file should
Obtaining and maintaining complete and name the bank as loss payee. The bank should
accurate information on every consumer credit maintain a tickler system to monitor the expi-
applicant is essential to approving credit in a ration of insurance policies. In addition, the
safe and sound manner. The loan policy should bank should implement procedures to ensure
establish what information will be required from single-interest insurance coverage is obtained
the borrower during the application process and in case the borrower’s insurance is canceled or
what, if any, subsequent information the bor- expires.
rower will be required to submit while the credit • Security agreements. The bank should imple-
remains outstanding. Credit files should be main- ment procedures to ensure that lien searches
tained on all borrowers, regardless of the credit are performed and that liens are perfected by
amount, with the exception of the latitude pro- appropriate filings.
vided by the March 30, 1993, Interagency Pol- • Indirect installment loans. The bank should
icy Statement on Documentation of Loans. Each implement procedures to reduce the risk that
borrower’s credit file should include the names can occur in this area. These procedures
of all other borrowers who are part of the same should ensure the following:
borrowing relationship, or the bank should have — payments are made directly to the bank
some other system for informing the reader of a and not through the dealer
credit file that the borrower is part of a more — dealer lines are reaffirmed at least
extensive credit relationship. A current credit annually
file should provide the loan officer, loan com- — selling prices as listed by the dealer are
mittee, and internal and external reviewers with accurate
all information necessary to (1) analyze the — credit checks on the borrowers are per-
credit before it is granted and (2) monitor the formed independently of the dealer
credit during its life. — overdrafts are prohibited in the dealer
Documentation requirements will vary accord- reserve and holdback accounts
ing to the type of loan, borrower, and collateral. — past-due accounts are monitored in aggre-
For example, the bank may not require a finan- gate per dealer to assess the quality of
cial statement from a borrower whose loans are loans received from each individual dealer
fully secured by certificates of deposit issued by
the bank. For most consumer credit loans, the CREDIT SCORING SYSTEM
borrower’s financial information is collected
only at the time of the loan application. Credit scoring is a method for predicting how
much repayment risk consumer credit borrowers
present. Credit scoring systems are developed
OPERATIONAL RISK using application or credit bureau data on con-
sumers whose performance has already been
The management of the consumer credit func- categorized as creditworthy or noncreditworthy.
tion and the accompanying internal controls is Items of information that help predict acceptable
of primary importance to the safe, sound, and performance are identified and assigned point
profitable operation of a bank. In evaluating values relative to their overall importance. These
controls for consumer credit administration, the values are then totaled to calculate an overall
examiner should review (1) the bank’s adher- credit score.

Page 7
The credit score is used to approve credit, and An empirically derived credit scoring system
frequently allows a bank to avoid the costly and may take the age of an applicant into account as
time-consuming process of individual underwrit- a predictive variable, provided that the age of an
ing. Management determines a minimum score, elderly applicant is not assigned a negative
which is sometimes called the cutoff score. factor or value. In a judgmental system, which
Borrowers whose credit scores are not within relies on a credit officer’s personal evaluation of
the approved cutoff-score range for the type of a potential borrower’s creditworthiness, a credi-
loan requested do not meet the bank’s minimum tor may not take age directly into account.
underwriting criteria. However, the bank may However, the applicant’s age may be related to
override a borrower’s unacceptable credit score other information that the creditor considers in
when other mitigating factors are present that evaluating creditworthiness. For example, a
may not have been included in the credit score. creditor may consider the applicant’s occupation
Exceptions to the bank’s credit scoring system and length of time to retirement to ascertain
should be documented. whether the applicant’s income (including
A number of banks have developed and retirement income) will support the extension of
implemented credit scoring systems as part of credit to maturity. Consumer credit regulations
the approval process for consumer credit; other allow any system of evaluating creditworthiness
banks use traditional methods that rely on a to favor an applicant who is 62 or older.
credit officer’s subjective evaluation of an ap- If the bank has a credit scoring system, the
plicant’s creditworthiness. Credit scoring sys- examiner should review the items or customer
tems are replacing credit officers’ subjective attributes that are included in it. In general,
evaluation of borrowers’ creditworthiness in credit scoring systems are built on an experien-
more and more banks, particularly in larger tial or historical database. Credit scoring meth-
institutions. Credit scoring systems are divided ods analyze the experiences of individuals who
into two categories: (1) empirically derived, have been previously granted credit and divide
demonstrably and statistically sound credit sys- them into creditworthy and noncreditworthy
tems and (2) judgmental systems. accounts for purposes of predicting future
Empirically derived credit scoring systems extensions of consumer credit.
are generally defined as systems that evaluate A successful credit scoring system provides a
creditworthiness by assigning points to various standardized way of measuring the inherent risk
attributes of the applicant and, perhaps, to of the borrower. An important measure of any
attributes of the credit requested. The points credit scoring system is its definition of risk and
assigned are derived from a statistical analysis the care with which explanatory variables are
of recent creditworthy and noncreditworthy defined, data are collected, and the system is
applicants of the bank. An empirically derived tested. The standardized risk measurement
credit scoring system is statistically sound when should be fundamentally sound, be based on
it meets the following requirements: historical data, measure the risk of default (or
loss), and produce consistent results across time
• The data used to develop the system are for a wide range of borrowers. The bank should
derived from an empirical comparison of further investigate potential borrowers who do
sample groups or from the population of not meet the credit scoring criteria.
creditworthy and noncreditworthy applicants Some banks may use more than one type of
who applied for credit within a reasonably credit scoring methodology in their underwrit-
recent period of time. ing and account-management practices. The fol-
lowing are three examples of credit scoring
• The system is developed to evaluate the cred- systems:
itworthiness of applicants in order to serve the
legitimate business interests of the bank using • Credit bureau scoring. The bank uses a con-
the system. sumer’s credit bureau information in a scoring
• The system is developed and validated using formula. The scoring model is developed by
statistical principles and methodology. the various credit bureaus, using the reported
• The bank periodically reevaluates the predic- experience of all credit grantors with whom
tive ability of the system by using statistical the applicant has or has had a relationship.
principles and methodologies and adjusts the • Custom-application scoring. The bank uses
system as necessary. both a consumer’s application and credit

Page 8
bureau data in a scoring formula. This scoring are often meaningless for periods of less than a
model is developed using only information on year. As a result, bank management may not
the bank’s applicants and borrowers. become aware of downward trends until year-
• Behavioral scoring. The bank uses a formula end or examiner-initiated charge-offs are made.
that includes a borrower’s repayment history, Recognition and implementation of any neces-
account utilization, and length of time with sary corrective action are thus delayed.
the bank to calculate a risk score for revolving The examiner should determine whether the
accounts. bank has adopted a well-enforced charge-off
procedure. If so, his or her review should be
Applicants who fail the scoring process may limited to ascertaining that exceptions meet
still be judgmentally reviewed if additional established guidelines. If the bank is properly
information exists that may not have been charging off delinquent consumer credit loans in
included in the scoring formula. In addition, if the normal course of business under a policy
an applicant passes the scoring process, but that generally conforms to that of the Federal
other information indicates that the loan should Reserve System, no specific request for charge-
not be made, the applicant can be denied but off should be necessary. When the bank has not
the reason for the credit denial should be established a program to ensure the timely
documented. charge-off of delinquent accounts, such a pro-
gram should be recommended in the examina-
tion report. If material misstatements in the
BANK CLASSIFICATION AND FFIEC Consolidated Reports of Condition and
CHARGE-OFF POLICY Income (Call Reports) for previous quarters
have resulted from management’s failure to
Consumer credit loans, based on their volume charge off loans, management should be in-
and size, are generally classified using criteria structed to amend the Call Reports for each
that are different from the classification of other affected quarter. The following loans are subject
types of loans. The examiner should use the to the uniform classification policy:
Uniform Retail Credit Classification and Account
Management Policy6 when determining con- • All loans to individuals for household, family,
sumer credit classifications. (See the appendix and other personal expenditures as defined in
to this section.) the Call Reports.
A bank should have procedures detailing • Mobile home paper, except when applicable
when consumer credit loans become watch list state laws define the purchase of a mobile
or problem credits. In addition, the bank should home as the purchase of real property and the
have charge-off procedures for consumer credit loan is secured by the purchased mobile home
loans. The examiner should review the bank’s as evidenced by a mortgage or similar
policies and procedures for adequacy and document.
compliance. • Federal Housing Authority (FHA) title 1 loans.
Identification of unfavorable trends must These loans are also subject to the following
include the review of past-due percentages and classification criteria:
income and loss trends in the consumer credit — Uninsured portions should be charged off
department, which management should monitor when claims have been filed.
closely. Unfortunately, in banks that lack a — When claims have not been filed, unin-
well-enforced charge-off program, loss ratios sured delinquent portions should be clas-
sified in accordance with the delinquent-
installment-loan classification policy.
6. The 1980 Federal Financial Institutions Examination — The portion covered by valid insurance is
Council (FFIEC) policy was revised and issued in February
1999 and June 2000. The June 2000 policy replaces the 1980 not subject to classification.
policy and its February 1999 revision. Reporting on the
FFIEC Call Report, based on the revised policy, is not
The uniform classification policy includes
required until December 31, 2000. In addition to discussing consumer credit loans. Small, delinquent con-
the revised policy statement, SR-00-8 advises examiners to sumer credit loans may be listed for classifica-
consider the methodology used for aging retail loans. In tion purposes in the report of examination with-
accordance with the FFIEC Call Report instructions, banks
and their consumer finance subsidiaries are required to use the
out detailed comments. Larger classified
contractual method, which ages loans based on the status of consumer loans might need to be supported with
contractual payments. detailed comments. When no specific proce-

Page 9
dures have been established, or when adherence to individuals for household, family, and other
to the established procedures is not evident, the personal expenditures, and includes consumer
examiner should make every effort to encourage loans and credit cards. For purposes of this
the bank to adopt and follow acceptable policy, retail credit also includes loans to indi-
procedures. viduals secured by their personal residence,
including first mortgage, home equity, and home-
improvement loans. Because a retail-credit port-
REPOSSESSED PROPERTY folio generally consists of a large number of
relatively small-balance loans, evaluating the
Repossessed property should be booked at its quality of the retail-credit portfolio on a loan-
fair value, less cost to sell, on the date the bank by-loan basis is inefficient and burdensome for
obtains clear title and possession of the property. the institution being examined and for examiners.
Any outstanding loan balance in excess of the Actual credit losses on individual retail cred-
fair value of the property, less selling costs, its should be recorded when the institution
should be charged off. Periodic repricing should becomes aware of the loss, but in no case should
be performed, and appropriate accounting entries the charge-off exceed the time frames stated in
should be made when necessary. Generally, this policy. This policy does not preclude an
repossessed property should be disposed of institution from adopting a more conservative
within 90 days of obtaining possession, unless internal policy. Based on collection experience,
legal requirements stipulate a longer period. when a portfolio’s history reflects high losses
and low recoveries, more conservative standards
are appropriate and necessary.
VIOLATIONS OF LAW The quality of retail credit is best indicated by
The consumer credit department is particularly the repayment performance of individual bor-
susceptible to violations of the various con- rowers. Therefore, in general, retail credit should
sumer credit laws and regulations. These types be classified based on the following criteria:
of violations may result in serious financial
penalties and loss of public esteem. Therefore, • Open- and closed-end retail loans past due 90
the examiner must be aware of any violations cumulative days from the contractual due date
discovered during the consumer compliance should be classified substandard.
examination and ensure that corrective action • Closed-end retail loans that become past due
has been effected. All examiners should be 120 cumulative days and open-end retail loans
familiar with the various consumer credit laws that become past due 180 cumulative days
and regulations and be alert to potential violations. from the contractual due date should be clas-
sified loss and charged off.2 In lieu of charging
off the entire loan balance, loans with non–
APPENDIX—RETAIL-CREDIT real estate collateral may be written down to
CLASSIFICATION POLICY the value of the collateral, less cost to sell, if
repossession of collateral is assured and in
The revised June 2000 Uniform Retail Credit process.
Classification and Account Management Policy • One- to four-family residential real estate
issued by the FFIEC and approved by the loans and home equity loans that are past due
Federal Reserve Board is reproduced below. 90 days or more with loan-to-value ratios
The Board has clarified certain provisions of
this policy. In this text, the Board’s revisions are 2. For operational purposes, whenever a charge-off is
in brackets. necessary under this policy, it should be taken no later than the
end of the month in which the applicable time period elapses.
Any full payment received after the 120- or 180-day charge-
The Uniform Retail Credit Classification and off threshold, but before month-end charge-off, may be
Account Management Policy1 establishes stan- considered in determining whether the charge-off remains
dards for the classification and treatment of appropriate.
retail credit by financial institutions. Retail credit OTS regulation 12 CFR 560.160(b) allows savings institu-
tions to establish adequate (specific) valuation allowances for
consists of open- and closed-end credit extended assets classified loss in lieu of charge- offs.
Open-end retail accounts that are placed on a fixed repay-
1. [For the Federal Reserve’s classification guidelines, see ment schedule should follow the charge-off time frame for
section 2060.1, ‘‘Classification of Credits.’’] closed-end loans.

Page 10
greater than 60 percent should be classified ing securities with an estimable value, less cost
substandard. Properly secured residential real to sell, sufficient to recover the recorded invest-
estate loans with loan-to-value ratios equal to ment in the loan, as well as a reasonable return
or less than 60 percent are generally not on that amount. ‘‘In the process of collection’’
classified based solely on delinquency status. means that either a collection effort or legal
Home equity loans to the same borrower at the action is proceeding and is reasonably expected
same institution as the senior mortgage loan to result in recovery of the loan balance or its
with a combined loan-to-value ratio equal to restoration to a current status, generally within
or less than 60 percent need not be classified. the next 90 days.
However, home equity loans where the insti-
tution does not hold the senior mortgage, that
are past due 90 days or more should be Partial Payments on Open- and
classified substandard, even if the loan-to-
value ratio is equal to, or less than, 60 percent.
Closed-End Credit
• For open- and closed-end loans secured by Institutions should use one of two methods to
residential real estate, a current assessment of recognize partial payments. A payment equiva-
value should be made no later than 180 days lent to 90 percent or more of the contractual
past due. Any outstanding loan balance in payment may be considered a full payment in
excess of the value of the property, less cost to computing past-due status. Alternatively, the
sell, should be classified loss and charged off. institution may aggregate payments and give
• Loans in bankruptcy should be classified loss credit for any partial payment received. For
and charged off within 60 days of receipt of example, if a regular installment payment is
notification of filing from the bankruptcy $300 and the borrower makes payments of only
court or within the time frames specified in $150 per month for a six-month period, [the
this classification policy, whichever is shorter, institution could aggregate the payments received
unless the institution can clearly demonstrate ($150 × six payments, or $900). It could then
and document that repayment is likely to give credit for three full months ($300 × three
occur. Loans with collateral may be written payments) and thus treat the loan as] three full
down to the value of the collateral, less cost to months past due. An institution may use either
sell. Any loan balance not charged off should or both methods in its portfolio, but may not use
be classified substandard until the borrower both methods simultaneously with a single loan.
re-establishes the ability and willingness to
repay for a period of at least six months.
• Fraudulent loans should be classified loss and
charged off no later than 90 days of discovery Re-aging, Extensions, Deferrals,
or within the time frames adopted in this Renewals, and Rewrites
classification policy, whichever is shorter.
• Loans of deceased persons should be classi- Re-aging of open-end accounts, and extensions,
fied loss and charged off when the loss is deferrals, renewals, and rewrites of closed-end
determined or within the time frames adopted loans3 can be used to help borrowers overcome
in this classification policy, whichever is
shorter.
3. These terms are defined as follows. Re-age: Returning a
delinquent, open-end account to current status without collect-
ing [at the time of aging] the total amount of principal,
interest, and fees that are contractually due. Extension:
Other Considerations for Extending monthly payments on a closed-end loan and rolling
Classification back the maturity by the number of months extended. The
account is shown current upon granting the extension. If
extension fees are assessed, they should be collected at the
If an institution can clearly document that a time of the extension and not added to the balance of the loan.
past-due loan is well secured and in the process Deferral: Deferring a contractually due payment on a closed-
of collection, such that collection will occur end loan without affecting the other terms, including maturity
regardless of delinquency status, then the loan [or the due date for subsequently scheduled payments] of the
loan. The account is shown current upon granting the deferral.
need not be classified. A well-secured loan is Renewal: Underwriting a matured, closed-end loan generally
collateralized by a perfected security interest in, at its outstanding principal amount and on similar terms.
or pledges of, real or personal property, includ- Rewrite: Underwriting an existing loan by significantly chang-

Page 11
temporary financial difficulties, such as loss of Open-end accounts should not be re-aged
job, medical emergency, or change in family more than once within any twelve-month period
circumstances like loss of a family member. A and no more than twice within any five-year
permissive policy on re-agings, extensions, period. Institutions may adopt a more conserva-
deferrals, renewals, or rewrites can cloud the tive re-aging standard; for example, some insti-
true performance and delinquency status of the tutions allow only one re-aging in the lifetime of
portfolio. However, prudent use is acceptable an open-end account. Additionally, an over-limit
when it is based on a renewed willingness and account may be re-aged at its outstanding bal-
ability to repay the loan, and when it is struc- ance (including the over-limit balance, interest,
tured and controlled in accordance with sound and fees), provided that no new credit is extended
internal policies. to the borrower until the balance falls below the
Management should ensure that comprehen- predelinquency credit limit.
sive and effective risk management and internal Institutions may re-age an account after it
controls are established and maintained so that enters a workout program, including internal
re-ages, extensions, deferrals, renewals, and and third-party debt-counseling services, but
rewrites can be adequately controlled and moni- only after receipt of at least three consecutive
tored by management and verified by examin- minimum monthly payments or the equivalent
ers. The decision to re-age, extend, defer, renew, cumulative amount, as agreed upon under the
or rewrite a loan, like any other modification of workout or debt-management program. Re-aging
contractual terms, should be supported in the for workout purposes is limited to once in a
institution’s management information systems. five-year period and is in addition to the once-
Adequate management information systems usu- in-twelve-months/twice-in-five-years limitation
ally identify and document any loan that is described above. To be effective, management
re-aged, extended, deferred, renewed, or rewrit- information systems should track the principal
ten, including the number of times such action reductions and charge-off history of loans in
has been taken. Documentation normally shows workout programs by type of program.
that the institution’s personnel communicated
with the borrower, the borrower agreed to pay
the loan in full, and the borrower has the ability
to repay the loan. To be effective, management
information systems should also monitor and Closed-End Loans
track the volume and performance of loans that
have been re-aged, extended, deferred, renewed, Institutions should adopt and adhere to explicit
or rewritten and/or placed in a workout program. standards that control the use of extensions,
deferrals, renewals, and rewrites of closed-end
loans. The standards should exhibit the following:
Open-End Accounts
• The borrower should show a renewed willing-
Institutions that re-age open-end accounts should ness and ability to repay the loan.
establish a reasonable written policy and adhere
to it. To be considered for re-aging, an account • The standards should limit the number and
should exhibit the following: frequency of extensions, deferrals, renewals,
and rewrites.
• The borrower has demonstrated a renewed • Additional advances to finance unpaid interest
willingness and ability to repay the loan. and fees should be prohibited.
• The account has existed for at least nine
months. Management should ensure that comprehen-
• The borrower has made at least three consecu- sive and effective risk management, reporting,
tive minimum monthly payments or the and internal controls are established and main-
equivalent cumulative amount. Funds may not tained to support the collection process and to
be advanced by the institution for this purpose. ensure timely recognition of losses. To be effec-
tive, management information systems should
track the subsequent principal reductions and
ing its terms, including payment amounts, interest rates, charge-off history of loans that have been granted
amortization schedules, or its final maturity. an extension, deferral, renewal, or rewrite.

Page 12
Examination Considerations segments thereof, where underwriting standards

are weak and present unreasonable credit risk,
Examiners should ensure that institutions adhere and may criticize account-management prac-
to this policy. Nevertheless, there may be tices that are deficient.
instances that warrant exceptions to the general In addition to reviewing loan classifications,
classification policy. Loans need not be classi- the examiner should ensure that the institution’s
fied if the institution can document clearly that allowance for loan and lease losses provides
repayment will occur irrespective of delin- adequate coverage for probable losses inherent
quency status. Examples might include loans in the portfolio. Sound risk- and account-
well secured by marketable collateral and in the management systems, including a prudent retail-
process of collection, loans for which claims are credit lending policy, measures to ensure and
filed against solvent estates, and loans supported monitor adherence to stated policy, and detailed
by valid insurance claims. operating procedures, should also be imple-
The Uniform Retail Credit Classification and mented. Internal controls should be in place to
Account Management Policy does not preclude ensure that the policy is followed. Institutions
examiners from classifying individual retail- that lack sound policies or fail to implement or
credit loans that exhibit signs of credit weakness effectively adhere to established policies will be
regardless of delinquency status. Similarly, an subject to criticism.
examiner may also classify retail portfolios, or Issued by the FFIEC on June 12, 2000.

Page 13
Consumer Credit
1. To determine the quality and adequacy of ing departments and what actions manage-
operations (including the adequacy of lend- ment has taken to identify, measure, control,
ing policies, practices, procedures, internal and monitor the level and types of risks.
controls, and management information sys- 6. To determine that the goals and objectives of
tems) for consumer credit and credit card specific credit card plans are being achieved
plans. and that the plans are profitable.
2. To determine if bank officers and employees
are operating in conformance with the estab- 7. To determine compliance with the board of
lished guidelines. directors’ and senior management’s policies
3. To evaluate the consumer credit portfolio for and procedures and with applicable laws and
credit quality, performance, adequate collat- regulations.
eral, and collectibility. 8. To initiate corrective action when policies,
4. To determine the scope and adequacy of the procedures, practices, or internal controls are
audit and loan-review function. deficient or when violations of law or regu-
5. To determine the level of risk inherent in a lations have been noted.
bank’s consumer credit and credit card lend-

Page 1
Consumer Credit
GENERAL CONSUMER CREDIT charge-off.)

j. management reports that are prepared by
1. If selected for implementation, complete or department personnel and that are not
update the installment loan section of the forwarded in their entirety to the board
internal control questionnaire. of directors or its committee
2. Based on the evaluation of internal controls k. a listing of the amount of recoveries on
and the work performed by internal or charged-off installment loans, by month,
external auditors, determine the scope of since the preceding examination
the examination. l. a listing of all outstanding loans that
3. Test for compliance with policies, practices, have been assigned to an attorney for
procedures, and internal controls in conjunc- collection
tion with performing the remaining exami- m. an identification of all columns and codes
nation procedures. Obtain a listing of any on the computer printout
deficiencies noted in the latest review con- 5. Obtain a trial balance of installment loans.
ducted by internal or external auditors. If Use of the bank’s latest trial balance is
applicable, also determine if the latest con- acceptable. If exact figures are required,
sumer compliance examination disclosed update the trial balance from the daily
any violation of laws or regulations. Deter- transaction journals. Using the trial balance—
mine if corrective action has been taken. a. agree or reconcile balances to depart-
4. Request that the bank supply the following: ment controls and the general ledger and
a. a listing of all dealers who have indirect- b. review reconciling items for reasonable-
paper, fleet-leasing, or discounted-lease ness.
lines, along with respective codes 6. Using an appropriate sampling technique,
b. an indirect paper or a fleet-leasing or select borrowers’ loans to be reviewed dur-
discounted fleet-leasing report by code, ing the examination.
along with the respective delinquency 7. Using an appropriate technique, select indir-
report for all loans past due 30 days or ect dealers and fleet-leasing and indirect-
more lease lines from indirect-dealer or leasing
c. a listing of dealer reserves, holdback reports. Transcribe the following onto con-
accounts, or both showing the dealer, sumer finance indirect line cards:
account number, and balance a. the amount and number of contracts,
d. the latest month-end extension and indicating whether they are with or with-
renewal reports out recourse
e. a schedule of all loans with irregular or b. the amount and number of contracts still
balloon payments or both accruing that are past due 30–89 days
f. a schedule of all loans with more than and 90 days or more
five prepaid installments c. the balance in dealer reserve or holdback
g. a listing of loans generated by brokers or accounts or both
finders 8. Obtain the following schedules from the
h. a listing of current repossessions, includ- bank or the appropriate examiner if they are
ing the name of the borrower, a descrip- applicable to this area:
tion of the item, the date of repossession, a. past-due loans (obtain separate schedules
the date title was acquired, and the by branch, if available)
balance b. loans transferred, either in whole or in
i. a copy of each monthly installment-loan part, to another lending institution as a
charge-off report since the preceding result of a sale, participation, or asset
examination (If the monthly reports do swap since the previous examination
not include all the information necessary c. loans acquired from another lending
to support the charge-off of the install- institution as a result of a purchase,
ment loans, request a revised listing that participation, or asset swap since the
includes the missing information for each previous examination

Page 1
2130.3 Consumer Credit: Examination Procedures
d. loan commitments and other contingent properly reflected on its books at

liabilities fair value (while fair value may be
e. extensions of credit to employees, offic- difficult to determine, it should at a
ers, directors, principal shareholders, and minimum reflect both the rate of
their interests, specifying which officers return being earned on such loans
are considered executive officers as well as an appropriate risk pre-
f. correspondent banks’ extensions of credit mium).
to executive officers, directors, and prin- — Determine that low-quality loans
cipal shareholders and their interests transferred to the parent holding
g. a list of correspondent banks company or a nonbank affiliate are
h. miscellaneous loan debit-and-credit sus- properly reflected at fair value on
pense accounts the books of both the bank and its
i. loans considered ‘‘problem loans’’ by affiliate.
management — If low-quality loans were trans-
j. each officer’s current lending authority ferred to or from another lending
k. the current structure of interest rates institution for which the Federal
l. any useful information obtained from the Reserve is not the primary regula-
review of the minutes of the loan tor, prepare a memorandum to be
and discount committee or any similar submitted to the Reserve Bank
committee supervisory personnel. The Reserve
m. reports furnished to the loan and Bank will then inform the local
discount committee or any similar office of the primary federal regu-
committee lator of the other institution involved
n. reports furnished to the board of directors in the transfer. The memorandum
o. loans classified during the preceding should include the following infor-
examination mation, as applicable:
p. the extent and nature of loans serviced (1) name of originating institution
9. Review the information received and per- (2) name of receiving institution
form the following for— (3) type of transfer (i.e., participa-
a. Loans transferred, either in whole or in tion, purchase/sale, swap)
part, to or from another lending institu- (4) date of transfer
tion as a result of a participation, sale or (5) total number of loans trans-
purchase, or asset swap: ferred
• Participations only: (6) total dollar amount of loans
— Test participation certificates and transferred
records and determine that the par- (7) status of the loans when trans-
ties share in the risks and contrac- ferred (e.g., nonperforming,
tual payments on a pro rata basis. classified, etc.)
— Determine that the bank exercises (8) any other information that
similar controls and procedures would be helpful to the other
over loans serviced for others as regulator
for loans in its own portfolio. b. Miscellaneous loan debit-and-credit sus-
• Procedures pertaining to all transfers: pense accounts:
— Investigate any situations in which • Discuss with management any large or
loans were transferred immediately old items.
before the date of examination to • Perform additional procedures as con-
determine if any were transferred sidered appropriate.
to avoid possible criticism during c. For loan commitments and other contin-
the examination. gent liabilities, if the borrower has been
— Determine whether any of the loans advised of the commitment and it exceeds
transferred were either nonperform- the cutoff alone or in combination with
ing at the time of transfer or clas- any outstanding debt, prepare a line card
sified at the previous examination. for subsequent analysis and review.
— Determine that low-quality loans d. For loans classified during the previous
transferred to or from the bank are examination, determine the disposition

Page 2
Consumer Credit: Examination Procedures 2130.3
of loans so classified by— k. a corporate resolution to borrow or

• obtaining current balances and their guarantee
payment status, or the date the loan l. provisions of the loan agreement or mas-
was repaid and source of payment; ter lease agreement
• investigating any situations in which m. the type of dealer endorsement:
all or part of the funds for the repay- • full recourse
ment came from the proceeds of • limited recourse
another loan at the bank or were a • nonrecourse
result of a participation, sale, or swap n. dealer repurchase agreements
with another lending institution; and o. reserve and holdback requirements
• referring to step 9a of this section for p. the amount of insurance coverage
the appropriate examination proce- 13. Check the central liability file on borrowers
dures, determine if repayment was a indebted above the cutoff or borrowers
result of a participation, sale, or swap. displaying credit weakness who are sus-
e. Select loans that require in-depth review pected of having additional liability in other
on the basis of information derived from loan areas.
the above schedules. 14. Transcribe significant liability and other
10. Consult with the examiner responsible for information on officers, principals, and
the asset-liability management analysis to affiliations of borrowers for which line cards
determine the appropriate maturity break- have been developed. Cross-reference, if
down of loans needed for the analysis. If appropriate.
requested, compile the information using 15. Review a listing of loans generated by
bank records or other appropriate sources. brokers or finders:
See section 6000.1, ‘‘Instructions for the a. Check the quality of the paper being
Report of Examination,’’ for considerations acquired.
to be taken into account when compiling b. Determine that sufficient financial data
maturity information for the gap analysis. have been obtained to support the credits.
11. Obtain liability and other information on c. Evaluate performance.
common borrowers from examiners assigned 16. Review the current past-due (delinquent)
to overdrafts, lease financing, and other loan list and determine that loans are aged
loan areas. Together decide who will review using the contractual method, which ages a
the borrowing relationship. loan on the basis of its contractual repay-
12. Obtain the credit files of all direct non- ment terms, as required by the Call Report
consumer borrowers, indirect dealers, and instructions. Discuss with management
fleet-leasing and discounted-leasing lines selected delinquent loans from the listings
for which line cards have been developed. of delinquent loans and repossessed
Transcribe and analyze the following as collateral.
appropriate: 17. Determine if management has a general
a. the purpose of the loan policy for the timely classification and
charge-off of past-due loans and ascertain
b. collateral information, including its value
whether the policy is adhered to. Determine
and the bank’s right to hold and negoti-
if loan-classification practices follow the
ate it
board of directors’ respective policies.
c. the source of repayment
Ascertain whether those policies comply
d. ancillary information, including the type with the provisions of the FFIEC’s Uniform
of business, its officers, and its affiliation Retail Credit Classification and Account
e. fiscal and interim financial exhibits Management Policy and with Federal
f. guarantors and the amount of any Reserve policy. Review with management
guarantee individual accounts that have not been
g. personal statements of borrowers, charged off in line with these policies.
endorsers, or guarantors 18. Review voluntary charge-offs made since
h. external credit checks and credit bureau the preceding examination and, on a test
reports basis, review files on borrowers and ascer-
i. loan officer’s credit memoranda tain the correctness of the charge-off.
j. subordination agreements 19. Review any reports being submitted on

Page 3
delinquent and defaulted loans guaranteed identifying current portfolio problems. The
by government agencies: examination process should include an investi-
a. Determine that management is informed gation of potential problems that may result
accurately and is complying with the from ineffective policies, unfavorable trends,
reporting requirements. lending concentrations, or nonadherence to poli-
b. Determine that claims are being promptly cies. The following examination procedures
filed after default. should be performed.
1. Review UBPR data to determine the vol-

ume of credit card activity.
OVERDRAFT-PROTECTION 2. Determine if management has recently
PROGRAMS offered or plans to offer new products or if
management plans to enter new market
1. Determine if the bank has developed and niches or expand the credit card portfolio
implemented adequate written overdraft- significantly (new offerings may include
protection-program policies and procedures affinity cards, co-branded cards, secured
for its ad hoc, automated, and other over- cards, or purchasing cards).
draft programs. Determine if the policies 3. Determine whether the bank is engaged or
and procedures comply with the February plans to engage in subprime credit card
18, 2005, interagency Joint Guidance on lending. If subprime lending exists or is
Overdraft Protection Programs. planned, perform the subprime-lending
2. Ascertain whether the bank’s management examination procedures in section 2133.3.
emphasizes and monitors adherence to its 4. Review correspondence that the bank has
overdraft policies and procedures, applies received or exchanged with credit card
generally accepted accounting principles to networks (i.e.,Visa, MasterCard). These
overdraft transactions, and applies the bank agencies perform periodic reviews of their
Call Report’s accounting and reporting members.
instructions and requirements to overdrafts.
Evaluate whether the bank maintains and
monitors safe and sound overdraft business Policy Considerations
practices to control the credit, operational,
and other risks associated with overdraft 1. Review the credit card policy. Policy guide-
programs. lines should include the following items:
3. Apply the additional examination proce- a. adequate screening of account applicants
dures for overdraft-protection programs (see b. standards for approving accounts and
section 3000.3) when weaknesses are found determining credit-line size
in (1) the bank’s compliance with the Feb- c. minimum standards for documentation
ruary 2005 interagency guidance and (2) the d. internal controls to prevent and detect
bank’s evaluation of the risks associated fraud, such as—
with overdraft-protection programs. • review procedures, including frequent
review of delinquent accounts;
• delinquency notification and collection
CREDIT CARD LENDING procedures;
• criteria for freezing accounts and charg-
The examiner’s analysis of operating policies ing off balances;
and procedures is key to the examination of • criteria for curing and re-aging delin-
credit card banks and credit card operations. quent accounts;
Credit card lending is characterized by a high • controls to avoid reissuances of expired
volume of accounts, homogeneous loan pools, cards to obligors who have unsatisfac-
and small-dollar balances. A concentrated review tory credit histories;
of individual accounts, therefore, may not be • approvals of and controls over over-
practical. Examination procedures should focus limits and overrides; and
on evaluating policies, procedures, and internal • cardholder information security controls
controls in conjunction with performing other e. due diligence before engaging the ser-
selected functions. The goal is not confined to vice of a third party, as well as the

Page 4
ongoing management of credit card ling fraud, including whether the strategies
operations frequently emphasize review of credit card
applications to prevent fraudulent accounts
from being booked or whether neural net-
Audit works are used to identify fraudulent trans-
actions. Common controls include the fol-
1. Review the adequacy of the audit function
lowing items:
regarding credit card operations.
a. methods of preventing application fraud,
a. Determine if the audit program identifies such as name and address verification,
contraventions of internal policy, credit duplicate-application detection, Social
card network (i.e., Visa, MasterCard) Security number verification, etc.
regulations, and written contracts. b. physical aspects of cards such as holo-
b. Determine if audit procedures include grams and enriched information on the
reviewing the accuracy and integrity of magnetic stripe
the bank’s system for reporting the past- c. adequate staffing and training of the
due status of credit card loans, over-limit fraud-detection department
accounts, and other management infor- d. computer systems to identify suspicious
mation systems. activity
c. Determine if audit procedures include e. procedures for issuing cards to prevent
reviewing computer-driven models. their interception and activation
d. Determine if independent tests of auto- f. procedures for handling returned cards,
mated procedures are performed (for statements, PINs, checks, and lost and
example, a sample of automatically stolen cards
re-aged accounts may be independently g. investigation and documentation of cases
reviewed to test the integrity of auto- of suspected fraud
mated systems). h. freezing of accounts with suspicious
e. Determine whether audit procedures activity
include a review of credit card process- i. procedures for filing a Suspicious Activ-
ing operations. Ascertain if the product ity Report by Depository Institutions
control file governing credit card process- (SAR-DI) (See SR-07-2 and the attached
ing was reviewed and whether it revealed June 2007 SAR-DI form, the requirements
any significant internal control weak- for suspicious-activity reporting in sec-
nesses, such as a lack of segregation of tion 208.62 of the Board’s Regulation H
duties and access controls. Determine (12 CFR 208.62), and the Bank Secrecy
whether management is aware of the Act compliance program in section 208.63
risks and if the audit staff has the exper- (12 CFR 208.63).)
tise to adequately evaluate procedures j. procedures for access to and alteration of
and suggest controls commensurate with customer information
the risks. k. controls over cardholder payments,
f. Determine if audit procedures include a account-balance records, and charge-
review of the services provided by out- back administration
side vendors (services such as telemar- l. account-authorization procedures
keting, data processing, and direct mail). 2. Determine whether management receives
Ascertain if the audit procedures included adequate fraud-monitoring reports, such
a review of the performance of the as—
vendors and documentation of the a. out-of-pattern-purchase or sequence-of-
relationships. purchase reports that identify suspicious
2. Determine if management has reviewed and transactions that do not fit an individual
appropriately responded to audit findings cardholder’s established purchasing pat-
regarding credit card operations. tern or
b. suspicious-purchasing-pattern reports that
identify certain types of purchases, such
Fraud as electronics or jewelry, that can corre-
late with fraudulent activity.
1. Evaluate management’s strategy for control- 3. Review consumer complaint correspon-

Page 5
dence from cardholders that is on file with over the approval and acceptance of such
the bank or primary federal regulator for accounts. (In co-branding, a third-party
irregularities or patterns of activity. relationship exists between a broad base of
cardholders and a jointly sponsored credit
card. Usually, the sponsors are the bank and
Account Solicitation a retail merchant for the affinity and
co-branding relationships. These cards have
1. Determine management’s general approach some type of value-added feature such as
to account solicitations (a variety of cash rebates or discounts on merchandise.)
approaches or a combination of approaches 8. Review new-product offerings and the
can exist). Solicitations may be for preap- adequacy of management’s market identifi-
proved or non-preapproved accounts. The cation, testing, and ongoing monitoring of
latter are usually solicited through mass new products. Ascertain if management
mailings, telemarketing, or counter displays. monitored and controlled key new-product
2. Determine the extent to which outside con- concerns, including whether—
tractors are used in marketing programs (for a. the amount of historical and test-sample
example, outsourced mass-mailing and data available to analyze the product or
telemarketing operations). solicitation was adequate;
3. Review management’s product and market- b. the speed at which the new product was
ing program, including the goals of the introduced was compatible with the
program, the basis of the marketing approach, internal controls for credit authoriza-
and product pricing. Ascertain whether tions; and
adequate supporting evidence exists to indi- c. the size of solicitations introduced was
cate (1) that management has a marketing adequately controlled, considering opera-
program and a product that appeal to the tional and managerial capabilities.
bank’s targeted markets and (2) that the 9. Determine if management had any prob-
projected product and marketing program lems with the wording of solicitations or
results will be obtained. applications and if any imprecise offer terms
4. Determine how management identifies mar- contributed to asset-quality and earnings
kets for new solicitations and evaluates problems. Ascertain if there were errors
expected performance. such as the following:
a. Identify the analytical procedures (for a. no expiration date on the offer
example, response rates, usage rates, b. an absence of wording giving manage-
credit-score distributions, and future ment discretion in setting credit lines
delinquency and loss rates) management c. insufficient information requirements on
uses to project the results of a particular applications
solicitation. 10. Review balance-transfer policies and moni-
b. Determine how management verifies toring practices. Determine if balance trans-
projections before proceeding with a fers generally resulted in higher credit
full-scale solicitation program (test exposures and a tendency to distort finan-
marketing). cial condition and performance ratios due to
5. Determine if management monitors solici- the immediate booking of relatively large
tation results for each major account seg- balances.
ment and if management incorporates the
11. Review teaser interest-rate practices. Deter-
findings into future solicitations.
mine if controls are adequate to prevent
6. Determine if management monitors and
teaser rates from disguising a borrower’s
responds to trends in adverse selection (such
repayment capacity and from resulting in
as when a disproportionate number of
higher attrition when the teaser rates expire.
respondents that are poor credit risks answer
an offer, which may result in a larger-than-
projected percentage of riskier accounts
being including in the solicitation-response Predictive Models
pool).
7. Review affinity and co-branding relation- 1. Review the integrated models management
ships. Determine if the bank has control uses to identify and select prospective cus-

Page 6
tomers. (Management usually uses two dis-

tinct credit card predictive models. The first
model, the credit-scoring model, is used in
the initial application process. The second
model, a behavioral model, is used in the
management of existing accounts. These
models use a credit scorecard, which is a
table of characteristics, attributes, and scores
that enable a credit grantor to calculate
default risk. Information derived from these
models assists management with quantify-
ing and minimizing credit risk and fraud
losses.)
Credit Scoring
1. Determine the nature and extent that credit
scores are used in the underwriting process.
2. Determine the degree of reliance placed on
credit bureau score ‘‘good’’ and ‘‘bad’’ odds
charts. Ascertain if management develops
and calibrates its own good and bad odds
chart with a sufficient quantity and quality
of historical account data (a customized
odds chart is more predictive than a credit
bureau odds chart).
3. Determine if a single- or dual-score model
is used. (A single-score model uses credit
bureau scores; a dual-score matrix calcu-
lates a score based on the combination of a
custom score, usually based on credit appli-
cation data, and a credit bureau score. For
the more complex operations, management
should be using the more sophisticated
dual-scoring model.)

Page 6.1
Behavior-Scoring System Portfolio Analysis

1. Determine whether management has imple- 1. Review and analyze the bank’s customized
mented a behavior-scoring system to man- credit card reports, which usually include
age existing accounts. (The score is derived performance and industry peer-group analy-
from a cardholder’s payment and usage sis data (be alert to the possibility that the
behavior with the credit cardholder’s issu- data may have been distorted by niche
ing bank. A cardholder’s historical perfor- marketing, specialized card products, or
mance with a particular bank is typically the extensive affiliate support).
best indicator of future performance with 2. Determine if management is segmenting
that bank. Behavior scores are frequently portfolios (such as by geographic or demo-
supplemented with credit bureau scores to graphic distribution, affinity relationship
enhance their predictive value.) (cardholders belonging to a particular union,
2. Ascertain if management continually refines corporation, professional association, etc.),
existing, or if it considers new, predictive product type (premium or standard cards),
models. or credit bureau scores). Consider the par-
a. Determine whether a champions and chal- ticular characteristics of each segment for
lengers system is used. (Such a system delinquency, profitability, future marketing
involves continual portfolio analysis and programs, ALLL calculations, and other
identification of predictive characteris- purposes.
tics. Based on this analysis, existing 3. Determine whether geographic, customer-
models are revised and enhanced. The base, card-type, or other concentrations
revised challenger model is then com- exist, and identify the unique risks posed by
pared with the existing champion model. any of these portfolio segments or concen-
If the challenger is more predictive, it is trations. Evaluate their degree of risk and
adopted. This procedure is an ongoing consider mitigating factors.
system of refinement.) 4. Review how management uses portfolio
b. Determine if management has adopted or information to identify developing trends,
is considering new predictive models make strategic decisions, and detect poten-
(for example, revenue, revolving, bank- tial problems.
ruptcy, and payment-predictor models). a. Determine how management reports iden-
tify the number and volume of workout
and re-aged credits.1
b. Evaluate the portfolio information that
Validation management reviews, such as asset-
quality ratios and vintage analysis (an
1. If credit scoring is used, determine if man- analysis of the account performance of
agement is validating scores by comparing homogeneous loans booked at a similar
account-quality rankings of accepted appli- time using the same credit and pricing
cations with those predicted by the system criteria).
(when the rank orderings remain substan- 5. Determine if cash advances are monitored
tially the same, the scoring system remains and authorization procedures are in place
valid).
a. Review the statistical techniques used to
validate each model used, and determine 1. A workout is a former open-end credit card account in
which credit availability has been closed and in which the
whether common statistical techniques balance owed has been placed on a fixed (dollar or percentage)
are being used, such as the K/S test, the repayment schedule in accordance with modified, concession-
chi square, the goodness-of-fit test, ary terms and conditions. Generally, the repayment terms
divergence statistics, and the population require amortization or liquidation of the balance owed over a
defined payment period. Such arrangements are typically used
stability test. when a customer is either unwilling or unable to repay the
b. Determine if high and low override con- open-end credit card account in accordance with the original
trols are in place and if they are detailed terms but shows the willingness and ability to repay the loan
in accordance with modified terms and conditions. In a
on exception reports (overrides can skew re-aged credit account, the bank changes the delinquency
a statistical population and distort status of an account without the full collection of its delin-
analysis). quent payments.

Page 7
(cardholders with excessive debt may obtain f. the average age of accounts, which may
cash advances to pay other debts). indicate that loss rates will rise for
6. Review the level and trend of the following unseasoned accounts (loss rates are usu-
portfolio ratios: ally low for new offerings and peak at 18
a. average balance of delinquent accounts to 24 months after issue).
(by 30-day time frames) to average bal- 8. Evaluate management’s practices for cure
ance of nondelinquent accounts programs, such as re-aging, loan extensions,
b. lagged delinquency rate and nine-month deferrals, fixed payment, and forgiveness.
net charge-offs to lag rates 9. Develop an overall assessment of the
c. net charge-off rate and lagged net charge- adequacy of a bank’s account-management
off rate practices for its credit card lending busi-
d. re-aged accounts and partial-payment ness, incorporating the risk profile of the
plans to total active accounts and to bank, the quality of management reporting,
average total loans and the adequacy of the bank’s charge-off
e. total past-due loans to gross loans policies and loss-allowance methodologies.
f. noncurrent loans to gross loans 10. Evaluate whether the bank clearly docu-
7. Consider indicators of possible deteriora- ments in its policies and procedures the
tion in asset quality and criticize prolonged basis for using the exceptions to the FFIEC
practices that result in negative amortiza- Uniform Retail Credit Classification and
tion (that is, when minimum payments con- Account Management Policy and whether
sistently fall short of covering all finance the bank documents the types of exceptions
charges and fees assessed during the billing used and the circumstances giving rise to
cycle and when the outstanding balance their use. Determine if the bank prudently
continues to increase), inappropriate fees, limits the use of exceptions. If it does not,
and other practices that inordinately com- criticize the bank’s management and require
pound or protract consumer debt and dis- corrective action when the exceptions are
guise portfolio performance and quality. Be not well managed, result in improper report-
alert to other indicators and practices that ing, or mask delinquencies and losses.
can reflect a deterioration of asset quality, 11. Criticize management and recommend
such as— appropriate supervisory corrective action
a. rapid growth that may indicate a lower- when workout programs are not managed
ing of underwriting standards; properly (characteristics of improperly man-
b. lower minimum-payment requirements aged workout programs include workout
and extended principal-payment cycles, programs that do not strive to have the
which may result in negative amortiza- borrowers repay credit card debt within 60
tion and may also indicate less creditwor- months, the existence of liberal repayment
thy accounts; terms with extended amortizations, high
c. a heightened ratio of total accounts being charge-off rates, accounts being moved from
charged off to the number of accounts or one workout program to another, multiple
a high average balance of accounts that re-agings, and poor MIS to monitor pro-
may indicate a lax policy toward the gram performance).
number and level of credit lines granted 12. Determine that the bank complies with the
to cardholders; FFIEC Uniform Retail Credit Classification
d. lower payment rates combined with and Account Management Policy.
higher average balances, which may indi- 13. Determine whether management monitors
cate that borrowers are having trouble and analyzes the performance of each work-
paying their debt; out program (whether the program achieves
e. an inordinately high ratio of income the objective of improving the borrower’s
earned not collected on loans to total subsequent performance, the effect of the
loans when compared with the percent- program on delinquency ratios, etc.)
age of total past-due loans to gross loans, 14. Assess the current and potential impact the
which may indicate frequent re-agings, workout programs have on reported perfor-
inadequate collection procedures, or a mance and profitability, including their
failure to charge off credit card receiv- ALLL implications.
ables on a timely basis; and 15. Determine if third parties purchase or fund

Page 8
loan payments to cure loan delinquencies significantly distort the calculation of

and, if so, assess the impact. required reserves).
16. Determine whether management developed 3. Determine if ALLL calculations are com-
contingent strategies to deal with rising prehensive and if they consider the follow-
delinquency levels, which are generally the ing factors:
first sign of account deterioration. Strategies a. contingent liabilities, or the risk associ-
could include the following issues: ated with undisbursed funds
a. reviewing accounts more frequently b. bankrupt and deceased cardholders (such
b. decreasing the size of credit lines losses are usually not predicted by a
c. freezing or closing accounts simple roll-rate analysis)
d. increasing collection efforts c. economic conditions, such as unemploy-
17. Ascertain the bank’s compliance with its ment and bankruptcy rates, that can sig-
credit card policies and procedures by nificantly affect asset quality
reviewing a sample of the bank’s credit card d. the number and volume of workout and
loans that were originated since the prior re-aged credits
examination. 4. Determine if the ALLL methodologies
18. Determine the level of classifications for adequately provide for the use of cure
credit card loans: programs, settlement arrangements,2 work-
a. Review a sample of loans to ascertain the out programs, existing over-the limit port-
accuracy and integrity of the bank’s folio segments, any resulting estimable prob-
system for reporting past-due status. able losses on those accounts, and any other
b. Verify that the bank’s classification and credit card loan accounts.
charge-off procedures adhere to, at a 5. Review the accounting practices for credit-
minimum, the guidance of the FFIEC ing recoveries on credit card loans. Deter-
Uniform Retail Credit Classification and mine that the total amount credited to the
Account Management Policy. ALLL as recoveries on individual credit
card loans is limited to the amounts previ-
ously charged off against the ALLL for the
credit card loan. Any excess recovery
Allowance for Loan and Lease Losses amount must be recognized as income.
6. Verify that fraud losses are not charged to
1. Ascertain whether an allowance for loan the ALLL or included in ALLL calculations
and lease losses (ALLL) policy exists for and that the losses are recorded as a non-
credit card loans and if adequate ALLL interest expense.
analytical procedures are in place. Roll-rate
analysis (analysis of the migration of an
account from one billing cycle to the next),
which is generally performed for each port- Asset Securitization
folio segment, is the industry standard.
However, some banks use the following Perform the following examination procedures
additional or alternative methods: when the bank has securitized its credit card
receivables (removed designated credit card
a. delinquency analysis using a set percent-
receivables from its balance sheet to a special-
age of loans over 60 days delinquent
purpose vehicle (SPV) while the bank retains its
b. exposure analysis that projects net charge-
account ownership).
off rates to each 30-day period of
delinquency
1. Determine if the credit card loan delin-
c. charge-off projections based on vintage quency and loss rates are similar for both
analysis the owned portfolio and the securitized
d. a historical rolling average based on portfolio. (Slightly higher delinquency and
charge-off rates for the last six months net charge-off ratios on securitized assets
e. analysis based on external economic fore-
casting services
2. In a settlement arrangement, the bank forgives a portion
2. Review ALLL-calculation techniques for of the amount owed. In exchange, the borrower agrees to pay
reasonableness (variables such as aggregat- the remaining balance either in a lump-sum payment or by
ing seasoned and unseasoned portfolios can amortizing the balance over several months.

Page 9
will be prevalent if the bank is experiencing BIN if the licensee fails to meet its mem-
high growth and possesses a significant bership obligations.)
portion of unseasoned accounts.) When the
delinquency and loss rates deviate signifi-
cantly, determine if management is priori-
tizing credit card receivables for securitiza-
BANK POLICIES AND
tion by selecting credit card accounts that PROCEDURES AND STATUTORY
have either a high credit quality or superior AND REGULATORY
past credit history. For example, in the REQUIREMENTS
following two ratios, the resulting percent-
ages on a managed and owned basis should 1. Determine compliance with laws, regula-
approximate one another: (1) noncurrent tions, and Federal Reserve Board policies
loans to gross loans and (2) total past-due pertaining to lending by performing the
loans to gross loans. following steps.
2. Determine the on- and off-balance-sheet a. Lending limits:
effects of asset securitization. (For example, • Determine the bank’s lending limits as
what is the on- and off-balance-sheet effect prescribed by state law.
of removing seasoned accounts?) (A perfor- • Determine advances or combinations
mance analysis is important because the of advances whose aggregate balances
level of a credit card bank’s earnings and are above the limit.
capital is largely dependent on the quality b. Sections 23A and 23B of the Federal
of its average total assets under manage- Reserve Act (12 USC 371c and 371c-1)
ment and not merely on the owned credit and the Federal Reserve’s Regulation
card portfolio.) W—Transactions with Affiliates:
• Obtain a listing of loans and other
extensions of credit to affiliates.
• Test-check the listing against the bank’s
Third Parties customer liability records to determine
the list’s accuracy and completeness.
1. Determine whether any credit card–related • Obtain a listing of other covered trans-
activities are outsourced. If so, complete the actions with affiliates (i.e., purchase of
third parties review located in the Subprime an investment or securities issued by
Lending Loan Reference. Third parties may an affiliate; purchase of loans or other
include brokers, marketing firms, collection credit-related assets, including assets
or servicing firms, correspondents, affinity subject to an agreement to repurchase
partners, and information systems firms. from an affiliate; the issuance of a
2. Determine whether the bank shares a BIN guarantee, acceptance, or letter of
(bank identification number) with a third credit, including an endorsement or
party. (Sharing of BINs can create financial standby letter of credit, on behalf of an
liability. A bank sharing a BIN should have affiliate; or acceptance of affiliate’s
a process to identify, monitor, and control securities as collateral for a loan to any
the risks associated with BIN sharing. Cer- person).
tain Visa and MasterCard members are • Determine the volume of transactions
assigned BINs (represented by a series of with third parties when the proceeds
numbers on the credit card) for clearing and were used or transferred for the benefit
settlement of their credit card activities. of any affiliate.
Members that are licensed specific BINs • Ensure that covered transactions with
may allow other members to deposit and affiliates do not exceed the limits of
receive transactions through those BINs. section 23A.
However, the BIN licensee (holder of the • Ensure that covered transactions with
BIN) has primary responsibility for transac- affiliates meet the collateral require-
tions processed through its BIN. In addi- ments of section 23A.
tion, users of a BIN other than the BIN • Determine that low-quality loans or
licensee (BIN holder) may share responsi- other assets have not been purchased
bility for transactions processed under that from an affiliate.

Page 10
• Determine that all transactions with the parent’s other subsidiaries, except
affiliates are on market terms and con- that the lending bank may impose
ditions that are consistent with safe conditions and requirements in a credit
and sound banking practices. transaction to ensure the soundness of
• Determine that the transactions were the credit.
conducted on terms and conditions that f. Insider lending activities. The examina-
reflect pricing that is generally avail- tion procedures for checking compliance
able to unaffiliated parties. with the relevant law and regulation
c. 18 USC 215—Commission or Gift for covering insider activities and reporting
Procuring Loan: requirements are as follows (the exam-
• While examining the installment loan iner should refer to the appropriate sec-
area, determine the existence of any tions of the statutes for specific defini-
possible cases in which a bank officer, tions, lending limitations, reporting
director, employee, agent, or attorney requirements, and conditions indicating
may have received anything of value preferential treatment):
for procuring or endeavoring to pro- • Regulation O (12 CFR 215)—Loans to
cure any extension of credit. Executive Officers, Directors, and
• Investigate any such suspected Principal Shareholders and Their
situation. Interests. While reviewing information
d. Federal Election Campaign Act (2 USC relating to insiders received from the
441b)—Political Contributions: bank or appropriate examiner (includ-
• While examining the installment loan ing information on loan participations,
area, determine the existence of any loans purchased and sold, and loan
loans in connection with any election swaps)—
to any political office. — Test the accuracy and complete-
• Review each such credit to determine ness of information about install-
whether it is made in accordance with ment loans by comparing it with
applicable banking laws and regula- the trial balance or loans sampled.
tions and in the ordinary course of — Review credit files on insider loans
business. to determine that required informa-
e. 12 USC 1972—Tie-In Provisions. While tion is available.
reviewing credit and collateral files (espe- — Determine that loans to insiders do
cially loan agreements), determine not contain terms more favorable
whether any extension of credit is con- than those afforded to other
ditioned upon the customer’s— borrowers.
• obtaining additional credit, property, — Determine that loans to insiders do
or services from the bank, other than not involve more than the normal
a loan, discount, deposit, or trust risk of repayment or present other
service; unfavorable features.
• obtaining additional credit, property, — Determine that loans to insiders, as
or service from the bank’s parent hold- defined by the various sections of
ing company or the parent’s other Regulation O, do not exceed the
subsidiaries; lending limits imposed by those
• providing an additional credit, prop- sections.
erty, or service to the bank, other than — If prior approval by the bank’s
those related to and usually provided in board was required for a loan to an
connection with a loan, discount, insider, determine that such appro-
deposit, or trust service; val was obtained.
• providing additional credit, property, — Determine compliance with the
or service to the bank’s parent holding various reporting requirements for
company or any of the parent’s other insider loans.
subsidiaries; or — Determine that the bank has made
• not obtaining other credit, property, or provisions to comply with the pub-
service from a competitor of the bank, lic disclosure requirements for
the bank’s parent holding company, or insider loans.

Page 11
— Determine that the bank maintains the bank’s credit life insurance cover-
records of such public requests and age and what the relationship of the
the disposition of the requests for a agent or agency is to the bank. Is the
period of two years. agent or agency in compliance with the
• Title VIII of the Financial Institutions provisions of this policy?
Regulatory and Interest Rate Control • which employees, officers, directors.
Act of 1978 (FIRA) (12 USC 1972(2))— and principal shareholders are licensed
Loans to Executive Officers, Directors, insurance agents.
and Principal Shareholders of Corre- • whether bank officers have entered
spondent Banks. into reciprocal arrangements with offi-
— Obtain from or request that the cers of other banks to act as agent for
examiners reviewing due from sale of credit life insurance and to
banks and deposit accounts verify receive commissions.
a list of correspondent banks pro- • if the credit life insurance income is
vided by bank management, and credited to an entity other than the
ascertain the profitability of those bank and whether the bank is being
relationships. appropriately reimbursed for the use of
— Determine that loans to insiders of its premises, personnel, and goodwill.
correspondent banks are not made Compute the percentage compensation
on preferential terms and that no paid to the bank (total credit life insur-
conflict of interest appears to exist. ance income). Include that percentage
g. Federal Reserve Board Policy Statement in the confidential section of the com-
on the Disposition of Credit Life Insur- mercial report of examination. As a
ance Income (67 Fed. Res. Bull. 431 general rule, a reasonable compensa-
(1981), FRRS 3–1556). Test for compli- tion would be an amount equivalent to
ance with the policy statement by at least 20 percent of the credited
determining— entity’s net income (if available) attrib-
• that the income generated from the utable to the credit life insurance sales.
sale of credit life, health, and accident h. Financial Recordkeeping and Reporting
insurance3 is— of Currency and Foreign Transactions
— not distributed directly to employ- (31 CFR 103.33)—Records to Be Retained
ees, officers, directors, or principal by Financial Institutions. Review oper-
shareholders in the form of com- ating procedures and credit life documen-
missions or other income for their tation and determine whether the bank
personal profit; however, such retains records of each extension of credit
individuals may participate in a over $10,000, specifying the name and
bonus or incentive plan in an address of the borrower, the amount of
amount not exceeding, in any one the credit, the nature and purpose of the
year, 5 percent of the recipient’s loan, and the date therefor. Loans secured
annual salary, and paid not more by an interest in real property are exempt.
often than quarterly; and 2. Perform appropriate procedural steps for the
— for accounting purposes, credited separate area, concentration of credits.
to the bank’s income account, the 3. Discuss with the appropriate officer (or
income account of an affiliate officers) and prepare comments to the
operating under the Bank Holding examiner-in-charge stating your findings on
Company Act, or in the case of an the following:
individual shareholder, to a trust a. delinquent loans, including breakout of
for the benefit of all shareholders. ‘‘A’’ paper
• whether an insurance agent or agency b. violations of laws and regulations
acted as an intermediary in arranging c. concentration of credits
d. classified loans
e. loans not supported by current and com-
3. This policy also applies to income derived from the sale
of mortgage life insurance; therefore, consult with the exam-
plete financial information
iner assigned real estate loans to coordinate work to avoid any f. loans on which collateral documentation
duplication of efforts. is deficient

Page 12
g. inadequately collateralized loans m. adverse trends within the installment area

h. extensions of credit to major stockhold- n. the accuracy and completeness of the
ers, employees, officers, directors, and/or schedules obtained from the bank or
their interests other examination areas
i. Small Business Administration or other o. internal-control deficiencies or exceptions
government-guaranteed delinquent or p. recommended corrective action when
criticized loans policies, practices, or procedures are
j. a list of installment loans requested to be deficient
charged off q. the quality of departmental management
k. the adequacy of written policies relating r. other matters of significance
to installment loans 4. Update the workpapers with any informa-
l. the manner in which bank officers are tion that will facilitate future examinations.
operating in conformance with estab-
lished policy

Page 13
Consumer Credit
Review the bank’s internal controls, policies, ing items investigated by persons who do
practices, and procedures for making and ser- not also handle cash?
vicing installment loans. The bank’s system 3. Are delinquent-account collection requests
should be documented completely and concisely and past-due notices checked to the trial
and should include, where appropriate, narrative balances that are used in reconciling
descriptions, flow charts, copies of forms used, installment-loan subsidiary records to
and other pertinent information. In the question- general ledger accounts, and are requests
naire below, items marked with an asterisk and notices handled only by persons who
require substantiation by observation or testing. do not also handle cash?
4. Are loan-balance inquiries received and
investigated by persons who do not also
POLICIES handle cash?
*5. Are documents supporting recorded credit
1. Has the board of directors, consistent with adjustments checked or tested subsequently
its duties and responsibilities, adopted writ- by persons who do not also handle cash?
ten installment-loan policies that (If not, explain why briefly.)
establish— 6. Is a daily record maintained that summa-
a. procedures for reviewing installment- rizes loan-transaction details, i.e., loans
loan applications? made, payments received, and interest col-
b. standards for determining credit lines? lected, to support applicable general ledger
c. minimum standards for documentation? account entries?
2. Are installment-loan policies reviewed at 7. Are frequent note and liability ledger trial
least annually to determine if they are balances prepared and reconciled with con-
compatible with changing market trolling accounts by employees who do not
conditions? process or record loan transactions?
3. Does the bank have adequate written 8. Are two authorized signatures required to
overdraft-protection-program policies and effect a status change in an individual
procedures that follow the February 28, customer’s account?
2005, interagency Joint Guidance on Over- 9. Does operating management produce and
draft Protection Programs? review an exception report that encom-
4. Does the bank’s management emphasize passes extensions, renewals, or any factors
and monitor adherence to its overdraft that would result in a change in a custom-
policies and procedures, apply generally er’s account status?
accepted accounting principles, and apply 10. Do customer account records clearly indi-
the bank Call Report’s accounting and cate accounts that have been renewed or
reporting requirements to overdrafts? Does extended?
the bank maintain and monitor safe and
sound overdraft business practices to con-
trol the credit, operational, and other risks
associated with overdraft programs? LOAN INTEREST
1. Is the preparation and posting of interest
RECORDS records performed or reviewed by persons
who do not also—
*1. Is the preparation and posting of subsidi- a. issue official checks or drafts?
ary installment-loan records performed or b. handle cash?
reviewed by persons who do not also— 2. Are any independent tests of loan-interest
a. issue official checks or drafts? computations made and compared with
b. handle cash? initial and subsequent borrowers’ interest
*2. Are the subsidiary installment-loan records by other persons who do not—
records reconciled daily to the appropriate a. issue official checks or drafts?
general ledger accounts, and are reconcil- b. handle cash?

Page 1
2130.4 Consumer Credit: Internal Control Questionnaire
COLLATERAL DEALER LOANS

1. Are multicopy, prenumbered records main- 1. On dealer loans, are—
tained that— a. separate controls maintained or can they
a. detail the complete description of col- be easily generated?
lateral pledged? b. payments made directly to the bank and
b. are typed or completed in ink? not through the dealer?
c. are signed by the customer? c. coupon books, if used in connection
2. Are receipts issued to customers for each with loans, mailed to the borrowers,
item of collateral deposited? instead of the dealer?
3. Are the functions of receiving and releas- d. monthly summaries of the total paper
ing collateral to borrowers and of making discounted and outstanding for each
entries in the collateral register performed dealer prepared and reviewed?
by different employees? e. dealer lines reaffirmed at least annually?
4. Is negotiable collateral held under joint f. required documents on file in connec-
custody? tion with the establishment of each
5. Is all collateral for a single loan main- dealer line?
tained in a separate file? g. signed extension agreements obtained
6. Are receipts obtained and filed for released from dealers before extending accounts
collateral? originally discounted on a repurchase
7. Is a record maintained of entry to the agreement or other recourse basis?
collateral vault? h. downpayment amounts checked to
ensure they do not misrepresent the
8. Are the following controls on collateral in
sales price?
effect:
i. procedures in effect to prevent the dealer
a. When the bank customers’ savings pass-
from making late payments?
books are held as collateral, the savings
j. prohibitions against bringing loans cur-
department is notified and the account
rent by charges to the dealer’s reserve
is so noted on the deposit ledger.
accounts in effect?
b. Descriptions of motor vehicles, as set k. selling prices, as listed by the dealer,
forth on the certificate of title and verified?
insurance policies, are checked to the l. overdrafts prohibited in the dealer
chattel mortgages or other appropriate reserve and holdback accounts?
documents granting security interest in m. procedures in effect to have the title
the vehicle. application controlled by someone other
c. An insurance-maturity tickler file is than the purchaser?
maintained. n. credit checks on borrowers performed
d. Procedures are in effect to ensure single- independently of the dealer, or are the
interest insurance coverage is dealer’s credit checks independently
obtained in case regular insurance is verified?
canceled or expires. o. delinquencies verified directly with the
e. All insurance policies on file include a customers?
loss-payable clause in favor of the bank.
f. Filings are made on all security
agreements. DISCOUNTED LEASING PAPER
g. Supporting lien searches and property
appraisals are performed when a judg- 1. If the bank discounts leasing paper—
ment action is returned involving real a. are separate controls maintained or can
property. they be easily generated?
9. Are control records maintained that iden- b. are payments made directly to the bank?
tify loans secured by junior liens on real c. are controls established or are audits of
estate? lessor’s books conducted if the lessor is
10. Do those records indicate the current bal- permitted to accept payments (if so,
ance for loans secured by superior liens on explain why briefly)?
the same property? d. are monthly summaries of total paper

Page 2
Consumer Credit: Internal Control Questionnaire 2130.4
discounted for each lessor prepared and 4. Do the bank’s policies and procedures
reviewed? require that minimum payments on credit
e. are lines for each lessor reaffirmed at card accounts amortize the current balances
least annually? over a reasonable period of time, consistent
f. is a master lease required and properly with the nature of the underlying debt and
recorded when fleet-leasing or blanket the borrower’s documented creditworthi-
purchase of leasing paper is handled? ness? Do the bank’s policies and practices
g. is the value of leased goods verified to foster or encourage prolonged negative
ensure that it is not less than the amount amortization, inappropriate fees, and other
advanced? practices that inordinately compound or
h. is lease paper screened for the credit protract consumer debt?
quality of the lessee? 5. Are workout programs designed to maxi-
i. are lease terms and payment amounts mize principal reduction, and do they strive
required to be adequate to liquidate the to have borrowers repay their credit card
debt in full? debt within 60 months? Has the bank docu-
mented and supported, with compelling evi-
dence, any exceptions to the 60-month time
CREDIT CARD LENDING frame for workout programs? Has the bank
also documented and supported any less
1. Has the bank tested, analyzed, and docu- conservative loan terms and conditions that
mented line-assignment and line-increase may be warranted?
criteria prior to broad implementation of a 6. Has the bank established and maintained
new credit card plan? adequate loss allowances for credit card
2. Is a borrower’s repayment capacity care- accounts subject to settlement arrangements?
fully considered when the bank assigns an a. Does the bank classify as a loss and
initial credit line or significantly increases charge off immediately amounts of debt
existing credit lines? forgiven in settlement arrangements?
a. Are credit-line assignments managed con- b. Are specific allowances for such settle-
servatively using proven credit criteria? ment accounts reported as a charge-off in
b. Does the bank have documentation and Schedule RI-B of the call report?
analyses of decision factors such as c. Does the bank charge off any deficiency
repayment history, risk scores, behavior balances within 30 days from the receipt
scores, or other relevant criteria? of a final settlement payment?
c. Does the bank consider its entire rela- 7. Does the bank evaluate the collectibility of
tionship with a borrower when making accrued interest and fees on credit card
decisions about credit-line assignments? accounts and recognize and properly account
d. If the bank offers multiple credit lines to for the amounts that are uncollectible?
borrowers, does it have sufficient con- a. Are appropriate methods employed to
trols and management information sys- ensure that income is accurately mea-
tems to aggregate related exposures and sured (such methods include providing
analyze borrowers’ performance before loan-loss allowances for uncollectible
offering them additional lines of credit? fees and finance charges or placing
3. Do the bank’s policies and procedures focus delinquent and impaired receivables on
on adequate control, authorizations, and the nonaccrual status)?
timely repayment of amounts that exceed b. Is the owned portion of accrued interest
established credit limits? and fees, including related estimated
a. Are the bank’s management information losses, accounted for separately from
systems sufficient to enable management the retained interest in accrued interest
to identify, measure, manage, and con- and fees from securitized credit card
trol the risks associated with over-limit receivables?
accounts? 8. Does the bank’s allowance for loan and
b. Does the bank have appropriate policies lease losses (ALLL) methodology fully rec-
and controls for over-limit authorizations ognize the incremental losses that may be
on open-end accounts, particularly inherent in over-limit accounts and port-
subprime accounts? folio segments?

Page 3
2130.4 Consumer Credit: Internal Control Questionnaire
9. Are accounts in workout programs segre- h. the bill of sale is properly completed
gated for performance-measurement, and signed by an officer?
impairment-analysis, and monitoring i. separate general ledger control is
purposes? maintained?
a. Are multiple workout programs with dif-
ferent performance characteristics tracked
separately? DELINQUENT ACCOUNTS AND
b. Is the allowance allocation for each work- OPERATING REVIEW SYSTEM
out program equal to the estimated loss
in each program, based on historical 1. Are collection policies established so that—
experience adjusted for current condi- a. a delinquent notice is sent before a loan
tions and trends? becomes 30 days past due?
10. Is the total amount credited to the ALLL as b. collection effort is intensified when a
recoveries on a loan limited to the amount loan becomes two payments past due?
previously charged off against the ALLL, c. records of collection efforts are main-
and are any amounts that are collected in tained in the customer’s file?
excess of this limit recognized as income? d. field or outside collectors are under the
11. Do the bank’s policies and procedures supervision of an officer and are required
address the types of allowed exceptions to to submit progress reports?
the FFIEC’s Uniform Retail Credit Classi- e. all collections are acknowledged on
fication and Account Management Policy multicopy prenumbered forms?
and also the circumstances permitting those f. all documents that are held outside the
exceptions? regular files and that pertain to
a. Is the volume of accounts that are granted installment loans under collection are
exceptions small and well controlled? evidenced by a transmittal sheet and
b. Is the performance of accounts that are receipt?
granted exceptions closely monitored? g. delinquency lists are generated on a
c. Does the bank use exceptions prudently? timely basis (indicate the frequency)?
If not, has management been criticized 2. Is an operating review system in place
and has appropriate supervisory correc- that—
tive action been recommended? a. determines that duties are properly seg-
regated and that loan officers are pro-
hibited from processing loan payments?
REPOSSESSIONS b. recomputes the amount of credit life
and accident and health insurance on
1. Are procedures established on reposses- new loans?
sions so that— c. recomputes the amount of discount on
a. management takes timely action to new loans?
receive full advantage of any dealer d. recomputes the rebates on prepaid
endorsement or repurchase agreement? loans?
b. the notice of intention to sell is mailed e. test-checks daily transactions to subse-
to all parties who are liable on the quent general ledger postings?
account? f. reviews new-loan documentation?
c. bids are required before the sale of the g. reviews all information in reports being
item? submitted to the board of directors, or
d. bids are retained in the borrower’s credit any committee thereof, for errors or
file? omissions?
e. open repossessions are physically h. conducts a periodic review of income
checked monthly? accruals for accuracy?
f. surplus funds received from the sale of i. reviews entries to unearned discount or
a repossession are mailed back to the income accounts?
borrower in the form of a cashier’s j. reviews all charged-off loans for proper
check? approval?
g. any deficiency balance remaining after k. periodically reconciles charged-off notes
the sale of repossession is charged off? to controls?

Page 4
Consumer Credit: Internal Control Questionnaire 2130.4
l. reviews dealer’s reserve and holdback t. reviews trial balance reconcilements to

agreements and periodically determines the general ledger?
the adequacy of the balances in the
deposit account?
m. periodically verifies dealer reserve
balances? CONCLUSION
n. determines that payments are accu-
rately and promptly posted? 1. Is the foregoing information an adequate
o. reviews collection or reversal of late basis for evaluating internal control that is,
charges? there are no significant deficiencies in
p. determines that extension fees are col- areas not covered in this questionnaire that
lected on all extended loans? impair any controls? Explain negative
q. determines that discounted dealer paper answers briefly and indicate any additional
is properly endorsed? examination procedures deemed necessary.
r. determines that discounted dealer paper 2. On the basis of a composite evaluation (as
is within established guidelines? evidenced by answers to the foregoing
s. reviews compliance with laws and questions), is internal control considered
regulations? adequate or inadequate?

Page 5
Subprime Lending
Federally insured banks tend to avoid lending to Subprime loans are loans to borrowers display-
customers with poor credit histories because of ing one or more of these characteristics at the
the higher risk of default and resulting loan time of origination or purchase.
losses. However, some lenders1 extend their
risk-selection standards to attract lower-credit-
quality accounts.
Subprime lending involves extending credit
to borrowers who exhibit characteristics that SUPERVISORY GUIDANCE FOR
indicate a significantly higher risk of default SUBPRIME LENDING
than traditional bank lending customers.2 The
risk of default may be measured by traditional The subprime supervisory guidance applies to
credit-risk measures (such as credit or repay- direct extensions of credit; the purchase of
ment history or debt-to-income levels) or by subprime loans from other lenders, including
alternative measures such as credit scores. delinquent or credit-impaired loans purchased at
Subprime borrowers represent a broad spec- a discount; the purchase of subprime automobile
trum of debtors, ranging from those who have or other financing ‘‘paper’’ from lenders or
repayment problems because of an adverse event, dealers; and the purchase of loan companies that
such as job loss or medical emergency, to those originate subprime loans.
who persistently mismanage their finances and Subprime lending does not include loans to
debt obligations. Subprime borrowers typically borrowers who have had minor, temporary credit
have weakened credit histories that include pay- difficulties but are now current. Also, the
ment delinquencies and possibly more severe subprime-lending guidance does not generally
problems, such as charge-offs, judgments, and apply to prime loans that develop credit prob-
bankruptcies. They may also display reduced lems after acquisition; loans that were initially
repayment capacity as measured by credit scores, extended in subprime programs and are later
debt-to-income ratios, or other criteria that may upgraded, as a result of their performance, to
encompass borrowers with incomplete credit programs targeted to prime borrowers; and com-
histories. Generally, subprime borrowers will munity development loans, as defined in the
display a range of one or more credit-risk Community Reinvestment Act (CRA) regula-
characteristics, such as— tions, that may have some higher risk character-
istics, but are otherwise mitigated by guarantees
• two or more 30-day delinquencies in the last from government programs, private credit
12 months, or one or more 60-day delinquen- enhancements, or other appropriate risk-
cies in the last 24 months; mitigation techniques.
• judgment, foreclosure, repossession, or charge- Subprime lending poses unique and signifi-
off in the prior 24 months; cant risks to banking institutions engaged in the
• bankruptcy in the last five years; activity. Market events have raised supervisory
• relatively high default probability as evi- issues about how well subprime lenders are
denced by, for example, a credit bureau risk prepared to manage and control the risks.
score (FICO) of 660 or below (depending on Subprime-lending institutions need strong risk-
the product or collateral), or other bureau or management practices and internal controls, as
proprietary scores with an equivalent default- well as board-approved policies and procedures
probability likelihood; or that appropriately identify, measure, monitor,
• debt-service-to-income ratio of 50 percent or and control all associated risks. Institutions
greater, or an otherwise limited ability to considering or engaging in this type of lending
cover family living expenses after deducting should recognize the additional risks inherent in
total monthly debt-service requirements from this activity and determine if these risks are
monthly income. acceptable and controllable, given their organi-
zation’s financial condition, asset size, level of
capital support, and staff size. Well-managed
1. The terms lenders, financial institutions, and institutions subprime lenders should recognize the height-
refer to federally insured banks and their subsidiaries.
2. For purposes of this section, loans to customers who are ened loss characteristics in their portfolios and
not subprime borrowers are referred to as prime. internally classify their delinquent accounts well

Page 1
2133.1 Subprime Lending
before the time frames in their respective inter- greater supervisory attention to subprime lend-
agency supervisory policy. ing and the ability of an insured bank to manage
Interagency guidance on subprime lending the unique risks associated with this activity.
was issued on March 1, 1999, to alert examiners
and financial institutions to some of the pitfalls
and hazards involved in this type of lending.3 Risk Management
(See SR-99-06.) Additional interagency exami-
nation guidance was issued on January 31, 2001, The following items are essential components of
to further strengthen the supervision of certain a well-structured risk-management program for
institutions, primarily those institutions having subprime lenders.
subprime-lending programs with an aggregate
credit exposure equaling or exceeding 25 per-
cent of their tier 1 capital.4 (See SR-01-04.) The Planning and Strategy
aggregate exposure includes principal outstand-
ing and committed, accrued and unpaid interest, Before engaging in subprime lending, the board
and any retained residual interests5 relating to and management should ensure that proposed
securitized subprime loans. The Federal Reserve activities are consistent with the institution’s
may also apply the additional guidelines to overall business strategy and risk tolerances,
certain smaller subprime portfolios, such as and that all involved parties have properly
those experiencing rapid growth or adverse acknowledged and addressed critical business-
performance trends, those administered by inex- risk issues. These issues include the costs asso-
perienced management, and those with inad- ciated with attracting and retaining qualified
equate or weak controls. personnel, investments in the technology neces-
Subprime loans command higher interest rates sary to manage a more complex portfolio, a
and loan fees than those offered to standard-risk clear solicitation and origination strategy that
borrowers. Subprime loans can be profitable, allows for after-the-fact assessment of under-
provided the price charged by the lender is writing performance, and the establishment of
sufficient to cover higher loan-loss rates and appropriate feedback and control systems. The
overhead costs related to underwriting, servic- risk-assessment process should extend beyond
ing, and collecting the loans. The ability to credit risk and appropriately incorporate operat-
securitize and sell subprime portfolios at a profit ing, compliance, and legal risks. Finally, the
while retaining the servicing rights makes planning process should set clear objectives for
subprime lending attractive to a larger number performance, including the identification and
of institutions, further increasing the number of segmentation of target markets or customers, as
subprime lenders and loans. Some financial well as set performance expectations and bench-
institutions have experienced losses attributable marks for each segment and the portfolio as a
to ill-advised or poorly structured subprime- whole. Institutions establishing a subprime-
lending programs. These losses have attracted lending program should proceed slowly and
cautiously into this activity to minimize the
3. The March 1999 and January 2001 statements were
impact of unforeseen personnel, technology, or
adopted and issued by the Board of Governors of the Federal internal-control problems and to determine if
Reserve System, the Federal Deposit Insurance Corporation, favorable initial profitability estimates are real-
the Office of the Comptroller of the Currency, and the Office istic and sustainable.
of Thrift Supervision.
4. The March 1999 and January 2001 subprime-lending
interagency guidance is consolidated within this section. To
focus on the supervisory guidance that applies primarily to Staff Expertise
institutions having subprime-lending programs equaling or
exceeding 25 percent of tier 1 capital, see the January 2001 Subprime lending requires specialized knowl-
release. The March 1999 interagency supervisory guidance
applies to all subprime-lending institutions.
edge and skills that many financial institutions
5. Residual interests are on-balance-sheet assets that rep- may not possess. Marketing, account-origination,
resent interests (including beneficial interests) in transferred and collections strategies and techniques often
financial assets retained by a seller (or transferor) after a differ from those employed for prime credit;
securitization or other transfer of financial assets. They are
structured to absorb more than a pro rata share of credit loss
thus, it may not be sufficient to have the same
related to the transferred assets through subordination provi- lending staff responsible for both subprime loans
sions or other credit-enhancement techniques. and other loans. Additionally, servicing and

Page 2
Subprime Lending 2133.1
collecting subprime loans can be very labor reports, and credit memoranda to support the
intensive. If necessary, the institution should loan decision
implement programs to train staff. The board • correspondent/broker/dealer approval process,
should ensure that staff possess sufficient exper- including measures to ensure that loans origi-
tise to appropriately manage the risks in subprime nated through this process meet the institu-
lending and that staffing levels are adequate for tion’s lending standards
the planned volume of subprime activity. The
experience, or seasoning, of staff and loans If the institution elects to use credit scoring
should be taken into account as performance is (including applications scoring) for approvals or
assessed over time. pricing, the scoring model should be based on a
development population that captures the behav-
ioral and credit characteristics of the subprime
Lending Policy population targeted for the products offered.
Because of the significant variance in character-
A subprime-lending policy should be appropri- istics between the subprime and prime popula-
ate to the size and complexity of the institution’s tions, institutions should not rely on models
operations and should clearly state the goals of developed solely for products offered to prime
the subprime-lending program. While not borrowers. Further, the model should be reviewed
exhaustive, the following lending standards frequently and updated as necessary to ensure
should be addressed in any subprime-lending that assumptions remain valid.
policy:
• types of products offered as well as those that Purchase Evaluation

are not authorized
• portfolio targets and limits for each credit As they evaluate expected profits, institutions
grade or class that purchase subprime loans from other lenders
• lending and investment authority clearly stated or dealers must give due consideration to the
for individual officers, supervisors, and loan cost of servicing these assets and to the loan
committees losses that may be experienced. For instance,
• a framework for pricing decisions and profit- some lenders who sell subprime loans charge
ability analysis that considers all costs associ- borrowers high up-front fees, which are usually
ated with the loan, including origination costs, financed into the loan. This provides incentive
administrative or servicing costs, expected for originators to produce a high volume of
charge-offs, and capital loans with little emphasis on quality, to the
• evaluation of collateral and appraisal detriment of a potential purchaser. Further,
standards subprime loans, especially those purchased from
• well-defined and specific underwriting param- outside the institution’s lending area, are at
eters (that is, on acceptable loan term, debt- special risk for fraud or misrepresentation (that
to-income ratios, and loan-to-collateral-value is, the quality of the loan may be less than the
ratios for each credit grade and a minimum loan documents indicate).
acceptable credit score) that are consistent Institutions should perform a thorough due-
with any applicable supervisory guidelines6 diligence review before committing to purchase
• procedures for the separate tracking and moni- subprime loans. Institutions should not accept
toring of loans approved as exceptions to loans from originators that do not meet their
stated policy guidelines underwriting criteria, and they should regularly
• credit-file documentation requirements, such review loans offered to ensure that loans pur-
as applications, offering sheets, loan and col- chased continue to meet those criteria. Deterio-
lateral documents, financial statements, credit ration in the quality of purchased loans or in the
portfolio’s actual performance versus expecta-
6. Extensions of credit secured by real estate, whether the tions requires a thorough reevaluation of the
credit is subprime or otherwise, are subject to the Interagency lenders or dealers who originated or sold the
Guidelines for Real Estate Lending Policies, which establish loans, as well as a reevaluation of the institu-
supervisory loan-to-value (LTV) limits on various types of
real estate loans and impose limits on an institution’s aggre-
tion’s criteria for underwriting loans and select-
gate investment in loans that exceed the supervisory LTV ing dealers and lenders. Any such deterioration
limits. (See 12 CFR 208, appendix C.) may also highlight the need to modify or termi-

Page 3
nate the correspondent relationship or to adjust that management can use to evaluate the perfor-
underwriting and dealer or lender selection mance of subprime loans. The review process
criteria. should focus on whether performance meets
expectations. Institutions then need to consider
the source and characteristics of loans that do
Loan-Administration Procedures not meet expectations and make changes in their
underwriting policies and loan-administration
After the loan is made or purchased, loan- procedures to restore performance to acceptable
administration procedures should provide for levels.
the diligent monitoring of loan performance and When evaluating actual performance against
establish sound collection efforts. To minimize expectations, it is particularly important that
loan losses, successful subprime lenders have management review credit scoring, pricing, and
historically employed stronger collection efforts, any ALLL-adequacy models. Models driven by
such as calling delinquent borrowers frequently, the volume and severity of historical losses
investing in technology (for example, using experienced during an economic expansion may
automatic dialing for follow-up telephone calls have little relevance in an economic slowdown,
on delinquent accounts), assigning more expe- particularly in the subprime market. Manage-
rienced collection personnel to seriously delin- ment should ensure that models used to estimate
quent accounts, moving quickly to foreclose or credit losses or to set pricing allow for fluctua-
repossess collateral, and allowing few loan tions in the economic cycle and are adjusted to
extensions. This aspect of subprime lending is account for other unexpected events.
very labor intensive but critical to the program’s
success. To a large extent, the cost of such
efforts can be a tradeoff with future loss expec- Consumer Protection
tations, when an institution analyzes the profit-
ability of subprime lending and assesses its Institutions that originate or purchase subprime
appetite to expand or continue this line of loans must take special care to avoid violating
business. Subprime-loan administration proce- fair lending and consumer protection laws and
dures should be in writing and at a minimum regulations. Higher fees and interest rates com-
should detail— bined with compensation incentives can foster
predatory pricing or discriminatory ‘‘steering’’
• billing and statement procedures; of borrowers to subprime products for reasons
• collection procedures; other than the borrower’s underlying creditwor-
• content, format, and frequency of manage- thiness. An adequate compliance-management
ment reports; program must identify, monitor, and control the
• asset-classification criteria; consumer protection hazards associated with
• methodology to evaluate the adequacy of the subprime lending.
allowance for loan and lease losses (ALLL); Subprime mortgage lending may trigger the
• criteria for allowing loan extensions, defer- special protections of the Home Ownership and
rals, and re-agings; Equity Protection Act of 1994, subtitle B of title
• foreclosure and repossession policies and pro- I of the Riegle Community Development and
cedures; and Regulatory Improvement Act of 1994. This act
• loss-recognition policies and procedures. amended the Truth in Lending Act to provide
certain consumer protections in transactions
involving a class of nonpurchase, closed-end
Loan Review and Monitoring home mortgage loans. Institutions engaging in
this type of lending must also be thoroughly
Once an institution books the loans, designated familiar with the obligations set forth in Regu-
staff must perform an ongoing analysis of lation Z (12 CFR 226.32), Regulation X (24
subprime loans, not only on an aggregate basis CFR 3500), and the Real Estate Settlement
but also for subportfolios. Information systems Procedures Act (RESPA) (12 USC 2601) and
should be in place to segment and stratify the should adopt policies and implement practices
institution’s portfolio (for example, by origina- that ensure compliance.
tor, loan-to-value, debt-to-income ratios, or credit The Equal Credit Opportunity Act makes it
scores). Assigned staff should produce reports unlawful for a creditor to discriminate against an

Page 4
applicant on a prohibited basis regarding any backup purchasers of the securities or the atten-
aspect of a credit transaction. Similarly, the Fair dant servicing functions, alternate funding
Housing Act prohibits discrimination in connec- sources, and measures for raising additional
tion with residential real estate–related transac- capital.
tions. Loan officers and brokers must treat all Institutions should refer to the Statement of
similarly situated applicants equally and without Financial Accounting Standards No. 140 (FAS
regard to any prohibited-basis characteristic (for 140), ‘‘Accounting for Transfers and Servicing
example, race, sex, or age). This is especially of Financial Assets and Extinguishments of
important with respect to how loan officers or Liabilities,’’ for guidance on accounting for
brokers assist customers in preparing their ap- these transactions. If a securitization transaction
plications or otherwise help them to qualify for meets FAS 140 sale or servicing criteria, the
loan approval. seller must recognize any gain or loss on the sale
of the pool immediately and carry any retained
interests in the assets sold (including servicing
Securitization and Sale rights or obligations and interest-only strips) at
fair value. Management should ensure that the
To increase their loan-production and -servicing key assumptions used to value these retained
income, some subprime lenders originate loans interests are reasonable and well supported, both
and then securitize and sell them in the asset- for the initial valuation and for subsequent
backed securities market. Strong demand from quarterly revaluations. In particular, manage-
investors and favorable accounting rules often ment should consider the appropriate discount
allow securitization pools to be sold at a gain, rates, credit-loss rates, and prepayment rates
providing further incentive for lenders to expand associated with subprime pools when valuing
their subprime-lending program. However, the these assets. Since the relative importance of
securitization of subprime loans carries inherent each assumption varies with the underlying
risks, including interim credit risk and liquidity characteristics of the product types, manage-
risks, which are potentially greater than those ment should segment securitized assets by spe-
for securitizing prime loans. Accounting for the cific pool, as well as by predominant risk and
sale of subprime pools requires assumptions that cash-flow characteristics, when making the un-
can be difficult to quantify, and erroneous derlying valuation assumptions. In all cases,
assumptions could lead to the significant over- however, institutions should take a conservative
statement of an institution’s assets. Moreover, approach when developing securitization
the practice of providing support and substitut- assumptions and capitalizing expected future
ing performing loans for nonperforming loans to income from subprime-lending pools. Institu-
maintain the desired level of performance on tions should also consult with their auditors as
securitized pools has the effect of masking necessary to ensure that their accounting for
credit-quality problems. securitizations is accurate.
Institutions should recognize the volatility of
the secondary market for subprime loans and the
significant liquidity risk incurred when originat- Reevaluation
ing a large volume of loans intended for secu-
ritization and sale. Investors can quickly lose Institutions should periodically evaluate whether
their appetite for risk in an economic downturn the subprime-lending program has met profit-
or when financial markets become volatile. As a ability, risk, and performance goals. Whenever
result, institutions that have originated, but have the program falls short of original objectives, an
not yet sold, pools of subprime loans may be analysis should be performed to determine the
forced to sell the pools at deep discounts. If an cause, and the program should be modified
institution lacks adequate personnel, risk- appropriately. If the program falls far short of
management procedures, or capital support to the institution’s expectations, management should
hold subprime loans that were originally intended consider terminating it. Questions that manage-
for sale, these loans may strain an institution’s ment and the board need to ask may include the
liquidity, asset quality, earnings, and capital. following:
Consequently, institutions actively involved in
the securitization and sale of subprime loans • Have cost and profit projections been met?
should develop a contingency plan that addresses • Have projected loss estimates been accurate?

Page 5
• Has the institution been called upon to provide of the ALLL and capital, and the adequacy of
support to enhance the quality and perfor- portfolio risk-management practices.
mance of loan pools it has securitized?
• Were the risks inherent in subprime lending
properly identified, measured, monitored, and Transaction-Level Testing
controlled?
Subprime-loan portfolios contain elevated risks,
• Has the program met the credit needs of the
and actual subprime-lending practices often can
community that it was designed to address?
deviate from stated policy and procedural guid-
ance. Therefore, examiners should supplement
the portfolio-level examination procedures with
Examination Review and Analysis transaction-level testing to determine whether—
The following supervisory guidance (up to the • individual loans adhere to existing policy,
examination objectives) applies only to banks underwriting, risk-selection, and pricing
that have subprime-lending programs equaling standards;
or exceeding 25 percent of tier 1 capital and to • individual loans and portfolios are classified
banks that have other designated subprime pro- in accordance with the subprime-lending
grams referenced in SR-01-4. guidelines described in this section, or in other
The heightened risk levels and potential vola- Federal Reserve credit-extending supervisory
tility in delinquency and loss rates posed by guidance;
subprime-lending programs warrant examiners’ • management, board, and regulatory reporting
increased ongoing attention. The risks inherent is accurate and timely;
in subprime-lending programs call for frequent • existing loans conform to specified account-
reviews. There are generally two levels of review management standards (such as over-limits,
appropriate for subprime activities: line increases, reductions, cancellations,
re-scoring, or collections);
• Portfolio-level reviews include assessments of • key risk controls and control processes are
underwriting standards, marketing practices, adequate and functioning as intended;
pricing, management information and control • roll rates and other loss-forecasting methods
systems (quality control, audit and loan review, used to determine ALLL levels are accurate
vendor management, compliance), portfolio and reliable; and
performance, and the appropriate application • lending practices exist that may appear unsafe,
of regulatory and internal allowance and capi- unsound, or abusive and unfair.
tal policies.
• Transaction-level testing includes the testing
of individual loans for compliance with un- Adequacy of the ALLL
derwriting and loan-administration guide-
lines; the appropriate treatment of loans under Examiners should assess the adequacy of the
delinquency, re-aging, and cure programs; and ALLL to ensure that the portion allocated to the
the appropriate application of regulatory and subprime portfolio is sufficient to absorb esti-
internal allowance and capital policies. mated credit losses for this portfolio. Consistent
with interagency policy,7 the term estimated
During each regularly scheduled examination credit losses means an estimate of the amount
cycle, examiners should perform a portfolio- that is not likely to be collected; that is, net
level review and some transaction testing at charge-offs that are likely to be realized given
each institution engaged in subprime lending. the facts and circumstances as of the evaluation
The Federal Reserve will perform regular off- date.8 These estimated losses should meet the
site supervisory monitoring and may require
subprime lenders to supply supplementary infor- 7. The 2006 Interagency Policy Statement on the Allow-
mation about their subprime portfolios between ance for Loan and Lease Losses was issued December 13,
examinations. The examiner’s findings from 2006. (See SR-06-17.) The Supplemental Interagency policy
statement on the ALLL methodologies and documentation
transaction-level testing and portfolio-level was issued July 2, 2001. (See SR-01-07.)
reviews should be incorporated into the conclu- 8. Estimates of credit losses should include accrued interest
sions about overall asset quality, the adequacy and other accrued fees (for example, uncollected credit card

Page 6
criteria for accrual of loss contingency, as set volume, underwriting, risk selection, account-
forth under generally accepted accounting prin- management practices, and current economic or
ciples (GAAP), consistent with supervisory business conditions that may alter such experi-
ALLL policy. ence. The allowance should represent a prudent,
conservative estimate of losses that allows a
reasonable margin for imprecision. Institutions
New Entrants to the Business should clearly document loss estimates and the
allowance methodology in writing. This docu-
In some instances, an institution (for example, a mentation should describe the analytical process
newly chartered institution or an existing insti- used, including—
tution entering the subprime-lending business)
may not have sufficient previous loss experience • portfolio-segmentation methods applied;
to estimate an allowance for subprime-lending • loss-forecasting techniques and assumptions
activities. In such cases, industry statistics or employed;
another institution’s loss data for similar loans • definitions of terms used in ratios and model
may be a better starting point to determine the computations;
ALLL than the institution’s own data for devel- • relevance of the baseline loss information
oping loss rates. When an institution uses loss used;
rates developed from industry statistics or from • rationale for adjustments to historical experi-
other institutions to determine its ALLL, it ence; and
should demonstrate and document that the • a reconciliation of forecasted loss rates to
attributes of the loans in its portfolio or portfolio actual loss rates, with significant variances
segment are similar to those in the other insti- explained.
tution’s (or industry’s) portfolio.
Pools of Subprime Loans—Not Classified Classification Guidelines for

Subprime Lending
The ALLL required for subprime loans should
be sufficient to absorb at least all estimated Well-managed subprime lenders should recog-
credit losses on outstanding balances over the nize the heightened loss characteristics in their
current operating cycle, typically 12 months. portfolios and internally classify their delin-
The board of directors and management are quent accounts well before the time frames
expected to ensure that the institution’s process outlined in the retail classification policy issued
for determining an adequate level for the ALLL by the Federal Financial Institutions Examina-
is based on a comprehensive and adequately tion Council (FFIEC) on June 12, 2000. Exam-
documented analysis of all significant factors. iners should classify subprime loans and port-
The consideration factors should include histori- folios in accordance with the guidelines in this
cal loss experience, ratio analysis, peer-group section and other applicable Federal Reserve
analysis, and other quantitative analysis as a supervisory guidelines. Classified loans are loans
basis for the reasonableness of the ALLL. To the that are not protected adequately by the current
extent that the historical net charge-off rate is sound worth and paying capacity of the bor-
used to estimate expected credit losses, it should rower or the collateral pledged. As such, full
be adjusted for changes in trends, conditions, liquidation of the debt may be in jeopardy. Pools
and other relevant factors, including business of classified subprime loans (to include, at a
minimum, all loans past due 90 days or more)
should be reviewed for impairment, and an
fees or uncollected late fees) that have been added to the loan adequate allowance should be established con-
balances and, as a result, are reported as part of the institu-
tion’s loans on the balance sheet. An institution may include sistent with existing interagency policy.
these types of estimated losses in either the ALLL or a
separate valuation allowance, which would be netted against
the aggregated loan balance for regulatory reporting purposes. Individual Loans
When accrued interest and other accrued fees are not added to
the loan balances and are not reported as part of loans on the
balance sheet, the collectibility of these accrued amounts
Examiners should not automatically classify or
should nevertheless be evaluated to ensure that the institu- place loans in special mention merely because
tion’s income is not overstated. they are subprime. Rather, classifications should

Page 7
reflect the borrower’s capacity and willingness Required Documentation for Cure
to repay and the adequacy of collateral pledged. Programs
Loans to borrowers that do not have the
capacity to service their loans generally will be Cure programs, including such practices as
classified substandard. When repayment capac- re-aging, extensions, renewals, rewrites, or other
ity is insufficient to support the orderly liquida- types of account restructuring, are subject to the
tion of the debt, and the collateral pledged is standards outlined in the retail classification
insufficient to mitigate risk of loss, then a more policy. In accordance with that policy, cure
severe classification and nonaccrual is war- programs should be used only when the institu-
ranted. Subprime loans that are past due 90 days tion has substantiated the customer’s renewed
or more should be classified at least substandard willingness and ability to repay. Examiners will
based on a reasonable presumption that their expect institutions to maintain documentation
past-due status indicates an inadequate capacity supporting their analysis of the customer’s
or unwillingness to repay. A more stringent renewed ability and willingness to repay the
classification approach may be appropriate based loan at the time it is extended, renewed, or
on the historical loss experience of a particular deferred. When the institution cannot demon-
institution. Classification of other subprime loans strate both the willingness and ability of the
as doubtful or loss will be based on examiners’ customer to repay, the loan should not be
analysis of the borrower’s capacity to repay, and renewed, extended, deferred, or rewritten, and
on the quality of institution underwriting and the loan should be moved back to its pre-cure
account-management practices as evidenced in delinquency status. Documentation should
the loan file or by other documentation. include one or more of the following:
In some cases, the repayment of principal,
interest, and fees on some subprime loans may • a new verification of employment
be overly dependent on collateral pledged. This • a recomputed debt-to-income ratio indicating
occurs when the risk of default is so high that an sufficient improvement in the borrower’s finan-
abundance of collateral is taken to mitigate risk cial condition to support orderly repayment
of loss in the event of default. From a safety- • a refreshed credit score or updated bureau
and-soundness perspective, institutions should report
be discouraged from lending solely on the basis • a file memo evidencing discussion with the
of collateral pledged. Such loans will generally customer
be classified substandard. Further, when the
borrower does not demonstrate the capacity to When documentation of the customer’s renewed
service the loan from sources other than col- willingness and ability to repay the loan is
lateral pledged, the loan may be placed on absent or deficient, management practices should
nonaccrual. be criticized.
Portfolios
Predatory or Abusive Lending
When the portfolio review or loan sample indi- Practices
cates serious concerns with credit-risk selection
practices, underwriting standards, or loan qual- The term ‘‘subprime’’ is often misused to refer
ity, examiners should consider classifying or to certain predatory or abusive lending practices.
criticizing the entire portfolio or segments of the Lending practices can be designed to responsi-
portfolio. Such a decision may be appropriate in bly provide service to customers and enhance
cases where risk is inordinately high or delin- credit access for borrowers with special credit
quency reports reflect performance problems. needs. Subprime lending that is appropriately
Some subprime-lending portfolios may pose underwritten, priced, and administered can serve
very high risk. These may include portfolios of these goals.
unsecured loans or secured, high loan-to-value Some forms of subprime lending may be
loans to borrowers who clearly exhibit inad- abusive or predatory, however. Lending prac-
equate capacity to repay the debt in a reasonable tices may be designed to transfer wealth from
time frame. Most such portfolios should be the borrower to the lender or loan originator
classified at least substandard. without a commensurate exchange of value.

Page 8
This is sometimes accomplished when the lender menting the methodology and analysis support-
structures a loan to a borrower who has little or ing the amount specified.
no ability to repay the loan from sources other The amount of additional capital necessary
than the collateral pledged. When default occurs, will vary according to the volume and type of
the lender forecloses or otherwise takes posses- subprime activities conducted and the adequacy
sion of the borrower’s property (generally the of the institution’s risk-management program.
borrower’s home or automobile). In other cases, An institution’s overall capital adequacy will be
the lender may use the threat of foreclosure or evaluated on a case-by-case basis through on-
repossession to induce duress on the borrower site examinations and off-site monitoring proce-
for payment. Typically, predatory lending dures, considering, among other factors, the
involves at least one, and perhaps all three, of institution’s own documented analysis of the
the following elements: capital needed to support subprime lending.
Institutions that are determined to have insuffi-
• making unaffordable loans based on the assets cient capital must correct the deficiency within a
of the borrower rather than on the borrower’s reasonable time frame or be subject to supervi-
ability to repay an obligation sory action. In light of the higher risks associ-
• inducing a borrower to refinance a loan ated with this type of lending, higher minimum-
repeatedly in order to charge high points and capital requirements may be imposed on
fees each time the loan is refinanced (that is, institutions engaging in subprime lending.
‘‘loan flipping’’) The sophistication of this analysis should be
• engaging in fraud or deception to conceal the commensurate with the size, concentration level,
true nature of the loan obligation or ancillary and relative risk of the institution’s subprime-
products from an unsuspecting or unsophisti- lending activities and should consider the fol-
cated borrower lowing elements:
Loans to borrowers who do not demonstrate the • portfolio-growth rates

capacity to repay the loan, as structured, from • trends in the level and volatility of expected
sources other than the collateral pledged are losses
generally considered unsafe and unsound. Such • the level of subprime-loan losses incurred
lending practices should be criticized in the over one or more economic downturns, if such
examination report as imprudent. Further, exam- data or analyses are available
iners should refer any loans with the aforemen- • the impact of planned underwriting or market-
tioned characteristics to Federal Reserve con- ing changes on the credit characteristics of the
sumer compliance/fair lending specialists for portfolio, including the relative levels of risk
additional review. of default, loss in the event of default, and the
level of classified assets
• any deterioration in the average credit quality
over time due to adverse selection or retention
Capitalization • the amount, quality, and liquidity of collateral
securing the individual loans
The Federal Reserve’s minimum capital require- • any asset, income, or funding-source
ments generally apply to portfolios that exhibit concentrations
substantially lower risk profiles than those that • the degree of concentration of subprime
exist in subprime-loan programs. Therefore, credits
these requirements may not be sufficient to • the extent to which current capitalization con-
reflect the risks associated with subprime port- sists of residual assets or other potentially
folios. Subprime-lending activities can present a volatile components
greater-than-normal risk for financial institu- • the degree of legal or reputation risk associ-
tions and the deposit insurance funds; therefore, ated with the subprime business lines pursued
the level of capital institutions need to support • the amount of capital necessary to support the
this activity should be commensurate with the institution’s other risks and activities
additional risks incurred. Each subprime lender
is responsible for quantifying the amount of Given the higher risk inherent in subprime-
capital needed to offset the additional risk in lending programs, examiners should reasonably
subprime-lending activities, and for fully docu- expect, as a starting point, that an institution

Page 9
would hold capital against such portfolios in an tests are performed manually, or through auto-
amount that is one and one-half to three times mated modeling techniques, it is expected that—
greater than what is appropriate for non-
subprime assets of a similar type. Refinements • the process is clearly documented, rational,
should depend on the factors analyzed above, and easily understood by the institution’s
with particular emphasis on the trends in the board and senior management;
level and volatility of loss rates, and on the • the inputs are reliable and relate directly to the
amount, quality, and liquidity of collateral subject portfolios (for example, baseline loss
securing the loans. Institutions should have history or default probabilities should reflect
capital ratios that are well above the averages each segment of the institution’s portfolio and
for their traditional peer groups or other simi- not just a blend of prime and subprime
larly situated institutions that are not engaged in borrowers);
subprime lending. • assumptions are well documented and conser-
Some subprime asset pools warrant increased vative; and
supervisory scrutiny and monitoring, but not • any models are subject to a comprehensive
necessarily additional capital. For example, well- validation process.
secured loans to borrowers who are slightly
below what is considered prime quality may The results of the stress-test exercises should be
entail minimal additional risks compared with a documented factor in the analysis and deter-
prime loans, and they may not require additional mination of capital adequacy for the subprime
capital if adequate controls are in place to portfolios.
address the additional risks. On the other hand, Institutions that engage in subprime-lending
institutions that underwrite higher-risk subprime programs without adequate procedures to esti-
pools, such as unsecured loans or high loan-to- mate and document the level of capital neces-
value second mortgages, may need significantly sary to support their activities should be criti-
higher levels of capital, perhaps as high as cized. Where capital is deemed inadequate to
100 percent of the loans outstanding, depending support the risk in subprime-lending activities,
on the level and volatility of risk. examiners should consult with their Reserve
Bank supervisory official to determine the
appropriate course of action. Such actions may
include requiring additional capital in accor-
Stress Testing dance with the Federal Reserve’s capital adequacy
rules, or requiring the institution to submit an
An institution’s capital adequacy analysis should acceptable capital plan in accordance with safety-
include stress testing as a tool for estimating and-soundness guidelines.
unexpected losses in its subprime-lending pools.
Institutions should project the performance of
their subprime-loan pools under conservative
stress-test scenarios, including an estimation of Subprime-Lending Examiner
the portfolio’s susceptibility to deteriorating eco- Responsibilities
nomic, market, and business conditions. Port-
folio stress testing should include ‘‘shock’’ test- Using the interagency guidance and any supple-
ing of basic assumptions, such as delinquency mental Federal Reserve guidelines, examiners
rates, loss rates, and recovery rates on collateral. should assess carefully management’s ability to
Stress tests should also consider other poten- administer the higher risk in subprime port-
tially adverse scenarios, such as changing attri- folios. The examiner should judge manage-
tion or prepayment rates; changing utilization ment’s ability to manage the risk involved in the
rates for revolving products; changes in credit- subprime-lending program, in particular, the
score distribution; and changes in the capital- quality of the risk-management and control
market demand for whole loans or asset-backed processes in place, and more importantly, the
securities supported by subprime loans. These extent to which management is adhering to
are representative examples; actual factors will those processes. When examiners determine that
vary by product, market segment, and the size risk-management practices are deficient, they
and complexity of the portfolio relative to the should criticize management and initiate correc-
institution’s overall operations. Whether stress tive action. Such actions may include formal or

Page 10
informal enforcement actions or a plan to achieve practices, and portfolio performance to deter-
adequate capitalization. When a primary super- mine if the institution has a program that war-
visor determines that an institution’s risk- rants the supervision and safeguards outlined in
management practices are materially deficient, the guidance.
the primary supervisor may instruct the institu-
tion to discontinue its subprime-lending Question 2: Does the guidance apply when an
programs. institution offers a product that attracts a dis-
proportionate number of subprime borrowers,
but which the institution does not explicitly
APPENDIX—QUESTIONS AND identify as subprime?
ANSWERS FOR EXAMINERS A subprime program commonly features prod-
REGARDING THE EXPANDED ucts specifically tailored to borrowers with weak-
GUIDANCE FOR SUBPRIME- ened credit histories. Such products often differ
LENDING PROGRAMS substantially in pricing and terms from products
offered to prime borrowers, and usually have
To assist examiners who review subprime- separate and distinctly different underwriting
lending activities, the following questions and standards. An institution offering a product that
answers were developed to provide additional attracts a disproportionate number of borrowers
guidance on the expanded interagency guidance with weakened credit histories likely has a
that was issued on January 31, 2001. subprime program whether or not the activity is
called a subprime program. The guidance will
apply to these programs when the resultant
Applicability of the Guidance aggregate credit exposure is at least 25 percent
of the institution’s tier 1 capital.
Question 1: Does the guidance apply to all Institutions with significant programs are
institutions? expected to have the necessary risk-management
and internal-control systems in place to properly
No. The guidance will not affect the vast major- identify, measure, monitor, and control the
ity of insured institutions engaged in traditional inherent risks in its subprime portfolio. Risk
consumer lending. The guidance applies to management and controls for these programs
institutions that systematically target the subprime typically involve enhanced performance moni-
market through programs that employ tailored toring, intensive collection activities, and other
marketing, underwriting standards, and risk loss-mitigation strategies. If an institution sys-
selection. tematically targets the subprime market but does
The guidance does not address traditional not segregate these loans from its prime port-
consumer lending that has historically been the folio, it is doubtful that the institution has the
mainstay of community banking. It does not necessary risk-management and control systems
apply to institutions extending credit to subprime in place to safely engage in the activity.
borrowers as part of their standard community-
lending process, or making loans to subprime
borrowers as an occasional exception to a prime-
lending program, even if the aggregate of these Subprime Characteristics
loans totals more than 25 percent of tier 1
capital. Such institutions continue to be subject Question 3: Why does the Expanded Guidance
to the normal supervisory process. for Subprime Lending Programs use a credit
Institutions engaging in subprime-lending pro- bureau risk score (FICO) of 660 as a cutoff
grams generally have knowingly and purpose- point for subprime lending?
fully focused on the subprime-lending markets
through planned business strategies, tailored The guidance does not use credit scores, or any
products, and explicit borrower targeting. In other single risk factor, as a definitive cutoff
instances where significant exposures to subprime point for subprime lending. The characteristics
borrowers are identified, examiners should con- listed are not explicit, bright-line definitions.
sider the institution’s marketing program, loan The range of credit characteristics used to
products, pricing, underwriting standards and describe subprime borrowers is intended to help

Page 11
examiners identify lenders that are engaged in • Standard & Poor’s subprime-mortgage under-
subprime-lending programs. These characteris- writing guidelines define subprime
tics describe borrowers with varying, but signifi- A-characteristics as two or more 30-day
cantly higher, probabilities of default than prime delinquencies on mortgage and consumer
borrowers. The guidance states that ‘‘this list is credit, one 60-day delinquency on consumer
illustrative rather than exhaustive and is not credit, debt-to-income ratio of 45 percent, and
meant to define specific parameters for all bor- no bankruptcy in the past five years. Standard
rowers.’’ & Poor’s also ‘‘...considers subprime borrow-
A credit bureau score of 660 (FICO) is used ers to have a FICO credit score of 659 or
only as an example to illustrate a credit score below.’’2
that generally indicates a higher default prob- • Standard & Poor’s has classified nonprime B
ability. The guidance indicates the probability of auto securitization pools as having occasional
default, as evidenced by the credit score, will delinquencies and minor charge-offs on re-
vary by product and collateral. The subprime volving debt, static pool net losses of 3.1 per-
guidance lists several characteristics that denote cent to 7.5 percent, and FICO credit scores
a higher probability of default. Examiners are ranging from 620–679.3
directed to use these characteristics as a starting • Freddie Mac has used the FICO score of 660
point to expand their review of lending pro- or below to designate higher-risk borrowers
grams targeting subprime borrowers in accor- requiring more comprehensive review. Fred-
dance with risk-focused examination proce- die Mac views a score in the 620–660 range as
dures. The severity of risk may vary significantly an indication that the ‘‘borrower’s willingness
for the different characteristics listed, as well as to repay debt as agreed is uncertain.’’ FICO
for the type and quality of collateral. Examiners scores below 620 are placed in the ‘‘cautious-
should take this into consideration when review- review category,’’ and Freddie Mac considers
ing the portfolio and determining the adequacy scores below 620 ‘‘as a strong indication that
of loan-loss reserves and capital. the borrower’s credit reputation is not
The characteristics used in the guidance are acceptable...’’4
well recognized in the investment and lending
industries. A number of public debt rating agen-
cies and financial institutions, including the Capital Guidance
government-sponsored enterprises (GSEs), use
similar credit characteristics to differentiate risk Question 4: If an institution is engaged in
among borrowers. Specific examples include the subprime lending as described by the guidance,
following: does the 1.5-to-3 times capital described in the
guidance automatically apply?
• Fitch defines a subprime borrower as ‘‘...one
with a credit profile worse than that of a prime No. The expanded interagency guidance on
A quality borrower, whose credit report would subprime lending is flexible examination guid-
typically reveal no recent mortgage delinquen- ance; the capital range does not automatically
cies and whose credit profile would yield a apply because the guidance is not a capital rule
[FICO] credit score in the range above 680.’’ or regulation. Rather, the guidance describes an
Fitch’s mortgage credit grade matrix lists the expectation that subprime lenders hold sufficient
following credit-history elements for A-, the loan-loss reserves and capital to offset the addi-
highest subprime grade: one 30-day delin- tional risks that may exist in subprime activities.
quency in the last 12 months on a mortgage The agencies expect institutions to have meth-
debt; one 30-day delinquency in the last 24 odologies and analyses in place to support and
months on installment debt, or two 30-day document the level of reserves and capital needed
delinquencies in the last 24 months on revolv-
ing debt; bankruptcy in past five years; charge- 2. Standard & Poor’s, ‘‘U.S. Residential Subprime Mort-
off or judgments exceeding $500 in the past gage Criteria,’’ Structured Finance, 1999: 12, 169.
24 months; and/or a debt-to-income ratio of 3. Standard & Poor’s, ‘‘Auto Loan Criteria and Market
45 percent.1 Overview 1998,’’ Structured Finance Ratings Asset-Backed
Securities, 6.
4. Freddie Mac, Single-Family Seller/Servicer Guide, chap-
1. Fitch IBCA, Duff & Phelps, ‘‘Rating U.S. Residential ter 37, section 37.6, ‘‘Using FICO Scores in Underwriting,’’
Subprime Mortgage Securities, March 16, 2001: 2. March 7, 2001.

Page 12
for the additional risks assumed. The higher the Yes. The regulatory expectations of higher capi-
risk, the more reserves and capital needed to tal maintenance are consistent with expectations
support the activity. Institutions with lower-risk in the capital markets. The 1.5-to-3-times-
subprime portfolios may not need additional capital multiple is risk based, e.g., the level of
reserves and capital. In addition, examiners are additional capital varies by relative loan quality
reminded that subprime lending is only one and is applied only to the subprime portfolio, not
element in the evaluation of the institution’s the institution’s entire asset structure. This is
overall capital adequacy. If the analysis shows consistent with the financial marketplace’s
that the institution has adequate capital for all its assessment of relative risk in subprime assets
assets and activities, including subprime lend- outside the banking industry. For example, the
ing, there is no additional capital requirement amount of credit enhancement required for
arising from the guidance. subprime securitization structures varies accord-
Examiners are instructed not to unilaterally ing to the level and volatility of perceived credit
require additional reserves and capital based on risk in the underlying assets. In addition, pub-
the guidance. Any determination made by an licly traded subprime-finance companies (that
examiner that an institution’s reserves or capital are not currently suffering from adverse ratings)
are deficient will be discussed with the institu- maintain equity-capital-to-managed-asset ratios
tion’s management and with each agency’s that are 1.5 to as much as 6 times (depending on
appropriate supervisory office before a final loan type and relative quality) those of finance
decision is made. companies that do not specialize in subprime
loans.
Question 5: Are the regulatory expectations for
higher capital levels consistent with capital
levels supporting subprime assets outside the
insured banking industry?

Page 13
Subprime Lending
1. To assess and evaluate the extent of subprime- ated with the subprime-lending program.
lending activities; whether management has 3. To conduct portfolio-level reviews and
adequately planned for this activity; and transaction-level testing of the subprime-
whether management has developed and lending activities, assessing the quality and
maintains board-approved policies and pro- performance of the subprime-loan portfolios
cedures, systems, and internal controls that and subprime-lending program, including its
identify, measure, monitor, and control the profitability, delinquency, and potential and
additional risks. actual loss experience.
2. To ascertain whether management has estab- 4. To assess the adequacy of the allowance for
lished adequate subprime-lending standards loan and lease losses (ALLL) for the
that are commensurate with the risks associ- subprime-loan portfolio.

Page 1
Subprime Lending
1. Determine whether the subprime-lending level and transaction-level testing reviews

activities are consistent with the bank’s into the conclusions about overall asset
overall business strategy and risk toler- quality, the adequacy of the ALLL and
ances, and that the critical business risks capital, and the adequacy of portfolio risk-
have been identified and considered. management practices.
2. Assess whether the bank has the financial 8. Review securitization transactions for com-
capacity, including capital adequacy, to con- pliance with Statement of Financial Account-
duct the high-risk activity of subprime lending Standards No. 140 (FAS 140) and this
ing safely, without any undue concentra- guidance, including whether the banking
tions of credit. organization has provided any support to
3. Ascertain if management has committed the maintain the credit quality of loan pools it
necessary resources, that is, technology and has securitized.
skilled personnel, to manage and control the 9. Evaluate the ALLL and regulatory capital
risks associated with the volume and com- allocated to support subprime-lending pro-
plexity of the subprime-lending program. grams, including whether the total protec-
4. Determine whether the banking institution’s tion for subprime-asset programs and the
contingency plans are adequate to address levels for each component are adequate.
the issues of (1) alternative funding sources, Ascertain that a sound risk-management
(2) back-up purchasers of the securities or program exists that includes the ability of
the attendant servicing functions, and management to determine and quantify
(3) methods of raising additional capital appropriate levels for each component.
during an economic downturn or when 10. Analyze the performance of the program,
financial markets become volatile. including its profitability, delinquency, and
5. Determine if management has established loss experience.
adequate lending standards that are appro- 11. Consider management’s response to adverse
priate for the size and complexity of the performance trends, such as higher-than-
banking organization’s operations, and if expected prepayments, delinquencies,
management is maintaining proper controls charge-offs, customer complaints, and
over the program. (See ‘‘Risk Manage- expenses.
ment’’ in section 2133.1 for the lending 12. Determine if the banking institution’s
standards that should be included in the subprime-lending program effectively man-
subprime-loan program.) ages the credit, market, liquidity, reputa-
6. Review and evaluate loan-administration tional, operational, and legal risks associ-
and loan-monitoring procedures for subprime ated with subprime-lending operations.
loans originated or purchased, including— 13. Evaluate the documented analysis of the
a. collection, repossession, and disclosure institution’s capital needed to support its
procedures; subprime-lending activities. Ascertain
b. the management of the number of staff whether the capital levels are risk sensitive,
members, the level and effective use of that is, does allocated capital reflect the
skilled staffing, and advanced technol- level and variability of loss estimates within
ogy; reasonably conservative parameters? Deter-
c. the adequacy of the allowance for loan mine if there is a direct link between the
and lease losses (ALLL); and expected loss rates used to determine the
d. the adequacy and accuracy of models required ALLL and the unexpected loss
used to estimate credit losses or set estimates used to determine capital. Docu-
pricing, making certain that the models ment and reference each institution’s
account for economic cycles and other subprime capital evaluation in the examina-
unexpected events. tion comments and conclusions regarding
7. Perform a portfolio-level review and con- capital adequacy.
duct some transaction testing. Incorporate 14. Classify loans according to the following
examination findings from the portfolio- criteria:

Page 1
2133.3 Subprime Lending: Examination Procedures
a. Classify as substandard loans to borrow- loan-to-value loans to borrowers who

ers that do not have the capacity to clearly exhibit inadequate capacity to
service their loans. repay the debt in a reasonable time
b. Classify as at least substandard subprime frame.
loans that are 90 days or more past due 15. Report as unsafe and unsound imprudent
based on a reasonable presumption that loans to borrowers who do not demonstrate
their past-due status indicates an inad- the capacity to repay the loan, as structured,
equate capacity or unwillingness to from sources other than the pledged collat-
repay. eral. Refer such loans to a consumer
c. Consider classifying or criticizing the compliance/fair lending specialist for review.
entire portfolio or segments of the port- 16. Carefully assess management’s ability to
folio when the portfolio review or loan administer the higher risk in subprime port-
sample indicates serious concerns with folios. If risk-management practices are
credit-risk selection practices, underwrit- deficient, criticize management and reach
ing standards, or loan quality. specific agreements with senior manage-
d. Classify as substandard high-risk unse- ment and the board of directors to initiate
cured loan portfolios or secured high corrective action.

Page 2
Subprime Mortgage Lending
An interagency Statement on Subprime Mort- subprime borrowers may not fully understand
gage Lending (the subprime statement) was the risks and consequences of obtaining these
issued on July 10, 2007 (72 Fed. Reg. 37569) by types of ARM products. Borrowers who obtain
the agencies1 (same effective date). The subprime these loans may face unaffordable monthly pay-
statement address issues and questions related to ments after the initial rate adjustment, difficulty
certain adjustable-rate mortgage (ARM) prod- in paying real estate taxes and insurance that
ucts marketed to subprime borrowers. The state- were not escrowed, or expensive refinancing
ment clarifies how institutions can offer certain fees, any of which could cause borrowers to
ARM products in a safe and sound manner, and default and potentially lose their homes.
in a way that clearly discloses the risks that a
borrower may assume from certain ARMs. The
statement applies to all banks and their subsid- SCOPE OF THE SUBPRIME
iaries and bank holding companies and their
nonbank subsidiaries. See SR-07-12/CA-07-3
STATEMENT
and its attachment (the full text of the inter- The subprime statement emphasizes the need for
agency statement). prudent underwriting standards and clear and
The guidance was developed to address balanced consumer information so that institu-
emerging risks associated with certain subprime tions and consumers can assess the risks arising
mortgage products and lending practices. The from certain ARM products with discounted or
agencies are particularly concerned about the low introductory rates. The statement is focused
growing use of ARM products2 that provide low on these types of ARMs and uses the inter-
initial payments based on a fixed introductory agency Expanded Guidance for Subprime Lend-
rate that expires after a short period, and then ing (the expanded guidance)3 issued in 2001 to
adjusts to a variable rate plus a margin for the determine subprime borrower characteristics.
remaining term of the loan. These products While the statement is focused on subprime
could result in payment shock to the borrower. borrowers, the principles in the statement are
Also, there is concern that these products, typi- also relevant to ARM products offered to non-
cally offered to subprime borrowers, present subprime borrowers.
heightened risks to lenders and borrowers. Often,
these products have additional characteristics
that increase risk. These include qualifying bor-
rowers based on limited or no documentation of RISK-MANAGEMENT PRACTICES
income or imposing substantial prepayment pen-
alties or prepayment penalty periods that extend The risk-management practices discussed in the
beyond the initial fixed-interest-rate period. subprime statement are generally consistent with
ARM products originally were extended to existing interagency guidance regarding real
customers primarily as a temporary credit accom- estate lending, subprime lending, and nontradi-
modation in anticipation of early sale of the tional mortgage products.4 Like the nontradi-
property or in expectation of future earnings
growth. However, these loans have been offered 3. As discussed in the 2001 interagency Expanded Guid-
to subprime borrowers as ‘‘credit repair’’ or ance for Subprime Lending Programs, the term ‘‘subprime’’
‘‘affordability’’ products. The agencies had con- refers to the characteristics of individual borrowers. Subprime
cerns that many of these subprime borrowers borrowers typically have weakened credit histories that include
payment delinquencies and possibly more severe problems,
may not have sufficient financial capacity to such as charge-offs, judgments, and bankruptcies. They may
service a higher debt load, especially if they also display reduced repayment capacity as measured by
were qualified based on a low introductory credit scores, debt-to-income ratios, or other criteria that may
payment. Also, there was concern that the encompass borrowers with incomplete credit histories.
4. The 1993 Interagency Guidelines for Real Estate Lend-
ing (see SR-93-1 and sections 2090.1–2090.4); the 1999
1. The Board of Governors of the Federal Reserve System Interagency Guidance on Subprime Lending (see SR-99-6 and
(the Board), the Office of the Comptroller of the Currency sections 2133.1–2133.3); the 2001 Expanded Guidance for
(OCC), the Federal Deposit Insurance Corporation (FDIC), Subprime Lending Programs (see SR-01-4 and sections
the Office of Thrift Supervision (OTS), and the National 2133.1–2133.3); and the 2006 Interagency Guidance on Non-
Credit Union Administration (NCUA). traditional Mortgage Product Risks (see SR-06-15/CA-06-12
2. See footnote 8. and sections 2043.1–2043.4).

Page 1
2135.1 Subprime Mortgage Lending
tional mortgage guidance issued in 2006, the STATEMENT ON SUBPRIME

subprime statement encourages institutions to MORTGAGE LENDING
evaluate the borrower’s repayment capacity and
ability to repay the loan by final maturity at the The Statement on Subprime Mortgage Lending
fully indexed rate, assuming a fully amortizing (the subprime statement) was developed by the
repayment schedule.5 Further, the subprime state- agencies to address emerging issues and ques-
ment emphasizes that an institution’s assess- tions relating to certain subprime6 mortgage
ment of a borrower’s repayment capacity should lending practices. The agencies stated their con-
include an evaluation of the borrower’s debt-to- cern that borrowers may not fully understand the
income ratio and states that this assessment risks and consequences of obtaining products
should include total monthly housing-related that can cause payment shock.7 In particular,
payments (i.e., principal, interest, taxes, and they have concerns with certain adjustable-rate
insurance). mortgage (ARM) products typically offered to
subprime borrowers that have one or more of the
following characteristics:
WORKOUT ARRANGEMENTS
• low initial payments based on a fixed intro-
The subprime statement reiterates the principles ductory rate that expires after a short period
in the interagency Statement on Working with and then adjusts to a variable index rate plus a
Borrowers (April 2007) in which the agencies margin for the remaining term of the loan;8
encouraged institutions to work constructively • very high or no limits on how much the
with residential borrowers who are in default or payment amount or the interest rate may
whose default is reasonably foreseeable. Both increase (‘‘payment or rate caps’’) on reset
documents indicate that prudent workout arrange- dates;
ments that are consistent with safe and sound • limited or no documentation of borrowers’
lending practices are generally in the long-term income;
best interest of both the financial institution and • product features likely to result in frequent
the borrower. The Federal Reserve will not refinancing to maintain an affordable monthly
criticize institutions that pursue reasonable work- payment; and/or
out arrangements with borrowers. • substantial prepayment penalties and/or pre-
payment penalties that extend beyond the
initial fixed-interest-rate period.
SUPERVISORY REVIEW Products with one or more of these features
Federal Reserve examiners are expected to care- present substantial risks to both consumers and
fully review an institution’s risk management, lenders. These risks are increased if borrowers
consumer-disclosure practices, and consumer are not adequately informed of the product
compliance, concerns which are contained in the features and risks, including their responsibility
subprime statement as a part of ongoing exami- for paying real estate taxes and insurance, which
nation activities. Examiners will take action may be separate from their monthly mortgage
against institutions that exhibit predatory lend- payments. The consequences to borrowers could
ing practices, violate consumer protection or fair
lending laws, engage in unfair or deceptive acts 6. The term ‘‘subprime’’ is described in the 2001 Expanded
or practices, or otherwise engage in unsafe or Guidance for Subprime Lending Programs. (See SR-01-4 and
unsound lending practices. sections 2133.1–2133.3)
7. Payment shock refers to a significant increase in the
amount of the monthly payment that generally occurs as the
interest rate adjusts to a fully indexed basis. Products with a
5. The nontraditional mortgage (NTM) guidance covers wide spread between the initial interest rate and the fully
mortgage products that allow borrowers to defer payment of indexed rate that do not have payment caps or periodic interest
principal and sometimes interest, including interest-only mort- rate caps, or that contain very high caps, can produce
gages when a borrower pays no loan principal for the first few significant payment shock.
years of the loan and payment-option ARMs when a borrower 8. For example, ARMs known as ‘‘2/28’’ loans feature a
has flexible payment options with the potential for negative fixed rate for two years and then adjust to a variable rate for
amortization. Because certain ARM products offered to the remaining 28 years. The spread between the initial fixed
subprime borrowers are fully amortizing, the NTM guidance interest rate and the fully indexed interest rate in effect at loan
does not cover such products. origination typically ranges from 300 to 600 basis points.

Page 2
Subprime Mortgage Lending 2135.1
include being unable to afford the monthly • making loans based predominantly on the
payments after the initial rate adjustment because foreclosure or liquidation value of a borrow-
of payment shock; experiencing difficulty in er’s collateral rather than on the borrower’s
paying real estate taxes and insurance that were ability to repay the mortgage according to its
not escrowed; incurring expensive refinancing terms;
fees, frequently due to closing costs and prepay- • inducing a borrower to repeatedly refinance a
ment penalties, especially if the prepayment loan in order to charge high points and fees
penalty period extends beyond the rate adjust- each time the loan is refinanced (‘‘loan flip-
ment date; and losing their homes. Conse- ping’’); or
quences to lenders may include unwarranted • engaging in fraud or deception to conceal the
levels of credit, legal, compliance, reputation, true nature of the mortgage loan obligation, or
and liquidity risks due to the elevated risks ancillary products, from an unsuspecting or
inherent in these products. unsophisticated borrower.
Many of these concerns are addressed in
existing interagency guidance. The most promi- Institutions offering mortgage loans such as
nent are the 1993 Interagency Guidelines for these face an elevated risk that their conduct will
Real Estate Lending (real estate guidelines) (see violate section 5 of the Federal Trade Commis-
SR-93-1 and sections 2090.1–2090.4), the 1999 sion Act (FTC Act), which prohibits unfair or
Interagency Guidance on Subprime Lending deceptive acts or practices.11
(see SR-99-6 and sections 2133.1–2133.3)) and
the 2001 Expanded Guidance for Subprime
Lending Programs (expanded subprime guid- Underwriting Standards
ance) (see SR-01-4 and sections 2133.1–2133.3).
While the 2006 Interagency Guidance on Institutions should refer to the real estate guide-
Nontraditional Mortgage Product Risks (NTM lines, which provide underwriting standards for
guidance)9 may not explicitly pertain to prod- all real estate loans.12 The real estate guidelines
ucts with the characteristics addressed in this state that prudently underwritten real estate
statement, it outlines prudent underwriting and loans should reflect all relevant credit factors,
consumer protection principles that institutions including the capacity of the borrower to
also should consider with regard to subprime adequately service the debt. The 2006 NTM
mortgage lending. This statement reiterates many guidance details similar criteria for qualifying
of the principles addressed in existing guidance borrowers for products that may result in pay-
relating to prudent risk-management practices ment shock.
and consumer protection laws.10 Prudent qualifying standards recognize the
potential effect of payment shock in evaluating a
borrower’s ability to service debt. An institu-
tion’s analysis of a borrower’s repayment capac-
Risk-Management Practices ity should include an evaluation of the borrow-
er’s ability to repay the debt by its final maturity
Predatory Lending Considerations at the fully indexed rate,13 assuming a fully
Subprime lending is not synonymous with preda- 11. The Board, the OCC, the OTS, and the FDIC enforce
tory lending, and loans with the features this provision under section 8 of the Federal Deposit Insur-
described above are not necessarily predatory in ance Act. The Board, the OCC, and the FDIC also have issued
nature. However, institutions should ensure that supervisory guidance to the institutions under their respective
jurisdictions concerning unfair or deceptive acts or practices.
they do not engage in the types of predatory See OCC Advisory Letter 2002-3, Guidance on Unfair or
lending practices discussed in the expanded Deceptive Acts or Practices, March 22, 2002, and 12 CFR 30,
subprime guidance. Typically, predatory lending appendix C; Joint Board and FDIC Guidance on Unfair or
involves at least one of the following elements: Deceptive Acts or Practices by State-Chartered Banks, March
11, 2004.
12. Refer to 12 CFR 208, subpart C.
13. The fully indexed rate equals the index rate prevailing
9. See SR-06-1, sections 2043.1–2043.4, and 71 Fed. Reg. at origination plus the margin to be added to it after the
58609 (October 4, 2006). expiration of an introductory interest rate. For example,
10. As with the NTM guidance, this statement applies to all assume that a loan with an initial fixed rate of 7 percent will
banks and their subsidiaries as well as to bank holding reset to the six-month London Interbank Offered Rate (LIBOR)
companies and their nonbank subsidiaries. plus a margin of 6 percent. If the six-month LIBOR rate

Page 3
amortizing repayment schedule.14 Workout Arrangements

One widely accepted approach in the mort-
gage industry is to quantify a borrower’s repay- As discussed in the April 2007 Interagency
ment capacity by a debt-to-income (DTI) ratio. Statement on Working with Borrowers (see
An institution’s DTI analysis should include, SR-07-6/CA-07-1), financial institutions are
among other things, an assessment of a borrow- encouraged to work constructively with residen-
er’s total monthly housing-related payments tial borrowers who are in default or whose
(e.g., principal, interest, taxes, and insurance, or default is reasonably foreseeable. Prudent work-
what is commonly known as PITI) as a percent- out arrangements that are consistent with safe
age of gross monthly income. and sound lending practices are generally in the
This assessment is particularly important if long-term best interest of both the financial
the institution relies upon reduced documenta- institution and the borrower.
tion or allows other forms of risk layering. Financial institutions should follow prudent
Risk-layering features in a subprime mortgage underwriting practices in determining whether
loan may significantly increase the risks to both to consider a loan modification or a workout
the institution and the borrower. Therefore, an arrangement.15 Such arrangements can vary
institution should have clear policies governing widely based on the borrower’s financial capac-
the use of risk-layering features, such as reduced- ity. For example, an institution might consider
documentation loans or simultaneous second- modifying loan terms, including converting loans
lien mortgages. When risk-layering features are with variable rates into fixed-rate products to
combined with a mortgage loan, an institution provide financially stressed borrowers with pre-
should demonstrate the existence of effective dictable payment requirements.
mitigating factors that support the underwriting The agencies will not criticize financial insti-
decision and the borrower’s repayment capacity. tutions that pursue reasonable workout arrange-
Recognizing that loans to subprime borrowers ments with borrowers. Further, existing super-
present elevated credit risk, institutions should visory guidance and applicable accounting
verify and document the borrower’s income standards do not require institutions to immedi-
(both source and amount), assets, and liabilities. ately foreclose on the collateral underlying a
Stated-income and reduced-documentation loans loan when the borrower exhibits repayment
to subprime borrowers should be accepted only difficulties. Institutions should identify and report
if there are mitigating factors that clearly mini- credit risk, maintain an adequate allowance for
mize the need for direct verification of repay- loan losses, and recognize credit losses in a
ment capacity. Reliance on such factors also timely manner.
should be documented. Typically, mitigating
factors arise when a borrower with favorable
payment performance seeks to refinance an
existing mortgage with a new loan of a similar
Consumer Protection Principles
size and with similar terms, and the borrower’s Fundamental consumer protection principles rel-
financial condition has not deteriorated. Other evant to the underwriting and marketing of
mitigating factors might include situations where mortgage loans include—
a borrower has substantial liquid reserves or
assets that demonstrate repayment capacity and • approving loans based on the borrower’s abil-
can be verified and documented by the lender. ity to repay the loan according to its terms;
However, a higher interest rate is not considered and
an acceptable mitigating factor. • providing information that enables consumers
to understand material terms, costs, and risks
equals 5.5 percent, lenders should qualify the borrower at
11.5 percent (5.5 percent + 6 percent), regardless of any
of loan products at a time that will help the
interest rate caps that limit how quickly the fully indexed rate consumer select a product.
may be reached.
14. The fully amortizing payment schedule should be Communications with consumers, including
based on the term of the loan. For example, the amortizing
payment for a ‘‘2/28’’ loan would be calculated based on a
30-year amortization schedule. For balloon mortgages that 15. Institutions may need to account for workout arrange-
contain a borrower option for an extended amortization ments as troubled-debt restructurings and should follow gen-
period, the fully amortizing payment schedule can be based on erally accepted accounting principles in accounting for these
the full term the borrower may choose. transactions.

Page 4
Subprime Mortgage Lending 2135.1
advertisements, oral statements, and promo- • balloon payments: the existence of any bal-
tional materials, should provide clear and balloon payment;
anced information about the relative benefits • cost of reduced-documentation loans: whether
and risks of the products. This information there is a pricing premium attached to a
should be provided in a timely manner to assist reduced-documentation or stated-income loan
consumers in the product-selection process, not program; and
just upon submission of an application or at • responsibility for taxes and insurance: the
consummation of the loan. Institutions should requirement to make payments for real estate
not use such communications to steer consumers taxes and insurance in addition to their loan
to these products to the exclusion of other payments, if not escrowed, and the fact that
products offered by the institution for which the taxes and insurance costs can be substantial.
consumer may qualify.
Information provided to consumers should
clearly explain the risk of payment shock and
the ramifications of prepayment penalties, bal-
Control Systems
loon payments, and the lack of escrow for taxes
Institutions should develop strong control sys-
and insurance, as necessary. The applicability of
tems to monitor whether actual practices are
prepayment penalties should not exceed the
consistent with their policies and procedures.
initial reset period. In general, borrowers should
Systems should address compliance and con-
be provided a reasonable period of time (typi-
sumer information concerns, as well as safety
cally at least 60 days prior to the reset date) to
and soundness, and encompass both institution
refinance without penalty.
personnel and applicable third parties, such as
Similarly, if borrowers do not understand that
mortgage brokers or correspondents.
their monthly mortgage payments do not include
Important controls include establishing appro-
taxes and insurance, and they have not budgeted
priate criteria for hiring and training loan per-
for these essential homeownership expenses,
sonnel, entering into and maintaining relation-
they may be faced with the need for significant
ships with third parties, and conducting initial
additional funds on short notice.16 Therefore,
and ongoing due diligence on third parties.
mortgage-product descriptions and advertise-
Institutions also should design compensation
ments should provide clear, detailed information
programs that avoid providing incentives for
about the costs, terms, features, and risks of the
originations inconsistent with sound underwrit-
loan to the borrower. Consumers should be
ing and consumer protection principles, and that
informed of—
do not result in the steering of consumers to
these products to the exclusion of other products
• payment shock: potential payment increases,
for which the consumer may qualify.
including how the new payment will be cal-
Institutions should have procedures and
culated when the introductory fixed rate
systems in place to monitor compliance with
expires;17
applicable laws and regulations, third-party
• prepayment penalties: the existence of any
agreements, and internal policies. An
prepayment penalty, how it will be calculated,
institution’s controls also should include
and when it may be imposed;
appropriate corrective actions in the event of
failure to comply with applicable laws, regula-
16. Institutions generally can address these concerns most
directly by requiring borrowers to escrow funds for real estate tions, third-party agreements, or internal poli-
taxes and insurance. cies. In addition, institutions should initiate
17. To illustrate: a borrower earning $42,000 per year procedures to review consumer complaints to
obtains a $200,000 ‘‘2/28’’ mortgage loan. The loan’s two- identify potential compliance problems or other
year introductory fixed interest rate of 7 percent requires a
principal and interest payment of $1,331. Escrowing $200 per negative trends.
month for taxes and insurance results in a total monthly
payment of $1,531 ($1,331 + $200), representing a 44 percent
DTI ratio. A fully indexed interest rate of 11.5 percent (based
on a six-month LIBOR index rate of 5.5 percent plus a Supervisory Review
6 percent margin) would cause the borrower’s principal and
interest payment to increase to $1,956. The adjusted total
monthly payment of $2,156 ($1,956 + $200 for taxes and
The agencies will continue to carefully review
insurance) represents a 41 percent increase in the payment risk-management and consumer compliance
amount and results in a 62 percent DTI ratio. processes, policies, and procedures. The agen-

Page 5
cies will take action against institutions that engage in unfair or deceptive acts or practices,
exhibit predatory lending practices, violate or otherwise engage in unsafe or unsound lend-
consumer protection laws or fair lending laws, ing practices.

Page 6
Agricultural Loans
INTRODUCTION AGRICULTURAL REAL ESTATE

LOANS
Agricultural loans can be broadly defined as
loans made to agricultural producers to finance Real estate loans are not intended as a primary
the production of crops or livestock. The term focus of this manual section. However, real
‘‘crops’’ is meant to include any of the many estate loans are a significant portion of total debt
types of plants that produce grains, fruits, veg- for many agricultural producers, and the exam-
etables, or fibers that can be harvested. Simi- iner should consider them when evaluating other
larly, a variety of animals is produced for profit, types of loans to agricultural producers. For a
although cattle, swine, sheep, and poultry are by more thorough discussion of real estate loans,
far the most common. Production cycles vary refer to section 2090.1, ‘‘Real Estate Loans.’’
with the type of crop or livestock, from a few Loans to finance agricultural land, together with
weeks or months to several years; in the case of related improvements (frequently including the
an orchard crop or timber, the time from plant- producer’s residence) comprise the most com-
ing to harvest (from cash outlay to the genera- mon type of real estate loan made by agricul-
tion of income) is quite lengthy. The type of tural banks. These loans are subject to the same
crop or livestock to be produced will determine general lending principles and legal and regula-
the nature of the financing needed, including its tory requirements1 as loans on other types of
timing, collateral considerations, and repayment real estate. Even if a bank has not made a real
terms. estate loan to the agricultural borrower, any real
Repayment terms for farm loans normally estate debt owed elsewhere must be considered
correspond to anticipated cash flows. Since in analyzing the borrower’s creditworthiness,
repayment of agricultural-related loans usually along with amounts due to the bank and any
comes from the sale of crops or livestock, other creditors. Additionally, any state laws on
annual repayment terms are not uncommon. homestead exemptions should be noted.
Depending on the type of operation and timing Agricultural real estate loans tend to have
of cash income, payments may be set to come special characteristics, particularly with regard
due semiannually, quarterly, or on an irregular to valuation and repayment considerations. For
schedule. However, many smaller farm opera- instance, farmland appraisers need special knowl-
tors also receive income from nonfarm employ- edge of soil types, topography, data on rain-
ment, which allows them to make monthly fall or water tables, and crop production data,
payments on some loans. as well as a knowledge of area market condi-
Agricultural producers need access to land tions and other extenuating information. Prevail-
(often with buildings and other improvements) ing market values for farmland tend not to
and equipment, in addition to the shorter-term permit as high a level of cash return as those
operating inputs directly involved in crop or for other types of income-producing property.
livestock production. Not all producers own Values always reflect supply and demand, and,
land; some are tenants who pay the landowners probably due to a number of factors, the demand
cash rent or a portion of the crop yield. Many for farmland has traditionally been relatively
producers both own and rent or lease land in an strong from neighboring landowners, other area
effort to maximize efficiency and income. farmers, nonfarmers, and absentee owners who
Accordingly, individual producers may need a have a strong desire to own land. A lower level
variety of types of loans, including— of return generally dictates a lower loan-to-
value ratio, although a borrower may be able to
• real estate loans,
• equipment loans,
• livestock loans, and 1. In connection with the supervisory loan-to-value limits
• operating (or production) loans. set forth in the ‘‘Interagency Guidelines for Real Estate
Lending Policies,’’ farmland, ranchland, or timberland com-
Information on each of these types of agricul- mitted to ongoing management and agricultural production is
considered ‘‘improved property,’’ subject to a loan-to-value
tural loans follows, as well as general comments limit of 85 percent. However, a bank may set a lower limit for
on agricultural lending and the examiner’s review itself and, as a matter of policy, probably will loan less than
of agricultural loans. 85 percent of appraised value on farmland in most cases.

Page 1
2140.1 Agricultural Loans
service debt at a higher level from other income Loans to farmers and ranchers may include
sources such as less-heavily encumbered land, individual notes to finance the purchase of
rented land, or nonfarm income. For example, it specific pieces of equipment or vehicles.
would not be unusual for a bank to advance However, many agricultural borrowers provide
100 percent of the purchase price of land if a the bank with a blanket lien on all equipment
lien on additional land is taken to lower the and vehicles to secure any and all debts owed
overall loan-to-value ratio. the bank. Frequently, borrowers have both
There is generally a well-established market purchase money loans on specific equipment
for agricultural land. Although values fluctuate and other loans secured by a blanket equipment
based on a variety of factors (just as they do lien.
with other types of real estate), there is normally Under the Uniform Commercial Code, a
a recognized range of values at any given time security interest in equipment is created with
for particular land types within a general area. a security agreement signed by the borrower and
The examiner should gain some knowledge of a bank officer, and the lien is perfected by a
current area land prices and trends through centrally filed financing statement. Many banks
published data from local universities or private file the financing statement in both the county
organizations, interviews with bank manage- and state in which the borrower resides and in
ment, and the review of appraisal reports. This the county and state in which the equipment is
knowledge will be vital in assessing collateral located. The filing is a public record that notifies
values and the borrower’s overall financial con- lenders or other interested parties that the assets
dition and future prospects. identified have been pledged, as well as to
An amortization period of up to 20 years is whom and when they were pledged.
not uncommon for agricultural real estate loans Since the filing record provides vital informa-
by banks. Longer-term loans (up to 30 years) on tion for potential lenders, bank management
farm real estate are sometimes made by com- must check it before extending credit to deter-
mercial banks, but are more common with other mine whether the collateral is already pledged
lenders such as Federal Land Banks. Many to another lender. In many cases, a bank might
banks structure real estate loans so that required approve a loan request only if it were to be in
payments are based on a 20- to 30-year amorti- a first lien position, but there can be excep-
zation, but they write the notes with a 5- to tions. For example, a bank may agree to advance
10-year maturity, at which time a balloon on a second lien position in a large piece of
payment is due. Major improvements, such equipment in which the borrower has substan-
as livestock-confinement buildings or grain- tial equity or take a blanket lien on all equip-
handling facilities, commonly have a shorter ment, including one or a few items of equipment
amortization period of 10 years or less. pledged elsewhere (such as a purchase money
lien held by an equipment dealer). As a matter
of prudent lending and sound loan administra-
tion, lien searches should be performed peri-
AGRICULTURAL MACHINERY odically on at least larger borrowers or on
AND EQUIPMENT LOANS those borrowers known to be or suspected of
having problems or of being involved with other
Agricultural producers often need to finance the lenders.
purchase of machinery, equipment, vehicles, Sound bank lending policies should prescribe
and implements. Typically, these loans are a maximum loan-to-value ratio for equipment,
secured by the durable goods being financed and as well as maximum repayment terms. The same
are amortized over an intermediate term of up to is true for vehicles, although the loan-to-value
seven years. As with any equipment loan, some limits on vehicles for highway use (automobiles
borrower equity should be required, the amorti- and trucks) tend to be higher because they have
zation period should be no longer than the a less-specialized use and are more liquid.
expected useful life of the equipment, and sched- Maximum loan-to-value limits, particularly for
uled payments should correlate reasonably with loans to purchase specific pieces of farm equip-
the timing and amount of anticipated income. In ment, may range to more than 80 percent or
some cases, equipment loan payments may be even to 100 percent for strong borrowers. How-
advanced under the borrower s operating line of ever, many farm lines of credit are supported in
credit. part by blanket liens on all the borrower’s

Page 2
Agricultural Loans 2140.1
equipment. Typically, overall loan-to-value ratios TYPES OF LIVESTOCK

on a line of equipment do not exceed 60 percent. OPERATIONS AND LOAN
CONSIDERATIONS
Livestock producers usually specialize in par-
LIVESTOCK LOANS ticular kinds or breeds of animals or in certain
phases of an animal’s life cycle. This special-
Livestock loans vary with the animal species
ization may vary depending on geographic
and the nature of the individual producer’s
area, climate, topography, soil type, or the
operation, but the same general lending prin-
availability of water and feed, or on the pro-
ciples apply to virtually all types of livestock
ducer’s preferences, experience, or physical
loans. The borrower should have an equity
facilities. A producer may change his special-
position in the livestock financed, ample feed on
ization from time to time based on recurring
hand, or another underlying financial strength
market cycles or more fundamental shifts in
that will protect the lender from risks such as
economic factors, such as consumer demand.
losses from animal diseases and deaths, rising
Some producers are involved in more than
feed costs, or market fluctuations. The size of
one type of livestock operation at any given
the livestock operation should be commensurate
time.
with the borrower’s physical facilities and man-
The following is a brief discussion of the
agement capability. Total debt should not over-
most common types of livestock operations, as
burden the borrower, and the timing and source
well as the lending and loan analysis consider-
of repayment for loans should be understood
ations for each.
when they are originated. The term of a live-
stock loan normally bears a close relationship to
the length of time the animals are to be held.
Feed is a necessity for livestock producers
and a major expense for those involved in Cattle
finishing animals for slaughter, dairy herds, or Beef Breeds
egg-laying operations. On the other hand, stocker
cattle feed mainly on pasture or silage, which • Cow-calf operation. A producer has breeding
reduces feed costs. Some livestock producers stock that produces calves, which are then
also raise feed crops, which may improve their sold as either feeder calves or future breeding
overall efficiency. Many producers, however, stock or are kept until the animal reaches full
need to buy feed. In any event, the loan officer maturity.
should have a firm understanding of how much The typical cow-calf loan is for financing
feed the borrower has on hand (or will be the breeding stock (cows and bulls) of a herd.
harvesting) and how much will have to be The loan term is usually three to five years,
purchased. Still, even though both borrower and with annual payments of principal and interest
banker may be experienced and capable at to fully amortize the loan within that term.
projecting feed costs, variables beyond their Often, loans for this type of operation are
control impose some risk of increased costs. written with one-year maturities and no pre-
These variables might include perils such as determined amount of principal reduction at
unfavorable weather or disease affecting feed maturity. However, this kind of loan structure
crop yields or rising feed prices or shortages is more suitable for borrowers who are not
brought on by other unanticipated forces. highly leveraged.
Many banks will advance up to 100 percent of Repayment is from the annual sale of calves
the cost of livestock if the borrower has suffi- and cull cows (older cows or those that fail to
cient feed on hand and a sound overall financial produce offspring). Approximately 10 to
position. Since the animals gain weight and 15 percent of a cow herd is culled each year;
value as feedstocks are consumed, the bank’s most cows are retained for seven to as many
collateral position normally strengthens as the as twelve years. Bulls are typically stocked at
livestock matures toward market weight. For one for each 20 to 25 cows; pregnancy rates
borrowers without adequate feedstocks on hand, are generally 80 to 100 percent, depending on
advance rates may be limited to 70 to 80 percent the age and health of the cows and on feed
of the purchase price. availability.

Page 3
Most calves are born in late winter and • Finishing operation. A finishing operation
early spring, weighing around 100 pounds. acquires cattle weighing approximately 700 to
Cows may be winter-fed on hay, but cows and 750 pounds and feeds them a high-protein
calves graze on pastureland from spring to grain ration until they are ready for slaughter
around October when the calves weigh 500 to at around 1,100 to 1,200 pounds.
550 pounds. At this time, the calves may be Finishing usually takes around 130 to
sold to another producer who specializes in 145 days. Most finishing cattle are now
raising stockers. (However, in some areas, custom-fed in commercial feedlots, but the
herds are managed to produce fall calves. producer (not the feedlot owner) usually retains
Also, depending on feed sources and market ownership of the cattle. Feeder steers usually
conditions, calves may be sold at lighter gain approximately 3.2 pounds per day, and
weights, around 300 to 400 pounds.) heifers around 2.8 pounds per day. However,
• Stocker or backgrounding operation. A pro- average daily gains vary depending on the
ducer in a stocker operation acquires calves breed, type of ration, time of year, or weather
weighing from 300 to 550 pounds and feeds conditions.
them, primarily on pasture, until they weigh Finishing cattle can be risky because of
around 700 to 750 pounds, when they are sold fluctuations in cattle prices between purchase
to a finisher. Since the growth gains of young and sale dates. Some producers use futures
cattle are generally the most efficient phase of contracts to lock in prices and reduce the risk,
beef production, some stock operators prefer or they enter into forward contracts with a
to buy lighter weight calves, although the packer. Larger producers may use a ‘‘moving
lighter weights require more care and super- hedge’’ to offset the risk imposed by market
vision to minimize death losses. Stocker cycles.2
operations are relatively high-risk programs Banks normally require 20 to 30 percent
that require specialized knowledge, but they initial margin in financing the purchase of
can also be quite profitable. feeder cattle, but may advance up to 100 per-
Backgrounding requires approximately cent of the feed costs. As the cattle gain
100 days, during which time the cattle may be weight, the bank’s collateral position tends to
fed a daily ration of silage (the entire corn or improve. Repayment comes from sale of the
grain sorghum plant chopped into feed and cattle, with loan maturity set near the antici-
stored in a silo) and grain and feed supple- pated sale date.
ments, including soybean meal, minerals, salt,
and vitamins. The supplements usually need
to be purchased. Steers gain approximately Dairy Operations
two pounds per day, and heifers slightly less.
Sometimes stocker cattle are placed on pas- Cows are milked for ten months each year, then
ture, which can include dormant wheat in the rested for two months and allowed to ‘‘dry up’’
winter or grass during the summer. (quit producing milk by not being milked).
Stocker cattle are typically financed with a Three months after a female dairy cow gives
90- to 120-day single-advance, single-maturity birth, she is rebred and calves nine months later.
note. Funds for feed purchases may be pro- Cows are commonly bred through artificial
vided as part of the note proceeds, but, more insemination, which allows the producer to
commonly, the feed is raised by the producer. improve the genetics of the herd. Each year
Loan repayment comes from the sale of approximately one-third of the cows are culled,
the cattle when they weigh around 700 to
750 pounds. Collateral for stocker loans is
typically the cattle financed and the feed. 2. In this strategy, the producer periodically buys a given
Banks usually require around a 30 percent number of lightweight feeders and at the same time sells a
similar number of fat cattle. When prices are down, lower
margin in the cattle, but may require as little revenues from sales of cattle are offset by the benefit of lower
as 20 percent or less for financially strong costs to purchase replacement lightweight feeders. By the
borrowers. same token, when prices are up, higher purchase costs are
The profitability of a backgrounding opera- offset by higher revenues on the slaughter cattle sold. This
strategy allows the producer to prevent or substantially
tion is sensitive to the average daily weight minimize losses due to fluctuating market prices. Otherwise,
gain, feed costs, weather, and purchase and the producer might too often be in the position of only buying
sale prices of the cattle. at high prices and only selling at low prices.

Page 4
with replacement heifers usually raised on the crops. Established operations may not require
farm. An 80 percent calf crop is common, with herd financing unless the herd is being expanded.
the males either sold soon after birth or fed for Financing replacement cows to maintain a herd,
slaughter. if necessary, should be included in a shorter-
Milk production is measured by pounds of term operating loan. Generally, operating loans
milk produced per cow per year. Production in are not a major financing activity as the dairy
the range of 13,500 to 20,500 pounds is com- farmer’s regular income from the sale of milk
mon. Milk production variables include the can often accommodate operating needs.
quality of the cows, number of days milked each Collateral for dairy loans, in addition to real
year, and amount and quality of feed. Feeding estate, typically includes the livestock, crops
cows a higher ratio of grain to dry hay will result and feed on hand, and equipment. The collateral
in higher milk production, but the higher feed is usually covered with a blanket security agree-
costs must be weighed against the returns of ment. Often, milk sale proceeds are assigned to
higher production. the bank, and the milk buyer sends a monthly
Feed is a major expense for a dairy operation. check directly to the bank to meet scheduled
Dairy cows consume a ration of corn or grain loan repayments.
sorghum, soybean meal, high-quality hay, silage, Clearly, the primary source of income for the
vitamins, and minerals. Family-oriented dairy dairy farmer is the sale of milk, which is
operations usually grow most of their own feed produced daily. Additional income is produced
on the farm, while larger operations purchase from the annual sale of calves and culled cows.
most of their feed and confine the cows to a
dry-lot facility.
A dairy operation is heavily capital intensive
because of the investment in cows, buildings, Hogs
and equipment. Dairying is also labor intensive,
which further adds to the cost of production. Hog production consists of a two-stage opera-
The efficiency of a dairy operation is mea- tion: (1) ‘‘farrowing’’ (breeding sows to produce
sured on a ‘‘per-cow’’ basis. Gross income, feeder pigs) and (2) ‘‘finishing’’ (fattening feeder
expenses, and net income can be divided by the pigs to slaughter weight). Many producers com-
number of cows to analyze trends and compare bine both enterprises and are called farrow-to-
them with other dairy operations. Several other finish operations.
key indicators of a dairy operation’s productiv- Hog producers range from small operators to
ity include the following: large corporate interests. The small producers
can be considered those who market less than
• Pounds of milk per cow per year. Herds 2,500 head per year; they can be involved either
averaging less than 14,000 pounds may be in finishing hogs or in farrow-to-finish opera-
struggling. tions. Small producers also tend to be involved
• Calving interval. Twelve to thirteen months is in grain farming (raising their own feed) and
favorable; if the interval lengthens, milk pro- other kinds of livestock production. The profit-
duction and the overall efficiency of the ability and financial strength of a small producer
operation will decline. is generally tied to the ability to market hogs
• Calf losses. A 10 percent or less loss on live frequently throughout the year, which lessens
calves born is favorable and considered an the impact of adverse market fluctuations. If the
indication of good management. producer cannot market frequently, he or she
• Culling rate. Cows should start milking when probably needs to be involved in hedging prac-
they are about two years old and should tices. A corporate hog farm is usually a farrow-
average four to five lactation periods before to-finish operation, with the number of sows
they are culled; if cows have to be culled ranging from 500 to as many as 100,000 for the
prematurely, efficiency declines. largest producers.
Loans to dairy operators may include longer-

term financing for land and improvements; Farrowing Operations
intermediate financing for the cow herd, special-
ized equipment, and vehicles; and operating Hog breeding normally requires one boar for
loans to help finance the production of feed approximately 20 sows. Sows typically have

Page 5
two litters per year, and litter size is one of the depending largely on the producer’s breeding
most crucial factors in determining the success schedule and the anticipated sale dates for feeder
of a farrowing operation. Eight hogs per litter is pigs. Usually, sows are bred at different times so
a goal for most producers. Up to 25 percent of they are not all having pigs at the same time. In
the sows will be culled each year. Some produc- the case of a farrow-to-finish operation, the
ers raise their own replacement sows, while cycle will be longer, and repayments will be
others purchase quality breeding stock in an scheduled according to anticipated sale dates of
attempt to improve herd quality. the fat hogs and culled breeding stock.
Pigs are farrowed (born) in confinement build-
ings, and after three weeks, they are moved to a
nursery facility where the pigs are weaned from Finishing Operations
the sow. The capital invested in farrowing
facilities varies greatly, but the trend has been Hog finishing is the process of acquiring young
toward higher investments in facilities that pigs that weigh 40 to 60 pounds, and feeding
require less labor. However, a large investment them until they reach a slaughter market weight
in a single-use, costly hog facility can pose a of 220 to 240 pounds. The process takes
significant risk if the farrowing operation is not approximately four months. The average death
profitable. loss for a finishing operation is generally 4 to
Feed costs are the largest operating expense 5 percent of the total number of hogs started on
of a farrowing operation. The feed required feed.
consists of a feed grain (corn or milo), a protein Loans for hog finishing are usually in the
supplement, vitamins and minerals, and a pig form of single-payment notes that mature in
starter (a commercial feed used in the transition approximately four months. Loan proceeds are
from nursing to eating solid food). In a feeder used to purchase young pigs and may also be
pig production operation, the young pigs are used to purchase feed. A bank commonly
typically kept until they weigh 40 to 60 pounds, advances up to 100 percent of the purchase price
which takes around two months. Feed costs are of the pigs. Usually, there is a blanket security
continually changing because of fluctuating grain agreement in place that gives the bank a security
prices, so it may be difficult to project cash flow interest in all hogs, as well as in feed and other
accurately. Historical cash flow may be more chattels to provide additional overall support for
useful in demonstrating the borrower’s overall the credit. Margin in the collateral increases as
management capabilities. the animals gain weight. Repayment comes
Loans to farrowing operations may include an from the sale of fat hogs to a packing plant.
intermediate- to mid-term loan on the facilities The main factors in determining a finisher’s
(usually not for more than ten years), breeding profitability are (1) the cost of the feeder pigs,
stock loans that should be amortized over no (2) the cost of feeding the pigs, and (3) revenues
more than four years, and operating loans. from the sale of hogs. Costs and revenues
Operating loans are often in the form of revolv- continually change because of fluctuations in
ing lines of credit to purchase feed, with repay- market prices for young pigs, slaughter hogs,
ment normally coming from the sale of hogs. grain, and feed. Because of the relatively short
The operating line should be cleaned up peri- cycle of hog finishing, a number of loans may be
odically, or the bank should establish systems to made during one year. In analyzing hog loans,
monitor advances and repayments to ensure that reviewing the overall profitability of the opera-
stale debt is not accumulating. tion (taking into account depreciation on facili-
Collateral for a farrowing operation could ties and equipment, interest, and insurance) is
include the facilities and the hogs and feed on more meaningful than reviewing the results
hand. For collateral purposes, the hogs should from each individual loan advance.
be valued at local market prices even though the
producer might have paid a premium for breed-
ing stock. Feed should be heavily margined, as
the proceeds from feed sale during a foreclosure Sheep
are likely to be limited.
Loan repayment comes primarily from the Sheep are raised for the production of meat and
sale of young feeder pigs and culled sows. The wool. The most common sheep enterprise is the
timing of scheduled repayments will vary, raising of ewe (female) flocks, which produces

Page 6
income from the sale of both wool and lambs. within fairly large corporate producers. Most
Larger flocks tend to be more efficient as they banks will not extend loans on these types of
can take better advantage of investments in operations, and any that do should have substan-
labor-saving equipment. tial background information on the industry in
Ewes give birth once a year, usually during their files. The examiner should review that
late fall or winter. They frequently have twins, information and discuss the industry and the
resulting in an overall lamb production per ewe borrower’s operation with the officer originating
of approximately 140 percent. About 20 percent or servicing the credit.
of the ewes are culled each year, with replace- The typical grower owns 60 to 80 acres of
ments usually being raised from lambs. There is land and has an average of three to four poultry
typically one ram for each 30 ewes in a breeding houses. Most growers also have other jobs and
flock. The sheep and lambs graze on pasture earn supplemental income from their growing
during the summer and are fed a ration of operations. Broiler (or fryer) chickens generally
roughage and grain during the winter. are grown to a live market weight of approxi-
Loans to ewe flock operators are made to mately 4.2 pounds at 42 days of age.
purchase breeding stock and to pay operating Most bank loans to contract poultry growers
expenses. Breeding-stock loans should be consist of construction loans to build poultry
amortized over no more than five years. Repay- houses and permanent financing for the houses
ment comes primarily from the sale of lambs and equipment. The houses are large but of
and wool. relatively simple construction. Permanent financ-
Typically, lambs are finished in commercial ing is typically amortized over 10 to 15 years.
feedlots until they reach slaughter weight, which Government guarantees (Farmers Home
involves purchasing 60-pound feeder lambs Administration, Small Business Administration,
and feeding them a hay-grain ration for about or various state agencies) are often available
90 days until they weigh approximately to mitigate the bank’s risk by guaranteeing from
120 pounds. The loan term is usually 90 to 85 percent to as much as 100 percent of the
120 days, with the sale of fat lambs to a permanent loan. Federal guarantees have not
processor being the source of repayment. been available for construction financing of
Collateral consists of the lambs, which should poultry houses, so the bank generally will have
be valued at local market prices. Margin to assume the full risk of the loan during the
required in the lambs, if any, will depend on construction period.
feedstocks owned or on the borrower’s financial Construction loans are generally converted
strength. into long-term loans that are repaid with the
contract income a grower receives from the
large corporate producer. Since feed and other
supplies are typically furnished by the large
Poultry producer, individual growers do not normally
require operating loans.
Poultry production has become a very large and Egg production for consumption (rather than
highly organized agribusiness. Large corporate hatching) is another aspect of the poultry indus-
producers dominate the industry. However, they try; it is also highly organized and controlled by
depend to a large extent on individual growers, large producers. Facilities, feed, and labor rep-
with whom they contract to raise the birds resent the primary costs for these operations,
almost from the day they are hatched until they with repayment coming primarily from the sale
are ready for slaughter. The large company of eggs. Some income is also derived from the
supplies an independent grower with the day-old sale of ‘‘spent’’ hens (older hens that are no
chicks, feed, and medications and provides tech- longer efficient layers). These operations are
nical support. Under the contract, the company capital intensive and highly specialized. Loans
pays the grower at a rate designed to provide an to egg producers need to be carefully analyzed
acceptable return on the grower’s investment in to determine whether they are properly struc-
poultry houses, equipment, and labor. tured and adequately margined. Assessment of
Producing breeding stock, incubating eggs, the borrower’s overall management ability, and
hatching chicks, and producing pullets and eggs record of profitability, industry trends, and any
are other aspects of the poultry industry that are special risk factors is particularly important in
highly specialized and relatively concentrated judging loan quality.

Page 7
OPERATING (PRODUCTION) are usually reserved for borrowers with strong

LOANS financial positions, proven financial manage-
ment, and a history of cooperation and perfor-
mance. Bank management should continually
Banks (and other lenders) commonly finance the monitor operating lines and clearly document
operating expenses of agricultural producers the purpose for advances and source of repay-
with short-term operating loans. Expenses ments. A clean-up period may or may not be
financed may include items such as cash rent; required after harvest or completion of the
seed; fertilizer; chemicals; irrigation; fuel; taxes; operating cycle, depending on the anticipated
hired labor; professional fees; and, for a live- schedule for selling farm or ranch production.
stock producer, feed, feed supplements, veteri- The primary source of repayment for an
nary care and medicines, and other supplies. agricultural operating loan is revenue from agri-
Operating loans may take the form of single- cultural production. Many farmers also receive
purpose financing or line-of-credit financing. some form of government support payments,
The single-purpose loan is the simplest and and they may have employment off the farm or
most basic form of financing, as it does not do custom work (such as harvesting) for hire. In
attempt to address the borrower’s total credit many cases, wages or salaries generated from
requirements, and the repayment source and the nonfarm employment of a farmer’s spouse
timing are relatively certain. will cover a significant portion of the family’s
Line-of-credit financing may accommodate living expenses, relieving the financial pressure
most of a borrower’s operating needs for the on the farming operation. To evaluate repay-
production cycle. Advances are made as needed ment capacity, the loan officer must determine
to purchase inputs or pay various expenses, with how much revenue will be generated from either
all income usually remitted to the lender to current production or inventories. Revenues will
reduce the line. Depending on the type of need to be sufficient to cover all expenses,
operation, the line may seldom be fully retired however, not just those funded by the loan.
because funds are advanced for a new operating These could include various operating expenses,
year before all inventories from prior years are family living expenses, payments on capital
marketed. An operating line of credit is gener- debt (for real estate and equipment), and any
ally established after cash-flow projections for anticipated new capital expenditures. There
the year are made to anticipate credit needs and should also be a margin to cover incorrect
repayment capacity. While this type of financing assumptions about yields and prices.
has the advantages of convenience and accurate Most agricultural lenders recognize the need
cash-flow monitoring (which permits comparing for yearly cash-flow projections to help deter-
actual cash flow with projections), it can also mine credit needs and repayment capacity. Pro-
have some disadvantages. The lender may be jections of both income and expense are usually
inadvertently funding or subsidizing other credi- made for each month (or each quarter) of the
tors’ payments with advances on the line and, year to anticipate the amount and timing of peak
because operating cycles overlap, it may be financing needs, as well as the total net cash
difficult for the lender to get out of an undesir- flow for the year. Obtaining and analyzing
able situation. yearly federal income tax returns (particularly
An operating line may be revolving or non- Schedule F) should be strongly encouraged as a
revolving. A revolving line replenishes itself as means of reviewing actual operating results.
repayments are made, so the outstanding bal- Actual data can then be compared with projec-
ance can fluctuate up and down during the tions to determine variances. Reasons for the
approved term. There is no limit on the total variances should be understood as a part of the
amount borrowed during the term of the line, as credit analysis process. This analysis will help
long as the amount outstanding never exceeds the bank decide whether to grant or deny credit
the established limit. A nonrevolving line is and service loans.
structured so that once the approved amount If a borrower loses money from operations in
is used, even though payments are made to one year and cannot fully repay the operating
reduce the line, the borrower must reapply and loan, there will be ‘‘carryover debt.’’ In general,
receive approval for any further advances. carryover debt should be segregated, secured
Revolving lines afford flexibility but have no with additional collateral if possible, and amor-
firm disbursement or repayment plan, so they tized over a reasonable term that is consistent

Page 8
with the borrower’s repayment capacity. Consis- During the term of the 10-year contract, the
tent losses and excessive carryover debt can landowner cannot plant a crop on the land, allow
preclude further advances and lead to the sale of grazing on it, or cut the grass for hay. The CRP
certain assets or even to full liquidation of the contract is assignable, so it can be transferred to
operation. a new owner along with title to the land.
Collateral for a typical operating loan includes
growing crops, feed and grain, livestock, and
other inventories. Normally, a bank also obtains
a security interest in equipment, vehicles, gov- Farmers Home Administration
ernment payments, and other receivables to
strengthen the collateral margin. For new bor- The Farmers Home Administration (FmHA) is a
rowers, a lien search is recommended to deter- federal lending agency operating within the U.S.
mine the presence of any senior liens. Pledged Department of Agriculture. The FmHA per-
assets should be valued, either by a knowledge- forms two main functions: (1) providing super-
able bank officer or an outside appraiser, and the vised credit to farmers who are unable to obtain
operation and collateral should be inspected adequate credit from commercial banks and
periodically to judge conditions and values. (2) improving rural communities and enhancing
Inspections for established borrowers are usu- rural development.
ally done at least annually. More frequent Three basic programs allow the FmHA to
inspections are usually performed on marginal extend funds to farmers: (1) grants, (2) direct
borrowers or if the borrower has a feeder live- loans, and (3) loan guarantees. The grant pro-
stock operation with more rapid turnover of gram is the smallest and generally relates to
assets. rural housing and community programs, most of
which are for water and waste disposal systems.
The direct loan programs are for loans made by
GOVERNMENT AGRICULTURAL FmHA through its county and state offices to
SUBSIDY PROGRAMS farmers. The loan guarantee program permits
the FmHA to guarantee up to 90 percent of the
Federal government programs have long been amount of loss on a loan made and serviced by
able to help farmers financially and, to an extent, another lender.
control the overproduction of agricultural prod- Most FmHA loans are (1) farm-operating
ucts. These programs are continually evolving, loans, (2) farm ownership loans, or (3) emer-
but remain important in determining many pro- gency farm loans. Operating loans and farm
ducers’ income levels and profitability. In addi- ownership loans are for operators of family
tion to establishing subsidies, the programs also farms. Eligible purposes for operating loans
set limits on the number of acres of certain crops include capital loans for machinery and live-
that a producer can plant to help control crop stock, as well as annual production inputs. Farm
surpluses and support price levels. ownership loans are available for buying land,
refinancing debts, and constructing buildings.
Emergency loans are designed for farmers in
Conservation Reserve Program counties where severe production losses have
resulted from a disaster or from economic
The Conservation Reserve Program (CRP) is a emergencies.
long-term retirement program for erodible land. To qualify for a loan, a borrower must (1) be
Landowners submit bids for a 10-year contract, unable to obtain sufficient credit elsewhere at
stating the annual payment per acre they would reasonable rates and terms, (2) be a citizen of the
accept to convert the highly erodible land to a United States, (3) be an owner or tenant operator
grass cover. The maximum bid per acre has been of a farm not larger than a family farm, and
established, and accepted bids must not exceed (4) have sufficient training or experience to
prevailing local rental rates for comparable land. ensure a reasonable chance of success in the
If the bid is accepted by the local Agricultural proposed operation.
Stabilization and Conservation Service (ASCS) Banks have been highly motivated to use the
office, the landowner must sow the land to grass, FmHA-guaranteed loan program as a means of
with the cost of planting grass shared by the mitigating risk and perhaps developing a sound
landowner and the government. customer for the future. An FmHA loan also

Page 9
improves the bank’s liquidity, since the guaran- ance. Two common types of crop insurance are
teed portion of the loan can be sold in the (1) crop hail insurance sold by private insurers,
secondary market. which insures only against hail damage, and
(2) multiperil crop insurance written by the
Federal Crop Insurance Corporation. As its
name implies, multiperil crop insurance insures
Small Business Administration against drought, rain, hail, fire, wind, frost,
winterkill, disease, and insect losses.
While it is not primarily a lender to agricultural The federal government subsidizes the multi-
producers, the Small Business Administration peril crop insurance premium by paying most of
(SBA) has made low-interest-rate disaster loans its administrative, actuarial, underwriting, and
available to individuals, including farmers. The selling expenses. By subsidizing premiums and
SBA can make or guarantee various types of encouraging more producers to purchase the
agricultural loans to producers whose annual insurance, the government hopes to reduce the
revenues do not exceed $500,000. Banks occa- dependency on crop disaster payments when
sionally make these loans, which are supported natural disasters occur. However, this program
by collateral as well as a substantial percentage has not been particularly popular with farmers
guarantee by the SBA. In many rural areas, because they would have to suffer a high level
however, it is probably more convenient for a of losses on all planted acres to receive any
bank to work with a nearby FmHA office than significant proceeds from the insurance. By
with an SBA office, which may be located some diversifying their crops and planting in fields
distance away in a metropolitan community. that are separated by significant distances, many
farmers are willing to risk planting without crop
insurance.
Federal Crop Insurance Corporation
The Federal Crop Insurance Corporation, which EVALUATING AGRICULTURAL
is a part of the U.S. Department of Agriculture, MANAGEMENT
writes multiperil crop insurance. The premiums
for this insurance are subsidized by the federal A crucial factor in loan analysis for banks, as
government. For further information, see the well as for examiners, is an evaluation of the
following subsection on crop insurance. management capabilities of the agricultural pro-
ducer. Cash earnings from an operation provide
the primary source of repayment for most agri-
CROP INSURANCE cultural loans, so it is important to evaluate the
borrower’s ability to manage a profitable oper-
The Federal Crop Insurance Reform Act of 1994 ation. The three kinds of management that
combined crop insurance and disaster aid into a agricultural lenders most often analyze are pro-
single, unified program. To be eligible for any duction, marketing, and financial management.
price support or production adjustment program
and for new contracts in the conservation reserve
program or any FmHA loan, farmers must carry Production Management
crop insruance coverage. The expanded crop
insurance program replaces the need for disaster A lender should first assess the borrower’s
bills as the federal response to emergencies technical ability as a producer of crops or
involving widespread crop loss. livestock. This is primarily an objective measure
Aside from the basic required coverage under because it consists of comparing an operation’s
the federal program, known as the catastrophic output against industry and area norms. An
coverage level, banks encourage some borrow- operator whose production levels are consis-
ers to carry crop insurance to reduce their risk of tently below average will probably have diffi-
not being repaid on farm-operating loans. Bor- culty meeting debt-service requirements and
rowers that are more highly leveraged and have may not be able to stay in business. There may
minimum margin in their operating loans are be justifiable reasons for occasional years of
most likely to be required to carry crop insur- below-average production, but lenders should

Page 10
be cautious of operators who consistently per- the form of stored grain or other nonperishable
form poorly. produce or they could be earning assets such as
Another factor to consider is the producer’s livestock, which is readily marketable. Con-
ability to successfully cope with the inherent trolled, reasonable equipment purchases are
variability of agricultural production. Adverse another indication of good financial manage-
weather, disease, and pest infestations are all ment. Overspending on equipment may be indi-
production risks that continually affect crops cated if the borrower’s equipment list includes
and livestock. Some producers diversify the many items that are new, especially costly,
commodities they produce to reduce their duplicative, or unneeded for the types of opera-
dependency on one crop or type of livestock. tions being conducted. The presence of sizable
nonbank equipment debt on the borrower’s finan-
cial statement can, in some cases, also reflect
overspending.
Marketing Management
Good marketing management enables the pro-
ducer to reduce price risk exposure. Volatile MARKETING FARM PRODUCTS
markets have convinced most producers and
lenders that sound marketing is crucial for an Marketing considerations have become more
ongoing agricultural operation, and almost every important for many producers as they attempt to
producer needs a marketing plan designed to maximize returns. Rather than merely selling
control price risk. Aside from helping to ensure crops or livestock at prevailing market prices
profitability, the plan can be incorporated in when the production cycle is complete, some
formulating a more reliable statement of pro- producers attempt to lock in a price through the
jected cash flow, which helps both the lender use of forward contracts or futures or options
and producer anticipate financing needs. trading. Some producers of nonperishables may
Some of the techniques that producers use to simply study market action and cycles and keep
manage price risk exposure are forward contract- harvested crops in storage, waiting for higher
ing, hedging, purchasing options, and using prices. Some livestock producers may buy and
government programs. See the subsection ‘‘Mar- sell throughout the year to help even out the
keting Farm Products’’ for details. effects of market fluctuations. Both the bank
lending officer and the borrower need to have a
clear understanding of the marketing plan,
Financial Management including its potential costs, benefits, and risks.
The following comments briefly describe some
A producer should have the ability and willing- of the basic tools producers use as alternatives to
ness to understand, maintain, and use financial the cash market to manage price risk.
records. The importance of sound financial
records began to be more fully appreciated in • Forward contracting. The producer contracts
the 1980s when agricultural loan losses rose, with a buyer to sell farm products at a fixed
and many agricultural producers and banks price in advance of the actual marketing date.
failed. During that time, the primary emphasis These contracts are simple to use if willing
for many agricultural lenders shifted from buyers can be found, but carry some risk of
collateral-based lending to cash-flow lending. the buyer’s defaulting, particularly if market
While collateral may afford ultimate protection prices decline significantly before the contract
for the lender under a liquidation scenario, cash matures. This risk may be mitigated to some
flow allows for repayment of debt in the normal extent by requiring the buyer to provide secu-
course of business. rity in the form of a 10 to 15 percent margin
In addition to recordkeeping, financial man- to help ensure that the buyer honors the
agement also encompasses how a producer uses contract.
his or her assets and liabilities. Maintaining • Minimum-price forward contract. This is a
financial reserves in the form of current assets is relatively new type of forward pricing that
one means by which a producer can be prepared may be available to some producers. It estab-
to overcome short-run adversity. The reserves lishes a floor but not a ceiling for the price the
need not necessarily be cash; they might be in producer will receive for his commodities, so

Page 11
it protects against price declines but permits becomes more valuable as prices fall. At the
the producer to garner additional profits if the same time, a put allows the producer to benefit
market rises. from rising prices, if they rise more than
• Basis contracting. This is a variation on for- enough to cover the cost of the put. Puts can
ward contracting, whereby the price the pro- also be attractive because they can limit losses
ducer receives is not fixed when the contract is by establishing a minimum price at times
drawn, but will be determined by the futures when current prices are not profitable and the
market price plus or minus some agreed-on producer is reluctant to fix a low price with
difference (basis). For example, cattle for forward contracting or short hedging. Puts
September delivery might be priced at the have the disadvantage of being more expen-
September futures price (as of a date to be sive than hedging; premiums for put options
selected by the seller) plus 50 cents per can be especially high when market prices are
hundredweight. Accordingly, a basis contract high.
does not reduce risk until the price is set by
the seller, so if the seller waits to set the price, Other more complex strategies are sometimes
he or she is still subject to all market risk. used that combine cash and futures instruments
However, a basis contract can be combined to minimize risk or to modify initial positions to
with a put option (see below) to set a mini- adjust for changing market conditions, including
mum price. the following.
• Hedging. Hedging involves the use of coun-
• Establishing minimum prices with basis con-
terbalancing transactions to substantially elimi-
tracts. Purchasing a put option along with
nate market risk. The type of hedge typically
selling commodities on a basis contract estab-
used by an agricultural producer is sometimes
lishes a minimum price, while allowing the
referred to as a ‘‘short hedge’’ because it
producer to gain from rising prices.
involves use of the futures market to, in effect,
• Converting a fixed price into a minimum
sell short. Later, when the producer’s com-
price. If a producer accepts a fixed price via
modities are ready for delivery, he sells them
forward contracting and later regrets that
in the cash market. If the price has declined,
decision, he or she may decide to purchase a
he makes a profit on the sale of the futures
call option (which becomes more valuable as
contract to offset the lower price he receives in
prices rise). The combination of a fixed-price
the cash market. Conversely, if the price has
contract and a call option is called a ‘‘syn-
increased, a loss on the futures contract will
thetic put’’ because the net effect is the same
be incurred to offset the gain in the cash
as buying a put option. The producer who has
market. Hedging is similar to fixing a price
accepted an estimated fixed price via a short
with a forward contract except that the price is
hedge can either lift the hedge (cover the open
said to be an ‘‘expected’’ fixed price, since the
short sale in the futures market) or, depending
difference between the cash and futures prices
on circumstances and relative costs, leave the
may not be correctly anticipated and the
hedge in place and purchase a call option.
resulting net price received will vary some
• Converting a minimum price into a fixed
from the expected level. Hedging can have an
price. If a put option has been used to set a
advantage over forward contracting because it
minimum price at very low levels, and prices
is readily available and based on competi-
subsequently increase, the producer can either
tively determined futures prices. Since posi-
roll up the put to a higher strike price or sell
tions in the futures market require the pro-
futures and establish a fixed price when the
ducer to keep a cash margin with the broker,
market reaches an acceptable level. Buying
and additional margin calls may have to be
one or a series of additional puts allows the
met if the market goes up (after the producer
producer to profit from a further rising market
has sold short), it is especially important that
but may become expensive.
the bank loan officer be aware of and under-
stand the borrower’s marketing plan.
• Put option. Buying a put option gives the FINANCIAL AND INCOME
producer the right, but not the obligation, to INFORMATION FOR
sell a commodity at a given (strike) price any AGRICULTURAL PRODUCERS
time before the put’s expiration date. It pro-
tects against falling prices because the put The financial and income information most

Page 12
commonly used by agricultural lenders includes The difference between total assets and total
balance sheets, income tax returns, and state- liabilities is the net worth of the producer or the
ments of projected cash flow. Many producers equity in the producer’s assets. Most producers
do not prepare income statements on an accrual are individual or family farmers whose balance
basis. Often, their only available income state- sheets also include personal assets not directly
ment is Schedule F of the annual federal income used in the operation, as well as debts owed on
tax return. those items.
It is important to remember that the amount
shown on the statement for net worth is subject
Balance Sheet to question. Since it is merely the difference
between the amounts shown for total assets and
Balance sheets for agricultural producers usu- total liabilities, its accuracy depends on how the
ally divide assets and liabilities into three assets are valued and whether all liabilities are
groups—current, intermediate, and long-term— reflected. Most agricultural borrowers value
based on the liquidity of assets and repayment assets on their balance sheets at what they
schedules of liabilities. Current assets are those assume to be ‘‘market value.’’ However, some
that will either be depleted within 12 months or tend to use rather optimistic valuations, particu-
can easily be converted to cash without affecting larly on items such as equipment and real estate.
the ongoing business operation. Current assets Also, some borrowers tend to carry the same
include cash, accounts receivable, livestock held values forward each year for real estate or
for sale, inventories of crops, feed, supplies, equipment, which may cast some doubt on
growing crops to be harvested within 12 months, accuracy. Examiners reviewing agricultural cred-
and prepaid expenses. its should try to determine prevailing market
Intermediate assets support production and prices for various types of land in the bank’s
may be held for several years. Principal inter- trade area and acquire general knowledge of
mediate assets include breeding stock, equip- equipment values. Recent published sales data
ment, and vehicles. While these assets may be on both real estate and equipment provide reli-
relatively liquid, their sale would seriously affect able indications of current values.
the productivity of the operation. Sometimes not all liabilities are fully or
Long-term, or fixed, assets are more perma- properly disclosed. A form of potential liability
nent in nature and benefit the operation on an that is often not disclosed is the amount of
ongoing basis. The principal fixed asset of an deferred income tax that will be due on the sale
agricultural operation is farm real estate, although of real estate in which the borrower may have a
the producer may have other long-term assets, substantial unrealized capital gain. It may not
such as investments, which may or may not be possible to readily estimate such deferred-tax
be related to his or her farming or ranching liability unless the borrower’s statement shows
operation. both cost and market values. However, the
Current liabilities include those which must examiner should keep these points in mind in
be paid within 12 months, including amounts analyzing the balance sheet, in an attempt
owed for feed, seed, supplies, interest, and to accurately assess the borrower’s financial
taxes. The amounts of any payments due within strength. Comparison with previous balance
12 months on intermediate-term and long-term sheets, other information in the loan file, and
debt should also be included in current liabilities. general knowledge about values will aid the
Intermediate liabilities are generally those examiner in this analysis.
due between one and ten years from the state-
ment date, and commonly represent debt to It is advisable to determine how the balance
finance equipment and vehicles. As mentioned sheet was prepared and by whom. Many are
above, the amounts of payments due on these prepared by the borrower and submitted to the
debts within 12 months are shown as current bank. Others may be prepared by the borrower
liabilities. and lending officer working together. Presum-
Long-term liabilities usually are those that, at ably, the latter method would tend to ensure a
inception, had a maturity of more than ten years. more accurate presentation but, if not, it could
Debt on real estate is the main type of long-term raise questions about lending practices or the
liability on the balance sheets of most agricul- lending officer’s competency. Similarly, balance
tural producers. sheets that do not balance (not an unusual

Page 13
occurrence) might indicate a lack of appropriate accompanies Form 1040. It is prepared on a

analysis by the lending officer. cash basis, showing cash income received and
cash expenses paid, although the taxpayer is
also permitted to deduct depreciation expense
Balance-Sheet Ratio Analysis for items such as equipment, improvements to
real estate, and breeding stock. Farmers may
The following are some basic, fairly simple
have other farm-related income reported on
ratios that can indicate the financial strength of a
Form 4797, which reports sales of dairy and
producer.
breeding livestock, or on Schedule D, which
shows sales of real estate and equipment. Addi-
• Current ratio (current assets/current liabili-
tional nonfarm income is reported on page 1 of
ties). This ratio can reflect a borrower’s ability
Form 1040. All sources of income need to be
to meet current obligations without additional
considered by lenders and examiners, but for
borrowing.
most farm borrowers, Schedule F is the primary
• Quick ratio (liquid assets/current liabilities).
report of income for the farming operation.
This ratio compares current assets that are
Tax returns probably provide the most accu-
easily converted into cash with current obli-
rate income and expense information for most
gations and reflects a borrower’s ability to
farm operations. Some lenders attempt to con-
immediately meet current obligations.
vert the cash basis Schedule F to an accrual
• Leverage ratio (total liabilities/net worth).
basis by adjusting for changes in inventory
This ratio shows the relationship between
values, receivables, payables, and similar items,
borrowed capital and owned capital. The
but the process requires timely, detailed finan-
higher the ratio, the greater is the reliance on
cial information that often is not readily avail-
borrowed capital, which means higher interest
able. Instead, many lenders and examiners look
expense, potentially lower net income, and
at cash-basis income over a three-to-five year
certainly less equity cushion to withstand risk
period to analyze trends and even out the cash-
and adversity. This is often called the debt-to-
flow variances caused by differences in produc-
worth ratio.
tion and marketing cycles.
While cash income is not necessarily a good
Ratio Interpretation Guidelines 3 measure of farm business profits, it does help
show the cash-flow situation and is useful in
planning debt repayment programs and family
Mod-
Low erate High budgets. In addition, cash income statements
Ratio Risk Risk Risk can be compared with projected cash flows to
determine variances that need explanation or
Current Ratio 1.5:1 1:1–1.5:1 <1:1 that may indicate the need for changes in the
Quick Ratio 1.1:1 .8:1–.5:1 <.5:1 operation.
Leverage Ratio .75:1 1:1 1.25:1
Operating Ratio Analysis

Income Statement
Key ratios can be calculated from income state-
Determining actual profitability for most agri- ments to aid in analysis. The most commonly
cultural borrowers is difficult, primarily because used ratios measure profitability, repayment abil-
of the absence of complete income and expense ity, and efficiency. Profitability is usually deter-
information on an accrual basis. The most com- mined by return on equity and return on assets.
mon income statement for agricultural produc- Repayment ability can be determined by the
ers is Schedule F of the federal income tax earnings coverage ratio and debt payment ratio.
return (‘‘Profit or Loss from Farming’’), which The most common economic efficiency ratio
used is the operating expense to revenue ratio.
Although many smaller banks have not used
3. These ratio interpretation guidelines are only rules of income statements to any extent to analyze
thumb and need to be viewed in conjunction with a thorough
analysis of other pertinent factors, including balance-sheet
agricultural credits, this type of analysis can
composition, the nature of the operation, and an assessment of provide useful insights into an operator’s effi-
the borrower’s management ability. ciency and repayment ability.

Page 14
Return on assets is usually calculated by 8. Remaining earnings available for

adding interest expense to net farm income and risk, uncertainty, or new
deducting a management fee (usually an amount investments 11,500
for unpaid family labor), then dividing the
resulting figure by average total farm assets for Earnings coverage ratio = line 8
the year. Return on equity is usually calculated divided by line 7 35%
by deducting a management fee or unpaid fam- Debt payment ratio = line 7
ily labor from net farm income and dividing the divided by line 3 14%
difference by total farm net worth. Operating expense to revenue ratio
Common ratios used to assess debt repayment = line 4 divided by line 1 73%
ability and repayment risk are the earnings
coverage ratio and the debt payment ratio. The
earnings coverage ratio (also known as the
cash-flow ratio) is a measure used to assess the Statement of Projected Cash Flow
operation’s ability to repay. A strong earnings
coverage ratio would be 30 percent or above. Projecting cash flow for an agricultural opera-
An acceptable but riskier level would be 10 to tion gives recognition to the importance of cash
30 percent. The debt payment ratio is used to flow in servicing the debt of an ongoing opera-
determine risk over the term of the loan. It is tion. It also tends to impose some discipline on
calculated by dividing total annual debt pay- both borrower and lender by requiring a thought-
ments by total revenue. As a general rule, total ful planning process for the year in terms of
principal and interest payments should not anticipated income, expenses, financing needs,
exceed 25 percent of total revenue. A ratio of debt-servicing requirements, and capital expen-
less than 15 percent would be relatively safe, ditures. For individual or family farm opera-
while a 15 to 25 percent range would indicate tions, family living expenses should be included
some degree of risk. in the projections, as well as nonfarm income.
The operating expense to revenue ratio mea- A cash-flow statement typically shows both
sures the operating efficiency of the farm exclu- the timing and amount of cash receipts and
sive of debt obligations. A ratio of less than expenses. It can be either a forecasting device
70 percent usually reflects an efficient manager (statement of projected cash flow) or historical
who can service larger amounts of debt. If the record (statement of actual cash flow). Banks
ratio exceeds 80 percent, repayment problems and other lenders most commonly use the state-
could occur if large amounts of debt are out- ment of projected cash flow because it aids in
standing. The ratio tends to be higher for smaller planning the borrower’s credit needs, usually for
operations. the coming 12-month period.
The following example shows how the earn- A statement of projected cash flow shows not
ings coverage, debt payment, and operating only how much credit is likely to be needed, but
expense to revenue ratios are determined from approximately when it will be needed. Perhaps
the income statement. This example reflects most importantly, it shows whether cash income
generally adequate ratios. is expected to exceed expenses for the year. It
also indicates the likely high point of the credit
1. Total farm revenue $210,000 (amount and time) and the expected cash or debt
2. PLUS: Nonfarm revenue 22,000 position at the end of the year. The projected
cash-flow statement represents a kind of budget
3. Total revenue (line 1 + line 2) 232,000
that provides benchmarks against which actual
4. LESS: Farm operating expenses performance can be compared. Significant vari-
(excluding interest and ances call for explanations and may prompt
depreciation) 153,000 certain actions to improve future operating
5. LESS: Family living expenses results. Historical statements of actual cash flow
and income taxes 35,000 have value for comparative purposes and can be
6. Earnings available for interest and an excellent aid in preparing projections for the
principal payments and new following year, although banks do not typically
investments 44,000 request them from most agricultural borrowers.
7. LESS: Interest and principal They tend to rely, instead, on income tax returns
payments 32,500 for information on actual operating results.

Page 15
Cash flow projections are usually made near AGRICULTURAL LOAN

the beginning of a calendar year, although tim- DOCUMENTATION
ing can vary depending on the nature of the
operation. The statement is prepared as a spread- Loan documentation establishes the bank’s legal
sheet normally listing, by month, anticipated position as creditor and secured party and evi-
cash receipts and disbursements. For each period, dences the borrower’s ownership of and actual
the projected operating-loan balance is shown existence of collateral. Some documents, such
after adjusting for the amount of projected net as an insurance policy, give some evidence of
cash flow. collateral values and ensure that tangible collat-
eral is protected. A number of documents play a
supporting role, as they provide information that
is vital in assessing a borrower s creditworthi-
ness and in demonstrating the borrower’s finan-
AGRICULTURAL LOAN POLICIES cial capacity to regulatory authorities, auditors,
loan reviewers, senior management, and the
Not all banks make agricultural loans, but for board of directors. The documents also help
many banks, these loans comprise a significant management to service and grade the credit,
portion of their portfolios. Any bank making determine the nature and extent of any prob-
agricultural loans should have developed an lems, and formulate plans to resolve them by
adequate, formalized set of written policies to strengthening the bank’s position or averting
guide the lending officers and staff. Agricultural losses.
loan policies should address the same general
considerations as the policies used for other loan Absence of complete and current loan docu-
categories, such as desirable, undesirable, or mentation is a weakness in the lending function
prohibited loans; collateral requirements (includ- and can pose a significant threat to the bank’s
ing evaluation guidelines); maximum loan-to- safety and soundness. Some documentation
value ratios; maximum maturities; documenta- exceptions are noted during virtually every
tion requirements; and concentration limitations. examination, largely due to inadvertent over-
Given the specialized nature of agricultural sights or unavoidable delays in obtaining origi-
assets and the varied types of operations, the nal or updated documents. However, an unusu-
policies should be comprehensive and specifi- ally large volume of exceptions can be an
cally address the types of agricultural loans the important indication of weak and deteriorating
bank intends to make. loan quality. Excessive exceptions reflect unfa-
vorably on management and indicate a need for
Some banks may have general policies, management to either formulate stronger loan
supplemented by separate procedures or prac- policies and procedures or to emphasize adher-
tices. Regardless of the individual bank’s termi- ence to established guidance.
nology or the way in which the material is
organized, it is important that the bank’s board Many banks use a standard checklist to help
of directors ensure that appropriate written ensure that all applicable documents are obtained
guidance is provided for management in the when a loan is made. Most banks also have
agricultural lending area. The policies should either an automated or manual ‘‘tickler’’ system
help ensure that loans are made on a sound to identify when updated documents are needed,
basis and provide a framework for identifying, such as current financial statements, tax returns,
addressing, and resolving problems that arise. UCC-1 filings, collateral inspections, and evi-
Loan grading, either by the loan officers, a dence of insurance. Because of the large volume
separate loan review function, or both is desir- of required documents, many of which need to
able, as well as a general plan for actions to be updated at least annually, it is imperative that
be taken on loans with unsatisfactory grades. bank management be firmly committed to a
The policies should also address collection and sound loan documentation program. The pro-
charge-off considerations. Agricultural loan poli- gram should establish responsibility for obtain-
cies should be reviewed by the bank’s board ing documents, monitoring compliance, and pro-
of directors and modified when deemed neces- viding follow-up to help ensure that all required
sary. For more detailed guidance on bank loan documents are obtained in a timely manner.
policy, refer to section 2040.1, ‘‘Loan Portfolio Not every document is applicable to each
Management.’’ agricultural loan. Examiners need to assess which

Page 16
documents are appropriate for a given loan ing collateral, and assembling required docu-
depending on its individual circumstances. There mentation, management needs to administer the
should be little disagreement between examiners portfolio of outstanding loans. They need to
and bank management about the basic docu- monitor borrowers’ performance relative to
ments needed. Basic documentation require- agreed-upon terms, collateral margins, financial
ments are usually listed in the bank’s loan and income data, cash flow, crop prospects, and
policies or procedures. The need for certain market trends that may affect borrower perfor-
supporting documents may be a matter of judg- mance. If problems arise, bankers need to for-
ment, particularly in regard to frequency of mulate and implement plans to protect the bank’s
updating documents. In most cases, however, position.
bankers and examiners tend to agree on items
that are to be considered documentation excep-
tions. Refer to section 2080.1, ‘‘Commercial and
Industrial Loans,’’ for further guidance on loan Farm and Livestock Inspections
documentation. Following is a list of the types
of documents a bank should have in connection A physical inspection of the farming operation
with agricultural loans: is usually performed by bank management
before advancing any substantial funds to a new
• promissory note borrower. Subsequent inspections, particularly
• security agreement for larger or more marginal borrowers and for
• financing statement readily moveable collateral, should be per-
• real estate mortgage or deed of trust formed periodically. Inspections may be per-
• other collateral assignments, as appropriate formed by the loan officer or by another bank
(such as assignments of third-party notes, officer or employee with agricultural experi-
mortgages or deeds of trust, life insurance ence. The inspector usually prepares a fairly
policies, deposit accounts, securities, or other detailed report listing farm assets (livestock,
contracts) equipment, grain and feed on hand, and growing
• subordination agreements (for example, a prior crops) and at least brief comments on the
lienholder may subordinate its lien position to condition of assets and crop prospects. Often,
a bank to induce the bank to make a loan) a listing of machinery, equipment, and vehicles
• appraisals is prepared from the bank’s records ahead
• hazard insurance policy or certificate of of time to aid in the inspection process; any
coverage additions, deletions, or exceptions noted
• cash-flow projections, usually prepared should be shown on the report. Livestock are
annually listed by type, showing numbers, sex, and
• income tax returns approximate weight. Values for all items should
• financial statements (balance sheets) for the be shown on the report, based on current mar-
borrower, cosigner, or guarantor ket prices. The report may note the number of
• collateral inspection reports by the bank acres the potential borrower owns and rents, as
• bill of sale for livestock or equipment well as the approximate value of real estate
owned. A real estate evaluation might be per-
• worksheet for each note (showing the pur-
formed as part of a farm inspection, but a full
pose, timing, and source of repayment; collat-
appraisal, if required, would almost always
eral; total existing bank debt; analysis)
be performed separately, usually by another
• overall credit analysis (particularly on large or
individual.
troubled loans)
• loan officer memos and comments Farm inspections are usually performed annu-
• correspondence ally, unless the borrower has a livestock feeding
operation or some other type of operation that
involves frequent turnover of assets. Generally,
it is desirable to inspect feeder operations
LOAN ADMINISTRATION AND approximately every six months or more fre-
SERVICING quently if deemed necessary. The absence of a
current inspection report, especially for larger or
In addition to making agricultural loans, analyz- troubled borrowers, may be considered a loan-
ing creditworthiness, setting loan terms, obtain- documentation exception.

Page 17
UNSOUND AGRICULTURAL TROUBLED AGRICULTURAL

LENDING PRACTICES LOANS
Following is a list of common unsound lend- Aside from readily identifiable problem loans
ing practices, some of which are general and such as past-due loans, loans on nonaccrual
apply to all types of loans while others relate status, loans on the bank’s watch list or those
more specifically to agricultural loans. This list that were previously classified, or loans to
includes the most common shortcomings. borrowers who have filed for bankruptcy, the
Depending on the extent of the unsound prac- following characteristics may indicate existing
tices, the examiner should incorporate specific or potential problems. Examiners should keep in
recommendations for improvement into the mind both current conditions and trends.
examination report or formal supervisory action
where appropriate. • undermargined collateral position
• unusually high leverage
• absence of or failure to follow sound lending • marginal liquidity
policies and procedures • heavy investment in equipment, vehicles, or
• failure to require adequate performance on real estate
debt • need for unplanned credit advances
• failure to monitor the borrower’s performance • deficiencies or problems revealed in the col-
and position, commonly evidenced by the— lateral inspection
• unfavorable financial trends (especially in-
—lack of periodic collateral inspections
creasing debt-to-worth ratio or declining col-
—absence of current income and financial lateral margins)
information • lack of performance (renewals without appro-
—failure to consider the borrower’s total priate performance)
debt-service requirements • capitalizing interest on debt
—presence of additional operating debt at • charge-offs
another bank; or • inability to meet scheduled debt payments
—absence of a lien search to verify the bank’s • tax problems
position in collateral • reluctance of borrower to provide current,
• inappropriate loan structuring, such as— complete, and accurate financial information
• notification of insurance cancellation for fail-
—untimely or inappropriate repayment
ure to pay premium
schedules
• evidence of legal action against the borrower
—failure to identify or segregate carryover • overdependence on guarantors
operating debt • overdependence on anticipated inheritance
• unwillingness to say ‘‘no’’ to a financially
stressed borrower, which could be an indica-
tion of—
CHAPTER 12 BANKRUPTCY
—overlending (building loan volume without
regard to quality or long-term effects on the Chapter 12 bankruptcy for family farmers
borrower and the bank) became effective in November 1986. It was
—failure to consider borrower’s management designed specifically for the family-farm debtor
capabilities and permits family farmers to reorganize farm
—failure to analyze or project costs of debt so that the amount of the debt approximates
production the value of the collateral. Only a ‘‘family
—failure to observe market trends. farmer with regular annual income’’ (which can
be a partnership or corporate structure) may file
• lending for speculative purposes a chapter 12 bankruptcy. To be eligible, a debtor
• lending outside of the bank’s normal trade must meet all of the following tests:
area
• lending on new or unproven types of opera- • have a farming operation
tions or operations in which bank manage- • have no more than $1.5 million in total debts
ment has little or no experience • derive at least 80 percent of total debts (exclud-

Page 18
ing debt on the principal residence) from the here are generally similar to those in chapter 11
farming operation and chapter 13 bankruptcy proceedings.
• derive more than 50 percent of the family’s
income from the farming operation during the
year immediately preceding the filing WORKING OUT PROBLEM
AGRICULTURAL LOANS
The family farmer will have regular annual
income if the court finds the annual income to be When significant problems arise in agricultural
sufficiently stable and regular to enable the credits, bank management resolves the problems
farmer to make payments under the chapter 12 in a timely manner to protect and strengthen the
plan. bank’s condition. A sound and accurate loan-
Under chapter 12, there is no requirement for grading system, supported by a competent inter-
accelerated payment of arrearage as there is with nal loan review program, will help to ensure
chapter 13. Instead, the farmer/debtor can com- timely identification of problems. Regulatory
mence making plan-required payments from the examinations provide an independent assess-
start of the chapter 12 bankruptcy. Also, a ment, which may identify additional problems
farmer/debtor will have the ability to modify a that management has not recognized. Once prob-
promissory note and continue payments on it lems are identified, the following considerations
beyond the life of the chapter 12 plan if the court are important in a workout program:
approves the modification; in such cases, the
creditor cannot object. • identify the source of the problem
A secured creditor will be ‘‘adequately pro- • establish a workout plan designed to strengthen
tected’’ during the chapter 12 bankruptcy if it the borrower and to minimize loss to the bank
receives cash payments to offset any decrease in • set at least a tentative timetable for the workout
the value of collateral and, in the case of • reach agreement with the borrower on the
farmland, if the creditor is paid a reasonable plan, if possible
rental fee based on the earning capacity of the • monitor progress frequently
property. Also, chapter 12 does not allow the
creditor to recover ‘‘lost opportunity costs,’’ so Alternative actions in a workout plan might
the creditor will not be entitled to interest and include—
other gains that would have been received by the
creditor had bankruptcy not been filed. Elimina- • reducing the bank’s exposure in outstanding
tion of the lost-opportunity-cost provision makes debt by—
it more difficult for creditors to obtain a lift of —obtaining additional collateral,
stay on the grounds that there is not adequate —obtaining financial assistance through sound
protection. cosigners, guarantors, or government
Before confirming the chapter 12 plan, a court guarantees,
may permit a farmer to sell pledged assets —encouraging the borrower to modify his
without the consent of the secured creditor, operations, or
although proceeds from the sale must go to the —restructuring the credit to reduce the inter-
secured creditor. Creditors may bid at the sale, est rate or payments
and collateral that is not sold will be subject to • advancing more funds to—
current evaluation in determining what amounts —refinance existing nonbank debt on more
will be claimed by secured creditors under the favorable terms or
plan. There is no time limit on the duration of a —improve the bank’s overall collateral posi-
chapter 12 plan, except for a three-year limit (or tion (for example, take out a small balance
five years with court approval) on unsecured to a senior lender to put the bank in a first
debts. lien position)
If a chapter 12 debtor voluntarily dismisses • reducing or eliminating outstanding bank debt
the case, he is prohibited from refiling for by—
180 days. The law also provides for a dismissal —selling assets, which can range from a
from chapter 12, or a conversion to chapter 7, partial sale to reduce debt burden and
when the debtor commits fraud. Any other improve chances for survival to a complete
provisions of chapter 12 that are not discussed liquidation;

Page 19
—refinancing a portion of bank debt (such as cash flow, collateral, history of performance,
real estate) elsewhere if more favorable and indications of management capabilities are
rates or terms are available; or much the same as for other loan types.
—recognizing a loss by partial or complete Sample size and sampling techniques will
charge-off of the credit. vary with the planned scope of the examination
and size of the bank and its agricultural loan
portfolio. As a minimum, the examination scope
would usually include past-due and nonaccrual
EXAMINER REVIEW OF loans, watch-list loans, previously classified
AGRICULTURAL LOANS loans, insider loans, and some portion of other
loans. See section 2080.1, ‘‘Commercial Loans,’’
A review of agricultural loans during an exami- for details regarding this topic.
nation will follow the same basic guidelines Classification of agricultural loans should be
employed in reviewing commercial or real estate made using the same criteria established for
loans. Certain practices, types of collateral, and other types of loans. See section 2060.1, ‘‘Clas-
documents may be unique to agricultural loans, sification of Credits,’’ for regulatory definitions
and credit analysis will be somewhat special- of substandard, doubtful, and loss classifica-
ized. However, the objectives of assessing credit tions, as well as the special mention category
quality based on the borrower’s financial strength, and guidance on classifying loans.

Page 20
Agricultural Loans
1. To determine if lending policies, practices, 4. To determine the scope and adequacy of the
procedures, and internal controls for agricul- audit function.
tural loans are adequate. 5. To determine compliance with applicable
3. To evaluate the agricultural loan portfolio for practices, procedures, objectives, or internal
credit quality, performance, collectibility, and controls are deficient or when violations of
collateral sufficiency. laws or regulations have been noted.

Page 1
Energy Lending—Production Loans
INTRODUCTION • Proved-developed-nonproducing. These are

generally proved-developed reserves behind
This section is intended to provide guidance the casing of existing wells or at minor depths
to examiners reviewing small, noncomplex below the present bottom of such wells that
production loans, usually to small independent are expected to be produced through these
oil and/or gas operators. The examination of wells in the predictable future. The develop-
a loan to a small oil or gas operator is con- ment cost of this type of reserves should be
siderably different from the examination of relatively small compared with the cost of a
most commercial loans, and is similar in some new well.
respects to examinations of real estate loans. • Proved-undeveloped. These are reserves that
The only asset that many small independent are proved resources to be recovered from
operators have is oil or gas in the ground or new wells on undrilled acreage or from exist-
both. Loans to operators are based solely on the ing wells requiring a relatively major expen-
predicted cash-flow value of the oil or gas diture for recompletion.
production. Therefore, a production loan is a
loan secured by interests in oil and/or gas
production properties. Cash flow generated Probable Reserves
from the future sale of encumbered oil and/or
gas reserves is the primary, and in some cases, • Probable reserves. These reserves might
the only credible source of repayment. There- include those expected to be producing from
fore, production payments are usually assigned existing or planned wells in areas anticipated
to the bank, and the liquidation value of collat- to be economically beneficial, based on geo-
eral is expected to be sufficient to pay off logical or seismic data.
the loan at any time. In considering this or any
type of secured loan, the banker will deter-
mine or judge the character, capacity, credit Possible Reserves
history, and other credit factors related to the
borrower. Also, the bank must determine that • Possible reserves. These reserves include those
the operator of the properties is capable and whose existence may be inferred from geo-
dependable. logical considerations, including potential
Because cash flow generated from the future reserves from planned waterfloods or other
sale of oil or gas is the justification or basis for recovery techniques that have not been proved.
production lending, only proved-producing
reserves are acceptable collateral for a bank
because they provide sufficiently predictable EVALUATION OF RESERVES
cash flow for debt service. For this reason, loan
values are predicated primarily on reserves that When a lender decides to proceed with financing
are proved-developed-producing properties. secured by oil or gas reserves, an engineering
report will be obtained. The initial step to
determining the loan value of the collateral or
assessing the creditworthiness of a production
DEFINITIONS OF RESERVES loan is an analysis of the engineering report.
Banks that make production loans will usually
Reserves are classified into one of three catego-
have a petroleum engineer on staff or contract
ries: proved, probable, or possible, with proved
with an engineering consultant firm to provide
divided into three subcategories.
an engineer’s report on the properties to be
pledged. Basically, the engineering report con-
sists of determining reserves and production
Proved Reserves forecasts and then applying the pricing and costs
to arrive at the net lease operating income
• Proved-developed-producing. These wells available for debt service. This report is compa-
have been drilled and completed, and are rable to a real estate appraisal in its importance
producing oil or gas. and function.

Page 1
2150.1 Energy Lending—Production Loans
The following table is a very simple presen- Pricing

tation compared with the typical evaluation of
oil and gas properties in an engineer’s report. The value assigned to production and expenses
Typically, most reports will detail five or more must be realistic. Operating costs are based on
years with the last row including all remaining what similar operations in similar areas have
years. Production is usually broken down into been or, in the case of producing reserves, on
categories of oil and gas, and sometimes the historical performance, which may be escalated
number of wells is detailed. Expenses may be at some reasonable percentage each year. The
divided into major components such as operat- report should consider increases and decreases
ing costs; production and ad valorem taxes; in price as well as cost inflation over the ‘‘life of
depreciation, depletion, and write-off of intan- the properties.’’ The future price of oil is a
gibles; general and administration expenses; and judgment factor and should be based on conser-
taxes on income. Also, if the owner expects to vative pricing and can include some reasonable
make capital improvements from income, a escalation each year. This information can be
column may be added for that factor. Some obtained from a number of reliable sources, and
reports include the pro forma amount and terms the examiner should determine the source to
of the loan to aid the analysis. judge the reliability of report information. The
Engineering reports must be generated by a prices used for gas are usually contract prices
fully qualified petroleum engineer. The lender plus escalation-clause rates. Special care is nec-
must have complete confidence in the engineer’s essary in evaluating gas contracts, including
ability and intellectual honesty, as well as in the their reasonableness in light of current condi-
quality of the data and its susceptibility to tions and the ability and willingness of the
analysis. The integrity of engineering data that purchasers to honor the contracts. In some
depict future cash stream is critical to the initial instances, certain purchasers have broken con-
lending decision and equally important to an tracts or exercised ‘‘market-out’’ clauses to cease
examiner in the assessment of credit quality. In complying with long-term purchase commit-
summary, an acceptable engineering report must ments. The Securities and Exchange Commis-
be an independent, detailed analysis of the sion requires reserves with renegotiable con-
reserves prepared by a competent engineer. The tracts or under market-out clauses to value the
examiner should carefully review the following reserves at spot prices at the date of renegotia-
three elements. tion or immediately, in the case of market-out
clauses.
TABLE 1
ENGINEER’S REPORT—EVALUATION OF OIL AND GAS PROPERTIES
Present
Worth (PW) PW
Production Operating Future Future
$18 per Future and Other Future Income Net Income
Year Barrel (bbl) Income Expenses Net Income @10% @10%
1 5,000 $ 90,000 $10,000 $ 80,000 $ 85,800 1 $ 76,300
2 4,000 72,000 8,000 64,000 62,400 55,500
3 3,000 54,000 7,000 47,000 42,600 37,000
4 2,000 36,000 6,000 30,000 25,800 21,500
5 1,000 18,000 5,000 13,000 11,700 8,500
Total 15,000 $270,000 $36,000 $234,000 $228,300 $198,800
1. For present-worth calculations, usually 1⁄2 year is
used for the first period, 11⁄2 for the second period, and
21⁄2 for the third period, and so on.

Page 2
Energy Lending—Production Loans 2150.1
Present Worth tion of the engineer’s report to help determine

its usefulness. It will detail what data were
Present worth is used to recast future income available, how they were used, the methods of
into the equivalent dollar value today; it should analysis, and whether a field inspection was
reflect current market interest rates. The present made, including individual well tests. This sec-
worth of future net revenues is used to help tion of the report should inform the examiner of
determine the maximum amount that can be the true condition of the well and reserves. It is
loaned. possible for the projected cash flow to portray
one picture while the narrative portrays an
entirely different one.
Timing Generally, a bank will loan up to 50 percent
of the net present value of proved-developed-
Preferably, the report should be no more than six producing reserves; however, a lower percent-
months old. A report that is up to 12 months old age may be needed depending on a number of
may be acceptable in some cases; however, it factors. If the reserves are in an area that is
should not be more than 12 months old. Change highly faulted, or if seismic work and drilling
is the most important factor in determining the indicated that a zone is contiguous from one
adequacy and timeliness of reports. Recent sig- well to the next and the porosity and permeabil-
nificant price fluctuations or changes in interest ity of the pay-zone rock are very similar, then a
rates may require the examiner to adjust the smaller percentage will be used. To avoid the
valuation of the reserves to reflect current possibility that any individual, unforeseen event
conditions. will have a significant effect on the total projec-
The engineer is responsible for ensuring that tion, a wide spread of properties is preferable.
the evaluation includes only proved-developed- This applies not only to a concentration of value
producing reserves, unless otherwise directed in any one well, but also to a concentration in
by the lender. In some cases, the lender might one reservoir, field, or producing area. Gener-
give value to a property or well that is proved- ally, a safety factor of not less than 2:1 will be
developed-nonproducing if it has been drilled used on proved-producing properties, but on
and completed, but is not producing because long-life and high-quality reserves, a safety
sales facilities or a gas pipeline hookup has not factor of 1.5:1 is sometimes used. However,
been completed. The lender would, however, wells that are highly faulted may require a 3:1 or
deduct a safety factor by cutting back the higher safety factor. Terms will usually require
reserves assumed to be dedicated to that well that the loan be fully repaid before the safety
because the margin of error increases. However, factor is reduced.
the lender will not generally loan against proved-
undeveloped, probable, or possible reserves
because of the speculative nature of those cate- DOCUMENTATION
gories. Their inclusion as collateral is usually as
an abundance of caution with little or no value The documentation for a term loan is relatively
assigned to them. simple. There is a note, a loan agreement, a deed
A judgment has to be made on the probable of trust/mortgage, an assignment of production
accuracy of predictions of future revenues. The (usually in the mortgage), a title opinion, and
engineer evaluates geologic conditions such as a security agreement/financing statement. The
sand continuity, faulting, spacing, the number of assignment of oil and gas interests is unique
wells, the diversity of properties, well produc- because oil and gas are treated as real property
tivity, the pressure production history, and overall while in the ground but convert to personal
data quality, as well as the degree of confidence property interests as production is generated at
the engineers have in their own numbers. Esti- the wellhead. Most lenders also require an
mates based on well-established production per- affidavit as to payment of bills. Also, the owner
formance are given the most credibility. Lesser or the operator is usually required to guarantee
weight is given to estimates derived from more payment of the loan.
speculative methods such as volumetrics, anal- The bank will obtain an acceptable title opin-
ogy with similar reservoirs, or a computer ion that indicates the borrower has, on the date
simulation of new producing zones. The exam- of the loan, clear title to each of the leases under
iner should carefully review the narrative por- mortgage and that properties are free and clear

Page 3
of all liens. After the loan is closed, the bank on an independent assessment of all credit
will send a letter of instruction to notify the factors that are germane to the specific credit
company sending out production checks that the being reviewed. A comprehensive analysis of
bank has taken a lien on the production and to the credit must take place if any of the following
request that production checks be sent directly factors are present:
to the bank. The mortgage covers surface rights
and mineral interests. A copy of the mortgage • The loan balance exceeds 65 percent of the
containing an assignment of production will be discounted present worth of future net income
sent to the company purchasing the production, (PWFNI) of proved-developed-producing
along with a request that division orders or reserves, or the cash-flow analysis indicates
transfer orders be prepared recording its interest that the loan will not amortize over four to five
in production payments. This authorizes the years.
purchaser to send production payments directly • The credit is not performing in accordance
to the bank for the account of the borrower. The with terms or payment of interest and/or
security agreement and financing statement cov- principal.
ers removable equipment, oil and gas inventory • The credit is identified by the bank as a
above the ground, and accounts receivable. The problem credit.
financing statements are filed in the real estate • Other factors indicate a potential problem
records of the county in which the properties are credit.
located (usually with the county clerk) and in
the secretary of state’s office. This filing is done After performing the analysis, the examiner
to perfect security interests in equipment, which must determine if classification is warranted.
may be moved from place to place. However, When classification is warranted, the following
some states have different requirements, and the guidelines are to be applied when repayment of
examiner should be familiar with each state’s the debt is solely dependent on oil and/or gas
filing requirements. The affidavit as to payment properties pledged as collateral. A lesser per-
of bills is executed by the borrower to ensure centage or less severe criticism may be appro-
that all the bills have been paid on the properties priate when other reliable means of repayment
or will be paid out of loan proceeds. If bills are exist for a portion of the debt.
to be paid out of proceeds, the bank should
ensure that payments are verified. The loan Proved-Developed-Producing
agreement should be read very carefully by the
examiner with close attention paid to both posi-
Reserves
tive and negative covenants. Sixty-five percent of discounted PWFNI should
The bank will usually take a collateral interest be classified substandard when the discounted
in equipment, accounts receivables, and inven- PWFNI is determined using historical produc-
tory. The deed of trust/mortgage will cover real tion data (decline-curve-analysis engineering).
estate, surface rights, and mineral interests, and When less than 75 percent of the reserve esti-
a security agreement will cover removable equip- mate is determined using historical production
ment, oil as inventory (in tanks), and accounts data, or when the discounted PWFNI is predi-
receivable. An appropriate filing is needed for cated on engineering estimates of the volume of
each type of collateral. Filing requirements may oil/gas flow (volumetric and/or analogy-based
vary from state to state and should be researched. engineering data), the collateral value assigned
Generally, collateral documents should be filed to substandard should be reduced accordingly.
with the state and county. It is reasonable to The balance, but not more than 100 percent of
expect the bank to have collateral files com- discounted PWFNI of proved-developed-
pleted within two to three months. producing (PDP) reserves, should be extended
doubtful. Any remaining deficiency balance
should be classified loss.
CLASSIFICATION GUIDELINES
FOR TROUBLED PRODUCTION
LOANS Other Reserves
The classification of production loans is like all In addition to PDP, many reserve-based credits
loan classifications in that it must be predicated will include proved-developed-nonproducing

Page 4
reserves, shut-in reserves, behind-the-pipe collateral and sources of repayment should be

reserves, and proved-undeveloped properties carefully evaluated on a case-by-case basis.
(PUPs) as collateral. Due to the nature of these
other reserves, there are no strict percentage
guidelines for the proportion of the credit sup-
ported by this type of collateral that should SAMPLE CASE
remain as a bankable asset. However, only in
very unusual situations would the proportion of The following case describes some of the gen-
collateral values assigned to a classification eral principles related to production lending. A
category approach the values for PDP. The customer applied for a $100,000 loan to help
examiner must ascertain the current status of fund the purchase of oil reserves, which will be
each reserve and develop an appropriate amount. used to secure the note. Based on an analysis,
Examples could be reserves that are shut in the loan officer agreed to make a loan and secure
due to economic conditions versus reserves that it with oil production. As part of the analysis,
are shut in due to the absence of pipeline or the loan officer ordered an engineer’s report on
transportation. PUPs require careful evaluation the properties to determine the half-life of the
before allowing any bankable collateral value. cash flow—the point at which 50 percent of cash
An example of a bankable value for a PUP could flow available for debt service has been depleted.
be one that has a binding purchase contract. In Using table 1 (presented earlier in the ‘‘Evalu-
every classification where a bankable value is ation of Reserves’’ subsection), the loan officer
given for any of these other reserves, the loan determined that cumulative PWFNI equals
write-up should fully support the examiner’s $198,800 and 50 percent of that amount equals
determination. $99,400. In the next step, the loan officer deter-
The above guidelines apply to production mined the point in time that $99,400 is reached,
loans that are considered collateral-dependent which in this case is 17 months. Based on these
and are devoid of repayment capacity from any calculations, the loan officer determined that
other tangible source. Rarely should bankable the maximum loan should not exceed $99,400
consideration be given to loans that are com- and should be repaid within 17 months. He
pletely collateral dependent in excess of the offered a term loan to the borrower for $99,400
liquidation value of the pledged reserves. Once with 17 monthly payments of $5,847 principal
again, there is no substitute for a specific, plus interest of 12 percent. Although the
case-by-case analysis of applicable credit and loan request was for $100,000, the borrower
collateral factors pertaining to each individual accepted the offer. Shortly after the loan is
credit. Frequently, when a lender encounters made, the value of oil declines from $18 bbl to
problems with a production credit, numerous $12 bbl, and the discount used for evaluations
other types of assets (for example A/R, inven- increases from 10 to 15 percent. As a result,
tories, or real estate) are encumbered in an effort table 1 was revised. Table 2 includes these new
to protect the bank’s interests. Other types of factors.
TABLE 2
ENGINEER’S REPORT—EVALUATION OF OIL AND GAS PROPERTIES
Operating PW Future PW Future

Production Future and Other Future Net Income Net Income
Year @$12 bbl Income Expenses Income @15% @15%
1 5,000 $ 60,000 $10,000 $ 50,000 $ 56,000 $ 46,600
2 4,000 48,000 8,000 40,000 38,900 32,400
3 3,000 36,000 7,000 29,000 25,400 20,400
4 2,000 24,000 6,000 18,000 14,700 11,000
5 1,000 12,000 5,000 7,000 6,400 3,700
Total 15,000 $180,000 $36,000 $144,000 $141,400 $114,100

Page 5
The loan now exceeds 65 percent of PWFNI Division orders. Set out the borrower’s interest
of PDP reserves, and a comprehensive analysis in the property and direct production payments.
of the credit is performed. Because the obligor is Division order title opinions can be used to
devoid of other repayment capacity or other verify ownership and will contain the legal
reliable means of repayment, with total support description of properties.
of the debt provided solely by the pledged
production, the loan should be classified. Sixty- Escalating. Involves the difficult task of predict-
five percent of discounted PWFNI of PDP ing future prices of oil and gas for valuing
reserves equals $74,165, and this amount will be production. Escalating the value of production
classified substandard. The balance of $16,827, usually increases the risk to the lender. Exam-
which is also supported by discounted PWFNI iners should carefully review the basis for esca-
of PDP reserves, should be classified doubtful. lating values when it has a significant impact
The loan should be placed on nonaccrual status on the value of the collateral and/or cash flow.
with any outstanding interest classified as loss. Also, the examiner should carefully review
how future expenses related to each well are
estimated.
TERMINOLOGY
Exploratory well. Also known as a ‘‘wildcat,’’ a
The following are abbreviated explanations or well drilled in an unproven area. The term
discussions of some of the terms found in originated in early drilling days in Pennsylvania
engineering reports and energy-lending when wells were drilled within the sight and
transactions. sound of wildcats.
Analogy-based engineering data. Comparative Fault. A break or fracture in the earth’s crust
analyses relating past performances of compa- that causes rock layers to shift.
rable properties to determine possible future
reserves. Field. An area in which a number of wells
produce from a reservoir or from several reser-
Assignment of production. Usually in the mort- voirs at various depths.
gage agreement, it allows direct payment from
purchaser to the bank for oil production. Gas Formation. A bed or deposit of substantially the
purchases generally are paid to the operator, and same kinds of rocks.
the operator then pays the bank.
Fracturing, frac’ing, frac job. Refers to pump-
Carried interest. When a party or parties have ing fluids under extremely high pressure into a
their expenses paid (carried) by other parties up formation to create or enlarge fractures through
to a specified limit. which oil or gas can move. Propping agents such
as sand are sent down with fluids to hold the
Decline curves. Used to determine reserves by fractures open. Many completed wells require
extrapolation of historical production data. additional treatment (stimulation) before oil or
gas can be produced.
Deed of trust/mortgage. Covers real estate, sur-
face rights, and mineral interests. Mortgage is Lease. A contract between the landowner (les-
unique because oil and gas are treated as real sor) and the lessee that gives the lessee the right
property while in the ground but converted to to exploit the premises for minerals or other
personal property interests as production is gen- products and to use the surface as needed.
erated at the wellhead and as oil and gas enter However, surface damages would normally have
storage tanks or a pipeline. The security agree- to be reimbursed. Surface ownership is different
ment portion of the oil and gas mortgage will from mineral ownership in many cases. Also, if
usually cover fixtures and equipment affixed to drilling does not begin during a specified time
the well site. period, the lease will expire.
Development wells. Drilled in the proven terri- Lithology. The scientific study of rocks.
tory of a field, they have a high likelihood of
producing oil or gas. Log(s). Used to record three basic measure-

Page 6
ments: electrical, radioactive, and sonic. The profitably recovered, assuming current costs,
logging device is lowered into the well bore prices, and technology. Not to be confused with
and transmits signals to the surface. These are oil and gas in place, which is the total amount of
recorded on film and used to make a log petroleum in the earth regardless of whether or
showing the recorded measurements that are not it can be recovered. Recovery is a function
used to analyze the formation’s porosity, fluid not only of technology, but of the marketplace.
saturation, and lithology. The log’s header gives
the log’s type and date, the operator, the well Reserve interest. The term used to describe the
name, and other information. percent of revenue received.
Market-out. A clause that basically allows the Royalty interest. The share of gross production
purchaser to stop paying the original contract proceeds from a property received by its mineral
price and institute a lower price with the intent owner(s), free of exploration, drilling, and pro-
of maintaining the marketability of the gas. duction costs. Typically one-eighth to one-sixth
Some contracts allow the producer to be released of production, but fractions may be higher.
from the contract if he refuses the lower price or Royalty payments take precedence over all other
may offer other remedies. payments from lease revenues.
Mineral rights. The ownership of minerals under Primary, secondary, and tertiary recovery. Re-
a tract, which includes the right to explore, drill, lates to the method of obtaining production from
and produce such minerals, or assign such rights a well. Primary recovery is production from a
in the form of a lease to another party. Mineral- reservoir through flowing or pumping wells
rights ownership may or may not be severed because of the existence of natural energy within
from land-surface ownership, depending on state the reservoir. This usually recovers about 10 to
law. Title in fee simple means all rights are held 35 percent of the oil and gas in place. Secondary
by one owner; the fee in surface owner does not recovery is any method by which essentially
hold mineral rights. The term ‘‘minerals’’ is depleted reservoir energy is restored. This may
loosely used to refer to mineral ownership and be accomplished by injection of liquids or gases
even, incorrectly, to royalty ownership. A min- or both. Tertiary recovery is any enhanced
eral acre is the full mineral interest under one method employed after secondary recovery and
acre of land. is generally very costly.
Operator. The manager of drilling and produc- Runs. A term used to refer to oil or gas produc-
tion for the owner. tion income from a lease.
Perforations. The holes in casing and cement Seismic survey or shooting. A method of gath-
through which oil and/or gas flow from forma- ering information by recording and analyzing
tion into wellbore and up to surface. shock waves artificially produced and reflected
from subsurface rocks.
Permeability. A measure of how easily fluids
may flow through pore spaces. A tight rock or Stripper wells. Wells that make less than 10
sand formation will have low permeability and, barrels of oil per day based on the last
thus, low capacity to produce oil or gas. Wells in 12 months or wells that make less than 60,000
these zones usually require fracturing or other cubic feet of gas per day based on the last
stimulation. 90 days.
Porosity. Refers to the pore space in rock that Volumetric calculations. Determine oil or
enables it to hold fluids. gas reserves by use of rock volume and
characteristics.
Reservoir or pool. A single accumulation of oil
or gas trapped in a rock body. Working interest. Also referred to as an operat-
ing interest, the term used to describe the lease
Reserves. The estimated amount of oil and gas owner’s interest in the well. Lease owners are
in a given reservoir that is capable of being the ones who pay for drilling and completing the

Page 7
well. Lease owners pay 100 percent of cost and Workover. Relates to the process of cleaning out
receive all revenues after taxes and royalties are or other work on a well to restore or increase its
paid. production.

Page 8
Energy Lending—Production Loans
1. To determine if policies, practices, proce- 4. To determine the scope and adequacy of the
dures, and internal controls for energy loans audit function.
are adequate to identify and manage the risks 5. To determine compliance with applicable
the bank is exposed to. laws and regulations.
2. To determine if bank officers are operating in 6. To initiate corrective action when policies,
conformance with the established guidelines. practices, procedures, or internal controls are
3. To evaluate the portfolio for performance, deficient or when violations of laws or regu-
credit quality, collateral sufficiency, and lations have been noted.
collectibility.

Page 1
Asset-Based Lending
INTRODUCTION expands along with increases in levels of

accounts receivables, inventory, and sales;
Asset-based lending is a specialized area of • the ability to take advantage of purchase
commercial bank lending in which borrowers discounts because the company receives
assign their interests in certain accounts receiv- immediate cash on its sales and is able to pay
able and inventory, and in selected cases fixed trade creditors in a timely manner (consistent
assets, to the lender as collateral. In asset-based usage of purchase discounts reduces the cost
lending, the primary repayment source is the of goods sold and enhances the gross profit
conversion of the pledged assets into cash. margin); and
Asset-based lending differs from a commercial • the interest paid on asset-based loans may be
loan in which the bank takes a security interest lower than for alternate sources of funds.
in all accounts receivable and inventory owned
or acquired by the borrower. This section will Some advantages of asset-based lending for
discuss asset-based lending in relation to the banks are—
characteristics of the borrower, its advantages to
the borrower and the bank, credit and collateral • a relatively high-yield loan is generated com-
analysis, documentation, and safeguards to mensurate with the perceived credit risk of the
ensure the authenticity and collectibility of the borrower;
assigned receivables. • a depository relationship is formed that pro-
The examiner must judge the quality of the vides income and enhances the bank’s ability
asset-based credit by evaluating the financial to monitor changes in the borrower’s cash
condition and debt-servicing ability of the bor- flow and overall financial condition;
rower and the quality of the collateral. In addi- • banking relationships with longstanding cus-
tion, the examiner must evaluate the bank’s tomers whose financial conditions no longer
credit policy, internal controls, audit procedures, warrant traditional commercial bank loans can
and operational practices. continue;
Many borrowers whose financial condition is • new business is generated by prudently lend-
not strong enough to allow them to qualify for ing to financially weaker customers who could
regular, secured commercial bank loans may use not qualify for normal commercial loans; and
asset-based loans to meet their financial needs. • potential loss is minimized when the loan is
Some examples of asset-based borrowers are— collateralized by a percentage of the accounts
receivable and inventory.
• businesses that are growing rapidly and need
year-round financing in amounts too large
to justify commercial lines of credit secured
by blanket liens on accounts receivable and CREDIT ANALYSIS
inventory,
• businesses that are nonseasonal and need Although asset-based loans are collateralized
year-round financing because working capital and closely monitored, it is important to analyze
and profits are insufficient to permit periodic the borrower’s financial statements. Even if the
cleanups, collateral is of good quality and supports the
• businesses whose working capital is inad- loan, the borrower should demonstrate financial
equate for their volume of sales and type of progress. Full repayment through collateral liq-
operation, and uidation is normally a solution of last resort. An
• businesses that cannot obtain regular commer- examiner should analyze the borrower’s finan-
cial loan terms because of deteriorating credit cial statements with particular emphasis on trends
factors. in working capital, review trade reports, analyze
accounts receivable and inventory turnover, and
Some advantages of asset-based lending for review the agings of receivables and payables.
the borrower are— Furthermore, the prompt payment of taxes, espe-
cially payroll taxes, should be verified. One
• efficiency in financing an expanding operation reason for a company to obtain asset-based
because the business’s borrowing capacity financing is to maximize discounts offered by

Page 1
2160.1 Asset-Based Lending
suppliers; therefore, it should pay creditors pledged. To do so, management should review
promptly upon receiving the financing. the quality of the receivables and inventory
Bank management’s ability to recognize a pledged, including documentation; the safe-
customer’s financial problems as they develop, guards imposed to ensure the authenticity and
and to initiate orderly liquidation, if necessary, collectibility of the assigned receivables; and the
is important in the supervision of asset-based loan agreement and compliance therewith. The
financing. Theoretically, a borrower’s line could information obtained is sometimes difficult to
be fully liquidated by discontinuing further interpret unless it is related to other periods,
advances, collecting the assigned receivables, comparable businesses, or industry statistics.
and liquidating pledged inventory. However, Comparative analysis helps indicate the continu-
such drastic action would most likely cause the ing value of the collateral.
borrower’s business to close, resulting in a Lender-liability exposure is a risk in all types
probable deterioration of the receivables from of commercial lending, but especially in asset-
new disputes and in returns and offsets. Conse- based lending. Borrowers using asset-based
quently, the bank usually notifies its borrower of financing are generally very dependent on its
a contemplated liquidation, which gives the continuation, so an abrupt cessation of a line of
borrower time to seek other means of continuing credit would be more likely to result in legal
business so that the bank’s loan may be liqui- action against a lender. To protect themselves as
dated in an orderly manner without losses or much as possible from lender-liability lawsuits,
other adverse effects. Unless the bank has initi- banks frequently use time notes (with renewal
ated an orderly liquidation, examiners should options). Time notes are supported by loan
specially mention or classify receivable and agreements that usually include more numerous
inventory lines in which the borrower’s financial and detailed loan covenants. Legal counsels for
position has declined so that continued financing both the lender and borrower should approve the
is not prudent. When a liquidation is occurring, loan agreement and covenants. At times, the
classification of the credit may not be necessary borrower may not comply with one or more
if the borrower’s business is continuing, the covenants in a loan agreement. The lender may
existing collateral is of good quality, liquidation agree to waive specific covenant violations to
value sufficiently covers outstanding debt, and give a borrower time to take corrective action. If
no collateral deterioration is anticipated. a covenant such as a financial covenant requir-
A related issue concerning asset-based loans ing a minimum capital level is waived, the
is the amount of excess availability associated waiver should be formally communicated to the
with the revolving line of credit. The quantity of borrower in writing. The lender should avoid
a borrowing company’s excess availability is an both not taking action for a period of time and
excellent indicator of whether it has the capacity not issuing a written waiver for a covenant
to service its loan. If a status report shows little violation. In either case, if a covenant violation
availability, the borrower has used all of the cash is subsequently used as a reason to cancel an
that the pledged receivables and inventory are asset-based loan, the lender is more vulnerable
capable of generating under the asset-based line to lender liability. The lender should be careful
of credit. Since these loans may not yet be on the to be consistent in all actions regarding the
bank’s watch list or problem-loan report, it is borrower.
important for the examiner to track, over a
fiscal-year period, a borrower’s changing levels
of availability when performing an analysis of ASSET-BASED LOAN
creditworthiness. This analysis is especially criti- AGREEMENTS
cal for borrowers whose business is seasonal.
Initial credit analyses of potential asset-based An asset-based loan agreement is a contract
loan customers should include detailed projec- between a borrower and the bank that sets forth
tions showing that availability under revolving conditions governing the handling of the account
lines of credit at anticipated advance rates would and the remedies available in the event of
be sufficient to meet the borrower’s working- default. The following areas should be addressed
capital needs. Occasionally, overadvance lines in the loan agreement:
are part of the initial credit facility.
Bank management must continually evaluate • Eligible accounts receivable. This involves
the realizable value of receivables and inventory identifying classes of receivables that will not

Page 2
Asset-Based Lending 2160.1
be regarded as acceptable collateral. Certain concentrated in a few accounts. Too many

types of receivables carry a higher degree of sales, even to a good creditworthy cus-
risk relative to the willingness and ability of tomer, could ultimately cause problems
account debtors to pay and, by their very should disputes arise over products or con-
nature, should be excluded from the lending tracts. A common benchmark is that no
formula. The following are typical classes of more than 20 percent of the receivables
ineligible receivables: assigned should be from one customer.
—Delinquent accounts. Eligible receivables Some lenders will use a percentage that is
generally exclude accounts that are more also subject to a dollar limit.
than a given number of days delinquent, —Bill-and-hold sales. These occur when a
most often 60 days or more past due. product ordered by a buyer has actually
Delinquency is frequently expressed in loan been billed and is ready for shipment, but is
agreements as a given number of days from held by the seller pending receipt of ship-
the invoice date, such as 90 days from the ping instructions from the buyer. Bill-and-
invoice date when payment is required in hold sales are not eligible as receivables to
30 days, which is the most common pay- be loaned against because they are not fully
ment term. Expressing delinquency in days executed transactions. A second party’s
from the invoice date prevents a borrower claim could be of little value when mer-
from reducing the volume of ineligible chandise has not been shipped and there is
delinquent accounts by giving dated terms no evidence of acceptance on behalf of the
(extending payment days). For example, buyer.
accounts with 30-day trade terms that are
—Progress billings. These are invoices issued
becoming 60 days delinquent could other-
on partial completion of contracts, usually
wise be maintained in the eligible-
on a percentage basis. This practice is
receivable base by increasing payment
standard in construction and other indus-
terms to 90 days. Also, under what is
tries where long-term contracts are gener-
commonly referred to as the ‘‘50 percent
ally used. Failure to complete a contract
rule,’’ accounts with multiple invoices that
could jeopardize the collectibility of progress
have more than 50 percent of the total
receivables and, therefore, should generally
balance past due are excluded from the
not be considered eligible collateral. More-
eligible-receivable base. For example, if a
over, failure to complete contracts can
borrower’s customer owes payment for ten
expose companies to lawsuits from their
invoices, of which six are delinquent, all
customers, who may be forced to pay
ten would be considered ineligible, not just
higher prices to other parties to complete
the six that are delinquent. While 50 per-
the contracts over much shorter time
cent is standard industry practice, lenders
periods. The only exception for progress
may be more conservative and require
billings is when, on partial completion,
ineligibility for an entire account if less
there has been delivery of the product, and
than 50 percent of it is past due.
the contract clearly states that buyers have
—Contra accounts. These usually arise when
accepted the product and are responsible
the borrower both sells to and purchases
for payment of the product delivered.
from the account debtor. The risk is the
possibility of direct offset against these —Receivables subject to a purchase-money
accounts. interest. These include floor-plan arrange-
—Affiliate accounts. These accounts, unlike ments, under which a manufacturer will
contra-accounts, occur when a borrower frequently file financing statements when
sells to an account debtor, both of whom merchandise is delivered to the borrower.
are associated through common ownership. That filing usually gives the manufacturer a
Associated risks include forgiveness of debt superior lien on the receivable. An alterna-
on behalf of the affiliate and a temptation tive would be to enter into an agreement
for the borrower to create fraudulent with the manufacturer, which specifies that
invoices. rights to the receivables are subordinated to
—Concentration accounts. A lender may be the bank.
vulnerable to loss if a large percentage of • Percentage advanced against eligible or
the dollar amount of receivables assigned is acceptable accounts receivable. The accounts-

Page 3
receivable advance rate, typically in the range This information is critical in determining
of 75 to 85 percent, must serve the two appropriate advance rates.
primary functions of providing adequate cash
flow for the borrower and providing a margin
that gives adequate protection for the lender.
Protection for the lender requires a sufficient Pledged Receivables
margin for the continual costs of collection
and absorption of dilution in the receivables. The following factors should be considered in
Selecting the proper advance rate for a bor- evaluating the quality of receivables pledged:
rower involves understanding the amounts
and causes of portfolio dilution. Causes of • Standard procedures require that the bank
dilution that are positive include the offering obtain a monthly aging report of the accounts
receivable pledged. The eligible receivables
of discounts and various allowances. Causes
base is then calculated by deducting the vari-
that are negative include merchandise returns,
ous classes of ineligible receivables. Usually
bad debts, product liability, or warranty claims.
the eligible receivables base will be adjusted
An abundance of negative causes, such as
daily during the month following receipt of
bad debts, might indicate poor receivable-
the aging report. If accounts are ledgered, the
management practices. A lender must know base will be increased by additional sales, as
how dilution is occurring in each receivable represented by duplicate copies of invoices
portfolio to measure it continually. This knowl- together with shipping documents and/or
edge should lead to proper advance-rate selec- delivery receipts received by the bank. The
tion, resulting in a loan balance protected by a receivables base will be decreased daily by
receivables base with sufficient liquidation accounts-receivable payments received by the
value to repay the loan. borrower, who then remits the payments to the
• Percentage advanced against eligible inven- bank. Another method of payment in which
tory. The inventory advance rate typically the bank has tighter control is a lockbox
ranges from 35 to 65 percent for finished arrangement. Under this arrangement, receiv-
products. Marketability and accessibility of ables are pledged on a notification basis and
the inventory are key factors in determining the borrower’s customers remit their pay-
the advance rate. Proper evaluation of the ments on accounts receivable directly to the
liquidation value of inventory requires a firm bank through deposit in a specially designated
understanding of marketability in all the vari- account. If accounts are not ledgered but a
ous inventory stages (raw materials, works-in- blanket assignment procedure is used, the
process, finished merchandise). Works-in- borrower periodically informs the bank of the
process often have very low marketability amount of receivables outstanding on its
because of their unfinished nature, and they books. Based on this information, the bank
will typically carry a very low advance rate—if advances the agreed percentage of the out-
they are even allowed as eligible inventory. standing receivables. Receivables are also
Conversely, the raw materials or commodities pledged on a non-notification basis, with pay-
(such as aluminum ingots, bars, and rolls) ments on the receivables made directly to the
have a broader marketability as separately borrower who then remits them to the bank.
financed collateral components. When setting Proper management of any asset-based credit
advance rates, it is also important to consider line requires that all payments on accounts
whether inventory is valued at LIFO (last in, receivable be remitted to the bank, with the
first out) or FIFO (first in, first out). In an accounts-receivable borrowing base reduced
inflationary environment, FIFO reporting will by a like amount. The borrower’s working-
result in higher overall inventory values on the capital needs should then be met by drawing
customer’s books. against the asset-based credit line.
• Slower turnover of the pledged receivables
The above factors are considerations in the can be a strong indication of deterioration in
conduct of inventory audits performed in con- credit quality of accounts receivable.
nection with the granting and monitoring of • Debtor accounts that are significant to the
asset-based loans. These audits will generally bank borrower’s business should be well rated
discuss the inventory from a liquidation basis. and financially strong. Borrowers should also

Page 4
Asset-Based Lending 2160.1
obtain financial statements on their major —verification that all taxes, especially sales
customers to make credit decisions. These and payroll, are paid timely; and
financial statements should be reviewed when —review of compliance with the loan
the bank performs its periodic audits. In addi- agreement.
tion, the borrower should maintain an appro- • Confirmation. To verify the authenticity of
priate level of reserves for doubtful accounts. the pledged collateral, the bank should institute
Credit insurance is often used, which indem- a program of direct confirmation. This proce-
nifies a company against noncollection of dure is particularly important if the accounts
accounts receivable for credit reasons. When receivable are pledged on a non-notification
credit insurance is used, the asset-based lender basis, since the bank does not have the same
should be named as beneficiary. control over debtor accounts as it does when
• Dilution or shrinking of the accounts- the receivables are pledged on a notification
receivable borrowing base can result from basis. Direct confirmation should be made
disputes, returns, and offsets. A large or in- before the initial lending arrangement and
creasing volume of these transactions could periodically thereafter. Confirmation should
adversely affect the bank’s collateral position. be on a positive basis. The bank should obtain
written approval from the borrower before
The following safeguards, which bank man- confirming accounts receivable on a non-
agement should consider and the examiner notification basis.
should evaluate, ensure the authenticity and
collectibility of the pledged accounts receivable:
• Audits. To verify the information supplied by Pledged Inventory

the borrower to the bank, the bank should
audit the borrower’s books. Audits should The following factors should be considered in
occur several times a year at the borrower’s evaluating the inventory pledged:
place of business. For satisfactory borrowers,
the audit is usually performed quarterly. How- • A borrowing-base certificate, obtained from
ever, audits can occur more frequently if the borrower at least monthly, is normally
deemed necessary. Individuals who perform used to calculate the dollar amount of inven-
bank audits should be independent of the tory eligible for collateral. The borrowing-
credit function. The scope of an audit should base certificate will show the different classes
include— of inventory, such as raw materials, works-in-
—verification that the information on the process, and finished goods. After this will be
borrowing-base certificate reconciles to the listed the different types of ineligible inven-
borrower’s books; tory, which will be subtracted to give the
—review of concentrations of accounts; amount of eligible inventory. Finally, the
—review of trends in accounts receivable, advance rates are applied to the different
accounts payable, inventory, sales, and costs classes of eligible inventory to determine the
of goods sold; borrowing base.
—review of the control of cash proceeds; • Factors affecting marketability, advance rates,
—determination that the general ledger is and the decision whether to allow a class of
regularly posted; inventory as eligible at even a low advance
—verification of submitted aging reports; rate:
—review of bank reconciliations and can- —Obsolescence. This could involve not only
celed checks; merchandise that is no longer in demand
—determination if any accounts receivable for various reasons, such as technological
are being settled with notes receivable; advances, but also style products, such as
—verification that the accounts-receivable led- clothing, which obviously have a greater
ger is noted to show that an assignment has potential for obsolescence.
been made to the bank; —Seasonal goods. It is necessary to know
—determination on non-notification accounts the seasonal highs and lows associated with
that all payments are remitted to the bank a particular class of inventory, as well as
and that positive written confirmations are the costs associated with these seasonal
issued timely (for example, semiannually); variations.

Page 5
—Oversupply. If there is an oversupply in the periodic lien searches if a borrower develops

general market of a particular class of financial problems.
inventory, then its value would be nega-
tively affected. Commercial lenders often use outside appraisal
—Limited-use raw materials and finished firms to help them determine prudent inventory-
goods. These would be difficult to liquidate advance rates. Also, normal industry practice
at a reasonable value. for advance rates on different classes of inven-
tory is available through the Commercial Finance
Two other areas a lender must analyze in Association Information Exchange.
setting the inventory advance rate are the ease Turnover rates should be analyzed to identify
or difficulty, in terms of cost, of liquidating potential slow-moving or obsolete inventory,
inventory in multiple locations, and the cost of which should be subject to a lower or no
maintaining certain inventory, such as food advance rate. The borrower should establish
products that require refrigeration, in a salable inventory reserves if the volume of slow-
state. moving or obsolete inventory is significant, and
charge-off procedures should be in effect. Inven-
In addition to marketability, accessibility of tory should be adequately insured in relation to
the collateral is extremely important, as liquida- its location and amount. Furthermore, bill-and-
tion plans become meaningless if a lender can- hold merchandise and goods held on consign-
not gain access to collateral. Constant vigilance ment should be physically segregated from other
is necessary to guard against actions that would warehoused inventory and should not be included
preempt a lender’s security interest in inventory. as inventory on the borrower’s books or on the
Following are some common actions that impede borrowing-base certificate submitted to the
a lender’s access to collateral: bank.
• Possessory liens. A landlord lien is a common
example. To protect their interest, lenders
need to obtain landlord waivers to the lien. UCC Requirements for Secured
• Nonpossessory liens. A purchase-money
Transactions
security interest is a common example. These Article 9 of the UCC applies to any transaction
are usually filed by trade suppliers against that is intended to create a security interest in
their customers. personal property. For a detailed discussion of
• Secret lien. A tax lien is the most common the UCC requirements regarding secured trans-
example. To ensure that a loss of collateral actions, refer to section 2080.1, ‘‘Commercial
does not occur, it is necessary to conduct and Industrial Loans.’’

Page 6
Asset-Based Lending
cedures, and internal controls for accounts audit function.
receivable and inventory financing are 5. To determine compliance with laws and
adequate. regulations.
2. To determine if bank officers are conforming 6. To initiate corrective action when policies,
to established guidelines. practices, procedures, or internal controls are
3. To evaluate the portfolio for collateral suffi- deficient or when violations of laws or regu-
ciency, credit quality, and collectibility. lations have been noted.

Page 1
Asset-Based Lending
1. If selected for implementation, complete ers and their interests, specifying which
or update the asset-based lending section of officers are considered executive officers
the internal control questionnaire. i. extensions of credit to executive officers,
2. On the basis of the evaluation of internal directors, and principal shareholders and
controls and the work performed by internal their interests of correspondent banks
or external auditors, determine the scope of j. a list of correspondent banks
the examination. k. miscellaneous loan-debit and credit-
3. Test for compliance with policies, practices, suspense accounts
procedures, and internal controls in conjunc- l. loans considered ‘‘problem loans’’ by
tion with performing the remaining exami- management
nation procedures. Also, obtain a listing of m. Shared National Credits
any deficiencies noted in the latest review
n. specific guidelines in the lending policy
done by internal or external auditors, and
determine if corrections have been o. each officer’s current lending authority
accomplished. p. current interest-rate structure
4. Obtain a trial balance of the customer lia- q. any useful information obtained from the
bility records. review of the minutes of the loan
a. Agree or reconcile balances to depart- and discount committee or any similar
ment controls and the general ledger. committee
b. Review reconciling items for reasonable- r. reports furnished to the loan and
ness. discount committee or any similar
5. Using an appropriate technique, select bor- committee
rowers for examination. Prepare credit line s. reports furnished to the board of
cards. directors
6. Obtain the following information from the t. loans classified during the preceding
bank or other examination areas, if examination
applicable: 7. Review the information received and per-
a. past-due loans form the following procedures.
b. loans in a nonaccrual status a. Loans transferred, either in whole or in
c. loans on which interest is not being part, to or from another lending institu-
collected in accordance with the terms of tion as a result of a participation, sale or
the loan (Particular attention should be purchase, or asset swap.
paid to loans that have been renewed • Participations only:
without payment of interest.) — Test participation certificates and
d. loans whose terms have been modified records, and determine that the par-
by a reduction of interest rate or princi- ties share in the risks and contrac-
pal payment, by a deferral of interest or tual payments on a pro rata basis.
principal, or by other restructuring of — Determine that the bank exercises
repayment terms similar controls and procedures
e. loans transferred, either in whole or in over loans serviced for others as
part, to another lending institution as for loans in its own portfolio.
a result of a sale, participation, or asset — Determine that the bank, as lead or
swap since the previous examination agent in a credit, exercises similar
f. loans acquired from another lending controls and procedures over syn-
institution as a result of a purchase, dications and participations sold as
participation, or asset swap since the for loans in its own portfolio.
previous examination • Procedures pertaining to all transfers:
g. loan commitments and other contingent — Investigate any situations in which
liabilities loans were transferred immediately
h. Extensions of credit to employees, offi- before the date of examination to
cers, directors, and principal sharehold- determine if any were transferred

Page 1
2160.3 Asset-Based Lending: Examination Procedures
to avoid possible criticism during suspense accounts.

the examination. • Discuss with management any large or
— Determine whether any of the loans old items.
transferred were either nonperform- • Perform additional procedures as
ing at the time of transfer or clas- deemed appropriate.
sified at the previous examination. c. Loan commitments and other contingent
— Determine that the consideration liabilities. Analyze the commitment or
received for low-quality loans trans- contingent liability if the borrower has
ferred from the bank to an affiliate been advised of the commitment, and
is properly reflected on the bank’s analyze the combined amounts of the
books and is equal to the fair current loan balance (if any) and the
market value of the transferred commitment or other contingent liability
loans. (While fair market value exceeding the cutoff.
may be difficult to determine, it d. Loans classified during the previous
should at a minimum reflect both examination.
the rate of return being earned on • Determine the disposition of loans so
these loans as well as an appropri- classified by transcribing—
ate risk premium.) Section 23A of — current balance and payment sta-
the Federal Reserve Act prohibits a tus, or
state member bank from purchas- — date loan was repaid and source of
ing a low-quality asset. payment.
— Determine that low-quality loans • Investigate any situations in which all
transferred to an affiliate are prop- or part of the funds for the repayment
erly reflected at fair market value came from the proceeds of another
on the books of both the bank and loan at the bank, or as a result of a
its affiliate. participation, sale, or swap with another
— If low-quality loans were trans- lending institution. If repayment was a
ferred to or from another lending result of a participation, sale, or swap,
institution for which the Federal refer to step 7a of this section for the
Reserve is not the primary regula- appropriate examination procedures.
tor, prepare a memorandum to be e. Uniform review of Shared National
submitted to the Reserve Bank Credits.
supervisory personnel. The Reserve • Compare the schedule of credits
Bank will then inform the local included in the uniform review of
office of the primary federal regu- Shared National Credits Program with
lator of the other institution involved line cards to ascertain which loans in
in the transfer. The memorandum the sample are portions of Shared
should include the following infor- National Credits.
mation, as applicable: • For each loan so identified, transcribe
(1) name of originating institution appropriate information from schedule
(2) name of receiving institution to line cards. (No further examination
(3) type of transfer (i.e., participa- procedures are necessary in this area.)
tion, purchase or sale, swap) 8. Consult with the examiner responsible for
(4) date of transfer the asset/liability management analysis to
(5) total number of loans trans- determine the appropriate maturity break-
ferred down of loans needed for the analysis. If
(6) total dollar amount of loans requested, compile the information using
transferred bank records or other appropriate sources.
(7) status of the loans when trans- See ‘‘Instructions for the Report of Exami-
ferred (e.g., nonperforming, nation,’’ section 6000.1, for the consider-
classified, etc.) ations to be taken into account when com-
(8) any other information that piling maturity information for the gap
would be helpful to the other analysis.
regulator 9. Prepare line cards for any loan not in the
b. Miscellaneous loan-debit and credit- sample that, on the basis of the information

Page 2
Asset-Based Lending: Examination Procedures 2160.3
derived from the above schedules, requires a. Lending limits.

in-depth review. • Determine the bank’s lending limit as
10. Obtain liability and other information on prescribed by state law.
common borrowers from examiners • Determine advances or combinations
assigned to cash items, overdrafts, lease of advances with aggregate balances
financing, and other loan areas, and together above the limit, if any.
decide who will review the borrowing b. Section 23A, Relations with Affiliates (12
relationship. USC 371c), and section 23B, Restric-
11. Obtain credit files for each loan for which tions on Transactions with Affiliates (12
line cards have been prepared. In ana- USC 371c-1), of the Federal Reserve
lyzing the loans, perform the following Act, and Regulation W.
procedures: • Obtain a listing of loans to affiliates.
a. Analyze balance-sheet and profit-and- • Compare the listing with the bank’s
loss items as reflected in current and customer liability records to determine
preceding financial statements, and deter- its accuracy and completeness.
mine the existence of any favorable or • Obtain a listing of other covered trans-
adverse trends. actions with affiliates (i.e., acceptance
b. Review components of the balance sheet of affiliate’s securities as collateral for
as reflected in the current financial state- a loan to any person).
ments, and determine the reasonableness • Ensure that covered transactions with
of each item as it relates to the total affiliates do not exceed the limits of
financial structure. section 23A and Regulation W.
c. Review supporting information and con- • Ensure that covered transactions with
solidation techniques for major balance- affiliates meet the collateral require-
sheet items. ments of section 23A and Regulation
d. Ascertain compliance with provisions of W.
loan agreements. • Determine that low-quality loans have
e. Review digests of officers’ memoranda, not been purchased from an affiliate.
mercantile reports, credit checks, and
• Determine that all covered transactions
correspondence.
with affiliates are on terms and condi-
f. Review the following:
tions that are consistent with safe and
• relationship between amount collected
sound banking practices.
in a month on the receivables pledged
as collateral and the borrower’s credit • Determine that all transactions with
limit affiliates comply with the market-
• aging of accounts receivable terms requirement of section 23B and
• ineligible receivables Regulation W.
• concentration of debtor accounts c. 18 USC 215, Receipt of Commission or
• financial strength of debtor accounts Gift for Procuring Loans.
• disputes, returns, and offsets • While examining the accounts receiv-
• management’s safeguards to ensure the able loan area, determine the existence
authenticity and collectibility of the of any possible cases in which a bank
assigned receivables officer, director, employee, agent, or
g. Analyze secondary support offered by attorney may have received anything
guarantors and endorsers. of value for procuring or endeavoring
h. Ascertain compliance with established to procure any extension of credit.
bank policy. • Investigate any such suspected
12. Transcribe significant liability and other situation.
information on officers, principals, and d. Federal Election Campaign Act (2 USC
affiliations of appropriate borrowers con- 441b), Political Contributions and Loans.
tained in the sample. Cross-reference line • While examining the accounts receiv-
cards to borrowers, where appropriate. able loan area, determine the existence
13. Determine compliance with laws and regu- of any loans in connection with any
lations pertaining to accounts receivable political campaign.
lending by performing the following steps. • Review each such credit to determine

Page 3
2160.3 Asset-Based Lending: Examination Procedures
whether it is made in accordance with — determine that loans to insiders do

applicable banking laws and regula- not exceed the lending limits
tions and in the ordinary course of imposed by Regulation O;
business. — if prior approval by the bank’s
e. 12 USC 1972, Tie-In Provisions. While board was required for a loan to an
examining the accounts receivable loan insider, determine that this approval
area, determine whether any extension of was obtained;
credit is conditioned upon— — determine compliance with the vari-
• obtaining or providing an additional ous reporting requirements for
credit, property, or service to or from insider loans;
the bank or its holding company (or a — determine that the bank has made
subsidiary of its holding company), provisions to comply with the dis-
other than a loan, discount, deposit, or closure requirements for insider
trust service, or loans; and
• the customer not obtaining a credit, — determine that the bank maintains
property, or service from a competitor records of public disclosure requests
of the bank or its holding company (or and the disposition of the requests
a subsidiary of its holding company), for a period of two years after the
other than a reasonable condition to dates of the requests.
ensure the soundness of the credit. • Title VIII of the Financial Institutions
f. Insider lending activities. The examina- Regulatory and Interest Rate Control
tion procedures for checking compliance Act of 1978 (FIRA) (12 USC 1972(2)),
with the relevant law and regulation Loans to Executive Officers, Directors,
covering insider lending activities and and Principal Shareholders of Corre-
reporting requirements are as follows. spondent Banks.
(The examiner should refer to the appro- — Obtain from or request that the
priate sections of the statutes for specific examiners reviewing due from
definitions, lending limitations, reporting banks and deposit accounts verify
requirements, and conditions indicating a list of correspondent banks pro-
preferential treatment.) vided by bank management, and
• Regulation O (12 CFR 215), Loans ascertain the profitability of those
to Executive Officers, Directors, relationships.
and Principal Shareholders and Their — Determine that loans to insiders
Related Interests. While reviewing of correspondent banks are not
information relating to insiders that is made on preferential terms and
received from the bank or appropriate that no conflict of interest appears
examiner (including loan participa- to exist.
tions, loans purchased and sold, and g. Financial Recordkeeping and Reporting
loan swaps)— of Currency and Foreign Transactions
— test the accuracy and completeness (31 CFR 103.33), Retention of Credit
of information about accounts Files. Review the operating procedures
receivable loans by comparing it and credit file documentation and deter-
with the trial balance or loans mine if the bank retains records of each
sampled; extension of credit over $10,000, speci-
— review credit files on insider loans fying the name and address of the bor-
to determine that required informa- rower, the amount of the credit, the
tion is available; nature and purpose of the loan, and the
— determine that loans to insiders date thereof. (Loans secured by an inter-
do not contain terms more favor- est in real property are exempt.)
able than those afforded other 14. Determine whether the consumer compli-
borrowers; ance examination uncovered any violations
— determine that loans to insiders do of law or regulation in this department. If
not involve more than normal risk violations were noted, determine whether
of repayment or present other corrective action was taken. Extend testing
unfavorable features; to determine subsequent compliance with

Page 4
Asset-Based Lending: Examination Procedures 2160.3
any noted law or regulation. k. other matters concerning the condition of

15. Perform the appropriate steps in ‘‘Concen- the department
trations of Credits,’’ section 2050.3. 17. Evaluate the function for—
16. Discuss with appropriate officers, and pre- a. the adequacy of written policies, relating
pare summaries in appropriate report form to accounts receivable financing;
of— b. the manner in which bank officers are
a. delinquent loans conforming with established policy;
b. loans not supported by current and com- c. adverse trends within the accounts
plete financial information receivable financing department;
c. loans on which documentation is defi- d. the accuracy and completeness of the
cient schedules obtained from the bank;
d. inadequately collateralized loans e. i n t e r n a l c o n t r o l d e f i c i e n c i e s o r
e. classified loans exceptions;
f. Small Business Administration delin- f. recommended corrective action when
quent or criticized loans policies, practices, or procedures are
g. transfers of low-quality loans to or from deficient;
another lending institution g. the competency of departmental
h. concentrations of credit management; and
i. extensions of credit to major sharehold- h. other matters of significance.
ers, employees, officers, directors, and/or 18. Update the workpapers with any information
their interests that will facilitate future examinations.
j. violations of laws and regulations

Page 5
Asset-Based Lending
Review the bank’s internal controls, policies, collection requests, and past-due notices
practices, and procedures for making and ser- checked to the trial balances that are used
vicing accounts receivable financing loans. The in reconciling subsidiary records of
bank’s system should be documented in a com- accounts receivable financing loans with
plete and concise manner and should include, general ledger accounts, and are they
where appropriate, narrative descriptions, flow handled only by persons who do not also
charts, copies of forms, and other pertinent handle cash?
information. Items marked with an asterisk 6. Are inquiries about accounts receivable
require substantiation by observation or testing. financing loan balances received and
investigated by persons who do not also
handle cash or pass adjustments?
POLICIES *7. Are documents supporting recorded credit
adjustments to loan accounts or accrued
*1. Has the board of directors, consistent with interest receivable accounts checked or
its duties and responsibilities, adopted writ- tested subsequently by persons who do not
ten accounts receivable financing policies also handle cash or initiate transactions
that— (if so, explain briefly)?
a. establish procedures for reviewing 8. Are terms, dates, weights, descriptions of
accounts receivable financing merchandise, etc., shown on invoices, ship-
applications, ping documents, delivery receipts, and
b. establish standards for determining bills of lading scrutinized for differences?
credit lines, 9. Are procedures in effect to determine if the
c. establish standards for determining per- signatures shown on the above documents
centage advance to be made against are authentic?
acceptable receivables, 10. Are payments from customers scrutinized
d. define acceptable receivables, for differences in invoice dates, numbers,
e. establish minimum requirements for terms, etc.?
verification of borrower’s accounts
receivable, and
f. establish minimum standards for LOAN INTEREST
documentation?
2. Are accounts receivable financing policies *11. Is the preparation and posting of loan
reviewed at least annually to determine if interest records performed or reviewed by
they are compatible with changing market persons who do not also—
conditions? a. issue official checks and drafts or
b. handle cash?
12. Are independent interest computations
RECORDS made and compared or tested to initial
loan interest records by persons who do
*3. Is the preparation and posting of subsidi- not also—
ary accounts receivable financing records a. issue official checks and drafts or
performed or reviewed by persons who do b. handle cash?
not also—
a. issue official checks and drafts or
b. handle cash? COLLATERAL
*4. Are the subsidiary accounts receivable
financing records reconciled, at least *13. Does the bank record, on a timely basis, a
monthly, to the appropriate general ledger first lien on the assigned receivables for
accounts, and are reconciling items inves- each borrower?
tigated by persons who do not also handle 14. Do all loans granted on the security of the
cash? receivables also have an assignment of the
5. Are loan statements, delinquent account inventory?

Page 1
2160.4 Asset-Based Lending: Internal Control Questionnaire
15. Does the bank verify the borrower’s basis for evaluating internal control in that
accounts receivable or require independent there are no significant deficiencies in
verification periodically? areas not covered in this questionnaire that
16. Does the bank require the borrower to impair any controls? Explain negative
provide aged accounts receivable sched- answers briefly and indicate any addi-
ules periodically? tional examination procedures deemed
17. If applicable, are cash receipts and invoices necessary.
block proven in the mailroom and subse- 19. Based on a composite evaluation, as evi-
quently traced to posting on daily transac- denced by answers to the foregoing
tion records? questions, internal control is considered
(adequate/inadequate).
CONCLUSION
18. Is the foregoing information an adequate

Page 2
Securities Broker and Dealer Loans
Some member banks provide lending services to ticipating banks receive daily reports showing
stock brokerage firms using marketable securi- their position in the program by broker name
ties as collateral. While various financial ser- and type of security.
vices are offered, typically most banks make The New York Stock Exchange formed a
loans to brokerage firms to provide them with subsidiary, the National Securities Clearing Cor-
the funding needed to carry their securities poration (NSCC), to provide equity clearance
portfolio. The securities can either be held by and continuous net settlement for the brokerage
the bank or a tri-party custodian or pledged to community. The Depository Trust Company in
the bank at a depository. Collateral securities New York, under contract with the NSCC,
can be in physical form or can be held at a handles the technical aspects of that operation,
depository in book-entry form. including final settlement. Collateral-pledging
To promote efficiency, a brokerage firm may services may be offered by other depositories as
use a depository to hold the securities it has well.
pledged as collateral for a bank loan. Brokerage Book-entry transfer of ownership is limited to
firms deposit shares of eligible securities with only those securities that are eligible for deposit
the depository, and the stock certificates repre- in a depository. However, even if a security was
senting those shares are registered in the name depository-eligible, it would not be eligible for
of a common nominee. Beneficial ownership of book-entry movement unless the lending bank
the securities is transferred through computer- was a direct or indirect participant in the deposi-
ized book entries, thus eliminating the physical tory. If the lending institution does not have a
movement of the securities. The depository has relationship, either directly or indirectly, with a
physical control of the securities while they are depository, the securities would have to be
on deposit. Loan arrangements are made between delivered physically to the ultimate custodian
the broker and the lending bank, with the broker (presumably the lending bank).
providing electronic instructions to the deposi- Securities lending is not always constrained
tory to debit the firm’s account and credit that of by eligibility. Depending on the bank’s under-
the lending bank. The depository acknowledges writing standards, some banks may be willing
the transaction to the lending bank and will not to lend on the basis of securities that are not
reverse the entry or allow partial withdrawals depository-eligible. This would preclude book-
without authorization from that institution. Par- entry movement and require physical delivery.

Page 1
1. To determine if policies, practices, proce- laws and regulations, including Regulations

dures, objectives, and internal controls for T and U, the Securities Act of 1933, and the
securities broker and dealer loans are adequate. Securities Exchange Act of 1934.
2. To determine the types of loans (underwrit- 6. To evaluate management information sys-
ing loan, day loan, inventory loan, margin tems, particularly the lender’s ability to ensure
loan, or guidance line) made, loan pricing adequate collateral coverage by being able to
and fees, loan-to-value ratios, and margin automatically price collateral daily.
calls. 7. To determine the scope and adequacy of the
3. To evaluate credit quality, credit analysis, audit function.
collateral and custody requirements, and pro- 8. To initiate corrective action when policies,
cedures for lost and stolen securities. practices, procedures, objectives, or internal
4. To determine if bank officers are operating in controls are deficient or when violations of
conformance with the established guidelines. laws or regulations have been noted.
5. To determine compliance with applicable

Page 1
1. If selected for implementation, complete or h. Reports furnished to the loan and

update the Securities Broker and Dealer discount committee or any similar
Loans section of the Internal Control committee.
Questionnaire. i. Reports furnished to the board of
2. Based on the evaluation of internal controls directors.
and of the work performed by internal/ j. Loans classified during the preceding
external auditors ascertain the scope of the examination.
examination. k. A listing of loans charged-off since the
3. Test for compliance with policies, practices, preceding examination.
procedures and internal controls in conjunc- 9. Review the information received and per-
tion with performing the remaining exami- form the following:
nation procedures. Also, obtain a listing of
a. For miscellaneous loan debit and credit
any deficiencies noted in the latest review
suspense accounts:
done by internal/external auditors, and
determine if corrections have been • Discuss with management any large or
accomplished. old items.
4. Request the bank to supply: • Perform additional procedures as
a. Schedule of approved lines for each deemed appropriate.
dealer including outstanding balances. b. For loans classified during the previous
b. Delinquent interest billings, date billed examination, determine disposition of
amount of past-due interest. loans so classified by transcribing:
5. Obtain a trial balance of all dealer accounts • Current balances and payment status,
and: or
a. Agree balances to department controls • Date loan was repaid and sources of
and general ledger. payment.
b. R e v i e w r e c o n c i l i n g i t e m s f o r c. For loan commitments and other contin-
reasonableness. gent liabilities, analyze if:
6. Using an appropriate technique, select bor- • The borrower has been advised of the
rowers to be reviewed. contingent liability.
7. Using the trial balance, transcribe the fol- • The combined amounts of the current
lowing information for each borrower loan balance and the commitment or
selected onto the credit line cards. contingent liability exceed the cutoff.
a. Total outstanding liability. d. Select loans which require in-depth
b. Amount of approved line. review based on information derived
8. Obtain from the appropriate examiner the when performing the above steps.
following schedules, if applicable to this 10. For those loans selected in step 6 above and
area: for any other loans selected while perform-
a. Past-due loans. ing the above steps, transcribe the following
b. Loan commitments and other contingent information from the bank’s collateral record
liabilities. onto the credit-line cards:
c. Miscellaneous loan debit and credit sus- a. A list of collateral held, including date of
pense accounts. entry, and amount advanced.
d. Loans considered ‘‘problem loans’’ by b. A brief of the agreement between the
management. bank and the dealer.
e. Each officer’s current lending authority. c. Evidence that the proper documentation
f. Current interest rate structure. is in place.
g. Any useful information obtained from d. Details of any other collateral held.
the review of the minutes of the loan 11. The examiner should be aware that certain
and discount committee or any similar stock-secured purpose transactions with and
committee. for brokers and dealers are exempt from the

Page 1
2170.3 Securities Broker and Dealer Loans: Examination Procedures
margin restrictions of Regulation U. Refer b. Loans on which collateral documenta-

to the regulation for a complete description tion is deficient.
of such transactions, which include the c. Recommended corrective action when
following: policies, practices or procedures are
a. Temporary advances to finance cash deficient.
transactions. d. Other matters regarding the condition of
b. Securities in transit or transfer. the department.
c. Day loans. 13. Prepare appropriate comments for examina-
d. Temporary financing of distributions. tion report stating your findings with regard
e. Arbitrage transactions. to:
f. C r e d i t e x t e n d e d p u r s u a n t t o a. The adequacy of written policies relating
hypothecation. to dealer loans.
g. Emergency credit. b. The manner in which bank officers are
h. Loans to specialists. conforming with established policy.
i. Loans to odd-lot dealers. c. Schedules applicable to the department
j. Loans to OTC market makers. that were discovered to be incorrect or
k. Loans to third-market makers incomplete.
l. Loans to block positioners. d. The competence of departmental
m. Loans for capital contributions. management.
12. Discuss with appropriate officer(s) and pre- e. I n t e r n a l c o n t r o l d e f i c i e n c i e s o r
pare summaries in appropriate report form exceptions.
of: f. Other matters of significance.
a. Delinquent loans, including a breakout 14. Update the workpapers with any informa-
of ‘‘A’’ paper. tion that will facilitate future examinations.

Page 2
Review the bank’s internal control, policies, records performed and reviewed by appro-
practices and procedures for making and servic- priate personnel?
ing loans. The bank’s system should be docu- 8. Are any independent interest computations
mented in a complete and concise manner and made and compared or adequately tested
should include, where appropriate, narrative to initial interest records by appropriate
descriptions, flowcharts, copies of forms used personnel?
and other pertinent information.
POLICIES COLLATERAL
1. Has the board of directors, consistent with 9. Are multicopy, prenumbered records main-
its duties and responsibilities, adopted writ- tained that:
ten loan policies that: a. Detail the complete description of collat-
a. Establish standards for determining broker eral pledged?
and dealer credit lines? b. Are typed or completed in ink?
b. Establish minimum standards for
10. Are receipts issued to customers covering
documentation?
each item of negotiable collateral
2. Are such loan policies reviewed at least
deposited?
annually to determine if they are compatible
with changing market conditions? 11. If applicable, are the functions of receiving
3. Is a daily record maintained summarizing and releasing collateral to borrowers and of
loan transaction details, i.e., loans made, making entries in the collateral register
payments received and interest collected to performed by different employees?
support applicable general ledger account 12. Are appropriate steps with regard to Regu-
entries? lation U being considered in granting dealer
4. Are frequent note and liability ledger trial and broker loans?
balances prepared and reconciled with con-
trolling accounts by employees who do not
process or record loan transactions?
5. Is an exception report produced and reviewed CONCLUSION
by operating management that encompasses
extensions, renewals or any factors that 13. Is the foregoing information an adequate
would result in a change in customer account basis for evaluating internal control in that
status? there are no significant deficienicies in areas
6. Do customer account records clearly indi- not covered in this questionnaire that impair
cate accounts which have been renewed or any controls? Explain negative answers
extended? briefly, and indicate any additional exami-
nation procedures deemed necessary.
14. Based on composite evaluation, as evi-
LOAN INTEREST denced by answers to the foregoing
questions, internal control is considered
7. Is the preparation and posting of interest (adequate/inadequate).

Page 1
Factoring
INTRODUCTION The factoring agreement should set limits on the

amount of overadvances available at any one
Factoring is the purchase, essentially without time, generally based on specified collateral,
recourse, of the accounts receivable of a client such as the client’s inventory. The relationship
by a bank (the factor). Generally, factor clients to inventory is based on the premise that the
are small, undercapitalized companies or start-up inventory will be sold, thus generating receiv-
firms with limited liquidity that generally do not ables that the factor has contracted to purchase.
qualify for more traditional bank financing. In Proceeds from the factored receivables resulting
contrast to accounts receivable financing, where from the sale of inventory are then used to repay
the client retains the credit and collection risk the overadvance. If the overadvance is unse-
associated with the receivables, factoring trans- cured, it should be offset by a corresponding
fers these risks to the factor. For the client, the reduction in the ‘‘client’s equity.’’ The factor’s
principal advantage of factoring is the assurance income statement will show factoring com-
that it will receive the proceeds of its sales, missions, which represent the discount on the
regardless of whether the factor is paid. Further- receivables purchased, as income. Interest income
more, the client does not have to maintain a for advances on the due-to-client balances may
credit department to evaluate the creditworthi- or may not be a separate line item.
ness of customers, collect past-due accounts, or Since factoring is a highly competitive indus-
maintain accounting records on the status of try, price cutting has reduced factoring commis-
receivables. The factor assumes these responsi- sions to the point that they provide minimal
bilities. An additional advantage for the client is support to a factor’s earnings. As a result,
that under the terms of an ‘‘advance factoring’’ interest margins on factoring advances represent
arrangement, the client receives payment for its an increasingly important part of a factor’s net
receivables before the time stated on the invoice. income. An analysis of proportional changes in
Two basic types of factoring service offered the due-to-clients account should provide valu-
by the industry are (1) maturity factoring and able insight into the analysis of the earnings of
(2) advance factoring. In maturity factoring, an a bank’s factoring activities. As more clients
average maturity due date is computed for the take advances (reducing due-to-clients), profit
receivables purchased within a given time period, margins should widen. Conversely, as the due-
and the client receives payment on that date. to-clients proportion of total liabilities rises,
Advance factoring is computed in the same way; profit margins may be expected to narrow.
however, the client has the option of taking a
percentage of the balance due on a receivable in
advance of the computed average maturity due
date. The remainder of the receivable, some- FACTORING AGREEMENT,
times called the ‘‘client’s equity,’’ is payable on APPROVAL PROCEDURES, AND
demand at the due date. EXAMINER’S EVALUATION
The typical factoring agreement stipulates that
all of a client’s accounts receivable are assigned
ACCOUNTING FOR FACTORING to the factor. However, the agreement between
the factor and the client will usually state that
The factor’s balance sheet reflects the purchased receivables subject to shipping disputes and
accounts receivable as an asset account, ‘‘fac- errors, returns, and adjustments are chargeable
tored receivables,’’ with ‘‘due to clients’’ as the back to the client because they do not represent
corresponding liability. Usually, the balance of bona fide sales. The agreement will, in most
due-to-clients will be less than the factored instances, require that a reserve be established
receivables because of payments and advances against the purchased receivables to ensure the
to the clients. If, however, the factor makes factor’s access to funds for any future charge-
advances to the client in amounts that exceed back adjustments.
amounts due to the client, the advances will be The usual approval process requires the client
shown as ‘‘overadvances.’’ Overadvances are to contact the factor’s credit department before
common and usually secured by other collateral. filling a sales order on credit terms. The credit

Page 1
2180.1 Factoring
department conducts a credit review, determines tions, such as overadvances and amounts
the creditworthiness of the customer, and advanced at the client’s risk, for which the
approves or rejects the sale. If the credit depart- account officers are responsible.
ment rejects the sale, the client may complete
the sale, but at its own risk. The most commonly
rejected sales are those to affiliates, known
bad risks, customers whose credit cannot be
CREDIT DEPARTMENT
verified, and customers whose outstanding pay- EVALUATION
ables exceed the factor’s credit line to that
customer. Sales made by the client without the Because of its integral function in the credit
factor’s approval are considered client-risk and collection process, the credit department is
receivables, and the factor has full recourse to the heart of a factoring operation. The depart-
the client. ment should maintain a credit file for each of its
Once a sale has been made and the receivable client’s customers, and these files should be
assigned to the factor, whether or not the factor continually updated as purchases are made and
has approved it, the client’s account will be paid for by the customers. These files should
credited for the net invoice amount of the sale. include financial statements, credit bureau reports,
Trade or volume discounts, early payment terms, and details of purchasing volume and paying
and other adjustments are deducted from the habits. Each customer should have an assigned
invoice amount. The receivable then becomes credit line based on the credit department’s
part of the client’s ‘‘availability’’ to be paid review of the customer’s credit capacity.
immediately or at the computed date, depending The objective of a credit department evalua-
on the basis of the factoring arrangement. tion is to critique the credit and collection
Each month the client receives an ‘‘accounts- process and to assess departmental effective-
current’’ statement from the factor, which details ness. The examiner should have a copy of
daily transactions. This statement reflects the departmental policies and procedures as well as
daily assignments of receivables, remittances a verbal understanding of them before beginning
made (including overadvances and amounts the review. The factor’s policies should include,
advanced at the client’s risk), deductions for at a minimum, well-defined field audit proce-
term loans, interest charges, and factoring com- dures, a fraud detection and monitoring plan,
missions. Credit memos, client-risk charge- and a computer back-up plan. Customer files
backs, and other adjustments will also be shown. selected for review may be drawn from large
Client-risk charge-backs are the amounts and closely monitored customers, or they may
deducted from the remittances to the client be selected by a random sample.
resulting from the failure of the client’s custom-
ers to pay receivables that were advanced at the
client’s risk. ASSET EVALUATION
The accounts-current statement and the avail-
ability sheets are necessary for analyzing asset The asset evaluation is a twofold process. The
quality. The factor’s ability to generate these first part is to evaluate credit accommodations
reports daily is a basic control feature. Account- to each client. The second part is to evaluate
ing systems for a high-volume operation prob- customer receivables purchased by the factor
ably will be automated, providing the factor at its own risk. For the first part of the process,
with the data necessary to properly monitor the the examiner should obtain a list that shows
client. If a monitoring system is in place, the the aggregate of each client’s credit exposure
examiner should use the data provided in the to the factor, both direct and indirect, including
asset analysis process. overadvances and receivables purchased at
The evaluation of a factoring operation the client’s risk. For the second part of the
includes a review of its systems and controls as process, the examiner should obtain an aging
well as an analysis of the quality of its assets. A schedule of factored receivables aggregated
major portion of a factor’s assets will be fac- by customer but net of client-risk receivables.
tored receivables, for which the credit depart- The selection of clients and customers for review
ment has the responsibility for credit quality and should be based on the same selection methods
collection. The other major portion of assets will as those used for the commercial loan review.
consist of client loans and credit accommoda- Clients with a high ‘‘dilution’’ of receivables

Page 2
Factoring 2180.1
(that is, customer nonpayment due to returns, CLASSIFICATION GUIDELINES

shipping disputes, or errors) and those with
client-risk receivables equal to 20 percent When classifying the credit exposure to a client,
or more of factored volume might also be the client-risk receivables portion of factored
selected for review. Past-due factored volume volume is the only amount subject to classifica-
is not a meaningful measure of client quality tion. Because of the recourse aspect, the balance
because a factor usually collects principal is considered an indirect obligation rather than a
and interest payments directly from the client’s direct obligation. Any other credit accommoda-
availability. tions to a client that are not included in factored
A maturity client’s availability is the sum of receivables, such as overadvances or term loans,
all factored receivables less trade and other are also subject to classification. Customer
discounts, factoring commissions, client-risk receivables purchased by the factor at its own
charge-backs, and other miscellaneous charges risk are subject to classification. Care should be
to the client’s account. There may also be taken not to classify any receivables that have
deductions for letters of credit and other credit already been classified under client-risk expo-
accommodations. An advance client’s availabil- sure. Seasonal aspects of clients’ businesses
ity would be further reduced by advances on the should be carefully analyzed in assessing asset
factored receivables, interest charges, and the quality based on classification data.
reciprocal of the contractually agreed-upon
‘‘advance’’ percentage. This reciprocal, 20 per-
cent in the case of a client who receives an
80 percent advance, is sometimes referred to as
CONCLUSION
the client’s equity in the factored receivables. Due to the large volume of daily transactions
Availability may be increased by liens on addi- that typically flows through a factor, any internal
tional collateral, such as inventory, machinery control procedure that can be easily circum-
and equipment, real estate, and other marketable vented is a potential problem. The review of the
assets. department’s internal systems and controls
A client’s balance sheet will show a ‘‘due- should be continuous throughout the examina-
from-factor’’ account instead of accounts receiv- tion. This review should include credit controls
able. The account balance may be somewhat for both clients and customers. Since credit
lower than a normal receivables balance, thus problems can develop rapidly in factoring,
distorting turnover ratios and other short-term credit controls and systems must be responsive
ratios. A client can convert sales to cash faster to the identification of these problems. Earnings
with a factor than if it collected the receivables. and capital adequacy are evaluated based on
The statement analysis should consider the the department’s own performance. The factor-
client’s ability to repay any advances received ing department’s earnings trends may be evalu-
from the factor in the form of overadvances, ated by comparing the yield on assets for vari-
term loans, or other credit accommodations. ous periods. Factors are subject to the same
The analysis should also assess the client’s price competition in the commercial finance
ability to absorb normal dilution and the poten- market as accounts receivable financiers. Declin-
tial losses associated with client-risk receiving portfolio yields may reflect competitive
ables, particularly when these elements are pressures and may portend declining future
unusually high. profitability.

Page 3
Factoring
dures, and internal controls for factoring are audit function.
adequate. 5. To determine compliance with applicable
3. To evaluate the portfolio for performance, practices, procedures, or internal controls are
credit quality, collectibility, and collateral deficient or when violations of laws or regu-
sufficiency. lations have been noted.

Page 1
Factoring
1. If selected for implementation, complete or l. Current fee schedule.

update the Factoring section of the Internal m. Any useful information obtained
Control Questionnaire. from the review of the minutes of the
2. Based on the evaluation of internal controls loan and discount committee or any sim-
and the work performed by internal/external ilar committees.
auditors, determine the scope of the n. Reports furnished to the board of directors.
examination. o. Any other management reports main-
3. Test for compliance with policies, practices, tained by the factoring department.
procedures and internal controls in conjunc- 6. After consulting with the examiner-in-
tion with performing the remaining exami- charge, determine the appropriate cut-off
nation procedures. Also obtain a listing of lines for:
any deficiencies noted in the latest reviews a. Client’s aggregate direct liability (i.e.,
done by internal/external auditors, and overadvances, term loans and other credit
determine if appropriate corrections have accommodations).
been made. b. Client’s indirect liability (i.e., client-risk
4. Obtain a trial balance(s) of applicable asset exposure).
and liability accounts and: c. Customer’s factored receivables not
a. Agree or reconcile balances to depart- including those in 6b above.
ment controls and general ledger. 7. Transcribe information to line cards for
b. R e v i e w r e c o n c i l i n g i t e m s f o r all client and customer credits over the
reasonableness. cut-off limits, for all credits recognized as
5. Obtain the following information: problems, and for credits classified at the
a. A list of all clients with their outstanding previous examination.
balances including total factored receiv- 8. Cross reference clients and customers with
ables with those purchased at the client’s the examiners assigned to other loan areas
risk segregated, overadvances, term loans for common borrowers, and together decide
and other credit accommodations. who will review the borrowing relationship.
b. If not included in 5a above, a list of 9. Obtain credit files for all clients and cus-
amounts due to each client by the factor tomers for whom line cards were prepared
(availability reports). and analyze the accounts by performing the
c. Aging schedules of factored receivables following procedures:
by client and by customer with client risk a. Analyze balance sheet and profit and loss
receivables segregated. items as reflected in current and preced-
d. Past due status reports for 5c, above. ing financial statements, determine the
e. Listings of all clients and customers existence of any favorable or adverse
considered to be problems. trends.
f. Credits classified at the previous b. Review components of the balance sheet
examination. as reflected in the current financial state-
g. Concentration reports by client and by ments and determine the reasonableness
customer. of each item as its relates to the total
h. Exception reports highlighting dilution financial structure.
of factored receivables because of ship- c. Review supporting information for the
ping disputes and errors, returns, or any major balance sheet items and the
other adjustments. techniques used in consolidation, if
i. Credit commitments/lines for each client applicable, and determine the primary
including amounts for overadvances and sources of repayment and evaluate their
receivables purchased at the client’s risk. adequacy.
j. Credit lines for each customer. d. Compare the amount of the credit line(s)
k. Specific lending policy guidelines with the lending officer’s authority.
including each officer’s current lending e. Determine compliance with the bank’s
authority. established commercial loan policy.

Page 1
2180.3 Factoring: Examination Procedures
In addition to the above procedures which b. Violations of laws and regulations.

are applicable to both client and customer c. Accounts not supported by current and
accounts, the following additional proce- complete financial information or on
dures should be performed for client accounts which other documentation is deficient.
only: d. Concentrations of credit.
e. Criticized accounts.
f. Determine compliance with provisions f. Other matters regarding condition of asset
of factoring agreements. quality.
g. Review digest of officers’ memoranda, 12. Evaluate the factoring department with
mercantile reports, credit checks and cor- respect to:
respondence to determine the existence a. The adequacy of written policies relating
of any problems which might deter the to factoring.
contractual program as set forth in the b. The manner in which bank officers are
factoring agreement. operating in conformance with estab-
h. Relate collateral values to outstanding lished policy.
debt. c. Adverse trends within the factoring
i. Compare fees charged to the fee sched- department.
ule and determine that the terms are d. Internal control deficiences or exceptions.
within established guidelines. e. Recommended corrective action when
j. Analyze secondary support afforded by policies, practices or procedures are
guarantors and endorsers. deficient.
10. Perform appropriate procedural steps f. The competency of departmental
in Concentration of Credits section, if management.
applicable. g. Other matters of significance.
11. Discuss with appropriate officer(s) and pre- 13. Update the workpapers with any informa-
pare summaries in appropriate report form tion that will facilitate future examinations.
of:
a. Delinquent amounts, segregating those
considered ‘‘A’’ paper.

Page 2
Factoring
Review the bank’s internal controls, policies, b. Handle cash?

practices and procedures for its factoring oper- *4. Are the subsidiary factoring records rec-
ation. The bank’s system should be documented onciled, at least monthly, to the appropri-
in a complete and concise manner and should ate general ledger accounts, and reconcil-
include, where appropriate, narrative descrip- ing items investigated by persons who do
tions, flowcharts, copies of forms used and other not also handle cash?
pertinent information. Items marked with an 5. Are accounts current statements, delin-
asterisk require substantiation by observation or quent account collection requests, and past-
testing. due notices checked to the trial balances
that are used in reconciling subsidiary
records of factoring accounts with general
POLICIES ledger accounts, and handled only by per-
sons who do not also handle cash?
1. Has the board of directors, consistent with 6. Are inquiries about factored balances
its duties and responsibilities, adopted writ- received and investigated by persons who
ten factoring policies that: do not also handle cash?
a. Establish procedures for reviewing fac- *7. Are documents supporting recorded credit
toring agreements? adjustments to factored receivable accounts
b. Establish standards for determining cli- and the due-to-clients accounts checked or
ent credit lines for each of the various tested subsequently by persons who do not
types of accommodations available (i.e., also handle cash (if so, explain briefly)?
factored receivables, client-risk receiv- 8. Are proper records maintained for approval
ables, overadvances, term loans, etc.)? of:
c. Establish standards for determining indi- a. Customer orders?
vidual customer limits? b. Client credit accommodations?
d. Require a client to contact the factor for 9. Are items, dates, weights, description of
approval before filling a sales order on merchandise, etc., shown on invoices, ship-
credit terms? ping documents, delivery receipts, and
e. Establish standards for approving the bills of lading scrutinized for differences?
sales orders referred to above. 10. Are procedures in effect to determine if the
f. Establish standards for determining the signatures shown on the above documents
percentage of advance that will be are authentic?
made against acceptable receivables in 11. Are payments from customers scrutinized
advance factoring arrangements? for differences in invoice dates, numbers,
g. Establish standards for determining terms, etc.?
the discount on factored receivables
and the interest rate or fee charged for
other credit accommodations?
h. Establish minimum standards for INTEREST AND FEES
documentation?
2. Are factoring policies reviewed at least *12. Is the preparation and posting of discount,
annually to determine if they are compat- interest, and fee records performed or
ible with changing market conditions? reviewed by persons who do not also:
a. Issue official checks and drafts singly?
b. Handle cash?
INTERNAL CONTROL 13. Are independent discount, interest and fee
computations made and compared or tested
*3. Is the preparation and posting of subsidi- to initial records by persons who do not
ary factoring records performed or re- also:
viewed by persons who do not also: a. Issue official checks and drafts?
a. Issue official checks and drafts? b. Handle cash?

Page 1
2180.4 Factoring: Internal Control Questionnaire
COLLATERAL CONCLUSION
*14. Does the bank record, on a timely basis, a 18. Is the foregoing information an adequate
first lien on the assigned receivables for basis for evaluating internal control in that
each borrower? there are no significant deficiencies in
15. Does the bank verify the borrower’s areas not covered in this questionnaire that
accounts receivable or require independent impair any controls? Explain negative
verification on a periodic basis? answers briefly, and indicate any addi-
16. Does the bank review aged accounts re- tional examination procedures deemed
ceivable schedules on a regular basis? necessary.
17. If applicable, are cash receipts and invoices 19. Based on a composite evaluation as evi-
block proved in the mailroom and subse- denced by answers to the foregoing
quently traced to posting on daily transac- questions, internal control is considered
tion records? (adequate/inadequate).

Page 2
Bank Premises and Equipment
Bank premises and equipment includes land, ensure that these assets are properly safeguarded
buildings, furniture, fixtures, and other equip- and appropriately recorded on the bank’s books.
ment, either owned or acquired by means of a Controls should be in place to inventory these
capitalized lease, and any leasehold improve- assets and periodically review their economic
ments. This section covers the fair valuation, usefulness. Furniture, fixtures, and equipment
general propriety, and legality of the bank’s whose economic usefulness has expired or that
investment in premises and equipment. Other are otherwise damaged, impaired, or obsolete
real estate owned and insurance coverage on should be written down to value. Assets that
fixed assets are discussed in other sections of cannot be located should be accounted for as a
this manual. (See sections 2200.1 and 4040.1, loss.
respectively.
LEASES
ACQUISITION AND VALUATION
Banks frequently lease their premises and equip-
Banks obtain premises and equipment in three ment rather than own them. Leases should be
primary ways: accounted for in accordance with Financial
Accounting Standards Board Statement No. 13
• directly purchasing premises and equipment (FAS 13), ‘‘Accounting for Leases.’’ FAS 13
with cash outlays or by incurring debt, such as requires, among other things, that the lessee
a mortgage capitalize certain leases. The instructions for the
• indirectly investing in a corporation that holds preparation of Reports of Condition and Income
title to bank premises (the corporation may or detail the capitalization of leases and specify
may not be affiliated with the bank) treatment for leases entered into before 1977. If
• leasing bank premises and equipment from a a lease is required to be capitalized, the lessee
third party records a capital lease as an asset and a corre-
sponding liability. The amount capitalized would
The bank’s initial investment in premises and be the present value of the minimum required
equipment should be booked at cost, which payments over the noncancelable term, as
should be determined according to generally defined, of the lease, plus the present value of
accepted accounting principles (GAAP). Non- the payment required under the bargain-purchase
depreciable assets such as land and art should option, if any, less any portion of the payments
remain on the books at cost, unless the asset representing executory expenses such as insur-
incurs a material and permanent decline in ance, maintenance, and taxes to be paid by the
value. Under such circumstances, the asset lessor. The amortization period should be the
should be reduced to fair market value on the life of the lease or a period established in a
books, and a loss should be recorded. manner consistent with the lessee’s normal
The bank should depreciate assets that, over schedule of depreciation for owned assets. The
time, decline in economic value. These assets requirements of FAS 13 are somewhat complex,
may be depreciated differently for book and tax and examiners who have questions on the capi-
purposes, which may give rise to deferred tax talization of leases are referred to that statement
implications. GAAP allows depreciation using for necessary detail. Leases not required to be
methods such as straight-line, double-declining, capitalized are called ‘‘operating leases,’’ and
or sum-of-years’-digits. The Internal Revenue lease payments associated with them are charged
Service allows accelerated depreciation methods to expense over the term of the lease as they
for many assets to encourage businesses to make become payable.
capital investments. While many banks follow Lease arrangements between a state member
these accelerated schedules for tax purposes, bank and its parent company or other affiliated
they may not depreciate these same assets as entity should be reviewed in detail. Examiners
rapidly for book purposes. should ensure that the lease arrangement is
Examiners should closely review internal con- reasonable in relation to the cost of the asset, its
trols for the bank’s premises and equipment to current fair market value, or similar lease

Page 1
2190.1 Bank Premises and Equipment
arrangements in the current market. Transac- Member banks are encouraged to plan for
tions that appear to be self-serving or otherwise their future premises needs. However, examin-
unreasonable to the bank should be criticized. ers should not arbitrarily classify real estate
acquired for future use. The examiner needs to
review the circumstances surrounding each
INVESTMENT IN BANK individual case and determine if the period of
time which the property has been held is rea-
PREMISES sonable relative to the intended use. Real estate
Investment in bank premises is limited by sec- acquired for future expansion is considered
tion 24A of the Federal Reserve Act, as amended ‘‘other real estate owned’’ from the date when
by the Economic Growth and Regulatory Paper- its use for banking is no longer contemplated. In
work Reduction Act of 1996. Section 208.21 of addition, former banking premises are consid-
Regulation H sets forth the Board’s rule on ered other real estate owned from the date of
investment limits for bank premises. Except as relocation to new banking quarters.
discussed below, no state member bank is per-
mitted to invest in bank premises or in the stock,
bonds, debentures, or other such obligations of
any corporation holding the premises of the TRANSACTIONS WITH INSIDERS
bank or make loans to or upon the security of
any such corporation (collectively, investments If a member bank contracts for or purchases any
in bank premises). securities or other property from any of its
A well-rated and well-capitalized bank may directors, any firm its directors are members of,
invest an amount that is 150 percent or less of or any of its affiliates, the transaction is subject
the amount of (1) its perpetual preferred stock to the requirements of sections 22(d) and 23B
and related surplus and (2) its common stock of the Federal Reserve Act. These sections
and surplus, provided it gives the appropriate require that transactions be made in the regular
Reserve Bank at least 15 days’ notice before course of business on terms not less favorable to
making such an investment, and the bank has the bank than those offered to others. When the
not received a notice that the investment is purchase is authorized by a majority of the
subject to further review by the end of that board of directors who have no interest in the
15-day notice period. State member banks that sale of such securities or property, the authority
have a CAMELS rating of 1 or 2 (as of the most should be evidenced by affirmative vote or
recent examination of the bank),1 and that are, written assent. In addition, a member bank may
and will continue to be, well capitalized, may sell securities or other property to any of its
make such investments without notice to the directors subject to the same stipulations.
Board. Banks that are not well capitalized or
well rated may have investments in bank prem-
ises only up to 100 percent or less of those
amounts, and only with the prior notice indi- EXAMINATION
cated above. CONSIDERATIONS
When considering the approval of domestic-
branch applications, the Board follows the guide- As indicated earlier, the examiner responsible
lines detailed in section 208.6(b) of Regulation for bank premises and equipment should assess
H. The Board will analyze whether the bank’s the appropriateness of the bank’s investment in
investment in premises for the branch is consis- this area and the overall impact of occupancy
tent with section 208.21 of Regulation H. expense on the bank. Even if a bank’s total
Reserve Banks, under their delegated authority, investment in bank premises is within legal
can also perform this analysis. limits and all of its fixed assets are valued fairly,
its total expenditures for or investment in prem-
1. Alternatively, the state member bank may have an
equivalent rating under a comparable rating system, also as
ises and equipment may be inappropriate rela-
defined in the FFIEC Consolidated Reports of Condition and tive to earnings, capital, or the nature and
Income. volume of the bank’s operations.

Page 2
cedures, and internal controls regarding bank regulations.
premises and equipment are adequate. 6. To initiate corrective action when policies,
2. To determine if bank officers and employees practices, procedures, or internal controls are
are operating in conformance with the estab- deficient or when violations of laws or regu-
lished guidelines. lations have been noted.
audit function.
4. To determine the adequacy and propriety of
the bank’s present and planned investment in
bank premises.

Page 1
1. If selected for implementation, complete or it equals or exceeds l percent of total

update the Bank Premises and Equip- operating revenues.
ment section of the Internal Control • If rental income is material, analyze
Questionnaire. the bank’s potential exposure from:
2. Based on the evaluation of internal controls — Concentrations among lessees.
and the work performed by internal/external — Impending expiration of major
auditors (see separate program) determine leases.
the scope of the examination. — Lack of creditworthiness of lessee.
3. Test for compliance with policies, practices, — Non-compliance with lease terms.
procedures and internal controls in conjuc- 8. Forward to the examiner assigned ‘‘Funds
tion with performing the remaining exami- Management:’’
nation procedures. Also obtain a listing of a. The total minimum annual commitment
any audit deficiencies noted in the latest under various lease agreements.
review done by internal/external auditors b. The dollar amount of any significant,
from the examiner assigned ‘‘Internal future fixed asset expenditure(s).
Control,’’ and determine if appropriate 9. Determine, by reference to appropriate work-
corrections have been made. papers (see ‘‘Insurance Coverage’’), that
4. Obtain a summary of changes in fixed asset fire and hazard insurance, in sufficient
and depreciation ledgers that have occurred amounts, is in force.
since the previous examination. Also, bal- 10. Perform a limited test of the records to
ance each of the fixed asset subsidiary verify that depreciation methods are consis-
accounts to the appropriate general ledger tent with bank policy, prior years’ calcula-
control account. tions, generally accepted accounting princi-
5. Determine, by reference to excerpts of the ples, and applicable IRS laws.
minutes of meetings of the board of direc- 11. Analyze the bank’s investment in fixed
tors, that all major additions and disposals assets and the annual expenditures required
of fixed assets are properly documented. to carry them and determine their reason-
6. Determine by observation and inquiry of ableness relative to:
appropriate management personnel, that the a. Present total capital structure.
bank’s books have been properly adjusted b. Present annual earnings.
to reflect significant assets that are idle, c. Projected future earnings.
abandoned, or useless.
d. Nature and volume of operations.
7. In instances where bank premises are sub- 12. Test for compliance with the limitations set
ject to lease, perform the following for: forth in section 24A of the Federal Reserve
a. Bank as lessee: Act.
• For each lease which has an initial 13. Review the following with appropriate man-
lease period of more than one year, agement personnel or prepare a memo to
obtain from the bank: other examiners for their use in reveiwing
— Name of lessor. with management:
— Expiration date. a. Any internal control deficiencies.
— Required minimum annual b. Any policy deficiencies.
payments. c. Any violations of law.
— Current status. 14. Review your findings with respect to the
— Renewable option provisions. propriety and adequacy of present and pro-
b. Bank as lessor: jected investment in bank premises. In for-
• Determine if the bank relies on rental mulating your conclusion, consider:
income to contribute to payment of a. Size of bank.
occupancy expenses and if that income b. Cash flow forecasts.
is material. As a general guideline, c. Existing fixed asset investments.
rental income is considered material if d. Anticipated growth potential.

Page 1
2190.3 Bank Premises and Equipment: Examination Procedures
e. Bank programs to maintain assets at their 15. Prepare comments regarding deficiencies or
most optimal use. violations of law for inclusion in the exam-
f. The policy used to establish the useful ination report.
life of each asset.
16. Prepare the appropriate write-ups for the
g. Control of inventory procedures.
report of examination.
h. Systems used to record all asset pur-
chases, sales and retirements between 17. Update workpapers with any information
physical inventories. that will facilitate future examinations.

Page 2
Review the bank’s internal controls, policies, 7. Do the bank’s procedures provide for
practices and procedures over additions, sales signed receipts for removal of equipment?
and disposals and depreciation of bank premises *8. Do the bank’s policies cover procedures
and equipment. The bank’s system should be for selecting a seller, servicer, insurer, or
documented in a complete and concise manner purchaser of major assets (through com-
and should include, where appropriate, narrative petitive bidding, etc.), to prevent any
descriptions, flowcharts, copies of forms used possibility of conflict of interest or self-
and other pertinent information. Items marked dealing?
with an asterisk require substantiation by obser- 9. Do the review procedures provide for
vation or testing. appraisal of an asset to determine the
propriety of the proposed purchase or sales
price?
CUSTODY OF PROPERTY
*1. Do the bank’s procedures preclude per- DEPRECIATION
sons who have access to property from
having ‘‘sole custody of property,’’ in that: *10. Is the preparation, addition and posting of
a. Its physical character or use would periodic depreciation records performed
make any unauthorized disposal readily and adequately reveiwed by persons who
apparent? do not also have sole custody of property?
b. Inventory control methods sufficiently 11. Do the bank’s procedures require that
limit accessibility? regular charges be made for depreciation
expense?
*12. Are the subsidiary depreciation records
ADDITIONS, SALES, AND balanced, at least annually, to the appro-
DISPOSALS priate general controls by persons who do
not also have sole custody of property?
2. Is the addition, sale or disposal of property
approved by the signature of an officer
who does not also control the related PROPERTY RECORDS
disbursement or receipt of funds?
3. Is board of directors’ approval required for *13. Are subsidiary property records posted by
all major additions, sales or disposals of persons who do not also have sole custody
property (if so, indicate the amount that of property?
constitutes a major addition, sale or dis- *14. Are the subsidiary property records bal-
posal $ )? anced, at least annually, to the appropriate
*4. Is the preparation, addition and posting of general ledger accounts by persons who do
property additions, sales and disposals not also have sole custody of property?
records, if any, performed and/or ade-
quately reviewed by persons who do not
also have sole custody of property?
*5. Are any property additions, sales and dis- BANK AS LESSOR (BANK
posals records, balanced, at least annually, PREMISES AND BANK-RELATED
to the appropriate general controls by per- EQUIPMENT ONLY)
sons who do not also have sole custody of
property? *15. Do policies provide for division of the
6. Are the bank’s procedures such that all duties involved in billing and collection of
additions are reviewed to determine whether rental payments?
they represent replacements and that any 16. Are the lease agreements subject to the
replaced items are cleared from the same direct verification program applied
accounts? to other bank assets and liabilities?

Page 1
2190.4 Bank Premises and Equipment: Internal Control Questionnaire
17. Are credit checks performed on potential differences from property records investi-
lesses? gated by persons who do not also have sole
18. Do policies provide for a periodic review custody of property?
of lessees for undue concentrations of 23. Do the bank’s procedures provide for
affiliated or related concerns? serial numbering of equipment?
24. Are the bank’s policies and procedures on
property in written form?
BANK AS LESSEE (BANK 25. Is the benefit of expert tax advice obtained
PREMISES AND BANK-RELATED prior to final decision-making on signi-
EQUIPMENT ONLY) ficant transactions involving fixed assets?
*26. Does the bank maintain separate property
19. Does the bank have a clearly defined files which include invoices (including
method of determining whether fixed assets settlement sheets and bills of sale, as
should be owned or leased, and is support- necessary), titles (on real estate, vehicles,
ing documentation maintained by the bank? etc.) and other pertinent ownership data as
20. Are procedures in effect to determine part of the required documentation?
whether a lease is a ‘‘capital’’ or an
‘‘operating’’ lease as defined by the gen-
erally accepted accounting principles? CONCLUSIONS
21. Do the bank’s operating procedures pro-
vide, on ‘‘capital’’ leases, that the amount 27. Is the foregoing information an adequate
capitalized is computed by more than one basis for evaluating internal control in that
individual and/or reviewed by an indepen- there are no significant additional deficien-
dent party? cies that impair any controls? Explain
negative answers briefly, and indicate any
additional examination procedures deemed
OTHER PROCEDURES necessary.
28. Based on a composite evaluation, as evi-
*22. Is the physical existence of bank equip- denced by answers to the foregoing
ment periodically checked or tested, such questions, internal control is considered
as by a physical inventory, and are any (adequate/inadequate).

Page 2
Other Real Estate Owned
A state member bank’s authority to hold real absence of a clear title in the bank’s name
estate is governed by its state laws. A bank is notwithstanding. Generally, the more involved
permitted to include owned real estate in its bank management is in such activity, the greater
premises account if the real estate serves as the bank’s exposure to any future clean-up costs
premises for operations or is intended to be used assessed in connection with the property. A
as premises. In addition, a bank may hold other more thorough discussion of environmental lia-
real estate owned (OREO), which is defined bility can be found in section 2040.1, ‘‘Loan
below. State laws dictate the terms and condi- Portfolio Management,’’ of this manual, under
tions under which state-chartered banks may the subsection ‘‘Other Lending Concerns.’’
acquire and hold OREO.
Transfer of Assets to Other Real

Definition Estate Owned
Bank holdings of OREO arise from the follow-
Real estate assets transferred to OREO should
ing events:
be accounted for individually on the date of
transfer, at the lower of the recorded investment
• the bank purchases real estate at a sale under
in the loan or fair value. The recorded invest-
judgment, decree, or mortgage when the prop-
ment in a loan is the unpaid balance, increased
erty secured debts previously contracted;
by accrued and uncollected interest, unamor-
• a borrower conveys real estate to the bank to
tized premium, finance charges, and loan-
fully or partially satisfy a debt previously
acquisition costs, if any, and decreased by pre-
contracted (acceptance of deed in lieu of
vious write-downs and unamortized discount, if
foreclosure);
any. Any excess of the recorded investment in
• real estate is obtained in exchange for future
the loan over the property’s fair value must be
advances to an existing borrower to fully or
charged against the allowance for loan and lease
partially satisfy debts previously contracted;
losses immediately upon the property’s transfer
• a bank takes possession (although not neces- to OREO. Legal fees should generally be charged
sarily title) of collateral in a collateral- to expenses unless payment of the fees is for the
dependent real estate loan (i.e., an in-substance purpose of enhancing the property’s value (for
foreclosure); example, obtaining a zoning variance).
• a bank has relocated its premises and has not
yet sold the old premises; Establishing a valuation allowance for esti-
mated selling expenses may also be necessary
• a bank abandons plans to use real estate as
upon transferring each property to OREO to
premises for future expansion.
comply with AICPA Statement of Position 92-3,
Accounting for Foreclosed Assets. According to
this pronouncement, the value of OREO prop-
Environmental Liability erties must be reported at the lesser of the fair
value minus estimated selling expenses or the
Under federal and state environmental liability recorded investment in the loan. For example, if
statutes, a bank may be liable for cleaning up the recorded investment of the property is $125,
hazardous substance contamination of other real the fair value is $100, and the estimated selling
estate owned. In some cases, the liability may expenses are $6, the carrying value for this
arise before the bank takes title to a borrower’s property would be $94. The difference between
collateral real estate. A property’s transition the recorded investment and the fair value ($25)
from collateral to bank ownership may take an would be charged to the allowance for loan and
extended period of time. As the financial prob- lease losses at the time the property was trans-
lems facing a borrower worsen, a bank may ferred to OREO. In addition, since the bank
become more involved in managing a company estimated it would incur selling expenses of $6,
or property. Such involvement may become a valuation reserve for this amount must be
extensive enough that the bank is deemed to established. The net of the fair value and this
have met substantially all ownership criteria, the valuation reserve for selling expenses is called

Page 1
2200.1 Other Real Estate Owned
the ‘‘net realizable value,’’ and in this example definition of value and the market conditions
would be $94. Changes to this valuation reserve that have been considered in estimating the
should be handled as outlined in the subsection property’s value.
‘‘Accounting for Subsequent Changes in Market When a bank acquires a property through
Value.’’ foreclosure as a junior lienholder, whether or not
On the other hand, if the recorded investment the first lien has been assumed, the fair value of
in the property is $250, the fair value is $300, the property should be recorded as an asset and
and the estimated selling expenses are $18, the the senior debt as a liability. The senior debt
carrying value of this property would be $250 should not be netted against the assets. Any
(the lesser of the recorded investment or the fair excess of the recorded investment of the prop-
value). In this example, a valuation reserve for erty over the fair value should be charged off, as
estimated selling expenses is unnecessary, as the recorded investment may not exceed the sum
netting the estimated selling expenses ($18) of the junior and senior debt. Payments made on
from the fair value ($300) would yield a net senior debt should be accounted for by reducing
realizable value of $282. both the asset and the liability, and interest that
The transfer of a loan to OREO is considered accrues on the senior debt after foreclosure
to be a ‘‘transaction involving an existing exten- should be recognized as interest expense.
sion of credit’’ under 12 CFR 225.63(a)(7) and For regulatory reporting purposes, a collateral-
is exempt from Regulation Y’s appraisal require- dependent real estate loan should be transferred
ment. However, under 12 CFR 225.63(b), the to OREO only when the lender has taken pos-
bank must obtain an ‘‘appropriate evaluation’’ session (title) of the collateral. Nevertheless, to
of the real estate that is ‘‘consistent with safe facilitate administration and tracking, banks may
and sound banking practices’’ to establish the choose to include a collateral-dependent real
carrying value of the OREO. A bank may elect, estate loan in the OREO portfolio as potential or
but is not required, to obtain an appraisal to probable OREO. Examiners should review these
serve as the ‘‘appropriate evaluation.’’ Until the loans using the same criteria applied to OREO.
evaluation is available, a bank should rely on its Property the bank originally acquired for
best estimate of the property’s value to establish future use as premises, but for which plans have
the carrying value. The federal banking agencies been abandoned, and property that formerly
have issued appraisal and evaluation guidelines served as bank premises, should be accounted
to provide guidance to examining personnel and for at the lower of book value or fair value on
federally regulated institutions regarding pru- the date of transfer to OREO. Any excess of
dent appraisal and evaluation policies, proce- book value over fair value should be charged to
dures, practices, and standards. other operating expense during the current
The appraisal or evaluation should provide an period.
estimate of the parcel’s market value. Refer to
section 4140.1, ‘‘Real Estate Appraisals and
Evaluations,’’ for a definition of market value.
Generally, market value and fair value are Carrying Value of Other Real Estate
equivalent when an active market exists for a Owned
property. In discussing OREO, it is common
practice to use the terms ‘‘fair value’’ and A bank should have a policy for periodically
‘‘market value’’ interchangeably. When no active determining the fair value of its OREO property
market exists for a property, the accounting by obtaining an appraisal or an evaluation, as
industry’s definition of fair value applies because appropriate. While the Federal Reserve has no
the appraiser cannot determine a market value. prescribed time frame for when a bank should
The accounting industry definition requires the reappraise or reevaluate its OREO property, the
appraisal or evaluation to contain an estimate of bank’s policy should conform to state law, if
the property’s fair value based on a forecast of applicable, and address the volatility of the local
expected cash flows, discounted at a rate com- real estate market. Specifically, a bank should
mensurate with the risks involved. The cash determine if there have been material changes to
flow estimate should include projected revenues the underlying assumptions in the appraisal or
and the costs of ownership, development, opera- valuation that have affected the original estimate
tion, marketing, and sale. In such situations, the of value. If material changes have occurred, the
appraiser or evaluator should fully describe the bank should obtain a new appraisal or evalua-

Page 2
Other Real Estate Owned 2200.1
tion based on assumptions that reflect the recorded investment, a valuation reserve for
changed conditions. estimated selling expenses was established. In
this example, assume these to be $6. Accord-
ingly, the net realizable value was $94 ($100
minus $6). Next, assume a new appraisal indi-
Accounting for Subsequent Changes cates a fair value of $90, reducing the estimated
in Market Value selling expenses to $5. Although the bank must
expense the depreciation in the fair value ($10),
Charges for subsequent declines in the fair value the valuation reserve for selling expenses would
of OREO property should never be posted to the be reduced by the difference in the estimate of
allowance for loan and lease losses. If an the selling expenses ($1). Given this scenario,
appraisal or evaluation indicates a subsequent the ‘‘adjusted’’ net realizable value would be
decline in the fair value of an OREO property, $85 ($90 minus $5).
the loss in value should be recognized by a
charge to earnings. Banks should attempt to
determine whether a property’s decline in value Appreciation in OREO Property Value
is temporary or permanent, taking into consid-
eration each property’s characteristics and exist- Assume a bank has written down its recorded
ing market dynamics. The preferred treatment investment in an OREO property to its fair value
for permanent losses in value is the direct of $100. Since the fair value of the property was
write-down method, in which the charge to less than the original recorded investment, an
expenses is offset by a reduction in the OREO estimated valuation reserve for selling expenses
property’s carrying value. If the reduction in of $6 was established. Accordingly, the net
value is deemed temporary, the charge to earn- realizable value was $94. A new appraisal
ings may be offset by establishing a valuation indicates an increase in the fair value of the
allowance specifically for that property. In the property to $110, with selling expenses now
event of subsequent appreciation in the value of estimated at $7. As a result, the net realizable
an OREO property, the increase can only be value is now $103. Given that the new net
reflected by reducing this valuation allowance or realizable value is greater than the recorded
recognizing a gain upon disposition, but never investment of $100, the selling expense valua-
by a direct write-up of the property’s value. A tion reserve is no longer necessary and the $6
change to the valuation allowance should be can be reversed to income. Notwithstanding the
offset with a debit or credit to expense in the property’s increased fair value, the recorded
period in which it occurs. investment value cannot be increased above
In addition to the preceding treatment of the $100. The valuation reserve for selling expenses
write-down in the OREO value, the previous can never be less than zero, thus prohibiting an
subsection ‘‘Transfer of Assets to Other Real increase in the value of the property above the
Estate Owned’’ discusses setting up a valuation recorded investment.
allowance for estimated selling expenses asso-
ciated with the sale of the other real estate. The
balance of this valuation reserve can fluctuate
based on changes in the fair value of the Accounting for Income and Expense
property held, but it can never be less than zero.
The following examples are presented to illus- Gross revenue from other real estate owned
trate the treatment that subsequent depreciation should be recognized in the period in which it is
and appreciation would have on OREO earned. Direct costs incurred in connection with
properties. holding an OREO property, including legal fees,
real estate taxes, depreciation, and direct write-
downs, should be charged to expense when
Depreciation in OREO Property Value incurred.
A bank can expend funds to develop and
Assume a bank has written down its initial improve OREO when it appears reasonable to
recorded investment in an OREO property from expect that any shortfall between the property’s
$125 to its fair value of $100. Since the fair fair value and the bank’s recorded book value
value of the property was less than the initial will be reduced by an amount equal to or greater

Page 3
than the expenditure. Such expenditures should The bank should determine whether such
not be used for speculation in real estate. The requirements exist and comply with them.
economic assumptions relating to the bank’s
decision to improve a particular OREO property
should be well documented. Any payments for
developing or improving OREO property are
Accounting for the Sale of
treated as capital expenditures and should be Other Real Estate Owned
reflected by increasing the property’s carrying
value. Gains and losses resulting from a sale of OREO
properties for cash must be recognized immedi-
ately. A gain resulting from a sale in which the
bank provides financing should be accounted for
Disposition of Other Real Estate under the standards described in Statement of
Owned Financial Accounting Standards 66 (SFAS 66).
SFAS 66 recognizes that differences in terms
OREO property must be disposed of within any of the sale and in selling procedures lead to
holding period established by state law and, in different profit recognition criteria and methods.
any case, as soon as it is prudent and reasonable. Banks may facilitate the sale of foreclosed real
Banks should maintain documentation reflecting estate by requiring little or no down payment, or
their efforts to dispose of OREO property, which by offering loans with favorable terms. Profit
should include— shall only be recognized in full when the col-
lectibility of the sales price is reasonably ensured
• a record of inquiries and offers made by and when the seller is not obligated to perform
potential buyers significant activities after the sale to earn the
• methods used in advertising the property for profit. Unless both conditions exist, recognition
sale whether by the bank or its agent of all or part of the profit shall be deferred.
• other information reflecting sales efforts Collectibility of the sale price of OREO prop-
erty is demonstrated when the buyer’s invest-
The sale or disposition of OREO property is ment is sufficient to ensure that the buyer will be
considered a real estate–related financial trans- motivated to honor his or her obligation to the
action under the Board’s appraisal regulation. A seller rather than lose the investment. Collect-
sale or disposition of an OREO property that ibility shall also be assessed by considering
qualifies as a federally related transaction under factors such as the credit standing of the buyer,
the regulation requires an appraisal conforming age and location of the property, and adequacy
to the regulation. A sale or disposition that does of cash flow from the property.
not qualify as a federally-related transaction The practice of recognizing all profit from the
nonetheless must comply with the regulation by sale of bank-financed OREO at the time of the
having an appropriate evaluation of the real sale is referred to as the full-accrual method. A
estate, that is consistent with safe and sound bank shall not recognize profit using this method
banking practices. until all of the following general criteria are met:
The bank should promptly dispose of OREO
if it can recover the amount of its original loan • a sale is consummated;
plus additional advances and other costs related • the buyer’s initial and continuing investments
to the loan or the OREO property before the end adequately demonstrate a commitment to pay
of the legal holding period. The holding period for the property;
generally begins on the date that legal title to the • the bank’s loan is not subject to future
property is transferred to the bank, except for subordination;
real estate that has become OREO because the • the bank has transferred to the buyer the usual
bank no longer contemplates using it as its risks and rewards of ownership in a trans-
premises. The holding period for this type of action that is in substance a sale, and it has no
OREO property begins on the day that plans for substantial continuing involvement in the
future use are formally terminated. Some states property.
require OREO property to be written off or
depreciated on a scheduled basis, or to be A sale will not be considered consummated until
written off at the end of a specified time period. the parties are bound by the terms of the

Page 4
Other Real Estate Owned 2200.1
contract, all consideration has been exchanged, sale of the property and the booking of the
and all conditions precedent to closing have corresponding loan, although profits from the
been performed. sale are recognized only as the bank receives
Initial investment, as defined by SFAS 66, payments from the buyer. Under this method,
includes only cash down payments, notes sup- interest income is recognized on an accrual
ported by irrevocable letters of credit from an basis, when appropriate.
independent lending institution, payments by Since default on the loan usually results in the
the buyer to third parties to reduce existing debt seller (the bank) reacquiring the real estate, the
on the property, and other amounts paid by the bank is reasonably assured that it will be able to
buyer that are part of the sale price. In these recover its costs with a relatively small down
situations, SFAS 66 requires that profit on the payment. Cost recovery is especially likely when
sale be deferred until a minimum down payment loans are made to buyers who have verifiable net
has been received and annual payments equal worth, liquid assets, and income levels adequate
those for a loan for a similar type of property to service the loan. Reasonable assurance of cost
with a customary amortization period. The recovery also may be achieved when the buyer
amount of down payment required varies by pledges adequate additional collateral.
category of property: land, 20–25 percent; com-
mercial and industrial, 10–25 percent; multifam-
ily residential, 10–25 percent; and single-family
residential, 5–10 percent. Ranges within these The Cost-Recovery Method
categories are defined further in the statement.
Continuing investment requires the buyer to Dispositions of OREO that do not qualify for
be contractually obligated to make level annual either the full accrual or installment methods are
payments on his or her total debt for the pur- sometimes accounted for using the cost-recovery
chase price of the property. This level annual method. This method recognizes the sale of the
payment must be able to service principal and property and the booking of the corresponding
interest payments amortized for no more than loan, but all income recognition is deferred.
20 years for raw land, and for no more than the Principal payments are applied by reducing the
customary amortization term for a first-mortgage loan balance, and interest payments are accounted
loan by an independent lending institution for for by increasing the unrecognized gross profit.
other types of real estate. No profit or interest income is recognized until
If a bank finances the sale of foreclosed either the buyer’s aggregate payments exceed
property it owns with a loan at less than current the recorded amount of the loan or a change to
market interest rates or noncustomary amortiza- another accounting method (for example, the
tion terms, generally accepted accounting prin- installment method) is appropriate. Conse-
ciples require that the loan be discounted to quently, the loan is maintained on nonaccrual
bring its yield to a market rate, using a custom- status while this method is being used.
ary amortization schedule. This discount will
either increase the loss or reduce the gain
resulting from the transaction. Interest income is
then generally recognized at a constant yield The Reduced Profit Method
over the life of the loan.
If a transaction does not qualify for the This method is used in certain situations when
full-accrual accounting method, SFAS 66 iden- the bank receives an adequate down payment,
tifies alternative methods of accounting for sales but the loan amortization schedule does not
of OREO property as described below. meet the requirements for use of the full-accrual
method. The bank again recognizes the sale of
the property and the booking of the correspond-
The Installment Method ing loan but, as under the installment method,
profits from the sale are recognized only as the
This method is used when the buyer’s down bank receives payments from the buyer. Since
payment is insufficient to allow the full-accrual sales with adequate down payments generally
method, but when recovery of the cost of the are not structured with inadequate loan-
property is reasonably assured if the buyer amortization schedules, this method is seldom
defaults. The installment method recognizes the used.

Page 5
The Deposit Method whether it is being disposed of according to the

bank’s plan. The amount of an OREO property
This method is used when a sale of OREO has subject to classification is the carrying value of
not been consummated. It also may be used for the property, net of any specific valuation allow-
dispositions that could be accounted for under ance. The existence of a specific valuation
the cost-recovery method. Under this method, a allowance does not preclude adverse classifica-
sale is not recorded, so the asset continues to be tion of OREO. The examiner should review all
reported as OREO. Further, no profit or interest types of OREO for classification purposes,
income is recognized. Payments received from including sales that fail to meet the standards
the buyer are reported as a liability until the use required for the full-accrual method of account-
of one of the other methods is appropriate. ing. When the bank provides financing, the
Banks may promote the sale of foreclosed examiner should determine whether it is pru-
real estate by offering nonrecourse financing to dently underwritten.
buyers. These loans should be made under the The examiner should review all relevant fac-
same credit terms and underwriting standards tors to determine the quality and risk of the
the bank employs for its regular lending activity. OREO property and the degree of probability
Financing arrangements associated with this that its carrying value will be realized. Some
type of transaction are subject to the accounting factors the examiner should consider include—
treatment discussed above.
Bank records should (1) indicate the account- • the property’s carrying value relative to its
ing method used for each sale of OREO, (2) sup- market value (including the date of any
port the choice of the method selected, and appraisal or evaluation relative to changes in
(3) sufficiently document that the institution is market conditions), the bank’s asking price,
correctly reporting associated notes receivable, and offers received;
as either loans or OREO property, with valua- • the source and quality of the appraisal or
tion allowances as appropriate. evaluation, including the reasonableness of
assumptions, such as projected cash flow for
commercial properties;
Classification of Other Real Estate • the length of time a property has been on the
Owned market and local market conditions for the
type of property involved, such as history and
The examiner should generally evaluate the trend of recent sales for comparable properties;
quality of each OREO property to determine if • bank management’s ability and track record in
classification is appropriate. OREO usually liquidating other real estate and assets acquired
should be considered a problem asset, even in satisfaction of debts previously contracted;
when it is carried at or below its appraised value.
Despite the apparent adequacy of the fair or • income and expenses generated by the prop-
market value, the bank’s acquisition of OREO erty and other economic factors affecting the
through foreclosure usually indicates a lack of probability of loss exposure;
demand. As time passes, the lack of demand can • the manner in which the bank intends to
become more apparent, and the value of the real dispose of the property;
estate can become increasingly questionable. • other pertinent factors, including property-
When evaluating the OREO property for title problems, statutory redemption privi-
classification purposes, the examiner must con- leges, pending changes in the property’s
sider the property’s market value, whether it is zoning, environmental hazards, other liens,
being held in conformance with state law, and tax status, and insurance.

Page 6
cedures, and internal controls regarding other audit function.
real estate owned are adequate. 5. To determine compliance with laws and
2. To determine that bank officers and employees regulations.
are operating in conformance with the estab- 6. To initiate corrective action when policies,
lished guidelines. practices, procedures, or internal controls are
3. To evaluate the validity and quality of all deficient or when violations of law or regu-
other real estate owned. lations have been noted.

Page 1
1. If selected for implementation, complete the • The property has been booked at its fair
Other Real Estate Owned section of the value.
Internal Control Questionnaire. • The documentation reflects the bank’s
2. Test for compliance with policies, practices, persistent and diligent effort to dispose
procedures and internal controls in conjunc- of the property.
tion with performing the remaining examina- • If the bank has made expenditures to
tion procedures and obtain a listing of any improve and develop other real estate
audit deficiencies noted in the latest review owned, proper documentation is in the
done by internal/external auditors and deter- file.
mine if appropriate corrections have been • Real estate that is former banking prem-
made. ises has been accounted for as other
3. Obtain a list of other real estate owned and real estate owned since the date of
agree total to general ledger. abandonment.
4. Review the other real estate owned account • Such property is disposed of in accor-
to determine if any property has been dis- dance with state law.
posed of since the prior examination and: 6. Review parcels of other real estate owned
a. If so, determine that: with appropriate management personnel and,
• The bank accepted written bids for the if justified, assign appropriate classification.
property. Classification comments should include:
• The bids are maintained on file. a. Description of property.
• There is justification for accepting a b. How real estate was acquired.
lower bid if the bank did not accept the c. Amount and date of appraisal.
highest one. d. Amount of any offers and bank’s asking
b. Investigate any insider transactions. price.
5. Test compliance with applicable laws and e. Other circumstances pertinent to the
regulations: classification.
a. Determine that other real estate owned is 7. Review the following with appropriate man-
held in accordance with the provisions of agement personnel or prepare a memo to
applicable state law. other examiners for their use in reviewing
b. Determine if other real estate is being with management:
amortized or written off in compliance a. Internal control exceptions and deficien-
with applicable state law. cies in, or non-compliance with, written
c. Consult with the examiners assigned to policies, practices and procedures.
‘‘Loan Portfolio Management,’’ ‘‘Other b. Uncorrected audit deficiencies.
Assets and Other Liabilities,’’ ‘‘Reserve c. Violations of law.
for Possible Loan Losses’’ and ‘‘Bank 8. Prepare comments in appropriate report form
Premises and Equipment’’ to determine if for all:
the situation holds real estate acquired as a. Criticized other real estate owned.
salvage on uncollectible loans, abandoned b. Deficiencies noted.
bank premises or property originally pur- c. Violations of law.
chased for future expansion, which is no 9. Update the workpapers with any information
longer intended for such usage. that will facilitate future examinations.
d. Review the details of all other real estate
owned transactions to determine that:

Page 1
Review the bank’s internal controls, policies, 6. Does the bank maintain insurance coverage
practices and procedures for other real estate on other real estate owned including liabil-
owned. The bank’s systems should be docu- ity coverage where necessary?
mented in a complete and concise manner and 7. Are all parcels of other real estate owned
should include, where appropriate, narrative reviewed at least annually for:
descriptions, flowcharts, copies of forms used a. Current appraisal or certification?
and other pertinent information. b. Documentation inquiries and offers?
c. Documented sales efforts?
d. Evidence of the prudence of additional
RECORDS advances?
1. Is the preparation, addition, and posting of

subsidiary other real estate owned records OTHER PROCEDURES
performed and/or tested by persons who do
not have direct, physical or accounting, 8. Are the bank’s policies and procedures
control of those assets? relating to the real estate owned in writing?
2. Are the subsidiary other real estate owned
records balanced at least annually to the
appropriate general ledger accounts by per-
sons who do not have direct, physical or CONCLUSION
accounting, control of those assets?
3. Is the posting to the general ledger other 9. Is the foregoing information an adequate
real estate owned accounts approved, prior basis for evaluating internal control in that
to posting, by persons who do not have there are no significant deficiencies in areas
direct, physical or accounting, control of not covered in this questionnaire that impair
those assets? any controls? Explain negative answers
4. Are supporting documents maintained for briefly, and indicate any additional exami-
all entries to other real estate owned nation procedures deemed necessary.
accounts? 10. Based on a composite evaluation, as
5. Are acquisitions and disposals of other real evidenced by answers to the foregoing
estate owned reported to the board of direc- questions, internal control is considered
tors or its designated committee? (adequate/inadequate).

Page 1
Other Assets and Other Liabilities
OTHER ASSETS future periods), equity securities (cost of) that do

not have readily determinable fair values (includ-
The term other assets, as used in this section, ing Federal Reserve stock and bankers’ bank
includes all balance-sheet asset accounts not stock), the cash surrender value of bank-owned
covered specifically in other areas of the exami- life insurance (BOLI), and other nonsecurity or
nation. Often, such accounts may be quite insig- other interest-only strips receivables.
nificant in the overall financial condition of the An interest-only strip receivable is the con-
bank. However, significant subquality assets tractual right to receive some or all of the
may be uncovered in banks lacking proper interest due on a bond, mortgage loan, collater-
internal controls and procedures. alized mortgage obligation, or other interest-
In many banks, other asset accounts are bearing financial asset. This includes, for exam-
maintained on the daily statement but must be ple, the contractual rights to future interest cash
reflected in a specific asset category for report- flows that exceed contractually specified servic-
ing. Schedule RC-F of the Consolidated Report ing fees on financial assets that have been sold.
of Condition lists the specific accounts classified The other assets category also consists of
as ‘‘other assets’’ and includes a catchall head- unique and unusual transactions that are not
ing of ‘‘other.’’ Certain accounts in that other appropriate to include in other line items of a
asset account, such as securities borrowed, are bank’s balance sheet. An unlimited number of
examined using the procedures described in the possible account titles could be included in this
appropriate section of this manual. category, such as redeemed food stamps, art
objects, antiques, and coin and bullion. Regard-
less, the examiner must design specific proce-
dures for review and testing to fit the particular
Types of Other Asset Accounts account and situation and must document the
scope of the review in the workpapers.
Types of other assets frequently found in banks
are the various temporary holding accounts,
such as suspense, interoffice, teller, transit, and
bookkeeping differences having debit balances. Examination Review of Other Assets
Those accounts should be used only for tempo-
rary recording until the offsetting entry is Examiners assigned to ‘‘other assets’’ must ob-
received or fully identified and posted to the tain the detailed breakdown of these accounts
proper account. A bank should have written when they are reported on the bank’s statement
internal control procedures to ensure that differ- of condition and when they are so designated for
ence accounts are reconciled and closed out on a the purposes of reporting on the bank’s Call
timely basis. Nothing should be allowed to Report. When the account can best be examined
remain in those accounts for any significant by examiners assigned to other areas of the
length of time—usually no more than a few bank, the detailed breakdown of the accounts
business days. All difference accounts should be should be furnished to those examiners. The
closed out at least quarterly. remaining accounts should be reviewed and
General categories of other assets common to evaluated by examiners assigned to this section.
banks are accrued interest receivables (on loans, The major factor in deciding which accounts are
debt securities, and other interest-bearing assets) to be reviewed are materiality and the volume of
and other types of income earned but not yet transactions flowing through the account.
collected (income derived from an asset that is With regard to materiality, the examiner
recognized but not yet collected or received on should evaluate whether to analyze the nature
the reporting date), net deferred tax assets (de- and quality of each individual item, on the basis
ferred tax assets less deferred tax liabilities that of its impact on the overall soundness of the
result in a debit balance for a particular tax bank or the quality of the bank’s earnings.
jurisdiction), interest-only strips receivables for Therefore, the examiner needs to verify—
mortgage loans and other financial assets, pre-
paid expenses (cash outlays for goods and ser- • the existence of the asset;
vices, the benefits of which will be realized in • the proper valuation of the asset;

Page 1
2210.1 Other Assets and Other Liabilities
• that the asset is properly classified, described, activities are monitored regularly by manage-
and disclosed in the financial statements ment. A bank with good control and review
(including the existence of any liens); procedures will periodically charge off all un-
• that the asset is being properly amortized on a collectible or unreconcilable items. However,
consistent basis over the estimated period of the examiner must frequently go beyond the
benefit; general ledger control accounts and scan the
• that any sales of assets, including the recog- underlying subsidiary ledgers to ensure that
nition of gains and losses, have been properly posting errors and the common practice of
recognized; and netting certain accounts against each other do
• the adequacy of the accounting and disposi- not cause significant balances to go unnoticed
tion controls for, as well as the quality of, the because of lack of proper detail.
asset.
With regard to transaction volume, the exam-

iner should evaluate whether any accounts with Deferred Tax Assets
small balances have an unusually high level of
transaction volume. Therefore, it is important For verifying compliance with the limits found
that the examiner verify that— in the risk-based capital guidelines, examiners
need to review the net deferred tax assets
• the account has a valid business purpose, (deferred tax assets less deferred tax liabilities)
• the account is reconciled on a regular basis, that a bank reports in its regulatory reports and
and the amount of limited deferred tax assets that are
• the accounting controls are adequate. not deducted from a bank’s tier 1 capital. The
net deferred taxes result from the application of
An examiner should authenticate the exist- an asset and liability approach for financial-
ence of the selected assets by ensuring that their accounting and reporting for income taxes. Net
supporting documentation is adequate. Also, the deferred taxes (net deferred tax assets) generally
examiner should verify that ownership of the arise from the tax effects of reporting income or
asset rests with the bank. (In the case of orga- expense charges in one period for financial-
nizational costs borne by the bank for the statement purposes and in another period for tax
formation of a holding company, those costs, purposes. This effect, known as a temporary
and the related ownership rights in the capital- difference, is at times sizable. Tax laws often
ized asset, should more properly be borne by the differ from the recognition and measurement
ownership interests and should not be recorded requirements of financial accounting standards.
as assets of the bank.) Differences can arise between (1) the amount of
Proper valuation and reporting of other asset taxable income and pretax financial income for a
accounts is another potential area of concern for year and (2) the tax bases of assets or liabilities
the examiner. Assets are generally acquired and their reported amounts in financial state-
through purchase, trade, repossession, prepayments. Charges that result in a significant
ment of expenses, or accrual of income. Gener- deferred tax asset are often caused by loan-loss
ally, assets purchased, traded, or repossessed are provisions exceeding bad debt deductions for
transferred at their fair market value. Prepaid tax purposes in a given period. While banks are
expenses and income accrued are booked at permitted to carry deferred income tax assets on
cost. An examiner should be particularly alert in their reports of condition, they are limited by
identifying those assets that lose value over time generally accepted accounting principles (GAAP)
to ensure that they are appropriately depreciated to the extent these items can be carried.
or amortized. All intangible assets should be The Financial Accounting Standards Board’s
regularly amortized, and management should (FASB) Statement No. 109 (FAS 109), ‘‘Account-
have a system in place to confirm the valuation ing for Income Taxes,’’ establishes procedures
of the remaining book balance of the intangible to (1) measure deferred tax assets and liabilities
assets. using a tax-rate convention and (2) assess
The examiner needs to ensure that the con- whether a valuation allowance should be estab-
trols concerning other assets protect the bank’s lished for deferred tax assets. Enacted tax laws
ownership rights, the accounts are properly and rates are considered in determining the
valued and accurately reported, and control applicable tax rate and in assessing the need for

Page 2
Other Assets and Other Liabilities 2210.1
a valuation allowance. FAS 109 was to be assets are limited, for regulatory capital pur-
adopted by banks as of January 1, 1993, or the poses, to (1) the amount that the bank expects to
beginning of their first fiscal year thereafter, if realize within one year of the quarter-end report
later. date (based on its projections of future taxable
FAS 109 requires a deferred tax asset to be income for that year) or (2) 10 percent of tier 1
recognized for all temporary differences that capital, whichever is less. The reported amount
will result in deductible amounts in future years of deferred tax assets, net of any valuation
and for tax credit carryforwards. For example, a allowance for deferred tax assets, in excess of
temporary difference may be created between the lesser of these two amounts is to be deducted
the reported amount and the tax basis of a from a bank’s core capital elements in determin-
liability for estimated expenses if, for tax pur- ing tier 1 capital. See section 3020.1 for more
poses, those estimated expenses are not deduct- detailed information on how to determine the
ible until a future year. Settlement of that capital composition and limitation on deferred
liability will result in tax deductions in future tax assets.
years, and a deferred tax asset is recognized in
the current year for the reduction in taxes
payable in future years. A valuation allowance is Bank-Owned Life Insurance to Be
recognized (deducted from the amount of the
deferred tax asset) if, based on the weight of
Included in Other Assets
available evidence, it is likely that some or all of
FASB’s Technical Bulletin No. 85-4 (FTB 85-
the deferred tax asset will not be realized.
4), ‘‘Accounting for the Purchases of Life Insur-
ance,’’ addresses the accounting for BOLI.
‘‘Other assets’’ are to include the amount of the
Deferred Tax Liabilities assets that represent the cash surrender value of
the insurance policy that is reported to the
A deferred tax liability is recognized for tempo-
institution by the insurance carrier (less any
rary differences that will result in taxable
applicable surrender charges not reflected by the
amounts in future years. Deferred tax liabilities
insurance carrier in the reported cash surrender
that may be related to a particular tax jurisdic-
value that could be realized under the insurance
tion (for example, federal, state, or local) may be
contract) as of the balance-sheet date. Because
offset against each other for reporting purposes.
there is no right of offset, an investment in BOLI
A resulting debit balance is included in ‘‘other
is reported as an asset separately from any
assets’’ on the bank Call Report and reported in
deferred compensation liability. BOLI is reported
Schedule RC-F; a resulting credit balance is
on the balance sheet of the bank Call Report as
included in ‘‘other liabilities’’ on the bank Call
‘‘other assets’’ and on its schedule RC-F as ‘‘all
Report and reported in Schedule RC-G. A bank
other assets—cash surrender value of life insur-
may report a net deferred tax debit (or asset) for
ance.’’ (See SR-04-4 and SR-04-19.) (The net
one tax jurisdiction (for example, federal taxes)
earnings (losses) on, or the net increases
and also report a net deferred tax credit (or
(decreases) in, the net cash surrender value of
liability) for another tax jurisdiction (for exam-
BOLI should be reported according to the bank
ple, state taxes).
Call Report instructions for the glossary and the
income statement, Schedules RI and RI-E.)
Limitation on Deferred Tax Assets for
Tier 1 Risk-Based Capital and Leverage
Capital OTHER LIABILITIES
The risk-based capital and leverage capital guide- The term other liabilities represents the bank’s
lines include a limit on the amount of certain authorized obligations. Other liabilities, as used
deferred tax assets that may be included in (that in this section, include all balance-sheet liability
is, not deducted from) tier 1 capital for deter- accounts not covered specifically in other areas
mining the amount of the bank’s required risk- of the examination. The accounts often may be
based and leverage capital levels. Certain quite insignificant when compared with the
deferred tax assets can only be realized if a bank overall size of the bank. In some banks, indi-
earns taxable income in the future. Deferred tax vidual accounts are established for control pur-

Page 3
2210.1 Other Assets and Other Liabilities
poses and appear on the balance sheet as ‘‘other determine that matters such as pending tax
liabilities.’’ For reporting, however, these litigation, equipment contracts, and accounts
accounts must be assigned to specific liability payable have been properly recorded and are
categories or netted from related asset catego- being discharged in accordance with their terms
ries, as appropriate. and requirements.
Schedule RC-G of the Consolidated Report of Various miscellaneous liabilities may be found
Condition lists the specific accounts classified as in accounts, such as undisbursed loan funds,
‘‘other liabilities.’’ The schedule includes inter- deferred credits, interoffice, suspense, and other
est accrued and unpaid on deposits and other titles denoting pending status. An unlimited
expenses that are accrued and unpaid (including number of possible items could be included. The
accrued income taxes payable), net deferred tax review of these accounts should determine that
liabilities, the allowance for credit losses on they are used properly and that all such items are
off-balance-sheet credit exposures, and all other clearing in the normal course of business.
liabilities. ‘‘All other liabilities’’ includes liabil- Because of the variety of such accounts, the
ity accounts such as accounts payable, deferred examiner must develop specific examination
compensation liabilities, dividends that are procedures to fit the particular account and
declared but not yet payable, and derivatives situation.
with a negative fair value held for purposes
other than trading.
As stated above, the ‘‘all other liabilities’’
term includes deferred compensation liabilities.
Examination Review of Other
This account is used to record the bank’s obli- Liabilities
gation under its deferred compensation agree-
ments. Section 3015.1 discusses deferred com- Examiners assigned to ‘‘other liabilities’’ are
pensation agreements in detail, both as to the responsible for obtaining the bank’s breakdown
nature and operation of the different types of of these accounts and, when the accounts are to
agreements and the accounting standards and be examined under other sections, must ensure
guidance that are applicable to those that examiners in charge of those sections receive
agreements—in particular, a revenue-neutral plan the necessary information. The remaining
or an indexed retirement plan. (See also SR- accounts should be reviewed and evaluated by
04-4, SR-04-19, and the glossary entry for examiners assigned to this section.
‘‘deferred compensation agreements’’ in the bank The primary emphasis of examining other
Call Report instructions.) liabilities is to obtain reasonable assurance that
(1) the liabilities represent the bank’s authorized
obligations and (2) all contingencies and esti-
mated current-period expenses that will be paid
Types of Other Liability Accounts in future periods that should be accrued during
the period have been accrued, classified, and
A general category of other liabilities common described in accordance with GAAP, and the
to banks is expenses accrued and unpaid. These related disclosures are adequate. Another
accounts represent periodic charges to income emphasis in examining this area should be the
based on anticipated or contractual payments of adequacy of the controls and procedures the
funds to be made at a later date. They include bank employs to promptly record the amount of
such items as interest on deposits, dividends, liability. Without proper management attention,
taxes, and expenses incurred in the normal these accounts may be advertently or inadvert-
course of business. There should be a correlation ently misstated. Unless properly supervised,
between the amount being accrued daily or these accounts may be used to conceal shortages
monthly and the amount due on the stated or that should be detected immediately. For instance,
anticipated payment date. other liabilities may include fraudulent entries
Other liability accounts should be reviewed to for suspense or interbranch accounts that could
determine that accounts, such as deferred taxes, be rolled over every other day to avoid stale
are being properly recognized when there are dates, causing shortages of any amount to be
temporary differences in the recognition of effectively concealed for indefinite periods of
income and expenses between the books and the time.
income tax returns. This review should also Similar to ‘‘other assets,’’ other liability

Page 4
Other Assets and Other Liabilities 2210.1
accounts with small balances may be significant. its committees. Responses from legal counsel
Scanning account balances may disclose a handling litigation could also be important
recorded liability, but it does not aid in deter- because this information might reveal a major
mining the accuracy of liability figures. There- understatement of liabilities. Determining accu-
fore, it is important to review the documented rate balances in other liability accounts requires
information obtained from examiners working an in-depth review of source documents or the
with and reviewing the minutes of the board and other accounts in which the liability arose.

Page 5
dures, and internal controls regarding ‘‘other audit function.
assets’’ and ‘‘other liabilities’’ are adequate. 6. To determine compliance with laws and
2. To determine that bank officers and employees regulations.
are operating in conformance with estab- 7. To initiate corrective action when policies,
lished guidelines. practices, procedures, or internal controls are
3. To evaluate the validity and quality of all deficient or when violations of laws or regu-
‘‘other assets.’’ lations have been noted.
4. To determine that ‘‘other liabilities’’ are prop-
erly recorded.

Page 1
1. Complete or update the Internal Con- 7. Determine that amortizing ‘‘other assets’’
trol Questionnaire, if selected for accounts are being amortized over a reason-
implementation. able period correlating to their economic
2. Based on the evaluation of internal controls life.
and the work performed by internal/ 8. If the bank has outstanding customer liabil-
external auditors, determine the scope of ity under letters of credit, obtain and for-
the examination. ward a list of the names and amounts to
3. Test for compliance with policies, practices, the examiner assigned ‘‘Loan Portfolio
procedures, and internal controls in conjunc- Management.’’
tion with performing the remaining exami- 9. Review the balance of any ‘‘other liabili-
nation procedures. Obtain a listing of any ties’’ owed to officers, directors, or their
deficiencies noted in the latest review done interests and investigate, by examining
by internal/external auditors from the exam- applicable supporting documentation,
iner assigned ‘‘Internal Control,’’ and deter- whether they have been used to—
mine if appropriate corrections have been a. record unjustified amounts; or
made. b. record amounts for items unrelated to
4. Obtain from the examiner assigned ‘‘Exam- bank operations.
ination Strategy’’ the list of ‘‘other assets’’ 10. Develop, and note in the workpapers, any
and ‘‘other liabilities’’ accounts. special programs considered necessary to
5. Obtain a trial balance of ‘‘other assets’’ and properly analyze any remaining ‘‘other
‘‘other liabilities’’ accounts, including a de- assets’’ or ‘‘other liabilities’’ account.
tailed listing of the interbank accounts and: 11. Test for compliance with applicable state
a. Agree or reconcile balances to depart- laws and regulations.
ment controls and general ledger. 12. For ‘‘other assets’’ items that are deter-
b. R e v i e w r e c o n c i l i n g i t e m s f o r mined to be stale, abandoned, uncollectible,
reasonableness. or carried in excess of estimated values, and
6. Scan the trial balances for: for ‘‘other liabilities’’ items that are deter-
a. Obvious misclassifications of accounts mined to be improperly stated, after consult-
and, if any are noted, discuss reclassifi- ing with the examiner-in-charge, request
cation with appropriate bank personnel management to make the appropriate
and furnish a list to appropriate examin- entries on the bank’s books.
ing personnel. 13. Prepare, in appropriate report form, and
b. Large, old, or unusual items and, if any discuss with appropriate officer(s):
are noted, perform additional procedures a. Violations of laws and regulations.
as deemed appropriate, being certain to b. Criticized ‘‘other assets.’’
appraise the quality of ‘‘other assets.’’ c. The adequacy of written policies relating
c. ‘‘Other assets’’ items that represent to ‘‘other assets’’ and ‘‘other liabilities.’’
advances to related organizations, direc- d. Recommended corrective action when
tors, officers, employees, or their inter- policies, practices, or procedures are
ests, and if any are noted, inform the deficient.
examiner assigned ‘‘Loan Portfolio 14. Update the workpapers with any informa-
Management.’’ tion that will facilitate future examinations.

Page 1
Review the bank’s internal controls, policies, 9. Are receivables reviewed at least quarterly
practices, and procedures concerning ‘‘other for collectibility by someone other than the
assets’’ and ‘‘other liabilities.’’ The bank’s sys- originator of the entry?
tems should be documented in a complete and 10. Is approval required to pay credit balances
concise manner and should include, where in receivable accounts?
appropriate, narrative descriptions, flowcharts, 11. Do credit entries to a receivables account,
copies of forms used, and other pertinent other than payments, require the approval
information. of an officer independent of the entry
preparation?
OTHER ASSETS
Other Procedures
Policies and Procedures
12. Does charge-off of a nonamortizing ‘‘other
1. Has the bank formulated written policies asset’’ initiate review of the item by a
and procedures governing ‘‘other assets’’ person not connected with entry authoriza-
accounts? tion or posting?
13. Do review procedures, where applicable,
provide for an appraisal of the asset to
Records determine the propriety of the purchase or
sale price?
2. Is the preparation of entries and posting of
subsidiary ‘‘other assets’’ records performed
or tested by persons who do not also have Conclusion
direct control, either physical or accounting,
of the related assets? 14. Does the foregoing information provide an
3. Are the subsidiary ‘‘other assets’’ records, if adequate basis for evaluating internal con-
any, balanced at least quarterly to the trols in that deficiencies in areas not covered
appropriate general ledger accounts by per- by this questionnaire do not significantly
sons who do not also have direct control, impair any controls? Explain negative
either physical or accounting, of the related answers briefly, and indicate any additional
assets? examination procedures deemed necessary.
4. Is the posting of ‘‘other assets’’ accounts to 15. Are internal controls adequate based on a
the general ledger approved prior to posting composite evaluation, as evidenced by
by persons who do not also have direct answers to the foregoing questions?
control, either physical or accounting, of the
related assets?
5. Are worksheets or other supporting records
maintained to support prepaid expense
OTHER LIABILITIES
amounts?
6. Are supporting documents maintained for Policies and Procedures
all entries to ‘‘other assets’’?
7. Are the items included in suspense accounts 1. Has the bank formulated written policies
aged and reviewed for propriety regularly and procedures governing the ‘‘other liabil-
by responsible personnel? ities’’ accounts?
Receivables Records
8. Are receivables billed at regular intervals? 2. Does the bank maintain subsidiary records
(If so, state frequency .) of items comprising ‘‘other liabilities’’?

Page 1
2210.4 Other Assets and Other Liabilities: Internal Control Questionnaire
3. Is the preparation of entries and posting of 10. Are invoices and bills verified and approved
subsidiary ‘‘other liabilities’’ records per- by designated employees prior to payment?
formed or tested by persons who do not also 11. Are procedures established to call attention,
originate or control supporting data? within the discount period, to invoices not
4. Are subsidiary records of ‘‘other liabilities’’ yet paid?
balanced at least monthly to appropriate 12. Does the bank have a system of advising the
general ledger accounts by persons who do board of directors of the acquisition and
not also originate or control supporting status of major ‘‘other liabilities’’ items?
data? 13. Are all payroll tax liabilities agreed to
5. Are the items included in suspense accounts appropriate tax returns and reviewed by an
aged and reviewed for propriety regularly officer to ensure accuracy?
by responsible personnel?
Conclusion
Other Procedures
14. Does the foregoing information provide an
6. Does the bank book obligations immedi- adequate basis for evaluating internal con-
ately on receipt of invoices or bills for trols in that deficiencies in areas not covered
services received? by this questionnaire do not significantly
7. If the bank uses a Federal Reserve deferred impair any controls? Explain negative
credit account, is the liability for incoming answers briefly, and indicate any additional
‘‘Fed’’ cash letters booked immediately upon examination procedures deemed necessary.
receipt? 15. Are internal controls adequate based on a
8. Does the bank book dividends that have composite evaluation, as evidenced by
been declared but are not yet payable? answers to the foregoing questions?
9. Are invoices and bills proved for accuracy
prior to payment?

Page 2
Deposit Accounts
Deposits are funds that customers place with a • the adequacy of current operations (staffing
bank and that the bank is obligated to repay on and systems) and the location and size of
demand, after a specific period of time or after banking quarters relative to the bank’s volume
expiration of some required notice period. of business,
Deposits are the primary funding source for • the degree of competition from banks and
most banks and, as a result, have a significant nonbank financial institutions and their pro-
effect on a bank’s liquidity. Banks use deposits grams to attract deposit customers, and
in a variety of ways, primarily to fund loans and • the effects of the national economy and the
investments. Management should establish a monetary and fiscal policies of the federal
procedure for determining the volatility and government on the bank’s service area.
composition of the deposit structure to ensure
that funds are employed profitably, while allow- The bank’s size and the composition of its
ing for their potential withdrawal. Therefore, a market determine how formal its deposit pro-
bank’s management should implement program should be. After a bank develops its
grams to retain and prudently expand the bank’s deposit program, management must continue to
deposit base. monitor the above factors and correlate any
Bankers place great significance on the deposit findings to determine if adjustments are needed.
structure because favorable operating results The long-term success of any deposit program
depend, in part, on a core deposit base. Because relates directly to the ability of management to
of competition for funds, the need for most make adjustments at the earliest possible time.
individuals and corporations to minimize idle
funds, and the effect of disintermediation (the
movement of deposits to other higher-yielding
markets) on a bank’s deposit base, bank man- DEPOSIT STRUCTURE
agement should adopt and implement a devel-
opment and retention program for all types of Management should look not only at deposit
deposits. growth but also at the nature of the deposit
structure. To invest deposited funds properly in
view of anticipated or potential withdrawals,
management must be able to determine what
DEPOSIT DEVELOPMENT AND percentage of the overall deposit structure is
RETENTION PROGRAM centered in core deposits, in fluctuating or sea-
sonal deposits, and in volatile deposits. It is
Important elements of the examination process important that internal reports with information
are the review of a bank’s deposit development concerning the composition of the deposit struc-
and retention program and the methods used to ture be provided to management periodically.
determine the volatility and composition of the Management’s lack of such knowledge could
deposit structure. A bank’s deposit development lead to an asset-liability mismatch, causing prob-
and retention program should include— lems at a later date.
In analyzing the deposit structure, informa-
• a marketing strategy, tion gathered by the various examination proce-
• projections of deposit structure and associated dures should be sufficient to allow the examiner
costs, and to evaluate the composition of both volatile and
• a formula for comparing results against core deposits. Ultimately, the examiner should
projections. be satisfied with management’s efforts to plan
for the bank’s future.
To structure a deposit program properly, bank Examiners must analyze the present and
management must consider many factors, some potential effect deposit accounts have on the
of which include— financial condition of the bank, particularly with
regard to the quality and scope of management’s
• the composition of the market-area economic planning. The examiner’s efforts should be
base, directed to the various types of deposit accounts
• the ability to employ deposits profitably, that the bank uses for its funding base. The

Page 1
3000.1 Deposit Accounts
examiners assigned to the areas of funds man- the basis on which service charges on dormant
agement and to the analytical review of the accounts are assessed and should document the
bank’s income and expenses should be informed review. There have been occasions when exces-
of any significant change in interest-bearing sive servicing charges have resulted in no pro-
deposit-account activity. ceeds being remitted at the time the account
became subject to escheat requirements. In these
cases, courts have required banks to reimburse
COST OF FUNDS the state. (See also the ‘‘Dormant Accounts’’
discussion later in this section.)
Interest paid on deposits is generally the largest
expense to a bank. As a result, interest-bearing
deposit accounts employed in a marginally prof- Bank Secrecy Act
itable manner could have significant and lasting
effects on bank earnings. The examiner should Examiners should be aware of the Bank Secrecy
consider the following in evaluating the effect of Act when examining the deposit area and should
interest-bearing deposit accounts on a bank’s follow up on any unusual activities or arrange-
earnings: ments noted. The act was implemented by the
Treasury Department’s Financial Recordkeep-
• an estimated change in interest expense resulting and Reporting of Currency and Foreign
ing from a change in interest rates on deposit Transactions Regulation. For further informa-
accounts or a shift in funds from one type of tion, see the Bank Secrecy Act Examination
account to another Manual and section 208.63 of the Federal
• service-charge income Reserve’s Regulation H.
• projected operating costs
• changes in required reserves
• promotional and advertising costs
• the quality of management’s planning Banking Hours and Processing of
Demand Deposits
The Board’s Regulation CC (12 CFR 229),
SPECIAL DEPOSIT-RELATED ‘‘Availability of Funds and Collection of Checks,’’
ISSUES and the Uniform Commercial Code (UCC) gov-
ern banking-day cutoff hours and the processing
The examiner should keep the following issues of deposits. A ‘‘banking day’’ is that part of a
in mind during an examination to ensure the day on which an office of the bank is open to the
bank is in compliance, where applicable. public for carrying on substantially all of its
banking functions. Saturdays, Sundays, and cer-
tain specified holidays are not banking days
Abandoned-Property Law under Regulation CC, although such days might
be banking days under the UCC if a bank is
State abandoned-property laws generally are open for substantially all of its functions on
called escheat laws. Although escheat laws vary those days.
from state to state, they normally require a bank Regulation CC requires a bank to make
to remit the proceeds of any deposit account to deposited funds available for withdrawal within
the state treasurer when— a certain period after the banking day on which
they are received. Cash deposits, wire transfers,
• the deposit account has been dormant for a and certain check deposits that pose little risk to
certain number of years and the depositary bank (such as Treasury checks
• the owner of the account cannot be located. and cashier’s checks) generally are to be made
available for withdrawal by the business day
Service charges on dormant accounts should after the day of deposit. The time when the
bear a direct relationship to the cost of servicing depositary bank must make other check deposits
the accounts, which ensures that the charges are available for withdrawal depends on whether the
not excessive. A bank’s board of directors (or a check is local or nonlocal to the depositary bank.
committee appointed by the board) should review As of September 1, 1990, proceeds of local and

Page 2
Deposit Accounts 3000.1
nonlocal checks must be available for with- there are varying degrees of risk associated with
drawal by the second and fifth business day such accounts, depending on the customer and
following deposit, respectively. However, Regu- the nature of the services provided. Institutions
lation CC allows a bank to set, within certain should take appropriate steps to manage such
limits, cutoff hours, after which the bank will risks consistent with sound practices and appli-
deem funds to be received on the next banking cable anti-money-laundering laws and regula-
day for purposes of calculating the availability tions. The advisory also encourages banking
date (12 CFR 229.19). Different cutoff-hour organizations to direct questions about embassy
limits apply to different types of deposits. banking to their primary federal bank regulators.
For the purpose of allowing banks to process
checks, the UCC provides that a bank may set a
cutoff hour of 2 p.m. or later and that items Interagency Advisory on Accessing
received after that time will be considered Accounts from Foreign Governments,
received as of the next banking day (UCC Embassies, and Foreign Political Figures
section 4-108). Under both the UCC and Regu-
lation CC, both the banking day on which a bank The interagency advisory answers questions on
is deemed to have received a check and the whether financial institutions should conduct
cutoff hour affect the time frames within which business with foreign embassies and whether
a bank must send the check through the forward- institutions should establish account services for
collection and return processes. foreign governments, foreign embassies, and
A bank that fails to set its cutoff hour appro- foreign political figures. As it would with any
priately, does not make funds available within new account, an institution should evaluate
the appropriate time frames, or processes checks whether or not to accept a new account for a
in an untimely manner may be subject to civil foreign government, embassy, or political fig-
liability for not performing its duties in accor- ure. That decision should be made by the
dance with various provisions of Regulation CC institution’s management, under standards and
and the UCC. guidelines established by the board of directors,
and should be based on the institution’s own
business objectives, its assessment of the risks
associated with particular accounts or lines of
Banking Accounts for Foreign business, and its capacity to manage those risks.
Governments, Embassies, and The agencies will not, in the absence of extraor-
Political Figures dinary circumstances, direct or encourage any
institution to open, close, or refuse a particular
On June 15, 2004, an interagency advisory account or relationship.
concerning the embassy banking business and Providing financial services to foreign gov-
related banking matters was issued by the fed- ernments and embassies and to foreign political
eral banking and thrift agencies (the Board of figures can, depending on the nature of the
Governors of the Federal Reserve System, the customer and the services provided, involve
Federal Deposit Insurance Corporation, the varying degrees of risk. Such services can range
Office of the Comptroller of the Currency, the from account relationships that enable an
Office of Thrift Supervision, and the National embassy to handle the payment of operational
Credit Union Administration (the agencies)). expenses, for example, payroll, rent, and utili-
The advisory was issued in coordination with ties, to ancillary services or accounts provided to
the U.S. Department of the Treasury’s Financial embassy staff or foreign government officials.
Crimes Enforcement Network. The purpose of Each of these relationships potentially poses
the advisory is to provide general guidance to different levels of risk. Institutions are expected
banking organizations regarding the treatment to assess the risks involved in any such relation-
of accounts for foreign governments, foreign ships and to take steps to ensure both that such
embassies, and foreign political figures. risks are appropriately managed and that the
The joint interagency statement advises bank- institution can do so in full compliance with its
ing organizations that the decision to accept or obligations under the Bank Secrecy Act, as
reject an embassy or foreign government account amended by the USA Patriot Act, and the
is theirs alone to make. The statement advises regulations promulgated thereunder.
that financial institutions should be aware that When an institution elects to establish finan-

Page 3
cial relationships with foreign governments, from and extending credit to foreign residents
embassies, or foreign political figures, the agen- (including banks), other IBFs, and the institu-
cies, consistent with their usual practice of tions establishing the IBF. IBFs are not required
risk-based supervision, will make their own to maintain reserves against their time deposits
assessment of the risks involved in such busi- or loans. The examiner should follow the special
ness. As is the case with all accounts, the examination procedures in the international sec-
institution should expect appropriate scrutiny by tion of this manual when examining an IBF.
examiners that is commensurate with the level
of risk presented by the account relationship. As
in any case where higher risks are presented, the
institution should expect an increased level of Deposits Insured by the Federal
review by examiners to ensure that the institu- Deposit Insurance Corporation
tion has in place controls and compliance over-
sight systems that are adequate to monitor and
manage such risks, as well as personnel trained The Federal Deposit Insurance Corporation
in the management of such risks and in the (FDIC) is an independent agency of the U.S.
requirements of applicable laws and regulations. government. The FDIC protects depositors
Institutions that have or are considering tak- against the loss of their insured deposits due to
ing on relationships with foreign governments, the failure of an insured bank, savings bank,
embassies, or political figures should ensure that savings association, insured branch of a foreign
such customers are aware of the requirements of bank, or other depository institution whose
U.S. laws and regulations to which the institu- deposits are insured pursuant to the Federal
tion is subject. Institutions should, to the maxi- Deposit Insurance Corporation Act. If a deposi-
mum extent feasible, seek to structure such tor’s accounts at one FDIC-insured depository
relationships in order to conform them to con- institution total $100,000 (or the standard maxi-
ventional U.S. domestic banking relationships so mum deposit insurance amount [SMDIA]) or
as to reduce the risks that might be presented by less, the funds are fully insured and protected. A
such relationships. depositor can have more than the SMDIA at one
insured depository institution and still be fully
insured provided the accounts meet certain
requirements. In addition, federal law currently
Foreign-Currency Deposits provides for insurance coverage of up to
Domestic depository institutions are permitted $250,000 or the SMDIA for ‘‘self-directed’’
to accept deposits denominated in foreign cur- retirement accounts.
rency. Institutions should notify customers that The FDIC insurance covers all types of depos-
such deposits are subject to foreign-exchange its received at an insured depository institution,
risk. The bank should convert such accounts to including deposits in checking, negotiable order
the U.S. dollar equivalent for purposes of report- of withdrawal (NOW), and savings accounts;
ing to the Federal Reserve. Examination staff money market deposit accounts; and time depos-
should ascertain that all reports are in order and its such as certificates of deposit (CDs). FDIC
should evaluate the bank’s use of such funds and deposit insurance covers the balance of each
its management of the accompanying foreign- depositor’s account, dollar-for-dollar, up to the
exchange risk. Accounts denominated in foreign SMDIA, including the principal and any accrued
currency are not subject to the requirements of interest through the date of an insured deposi-
Regulation CC. (See SR-90-03 (IB), ‘‘Foreign tory institution’s closing.
(Non–U.S.) Currency Denominated Deposits Deposits in separate branches of an insured
Offered at Domestic Depository Institutions.’’) depository institution are not separately insured.
Deposits in one insured institution are insured
separately from deposits in another insured insti-
International Banking Facilities tution. Deposits maintained in different catego-
ries of legal ownership at the same depository
An international banking facility (IBF) is a set institution can be separately insured. Therefore,
of asset and liability accounts segregated on the it is possible to have deposits of more than the
books of a depository institution. IBF activities SMDIA at one insured institution and still be
are essentially limited to accepting deposits fully insured.

Page 4
Deposit Insurance Reform Acts SMDIA, subject to the inflation adjustment

described previously.
On March 14, 2006, the FDIC amended its
deposit insurance regulations (effective April 1,
2006) by issuing an interim rule with a request Deposit Insurance Rule Amendments
for public comment on or before May 22, 2006.
(See 71 Fed. Reg. 14,629 and 12 CFR Part 330.) Retirement and Employee Benefit Plan
The interim rule implemented applicable revi- Accounts
sions to the Federal Deposit Insurance Act made
by the Federal Deposit Insurance Reform Act of When deposits from a retirement or employee
2005 (Reform Act) and the Federal Deposit benefit plan (EBP)—such as a 401(k) retirement
Insurance Reform Conforming Amendments Act account, Keogh plan account, corporate pension
of 2005 (the Conforming Amendments Act). plan, or profit-sharing program—are entitled to
The Reform Act provided for consideration of pass-through insurance, the SMDIA on FDIC
inflation adjustments (cost-of-living adjustment) insurance does not apply to the entire EBP
to increase the current SMDIA of $100,000 on a account balance. Rather, the FDIC insurance
five-year cycle beginning on April 1, 2010. coverage ‘‘passes through’’ to each owner or
Second, the Reform Act increased the deposit beneficiary, and the deposited funds of each
insurance limit for certain retirement accounts individual EBP participant are insured up to the
from $100,000 to $250,000, also subject to SMDIA.
inflation adjustments. The types of accounts The Reform Act and the Conforming Amend-
included are individual retirement accounts ments Act, and the FDIC’s March 23, 2006,
(IRAs),1 eligible deferred compensation plan interim rule eliminated the previous requirement
accounts,2 and individual account plan accounts,3 that pass-through coverage for employee benefit
and any plan described in section 401(d) of the plan accounts be dependent on the capital level
IRC, to the extent that participants and benefi- of a depository institution where such deposits
ciaries under such plans have a right to direct the are placed. Pass-through coverage for employee
investment of assets held in individual accounts benefit plan deposits was not available if the
maintained on their behalf by the plans. deposits were placed with an institution that was
Third, the Reform Act provided per-participant not permitted to accept brokered deposits
insurance coverage to employee benefit plan because of the capital requirements. Insured
accounts, even if the depository institution at institutions that are not ‘‘well capitalized’’ or
which the deposits are placed is not authorized ‘‘adequately capitalized’’ are now prohibited by
to accept employee benefit plan deposits. The the Reform Act from accepting employee benefit
cost-of-living adjustment is to be calculated plan deposits. Under the Reform Act, employee
according to the Personal Consumption Expen- benefit plan deposits accepted by an insured
ditures Chain-type Price Index published by the depository institution, even those prohibited
U.S. Department of Commerce and rounded from accepting such deposits, are nonetheless
down to the nearest $10,000. eligible for pass-through deposit insurance
The Conforming Amendments Act created coverage. The rule’s amendment (see 12 CFR
the term government depositor in connection 330.14) applies to all employee benefit plan
with public funds described in and insured deposits, including employee benefit plan depos-
pursuant to section 11(a)(2) of the Federal its placed before April 1, 2006. The rule’s other
Deposit Insurance Act (FDIA). (See 12 USC requirements in section 330.14 continue to apply.
1821(a)(2).) The Conforming Amendments Act In particular, only the ‘‘noncontingent’’ interests
provides that the deposits of a government of plan participants in an applicable plan are
depositor are insured in an amount up to the eligible for pass-through coverage. A ‘‘noncon-
tingent interest’’ is an interest that can be
determined without the evaluation of contingen-
1. IRAs described in section 408(a) of the Internal Revenue cies other than life expectancy. This rule
Code (IRC). (See 26 USC 408(a).) indicates that the maximum coverage for certain
2. Eligible deferred compensation plan accounts described retirement accounts is $250,000 or the SMDIA.
in section 457 of the IRC. (See 26 USC 457.)
3. Individual account plan accounts such as those defined
These retirement accounts continue to be made
in section 3(34) of the Employee Retirement Income Security up of individual retirement accounts (the tradi-
Act. tional IRAs and the Roth IRAs); section 457

Page 5
deferred compensation plan accounts, ‘‘self- denced by an interest-bearing, variable-rate,

directed’’ Keogh plan accounts (or HR 10 open-ended, secured note callable on demand by
accounts); and ‘‘self-directed’’ defined contribu- Treasury. Rates paid are 1⁄4 of 1 percent less than
tion plan accounts, which are primarily 40l(k) the average weekly rate on federal funds. Inter-
plan accounts. The term self-directed means that est is calculated on the weekly average daily
the plan participants have the right to direct how closing balance in the TT&L note-option account.
their funds are invested, including the ability to Although there is no required maximum note-
direct that the funds be invested at an FDIC- option ceiling, banks may establish a maximum
insured institution. balance by providing written notice to the Fed-
eral Reserve Bank. As per 31 CFR 203.24, the
TT&L balance requires the bank to pledge
collateral to secure these accounts, usually from
Reserve Requirements its investment portfolio. The note option is not
included in reserve-requirement computations
The Monetary Control Act of 1980 and the
and is not subject to deposit insurance because it
Federal Reserve’s Regulation D, ‘‘Reserve
is classified as a demand note issued to the U.S.
Requirements of Depository Institutions,’’ estab-
Treasury, a type of borrowing.
lish two categories of deposits for reserve-
requirement purposes. The first category is the
transaction account, which represents a deposit
or account from which the depositor or account POTENTIAL PROBLEM AREAS
holder is permitted to make orders of withdraw-
als by negotiable instrument, payment orders of The following types of deposit accounts and
withdrawal, telephone transfer, or similar devices related activities have above-average risk and,
for making payments to a third party or others. therefore, require the examiner’s special attention.
Transaction accounts include demand deposits,
NOW accounts, automatic transfer (ATS)
accounts, and telephone or preauthorized trans- Bank-Controlled Deposit Accounts
fer accounts. The second category is the non-
transaction deposit account, which includes
Bank-controlled deposit accounts, such as sus-
all deposits that are not transaction accounts,
pense, official checks, cash-collateral, dealer
such as (1) savings deposits, that is, money
reserves, and undisbursed loan proceeds, are
market deposit accounts and other savings depos-
used to perform many necessary banking func-
its, and (2) time deposits, that is, time certifi-
tions. However, the absence of sound adminis-
cates of deposit and time deposits, open account.
trative policies and adequate internal controls
See Regulation D for specific definitions of the
can cause significant loss to the bank. To ensure
various deposit accounts.
that such accounts are properly administered
and controlled, the directorate must ensure that
operating policies and procedures are in effect
Treasury Tax and Loan Accounts that establish acceptable purpose and use;
appropriate entries; controls over posting
Member banks may select either the ‘‘remittance- entries; and the length of time an item may
option’’ or the ‘‘note-option’’ method to forward remain unrecorded, unposted, or outstanding.
deposited funds to the U.S. Treasury. With the Internal controls that limit employee access to
remittance option, the bank remits the Treasury bank-controlled accounts, determine the respon-
Tax and Loan (TT&L) account deposits to the sibility for frequency of reconcilement, discour-
Federal Reserve Bank the next business day age improper posting of items, and provide for
after deposit. The remittance portion is not periodic internal supervisory review of account
interest-bearing. activity are essential to efficient deposit
The note option permits the bank to retain the administration.
TT&L deposits. With the note option, the bank The deposit suspense account is used to
debits the TT&L remittance account for the process unidentified, unposted, or rejected items.
amount of the previous day’s deposit and simul- Characteristically, items posted to such accounts
taneously credits the note-option account. Thus, clear in one business day. The length of time an
TT&L funds are now purchased funds evi- item remains in control accounts often reflects

Page 6
on the bank’s operational efficiency. This deposit deposits, or facilitating the placement of depos-
type has a higher risk potential because the its, of third parties with insured depository
transactions are incomplete and require manual institutions or the business of placing deposits
processing to be completed. As a result of the with insured depository institutions for the
need for human interaction and the exception purpose of selling interests in those deposits to
nature of these transactions, the possibility of third parties; and
misappropriation exists. • an agent or a trustee who establishes a deposit
Official checks, a type of demand deposit, account to facilitate a business arrangement
include bank checks, cashier’s checks, expense with an insured depository institution to use
checks, interest checks, dividend-payment the proceeds of the account to fund a prear-
checks, certified checks, money orders, and ranged loan.
traveler’s checks. Official checks reflect the
bank’s promise to pay a specified sum upon The term deposit broker does not include —
presentation of the bank’s check. Because
accounts are controlled and reconciled by bank • an insured depository institution, with respect
personnel, it is important that appropriate inter- to funds placed with that depository institution;
nal controls are in place to ensure that account • an employee of an insured depository institu-
reconcilement is segregated from check origination, with respect to funds placed with the
tion. Operational inefficiencies, such as unre- employing depository institution;
corded checks that have been issued, can result • a trust department of an insured depository
in a significant understatement of the bank’s institution, if the trust or other fiduciary rela-
liabilities. Misuse of official checks may result tionship in question has not been established
in substantial losses through theft. for the primary purpose of placing funds with
Cash-collateral, dealer differential or reserve, insured depository institutions;
undisbursed loan proceeds, and various loan • the trustee of a pension or other employee
escrow accounts are also sources of potential benefit plan, with respect to funds of the plan;
loss. The risk lies in inefficiency or misuse if the
accounts become overdrawn or if funds are • a person acting as a plan administrator or an
diverted for other purposes, such as the payment investment adviser in connection with a pen-
of principal or interest on bank loans. Funds sion plan or other employee benefit plan
deposited to these accounts should be used only provided that person is performing managerial
for their stated purposes. functions with respect to the plan;
• the trustee of a testamentary account;
• the trustee of an irrevocable trust,4 as long as
the trust in question has not been established
Brokered Deposits for the primary purpose of placing funds with
insured depository institutions;
As defined in Federal Deposit Insurance Corpo- • a trustee or custodian of a pension or profit-
ration (FDIC) regulations, brokered deposits are sharing plan qualified under section 401(d) or
funds a depository institution obtains, directly or 403(a) of the Internal Revenue Code of 1986
indirectly, from or through the mediation or (26 USC 401(d), 503(a)); or
assistance of a deposit broker, for deposit into
• an agent or a nominee whose primary purpose
one or more deposit accounts (12 CFR 337.6).
is not the placement of funds with depository
Thus, brokered deposits include both those in
institutions; or
which the entire beneficial interest in a given
bank deposit account or instrument is held by a • an insured depository institution acting as an
single depositor and those in which the deposit intermediary or agent of a U.S. government
broker pools funds from more than one investor department or agency for a government-
for deposit in a given bank deposit account. sponsored minority or women-owned deposi-
Section 29 of the Federal Deposit Insurance tory institution deposit program.
Act (the FDI Act) (12 USC 1831f(g)(1)) and the
FDIC’s regulations (12 CFR 337.6 (a)(5)) define
4. This exception does not apply to an agent or a trustee
deposit broker to mean— who establishes a deposit account to facilitate a business
arrangement with an insured depository institution to use the
• any person engaged in the business of placing proceeds of the account to fund a prearranged loan.

Page 7
A small- or medium-sized bank’s dependence bank. Extensive reliance on funding products of

on the deposits of customers who reside or this type, especially those obtained from outside
conduct their business outside of the bank’s a bank’s geographic market area, has the poten-
normal service area should be closely monitored tial to weaken a bank’s funding position.
by the bank and analyzed by the examiner. Such Some banks have used brokered and Internet-
deposits may be the product of personal rela- based funding to support rapid growth in loans
tionships or good customer service; however, and other assets. In accordance with the safety-
large out-of-area deposits are sometimes attracted and-soundness standards, a bank’s asset growth
by liberal credit accommodations or signifi- should be prudent and its management must
cantly higher interest rates than competitors consider the source, volatility, and use of the
offer. Deposit growth that is due to liberal credit funds generated to support asset growth. (See 12
accommodations generally proves costly in terms CFR 208 appendix D-1.)
of the credit risks taken relative to the benefits To compensate for the high rates typically
received from corresponding deposits, which offered for brokered deposits, institutions hold-
may be less stable. Banks outside dynamic ing them tend to seek assets that carry commen-
metropolitan areas are limited in growth because surately high yields. These assets can often
they usually can maintain stable deposit growth involve excessive credit risk or cause the bank
only as a result of prudent reinvestment in the to take on undue interest-rate risk through a
bank’s service area. Deposit development and mismatch in the maturity of assets and liabili-
retention policies should recognize the limits ties. The FDI Act (12 USC 1831f) includes
imposed by prudent competition and the bank’s certain restrictions on the use of brokered depos-
service area. its to prohibit undercapitalized insured deposi-
Historically, most banking organizations have tory institutions from accepting funds obtained,
not relied on funds obtained through deposit directly or indirectly, by or through any deposit
brokers to supplement their traditional funding broker for deposit into one or more deposit
sources. A concern regarding the activities of accounts.
deposit brokers is that the ready availability of
large amounts of funds through the issuance of
insured obligations undercuts market discipline. Capital Categories
The use of brokered deposits by sound,
well-managed banks can play a legitimate role in For the purposes of section 29 of the FDI Act,
the asset-liability management of a bank and the regulations of the FDIC and the Federal
enhance the efficiency of financial markets. Reserve (for the FDIC, 12 CFR 325.103 and for
However, the use of brokered deposits also can the Federal Reserve, 12 CFR 208.43) provide
contribute to the weakening of a bank by the definitions of well-capitalized, adequately
allowing it to grow at an unmanageable or capitalized, and undercapitalized financial insti-
imprudent pace and can exacerbate the condition tutions (banks). These definitions are tied to
of a troubled bank. Consequently, without proper percentages of leverage and risk-based capital.
monitoring and management, brokered and other Section 29 of the FDI Act limits the rates of
highly rate-sensitive deposits, such as those interest on brokered deposits that may be offered
obtained through the Internet, certificate of by insured depository institutions that are
deposit (CD) listing services, and similar adver- adequately capitalized or undercapitalized.
tising programs, may be unstable sources of
funding for an institution.
Deposits attracted over the Internet, through Well-capitalized bank. A bank is deemed to be
CD listing services, or through special advertis- well capitalized if it—
ing programs offering premium rates to custom-
ers without another banking relationship, require • has a total risk-based capital ratio of 10.0
special monitoring. Although these deposits may percent or greater;
not fall within the technical definition of ‘‘bro- • has a tier 1 risk-based capital ratio of 6.0
kered’’ in 12 USC 1831f and 12 CFR 337.6, percent or greater;
their inherent risk characteristics are similar to • has a leverage ratio of 5.0 percent or greater;
brokered deposits. That is, such deposits are and
typically attractive to rate-sensitive customers • is not subject to any written agreement, order,
who may not have significant loyalty to the capital directive, or prompt-corrective-action

Page 8
directive issued by the Board pursuant to insured limit, as detailed in the rule).
section 8 of the FDI Act (12 USC 1818), the If an FDIC-insured bank is adequately capi-
International Lending Supervision Act of 1983 talized and does not have a waiver from the
(12 USC 3907), or section 38 of the FDI Act FDIC, it may not use a broker to obtain deposits.
(12 USC 1831o), or any regulation thereunder, The following rate restrictions on deposits also
to meet and maintain a specific capital level apply: (1) the deposit rates may be no more than
for any capital measure. 75 basis points over the effective yield on
deposits of comparable size and maturity within
A well-capitalized insured depository institution the bank’s normal market area and (2) the
may solicit and accept, renew, or roll over any deposit rates may not be based on a ‘‘national’’
brokered deposit without restriction. rate.
Adequately capitalized bank. A bank is Undercapitalized bank. A bank is deemed to

deemed to be adequately capitalized if it— be undercapitalized if it—
• has a total risk-based capital ratio of 8.0 per- • has a total risk-based capital ratio that is less
cent or greater; than 8.0 percent;
• has a tier 1 risk-based capital ratio of 4.0 per- • has a tier 1 risk-based capital ratio that is less
cent or greater; than 4.0 percent;
• has— • has a leverage ratio that is less than 4.0 per-
— a leverage ratio of 4.0 percent or greater or cent;6 or
— a leverage ratio of 3.0 percent or greater if
• has a leverage ratio that is less than 3.0 per-
the bank is rated composite 1 under the
cent, if the bank is rated composite 1 under the
CAMELS rating system in the most recent
CAMELS rating system in the most recent
examination of the bank and is not expe-
examination of the bank and is not experienc-
riencing or anticipating significant growth;
ing or anticipating significant growth.
and
• does not meet the definition of a well capital-
An undercapitalized insured depository institu-
ized bank.
tion may not accept, renew, or roll over any
brokered deposit. Also, an undercapitalized
An adequately capitalized insured depository
insured depository institution (and any employee
institution may not accept, renew, or roll over
of the institution) may not solicit deposits by
any brokered deposit unless it has applied for
offering an effective yield that exceeds by more
and been granted a waiver of this prohibition by
than 75 basis points the prevailing effective
the FDIC. If the insured depository institution
yields on insured deposits of comparable matu-
has been granted a waiver by the FDIC, the
rity in the institution’s normal market area or in
institution may accept, renew, or roll over a
the market area in which such deposits are being
brokered deposit. The institution may not pay an
solicited.
effective yield on the deposit that exceeds, by
Each examination should include a review for
more than 75 basis points: (1) the effective yield
compliance with the FDIC’s limitations on the
paid on deposits of comparable size and matu-
acceptance of brokered deposits and guidelines
rity, and for deposits accepted, within the insti-
on interest payments. The use of brokered depos-
tution’s normal market area5 or (2) the ‘‘national
its should be reviewed during all on-site exami-
rate’’ paid on deposits of comparable size and
nations, even in those institutions not subject to
maturity for deposits accepted outside the insti-
the FDIC’s restrictions. Given the potential risks
tution’s normal market area. The national rate is
involved in using brokered deposits, the exami-
either 120 or 130 basis points of the current
nation should focus on the—
yield on similar-maturity U.S. Treasury obliga-
tions, depending on whether the deposit is FDIC
insured or more than half uninsured (the portion
6. An exception is available when (1) the bank the (the
of the deposit that is in excess of the FDIC- insured depository institution) has a leverage ratio of 3.0
percent or greater, (2) the bank is rated composite 1 under the
5. For deposits obtained through Internet solicitations, the CAMELS rating system following its most-recent bank exami-
determination of the bank’s ‘‘normal market area’’ is particu- nation, and (3) the bank is not experiencing or anticipating
larly problematic and difficult. significant growth.

Page 9
• rate of growth and the credit quality of the deposit broker. The agencies do not regulate
loans or investments funded by brokered deposit brokers.
deposits;
• corresponding quality of loan files, documen- • Due diligence in assessing the potential risk to
tation, and customer credit information; earnings and capital associated with brokered
• ability of bank management to adequately or other rate-sensitive deposits, and prudent
evaluate and administer these credits and strategies for their use. Bankers should man-
manage the resulting growth; age highly sensitive funding sources carefully,
• degree of interest-rate risk involved in the avoiding excessive reliance on funds that may
funding activities and the existence of a pos- be only temporarily available or which may
sible mismatch in the maturity or rate sensi- require premium rates to retain.
tivity of assets and liabilities;
• composition and stability of the deposit • Reasonable control structures to limit funding
sources and the role of brokered deposits in concentrations. Limit structures should con-
the bank’s overall funding position and sider typical behavioral patterns for depositors
strategy; and or investors and be designed to control exces-
• effect of brokered deposits on the bank’s sive reliance on any significant source(s) or
financial condition and whether the use of type of funding. This includes brokered funds
brokered deposits constitutes an unsafe and and other rate-sensitive or credit-sensitive
unsound banking practice. deposits obtained through the Internet or other
types of advertising.
The examiner should identify relevant concerns
in the examination report when brokered depos- • Management information systems (MIS) that
its amount to 5 percent or more of the bank’s clearly identify nonrelationship or higher-cost
total deposits. funding programs and allow management to
track performance, manage funding gaps, and
monitor compliance with concentration and
Risk-Management Expectations for other risk limits. At a minimum, MIS should
Brokered Deposits include a listing of funds obtained through
each significant program, rates paid on each
On May 11, 2001, the Federal Reserve Board and instrument and an average per program, infor-
the other federal banking agencies (the agencies) mation on maturity of the instruments, and
issued a Joint Agency Advisory on Brokered and concentration or other limit monitoring and
Rate-Sensitive Deposits. The advisory sets forth reporting. Management also should ensure
the following risk-management guidelines for that brokered deposits are properly reported in
brokered deposits. The bank’s management is the bank’s Consolidated Reports of Condition
expected to implement risk-management sys- and Income.7
tems that are commensurate in complexity with
the liquidity and funding risks that the bank • Contingency funding plans that address the
undertakes. (See SR-01-14.) Such systems should risk that these deposits may not ‘‘roll over’’
incorporate the following principles: and provide a reasonable alternative funding
strategy. Contingency funding plans should
• Proper funds-management policies. A good factor in the potential for changes in market
policy should generally provide for forward acceptance if reduced rates are offered on
planning, establish an appropriate cost struc- rate-sensitive deposits. The potential for trig-
ture, and set realistic limitations and business gering legal limitations that restrict the bank’s
strategies. It should clearly convey the board’s access to brokered deposits under Prompt
risk tolerance and should not be ambiguous Corrective Action (PCA) standards, and the
about who holds responsibility for funds- effect that this would have on the bank’s
management decisions. liability structure, should also be factored into
the plan.
• Adequate due diligence when assessing deposit
brokers. Bank management should implement 7. See the FFIEC bank Call Report and Instructions for
adequate due diligence procedures before Consolidated Reports of Condition and Income, Schedule
entering any business relationship with a RC-E—Deposit Liabilities.

Page 10
Examiners should assess carefully the liquidity- float—that is, the time required for the bank of
risk management framework at all banks. Banks deposit to collect from the paying bank, and
with meaningful reliance on brokered or other • the depositor initiates the transaction with the
rate-sensitive deposits should receive the appro- knowledge that sufficient collected funds will
priate level of supervisory attention. Examiners not be available to support the amount of the
should not wait for PCA provisions to be trig- checks drawn on all of the accounts.
gered or the viability of the bank to come into
question, before raising relevant safety-and- The key to this deceptive practice, the most
soundness issues with regard to the use of these prevalent type of check fraud, is the ability to
funding sources. If a determination is made that draw against uncollected funds. However, draw-
a bank’s use of these funding sources is not safe ing against uncollected funds in and of itself
and sound, or that these risks are excessive or does not necessarily indicate kiting. Kiting only
that they adversely affect the bank’s condition, occurs when the aggregate amount of drawings
then the examiner or central point of contact exceeds the sum of the collected balances in all
should recommend to the Reserve Bank man- accounts. Nevertheless, since drawing against
agement that it consider taking immediate appro- uncollected funds is the initial step in the kiting
priate supervisory action. The following repre- process, management should closely monitor
sent potential red flags that may indicate the this activity. The requirements of Regulation
need to take such action to ensure the risks CC, Availability of Funds and Collection of
associated with brokered or other rate-sensitive Checks, increased the risk of check kiting, and
funding sources are managed appropriately: should be addressed in a bank’s policies and
procedures.
• ineffective management or the absence of By allowing a borrower to draw against
appropriate expertise uncollected funds, the bank is extending credit
• a newly chartered institution with few rela- that should be subject to an appropriate approval
tionship deposits and an aggressive growth process. Accordingly, management should
strategy promptly investigate unusual or unauthorized
• inadequate internal audit coverage activity since the last bank to recognize check
• inadequate information systems or controls kiting and pay on the uncollected funds suffers
• identified or suspected fraud the loss. Check kiting is illegal and all suspected
• high on- or off-balance-sheet growth rates or known check kiting operations should be
• use of rate-sensitive funds not in keeping with reported pursuant to established Federal Reserve
the bank’s strategy policy. Banks should maintain internal controls
• inadequate consideration of risk, with man- to preclude loss from kiting, and the examiner
agement focus exclusively on rates should remember that in most cases kiting is not
• significant funding shifts from traditional fund- covered under Blanket Bond Standard Form 24.
ing sources
• the absence of adequate policy limitations on
these kinds of funding sources
• high loan delinquency rate or deterioration in
Delayed Disbursement Practices
other asset-quality indicators
• deterioration in the general financial condition Although Regulation CC, Availability of Funds
of the institution and Collection of Checks, stipulates time frames
for funds availability and return of items, delayed
• other conditions or circumstances warranting
disbursement practices (also known as remote
the need for administrative action
disbursement practices) can present certain risks,
especially concerning cashier’s checks, which
have next-day availability. Delayed disburse-
Check Kiting ment is a common cash management practice
that consists of arrangements designed to delay
Check kiting occurs when— the collection and final settlement of checks by
drawing checks on institutions located substan-
• a depositor with accounts at two or more tial distances from the payee or on institutions
banks draws checks against the uncollected located outside the Federal Reserve cities when
balance at one bank to take advantage of the alternate and more efficient payment arrange-

Page 11
ments are available. Such practices deny deposi- program notes, and master-note agreements.
tors the availability of funds to the extent that (See SR-90-31.)
funds could otherwise have been available ear- The disclosure agreement regarding the sale
lier. A check drawn on an institution remote of the nondeposit debt obligations should include
from the payee often results in increased possi- a statement indicating that these instruments are
bilities of check fraud and in higher processing not federally insured deposits or obligations of
and transportation costs for return items. or guaranteed by an insured depository institu-
Delayed disbursement arrangements could tion. In addition, banks and their subsidiaries
give rise to supervisory concerns because a bank that have issued or plan to issue nondeposit debt
may unknowingly incur significant credit risk obligations should not market or sell these
through such arrangements. The remote location instruments in any public area of the bank where
of institutions offering delayed disbursement retail deposits are accepted, including any lobby
arrangements often increases the collection time area of the bank. This requirement exists to
for checks by at least a day. The primary risk is convey the impression or understanding that the
payment against uncollected funds, which could purchase of such obligations by retail depositors
be a method of extending unsecured credit to a of the subsidiary bank can, in the event of
depositor. Absent proper and complete docu- default, result in losses to individuals who
mentation regarding the creditworthiness of the believed they had acquired federally insured or
depositor, paying items against uncollected funds guaranteed obligations.
could be considered an unsafe or unsound bank-
ing practice. Furthermore, such loans, even if Bank Policies and Procedures
properly documented, might exceed the bank’s
legal lending limit for loans to one customer. Banking organizations with sweep programs
Examiners should routinely review a bank’s should have adequate policies, procedures, and
practices in this area to ensure that such prac- internal controls in place to ensure that the
tices are conducted prudently. If undue or activity is conducted in a manner consistent with
undocumented credit risk is disclosed or if safe and sound banking principles and in accor-
lending limits are exceeded, appropriate correc- dance with all banking laws and regulations.
tive action should be taken. Bank policies and procedures should further
ensure that deposit customers participating in a
sweep program are given proper disclosures and
information. When a sweep program is used as
Deposit Sweep Programs or part of a funding strategy for a BHC or a
Master-Note Arrangements nonbank affiliate, examiners should ensure that
liquidity and funding strategies are carried out in
Deposit sweep programs or master-note arrange- a prudent manner.
ments (sweep programs) can be implemented on
a bank level or on a parent bank holding
company (BHC) level. On a bank level, these Application of Deposit Proceeds
sweep programs exist primarily to facilitate the In view of the extremely short-term maturity of
cash-management needs of bank customers, most swept funds, banks and BHCs are expected
thereby retaining customers who might other- to exercise great care when investing the pro-
wise move their account to an entity offering ceeds. Banks, from whom deposit funds are
higher yields. On a BHC level, the sweep swept, have a fiduciary responsibility to their
programs are maintained with customers at the customers to ensure that such transactions are
bank level, and the funds are upstreamed to the conducted properly. Appropriate uses of the
parent as part of the BHC’s funding strategy. proceeds of deposit sweep funds are limited to
Sweep programs use an agreement with the short-term bank obligations, short-term U.S.
bank’s deposit customers (typically corporate government securities, or other highly liquid,
accounts) that permits these customers to rein- readily marketable, investment-grade assets that
vest amounts in their deposit accounts above a can be disposed of with minimal loss of princi-
designated level in overnight obligations of the pal.8 When deposit sweep funds are invested in
parent bank holding company, another affiliate
of the bank, or a third party. These obligations 8. Some banking organizations have interpreted language
include instruments such as commercial paper, in a 1987 letter signed by the secretary of the Board as

Page 12
U.S. government securities, appropriate agree- funding problem. Thus BHCs relying on over-
ments must be in place, required disclosures night or extremely short-term funding sources
must be made, and daily confirmations must be should maintain a sufficient level of superior-
provided to the customer in accordance with the quality assets (at a level at least equal to the
requirements of the Government Securities Act amount of the funding sources’) that can be
of 1986. Use of such proceeds to finance mis- immediately liquidated or converted to cash
matched asset positions, such as those involving with minimal loss.
leases, loans, or loan participations, can lead to
liquidity problems and are not considered Dormant Accounts
appropriate. The absence of a clear ability to
redeem overnight or extremely short-term liabili- A dormant account is one in which customer-
ties when they become due should generally be originated activity has not occurred for a prede-
viewed as an unsafe and unsound banking termined period of time. Because of this inac-
activity. tivity, dormant accounts are frequently the target
of malfeasance and should be carefully con-
Funding Strategies trolled by a bank. Bank management should
establish standards that specifically outline the
A key principle underlying the Federal Reserve’s bank’s policy for the effective control of dor-
supervision of banking organizations is that mant accounts, addressing—
BHCs operate in a way that promotes the
soundness of their subsidiary banks. BHCs are • the types of deposit categories that could
expected to avoid funding strategies or practices contain dormant accounts, including demand,
that could undermine public confidence in the savings, and official checks;
liquidity or stability of their banks. Any funding • the length of time without customer-originated
strategy should maintain an adequate degree of activity that qualifies an account to be identi-
liquidity at both the parent level and the subsid- fied as dormant;
iary bank level. Bank management should avoid, • the controls exercised over the accounts and
to the extent possible, allowing sweep programs their signature cards, that is, prohibiting
to serve as a source of funds for inappropriate release of funds by a single bank employee;
uses at the BHC or at an affiliate. Concerns exist and
in this regard because funding mismatches can • the follow-up by the bank when ordinary bank
exacerbate an otherwise manageable period of mailings, such as account statements and
financial stress and, in the extreme, undermine advertising flyers, are returned to the bank
public confidence in a banking organization’s because of changed addresses or other reasons
viability. for failure to deliver.
Funding Programs
Employee Deposit Accounts
In developing and carrying out funding pro- Historically, examiners have discovered various
grams, BHCs should give special attention to irregularities and potential malfeasance through
the use of overnight or extremely short-term review of employee deposit accounts. As a
liabilities, since a loss of confidence in the result, bank policy should establish standards
issuing organization could lead to an immediate that segregate or specially encode employee
accounts and should encourage periodic internal
condoning funding practices that may not be consistent with supervisory review. In light of these concerns,
the principles set forth in a subsequent supervisory letter dated examiners should review related bank proce-
September 21, 1990, as well as with prior Board rulings. The dures and practices, taking appropriate measures
1987 letter involved a limited set of facts and circumstances
that pertained to a particular banking organization; it did not when warranted.
establish or revise Federal Reserve policies on the proper use
of the proceeds of short-term funding sources. In any event,
banking organizations should no longer rely on the 1987 letter
to justify the manner in which they use the proceeds of sweep Overdrafts
programs. Banking organizations employing sweep programs
are expected to ensure that these programs conform with the The size, frequency, and duration of deposit-
policies in this manual section. account overdrafts are matters that should be

Page 13
governed by bank policy and controlled by material relative to the bank’s asset-liability
adequate internal controls, practices, and proce- management practices. Another factor that can
dures. Overdraft authority should be approved cause potential liquidity concerns relates to the
in the same manner as lending authority and volatile nature of these deposits.
should never exceed the employee’s lending This volatility occurs because the volume of
authority. Systems for monitoring and reporting public funds normally fluctuates on a seasonal
overdrafts should emphasize a secondary level basis due to timing differences between tax
of administrative control that is distinct from collections and expenditures. A bank’s ability to
other lending functions so account officers who attract public funds is typically based upon the
are less than objective do not allow influential government entity’s assessment of three key
customers to exploit their overdraft privileges. points:
A bank’s payment of overdrafts of executive
officers and directors of the bank is generally • the safety and soundness of the institution
prohibited under Regulation O. (See 12 CFR with which the funds have been placed
215.4(e).) It is the board of directors’ responsi- • the yield on the funds being deposited
bility to review overdrafts as they would any • that such deposits are placed with a bank that
other extension of credit. Overdrafts outstanding can provide or arrange the best banking ser-
for more than 60 days, lacking mitigating cir- vice at the least cost
cumstances, should be considered for charge-
off. See SR-05-3/CA-05-2 and section 2130.1 Additionally, banks that offer competitive inter-
on the February 18, 2005, Interagency Joint est rates and provide collection, financial advi-
Guidance on Overdraft Protection Programs. sory, underwriting, and data processing services
at competitive costs are frequently chosen as
depositories. Public funds deposits acquired
Payable-Through Accounts through political influence should be regarded as
particularly volatile. As a result, an examiner
A payable-through account is an accommoda- should pay particular attention to assessing the
tion offered to a correspondent bank or other volatility of such funds in conjunction with the
customer by a U.S. banking organization whereby review of liquidity.
drafts drawn against client subaccounts at thecor-
respondent are paid upon presentation by the
U.S. banking institution. The subaccount holders
of the payable-through bank are generally non– Zero-Balance Accounts
U.S. residents or owners of businesses located
outside of the United States. Usually the con- Zero-balance accounts (ZBAs) are demand
tract between the U.S. banking organization and deposit accounts used by a bank’s corporate
the payable-through bank purports to create a customers through which checks or drafts are
contractual relationship solely between the two received for either deposit or payment. The total
parties to the contract. Under the contract, the amount received on any particular day is offset
payable-through bank is responsible for screen- by a corresponding debit or credit to the account
ing subaccount holders and maintaining ade- before the close of business to maintain the
quate records with respect to such holders. The balance at or near zero. ZBAs enable a corporate
examiner should be aware of the potential effect treasurer to effectively monitor cash receipts and
of money laundering. disbursements. For example, as checks arrive
for payment, they are charged to a ZBA with the
understanding that funds to cover the checks
Public Funds will be deposited before the end of the banking
day. Several common methods used to cover
Public funds generally represent deposits of the checks include—
U.S. government, as well as state and political
subdivisions, and typically require collateral in • wire transfers;
the form of securities to be pledged against • depository transfer checks, a bank-prepared
them. A bank’s reliance upon public funds can payment instrument used to transfer money
cause potential liquidity concerns if the aggre- from a corporate account in one bank to
gate amount, as a percentage of total deposits, is another bank;

Page 14
• concentration accounts, a separate corporate between the account holder and the bank). If
demand deposit account at the same bank used these checks are not covered, an overdraft occurs,
to cover deficits or channel surplus funds which will be reflected on the bank’s financial
relative to the ZBA; or statement.
• extended settlement, a cash-management The absence of prudent safeguards and a lack
arrangement that does not require the corpo- of full knowledge of the creditworthiness of
rate customer to provide same-day funds for the depositor may expose the bank to large,
payment of its checks. unwarranted, and unnecessary risks. Moreover,
the magnitude of unsecured credit risk may
Because checks are covered before the close exceed prudent limits. Examiners should rou-
of business on the day they arrive, the bank’s tinely review cash-management policies and
exposure is not reflected in the financial state- procedures to ensure that banks do not engage
ment. The bank, however, assumes risk by in unsafe and unsound banking practices, mak-
paying against uncollected funds, thereby creating appropriate comments in the report of
ing unsecured extensions of credit during the examination, as necessary.
day (which is referred to as a daylight overdraft

Page 15
Deposit Accounts
1. To determine if the policies, practices, pro- 4. To determine if bank officers and employees
cedures, and internal controls regarding are operating in conformance with the bank’s
deposit accounts are adequate. established guidelines.
2. To determine if the bank’s management 5. To evaluate the deposit structure and deter-
implemented adequate risk-management sys- mine its characteristics and volatility.
tems for brokered and rate-sensitive deposits
that are commensurate with the liquidity and
audit function.
funding risks the bank has undertaken.
3. To determine if the bank’s policies, practices, 7. To determine compliance with applicable
procedures, and internal controls (including laws and regulations.
compliance oversight, management report- 8. To initiate corrective action when policies,
ing, and staff training) for account relation- practices, procedures, or internal controls are
ships involving foreign governments, foreign deficient, or when violations of laws or
embassies, and foreign political figures (as regulations are noted.
well as foreign-currency customer deposit
accounts) are adequate for the varied risks
posed by these accounts.

Page 1
Deposit Accounts
1. Determine the scope of the examination of • matured certificates of deposit without

the deposit-taking function. In so doing, an automatic renewal feature
consider the findings of prior examinations, • large-balance report
related work prepared by internal and b. For official checks:
external auditors, deficiencies in internal • trial balance(s)
controls noted within other bank functions, • exception list
and the requirements of examiners assigned c. For savings accounts:
to review the asset/liability management • trial balance
and interest-rate risk aspects of the bank. • unposted items
2. If required by the scope, implement the • overdrafts
‘‘Deposit Accounts’’ internal control • dormant accounts
questionnaire. • public funds
3. Test the deposit function for compliance • trust department funds
with policies, procedures, and internal con- • large-balance report
trols in conjunction with performing the d. For other time deposits:
remaining examination procedures. Also, • trial balance(s)
obtain a listing of any deficiencies noted in • large-balance report
the latest internal or external audit review, • unposted items
then determine if appropriate corrections • public funds
have been made. • trust department funds
4. In conducting the examination, use avail- • money market accounts
able bank copies of printouts plus transac- e. For certificates of deposit:
tions journals, microfiche, or other visual • trial balance(s)
media to minimize expense to the bank. • unposted items
However, if copies of these reports are not • public funds
available, determine what information is • certificates of $100,000 or more
necessary to complete the examination pro- • negotiable certificates of deposit
cedures and request that information from • maturity reports
the bank. • matured certificates of deposit
Obtain or prepare, as applicable, the f. For deposit sweep programs or master-
reports indicated below, which are used for note arrangements, list individually by
a variety of purposes, including the deposit type and amount.
assessment of deposit volatility and liquidity, g. For brokered deposits, list individually
the assessment of the adequacy of internal by deposit type, including amount and
controls, the verification of information on rate.
required regulatory reports, and the assess- h. For bank-controlled accounts:
ment of loss. • reconcilement records for all such
a. For demand deposits and other transac- accounts
tion accounts: • names and extensions of individuals
• trial balance authorized to make entries to such
• overdrafts accounts
• unposted items • name and phone extension of recon-
• nonsufficient-funds (NSF) report cilement clerk(s)
• dormant accounts i. For the bank’s foreign-currency cus-
tomer deposit accounts and the deposit
• public funds
accounts for foreign governments,
• uncollected funds embassies, and political figures:
• due to banks • list of accounts and currency type
• trust department funds • list of currency transactions over
• significant activity $10,000 for each account, and the
• suspected kiting report copies of their Currency Transaction

Page 1
3000.3 Deposit Accounts: Examination Procedures
Report (IRS Form 4789) or its equiva- • officer-approval limits have been
lent, since the previous examination established, and
• the most recent internal audit report • a formal system of review and approval
covering the review of those accounts, is in effect.
the risks associated with the accounts, b. Ascertain the existence of formal over-
the internal controls over those draft protection. If the bank provides
accounts, and the staff’s completion of overdraft protection, perform the follow-
the Currency Transaction Report (IRS ing procedures:
Form 4789) • Obtain a master list of all depositors
• the completed copies of the Report of with formal overdraft protection.
Foreign (Non-U.S.) Currency Depos- • Obtain a trial balance indicating
its, Form 2915, that have been submit- advances outstanding and compare it
ted since the previous examination with the master list to ensure compli-
5. Review the reconcilement of all types of ance with approved limits.
deposit accounts. Verify the balances to • Cross-reference the trial balance or
department controls and the general ledger. master list to examiner loan line sheets.
a. Determine if reconciliation items are • Review credit files on significant for-
legitimate and if they clear within a mal agreements not cross-referenced
reasonable time frame. above.
b. Retain custody of all trial balances until • Determine whether the depository insti-
items outstanding are resolved. tution has an overdraft-protection pro-
6. Review the reconciliation process for bank- gram and if it has adequate written
controlled accounts, such as official checks policies and procedures to address the
and escrow deposits, by— credit, operational, and other risks asso-
a. determining if reconciling items are ciated with those programs. See the
legitimate and if they clear within a February 18, 2005, interagency Joint
reasonable time frame; Guidance on Overdraft Protection Pro-
b. scanning activity in such accounts to grams (SR-05-3/CA-05-2).
determine the potential for improper • Ascertain whether there is ongoing
diversion of funds for various uses, such monitoring of overdrafts to identify
as— customers who may pose an undue
credit risk to the bank.
• political contributions,
• Find out if the bank has incorporated
• loan payments (principal and interest),
into its overdraft-protection program
or
prudent risk-management practices per-
• personal use; and taining to account repayment and the
c. determining if checks are being pro- suspension of a customer’s overdraft-
cessed before their related credits. protection services when the customer
7. Review the bank’s operating procedures does not satisfy repayment and eligi-
and reconciliation process relative to sus- bility requirements.
pense accounts. Determine if— • Determine whether overdrafts are prop-
a. the disposition process of unidentified erly and accurately reported according
items is completed in a timely fashion; to generally accepted accounting prin-
b. reports are generated periodically to ciples on the bank’s financial state-
inform management of the type, age, and ments and on its Reports of Condition
amount of items in such accounts; and and Income (Call Reports). Verify that
c. employees responsible for clearing overdrafts are reported as loans on the
suspense-account items are not shifting Report of Condition.
the items between accounts. • Verify the existence of the bank’s
8. Evaluate the effectiveness of the written loss-estimation procedures for over-
policies and procedures and of manage- draft and fee balances. Determine if
ment’s reporting methods regarding over- the procedures are adequately rigorous
drafts and drawings against uncollected and if losses are properly accounted
funds. for as part of (1) the allowance for loan
a. Concerning overdrafts, determine if— and lease losses or (2) the loss allow-

Page 2
Deposit Accounts: Examination Procedures 3000.3
ance for uncollectible fees (alterna- • cross-reference overdraft and

tively, the bank may recognize only uncollected-funds reports to examiner
that portion of earned fees estimated to loan line sheets;
be collectible), if applicable.1 • review the credit files of depositors
• When applicable, validate (1) whether with significant overdrafts, if avail-
the bank’s overdraft commitments were able, or the credit files of depositors
assigned the correct conversion factor, who frequently draw significant
(2) whether they are accurately risk- amounts against uncollected funds, for
weighted by obligor, and (3) if the those depositors not cross-referenced
commitment terms comply with the in the preceding step;
risk-based capital guidelines. • request management to charge off over-
• Determine whether the bank has drafts deemed to be uncollectible; and
obtained assurances from its legal • submit a list of the following items to
counsel that its overdraft-protection the appropriate examiner:
program is fully compliant with all — overdrafts considered loss, indicat-
applicable federal and state laws and ing borrower and amount
regulations, including the Federal Trade — aggregate amounts overdrawn
Commission Act. 30 days or more past due, for
• When the bank contracts with third- inclusion in past-due statistics
party vendors to do information tech- 9. Review the bank’s deposit development and
nology work, determine if the bank retention policy, which is often included in
conducted proper due diligence before the funds-management policy.
entering into the contract and that it a. Determine if the policy addresses the
followed the November 28, 2000, deposit structure and related interest
guidance on the Risk Management of costs, including the percentages of time
Outsourced Technology Services. (See deposits and demand deposits of—
SR-00-17.) • individuals,
c. Concerning drawings against uncol- • corporations, and
lected funds, determine if— • public entities.
• the uncollected-funds report reflects b. Determine if the policy requires periodic
balances as uncollected until they are reports to management comparing the
actually received; accuracy of projections with results.
• management is comparing reports of c. Assess the reasonableness of the policy,
significant changes in balances and and ensure that it is routinely reviewed
activity volume with uncollected-funds by management.
reports; 10. If a deposit sweep program or master-note
• management knows the reasons why a arrangement exists, review the minutes of
depositor is frequently drawing against the board of directors for approval of related
uncollected funds; policies and procedures.
• a reporting system to inform senior 11. For banks with deposit sweep programs or
management of significant activity in master-note arrangements (sweep programs),
the uncollected-funds area has been compare practices for adherence to approved
instituted; and policies and procedures. Review the
• appropriate employees clearly under- following:
stand the mechanics of drawing against a. The purpose of the sweep program: Is it
uncollected funds and the risks strictly a customer-accommodation trans-
involved, especially in the area of action, or is it intended to fund certain
potential check-kiting operations. assets at the holding company level or
d. After completing steps 8.a., 8.b., and at an affiliate? Review funding trans-
8.c.— actions in light of liquidity and fund-
ing needs of the banking organization by
1. Institutions may charge off uncollectible overdraft fees referring to section 4020.1.
against the allowance for loan and lease losses if such fees are
recorded with overdraft balances as loans and if estimated
b. The eligibility requirements used by the
credit losses on the fees are provided for in the allowance for bank to determine the types of customers
loan and lease losses. and accounts that may participate in a

Page 3
sweep program, including— ment be confirmed in writing at the

• a list of customers participating in end of the day of initiation and that
sweep programs, with dollar amounts the confirmation confirms specific
of deposit funds swept on the date of securities. If any other securities are
examination, and substituted that result in a change of
• the name of the recipient(s) of swept issuer, maturity date, par amount, or
funds. coupon rate, another confirmation must
— If the recipient is an affiliate of the be issued at the end of the day during
bank, include a schedule of the which the substitution occurred.
instruments into which the funds Because the confirmation or safekeep-
were swept, including the effective ing receipt must list specific securities,
maturity of these instruments. ‘‘pooling’’ of securities for any type of
— If the recipient is an unaffiliated sweep program involving government
third party, determine if the bank securities is not permitted. Addition-
adequately evaluates the third ally, if funds are swept into other
party’s financial condition at least instruments, similar confirmation pro-
annually. Also, verify if a fee is cedures should be applied.)
received by the bank for the trans- • Conditions of the sweep program are
action. If so, determine that the stated clearly, including the dollar
fee is disclosed in customer amount (minimum or maximum
documentation. amounts and incremental amounts),
c. Whether the proceeds of sweep pro- time frame of sweep, time of day the
grams are invested only in short-term sweep transaction occurs, fees pay-
bank obligations; short-term U.S. govern- able, transaction confirmation notice,
ment securities; or other highly liquid, prepayment terms, and termination
readily marketable, investment-grade notice.
assets that can be disposed of with mini- • The length of any single transaction
mal loss of principal. under sweep programs in effect has not
d. Whether the bank and its subsidiaries exceeded 270 days and the amount is
have issued or plan to issue nondeposit $25,000 or more (as stipulated by SEC
debt obligations in any public area of policy). Ongoing sweep-program dis-
the bank where retail deposits are closures should occasionally be sent to
accepted, including any lobby area of the customer to ensure that the terms
the bank. of the program are updated and the
e. Completed sweep-program documents to customer understands the terms.
determine the following: f. Samples of advertisements (newspaper,
• Signed documents boldly disclose that radio, television spots, etc.) by the bank
the instrument into which deposit funds for sweep programs to determine if the
will be swept is not insured by the advertisements—
FDIC and is not an obligation of, or • boldly disclose that the instrument into
guaranteed by, the bank. which deposit funds are swept is not
• Proper authorization for the instrument insured by the FDIC and is not an
exists between the customer and an obligation of, or guaranteed by, the
authorized representative of the bank. bank, and
• Signed documents properly disclose • are not enclosed with insured deposit
the name of the obligor and the type of statements mailed to customers.
instrument into which the depositor’s g. Whether the sweep program has had a
funds will be swept. If funds are being negative effect on bank liquidity or has
swept into U.S. government securities the potential to undermine public confi-
held by the banking organization, dence in the bank.
verify that adequate confirmations are • Review the bank’s federal funds and
provided to customers in accordance borrowing activities to ascertain
with the Government Securities Act of whether borrowings appear high. If so,
1986. (This act requires that all trans- compare the bank’s borrowing activity
actions subject to a repurchase agree- with daily balances of aggregate sweep

Page 4
transactions on selected dates to see if current publicly quoted rates within

a correlation exists. the market;
• If sweep activity is significant, com- • whether the bank is paying current
pare the rates being paid on swept market rates on CDs;
deposits with the yields received on • the dollar amount of brokered CDs, if
the invested funds and with the rates any; and
on other overnight funding instru- • the dollar volume of deposits obtained
ments, such as federal funds, to deter- as a result of special promotions.
mine if they are reasonable. b. Federal Deposit Insurance Corporation
12. Forward the following to the examiner Improvement Act of 1991 (12 USC
assigned to asset/liability management: 1831F).
a. the amount of any deposit decline or • If the bank is undercapitalized, as
deposit increase anticipated by manage- defined in the FDIC’s regulation on
ment (the time period will be determined brokered deposits, ensure that it is not
by the examiner performing asset/liability accepting brokered deposits. (See 12
management) CFR 337.6.)
b. a listing by name and amount of any • If the bank is only adequately capital-
depositor controlling more than 1 per- ized, as defined in the FDIC’s regula-
cent of total deposits tion and is accepting brokered depos-
c. a listing, if available, by name and its, ensure that a waiver authorizing
amount of any deposits held solely acceptance of such deposits has been
because of premium rates paid (brokered obtained from the FDIC and that the
deposits) bank is in compliance with the interest-
d. the aggregate amount of brokered rate restrictions. (See 12 CFR
deposits 337.6(b)(3).)
e. a maturity schedule of certificates of c. Determine if the bank has risk-
deposit, detailing maturities within the management systems to monitor and con-
next 30, 60, 90, 180, and 360 days trol its liquidity and funding risks that
f. an assessment of the overall characteris- are associated with the bank’s brokered
tics and volatility of the deposit structure and rate-sensitive deposits.
13. Analyze UBPR data on deposits and related d. Ascertain if the bank’s risk-management
expense ratios, and compare with peer- systems for its brokered and rate-sensitive
group norms to determine— deposits are adequate and if they are
a. variations from the norm, and commensurate with the complexity of its
b. trends in the deposit structure with liquidity and funding risks. Determine if
respect to— the bank has the following:
• growth patterns, and • proper funds-management policies;
• shifts between deposit categories. • adequate due diligence when assess-
14. Assess the volatility and the composition of ing the risks associated with deposit
the bank’s deposit structure. brokers;
a. Review the list of time certificates of • due diligence in assessing the potential
deposit of $100,000 or more and related risk to earnings and capital associated
management reports, including those on with brokered or other rate-sensitive
brokered deposits, to determine— deposits, and prudent strategies for
• whether concentrations of maturing their use;
deposits exist; • reasonable control structures to limit
• whether a concentration of deposits to funding concentrations;
a single entity exists; • management information systems (MIS)
• the aggregate dollar volume of accounts that clearly identify nonrelationship or
of depositors outside the bank’s nor- higher-cost funding programs that allow
mal service area, if significant, and the management to track performance,
geographic areas from which any sig- manage funding gaps, and monitor
nificant volume emanates; compliance with concentration and
• the aggregate dollar volume of CDs other risk limits; and
that have interest rates higher than • contingency funding plans that address

Page 5
the risk that these deposits may not with current deposit trends, to estimate its
‘‘roll over’’ and provide a reasonable effect on the bank’s deposit structure.
alternative funding strategy. 16. Perform the following procedures to test for
e. Review public funds and the bank’s compliance with the applicable laws and
method of acquiring such funds to assess regulations listed below:
whether the bank uses competitive bid- a. Regulation O (12 CFR 215), Loans to
ding in setting the interest rate paid on Executive Officers, Directors, and Prin-
public deposits. If so, does the bank cipal Shareholders of Member Banks.
consider variables in addition to rates Review the overdraft listing to ensure
paid by competition in determining pric- that the bank has not paid an overdraft on
ing for bidding on public deposits? any account of an executive officer or
f. Review appropriate trial balances for all director, unless the payment is made
other deposits (demand, savings, and according to—
other time deposits). Review manage- • a written, preauthorized, interest-
ment reports that relate to large deposits bearing extension of a credit plan that
for individuals, partnerships, corpora- provides a method of repayment, or
tions, and related deposit accounts to • a written, preauthorized transfer from
determine whether a deposit concentra- another account of that executive offi-
tion exists. cer or director.
• Select, at a minimum, the 10 largest Payment of inadvertent overdrafts in an
accounts to determine if the retention aggregate amount of $1,000 or less is not
of those accounts depends on— prohibited, provided the account is not
— criticizable loan relationships; overdrawn more than five business days
— liberal service accommodations, and the executive officer or director is
such as permissive overdrafts and charged the same fee charged to other
drawings against uncollected funds; customers in similar circumstances. Over-
— interbank correspondent relation- drafts are extensions of credit and must
ships; be included when considering each insid-
— deposits obtained as a result of er’s lending limits and other extension-
special promotions; and of-credit restrictions, as well as when
— a recognizable trend with respect considering the aggregate lending limit
to— for all outstanding extensions of credit
• frequent significant balance by the bank to all insiders and their
fluctuations, related interests.
• seasonal fluctuations, and b. 12 USC 1972(2), Loans to Executive
• nonseasonal increases or de- Officers, Directors, and Principal Share-
creases in average balances. holders of Correspondent Banks. Review
g. Elicit management’s comments to deter- the overdraft listing to ensure that no
mine, to the extent possible— preferential overdrafts exist from the bank
• the potential renewal of large CDs that under examination to the executive offi-
mature within the next 12 months; cers, directors, or principal shareholders
• if public fund deposits have been of the correspondent bank.
obtained through political influence; c. Section 22(e) of the Federal Reserve Act
• if a significant dollar volume of (12 USC 376), Interest on Deposits of
accounts is concentrated in customers Directors, Officers, and Employees.
engaged in a single business or indus- Obtain a list of deposit accounts, with
try; and account numbers, of directors, officers,
• if there is a significant dollar volume attorneys, and employees. Review the
of deposits from customers who do not accounts for any exceptions to standard
reside within the bank’s service area. policies on service charges and interest
15. Obtain information on competitive pres- rates paid that would suggest self-dealing
sures and economic conditions from the or preferential treatment.
examiner responsible for the ‘‘Economic d. Sections 23A and 23B of the Federal
Conditions and Competition’’ report sec- Reserve Act (12 USC 371c), and Regu-
tion, and evaluate that information, along lation W. Determine the existence of

Page 6
any non-intraday overdrawn affiliate i. Local escheat laws. Determine if the

accounts. If such overdrawn accounts are bank is adhering to the local escheat laws
identified, review for compliance with with regard to all forms of dormant
sections 23A and 23B of the act and with deposits, including official checks.
Regulation W. 17. If applicable, determine if the bank is
e. Regulation D (12 CFR 204), Reserve appropriately monitoring and limiting the
Requirements of Depository Institutions. foreign-exchange risk associated with
Review the accuracy of the deposit data foreign-currency deposits.
used in the bank’s reserve-requirement 18. For a bank that accepts accounts from
calculation for the examination date. foreign governments, embassies, and politi-
When a bank issues nondeposit, unin- cal figures, evaluate—
sured obligations that are classified as a. the existence and effectiveness of the
‘‘deposits’’ in the calculation of reserve bank’s policies, procedures, compliance
requirements, examiners should deter- oversight, and management reporting
mine if these items are properly catego- with regard to such foreign accounts;
rized. Ascertain that the TT&L remit- b. whether the bank and its staff have the
tance option is included in the necessary controls, as well as the ability,
computations for reserve requirements. to manage the risks associated with such
f. Regulation Q (12 CFR 217), Prohibition foreign accounts;
Against Payment of Interest on Demand c. whether the bank’s board of directors
Deposits. Ensure that interest is not being and staff can ensure full compliance with
paid on the proceeds of nonautomatically its obligations under the Bank Secrecy
renewable matured certificates of Act, as amended by the USA Patriot Act,
deposit held in demand deposit and its regulations;
accounts (as opposed to NOW accounts, d. the adequacy of the level of training of
which permit the payment of interest). the bank’s personnel responsible for man-
g. 12 USC 501 and 18 USC 1004, False aging the risks associated with such for-
Certification of Checks. Compare several eign accounts and for ensuring that the
certified checks by date, amount, and bank is and remains in compliance with
purchaser with the depositors’ names the requirements of the applicable laws
appearing on uncollected-funds and over- and regulations; and
draft reports of the same dates to deter- e. the effectiveness of the bank’s program
mine that the checks were certified that communicates its policies and pro-
against collected funds. cedures for such foreign accounts to
h. Uniform Commercial Code 4-108, Bank- ensure that foreign government, embassy,
ing Hours and Processing of Items. and political-figure customers are fully
• Determine the bank’s cutoff hour, informed of the requirements of applica-
after which items received are ble U.S laws and regulations.
included in the processing for the next 19. Discuss overall findings with bank manage-
‘‘banking day,’’ to ensure that the cutoff ment. Prepare report comments on—
hour is not earlier than 2:00 p.m. a. policy deficiencies,
• If the bank’s cutoff hour is before 2:00 b. noncompliance with policies,
p.m., advise management that fail- c. weaknesses in supervision and reporting,
ure to process items received before a d. violations of laws and regulations, and
2:00 p.m. cutoff may result in civil e. possible conflicts of interest.
liability for delayed handling of those 20. Update workpapers with any information
items. that will facilitate future examinations.

Page 7
Deposit Accounts
Review the bank’s internal controls, policies, tories of new-account documents and CDs,
practices, and procedures for demand and time and do the inventories include an account-
deposit accounts. The bank’s systems should be ability of numbers issued out of sequence
documented completely and concisely and or canceled prior to issuance?
should include, where appropriate, narrative *4. Are CDs signed by a properly authorized
descriptions, flow charts, copies of forms used, individual?
and other pertinent information. 5. Are new-account applications and signa-
For large institutions or those institutions that ture cards reviewed by an officer?
have individual demand and time deposit book-
keeping functions, the examiner should consider
administering this questionnaire separately for CLOSING DEPOSIT ACCOUNTS
each function, as applicable.
Questions pertain to both demand and time 1. Are signature cards for closed accounts
deposits unless otherwise indicated. Negative promptly pulled from the active-account
responses to the questions in this section should file and placed in a closed file?
be explained, and additional procedures deemed 2. Are closed-account lists prepared? If so,
necessary should be discussed with the examiner- how frequently?
in-charge. Items marked with an asterisk require 3. Is the closed-account list circulated to
substantiation by observation or testing. appropriate management?
4. Is verification of closed accounts, in the
form of statements of ‘‘goodwill’’ letters,
OPENING DEPOSIT ACCOUNTS required? Are such letters mailed under
the control of someone other than a teller
*1. Are new-account documents prenumbered? or an individual who can make internal
a. Are new-account documents issued in entries to an account (such as a private
strict numerical sequence? banker or branch manager)?
b. Are the opening of new accounts and *5. For redeemed CDs:
access to unused new-account records a. Are the CDs stamped paid?
and certificate of deposit (CD) forms b. Is the disposition of proceeds docu-
handled by an employee who is not a mented to provide a permanent record
teller or who cannot make internal as well as a clear audit trail?
entries to customer accounts or the c. Are penalty calculations on CDs and on
general ledger? other time deposits that are redeemed
*2. Does the institution have a written ‘‘know- before maturity rechecked by a second
your-customer’’ policy? employee?
a. Do new-account applications require *6. Except for deposit-account agreements that
sufficient information to clearly identify authorize the transfer of deposited funds to
the customer? other nondemand deposit accounts, are
b. Are ‘‘starter’’ checks issued only matured CDs that are not automatically
after the verification of data on new renewable classified as demand deposits
transaction-account applications? on the Call Report and on the Report of
c. Are checkbooks and statements mailed Transaction Accounts, Other Deposits and
only to the address of record? If not, is Vault Cash (FR 2900)?
a satisfactory explanation and descrip-
tion obtained for any other mailing
address (post office boxes, a friend or DEPOSIT-ACCOUNT RECORDS
relative, etc.)?
d. Are the employees responsible for open- *1. Does the institution have documentation
ing new accounts trained to screen supporting a current reconcilement of each
depositors for signs of check kiting? deposit-account category recorded on its
*3. Does the bank perform periodic inven- general ledger, including customer accounts

Page 1
3000.4 Deposit Accounts: Internal Control Questionnaire
and bank-controlled accounts such as 10. If the bank’s bookkeeping system is not
dealer reserves, escrow, Treasury tax and automated, are deposit bookkeepers
loan, etc.? (Prepare separate workpapers rotated?
for demand and time accounts, listing each 11. Does the bank segregate the deposit
account and the date and frequency of account files of—
reconcilement, the general-ledger balance, a. employees and officers?
the subsidiary-ledger balance, adjustments, b. directors?
and unexplained differences.) c. the business interests of employees and
*2. Are reconciliations performed by an indi- officers, or interests controlled by
vidual or group not directly engaged in employees and officers?
accepting or preparing transactions or in d. the business interests of directors, or
data entry to customers’ accounts? interests controlled by directors?
*3. If the size of the bank precludes full e. foreign goverments, embassies, and
separation of duties between data entry political figures?
and reconcilement, are reconcilement *12. Are posting and check filing separated
duties rotated on a formal basis, and is a from statement preparation?
record maintained to support such action? 13. Are statements mailed or delivered to all
*4. Are reconciliations reviewed by appropri- customers as required by the bank’s
ate independent management, especially in deposit-account agreement?
circumstances when full separation of *14. Are customer transaction and interest state-
duties is not evident? ments mailed in a controlled environment
*5. Are periodic reports prepared for manage- that precludes any individual from receiv-
ment, and do the reports provide an aging ing any statement not specifically autho-
of adjustments and differences and detail rized by the customer or the institution’s
the status of significant adjustments and policy (for example, dormant-account
differences? statements)?
*6. Has management adequately addressed any
significant or long-outstanding adjust-
ments or differences?
*7. Is the preparation of input and the posting DORMANT ACCOUNTS AND
of subsidiary demand deposit records per- RETURNED MAIL
formed or adequately reviewed by persons
who do not also— *1. Does the bank have formal policies and
a. accept or generate transactions? procedures for the handling of customers’
b. issue official checks or handle funds- transaction and interest statements that are
transfer transactions? returned as undeliverable? Does the
c. prepare or authorize internal entries policy—
(return items, reversals, and direct a. require that statements be periodically
charges, such as loan payments)? mailed on dormant accounts? If so, how
d. prepare supporting documents required often?
for disbursements from an account? b. prohibit the handling of dormant-
e. perform maintenance on the accounts, account statements by (1) employees of
such as changes of address, stop pay- the branch where the account is assigned,
ments, holds, etc.? (2) the account officer, and (3) other
*8. Are in-process, suspense, interoffice, and individuals with exclusive control of
other accounts related to deposit accounts accounts?
controlled or closely monitored by persons c. require positive action to follow up on
who do not have posting or reconcilement obtaining new addresses?
duties? d. place statements and signature cards for
*9. Are periodic reports prepared for manage- accounts for which contact cannot be
ment on open items in suspense and on re-established (the mail is returned more
in-process, interoffice, overdrawn, and than once or is marked ‘‘deceased’’)
other deposit accounts, and do the reports into a controlled environment?
include aging of items and the status of e. require the bank to change the address
significant items? on future statements to the department

Page 2
Deposit Accounts: Internal Control Questionnaire 3000.4
of the bank (the controlled environ- c. require the customer to sign a statement
ment) designated to receive returned describing the purpose of the request
mail? and the proposed times for pickup, and
f. require a written request from the cus- designate the individuals authorized to
tomer and verification of the customer’s pick up the statement?
signature before releasing an account d. require the maintenance of signature
from the controlled environment? cards for individuals authorized to pick
*2. Are accounts for which contact cannot be up statements, and compare the autho-
re-established and that do not reflect recent rized signatures with those who sign for
activity removed from active files and statements held for pickup?
clearly classified as dormant? e. prohibit the delivery of statements to
*3. Before returning a dormant account to officers and employees requiring spe-
active status, are transactions reactivating cial attention unless it is part of the
the account verified, and are independent formal ‘‘hold-mail’’ function?
confirmations obtained directly from the *2. Is a central record of hold-mail arrange-
customer? ments maintained in a control area that
*4. Does transfer from dormant to active sta- does not originate entries to customers’
tus require the approval of an officer who accounts? Does the record identify each
cannot approve transactions on dormant hold-mail arrangement, the designated
accounts? location for pickup, and the scheduled
pickup times? Does the control area—
a. maintain current signature cards of
INACTIVE ACCOUNTS individuals authorized to pick up
statements?
1. Are demand accounts that have been inac- b. obtain signed receipts showing the date
tive for one year, and time accounts that of pickup, and compare the receipts
have been inactive for three years, classi- with the signature cards?
fied as inactive? If not, state the time c. follow up on the status of statements
period for classifying a demand or time not picked up as scheduled?
account as inactive. *3. Does management review activity in hold-
2. Does the bank periodically review the mail accounts that have not been picked up
inactive accounts to determine if they for extended periods of time (for example,
should be placed in a dormant status, and one year), and, when there is no activity,
are decisions to keep such accounts in place the accounts in a dormant status?
active files documented?
HOLD MAIL OVERDRAFTS

*1. Does the institution have a formal policy *1. Are overdraft authorization limits for offi-
and procedure for handling statements and cers formally established?
documents that a customer requests not to *2. Does the bank require an authorized offi-
be mailed but that will be picked up at a cer to approve overdrafts?
location within the institution? Does the *3. Is an overdraft listing prepared daily for
policy— demand deposit and time transaction
a. require that statements will not be held accounts?
by an individual (an account officer, 4. For banks processing overdrafts that are
branch manager, bookkeeper, etc.) who not automatically approved (a ‘‘pay none’’
could establish exclusive control over system), is the nonsufficient-funds report
entries to and the delivery of statements circulated among bank officers?
for customer accounts? *5. Are overdraft listings circulated among
b. discourage such pickup arrangements the officers?
and grant them only after the customer 6. Are the statements of accounts with large
provides a satisfactory reason for the overdrafts reviewed for irregularities and
arrangement? prompt repayment?

Page 3
7. Is an aged record of large overdrafts eign accounts or lines of business,

included in the monthly report to the board and
of directors or its committee, and does the • capacity to manage those risks?
report include the overdraft origination c. Does the bank have adequate internal
date? controls and compliance oversight sys-
8. Is there an established schedule of service tems to monitor and manage the vary-
charges? ing degrees of risks associated with
such foreign accounts? Do these inter-
nal controls and compliance systems
ensure full compliance with the Bank
UNCOLLECTED FUNDS Secrecy Act, as amended by the USA
Patriot Act, and its respective
*1. Does the institution generate a daily report regulations?
of drawings against uncollected funds for d. Does the bank have personnel that are
demand deposit and time transaction sufficiently trained in the management
accounts? of such risks and in the requirements of
a. Is the computation of uncollected funds applicable laws and regulations?
positions based on reasonable check- e. Does the bank have policies and proce-
collection criteria? dures for ensuring that such foreign-
b. Can the reports, or a separate account account customers receive adequate
activity report, be used to detect potential communications from the bank? Com-
kiting conditions? munications should ensure that these
c. If reports are not generated for time customers are made fully aware of the
transaction accounts, is a system in requirements of U.S laws and regula-
place to control drawings against uncol- tions to which the bank is subject.
lected funds? f. Does the bank seek to structure its
*2. Do authorized officers review the relationships with such foreign-account
uncollected-funds reports and approve customers so as to minimize the vary-
drawings against uncollected funds within ing degrees of risks these customers
established limits? may pose?
*3. Are accounts that frequently appear on the
uncollected-funds or kite-suspect reports
reviewed regardless of account balances?
(For example, accounts with simultaneous OTHER MATTERS
large debits and credits can reflect low
balances.) *1. Are account-maintenance activities
(changes of address, status changes, rate
changes, etc.) separated from data entry
and reconciling duties?
ACCOUNTS FOR FOREIGN *2. Do all internal entries other than service
GOVERNMENTS, EMBASSIES, charges require the approval of appropri-
AND POLITICAL FIGURES ate supervisory personnel?
*3. If not included in the internal or external
1. For bank relationships with a foreign gov- audit program, are employees’ and offi-
ernment, embassy, or political figure: cers’ accounts, accounts of employees’
a. Has the board of directors established and officers’ business interests, and accounts
standards and guidelines for manage- controlled by employees and officers peri-
ment to use when evaluating whether or odically reviewed for unusual or prohib-
not the bank should accept such new ited activity?
accounts? *4. For unidentified deposits:
b. Are the standards and guidelines con- a. Are deposit slips kept under dual
sistent with the bank’s— control?
• own business objectives, b. Is the disposition of deposit slips
• assessment of the varying degrees of approved by an appropriate officer?
risks associated with particular for- *5. For returned checks, unposted items, and

Page 4
Deposit Accounts: Internal Control Questionnaire 3000.4
other rejects: ‘‘hold-mail’’ program and kept under

a. Are daily listings of such items dual control?
prepared? e. Are customers prohibited from with-
b. Are all items reviewed daily, and is drawing funds without a passbook? If
disposition of items required within a not, state the policy.
reasonable time period? If so, indicate 13. For withdrawals from savings or other
the time period. time accounts:
c. Are reports prepared for management a. Are withdrawal tickets canceled daily?
that show items not disposed of within b. Are procedures in place to preclude
the established time frames? overdrafts?
6. Are customers immediately notified in writ- c. Are procedures in effect to place holds
ing of deposit errors? on, and to check for holds on, withdraw-
7. Does the bank require a customer’s signa- als over a stated amount? If so, indicate
ture for stop-payment orders? the amount.
8. For automatic transfer accounts: 14. For signature cards on demand and time
a. Are procedures in effect that require accounts:
officer approval for transfers in excess a. Are procedures in effect to guard against
of the savings balance? the substitution of false signatures?
b. For nonautomated systems, are trans- Describe the procedures.
fers made by employees who do not b. Are signature cards stored to preclude
also handle cash, execute external funds physical damage?
transfers, issue official checks singly, or c. Are signatures compared for withdraw-
post subsidiary records? als and cashed checks? Describe the
9. For telephone transfer accounts: procedures.
a. Do depositors receive an individual
identification code for use in making
transfers?
b. Are transfers made by employees who OFFICIAL CHECKS, MONEY
do not also handle cash, execute exter- ORDERS, AND CERTIFIED
nal funds transfers, issue official checks CHECKS
singly, or post subsidiary records?
*10. If not included in the internal or external *1. Are separate general-ledger accounts main-
audit program, are accrual balances for the tained for each type of official check?
various types of deposits verified periodi- *2. For each type of check issued:
cally by an authorized official? If so, a. Are multicopy checks and certified-
indicate how often. check forms used? If not, are
*11. Are accounts with a ‘‘hold-balance’’ detailed registers of disbursed checks
status—those accounts on which court maintained?
orders have been placed, those pledged as b. Are all checks prenumbered and issued
security to customers’ loans, those pend- in sequence?
ing the clearing of a large check, those for c. Is check preparation and issuance
which the owner is deceased, and those for separate from recordkeeping?
which the passbook has been lost—‘‘locked d. Is the signing of checks in advance
out’’ for transactions unless the transaction prohibited?
is approved by appropriate management? e. Do procedures prohibit the issuance of
12. For passbook accounts: a check before the credit is processed?
a. Do all entries to passbooks contain *3. Is the list authorizing bank personnel to
teller identification? sign official checks kept current? Does the
b. Under a window-posting system, are list include changes in authorization limits,
recording media and passbooks posted delete employees who no longer work at
simultaneously? the bank, and indicate employees added to
c. Are tellers prohibited from holding cus- the list?
tomers’ savings passbooks? *4. Are appropriate controls in effect over
d. If customers’ passbooks are held, are check-signing machines (if used) and cer-
they maintained under the institution’s tification stamps?

Page 5
*5. Are voided checks and voided certified- business day after deposit?
check forms promptly defaced and filed *3. Has the TT&L-account reconcilement
with paid checks? been completed in a timely manner and
*6. If reconcilements are not part of the over- approved by a supervisor?
all deposit-reconciliation function— 4. Has adequate collateral been pledged to
a. are outstanding checks listed and rec- secure the TT&L account?
onciled regularly to the general ledger?
If so, state how often.
b. is permanent evidence of reconcile-
ments maintained? AUDIT
c. is there clear separation between the
preparation of checks, data entry, and *1. Are deposit-account activities audited on a
check reconcilement? sufficiently frequent basis?
d. are the reconcilements reviewed regu- *2. Does the scope of the audit program
larly by an authorized officer? require, and do audit records support, sub-
e. are reconcilement duties rotated on a stantive testing or quantitative measure-
formal basis in institutions where size ments of deposit-account activities that, at
precludes the full separation of duties a minimum, include the matters set forth in
between data entry and reconcilement? this questionnaire?
f. are authorized signatures and endorse- *3. Does the audit program include a compre-
ments checked by the filing clerk? hensive confirmation program with the
*7. For supplies of official checks: customers of each deposit category main-
a. Are records of unissued official checks tained by the institution?
maintained centrally and at each loca- *4. Do audit department records support the
tion storing them? execution of the confirmation program,
b. Are periodic inventories of unissued and do the records reflect satisfactory
checks independently performed? follow-up of responses and of requests
c. Do the inventories include a description returned as undeliverable?
of all checks issued out of sequence? *5. Are audit and prior-examination recom-
d. If users are assigned a supply, is that mendations for deposit-account activities
supply replenished on a consignment appropriately addressed?
basis?
*8. Are procedures in effect to preclude certi-
fication of checks drawn against uncol- CONCLUSION
lected funds?
*1. Does the foregoing information provide an
TREASURY TAX AND LOAN trol in that deficiencies in areas not cov-
ACCOUNTS (31 CFR 203) ered by this questionnaire do not signifi-
cantly impair any controls? Explain
1. Do transfers from the remittance-option negative answers briefly, and indicate any
account to the Federal Reserve Bank occur additional examination procedures deemed
the next business day after deposit? necessary.
2. When the note option is used, do transfers *2. Are internal controls adequate on the basis
from the Treasury Tax and Loan (TT&L) of a composite evaluation, as evidenced by
demand deposit account occur the next answers to the foregoing questions?

Page 6
Borrowed Funds
Borrowed funds are a common and practical its own merit to determine its purpose, effective-
method for banks of all sizes to meet customers’ ness, and stability. Some of the more frequently
needs and enhance banking operations. For the used sources of borrowings are discussed below.
purposes of this section, borrowings exclude
long-term subordinated debt, such as capital
notes and debentures (discussed in ‘‘Assessment
of Capital Adequacy,’’ section 3020.1). Borrow- COMMON SOURCES OF
ings may exist in a number of forms, both on a BORROWINGS
direct and indirect basis. Common sources of
direct bank borrowings include Federal Home
Loan Bank credit lines, federal funds purchased, Federal Home Loan Bank Borrowings
loans from correspondent banks, repurchase
agreements, negotiable certificates of deposit,
and borrowings from the Federal Reserve dis- The Federal Home Loan Bank (FHLB) origi-
count window. These are discussed in some nally served solely as a source of borrowings to
detail below. Other borrowings include bills savings and loan companies. With the imple-
payable to the Federal Reserve, interest-bearing mentation of the Financial Institutions Reform,
demand notes issued to the U.S. Treasury (the Recovery, and Enforcement Act of 1989
Treasury tax and loan note option account), (FIRREA), FHLB’s lending capacity was
mortgages payable, due bills, and other types of expanded to include banks.
borrowed securities. Indirect forms of borrow- Compared with borrowings from the discount
ings include customer paper rediscounted and window of the Reserve Banks, borrowings from
assets sold with the bank’s endorsement or the FHLB have fewer conditions. Both short-
guarantee or subject to a repurchase agreement. term and long-term borrowings, with maturities
The primary reasons a bank may borrow ranging from overnight to 30 years, are avail-
include the following: able to institutions at generally competitive
interest rates. The flexibility of the facility
• To meet the temporary or seasonal loan or enables bank management to use this source of
deposit withdrawal needs of its customers, if funds for the purpose of asset/liability manage-
the borrowing period is temporary and the ment, and it allows management to secure a
bank is quickly restored to a position in which favorable interest-rate spread. For example,
the quantity of its principal earning assets and FHLB borrowings may provide a lower-cost
cash reserves is in proper relation to the alternative to the conventional deposit, particu-
requirements of its normal deposit larly in a highly competitive local market.
volume. Management should be capable of explaining
• To meet large and unanticipated deposit with- the purpose of the borrowing transaction. The
drawals that may arise during periods of borrowing transaction should then be analyzed
economic distress. The examiner should dis- to determine whether the arrangement achieved
tinguish between ‘‘large and unanticipated the stated purpose or whether the borrowings are
deposit withdrawals’’ and a predeterminable a sign of liquidity deficiencies. Further, the
contraction of deposits, such as the cessation borrowing agreement between the institution
of activities in a resort community or the and the FHLB should be reviewed to determine
withdrawal of funds on which the bank the asset collateralizing the borrowings and the
received adequate prior withdrawal notice. potential risks presented by the agreement. In
Those situations should be met through ample some instances, the borrowing agreement may
cash reserves and readily convertible assets provide for collateralization by all assets not
rather than borrowing. already pledged for other purposes.
• To manage liabilities effectively. Generally, The types of collateral necessary to obtain an
the effective use of this type of continuous FHLB loan include residential mortgage loans
borrowing is limited to money-center or large and mortgage-backed securities. The composite
regional banks. rating of an institution is a factor in both the
approval for obtaining an FHLB loan and the
It is important to analyze each borrowing on level of collateral required.

Page 1
3010.1 Borrowed Funds
Federal Funds Purchased periods of time. Agency-based federal funds

transactions are discussed in ‘‘Bank Dealer
The day-to-day use of federal funds is a rather Activities,’’ section 2030.1.
common occurrence, and federal funds are con-
sidered an important money market instrument.
Many regional and money-center banks, acting Loans from Correspondent Banks
in the capacity of correspondents to smaller
community banks, function as both providers Small and medium-sized banks often negotiate
and purchasers of federal funds and, in the loans from their principal correspondent banks.
process of these transactions, often generate a The loans are usually for short periods and may
small return. be secured or unsecured.
A brief review of bank reserves is essential to
a discussion of the federal funds market. As a
condition of membership in the Federal Reserve Repurchase Agreements
System, member banks are required to maintain
a portion of their deposits as reserves. Reserves The terms ‘‘repurchase agreement’’1 (repo) and
can take the form of vault cash and deposits in ‘‘reverse repurchase agreement’’ refer to a type
the Reserve Bank. The amount of these reserve of transaction in which a money market partici-
balances is reported weekly or quarterly and pant acquires immediately available funds by
computed on the basis of the daily average selling securities and simultaneously agreeing to
deposit balances. For institutions that report repurchase the securities after a specified time at
their reserves on a weekly basis, required a given price, which typically includes interest
reserves are computed on the basis of daily at an agreed-on rate. Such a transaction is called
average balances of deposits and Eurocurrency a repo when viewed from the perspective of the
liabilities during a 14-day period ending every supplier of the securities (the borrower), and a
second Monday. Institutions that report their reverse repo or matched sale-purchase agree-
reserves on a quarterly basis compute their ment when described from the point of view of
reserve requirement on the basis of their daily the supplier of funds (the lender).
average deposit balances during a seven-day Frequently, instead of resorting to direct bor-
computation period that begins on the third rowings, a bank may sell assets to another bank
Tuesday of March, June, September, and Decem- or some other party and simultaneously agree to
ber. (See 12 CFR 204.3(c)–(d).) repurchase the assets at a specified time or after
Since member banks do not receive interest certain conditions have been met. Bank securi-
on the reserves, banks prefer to keep excess ties as well as loans are often sold under a repo
balances at a minimum to achieve the maximum to generate temporary working funds. These
utilization of funds. To accomplish this goal, kind of agreements are often used because the
banks carefully analyze and forecast their daily rate on this type of borrowing is less than the
reserve position. Changes in the volume of rate on unsecured borrowings, such as federal
required reserves occur frequently as the result funds purchased.
of deposit fluctuations. Deposit increases require The usual terms for the sale of securities
member banks to maintain more reserves; con- under a repo require that, after a stated period of
versely, deposit decreases require less reserves. time, the seller repurchase the securities at a
The most frequent type of federal funds predetermined price or yield. A repo commonly
transaction is unsecured for one day and repay- includes a near-term maturity (overnight or a
able the following business day. The rate is few days) and is usually arranged in large-dollar
usually determined by overall money market amounts. The lender or buyer is entitled to
rates as well as by the available supply of and receive compensation for use of the funds pro-
demand for funds. In some instances, when the vided to its counterparty. The interest rate paid
selling and buying relationship between two on a repo is negotiated based on the rates on the
banks is quite continuous, something similar to underlying securities. U.S. government and
a line of credit may be established on a funds- agency securities are the most common type of
availability basis. Although the most common
federal funds transaction is unsecured, the sell-
ing of funds can also be secured and for longer 1. See sections 2015.1, 2020.1, and 4170.1.

Page 2
Borrowed Funds 3010.1
instruments sold under repurchase agreements, financial condition of those institutions and
since those types of repos are exempt from brokers with whom they engage in repurchase
reserve requirements. transactions.
Although standard overnight and term repo ‘‘Retail repurchase agreements’’ (retail repos)2
arrangements in Treasury and federally related for a time were a popular vehicle for some
agency securities are most prevalent, market commercial banks to raise short-term funds and
participants sometimes alter various contract compete with certain instruments offered by
provisions to accommodate specific investment nonbanking competitors. For booking purposes,
needs or to provide flexibility in the designation a retail repo is a debt incurred by the issuing
of collateral. For example, some repo contracts bank that is collateralized by an interest in a
allow substitutions of the securities subject to security that is either a direct obligation of or
the repurchase commitment. These are called guaranteed as to principal and interest by the
‘‘dollar repurchase agreements’’ (dollar rolls), U.S. government or an agency thereof. Retail
and the initial seller’s obligation is to repurchase repos are issued in amounts not exceeding
securities that are substantially similar, but not $100,000 for periods of less than 90 days. With
identical, to the securities originally sold. the advent of money market certificates issued
Another common repo arrangement is called a by commercial banks, the popularity of the retail
‘‘flex repo,’’ which, as implied by the name, repo declined.
provides a flexible term to maturity. A flex repo Both retail and large-denomination, whole-
is a term agreement between a dealer and a sale repurchase agreements are in many respects
major customer in which the customer buys equivalent to short-term borrowings at market
securities from the dealer and may sell some of rates of interest. Therefore, banks engaging in
them back before the final maturity date. repurchase agreements should carefully evaluate
Bank management should be aware of certain their interest-rate-risk exposure at various matu-
considerations and potential risks of repurchase rity levels, formulate policy objectives in light
agreements, especially when entering into large- of the institution’s entire asset and liability mix,
dollar-volume transactions with institutional and adopt procedures to control mismatches
investors or brokers. Both parties in a term repo between assets and liabilities. The degree to
arrangement are exposed to interest-rate risk. It which a bank borrows through repurchase agree-
is a fairly common practice to have the collateral ments also should be analyzed with respect to its
value of the underlying securities adjusted daily liquidity needs, and contingency plans should
to reflect changes in market prices and to main- provide for alternative sources of funds.
tain the agreed-on margin. Accordingly, if the
market value of the repo securities declines
appreciably, the borrower may be asked to Negotiable Certificates of Deposit
provide additional collateral. Conversely, if the
market value of the securities rises substantially, Certificates of deposit (CDs) have not been
the lender may be required to return the excess legally defined as borrowings and continue to be
collateral to the borrower. If the value of the reflected as deposits for reporting purposes.
underlying securities exceeds the price at which However, the fundamental distinction between a
the repurchase agreement was sold, the bank negotiable money market CD as a deposit or as
could be exposed to the risk of loss if the buyer a borrowing is nebulous at best; in fact, the
is unable to perform and return the securities. negotiable money market CD is widely recog-
This risk would obviously increase if the secu- nized as the primary borrowing vehicle for
rities are physically transferred to the institution many banks. Dependence on CDs as sources of
or broker with which the bank has entered into funds is discussed in ‘‘Deposit Accounts,’’ sec-
the repurchase agreement. Moreover, if the tion 3000.1.
securities are not returned, the bank could be
exposed to the possibility of a significant write-
off, to the extent that the book value of the
securities exceeds the price at which the securi-
ties were originally sold under the repurchase
agreement. For this reason, banks should avoid
pledging excessive collateral and obtain suffi-
cient financial information on and analyze the 2. See sections 2015.1, 2020.1, and 4170.1.

Page 3
Borrowings from the Federal Reserve Primary Credit
In accordance with the Board’s Regulation A Reserve Banks may extend primary credit on a
very short term basis (typically overnight) to
(12 CFR 201), the Federal Reserve Banks gen-
depository institutions that the Reserve Banks
erally make credit available through the pri-
judge to be in generally sound financial condi-
mary, secondary, and seasonal credit programs
tion. Reserve Banks extend primary credit at a
to any depository institution that maintains trans-
rate above the target federal funds rate of the
action accounts or nonpersonal time deposits.3 Federal Open Market Committee. Minimal
However, the Federal Reserve expects deposi- administrative requirements apply to requests
tory institutions to rely on market sources of for overnight primary credit, unless some aspect
funds for their ongoing funding needs and to use of the credit request appears inconsistent with
these credit programs as a backup source of the conditions of primary credit (for example, if
funding rather than a routine one. An institution a pattern of behavior indicates strongly that an
that borrows primary credit may use those funds institution is using primary credit other than as a
to finance sales of federal funds, but secondary backup source of funding). Reserve Banks also
and seasonal credit borrowers may not act as the may extend primary credit to eligible institu-
medium or agent of another depository institutions for periods of up to several weeks if such
tion in receiving Federal Reserve credit except funding is not available from other sources.
with the permission of the lending Federal However, longer-term extensions of primary
Reserve Bank. credit will be subject to greater administration
A Federal Reserve Bank is not obligated to than are overnight loans.
extend credit to any depository institution but Reserve Banks determine eligibility for pri-
may lend to a depository institution either by mary credit according to a uniform set of criteria
making an advance secured by acceptable col- that also is used to determine eligibility for
lateral or by discounting certain types of paper daylight credit under the Board’s Policy State-
described in the Federal Reserve Act. Although ment on Payments System Risk. These criteria
Reserve Banks now always extend credit in the are based mainly on examination ratings and
form of an advance, the Federal Reserve’s credit capitalization, although Reserve Banks also may
facility nonetheless is known colloquially as the use supplementary information, including market-
‘‘discount window.’’ Before lending to a deposi- based information when available. Specifically,
tory institution, a Reserve Bank can require any an institution that is at least adequately capital-
information it believes is appropriate to ensure ized and rated CAMELS 1 or 2 (or SOSA 1 and
that the assets tendered as collateral are accept- ROCA 1, 2, or 3) almost certainly would be
able. A Reserve Bank also should determine eligible for primary credit. An institution that is
prior to lending whether the borrowing institu- at least adequately capitalized and rated CAMELS
3 (or SOSA 2 and ROCA 1, 2, or 3) generally
tion is undercapitalized or critically undercapi-
would be eligible. An institution that is at least
talized. Operating Circular No. 10, ‘‘Lending,’’
adequately capitalized and rated CAMELS 4 (or
establishes the credit and security terms for
SOSA 1 or 2 and ROCA 4 or 5) would be
borrowings from the Federal Reserve.
eligible only if an ongoing examination indi-
cated a substantial improvement in condition.
An institution that is not at least adequately
capitalized, or that is rated CAMELS 5 (or
3. In unusual and exigent circumstances and after consul-
tation with the Board, a Reserve Bank may extend credit to
SOSA 3 regardless of the ROCA rating), would
individuals, partnerships, and corporations that are not deposi- not be eligible for primary credit.
tory institutions if, in the judgment of the Reserve Bank, credit
is not available from other sources and failure to obtain credit
would adversely affect the economy. A Reserve Bank may
extend credit to a nondepository entity in the form of an Secondary Credit
advance only if the advance is secured by a direct obligation
of the United States or a direct obligation of, or an obligation Secondary credit is available to institutions that
that is fully guaranteed as to principal and interest by, any do not qualify for primary credit. Secondary
agency of the United States. An extension of credit secured by
any other type of collateral must be in the form of a discount
credit is available as a backup source of liquidity
and must be authorized by an affirmative vote of at least five on a very short term basis, provided that the loan
members of the Board. is consistent with a timely return to a reliance on

Page 4
Borrowed Funds 3010.1
market sources of funds. Longer-term secondary house arrangement. Collateral may also be held
credit is available if necessary for the orderly at the borrowing institution’s correspondent or
resolution of a troubled institution, although any another third party. All book-entry collateral
such loan would have to comply with additional must be held at the Federal Reserve Bank.
requirements for lending to undercapitalized and Definitive collateral, not in bearer form, must be
critically undercapitalized institutions. Unlike properly assigned and endorsed.
the primary credit program, secondary credit is
not a minimal administration facility because
Reserve Banks must obtain sufficient informa- Lending to Undercapitalized and
tion about a borrower’s financial situation to Critically Undercapitalized Depository
ensure that an extension of credit complies with Institutions
the conditions of the program. Secondary credit
is available at a rate above the primary credit Credit from any Reserve Bank to an institution
rate. that is ‘‘undercapitalized’’ may be extended or
outstanding for no more than 60 days during
which the institution is undercapitalized in any
Seasonal Credit 120-day period.4 An institution is considered
undercapitalized if it is not critically undercapi-
Seasonal credit is available under limited con- talized under section 38 of the Federal Deposit
ditions to meet the needs of depository institu- Insurance Act (the FDI Act) but is either deemed
tions that have seasonal patterns of movement in undercapitalized under that provision and its
deposits and loans but that lack ready access to implementing regulations or has received a com-
national money markets. In determining a deposi- posite CAMELS rating of 5 as of the most
tory institution’s eligibility for seasonal credit, recent examination. A Reserve Bank may make
Reserve Banks consider not only the institu- or have outstanding advances or discounts to an
tion’s historical record of seasonal fluctuations institution that is deemed ‘‘critically undercapi-
in loans and deposits, but also the institution’s talized’’ under section 38 of the FDI Act and its
recent and prospective needs for funds and its implementing regulations only during the five-day
liquidity conditions. Generally, only very small period beginning on the date the institution
institutions with pronounced seasonal funding became critically undercapitalized or after con-
needs will qualify for seasonal credit. Seasonal sultation with the Board.
credit is available at a flexible rate that takes into
account the rate for market sources of funds.
Collateral Requirements INTERNATIONAL BORROWINGS
All loans advanced by the Reserve Bank must International borrowings may be direct or indi-
be secured to the satisfaction of the Reserve rect. Common forms of direct international bor-
Bank. Collateral requirements are governed by rowings include loans and short-term call money
Operating Circular No. 8. Reserve Banks re- from foreign banks, borrowings from the Export-
quire a perfected security interest in all collat- Import Bank of the United States, and over-
eral pledged to secure loans. Satisfactory collat- drawn nostro (due from foreign banks—demand)
eral generally includes U.S. government and accounts. Indirect forms of borrowing include
federal-agency securities, and, if they are of notes and trade bills rediscounted with the
acceptable quality, mortgage notes covering one- central banks of various countries; notes, accep-
to four-family residences; state and local gov- tances, import drafts, or trade bills sold with the
ernment securities; and business, consumer, and bank’s endorsement or guarantee; notes and
other customer notes. Traditionally, collateral is other obligations sold subject to repurchase
held in the Reserve Bank vault. Under certain agreements; and acceptance pool participations.
circumstances, collateral may be retained on the
borrower’s premises under a borrower-in-
4. Generally, a Reserve Bank also may lend to an under-
custody arrangement, or it may be held on the capitalized institution during 60 calendar days after receipt of
borrower’s premises under the Reserve Bank’s a certificate of viability from the Chairman of the Board of
exclusive custody and control in a field ware- Governors or after consultation with the Board.

Page 5
ANALYZING BORROWINGS do not generally have ready access to alternative

sources of funds available to larger institutions
If a bank borrows extensively or in large through the money and capital markets. Bro-
amounts, the examiner should thoroughly ana- kered deposits generally carry higher interest
lyze the borrowing activity. An effective analy- rates than alternative sources, and they tend to
sis includes a review of the bank’s reserve be particularly susceptible to interest-rate changes
records, both required and maintained, to deter- in the overall financial market. For further
mine the frequency of deficiencies at the closing discussion of brokered deposits, see ‘‘Deposit
of reserve periods. The principal sources of Accounts,’’ section 3000.1.
borrowings, range of amounts, frequency, length Other indicators of deterioration in a bank’s
of time indebted, cost, and reasons for the borrowing ability and overall creditworthiness
borrowings should be explored. The actual use include, but are not limited to, requests for
of the funds should be verified. collateral on previously unsecured credit lines or
Examiners should also analyze changes in a increases in collateral margins, the payment of
bank’s borrowing position for signs of deterio- above-market interest rates, or a shortening of
ration in its borrowing ability and overall cred- maturities that is inconsistent with manage-
itworthiness. One indication of deterioration is ment’s articulated balance-sheet strategies. If
the payment of large fees to money brokers to the examiner finds that a bank’s borrowing
obtain funds because the bank is having diffi- position is not properly managed, appropriate
culty obtaining access to conventional sources comments should be included in the report of
of borrowings. These ‘‘brokered deposits’’ are examination.
usually associated with small banks since they

Page 6
Borrowed Funds
cedures, and internal controls for borrowed regulations.
funds are adequate. 5. To initiate corrective action when policies,
2. To determine if bank officers are operating in practices, procedures, or internal controls are
conformance with the established guidelines. deficient or when violations of laws or regu-
3. To determine the scope and adequacy of the lations have been noted.
audit function.

Page 1
Borrowed Funds
1. If selected for implementation, complete or rowing agreements for indications of

update the Borrowed Funds section of the deteriorating credit position by noting—
Internal Control Questionnaire. • recent substantive changes in borrow-
2. Based on the evaluation of internal controls ing agreements,
and the work performed by the internal/ • increases in collateral to support bor-
external auditors, determine the scope of the rowing transactions,
examination. • general shortening of maturities,
3. Test for compliance with policies, practices, • interest rates exceeding prevailing mar-
procedures, and internal controls in conjunc- ket rates,
tion with performing the remaining exami- • frequent changes in lenders, and
nation procedures. Also obtain a listing of • large fees paid to money brokers.
any audit deficiencies noted in the latest c. If the bank has obtained funds from
review done by internal/external auditors money brokers (brokered deposits),
from the examiner assigned to ‘‘Internal determine—
Control’’ and determine if appropriate cor- • why such deposits were originally
rections have been made. obtained,
4. Obtain the listing of accounts related to • who the deposits were obtained from,
domestic and international borrowed funds • what the funds are used for,
from the examiner assigned to ‘‘Examina- • the relative cost of brokered deposits
tion Strategy.’’ in comparison to alternate sources of
5. Prepare or obtain a listing of borrowings, by funds, and
type, and— • the overall effect of the use of
a. agree or reconcile balances to depart- brokered deposits on the bank’s con-
ment controls and general ledger, and dition and whether there appear to be
b. review reconciling items for reason- any abuses related to the use of such
ableness. deposits.
6. From consultation with the examiners d. If there is an indication that the bank’s
assigned to the various loan areas, deter- credit position has deteriorated, ascertain
mine that the following schedules were why.
reviewed in the lending departments and 9. If the bank engages in the issuance of retail
that there was no endorsement, guarantee, repurchase agreements (retail repos), check
or repurchase agreement which would for compliance with section 4170.1; also
constitute a borrowing: 2015.1 and 2020.1.
10. Determine the purpose of each type of
a. participations sold
borrowing and conclude whether the bank’s
b. loans sold in full since the preceding borrowing posture is justified in light of
examination its financial condition and other relevant
7. Based on the information obtained in steps circumstances.
5 and and 6, and through observation and 11. Provide the examiner assigned to ‘‘Asset/
discussion with management and other Liability Management’’ the following
examining personnel, determine that all bor- information:
rowings are properly reflected on the books a. A summary and an evaluation of the
of the bank. bank’s borrowing policies, practices, and
8. If the bank engages in any form of borrow- procedures. The evaluation should give
ing which requires written borrowing consideration to whether the bank—
agreement(s), complete the following: • evaluates interest-rate-risk exposure at
a. Prepare or update a carry-forward work- various maturity levels;
paper describing the major terms of each • formulates policy objectives in light of
borrowing agreement, and determine that the entire asset and liability mix, and
the bank is complying with those terms. liquidity needs;
b. Review terms of past and present bor- • has adopted procedures to control mis-

Page 1
3010.3 Borrowed Funds: Examination Procedures
matches between assets and liabilities; b. low point

and c. average amounts outstanding
• has contingency plans for alternate d. frequency of borrowing and lending activ-
sources of funds in the event of a ity, expressed in terms of number of days
run-off of current funding sources. 13. Prepare, in appropriate report form, and
b. An evaluation of the bank’s adherence to discuss with appropriate management—
established policies and procedures. a. the adequacy of written policies regard-
c. A repricing maturity schedule of ing borrowings;
borrowings. b. the manner in which bank officers are
d. A listing of prearranged federal funds operating in conformance with estab-
lines and other lines of credit. Indicate lished policy;
the amount currently available under c. the existence of any unjustified borrow-
those lines, i.e., the unused portion of the ing practices;
lines. d. any violation of laws or regulations; and
e. The amount of any anticipated decline in e. recommended corrective action when
borrowings over the next policies, practices, or procedures are
day period. (The time period will be deficient; violations of laws or regula-
determined by the examiner assigned to tions exist; or when unjustified borrow-
‘‘Asset/Liability Management.’’) ing practices are being pursued.
12. Prepare a list of all borrowings by category, 14. Update the workpapers with any informa-
on a daily basis for the period since the tion that will facilitate future examinations.
last examination. Also, include on the list 15. Review the market value of collateral and
short-term or overnight money market collateral-control arrangements for repur-
lending activities such as federal funds chase agreements to ensure that excessive
sold and securities purchased under resale collateral has not been pledged and that the
agreement. For each category on the list, bank is not exposed to excessive credit
compute for the period between risks.
examinations—
a. high point

Page 2
Borrowed Funds
Review the bank’s controls, policies, practices c. Prepare all supporting documents
and procedures for obtaining and servicing bor- required for payment of debt?
rowed funds. The bank’s system should be *4. Are subsidiary borrowed funds records
documented in a complete and concise manner reconciled with the general ledger accounts
and should include, where appropriate, narrative at an interval consistent with borrowing
descriptions, flowcharts, copies of forms used activity, and are the reconciling items
and other pertinent information. Items marked investigated by persons, who do not also:
with an asterisk require substantiation by obser- a. Handle cash?
vation or testing. b. Prepare or post to the subsidiary bor-
rowed funds records?
POLICY
INTEREST
1. Has the board of directors approved a
written policy which: *5. Are individual interest computations
a. Outlines the objectives of bank checked by persons who do not have
borrowings? access to cash?
b. Describes the bank’s borrowing philos- 6. Is an overall test of the total interest paid
ophy relative to risk considerations, made by persons who do not have access
i.e., leverage/growth, liquidity/income? to cash?
c. Provides for risk diversification in terms 7. Are payees on the checks matched to
of staggered maturities rather than solely related records of debt, note or debenture
on cost? owners?
d. Limits borrowings by amount outstand- 8. Are corporate resolutions properly pre-
ing, specific type or total interest pared as required by creditors and are
expense? copies on file for reviewing personnel?
e. Limits or restricts execution of borrow- 9. Are monthly reports furnished to the board
ings by bank officers? of directors reflecting the activity of bor-
f. Provides a system of reporting require- rowed funds, including amounts outstand-
ments to monitor borrowing activity? ing, interest rates, interest paid to date and
g. Requires subsequent approval of anticipated future activity?
transactions?
h. Provides for review and revision of
established policy at least annually? CONCLUSION
RECORDS basis for evaluating internal control in that
there are no significant deficiencies in
*2. Does the bank maintain subsidiary records areas not covered in this questionnaire
for each type of borrowing, including that impair any controls? Explain negative
proper identification of the obligee? answers briefly, and indicate any addi-
*3. Is the preparation, addition and posting of tional examination procedures deemed
the subsidiary borrowed funds records per- necessary.
formed or adequately reviewed by persons 11. Based on a composite evaluation, as
who do not also: evidenced by answers to the foregoing
a. Handle cash? questions, internal control is considered
b. Issue official checks and drafts? (adequate/inadequate).

Page 1
Complex Wholesale Borrowings
Commercial banks rely on wholesale borrow- the borrowing (or borrowings), and (3) identify
ings obtained from a number of financial inter- the potential risks presented by the agreement.
mediaries, including Federal Home Loan Banks, (See SR-01-8.)
other commercial banks, and securities firms. In addition to determining if a bank follows
These borrowings frequently have attractive fea- the sound-practice guidance for bank liability
tures and pricing. If properly assessed and management and funding in general, supervisors
prudently managed, they can enhance a bank’s should take the following steps, as appropriate,
funding options and assist in controlling interest- when assessing a bank that has material amounts
rate and liquidity risks. Some of the reasons that of wholesale borrowings:
banks use these types of borrowings include the
initial low cost of funds when compared with • Review the bank’s borrowing contracts for
other liabilities with similar maturities. At the embedded options or other features that may
same time, certain wholesale borrowings have affect the bank’s liquidity and sensitivity to
become more complex, and some structures market risks. In addition, examiners should
include various types of embedded options.1 If review the collateral agreements for fees,
not thoroughly assessed and prudently managed, collateral-maintenance requirements (includ-
these more complex funding instruments have ing triggers for increases in collateral), and
the potential over time to significantly increase a other features that may affect the bank’s
bank’s sensitivity to market and liquidity risks. liquidity and earnings.
Maturity mismatches or the embedded options • Assess the bank’s management processes for
themselves can, in some circumstances, ad- identifying and monitoring the risks of the
versely affect a bank’s financial condition, espe- various terms of each borrowing contract,
cially when the terms and conditions of the including penalties and option features over
borrowings are misunderstood. the expected life of the contract. Examiners
A growing use of wholesale borrowings, should review for evidence that the bank’s
combined with the risks associated with the management, or an independent third party,
complex structures of some of these borrowings, completed stress tests (1) before the bank
makes it increasingly important for bank super- entered into the borrowing agreement (or
visors to assess the risks and risk-management agreements) and (2) periodically thereafter. If
processes associated with these sources of funds. the bank relies on independent third-party
The supervisory guidance provided below supple- testing, examiners should verify that manage-
ments and expands upon existing general guid- ment reviewed and accepted the underlying
ance on bank funding and borrowings.2 Where assumptions and test results. In any case,
appropriate, examiners should (1) review the management should not be relying solely on
provisions of each significant borrowing agree- the wholesaler’s stress-test results. Also, the
ment between the bank and the wholesale insti- stress tests employed should cover a reason-
tution, (2) determine what assets collateralize able range of contractual triggers and external
events. Such triggers or events include interest-
rate changes that may result in the exercise of
1. Wholesale borrowings with embedded options may have
variable interest payments or average lives or redemption embedded options or the bank’s termination
values that depend on external measures such as reference of the agreement, which may entail prepay-
rates, indexes, or formulas. Embedded options include putable, ment penalties. In general, stress-test results
callable, convertible, and variable rate advances with caps, should depict the potential impact of these
floors, collars, step-ups, or amortizing features. In addition,
these types of borrowings may contain prepayment penalties. variables on the individual borrowing facility,
2. See the supervisory guidance for ‘‘Borrowed Funds,’’ as well as on the overall earnings and liquidity
section 3010.1; ‘‘Asset/Liability Management,’’ section 4020.1; position of the bank.
and ‘‘Interest-Rate Risk Management,’’ section 4090.1. See
also the Trading and Capital-Markets Activities Manual,
• Evaluate management processes for control-
sections 2030.1, ‘‘Liquidity Risk,’’ and 3010.1, ‘‘Interest-Rate ling risks, including interest-rate risks arising
Risk Management.’’ In general, this guidance collectively from the borrowings and liquidity risks. Proper
calls for supervisors to analyze the purpose, effectiveness, controls include (1) hedges or other plans for
concentration exposure, and stability of borrowings and to
assess bank management’s understanding of liquidity and
minimizing the adverse effects of penalties or
interest-rate risks associated with borrowing and funding interest-rate changes and other triggers for
strategies. embedded options and (2) contingent funding

Page 1
3012.1 Complex Wholesale Borrowings
plans if borrowings or lines are terminated plex wholesale borrowings should not be
before the original expected maturity. using this funding.
• Determine whether the asset/liability manage-
ment committee or board of directors, as Reliance on wholesale borrowings is consistent
appropriate, is fully informed of the risks and with safe and sound banking when management
ramifications of complex wholesale-borrowing understands the risks of these activities and has
agreements before engaging in the transac- systems and procedures in place to properly
tions and on an ongoing basis. monitor and control the risks. Supervisors and
• Determine whether funding strategies for examiners, however, should take appropriate
wholesale borrowings, especially those with steps to follow up on institutions that use com-
embedded options, are consistent with both plex funding instruments without adequately
the portfolio objectives of the bank and the understanding their risks or without proper risk-
level of sophistication of the bank’s risk management systems and controls. Examiners
management. Banks without the technical should also seek corrective action when funding
knowledge and whose risk-management sys- mechanisms or strategies are inconsistent with
tems are insufficient to adequately identify, prudent funding needs and objectives.
assess, monitor, and control the risks of com-

Page 2
1. To review the terms of wholesale-borrowing 3. To determine if the bank’s board of directors

contracts to identify embedded options or or its asset/liability management committee
other features that may affect the bank’s is fully aware of the risks associated with and
liquidity and sensitivity to market risks. ramifications of engaging in complex
2. To assess management’s technical knowl- wholesale-borrowing agreements.
edge, systems, and processes for identifying, 4. To ascertain whether the bank’s wholesale-
assessing, monitoring, and controlling the borrowing funding and hedging strategies are
risks (including liquidity risk and interest- consistent with its portfolio objectives and
rate risk) associated with wholesale borrow- the level of management’s sophistication.
ing, and to assess the bank’s stress-testing
practices and contingency-funding plans.

Page 1
1. Review the bank’s borrowing contracts to reviewed and accepted the underlying
identify embedded options or other features assumptions and test results.
that may affect the bank’s liquidity and 3. Evaluate the management processes for con-
sensitivity to market risks. Also review the trolling risks, including (1) interest-rate risks
collateral agreements to determine what fees, arising from the borrowings and (2) liquidity
collateral-maintenance requirements (includ- risks.
ing triggers for increases in collateral), and 4. Determine if the asset/liability management
other agreed-upon features may affect the committee or board of directors, as appropri-
bank’s liquidity and earnings. ate, is fully informed of the risks and rami-
2. Assess the bank’s management processes for fications of complex wholesale-borrowing
identifying and monitoring the risks of the agreements both before engaging in the trans-
various terms of each borrowing contract, actions and on an ongoing basis.
including penalties and option features over 5. Determine if funding strategies for whole-
the expected life of the contract. sale borrowings, especially those with
a. Obtain and examine evidence to deter- embedded options, are consistent with both
mine whether the bank’s management, or the portfolio objectives of the bank and the
an independent third party, completed level of sophistication of the bank’s risk
stress tests before the bank entered into management.
the borrowing agreement (or agreements) 6. Seek the corrective action taken by the insti-
and periodically thereafter. tution when funding mechanisms or strate-
b. If the bank relies on independent third- gies are inconsistent with prudent funding
party testing, verify that management needs and objectives.

Page 1
Deferred Compensation Agreements
As part of their executive compensation and tax benefit payments and the amount initially
retention programs, banks and other financial invested to purchase the BOLI in the notional
institutions (collectively referred to in this sec- amount, the hypothetical earnings reflect an
tion as ‘‘institutions’’) often enter into deferred estimate of what the institution could have
compensation agreements with selected employ- earned if it had not invested in the BOLI or
ees. These agreements are generally structured entered into the IRP with the employee. Each
as nonqualified retirement plans for federal employee’s IRP may have a different notional
income tax purposes and are based on individual amount on which the index is based. The indi-
agreements with selected employees. vidual IRP agreements also specify the retire-
Institutions often purchase bank-owned life ment age and vesting provisions, which can vary
insurance (BOLI) in connection with many of from employee to employee.
their deferred compensation agreements. (See An IRP agreement typically requires the
sections 4042.1 and 2210.1 for an explanation of excess earnings that accrue before an employ-
the accounting for BOLI transactions). BOLI ee’s retirement to be recorded in a separate
may produce attractive tax-equivalent yields liability account. Once the employee retires, the
that offset some or all of the costs of the balance in the liability account is generally paid
agreements. to the employee in equal, annual installments
Deferred compensation agreements are com- over a set number of years (for example, 10 or
monly referred to as indexed retirement plans 15 years). These payments are commonly
(IRPs) or as revenue-neutral plans. The institu- referred to as the primary benefit or pre-
tion’s designated management and accounting retirement benefit.
staff that is responsible for the institution’s An employee may also receive the excess
financial reporting must regularly review the earnings that are earned after his or her retire-
accounting for deferred compensation agreement. This benefit may continue until the
ments to ensure that the obligations under the employee’s death and is commonly referred to
agreements are appropriately measured and as the secondary benefit or post-retirement bene-
reported in accordance with generally accepted fit. The secondary benefit is paid annually, once
accounting principles (GAAP). In so doing, the the employee has retired, and is in addition to
management and accounting staff should apply the primary benefit.
and follow Accounting Principles Board Opin- Examiners should be aware that some insti-
ion No. 12, ‘‘Omnibus Opinion—1967,’’ as tutions may not be correctly accounting for the
amended by Statement of Financial Accounting obligations under an IRP. Because many insti-
Standards No. 106 (FAS 106), ‘‘Employers’ tutions were incorrectly accounting for IRPs, the
Accounting for Postretirement Benefits Other federal banking and thrift agencies issued on
Than Pensions’’ (hereafter referred to as APB February 11, 2004, an Interagency Advisory on
12). Accounting for Deferred Compensation Agree-
IRPs are one type of deferred compensation ments and Bank-Owned Life Insurance. (See
agreement that institutions enter into with SR-04-4.) The guidance is stated here, except
selected employees. IRPs are typically designed for the information on the reporting of deferred
so that the spread each year, if any, between the compensation agreement obligations in the bank
tax-equivalent earnings on the BOLI covering Call Reports and on changes in accounting for
an individual employee and a hypothetical earn- those agreements. Examiners should determine
ings calculation is deferred and paid to the whether an institution’s deferred compensation
employee as a post-retirement benefit. This agreements are correctly accounted for. If the
spread is commonly referred to as excess earn- accounting is incorrect, assurance should be
ings. The hypothetical earnings are computed on obtained from the institution’s management that
the basis of a predefined variable index rate (for corrections will be made in accordance with
example, the cost of funds or the federal funds GAAP and the advisory’s instructions for
rate) times a notional amount. The notional changes in accounting. The examiner’s findings
amount is typically the amount the institution should be reported in the examination report.
initially invested to purchase the BOLI plus Also report the nature of the accounting errors
subsequent after-tax benefit payments actually and the estimated financial impact that correct-
made to the employee. By including the after- ing the errors will have on the institution’s

Page 1
3015.1 Deferred Compensation Agreements
financial statements, including its earnings and the current rate of return on high-quality fixed-
capital position. income debt securities2 should be the acceptable
discount rates to measure deferred compensa-
tion agreement obligations. An institution must
ACCOUNTING FOR DEFERRED select and consistently apply a discount-rate
policy that conforms with GAAP.
COMPENSATION AGREEMENTS, For each IRP, an institution should calculate
INCLUDING IRPs the present value of the expected future benefit
payments under the IRP at the employee’s full
Deferred compensation agreements with select
eligibility date. The expected future benefit
employees under individual contracts generally
payments can be reasonably estimated. They
do not constitute post-retirement income plans
should be based on reasonable and supportable
(that is, pension plans) or post-retirement health
assumptions and should include both the pri-
and welfare benefit plans. The accounting for
mary benefit and, if the employee is entitled to
individual contracts that, when taken together,
excess earnings that are earned after retirement,
do not represent a post-retirement plan should
the secondary benefit. The estimated amount of
follow APB 12. If the individual contracts, taken
these benefit payments should be discounted
together, are equivalent to a plan, the plan
because the benefits will be paid in periodic
should be accounted for under Statement of
installments after the employee retires. The
Financial Accounting Standards No. 87,
number of periods the primary and any second-
‘‘Employers’ Accounting for Pensions,’’ or under
ary benefit payments should be discounted may
FAS 106.
differ because the discount period for each type
APB 12 requires that an employer’s obliga-
of benefit payment should be based on the
tion under a deferred compensation agreement
length of time during which each type of benefit
be accrued according to the terms of the indi-
will be paid, as specified in the IRP.
vidual contract over the required service period
After the present value of the expected future
to the date the employee is fully eligible to
benefit payments has been determined, the insti-
receive the benefits, or the full eligibility date.
tution should accrue an amount of compensation
Depending on the individual contract, the full
expense and a liability each year from the date
eligibility date may be the employee’s expected
the employee enters into the IRP until the full
retirement date, the date the employee entered
eligibility date. The amount of these annual
into the contract, or a date between these two
accruals should be sufficient to ensure that a
dates. APB 12 does not prescribe a specific
deferred compensation liability equal to the
accrual method for the benefits under deferred
present value of the expected benefit payments
compensation contracts, stating only that the
is recorded by the full eligibility date. Any
‘‘cost of those benefits shall be accrued over that
method of deferred compensation accounting
period of the employee’s service in a systematic
that does not recognize some expense for the
and rational manner.’’ The amounts to be accrued
primary benefit and any secondary benefit in
each period should result in a deferred compen-
each year from the date the employee enters into
sation liability at the full eligibility date that
the IRP until the full eligibility date is not
equals the then-present value of the estimated
considered to be systematic and rational.
benefit payments to be made under the indi-
Vesting provisions should be reviewed to
vidual contract.
ensure that the full eligibility date is properly
APB 12 does not specify how to select the
determined because this date is critical to the
discount rate to measure the present value of the
measurement of the liability estimate. Because
estimated benefit payments. Therefore, other
APB 12 requires that the present value of the
relevant accounting literature must be consid-
expected benefit payments be recorded by the
ered in determining an appropriate discount rate.
full eligibility date, institutions also need to
An institution’s incremental borrowing rate1 and
consider changes in market interest rates to
appropriately measure deferred compensation
1. Accounting Principles Board Opinion No. 21, ‘‘Interest
on Receivables and Payables,’’ paragraph 13, states in part 2. FAS 106, paragraph 186, states that ‘‘[t]he objective of
that ‘‘the rate used for valuation purposes will normally be at selecting assumed discount rates is to measure the single
least equal to the rate at which the debtor can obtain financing amount that, if invested at the measurement date in a portfolio
of a similar nature from other sources at the date of the of high-quality debt instruments, would provide the necessary
transaction.’’ future cash flows to pay the accumulated benefits when due.’’

Page 2
Deferred Compensation Agreements 3015.1
liabilities. Therefore, to comply with APB 12, Example 1: Fully Eligible at

institutions should periodically review both their Agreement Inception
estimates of the expected future benefits under
IRPs and the discount rates used to compute the
A company enters into a deferred compensation
present value of the expected benefit payments,
agreement with a 55-year-old employee who has
and revise those estimates and rates, when
worked five years for the company. The agree-
appropriate.
ment states that, in exchange for the employee’s
Deferred compensation agreements, includ- past and future services and for his or her
ing IRPs, may include noncompete provisions service as a consultant for two years after
or provisions requiring employees to perform retirement, the company will pay an annual
consulting services during post-retirement years. benefit of $20,000 to the employee, commenc-
If the value of the noncompete provisions can- ing on the first anniversary of the employee’s
not be reasonably and reliably estimated, no retirement. The employee is fully eligible for the
value should be assigned to the noncompete deferred compensation benefit payments at the
provisions in recognizing the deferred compen- inception of the agreement, and the consulting
sation liability. Institutions should allocate a services are not substantive.
portion of the future benefit payments to con-
sulting services to be performed in post- Other key facts and assumptions used in deter-
retirement years only if the consulting services mining the benefits payable under the agreement
are determined to be substantive. Factors to and in determining the liability and expense the
consider in determining whether post-retirement company should record in each period are sum-
consulting services are substantive include but marized in the following table:
are not limited to (1) whether the services are
required to be performed, (2) whether there is an
economic benefit to the institution, and
(3) whether the employee forfeits the benefits Expected retirement age 60
under the agreement for failure to perform such Number of years to expected
services. retirement age 5
Discount rate (%) 6.75
Expected mortality age based on
present age 70
APPENDIX—EXAMPLES OF
ACCOUNTING FOR DEFERRED
COMPENSATION AGREEMENTS At the employee’s expected retirement date, the
present value of a lifetime annuity of $20,000
The following are examples of the full-eligibility- that begins on that date is $142,109 (computed
date accounting requirements for a basic deferred as $20,000 times 7.10545, the factor for the
compensation agreement. The assumptions used present value of 10 annual payments at 6.75
in these examples are for illustrative purposes percent). At the inception date of the agreement,
only. An institution must consider the terms of the present value of that annuity of $102,514
its specific agreements, the current interest-rate (computed as $142,109 times 0.721375, the
environment, and current mortality tables in factor for the present value of a single payment
determining appropriate assumptions to use in in five years at 6.75 percent) is recognized as
measuring and recognizing the present value of compensation expense because the employee is
the benefits payable under its deferred compen- fully eligible for the deferred compensation
sation agreements. benefit at that date.
Institutions that enter into deferred compen- The following table summarizes one system-
sation agreements with employees, particularly atic and rational method of recognizing the
more-complex agreements (such as IRPs), should expense and liability under the deferred com-
consult with their external auditors and their pensation agreement:
respective Federal Reserve Bank to determine
the appropriate accounting for their specific
agreements.

Page 3
A B C D E F
(B + C) (E + D – A)
Beginning- End-
Benefit Service Interest Compensation of-year of-year
Year payment ($) component ($) component ($) expense ($) liability ($) liability ($)
0 – 102,514 – 102,514 – 102,514

1 – – 6,920 6,920 102,514 109,434
2 – – 7,387 7,387 109,434 116,821
3 – – 7,885 7,885 116,821 124,706
4 – – 8,418 8,418 124,706 133,124
5 – – 8,985 8,985 133,124 142,109
6 20,000 – 9,593 9,593 142,109 131,702
7 20,000 – 8,890 8,890 131,702 120,592
8 20,000 – 8,140 8,140 120,592 108,732
9 20,000 – 7,339 7,339 108,732 96,071
10 20,000 – 6,485 6,485 96,071 82,556
11 20,000 – 5,572 5,572 82,556 68,128
12 20,000 – 4,599 4,599 68,128 52,727
13 20,000 – 3,559 3,559 52,727 36,286
14 20,000 – 2,449 2,449 36,286 18,735
15 20,000 – 1,265 1,265 18,735 0
Totals 200,000 102,514 97,486 200,000
The following entry would be made at the

inception date of the agreement (the final day of
year 0) to record the service component of the
compensation expense and related deferred com-
pensation agreement liability:
Debit Credit
Compensation expense $102,514
Deferred compensation liability $102,514
[To record the column B service component]
In each period after the inception date of the tion of the agreement, and revise the assump-
agreement, the company would adjust the tions and rate, as appropriate.
deferred compensation liability for the interest Assuming that no changes were necessary to
component and any benefit payment. In addi- the assumptions used to determine the expected
tion, the company would reassess the assump- future benefits under the agreement or to the
tions used in determining the expected future discount rate used to compute the present value
benefits under the agreement and the discount of the expected benefits, the following entry
rate used to compute the present value of the would be made in year 1 to record the interest
expected benefits in each period after the incep- component of the compensation expense:

Page 4
Debit Credit
[To record the column C interest component (computed by multiplying the prior-year
column F balance by the discount rate)]
Similar entries (but for different amounts) would

be made in year 2 through year 15 to record the
interest component of the compensation expense.
The following entry would be made in year 6
to record the payment of the annual benefit:
Debit Credit
Cash $20,000
[To record the column A benefit payment]
Similar entries would be made in year 7 through

year 15 to record the payment of the annual
benefit.
Example 2: Fully Eligible at 5.72213, the factor for the future value of five
Retirement Date annual payments at 6.75 percent).
Other key facts and assumptions used in
If the terms of the contract described in example determining the benefits payable under the agree-
1 had stated that the employee is only entitled to ment and in determining the liability and expense
receive the deferred compensation benefit if the the company should record in each period are
sum of the employee’s age and years of service summarized in the following table:
equals 70 or more at the date of retirement, the
employee would be fully eligible for the deferred
compensation benefit at age 60, after rendering
Expected retirement age 60
five more years of service. At the employee’s Number of years to expected
expected retirement date, the present value of a retirement age 5
lifetime annuity of $20,000 that begins on the
Discount rate (%) 6.75
first anniversary of that date is $142,109 (com-
puted as $20,000 times 7.10545, the factor for Expected mortality age based on
the present value of 10 annual payments at 6.75 present age 70
percent). The company would accrue this amount
in a systematic and rational manner over the
five-year period from the date it entered into the The following table summarizes one systematic
agreement to the date the employee is fully and rational method of recognizing the expense
eligible for the deferred compensation benefit. and liability under the deferred compensation
Under one systematic and rational method, the agreement:
annual service component accrual would be
$24,835 (computed as $142,109 divided by

Page 5
A B C D E F
(B + C) (E + D – A)
Beginning- End-
Benefit Service Interest Compensation of-year of-year
Year payment ($) component ($) component ($) expense ($) liability ($) liability ($)
1 – 24,835 – 24,835 – 24,835

2 – 24,835 1,676 26,511 24,835 51,346
3 – 24,835 3,466 28,301 51,346 79,647
4 – 24,835 5,376 30,211 79,647 109,858
5 – 24,835 7,416 32,251 109,858 142,109
6 20,000 – 9,593 9,593 142,109 131,702
7 20,000 – 8,890 8,890 131,702 120,592
8 20,000 – 8,140 8,140 120,592 108,732
9 20,000 – 7,339 7,339 108,732 96,071
10 20,000 – 6,485 6,485 96,071 82,556
11 20,000 – 5,572 5,572 82,556 68,128
12 20,000 – 4,599 4,599 68,128 52,727
13 20,000 – 3,559 3,559 52,727 36,286
14 20,000 – 2,449 2,449 36,286 18,735
15 20,000 – 1,265 1,265 18,735 0
Totals 200,000 124,175 75,825 200,000
No entry would be made at the inception date of

the agreement. The following entry would be
made in year 1 to record the service component
of the compensation expense and related deferred
compensation agreement liability:
Debit Credit
[To record the column B service component]
Similar entries would be made in year 2 through tion liability for the interest component and any
year 5 to record the service component of the benefit payment. In addition, the company would
compensation expense. reassess the assumptions used in determining
In each subsequent period, until the date the the expected future benefits under the agreement
employee is fully eligible for the deferred com- and the discount rate used to compute the
pensation benefit, the company would adjust the present value of the expected benefits in each
deferred compensation liability for the total period after the inception of the agreement, and
expense (the service and interest components). revise the assumptions and rate, as appropriate.
In each period after the full eligibility date, the Assuming no changes were necessary to the
company would adjust the deferred compensa- assumptions used to determine the expected

Page 6
future benefits under the agreement or to the

discount rate used to compute the present value
of the expected benefits, the following entry
would be made in year 2 to record the interest
component of the compensation expense:
Debit Credit
[To record the column C interest component (computed by multiplying the prior-year column F
balance by the discount rate)]
Similar entries (but for different amounts) would

be made in year 3 through year 15 to record the
interest component of the compensation expense.
The following entry would be made in year 6
to record the payment of the annual benefit:
Debit Credit
Cash $20,000
[To record the column A benefit payment]
Similar entries would be made in year 7 through

year 15 to record the payment of the annual
benefit.

Page 7
Assessment of Capital Adequacy
Although both bank directors and bank regula- definition of capital and a framework for calcu-
tors must look carefully at the quality of bank lating risk-weighted assets by assigning assets
assets and management and at the ability of the and off-balance-sheet items to broad categories
bank to control costs, evaluate risks, and main- of credit risk. A bank’s risk-based capital ratio is
tain proper liquidity, capital adequacy is the area calculated by dividing its qualifying capital (the
that triggers the most regulatory action, espe- numerator of the ratio) by its risk-weighted
cially in view of prompt corrective action. The assets (the denominator). The definition of
primary function of capital is to support the qualifying capital is outlined below, as are the
bank’s operations, act as a cushion to absorb procedures for calculating risk-weighted assets.
unanticipated losses and declines in asset values The major objectives of the risk-based capital
that could otherwise cause a bank to fail, and guidelines are to make regulatory capital require-
provide protection to uninsured depositors and ments more sensitive to differences in credit-risk
debt holders in the event of liquidation. A profiles among banking organizations; to factor
bank’s solvency promotes public confidence in off-balance-sheet exposures into the assessment
the bank and the banking system as a whole by of capital adequacy; to minimize disincentives
providing continued assurance that the bank to holding liquid, low-risk assets; and to achieve
will continue to honor its obligations and pro- greater consistency in the evaluation of the
vide banking services. By exposing stockhold- capital adequacy of major banking organizations
ers to a larger percentage of any potential loss, worldwide.
higher capital levels also reduce the subsidy The guidelines set forth minimum supervi-
provided to banks by the federal safety net. sory capital standards that apply to all state
Capital regulation is particularly important member banks on a consolidated basis. Most
because deposit insurance and other elements of banks are expected to operate with capital levels
the federal safety net provide banks with an above the minimum ratios. Banking organiza-
incentive to increase their leverage beyond tions that are undertaking significant expansion
what the market—in the absence of depositor or that are exposed to high or unusual levels of
protection—would permit. Additionally, higher risk are expected to maintain capital well above
capital levels can reduce the need for regulatory the minimum ratios; in such cases, the Federal
supervision, thereby lowering costs to the bank- Reserve may specify a higher minimum require-
ing industry and the government. ment. In addition, the risk-based capital ratio is
The Federal Reserve uses two ratios to help used as a basis for categorizing institutions for
assess the capital adequacy of state members: purposes of prompt corrective action.1
the risk-based capital ratio and the tier 1 lever- For most institutions, the risk-based capital
age ratio. State member banks may also be ratio focuses principally on broad categories of
subject to separate capital requirements imposed credit risk, although the framework for assign-
by state banking supervisors. ing assets and off-balance-sheet items to risk
categories does incorporate elements of transfer
risk as well as limited instances of interest-rate
OVERVIEW OF THE RISK-BASED and market risk.2 The framework incorporates
CAPITAL MEASURE FOR STATE risks arising from traditional banking activities
MEMBER BANKS as well as risks arising from nontraditional
activities. The ratio does not, however, incorpo-
The Federal Reserve’s risk-based capital guide- rate other factors that can affect an institution’s
lines (the guidelines) focus principally on the financial condition. These factors include over-
credit risk associated with the nature of banks’ all interest-rate exposure; liquidity, funding, and
on- and off-balance-sheet exposures and on the market risks; the quality and level of earnings;
type and quality of banks’ capital. The risk-
based capital guidelines apply to all state mem- 1. See section 4133.1, ‘‘Prompt Corrective Action.’’
ber banks. The information provided in this 2. A small number of institutions are required to hold
section should be used in conjunction with the capital to support their exposure to market risk. For more
information, see the ‘‘Market-Risk Measure’’ subsection below,
guidelines, which are found in Regulation H SR-09-1, ‘‘Application of the Market Risk Rule in BHCs and
(12 CFR 208, appendix A). SMBs,’’ or the Federal Reserve’s Trading and Capital-
The risk-based capital guidelines provide a Markets Activities Manual, section 2110.1, ‘‘Capital Adequacy.’’

Page 1
3020.1 Assessment of Capital Adequacy
investment, loan portfolio, and other concentra- petual preferred stock that does not qualify for
tions of credit; certain risks arising from nontra- inclusion in tier 1 capital; certain other hybrid
ditional activities; the effectiveness of loan and capital instruments; mandatory convertible
investment policies; and management’s overall securities; long-term preferred stock with an
ability to monitor and control financial and original term of 20 years or more; and limited
operating risks, including the risks presented by amounts of term subordinated debt, intermediate-
concentrations of credit and nontraditional term preferred stock, including related surplus,
activities. An overall assessment of capital and unrealized holding gains on qualifying equity
adequacy must take into account these other securities.
factors, including, in particular, the level and Capital investments in unconsolidated bank-
severity of problem and classified assets as well ing and finance subsidiaries, and reciprocal
as a bank’s exposure to declines in the economic holdings of other banking organizations’ capital
value of its capital due to changes in interest instruments, are deducted from a bank’s capital.
rates. For this reason, the final supervisory The sum of tier 1 and tier 2 capital less any
judgment on a bank’s capital adequacy may deductions makes up total capital, which is the
differ significantly from conclusions that might numerator of the total risk-based capital ratio.
be drawn solely from the level of its risk-based The maximum amount of tier 2 capital that may
capital ratio. be included in a bank’s qualifying total capital is
limited to 100 percent of tier 1 capital (net of
goodwill, other intangible assets, and interest-
DEFINITION OF CAPITAL only strips receivables and nonfinancial equity
investments that are required to be deducted).
For the purpose of risk-based capital, a bank’s
total capital consists of two types of compo-
nents: ‘‘core capital elements’’ (which are RISK-WEIGHTING PROCESS
included in tier 1 capital) and ‘‘supplementary
capital elements’’ (which are included in tier 2 Each asset and off-balance-sheet item is assigned
capital). To qualify as an element of tier 1 or to one of four broad risk categories based on the
tier 2 capital, a capital instrument must be perceived credit risk of the obligor or, if rel-
unsecured and may not contain or be covered by evant, the guarantor or type of collateral. These
any covenants, terms, or restrictions that are risk categories are assigned weights of 0 per-
inconsistent with safe and sound banking cent, 20 percent, 50 percent, and 100 percent.
practices. The majority of items fall into the 100 percent
Tier 1 capital is generally defined as the sum risk-weight category. A brief explanation of the
of core capital elements (common equity, includ- components of each category follows. For more
ing capital stock, surplus, and undivided profits; detailed information, see the capital adequacy
qualifying noncumulative perpetual preferred guidelines.
stock; and minority interest in the equity accounts
of consolidated subsidiaries) less any amounts Risk Categories
of goodwill, other intangible assets, interest-
only strips receivables and nonfinancial equity Category 1: Zero Percent
investments that are required to be deducted,3
and unrealized holding losses in the available- Category 1 includes cash (domestic and foreign)
for-sale equity portfolio, as well as any invest- owned and held in all offices of the bank or in
ments in subsidiaries that the Federal Reserve transit, as well as gold bullion held in the bank’s
determines should be deducted from tier 1 own vaults or in another bank’s vaults on an
capital. Tier 1 capital elements represent the allocated basis to the extent it is offset by gold
highest form of capital, namely, permanent bullion liabilities. The category also includes all
equity. direct claims on (including securities, loans, and
Tier 2 capital consists of a limited amount of leases), and the portions of claims that are
the allowance for loan and lease losses; per- directly and unconditionally guaranteed by, the
central governments of the Organisation for
3. In this subsection, the words ‘‘required to be deducted’’
refer to section II.B. of the capital adequacy guidelines:
Economic Co-operation and Development
risk-based measure (Regulation H, appendix A (12 CFR 208, (OECD) countries and U.S. government agen-
appendix A)). cies, as well as all direct local currency claims

Page 2
Assessment of Capital Adequacy 3020.1
on, and the portions of local currency claims that multilateral lending institutions or regional
are directly and unconditionally guaranteed by, development banks in which the U.S. govern-
the central governments of non-OECD coun- ment is a shareholder or contributing member.
tries, to the extent that the bank has liabilities General obligation claims on, or portions of
booked in that currency. A claim is not consid- claims guaranteed by the full faith and credit of,
ered to be unconditionally guaranteed by a states or other political subdivisions of the
central government if the validity of the guar- United States or other countries of the OECD-
antee depends on some affirmative action by the based group are also assigned to this category.
holder or a third party. Generally, securities Category 2 also includes the portions of claims
guaranteed by the U.S. government or its agen- (including repurchase transactions) that are
cies that are actively traded in financial markets, (1) collateralized by cash on deposit in the bank
such as Government National Mortgage Asso- or by securities issued or guaranteed by OECD
ciation (GNMA) securities, are considered to be central governments or U.S. government agen-
unconditionally guaranteed. This zero percent cies that do not qualify for the zero percent
category also includes claims collateralized risk-weight category; (2) collateralized by secu-
(1) by cash on deposit in the bank or (2) by rities issued or guaranteed by U.S. government–
securities issued or guaranteed by OECD central sponsored agencies; or (3) collateralized by
governments or (3) by U.S. government agen- securities issued by multilateral lending institu-
cies for which a positive margin of collateral is tions or regional development banks in which
maintained on a daily basis, fully taking into the U.S. government is a shareholder or contrib-
account any change in the bank’s exposure to uting member.
the obligor or counterparty under a claim in This risk category also includes claims on, 3a
relation to the market value of the collateral held or guaranteed by, a qualifying securities firm
in support of that claim. incorporated in the United States or other coun-
tries that are members of the OECD-based
group of countries 3b provided that (1) the quali-
Category 2: 20 percent fying securities firm has a long-term issuer
credit rating, or a rating on at least one issue of
Category 2 includes cash items in the process of long-term debt, in one of the three highest
collection, both foreign and domestic; short- investment-grade rating categories from a
term claims on (including demand deposits), nationally recognized statistical rating organiza-
and the portions of short-term claims that are tion or (2) the claim is guaranteed by the firm’s
guaranteed by, U.S. depository institutions and parent company and the parent company has
foreign banks; and long-term claims on, and the such a rating. If ratings are available from more
portions of long-term claims that are guaranteed than one rating agency, the lowest rating will be
by, U.S. depository institutions and OECD banks. used to determine whether the rating require-
This category also includes the portions of ment has been met. This category also includes
claims that are conditionally guaranteed by a collateralized claim on a qualifying securities
OECD central governments and U.S. govern- firm in such a country, without regard to satis-
ment agencies, as well as the portions of local
currency claims that are conditionally guaran- 3a. Claims on a qualifying securities firm that are instru-
teed by non-OECD central governments, to the ments the firm, or its parent company, uses to satisfy its
extent that the bank has liabilities booked in that applicable capital requirements are not eligible for this risk
currency. In addition, this category includes weight.
3b. With regard to securities firms incorporated in the
claims on, and the portions of claims that are United States, qualifying securities firms are those securities
guaranteed by, U.S. government–sponsored agen- firms that are broker–dealers registered with the Securities and
cies and claims on, and the portions of claims Exchange Commission (SEC) and are in compliance with the
guaranteed by, the International Bank for SEC’s net capital rule, 17 CFR 240.15c3-1. With regard to
securities firms incorporated in any other country in the
Reconstruction and Development (the World OECD-based group of countries, qualifying securities firms
Bank), the International Finance Corporation, are those securities firms that a bank is able to demonstrate are
the Inter-American Development Bank, the subject to consolidated supervision and regulation (covering
Asian Development Bank, the African Develop- their direct and indirect subsidiaries, but not necessarily their
parent organizations) comparable to that imposed on banks in
ment Bank, the European Investment Bank, the OECD countries. Such regulation must include risk-based
European Bank for Reconstruction and Devel- capital requirements comparable to those applied to banks
opment, the Nordic Investment Bank, and other under the Basel Accord.

Page 3
faction of the rating standard, provided that the year must not be less than 120 percent of the
claim arises under a contract that (1) is a loan’s current annual debt service (115 percent
reverse-repurchase/repurchase agreement or if the loan is based on a floating interest rate) or,
securities-lending/borrowing transaction exe- in the case of a cooperative or other not-for-
cuted using standard industry documentation; profit housing project, the property must gener-
(2) is collateralized by debt or equity securities ate sufficient cash flow to provide comparable
that are liquid and readily marketable; (3) is protection to the institution. Also included in
marked to market daily; (4) is subject to a daily category 3 are privately issued mortgage-backed
margin-maintenance requirement under the stan- securities, provided that (1) the structure of the
dard industry documentation; and (5) can be security meets the criteria described in section
liquidated, terminated, or accelerated immedi- III.B.3. of the risk-based measure of the capital
ately in bankruptcy or a similar proceeding, and guidelines (12 CFR 208, appendix A); (2) if the
the security or collateral agreement will not be security is backed by a pool of conventional
stayed or avoided, under applicable law of the mortgages on one- to four-family residential or
relevant jurisdiction. 3c multifamily residential properties, each under-
lying mortgage meets the criteria described
Category 3: 50 percent above for eligibility for the 50 percent risk
category at the time the pool is originated; (3) if
Category 3 includes loans fully secured by first the security is backed by privately issued
liens on one- to four-family residential proper- mortgage-backed securities, each underlying
ties (either owner-occupied or rented), or on security qualifies for the 50 percent risk cate-
multifamily residential properties, that meet cer- gory; and (4) if the security is backed by a pool
tain criteria. To be included in category 3, loans of multifamily residential mortgages, principal
must have been made in accordance with pru- and interest payments on the security are not 30
dent underwriting standards, be performing in days or more past due. Privately issued mortgage-
accordance with their original terms, and not be backed securities that do not meet these criteria
90 days or more past due or carried in nonac- or that do not qualify for a lower risk weight are
crual status. The following additional criteria generally assigned to the 100 percent risk
must be applied to a loan secured by a multi- category.
family residential property that is included in
this category: (1) all principal and interest pay- Also assigned to category 3 are revenue
ments on the loan must have been made on time (nongeneral obligation) bonds or similar obliga-
for at least the year preceding placement in this tions, including loans and leases, that are obli-
category, or, in the case of an existing property gations of states or other political subdivisions
owner who is refinancing a loan on that prop- of the United States (for example, municipal
erty, all principal and interest payments on the revenue bonds) or other countries of the OECD-
loan being refinanced must have been made on based group, but for which the government
time for at least the year preceding placement in entity is committed to repay the debt with
this category; (2) amortization of the principal revenues from the specific projects financed,
and interest must occur over a period of not rather than from general tax funds. Credit-
more than 30 years, and the minimum original equivalent amounts of derivative contracts
maturity for repayment of principal must not be involving standard risk obligors (that is, obli-
less than seven years; and (3) the annual net gors whose loans or debt securities would be
operating income (before debt service) gener- assigned to the 100 percent risk category) are
ated by the property during its most recent fiscal included in the 50 percent category, unless they
are backed by collateral or guarantees that allow
them to be placed in a lower risk category.
3c. For example, a claim is exempt from the automatic stay
in bankruptcy in the United States if it arises under a securities
contract or a repurchase agreement subject to section 555 or
559 of the Bankruptcy Code, respectively (11 USC 555 or Category 4: 100 percent
559); a qualified financial contract under section 11(e)(8) of
the Federal Deposit Insurance Act (12 USC 1821(e)(8)); or a
netting contract between financial institutions under sections All assets not included in the categories above
401–407 of the Federal Deposit Insurance Corporation are assigned to category 4, which comprises
Improvement Act of 1991 (12 USC 4401–4407) or the
Board’s Regulation EE (12 CFR 231).

Page 4
standard risk assets. The bulk of the assets categories are added together. The resulting sum
typically found in a loan portfolio would be is the bank’s total risk-weighted assets and is the
assigned to the 100 percent category. denominator of the risk-based capital ratio.
Category 4 includes long-term claims on, and
the portions of long-term claims that are guar-
anteed by, non-OECD banks, and all claims on
non-OECD central governments that entail some
Risk Weighting of Off-Balance-Sheet
degree of transfer risk. This category includes Items
all claims on foreign and domestic private-
sector obligors not included in the categories Off-balance-sheet items are incorporated into
above (including loans to nondepository finan- the risk-based capital ratio through a two-step
cial institutions and bank holding companies); process. First, an on-balance-sheet ‘‘credit-
claims on commercial firms owned by the public equivalent amount’’ is calculated, generally by
sector; customer liabilities to the bank on accep- multiplying the face amount of the item by a
tances outstanding that involve standard risk credit-conversion factor (except for direct-credit
claims; investments in fixed assets, premises, subsitutes and recourse obligations). Most off-
and other real estate owned; common and pre- balance-sheet items are assigned to one of the
ferred stock of corporations, including stock five credit-conversion factors: 0 percent, 10 per-
acquired for debts previously contracted; all cent, 20 percent, 50 percent, or 100 percent.
stripped mortgage-backed securities and similar These factors are intended to reflect the risk
instruments; and commercial and consumer loans characteristics of the activity in terms of an
(except those assigned to lower risk categories on-balance-sheet equivalent. Second, once the
due to recognized guarantees or collateral and credit-equivalent amount of the off-balance-
loans secured by residential property that qualify sheet item is calculated, the resultant credit-
for a lower risk weight). This category also equivalent amount is assigned to the appropriate
includes claims representing capital of a quali- risk category according to the obligor or, if
fying securities firm. relevant, the guarantor, the nature of any collat-
This category also includes industrial- eral, or external credit ratings. Briefly, the credit-
development bonds and similar obligations conversion factors are as follows:
issued under the auspices of states or political
subdivisions of the OECD-based group of coun- • Items with a zero percent credit-conversion
tries for the benefit of a private party or enter- factor include unused portions of commit-
prise when that party or enterprise, not the ments (with the exception of asset-backed
government entity, is obligated to pay the prin- commercial paper (ABCP) liquidity facilities)
cipal and interest. All obligations of states or with an original maturity of one year or less,
political subdivisions of countries that do not or which are unconditionally cancelable at any
belong to the OECD-based group are also time, provided a separate credit decision is
assigned to category 4. The following assets are made before each drawing under the facility.
assigned a risk weight of 100 percent if they • Items with a 10 percent credit-conversion
have not been deducted from capital: invest- factor include unused portions of eligible
ments in unconsolidated companies, joint ven- ABCP liquidity facilities with an original
tures, or associated companies; instruments that maturity of one year or less.
qualify as capital that are issued by other bank- • Items with a 20 percent credit-conversion
ing organizations; and any intangibles, includ- factor include short-term, self-liquidating
ing those that may have been grandfathered into trade-related contingencies that arise from the
capital. movement of goods.
• Items with a 50 percent credit-conversion
factor include transaction-related contingen-
cies, which include bid bonds, performance
Application of the Risk Weights bonds, warranties, standby letters of credit
related to particular transactions, and perfor-
The appropriate aggregate dollar value of the mance standby letters of credit, as well as
amount in each risk category is multiplied by the acquisitions of risk participations in perfor-
risk weight associated with that category. The mance standby letters of credit. In addition,
resulting weighted values for each of the risk this credit-conversion factor includes unused

Page 5
portions of commitments, including eligible ernment agency, rather than the 100 percent risk
ABCP liquidity facilities, with an original weight that is appropriate to high loan-to-value
maturity exceeding one year; revolving- single-family mortgages.
underwriting facilities; note-issuance facili- While the primary determinant of the risk
ties; and other similar arrangements. category of a particular on-balance-sheet asset
• Items with a 100 percent credit-conversion or off-balance-sheet credit-equivalent amount is
factor include, except as otherwise provided the obligor, collateral or guarantees may be used
within the risk-based capital guidelines, direct- to a limited extent to assign an item to a lower
credit substitutes, recourse obligations, sale risk category than would be available to the
and repurchase agreements, ineligible ABCP obligor. The only forms of collateral that are
liquidity facilities, and forward agreements, as recognized for risk-based capital purposes are
well as securities lent where the securities
cash on deposit in the lending bank;4 securities
lender is at risk of loss.
issued or guaranteed by the central governments
of the OECD-based group of countries,5 U.S.
See the risk-based capital guidelines for more
information on the use, treatment, and applica- government agencies, or U.S. government–
tion of credit-conversions factors for off-balance- sponsored agencies; and securities issued by
sheet items and transactions. multilateral lending institutions or regional
For derivative contracts, the credit-equivalent development banks in which the U.S. govern-
amount for each contract is determined by ment is a shareholder or contributing member.
multiplying the notional principal amount of the In order for a claim to be considered collateral-
underlying contract by a credit-conversion fac- ized for risk-based capital purposes, the under-
tor and adding the resulting product (which is an lying arrangements must provide that the claim
estimate of potential future exposure) to the will be secured by recognized collateral through-
positive mark-to-market value of the contract out its term. A commitment may be considered
(which is the current exposure). A contract with collateralized for risk-based capital purposes to
a negative mark-to-market value is treated as the extent that its terms provide that advances
having a current exposure of zero. Where made under the commitment will be secured
appropriate, a bank may offset positive and throughout their term.
negative mark-to-market values of derivative The extent to which qualifying securities are
contracts entered into with a single counterparty recognized as collateral is determined by their
subject to a qualifying, legally enforceable, current market value. The full amount of a claim
bilateral netting arrangement. for which a positive margin (that is, greater than
As a general rule, if the terms of a claim can 100 percent of the claim) of recognized collat-
change, the claim should be assigned to the risk eral is maintained daily may qualify for a
category appropriate to the highest risk option
available under the terms of the claim. For
example, in a collateralized loan where the
borrower has the option to withdraw the collat- 4. There is a limited exception to the rule that cash must be
eral before the loan is due, the loan would be on deposit in the lending bank to be recognized as collateral.
A bank participating in a syndicated credit secured by cash on
treated as an uncollateralized claim for risk- deposit in the lead bank may treat its pro rata share of the
based capital purposes. Similarly, a commitment credit as collateralized, provided that it has a perfected interest
that can be drawn down in the form of a loan or in its pro rata share of the collateral.
a standby letter of credit would be treated as a 5. The OECD-based group of countries comprises all full
members of the Organization for Economic Cooperation and
commitment to make a standby letter of credit, Development (OECD), as well as countries that have con-
the higher risk option available under the terms cluded special lending arrangements with the International
of the commitment. Monetary Fund (IMF) associated with the Fund’s General
When an item may be assigned to more than Arrangements to Borrow. The OECD’s thirty member coun-
tries include Australia, Austria, Belgium, Canada, Czech
one category, that item generally is assigned to Republic, Denmark, Finland, France, Germany, Greece, Hun-
the lowest eligible risk category. For example, a gary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg,
mortgage originated by the bank for which a Mexico, Netherlands, New Zealand, Norway, Poland, Portu-
100 percent Federal Housing Administration gal, Slovak Republic, Spain, Sweden, Switzerland, Turkey,
United Kingdom, and United States. Any country that has
guarantee has been obtained would be assigned rescheduled its external sovereign debt within the previous
the 20 percent risk weight that is appropriate to five years is not considered to be part of the OECD-based
claims conditionally guaranteed by a U.S. gov- group of countries for risk-based capital purposes.

Page 6
zero percent risk weight. The full amount of a further erode their capital positions. In these
claim that is 100 percent secured by recognized cases, examiners are to review and comment on
collateral may be assigned to the 20 percent risk banks’ capital plans and their progress in meet-
category. For partially secured obligations, the ing, and continuing to maintain, the minimum
secured portion is assigned a 20 percent risk risk-based capital requirements.
weight. Any unsecured portion is assigned the The bank’s board of directors and senior
risk weight appropriate for the obligor or guar- management should be encouraged to establish
antor, if any. The extent to which an off-balance- capital levels and ratios that are consistent with
sheet item is secured by collateral is determined the bank’s overall financial profile. When assess-
by the degree to which the collateral covers the ing the bank’s capital adequacy, it is appropriate
face amount of the item before it is converted to to include comments on risk-based capital in the
a credit-equivalent amount and assigned to a open section of the examination report. Exam-
risk category. For derivative contracts, this iner comments should address the adequacy of
determination is made in relation to the credit- the bank’s plans and progress toward meeting
equivalent amount. the relevant target ratios.
The only guarantees that are recognized for
risk-based capital purposes are those provided
by central or state and local governments of the Market-Risk Rule
OECD-based group of countries, U.S. govern-
ment agencies, U.S. government–sponsored Institutions are responsible for identifying their
agencies, multilateral lending institutions or trading and other market risks and for imple-
regional development banks in which the United menting a sound risk-management program com-
States is a shareholder or contributing member, mensurate with those risks. Such programs
U.S. depository institutions, and foreign banks. should include appropriate quantitative metrics
If an obligation is partially guaranteed, the as well as ongoing qualitative analysis per-
portion that is not fully covered is assigned the formed by competent, independent risk-
risk weight appropriate to the obligor or to any management staff. At a minimum, institutions
collateral. An obligation that is covered by two should reassess annually and adjust their market-
types of guarantees having different risk weights risk management programs, taking into account
is apportioned between the two risk categories changing firm strategies, market developments,
appropriate to the guarantors. organizational incentive structures, and evolv-
ing risk-management techniques.
In August 1996, the Federal Reserve amended
Minimum Risk-Based Capital Ratios its risk-based capital framework to incorporate a
measure for market risk for state member banks.
Banks are expected to meet a minimum ratio of The market-risk rule is found in Regulation H
capital to risk-weighted assets of 8 percent, with (12 CFR 208), appendix E. Under the market-
at least 4 percent taking the form of tier 1 risk rule, certain institutions with significant
capital. Banks that do not meet the minimum exposure to market risk must measure that risk
risk-based capital ratios, or that are considered using their internal value-at-risk (VaR) measure-
to lack sufficient capital to support their activi- ment model and, subject to parameters in the
ties, are expected to develop and implement market-risk rule, hold sufficient levels of capital
capital plans acceptable to the Federal Reserve to cover the exposure. The market-risk rule
for achieving adequate levels of capital.6 Such applies to any insured state member bank whose
plans should satisfy the provisions of the guide- trading activity (the gross sum of its trading
lines or established arrangements that the Fed- assets and liabilities) equals (1) 10 percent or
eral Reserve has agreed on with designated more of its total assets or (2) $1 billion or more.
banks. In addition, such banks should avoid On a case-by-case basis, the Federal Reserve
any actions, including increased risk taking or may require an institution that does not meet
unwarranted expansion, that would lower or these criteria to comply with the market-risk
rule if deemed necessary for safety-and-
soundness reasons. The Federal Reserve may
6. Under the prompt-corrective-action framework, banks
that do not meet the minimum risk-based capital ratio are
also exclude an institution that meets the criteria
considered undercapitalized and must file capital-restoration if such exclusion is deemed to be consistent with
plans that meet certain requirements. safe and sound banking practices.

Page 7
The market-risk rule supplements the risk- Market Risk Rule Provisions for
based capital rules for credit risk; an institution Securities Lending
applying the market-risk rule remains subject to
the requirements of the credit-risk rules but must On February 6, 2006, the Board approved a
adjust its risk-based capital ratio to reflect mar- revision to Regulation H for its market-risk
ket risk. In January 2009, the Board issued measure of the capital adequacy guidelines. (See
SR-09-1, ‘‘Application of the Market Risk Rule 12 CFR 208, appendix E.) The amendment
in Bank Holding Companies and State Member lessened and aligned the capital requirement of
Banks,’’ which reiterated some of the market- state member banks (those that have adopted the
risk rule’s core requirements, provided guidance market-risk rule) to the risk involved with cer-
on certain technical aspects of the rule, and tain cash collateral that is posted in connection
clarified several issues. SR-09-1 discusses (1) the with securities-borrowing transactions. 6a It also
core requirements of the market-risk rule, (2) the broadened the scope of counterparties for which
market-risk rule capital computational require- favorable capital treatment would be applied.
ments, and (3) the communication and Federal (See 71 Fed. Reg. 8932, February 22, 2006.) For
Reserve requirements in order for a bank to use a detailed description of the market-risk mea-
its VaR models. A bank that is applying the sure, see the Federal Reserve’s Trading and
market-risk rule must hold capital to support its Capital-Markets Activities Manual, section
exposure to two types of risk: (1) general market 2110.1.
risk arising from broad fluctuations in interest
rates, equity prices, foreign exchange rates, and
commodity prices, including risk associated with Documentation
all derivative positions, and (2) specific risk
arising from changes in the market value of debt Banks are expected to have adequate systems
and equity positions in the trading account due in place to compute their risk-based capital
to factors other than broad market movements, ratios. Such systems should be sufficient to
including the credit risk of an instrument’s document the composition of the ratios to be used
issuer. A bank’s covered positions include all for regulatory reporting and other supervisory
trading-account positions as well as all foreign- purposes. Generally, supporting documentation
exchange and commodity positions, whether or will be expected to establish how banks track and
not they are in the trading account. Banks that report their capital components and on- and
are subject to the market-risk capital rules are off-balance-sheet items that are assigned prefer-
precluded from applying those rules to positions ential risk weights, that is, risk weights less than
held in the bank’s trading book that act, in form 100 percent. Where a bank has inadequate
or in substance, as liquidity facilities supporting documentation to support its assignment of a
asset-backed commercial paper (ABCP). (See preferential risk weight to a given item, it may be
the definition of covered positions in appendix necessary for examiners to assign an appropriate
E, section 2(a).) Any facility held in the trading higher weight to that item. Examiners are
book whose primary function, in form or in expected to verify that banks are correctly
substance, is to provide liquidity to ABCP— reporting the information requested on the
even if the facility does not qualify as an eligible Reports of Condition and Income, which are used
ABCP liquidity facility under the rule—will be in computing banks’ risk-based capital ratios.
subject to the banking-book risk-based capital
requirements. Specifically, organizations will be
required to convert the notional amount of all SUPERVISORY CONSIDERATIONS
trading-book positions that provide liquidity to FOR CALCULATING AND
ABCP to credit-equivalent amounts by applying EVALUATING RISK-BASED
the appropriate banking-book credit-conversion CAPITAL
factors. For example, the full notional amount of
all eligible ABCP liquidity facilities with an Certain requirements and factors should be con-
original maturity of one year or less will be sidered in assessing the risk-based capital ratios
subject to a 10 percent conversion factor, as
described previously, regardless of whether the 6a. See the Board staff’s August 21, 2007, legal interpre-
facility is carried in the trading account or the tation as to the appropriate risk-based capital risk weight to be
banking book. applied to certain collateralized loans of cash.

Page 8
and the overall capital adequacy of banks. Analy- Capital Elements

sis of these requirements and factors may have
a material impact on the amount of capital banks This subsection discusses the characteristics of
must hold to appropriately support certain
the principal types of capital elements. It also
activities for on- and off-balance-sheet items,
covers terms and conditions that may disqualify
and this analysis must be used in assessing
an instrument from inclusion in a particular
compliance with the guidelines. The require-
element of capital.
ments and factors to be considered relate to
certain capital elements, capital adjustments,
balance-sheet activities, off-balance-sheet activi- Common Stockholders’ Equity
ties, and the overall assessment of capital
adequacy. Common stockholders’ equity includes common
stock; related surplus; and retained earnings,
including capital reserves and adjustments for
Federal Reserve Review of a Capital the cumulative effect of foreign-currency trans-
Instrument lation, net of any treasury stock. A capital
instrument that is not permanent or that has
If the terms and conditions of a particular preference with regard to liquidation or the
instrument cause uncertainty as to how the payment of dividends is not deemed to be
instrument should be treated for capital pur- common stock, regardless of whether it is called
poses, it may be necessary to consult with common stock. Other preferences may also call
Federal Reserve staff for a final determination. into question whether the capital instrument is
The Federal Reserve will, on a case-by-case common stock. Close scrutiny should be paid to
basis, determine whether a capital instrument the terms of common-stock issues of banks that
has characteristics that warrant its inclusion in have issued more than one class of common
tier 1 or tier 2 capital, as well as determine any stock. If preference features are found in one of
quantitative limit on the amount of an instru-
the classes, that class generally should not be
ment that will be counted as an element of tier 1
treated as common stock.
or tier 2 capital. In making this determination,
the Federal Reserve will consider the similarity From a supervisory standpoint, it is desirable
of the instrument to instruments explicitly treated that voting common stockholders’ equity remain
in the guidelines, the ability of the instrument to the dominant form of tier 1 capital. Accordingly,
absorb losses while the bank operates as a going the risk-based capital guidelines state that banks
concern, the maturity and redemption features should avoid overreliance on nonvoting equity
of the instrument, and other relevant terms and elements in tier 1 capital. Nonvoting equity
factors. elements can arise in connection with common
stockholders’ equity when a bank has two classes
of common stock, one voting and the other
Redemptions of Capital nonvoting. Alternatively, one class may have
so-called super-voting rights entitling the holder
Redemptions of permanent equity or other capi- to substantially more votes per share than the
tal instruments before their stated maturity could other class. In this case, the super-voting shares
have a significant impact on a bank’s overall may have so many votes per share that the
capital structure. Consequently, a bank consid- voting power of the other shares is effectively
ering such a step should consult with the Federal overwhelmed.
Reserve before redeeming any equity or debt
Banks that have nonvoting, or effectively
capital instrument (before maturity) if its
nonvoting, common equity and tier 1 perpetual
redemption could have a material effect on the
level or composition of the institution’s capital preferred stock in excess of their voting com-
base.7 mon stock are clearly overrelying on nonvoting
equity elements in tier 1 capital. In such cases, it
7. Consultation would not ordinarily be necessary if an
may be appropriate to reallocate some of the
instrument was redeemed with the proceeds of, or replaced by, nonvoting equity elements from tier 1 capital to
a like amount of a similar or higher-quality capital instrument tier 2 capital.
and if the organization’s capital position is considered fully
adequate by the Federal Reserve.

Page 9
Perpetual Preferred Stock included in tier 1 capital, provided they are

noncumulative.
The risk-based capital guidelines define per- Some preferred-stock issues incorporate cer-
petual preferred stock as preferred stock that has tain features that raise serious questions about
no maturity date, cannot be redeemed at the whether these issues will truly serve as a
option of the holder, and has no other provisions permanent, or even long-term, source of capital.
that will require future redemption of the issue. Such features include so-called exploding-rate
Perpetual preferred stock qualifies for inclusion mechanisms, or similar mechanisms, in which,
in capital only if it can absorb losses while the after a specified period, the dividend rate auto-
issuer operates as a going concern and only if matically increases to a level that could create
the issuer has the ability and legal right to defer an incentive for the issuer to redeem the instru-
or eliminate preferred dividends. ment. Perpetual preferred stock with this type of
Perpetual preferred stock with a feature per- feature could cause the issuing bank to be faced
mitting redemption at the option of the issuer with higher dividend requirements at a future
may qualify for tier 1 or unlimited tier 2 capital date when the bank may be experiencing finan-
only if the redemption is subject to prior approval cial difficulties; it is generally not includable in
of the Federal Reserve. An issue that is convert- tier 1 capital.
ible at the option of the issuer into another issue Traditional convertible perpetual preferred
of perpetual preferred stock or a lower form of stock, which the holder can convert into a fixed
capital, such as subordinated debt, is considered number of common shares at a preset price,
to be redeemable at the option of the issuer. ordinarily does not raise supervisory concerns
Accordingly, such a conversion must be subject and generally qualifies as tier 1 capital, provided
to prior Federal Reserve approval. the stock is noncumulative. However, forms of
Banks may include perpetual preferred stock preferred stock that the holder must or can
in tier 1 capital only if the stock is noncumula- convert into common stock at the market price
tive. A noncumulative issue may not permit the prevailing at the time of conversion do raise
accruing or payment of unpaid dividends in any supervisory concerns. Such preferred stock may
form, including the form of dividends payable in be converted into an increasing number of
common stock. Perpetual preferred stock that common shares as the bank’s condition deterio-
calls for the accumulation and future payment of rates and as the market price of the common
unpaid dividends is deemed to be cumulative, stock falls. The potential conversion of such
regardless of whether it is called noncumulative, preferred stock into common stock could pose a
and it is generally includable in tier 2 capital. threat of dilution to the existing common share-
Perpetual preferred stock (including auction- holders. The threat of dilution could make the
rate preferred) in which the dividend rate is reset issuer reluctant to sell new common stock, or it
periodically based, in whole or in part, on the could place the issuer under strong market
bank’s financial condition or credit standing is pressure to redeem or repurchase the convertible
excluded from tier 1 capital but may generally preferred stock. Such convertible preferred stock
be included in tier 2 capital. The obligation should generally be excluded from tier 1 capital.
under such instruments to pay out higher divi- Perpetual preferred stock issues may include
dends when a bank’s condition deteriorates is other provisions or pricing mechanisms that
inconsistent with the essential precept that capi- would provide significant incentives or pres-
tal should provide both strength and loss- sures for the issuer to redeem the stock for cash,
absorption capacity to a bank during periods of especially at a time when the issuer is in a
adversity. weakened financial condition. As a general mat-
Ordinarily, fixed-rate preferred stock and tra- ter, an issue that contains such features would be
ditional floating- or adjustable-rate preferred ineligible for tier 1 treatment.
stock—in which the dividend rate adjusts in While no formal limit is placed on the amount
relation to an independent index based solely on of noncumulative perpetual preferred stock that
general market interest rates and is in no way may be included in tier 1 capital, the guidelines
tied to the issuer’s financial condition—do not state that banks should avoid overreliance on
raise significant supervisory concerns, espe- preferred stock and other nonvoting equity ele-
cially when the adjustable-rate instrument is ments in tier 1 capital. A bank that includes in
accompanied by reasonable spreads and cap tier 1 capital perpetual preferred stock in an
rates. Such instruments may generally be amount in excess of its voting common stock is

Page 10
clearly overrelying on perpetual preferred stock sents equity that is freely available to absorb
in tier 1 capital. In such cases, it may be losses in operating subsidiaries whose assets are
appropriate to reallocate the excess amount of included in a bank’s risk-weighted asset base.
perpetual preferred stock from tier 1 capital to While not subject to an explicit sublimit within
tier 2 capital. tier 1, banks are expected to avoid using minor-
ity interest as an avenue for introducing into
their capital structures elements that might not
Forward Equity Transactions otherwise qualify as tier 1 capital (such as
cumulative or auction-rate perpetual preferred
Banking organizations have engaged in various stock) or that would, in effect, result in an
types of forward transactions involving the repur- excessive reliance on preferred stock within
chase of their common stock. In these transac- tier 1 capital. If a bank uses minority interest in
tions, the banking organization enters into an these ways, supervisory concerns may warrant
arrangement with a counterparty, usually an reallocating some of the bank’s minority interest
investment bank or another commercial bank, in equity accounts of consolidated subsidiaries
under which the counterparty purchases com- from tier 1 to tier 2 capital.
mon shares of the banking organization, either Whenever a bank has included perpetual
in the open market or directly from the institu- preferred stock of an operating subsidiary
tion. The banking organization agrees that it will in minority interest, a possibility exists that such
repurchase those shares at an agreed-on forward capital has been issued in excess of the subsid-
price at a later date (typically three years or less iary’s needs, for the purpose of raising cheaper
from the execution date of the agreement). capital for the bank. Stock issued under these
These transactions are used to ‘‘lock in’’ stock circumstances may, in substance if not in legal
repurchases at price levels that are perceived to form, be secured by the subsidiary’s assets.
be advantageous, and they are a means of If the subsidiary fails, the outside preferred
managing regulatory capital ratios. investors would have a claim on the subsidiary’s
Some banking organizations have treated assets that is senior to the claim that the bank,
shares under forward equity arrangements as tier as a common shareholder, has on those assets.
1 capital. However, because these transactions Therefore, as a general matter, issuances in
can impair the permanence of the shares and excess of a subsidiary’s needs do not qualify for
typically have certain features that are undesir- inclusion in capital. The possibility that a
able from a supervisory point of view, shares secured arrangement exists should be consid-
covered by these arrangements have qualities ered if the subsidiary on-lends significant
that are inconsistent with tier 1 capital status. amounts of funds to the parent bank, is unusu-
Accordingly, any common stock covered by ally well capitalized, has cash flow in excess
forward equity transactions entered into after the of its operating needs, holds a significant
issuance of SR-01-27 (November 9, 2001), other amount of assets with minimal credit risk
than those specified for deferred compensation (for example, U.S. Treasury securities) that are
or other employee benefit plans, will be excluded not consistent with its operations, or has issued
from the tier 1 capital of a state member bank, preferred stock at a significantly lower rate than
even if executed under a currently existing the parent could obtain for a direct issue.
master agreement. The amount to be excluded is Some banks may use a nonoperating subsid-
equal to the common stock, surplus, and retained iary or special-purpose entity (SPE) to issue
earnings associated with the shares. This guid- perpetual preferred stock to outside investors.
ance does not apply to shares covered under Such a subsidiary may be set up offshore so a
traditional stock buyback programs that do not bank can receive favorable tax treatment for the
involve forward agreements. dividends paid on the stock. In such arrange-
ments, a strong presumption exists that the stock
is, in effect, secured by the assets of the subsid-
Minority Interest in Equity Accounts of iary. It has been agreed internationally that a
Consolidated Subsidiaries bank may not include in its tier 1 capital
minority interest in the perpetual preferred stock
Minority interest in equity accounts of consoli- of nonoperating subsidiaries. Furthermore, such
dated subsidiaries is included in tier 1 capital minority interest may not be included in tier 2
because, as a general rule, this interest repre- capital unless a bank can conclusively prove that

Page 10.1
the stock is unsecured. Even if the bank’s losses that is includable in tier 2 capital is
accountants have permitted the bank to account limited to 1.25 percent of risk-weighted assets.
for perpetual preferred stock issued through an
SPE as stock of the bank, rather than as minority
interest in the equity accounts of a consolidated Net Unrealized Holding Gains (Losses)
subsidiary, the stock may not be included in on Securities Available for Sale
tier 1 capital and most likely is not includable in
tier 2 capital. The Financial Accounting Standards Board’s
Banks may also use operating or nonoperat- Statement No. 115 (FAS 115), ‘‘Accounting for
ing subsidiaries to issue subordinated debt. As Certain Investments in Debt and Equity Securi-
with perpetual preferred stock issued through ties,’’ created a new common stockholders’
such subsidiaries, a possibility exists that such equity account known as ‘‘net unrealized hold-
debt is in effect secured and therefore not ing gains (losses) on securities available for
includable in capital. sale.’’ Although this equity account is consid-
ered to be part of a bank’s GAAP equity capital,
this account should not be included in a bank’s
Minority Interests in Consolidated regulatory capital calculations. There are excep-
Asset-Backed Commercial Paper tions, however, to this rule. A bank that legally
Programs holds equity securities in its available-for-sale
portfolio8 may include up to 45 percent of the
Minority interests in consolidated asset-backed
commercial paper (ABCP) programs that are
sponsored by a bank are not to be included in the
bank’s tier 1 capital or total capital base if the
bank excludes the consolidated assets of such
programs from risk-weighted assets pursuant to
section III.B.6. of the capital guidelines (12
CFR 208, appendix A).
Minority Interests in Small Business

Investment Companies
Minority interests in small business investment
companies (SBICs), in investment funds that
hold nonfinancial equity investments, and in
subsidiaries engaged in nonfinancial activities
are not included in a bank’s tier 1 or total capital
base if the bank’s interest in the company or
fund is held under the legal authorities listed in
section II.B.5.b. of the capital guidelines (12
CFR 208, appendix A).

The allowance for loan and lease losses is a
reserve that has been established through a
charge against earnings to absorb anticipated,
but not yet identified, losses on loans or lease-
financing receivables. The allowance excludes
allocated transfer-risk reserves and reserves cre- 8. Although banks are generally not allowed to hold equity
securities except in lieu of debts previously contracted and
ated against identified losses. Neither of these certain mutual fund holdings, some banks have grandfathered
two types of reserves is includable in capital. holdings of equity securities in accordance with provisions of
The amount of the allowance for loan and lease the National Bank Act, passed in the 1930s.

Page 10.2
pretax net unrealized holding gains on those tions should be included in capital as subordi-
securities in tier 2 capital. These equity securi- nated debt, subject to amortization in the last
ties must be valued in accordance with generally five years of its life and limited, together with
accepted accounting principles and have readily other subordinated debt and intermediate-term
determinable fair values. Unrealized holding preferred stock, to 50 percent of tier 1 capital.
gains may not be included in tier 2 capital if the For example, a bank has an outstanding equity
Federal Reserve determines that the equity contract note for $1 million and issues $300,000
securities were not prudently valued. Moreover, of common stock, dedicating the proceeds to the
if a bank experiences unrealized holding losses retirement of the note. The bank would include
in its available-for-sale equity portfolio, these the $300,000 of common stock in its tier 1
losses must be deducted from tier 1 capital. capital. The $700,000 of the equity contract note
not covered by the dedication would be treated
as an unlimited element of the bank’s tier 2
Mandatory Convertible Debt Securities capital. The $300,000 of the note covered by the
dedication would be treated as subordinated
Mandatory convertible debt securities are essen- debt.
tially subordinated-debt securities that receive In some cases, the indenture of a mandatory
special capital treatment because a bank has convertible debt issue may require the bank to
committed to repay the principal from proceeds set up segregated trust funds to hold the pro-
obtained through the issuance of equity. Banks ceeds from the sale of equity securities dedi-
may include such securities (net of any stock cated to pay off the principal of the manda-
issued that has been dedicated to their retire- tory convertibles at maturity. The portion of
ment) in the form of equity contract notes or mandatory convertible securities covered by
equity commitment notes9 issued before May the amount of such segregated trust funds is
15, 1985, as unlimited elements of tier 2 capital, considered secured and may therefore not be
provided that the criteria set forth in 12 CFR included in capital. The maintenance of such
225, appendix B, are met. Consistent with these a separate segregated fund for the redemption
criteria, mandatory convertible notes are subject of mandatory convertibles exceeds the require-
to a maximum maturity of 12 years, and a bank ments of 12 CFR 225, appendix B. Accord-
must receive Federal Reserve approval before ingly, if a bank, with the agreement of the
redeeming (or repurchasing) such securities debtholders, seeks regulatory approval to elimi-
before maturity. The terms of the securities nate the fund, the approval normally should be
should note that such approval is required. given unless supervisory concerns warrant
If a bank has issued common or perpetual otherwise.
preferred stock and dedicated the proceeds to
the retirement or redemption of mandatory con-
vertibles,10 the portion of mandatory convert- Subordinated Debt and Intermediate-Term
ibles covered by the dedication no longer carries Preferred Stock
a commitment to issue equity and is effectively
rendered into ordinary subordinated debt. To qualify as supplementary capital, subordi-
Accordingly, the amount of the stock dedicated nated debt and intermediate-term preferred
is netted from the amount of mandatory convert- stock must have an original average maturity of
ibles includable as unlimited tier 2 capital. The at least five years. The average maturity of an
portion of such securities covered by dedica- obligation whose principal is repayable in
scheduled periodic payments (for example, a
9. Equity contract notes are debt securities that obligate the so-called ‘‘serial-redemption issue’’) is the
holder to take common or perpetual preferred stock for weighted average of the maturities of all such
repayment of principal. Equity commitment notes are redeem- scheduled repayments. If the holder has the
able only with the proceeds from the sale of common or
perpetual preferred stock.
option to require the issuer to redeem, repay, or
10. Such a dedication generally must be made in the repurchase the instrument before the original
quarter in which the new common or perpetual preferred stock stated maturity, maturity is defined as the earli-
is issued. There are no restrictions on the actual use of the est possible date on which the holder can put the
proceeds of dedicated stock. For example, stock issued under
dividend-reinvestment plans or issued to finance acquisitions
instrument back to the issuing bank. This date
may be dedicated to the retirement of mandatory convertible may be much earlier than the instrument’s stated
debt securities. maturity date. In the last five years before the

Page 11
maturity of a limited-life instrument, the out- the bank. Other events of default, such as
standing amount includable in tier 2 capital change of control of the bank or disposal of a
must be discounted by 20 percent a year. The bank subsidiary, may limit the flexibility of
aggregate amount of subordinated debt and management or banking supervisors to work out
intermediate-term preferred stock that may be the problems of a troubled bank. Still other
included in tier 2 capital is limited to 50 percent events of default, such as failure to maintain
of tier 1 capital. certain capital ratios or rates of return or to limit
Consistent with longstanding Federal Reserve the amount of nonperforming assets or charge-
policy, a bank may not repay, redeem, or repur- offs to a certain level, may be intended to allow
chase a subordinated debt issue without the prior the debtholder to be made whole before a
written approval of the Federal Reserve. The deteriorating institution becomes truly troubled.
terms of the debt indenture should note that Debt issues that include any of these types of
such approval is required. The Federal Reserve events of default are not truly subordinated and
requires this approval to prevent a deteriorating should not be included in capital. Likewise,
institution from redeeming capital at a time banks should not include debt issues in capital
when it needs to conserve its resources and to that otherwise contain terms or covenants that
ensure that subordinated debtholders in a failing could adversely affect the liquidity of the issuer;
bank are not paid before depositors. unduly restrict management’s flexibility to run
Close scrutiny should be given to terms that the organization, particularly in times of finan-
permit the holder to accelerate payment of cial difficulty; or limit the regulator’s ability to
principal upon the occurrence of certain events. resolve problem-bank situations.
The only acceleration clauses acceptable in a Debt issues, including mandatory convertible
subordinated-debt issue included in tier 2 capital securities, in which interest payments are tied to
are those that are triggered by the issuer’s the financial condition of the borrower should
insolvency, that is, the appointment of a receiver. generally not be included in capital. The interest
Terms that permit the holder to accelerate payments may be linked to the financial condi-
payment of principal upon the occurrence of tion of an institution through various ways, such
other events jeopardize the subordination of the as (1) an auction-rate mechanism; (2) a preset
debt since such terms could permit debtholders schedule mandating interest-rate increases, either
in a troubled institution to be paid out before as the credit rating of the bank declines or over
the depositors. In addition, debt whose terms the passage of time;11 or (3) a term that raises
permit holders to accelerate payment of princi- the interest rate if payment is not made in a
pal upon the occurrence of events other than timely fashion. These debt issues raise concerns
insolvency does not meet the minimum five- because as the financial condition of a bank
year maturity requirement for debt capital declines, it faces ever-increasing payments on
instruments. Holders of such debt have the right its credit-sensitive subordinated debt at a time
to put the debt back to the issuer upon the when it most needs to conserve its resources.
occurrence of the named events, which could Thus, credit-sensitive debt does not provide
happen on a date well in advance of the debt’s the support expected of a capital instrument to
stated maturity. an institution whose financial condition is
Close scrutiny should also be given to the deteriorating; rather, the credit-sensitive feature
terms of those debt issues in which an event of can accelerate depletion of the institution’s
default is defined more broadly than insolvency resources and increase the likelihood of default
or a failure to pay interest or principal when due.
There is a strong possibility that such terms are 11. Although payment on debt whose interest rate increases
inconsistent with safe and sound banking prac- over time may not on the surface appear to be directly linked
tice, so the debt issue should not be included to the financial condition of the issuing bank, such debt
in capital. Concern is heightened where an (sometimes referred to as expanding- or exploding-rate debt)
has a strong potential to be credit-sensitive in substance.
event of default gives the holder the right to Banks whose financial condition has strengthened are more
accelerate payment of principal or where other likely to be able to refinance the debt at a lower rate than that
borrowings exist that contain cross-default mandated by the preset increase, whereas banks whose con-
clauses. Some events of default, such as issuing dition has deteriorated are less likely to do so. Moreover, just
when these latter institutions would be in the most need of
jumbo certificates of deposit or making addi- conserving capital, they would be under strong pressure to
tional borrowings in excess of a certain amount, redeem the debt as an alternative to paying higher rates and
may unduly restrict the day-to-day operations of would therefore accelerate the depletion of their resources.

Page 12
on the debt. While such terms may be acceptable interest-only strips (I/Os) (both purchased and
in perpetual preferred stock qualifying for tier 2 retained) that may be included in capital cannot
capital, they are not acceptable in a capital debt exceed 25 percent of tier 1 capital. Amounts of
issue because a bank in a deteriorating financial MSAs, NMSAs, PCCRs, and credit-enhancing
condition does not have the option available in I/Os (both retained and purchased) in excess of
equity issues of eliminating the higher payments these limitations, as well as all other identifiable
without going into default. intangible assets, including core deposit intan-
When a bank has included subordinated debt gibles and favorable leaseholds, are to be
issued by an operating or nonoperating subsid- deducted from a bank’s core capital elements in
iary in its capital, a possibility exists that the determining tier 1 capital. However, identifiable
debt is in effect secured, and thus not includable intangible assets (other than MSAs and PCCRs)
in capital. Further details on arrangements acquired on or before February 19, 1992, gen-
regarding a bank’s issuance of capital instru- erally will not be deducted from capital for
ments through subsidiaries are discussed in an supervisory purposes, although they will con-
earlier subsection, ‘‘Minority Interest in Equity tinue to be deducted for applications purposes.
Accounts of Consolidated Subsidiaries.’’ For purposes of calculating the limitations on
MSAs, NMSAs, PCCRs, and credit-enhancing
I/Os, tier 1 capital is defined as the sum of core
capital elements, net of goodwill and net of all
Capital Adjustments identifiable intangible assets other than MSAs,
NMSAs, and PCCRs. This calculation of tier 1
Intangible Assets is before the deduction of any disallowed
MSAs, any disallowed NMSAs, any disallowed
Goodwill and other intangible assets. Certain
PCCRs, any disallowed credit-enhancing I/Os
intangible assets are deducted from a bank’s
(both purchased and retained), any disallowed
capital for the purpose of calculating the risk-
deferred tax assets, and any nonfinancial equity
based capital ratio.12 Those assets include good-
investments.
will and certain other identifiable assets. These
Banks may elect to deduct disallowed servic-
assets are deducted from the sum of the core
ing assets and disallowed credit-enhancing I/Os
capital components (tier 1 capital).
(both purchased and retained) on a basis that is
The only identifiable intangible assets that are net of any associated deferred tax liability.
eligible to be included in—that is, not deducted Deferred tax liabilities netted in this manner
from—a bank’s capital are marketable mortgage- cannot also be netted against deferred tax assets
servicing assets (MSAs), nonmortgage-servicing when determining the amount of deferred tax
assets (NMSAs), and purchased credit-card assets that are dependent on future taxable
relationships (PCCRs).13 The total amount of income.
MSAs and PCCRs that may be included in a Banks must review the book value of all
bank’s capital, in the aggregate, cannot exceed intangible assets at least quarterly and make
100 percent of tier 1 capital. The total amount of adjustments to these values as necessary. The
NMSAs and PCCRs is subject to a separate fair value of MSAs, NMSAs, and PCCRs must
aggregate sublimit of 25 percent of tier 1 capital. also be determined at least quarterly. This deter-
In addition, the total amount of credit-enhancing mination of fair value should include adjustments
for any significant changes in original valuation
assumptions, including changes in prepayment
12. Negative goodwill is a liability and is therefore not
taken into account in the risk-based capital framework.
estimates or account-attrition rates. Examiners
Accordingly, a bank may not offset goodwill to reduce the should review both the book value and fair value
amount of goodwill it must deduct from tier 1 capital. assigned to these assets, as well as supporting
13. Purchased mortgage-servicing rights (PMSRs) no longer documentation. The Federal Reserve may require,
exist under the most recent accounting rules that apply to
servicing of assets. Under these rules (Financial Accounting
on a case-by-case basis, an independent valua-
Standards Board statements No. 122, ‘‘Accounting for Mort- tion of a bank’s intangible assets.
gage Servicing Rights,’’ and No. 140, ‘‘Accounting for Trans-
fers and Servicing of Financial Assets and Extinguishments of Value limitation. The amount of eligible servic-
Liabilities’’), organizations are required to recognize separate
servicing assets (or liabilities) for the contractual obligation to
ing assets and PCCRs that a bank may include in
service financial assets that entities have either sold or capital is further limited to the lesser of 90 per-
securitized with servicing retained. cent of their fair value, or 100 percent of their

Page 13
book value, as adjusted for capital purposes in Disallowed Deferred Tax Assets
accordance with the instructions in the commer-
cial bank Consolidated Report of Condition and In response to the Financial Accounting Stan-
Income (call report). The amount of I/Os that a dards Board’s Statement No. 109 (FAS 109),
bank may include in capital shall be its fair ‘‘Accounting for Income Taxes,’’ the Federal
value. If both the application of the limits on Reserve adopted a limit on the amount of certain
MSAs, NMSAs, and PCCRs and the adjustment deferred tax assets that may be included in (that
of the balance-sheet amount for these assets is, not deducted from) tier 1 capital for risk-
would result in an amount being deducted from based and leverage capital purposes. Under the
capital, the bank would deduct only the greater rule, certain deferred tax assets can only be
of the two amounts from its core capital ele- realized if an institution earns taxable income in
ments in determining tier 1 capital. the future. Those deferred tax assets are limited,
Consistent with longstanding Federal Reserve for regulatory capital purposes, to the amount
policy, banks experiencing substantial growth, that the institution expects to realize within one
whether internally or by acquisition, are expected year of the quarter-end report date (based on its
to maintain strong capital positions substantially projections of future taxable income for that
above minimum supervisory levels, without sig- year) or to 10 percent of tier 1 capital, whichever
nificant reliance on intangible assets or credit- is less.
enhancing I/Os. The reported amount of deferred tax assets,
An arrangement whereby a bank enters into a net of any valuation allowance for deferred tax
licensing or leasing agreement or similar trans- assets, in excess of the lesser of these two
action to avoid booking an intangible asset amounts is to be deducted from a bank’s core
should be subject to particularly close scrutiny. capital elements in determining tier 1 capital.
Normally, such arrangements will be dealt with For purposes of calculating the 10 percent limi-
by adjusting the bank’s capital calculation tation, tier 1 capital is defined as the sum of core
appropriately. In making an overall assessment capital elements, net of goodwill and net of all
of a bank’s capital adequacy for applications identifiable intangible assets other than MSAs,
purposes, the institution’s quality and composi- NMSAs, and PCCRs, but before the deduction
tion of capital are considered together with its of any disallowed MSAs, any disallowed
holdings of tangible and intangible assets. NMSAs, any disallowed PCCRs, any disal-
lowed credit-enhancing I/Os, any disallowed
Credit-enhancing interest-only strips receiv- deferred tax assets, and any nonfinancial equity
ables (I/Os). Credit-enhancing I/Os are on- investments.
balance-sheet assets that, in form or substance, To determine the amount of expected deferred
represent the contractual right to receive some tax assets realizable in the next 12 months, a
or all of the interest due on transferred assets. bank should assume that all existing temporary
I/Os expose the bank to credit risk directly or differences fully reverse as of the report date.
indirectly associated with transferred assets that Projected future taxable income should not
exceeds a pro rata share of the bank’s claim on include net operating-loss carry-forwards to be
the assets, whether through subordination pro- used during that year or the amount of existing
visions or other credit-enhancement techniques. temporary differences a bank expects to reverse
Such I/Os, whether purchased or retained and within the year. Such projections should include
including other similar ‘‘spread’’ assets, may be the estimated effect of tax-planning strategies
included in, that is, not deducted from, a bank’s that the organization expects to implement to
capital subject to the fair value and tier 1 realize net operating losses or tax-credit carry-
limitations. (See sections II.B.1.d. and e. of the forwards that would otherwise expire during the
capital guidelines (12 CFR 208, appendix A).) year. A new 12-month projection does not have
Both purchased and retained credit-enhancing to be prepared each quarter. Rather, on interim
I/Os, on a non-tax-adjusted-basis, are included report dates, the future-taxable-income projec-
in the total amount that is used for purposes of tions may be used for their current fiscal year,
determining whether a bank exceeds the tier 1 adjusted for any significant changes that have
limitation. In determining whether an I/O or occurred or are expected to occur.
other types of spread assets serve as a credit Deferred tax assets that can be realized from
enhancement, the Federal Reserve will look to taxes paid in prior carry-back years or from
the economic substance of the transaction. future reversals of temporary differences are

Page 14
generally not limited. For banks that have a ments made by a state bank under the authority
parent, however, this amount may not exceed in section 24(f) of the Federal Deposit Insurance
the amount the bank could reasonably expect its Act (FDI Act). The higher capital charges also
parent to refund. The disallowed deferred tax do not apply to equity securities acquired and
assets are subtracted from tier 1 capital and also held by a bank as a bona fide hedge of an equity
from risk-weighted assets. derivatives transaction it entered into lawfully,
or to equity securities that are acquired in
Nonfinancial Equity Investments satisfaction of a debt previously contracted and
that are held and divested in accordance with
In general, a bank must deduct from its core applicable law. The adjusted carrying value of
capital elements the sum of the appropriate these investments is not included in determining
percentages (as determined below) of the the total amount of nonfinancial equity invest-
adjusted carrying value of all nonfinancial equity ments held by the bank. (See SR-02-4 for a
investments held by it or its direct or indirect general discussion of the risk-based and lever-
subsidiaries. An equity investment includes the age capital rule changes.)
purchase, acquisition, or retention of any equity The bank must deduct from its core capital
instrument (including common stock, preferred elements the sum of the appropriate percentages,
stock, partnership interests, interests in limited- as stated in table 1, of the adjusted carrying
liability companies, trust certificates, and war- value of all nonfinancial equity investments held
rants and call options that give the holder the by the bank or its direct or indirect subsidiaries.
right to purchase an equity instrument), any The amount of the percentage deduction increases
equity feature of a debt instrument (such as a as the aggregate amount of nonfinancial equity
warrant or call option), and any debt instrument investments held by the bank increases as a
that is convertible into equity.14 The Federal percentage of its tier 1 capital.
Reserve may treat any other instrument (includ- The ‘‘adjusted carrying value’’ of investments
ing subordinated debt) as an equity investment is the aggregate value at which the investments
if, in its judgment, the instrument is the func- are carried on the balance sheet of the bank,
tional equivalent of equity or exposes the state reduced by (1) any unrealized gains on those
member bank to essentially the same risks as an investments that are reflected in such carrying
equity instrument. value but excluded from the bank’s tier 1 capital
A nonfinancial equity investment, subject to and (2) associated deferred tax liabilities. For
the risk-based capital rule (the rule), is an equity example, for investments held as available-for-
investment in a nonfinancial company made sale (AFS), the adjusted carrying value of the
under the following authorities: investments would be the aggregate carrying
value of the investments (as reflected on the
• the authority to invest in SBICs under section consolidated balance sheet of the bank) less any
302(b) of the Small Business Investment Act unrealized gains on those investments that are
of 1958 (15 USC 682(b)) included in other comprehensive income and not
• the portfolio investment provisions of Regu- reflected in tier 1 capital, and associated deferred
lation K (12 CFR 211.8(c)(3)), including the tax liabilities.15 The total adjusted carrying value
authority to make portfolio investments through of any nonfinancial equity investment that is
Edge and agreement corporations subject to deduction is excluded from the bank’s
risk-weighted assets and for purposes of com-
A nonfinancial company is an entity that engages puting the denominator of the bank’s risk-based
in any activity that has not been determined to capital ratio.16 The total adjusted carrying
be permissible for the bank to conduct directly,
or to be financial in nature or incidental to 15. Unrealized gains on AFS equity investments may be
included in supplementary capital to the extent permitted by
financial activities under section 4(k) of the the capital guidelines. In addition, the unrealized losses on
Bank Holding Company Act (12 USC 1843(k)). AFS equity investments are deducted from tier 1 capital.
The rule does not apply to investments made in 16. For example, if 8 percent of the adjusted carrying value
companies that engage solely in banking and of a nonfinancial equity investment is deducted from tier 1
capital, the entire adjusted carrying value of the investment
financial activities, nor does it apply to invest- will be excluded from risk-weighted assets when calculating
the denominator for the risk-based capital ratio, and from
14. This requirement generally does not apply to invest- average total consolidated assets when computing the lever-
ments in nonconvertible senior or subordinated debt. age ratio.

Page 15
Table 1—Deduction for Nonfinancial Equity Investments

Aggregate adjusted carrying value of
all nonfinancial equity investments
held directly or indirectly by the Deduction from core capital elements (as
bank (as a percentage a percentage of the adjusted carrying
of the tier 1 capital of the bank)1 value of the investment)
Less than 15 percent 8 percent
15 percent to 24.99 percent 12 percent
25 percent and above 25 percent
1. For purposes of calculating the adjusted carrying value the deduction for any disallowed MSAs, any disallowed
of nonfinancial equity investments as a percentage of tier 1 NMSAs, any disallowed PCCRs, any disallowed credit
capital, tier 1 capital is defined as the sum of core capital enhancing I/Os (both purchased and retained), any disallowed
elements net of goodwill and net of all identifiable intangible deferred tax assets, and any nonfinancial equity investments.
assets other than MSAs, NMSAs, and PCCRs, but before
value is also deducted from average total con- with the investment that are deducted from the
solidated assets when computing the leverage bank’s core). Even though the assets of the
ratio. nonfinancial company are consolidated for
The deductions are applied on a marginal accounting purposes, these assets (as well as the
basis to the portions of the adjusted carrying credit-equivalent amounts of the company’s off-
value of nonfinancial equity investments that balance-sheet items) should be excluded from
fall within the specified ranges of the parent the bank’s risk-weighted assets for regulatory
bank’s tier 1 capital. The rule sets forth a capital purposes.
‘‘stair-step’’ approach under which each tier of The capital adequacy guidelines for state
capital charges applies, on a marginal basis, to member banks establish minimum risk-based
the adjusted carrying value of the bank’s aggre- capital ratios. Banks are at all times expected to
gate nonfinancial equity investment portfolio maintain capital commensurate with the level
that falls within the specified ratios of the and nature of the risks to which they are
organization’s tier 1 capital. The stair-step exposed. The risk to a bank from nonfinancial
approach reflects the fact that the financial risks equity investments increases with its concentra-
to a bank from equity investment activities tion in such investments, and strong capital
increase as the level of these activities accounts levels above the minimum requirements are
for a larger portion of the bank’s capital, earn- particularly important when a bank has a high
ings, and activities. For example, if the adjusted degree of concentration in nonfinancial equity
carrying value of all nonfinancial equity invest- investments (for example, in excess of 50 per-
ments held by a bank equals 20 percent of its tier cent of tier 1 capital).
1 capital, then the amount of the deduction The Federal Reserve will monitor banks and
would be 8 percent of the adjusted carrying apply heightened supervision, as appropriate, to
value of all investments up to 15 percent of the equity investment activities, including where the
bank’s tier 1 capital, and 12 percent of the bank has a high degree of concentration in
adjusted carrying value of all investments in nonfinancial equity investments, to ensure that
excess of 15 percent of the bank’s tier 1 each bank maintains capital levels that are
capital. appropriate in light of its equity investment
With respect to consolidated SBICs, some activities. In addition, the Federal Reserve may
equity investments may be in companies that are impose capital levels established by the capital
consolidated for accounting purposes. For invest- adequacy rules, in light of the nature or perfor-
ments in a nonfinancial company that is consoli- mance of a particular organization’s equity
dated for accounting purposes under GAAP, the investments or the sufficiency of the organiza-
bank’s adjusted carrying value of the investment tion’s policies, procedures, and systems to moni-
is determined under the equity method of tor and control the risks associated with its
accounting (net of any intangibles associated equity investments.

Page 16
SBIC investments. Investments may be made by any nonfinancial equity investment (or portion
banks in or through SBICs under section 4(c)(5) of such an investment) that the bank made
of the BHC Act and section 302(b) of the Small before March 13, 2000, or that the bank made on
Business Investment Act. No deduction is or after this date pursuant to a binding written
required for nonfinancial equity investments that commitment18 entered into before March 13,
are held by a bank (1) through one or more 2000, provided that in either case the bank has
SBICs that are consolidated with the bank or continuously held the investment since the rel-
(2) in one or more SBICs that are not consoli- evant investment date.19 A nonfinancial equity
dated with the bank, to the extent that all such investment made before March 13, 2000,
investments, in the aggregate, do not exceed includes any shares or other interests the bank
15 percent of the bank’s tier 1 capital. Any received through a stock split or stock dividend
nonfinancial equity investment that is held on an investment made before March 13, 2000,
through or in an SBIC and that is not required to provided the bank provides no consideration for
be deducted from tier 1 capital will be assigned the shares or interests received and the transac-
a 100 percent risk weight and included in the tion does not materially increase the bank’s
bank’s consolidated risk-weighted assets.17 proportional interest in the company. The exer-
To the extent the adjusted carrying value of cise on or after March 13, 2000, of options or
all nonfinancial equity investments that a bank warrants acquired before March 13, 2000, is not
holds through one or more SBICs that are considered to be an investment made before
consolidated with the bank, or in one or more March 13, 2000, if the bank provides any
SBICs that are not consolidated with the bank, consideration for the shares or interests received
exceeds, in the aggregate, 15 percent of the upon exercise of the options or warrants. Any
bank’s tier 1 capital, the appropriate percentage nonfinancial equity investment (or portion
of such amounts (as set forth in table 1) must be thereof) that is not required to be deducted from
deducted from the bank’s core capital elements. tier 1 capital must be included in determining
In addition, the aggregate adjusted carrying the total amount of nonfinancial equity invest-
value of all nonfinancial equity investments held ments held by the bank in relation to its tier 1
through a consolidated SBIC and in a noncon- capital for purposes of table 1. In addition, any
solidated SBIC (including any investments for nonfinancial equity investment (or portion
which no deduction is required) must be included thereof) that is not required to be deducted from
in determining, for purposes of table 1, the total tier 1 capital will be assigned a 100 percent risk
amount of nonfinancial equity investments held weight and included in the bank’s consolidated
by the bank in relation to its tier 1 capital.
Grandfather provisions. No deduction is required

to be made for the adjusted carrying value of 18. A ‘‘binding written commitment’’ means a legally
binding written agreement that requires the bank to acquire
shares or other equity of the company, or make a capital
contribution to the company, under terms and conditions set
17. If a bank has an investment in an SBIC that is forth in the agreement. Options, warrants, and other agree-
consolidated for accounting purposes but that is not wholly ments that give a bank the right to acquire equity or make an
owned by the bank, the adjusted carrying value of the bank’s investment, but do not require the bank to take such actions,
nonfinancial equity investments through the SBIC is equal to are not considered a binding written commitment for purposes
the bank’s proportionate share of the adjusted carrying value of this provision.
of the SBIC’s equity investments in nonfinancial companies. 19. For example, if a bank made an equity investment in
The remainder of the SBIC’s adjusted carrying value (that is, 100 shares of a nonfinancial company before March 13, 2000,
the minority interest holders’ proportionate share) is excluded the adjusted carrying value of that investment would not be
from the risk-weighted assets of the bank. If a bank has an subject to a deduction. However, if the bank made any
investment in an SBIC that is not consolidated for accounting additional equity investment in the company after March 13,
purposes, and the bank has current information that identifies 2000, such as by purchasing additional shares of the company
the percentage of the SBIC’s assets that are equity invest- (including through the exercise of options or warrants acquired
ments in nonfinancial companies, the bank may reduce the before or after March 13, 2000) or by making a capital
adjusted carrying value of its investment in the SBIC propor- contribution to the company, and such investment was not
tionately to reflect the percentage of the adjusted carrying made pursuant to a binding written commitment entered into
value of the SBIC’s assets that are not equity investments in before March 13, 2000, the adjusted carrying value of the
nonfinancial companies. If a bank reduces the adjusted carry- additional investment would be subject to a deduction. In
ing value of its investment in a nonconsolidated SBIC to addition, if the bank sold and repurchased, after March 13,
reflect financial investments of the SBIC, the amount of the 2000, 40 shares of the company, the adjusted carrying value of
adjustment will be risk-weighted at 100 percent and included those 40 shares would be subject to a deduction under this
in the bank’s risk-weighted assets. provision.

Page 17
risk-weighted assets. The following example Advances to banking and finance subsidiaries
illustrates these calculations. (that is, loans, extensions of credit, guarantees,
A bank has $1 million in tier 1 capital and has commitments, or any other credit exposures) not
nonfinancial equity investments with an aggre- considered as capital are included in risk-
gate adjusted carrying value of $375,000. Of weighted assets at the 100 percent risk weight
this amount, $100,000 represents the adjusted (unless recognized collateral or guarantees dic-
carrying value of investments made before tate weighting at a lower percentage). However,
March 13, 2000, and an additional $175,000 such advances may be deducted from the parent
represents the adjusted carrying value of invest- bank’s consolidated capital where examiners
ments made through the bank’s wholly owned find that the risks associated with the advances
SBIC. The $100,000 in investments made be- are similar to the risks associated with capital
fore March 13, 2000, and $150,000 of the investments, or if such advances possess risk
bank’s SBIC investments would not be subject factors that warrant an adjustment to capital for
to the rule’s marginal capital charges. These supervisory purposes. These risk factors could
amounts are considered for purposes of deter- include the absence of collateral support or the
mining the marginal charge that applies to the clear intention of banks to allow the advances to
bank’s covered investments (including the serve as capital to subsidiaries regardless of
$25,000 of nonexempt SBIC investments). In form.
this case, the total amount of the bank’s tier 1 Although the Federal Reserve does not auto-
capital deduction would be $31,250. This figure matically deduct investments in other unconsoli-
is 25 percent of $125,000, which is the amount dated subsidiaries or investments in joint ven-
of the bank’s total nonfinancial equity portfolio tures and associated companies,22 the level and
subject to the rule’s marginal capital charges. nature of such investments should be closely
The average tier 1 capital charge on the bank’s monitored. Resources invested in these entities
entire nonfinancial equity portfolio would be support assets that are not consolidated with the
8.33 percent. rest of the bank and therefore may not be
generally available to support additional lever-
age or absorb losses of affiliated institutions.
Investments in Unconsolidated Banking Close monitoring is also necessary because
and Finance Subsidiaries and Other experience has shown that banks often stand
Subsidiaries behind the losses of affiliated institutions to
protect the reputation of the organization as a
Generally, debt and equity capital investments whole. In some cases, this support has led to
and any other instruments deemed to be capital losses that have exceeded the investments in
in unconsolidated banking and finance subsidi- such entities.
aries20 are to be deducted from the consolidated Accordingly, for risk-based capital purposes,
capital of the parent bank, regardless of whether a bank may be required, on a case-by-case basis,
the investment is made by the parent bank or its to (1) deduct such investments from total capi-
direct or indirect subsidiaries.21 Fifty percent of tal; (2) apply an appropriate risk-weighted charge
the investment is to be deducted from tier 1 against the bank’s pro rata share of the assets
capital and 50 percent from tier 2 capital. When of the affiliated entity; (3) consolidate the entity
tier 2 capital is not sufficient to absorb the on a line-by-line basis; or (4) operate with a
portion (50 percent) of the investment allocated risk-based capital ratio above the minimum.
to it, the remainder (up to 100 percent) is to be In determining the appropriate capital treatment
deducted from tier 1 capital. for such actions, the Federal Reserve will
generally take into account whether (1) the bank
has significant influence over the financial or
managerial policies or operations of the affili-
20. A banking and finance subsidiary is generally defined
as any company engaged in banking or finance in which the
ated entity, (2) the bank is the largest investor in
parent organization holds directly or indirectly more than the entity, or (3) other circumstances prevail
50 percent of the outstanding voting stock, or any such
company which is otherwise controlled or capable of being
controlled by the parent organization. 22. Such entities are defined in the instructions to the call
21. An exception to this deduction is to be made for shares report. Associated companies and joint ventures are generally
acquired in the regular course of securing or collecting a debt defined as companies in which the bank owns 20 to 50 percent
previously contracted in good faith. of the voting stock.

Page 18
(such as the existence of significant guaran- that are directly but conditionally guaranteed are
tees from the bank) that appear to closely tie assigned to the 20 percent risk category. A claim
the activities of the affiliated company to the is considered to be conditionally guaranteed by
bank. a central government if the validity of the
guarantee depends on some affirmative action
by the holder or a third party. Generally, secu-
Reciprocal Holdings of Banking rities guaranteed by the U.S. government or its
Organizations’ Capital Instruments agencies that are actively traded in financial
markets are considered to be unconditionally
Reciprocal holdings are intentional cross- guaranteed. These include Government National
holdings resulting from formal or informal Mortgage Association (GNMA or Ginnie Mae)
arrangements between banking organizations to and Small Business Administration (SBA)
swap or exchange each other’s capital instru- securities.
ments. Such holdings of other banking organi- A limited number of U.S. government agency–
zations’ capital instruments are to be deducted guaranteed loans are deemed to be uncondition-
from the total capital of an organization for the ally guaranteed and can be assigned to the zero
purpose of determining the total risk-based percent risk category. These include most loans
capital ratio. Holdings of other banking organi- guaranteed by the Export-Import Bank (Exim-
zations’ capital instruments taken in satisfac- bank),23 loans guaranteed by the U.S. Agency
tion of debts previously contracted or that con- for International Development (AID) under its
stitute stake-out investments that comply with Housing Guaranty Loan Program, SBA loans
the Federal Reserve’s policy statement on non- subject to a secondary participation guaranty in
voting equity investments (12 CFR 225.143) accordance with SBA form 1086, and Farmers
are not deemed to be intentional cross-holdings Home Administration (FmHA) loans subject to
and are therefore not deducted from a bank’s an assignment guaranty agreement in accor-
capital. dance with FmHA form 449-36.
Apart from the exceptions noted in the pre-
ceding paragraph, loans guaranteed by the U.S.
On-Balance-Sheet Activities government or its agencies are considered to be
conditionally guaranteed. The guaranteed por-
tion of such loans is assigned to the 20 percent
Claims on, and Guaranteed by, OECD risk category. These include, but are not limited
Central Governments to, loans guaranteed by the Commodity Credit
Corporation (CCC), the Federal Housing
The risk-based capital guidelines assign a zero
Administration (FHA), the Overseas Private
percent risk weight to all direct claims (includ-
Investment Corporation (OPIC), the Department
ing securities, loans, and leases) on the central
of Veterans Affairs (VA), and, except as indi-
governments of the OECD-based group of coun-
cated above, the FmHA and SBA. Loan guaran-
tries and U.S. government agencies. Generally,
tees offered by OPIC often guarantee against
the only direct claims banks have on the U.S.
political risk. However, only that portion of a
government and its agencies take the form of
loan guaranteed by OPIC against commercial or
Treasury securities. Zero-coupon, that is, single-
credit risk may receive a preferential 20 percent
payment, Treasury securities trading under the
risk weight. The portion of government trust
U.S. Treasury’s Separately Traded Registered
certificates issued to provide funds for the refi-
Interest and Principal (STRIP) program are
nancing of foreign military sales loans made by
assigned to the zero percent risk category. A
the Federal Financing Bank or the Defense
security that has been stripped by a private-
Security Assistance Agency that are indirectly
sector entity, such as a brokerage firm, is con-
guaranteed by the U.S. government also qualify
sidered an obligation of that entity and is
for the 20 percent risk weight.
accordingly assigned to the 100 percent risk
category.
Claims that are directly and unconditionally
guaranteed by an OECD-based central govern- 23. Loans guaranteed under Eximbank’s Working Capital
ment or a U.S. government agency are also Guarantee Program, however, receive a 20 percent risk
assigned to the zero percent risk category. Claims weight.

Page 19
Most guaranteed student loans are guaranteed guidelines. Also eligible for the 50 percent risk
by a state agency or nonprofit organization that weight are loans to builders with substantial
does not have the full faith and credit backing project equity for the construction of one- to
of the state. The loans are then indirectly guar- four-family residences that have been presold
anteed or reinsured by the U.S. government’s under firm contracts to purchasers who have
Guaranteed Student Loan Program. Under the obtained firm commitments for permanent quali-
program, a minimum percentage of the loan is fying mortgage loans and have made substantial
reinsured, but a higher percentage could be earnest-money deposits.
guaranteed if the bank has experienced an over- In addition, qualifying multifamily residential
all low default rate on guaranteed student loans. loans that meet certain criteria may be assigned
Only the portion of the loan covered by the to the 50 percent risk category. These criteria are
minimum guarantee under the program may be as follows: All principal and interest payments
assigned to the 20 percent risk category; the must have been made on time for at least one
remainder should be assigned a 100 percent risk year preceding placement in the 50 percent risk
weight. category, amortization of the principal and
interest must occur within 30 years, the mini-
mum original maturity for repayment of princi-
Claims on, or Guaranteed by, a U.S. pal cannot be less than seven years, and annual
Government–Sponsored Agency net operating income (before debt service) gen-
erated by the property during the most recent
U.S. government–sponsored agencies are agen- fiscal year must not be less than 120 percent of
cies originally established or chartered by the the loan’s current annual debt service (115 per-
federal government to serve public purposes cent if the loan is based on a floating interest
specified by the U.S. Congress. Such agencies rate). In the case of cooperative or other not-for-
generally carry out functions performed directly profit housing projects, the property must gen-
by the central government in other countries. erate sufficient cash flow to provide comparable
The obligations of government-sponsored agen- protection to the bank.
cies generally are not explicitly guaranteed by To ensure that only qualifying residential
the full faith and credit of the U.S. government. mortgage loans are assigned to this preferential
Claims (including securities, loans, and leases) risk weight, examiners are to review the one-
on, or guaranteed by, such agencies are assigned to four-family and multifamily residential real
to the 20 percent risk category. U.S. government– estate loans that are included in the 50 percent
sponsored agencies include, but are not limited risk category. Such loans are not eligible for
to, the College Construction Loan Insurance preferential treatment unless they meet the fol-
Association, Farm Credit Administration, Fed- lowing criteria: The loans are made subject to
eral Agricultural Mortgage Corporation, Federal prudent underwriting standards, the loans are
Home Loan Bank System, Federal Home Loan performing in accordance with their original
Mortgage Corporation (FHLMC or Freddie terms and are not delinquent for 90 days or more
Mac), Federal National Mortgage Association or carried on nonaccrual status, and the loan-to-
(FNMA or Fannie Mae), Financing Corporation value ratios are conservative.24 For the purpose
(FICO), Postal Service, Resolution Funding Cor- of this last criterion, the loan-to-value ratio
poration (REFCORP), Student Loan Marketing should be based on the value of the property
Association (SLMA or Sallie Mae), Smithso- determined by the most current appraisal or, if
nian Institution, and Tennessee Valley Authority appropriate, the most current evaluation. Nor-
(TVA). mally, this would be the appraisal or evaluation
performed at the time the loan was originated.25
If a bank has assigned a 50 percent risk
Loans Secured by First Liens on One- to weight to residential mortgage loans made for
Four-Family Residential Properties and
Multifamily Residential Properties 24. A conservative loan-to-value ratio for loans secured by
multifamily residential property must not exceed 80 percent
Qualifying loans on one- to four-family residen- (or 75 percent if the loan is based on a floating interest rate).
25. When both first and junior liens are held by the bank
tial properties, either owner-occupied or rented and no intervening liens exist, these transactions are treated as
(as defined in the instructions to the call report), single loans secured by a first lien for the purpose of
are accorded a 50 percent risk weight under the determining the loan-to-value ratio.

Page 20
the purpose of speculative real estate develop- Transfers and Servicing of Financial Assets and
ment or whose eligibility for such preferential Extinguishments of Liabilities.’’ These criteria
treatment is otherwise questionable, and the are summarized in the definition of ‘‘transfers of
amounts of nonqualifying loans are readily iden- financial assets’’ in the glossary to the commer-
tifiable, such loans should be reassigned to the cial bank Call Report instructions. If a transfer
100 percent risk-weight category. If material of assets does not meet these criteria, the assets
evidence exists that a bank has assigned a must remain on the bank’s balance sheet and are
preferential risk weight to residential mortgage subject to the standard risk-based capital charge.
loans of questionable eligibility, but the amount If a transfer of assets qualifies as a sale under
of the inappropriately weighted amount cannot GAAP but the bank retains any risk of loss or
be readily identified, the overall evaluation of obligation for payment of principal or interest,
the bank’s capital adequacy should reflect a then the transfer is considered to be a sale with
higher capital requirement than would otherwise recourse. A more detailed definition of an asset
be the case. sale with recourse may be found in the definition
of ‘‘sales of assets for risk-based capital pur-
poses’’ in the glossary to the commercial bank
Accrued Interest Call Report instructions. Although the assets are
removed from a bank’s balance sheet in an asset
Banks normally report accrued interest on loans sale with recourse, the credit-equivalent amount
and securities in ‘‘Other Assets’’ on the Call is assigned to the risk category appropriate to
Report. The majority of banks will risk-weight the obligor in the underlying transaction, after
the entire amount of accrued interest at 100 per- considering any associated guaranties or collat-
cent. However, for risk-based capital purposes, eral. This assignment also applies when the
a bank is permitted to allocate accrued interest contractual terms of the recourse agreement
among the risk categories associated with the limit the seller’s risk to a percentage of the value
underlying claims, provided the bank has sys- of the assets sold or to a specific dollar amount.
tems in place to carry out such an allocation If, however, the risk retained by the seller is
accurately. limited to some fixed percentage of any losses
that might be incurred and there are no other
provisions resulting in the direct or indirect
Off-Balance-Sheet Activities retention of risk by the seller, the maximum
amount of possible loss for which the selling
Off-balance-sheet transactions include recourse bank is at risk (the stated percentage times the
obligations, direct-credit substitutes, residual amount of assets to which the percentage applies)
interests, and asset- and mortgage-backed secu- is subject to risk-based capital requirements.
rities. The treatments for direct-credit substi- The remaining amount of assets transferred
tutes, assets transferred with recourse, and secu- would be treated as a sale that is not subject to
rities issued in connection with asset the risk-based capital requirements. For exam-
securitizations and structured financings are ple, a seller would treat a sale of $1 million in
described later in this section. The terms asset assets with a recourse provision that the seller
securitizations or securitizations, as used in this and buyer proportionately share in losses incurred
subsection, include structured financings, as well on a 10 percent and 90 percent basis, respec-
as asset-securitization transactions. tively, and with no other retention of risk
by the seller, as a $100,000 asset sale with
recourse and a $900,000 sale not subject to
Assets Sold with Recourse risk-based capital requirements.
There are several exceptions to the general
For risk-based capital adequacy purposes, a reporting rule for recourse transactions. The first
bank must hold capital against assets sold with exception applies to recourse transactions for
recourse if the bank retains any risk of loss. To which the amount of recourse the institution is
qualify as an asset sale with recourse, a transfer contractually liable for is less than the capital
of assets must first qualify as a sale according to requirement for the assets transferred under the
the GAAP criteria set forth in paragraph 14 of recourse agreement. For such transactions, a
the Financial Accounting Standards Board’s bank must hold capital equal to its maximum
Statement No. 140 (FAS 140), ‘‘Accounting for contractual recourse obligation. For example,

Page 21
assume an institution transfers a $100 pool of servicing rights, it customarily makes represen-
commercial loans and retains a recourse obliga- tations and warranties concerning those assets.
tion of 2 percent. Ordinarily, the bank would be When a bank purchases loan-servicing rights,
subject to an 8 percent capital charge, or $8. it may also assume representations and warran-
Because the recourse obligation is only 2 per- ties made by the seller or a prior servicer. These
cent, however, the bank would be required to representations and warranties give certain rights
hold capital of $2 against the recourse exposure. to other parties and impose obligations on the
This capital charge may be reduced further by seller or servicer of the assets. To the extent a
the balance of any associated noncapital GAAP bank’s representations and warranties function
recourse liability account. as credit enhancements to protect asset purchas-
A second exception to the general rule applies ers or investors from credit risk, they are con-
to the transfer of small-business loans and to the sidered as recourse or direct-credit substitutes.
transfer of leases on personal property with The Federal Reserve’s risk-based capital
recourse. A bank that is considered to be well adequacy rule is consistent with the agencies’
capitalized according to the Federal Reserve’s long-standing recourse treatment of representa-
prompt-corrective-action framework should tions and warranties that effectively guarantee
include in risk-weighted assets only the amount the performance or credit quality of transferred
of retained recourse—instead of the entire loans. However, banks typically make a number
amount of assets transferred—in connection with of factual warranties that are unrelated to the
a transfer of small-business loans or a transfer of ongoing performance or credit quality of trans-
leases on personal property with recourse, pro- ferred assets. These warranties entail opera-
vided two conditions are met. First, the transactional risk, as opposed to the open-ended credit
tion must be treated as a sale under GAAP; risk inherent in a financial guaranty, and are
second, the bank must establish a noncapital not considered recourse or a direct-credit sub-
reserve that is sufficient to cover the bank’s stitute. Warranties that create operational risk
estimated liability under the recourse arrange- include warranties that assets have been under-
ment. With the Board’s approval, this exception written or collateral appraised in conformity
may also apply to a bank that is considered to be with identified standards, as well as warranties
adequately capitalized under the prompt- that provide for the return of assets in instances
corrective-action framework. The total outstand- of incomplete documentation, fraud, or
ing amount of recourse retained under such misrepresentation.
transactions may not exceed 15 percent of a Warranties can impose varying degrees of
bank’s total risk-based capital without Board operational risk. For example, a warranty that
approval. asset collateral has not suffered damage from
potential hazards entails a risk that is offset to
some extent by prudent underwriting practices
Definitions requiring the borrower to provide hazard insur-
ance to the bank. A warranty that asset collateral
The capital adequacy guidelines provide special is free of environmental hazards may present
treatment for recourse obligations, direct-credit acceptable operational risk for certain types
substitutes, residual interests, and asset- and of properties that have been subject to environ-
mortgage-backed securities involved in asset- mental assessment, depending on the circum-
securitization activities. A brief discussion of stances. The appropriate limits for these opera-
some of the primary definitions follows. tional risks are monitored through supervision
of a bank’s loan-underwriting, -sale, and
Credit derivatives. Credit derivative means a -servicing practices. Also, a bank that pro-
contract that allows one party (the protection vides warranties to loan purchasers and inves-
purchaser) to transfer the credit risk of an asset tors must include associated operational risks in
or off-balance-sheet credit exposure to another its risk management of exposures arising from
party (the protection provider). The value of a loan-sale or securitization-related activities.
credit derivative is dependent, at least in part, on Banks should be prepared to demonstrate to
the credit performance of a ‘‘reference asset.’’ examiners that operational risks are effectively
managed.
Credit-enhancing representations and warran- Recourse or direct-credit-substitute treatment
ties. When a bank transfers assets, including is required for warranties providing assurances

Page 22
about the actual value of asset collateral, includ- expired, the early-default clause will no longer
ing that the market value corresponds to its trigger recourse treatment, provided there are no
appraised value or that the appraised value will other provisions that constitute recourse.
be realized in the event of foreclosure and sale.
Warranties such as these, which make represen- Direct-credit substitutes. The term direct-credit
tations about the future value of a loan or related substitute refers to an arrangement in which a
collateral, constitute an enhancement of the bank assumes, in form or in substance, credit
loan transferred, and thus are recourse arrange- risk associated with an on- or off-balance-sheet
ments or direct-credit substitutes. When a seller asset or exposure that was not previously owned
represents that it ‘‘has no knowledge’’ of cir- by the bank (third-party asset), and the risk
cumstances that could cause a loan to be other assumed by the bank exceeds the pro rata share
than investment quality, the representation is not of its interest in the third-party asset. If the bank
recourse. Banks may limit recourse exposure has no claim on the third-party asset, then the
with warranties that directly address the condi- bank’s assumption of any credit risk on the
tion of the asset at the time of transfer (that third-party asset is a direct-credit substitute.
is, creation of an operational warranty) and The term direct-credit substitute explicitly
by monitoring compliance with stated underwrit- includes items such as purchased subordinated
ing standards. Alternatively, banks might create interests, agreements to cover credit losses that
warranties with exposure caps that would permit arise from purchased loan-servicing rights, credit
it to take advantage of the low-level-recourse derivatives, and lines of credit that provide
rule. credit enhancement. Some purchased subordi-
The definition of credit-enhancing represen- nated interests, such as credit-enhancing I/O
tations and warranties excludes warranties— strips, are also residual interests for regulatory
such as early-default clauses and similar war- capital purposes.
ranties that permit the return of, or premium- Direct-credit substitutes include, but are not
refund clauses covering, one- to four-family limited to—
residential first mortgage loans that qualify for a
50 percent risk weight for a maximum period of • financial standby letters of credit that support
120 days from the date of transfer. These war- financial claims on a third party that exceed a
ranties may cover only those loans that were bank’s pro rata share of losses in the financial
originated within one year of the date of transfer. claim;
A premium-refund clause is a warranty that • guarantees, surety arrangements, credit deriva-
obligates a seller who has sold a loan at a price tives, and similar instruments backing finan-
in excess of par, that is, at a premium, to refund cial claims that exceed a bank’s pro rata share
the premium, either in whole or in part, if the in the financial claim;
loan defaults or is prepaid within a certain • purchased subordinated interests or securities
period of time. Premium-refund clauses that that absorb more than their pro rata share of
cover assets guaranteed, in whole or in part, by losses from the underlying assets;
the U.S. government, a U.S. government agency, • credit derivative contracts under which the
or a government-sponsored enterprise are not bank assumes more than its pro rata share of
included in the definition of credit-enhancing credit risk on a third-party exposure;
representations and warranties, provided the • loans or lines of credit that provide credit
premium-refund clauses are for a period not to enhancement for the financial obligations of
exceed 120 days from the date of transfer. The an account party;
definition also does not include warranties that • purchased loan-servicing assets if the servicer
permit the return of assets in instances of is responsible for credit losses or if the ser-
misrepresentation, fraud, or incomplete vicer makes or assumes credit-enhancing rep-
documentation. resentations and warranties with respect to the
loans serviced (mortgage-servicer cash
Early-default clauses. Early-default clauses typi- advances that meet the conditions of section
cally give the purchaser of a loan the right to III.B.3.a.x. of the guidelines (12 CFR 208,
return the loan to the seller if the loan becomes appendix A) are not direct-credit substitutes);
30 or more days delinquent within a stated • clean-up calls on third-party assets (clean-up
period after the transfer, for example, four calls that are 10 percent or less of the original
months after transfer. Once the stated period has pool balance that are exercisable at the option

Page 23
of the bank are not direct-credit substitutes); remaining loans in a pool when the balance of
and those loans is equal to or less than 10 percent of
• liquidity facilities that provide liquidity sup- the original pool balance. This treatment will
port to ABCP (other than eligible ABCP also apply to clean-up calls written with refer-
liquidity facilities). ence to less than 10 percent of the outstanding
principal amount of securities. If, however, an
Clean-up calls. A clean-up call is an option that agreement permits the remaining loans to be
permits a servicer or its affiliate (which may be repurchased when their balance is greater than
the originator) to take investors out of their 10 percent of the original pool balance, the
positions in a securitization before all of the agreement is considered to be a recourse obli-
transferred loans have been repaid. The servicer gation or a direct-credit substitute. The exemp-
accomplishes this by repurchasing the remain- tion from recourse or direct-credit-substitute
ing loans in the pool once the pool balance has treatment for a clean-up call of 10 percent or
fallen below some specified level. This option in less recognizes the real market need to be able to
a securitization raises long-standing agency con- call a transaction when the costs of keeping it
cerns that a bank may implicitly assume a outstanding are burdensome. However, to mini-
credit-enhancing position by exercising the mize the potential for using such a feature as a
option when the credit quality of the securitized means of providing support for a troubled port-
loans is deteriorating. An excessively large folio, a bank that exercises a clean-up call
clean-up call facilitates a securitization servic- should not repurchase any loans in the pool that
er’s ability to take investors out of a pool to are 30 days or more past due. Alternatively, the
protect them from absorbing credit losses, and bank should repurchase the loans at the lower of
thus may indicate that the servicer has retained their estimated fair value or their par value plus
or assumed the credit risk on the underlying accrued interest.
pool of loans. Banks that repurchase assets pursuant to a
Generally, clean-up calls (whether or not they clean-up call may do so based on an aggregate
are exercised) are treated as recourse and direct- fair value for all repurchased assets. Banks do
credit substitutes. The purpose of treating large not have to evaluate each individual loan remain-
clean-up calls as recourse or direct-credit sub- ing in the pool at the time a clean-up call is
stitutes is to ensure that a bank is not able to exercised to determine fair value. Rather, the
provide credit support to the trust investors by overall repurchase price should reflect the aggre-
repaying its investment when the credit quality gate fair value of the assets being repurchased so
of the pool is deteriorating without holding that the bank is not overpaying for the assets
capital against the exposure. The focus should and, in so doing, providing credit support to the
be on the arrangement itself and not the exercise trust investors. Examiners will review the terms
of the call. Thus, the existence, not the exercise, and conditions relating to the repurchase arrange-
of a clean-up call that does not meet the requirements in clean-up calls to ensure that transac-
ments of the risk-based capital rule will trigger tions are done at the lower of fair value or par
treatment as a recourse obligation or a direct- value plus accrued interest. Banks should be
credit substitute. A clean-up call can function as able to support their fair-value estimates. If the
a credit enhancement because its existence pro- Federal Reserve concludes that a bank has
vides the opportunity for a bank (as servicer or repurchased assets at a price that exceeds the
an affiliate of a servicer) to provide credit lower of these two amounts, the clean-up call
support to investors by taking an action that is provisions in its future securitizations may be
within the contractual terms of the securitization treated as recourse obligations or direct-credit
documents. substitutes. Regardless of the size of the clean-up
Because clean-up calls can also serve an call, the Federal Reserve will closely scrutinize
administrative function in the operation of a and take appropriate supervisory action for any
securitization, a limited exemption exists for transaction in which the bank repurchases dete-
these options. When an agreement permits a riorating assets for an amount greater than a
bank that is a servicer or an affiliate of the reasonable estimate of their fair value.
servicer to elect to purchase loans in a pool, the
agreement is not considered a recourse obliga- Eligible ABCP liquidity facility. An eligible
tion or a direct-credit substitute if the agreement ABCP liquidity facility is a liquidity facility that
permits the banking organization to purchase the supports ABCP, in form or in substance, and is

Page 24
subject to an asset-quality test at the time of derived from assets an organization has sold into
draw that precludes funding against assets that a securitization. In those cases, the spread
are 90 days or more past due or in default. In account is considered to be a ‘‘credit-enhancing
addition, if the assets that an eligible ABCP interest-only strip’’ and is subject to the concen-
liquidity facility is required to fund against are tration limit. (See SR-02-16.) However, any
externally rated assets or exposures at the incep- portion of a spread account that represents an
tion of the facility, the facility can be used to interest in cash that has already been collected
fund only those assets or exposures that are and is held by the trustee is a ‘‘residual interest’’
externally rated investment grade at the time of subject to dollar-for-dollar capital, but is not a
funding. Notwithstanding the eligibility require- credit-enhancing interest-only strip subject to
ments set forth in the two preceding sentences, a the concentration limit. For example, assume
liquidity facility will be considered an eligible that a bank books a single spread-account asset
ABCP liquidity facility if the assets that are that is derived from two separate cash-flow
funded under the liquidity facility and which do streams:
not meet the eligibility requirements are guar-
anteed, either conditionally or unconditionally, • A receivable from the securitization trust that
by the U.S. government or its agencies or by the represents cash that has already accumulated
central government of an OECD country. in the spread account. In accordance with the
securitization documents, the cash will be
Externally rated. Externally rated is a term returned to the bank at some date in the future
which means that an instrument or obligation after having been reduced by amounts used to
has received a credit rating from a nationally reimburse investors for credit losses. Based on
recognized statistical rating organization. the date when the cash is expected to be paid
out to the bank, the present value of this asset
Face amount. The face amount is the notional is currently estimated to be $3.
principal, or face value, amount of an off- • A projection of future cash flows that are
balance-sheet item; the amortized cost of an expected to accumulate in the spread account.
asset not held for trading purposes; and the fair In accordance with the securitization docu-
value of a trading asset. ments, the cash, to the extent collected, will
also be returned to the bank at some date in
Financial asset. A financial asset is cash or other the future after having been reduced by
monetary instrument, evidence of debt, evidence amounts used to reimburse investors for credit
of an ownership interest in an entity, or a losses. Based on the date when the cash is
contract that conveys a right to receive or expected to be paid out to the bank, the
exchange cash or another financial instrument present value of this asset is currently esti-
from another party. mated to be $2.
Financial standby letters of credit. A finan- Both components of the above spread account
cial standby letter of credit means a letter are considered to be residual interests under the
of credit or similar arrangement that represents current capital standards because both represent
an irrevocable obligation to a third-party on-balance-sheet assets subject to more than
beneficiary— their pro rata share of losses on the underlying
portfolio of sold assets. However, the $2 asset
• to repay money borrowed by, advanced to, or that represents the bank’s retained interest in
for the account of a second party (the account future cash flows exposes the organization to a
party), or greater degree of risk because the $2 asset
• to make payment on behalf of the account presents additional uncertainty as to whether it
party, in the event that the account party fails will ever be collected. This additional uncer-
to fulfill its obligation to the beneficiary. tainty associated with the recognition of future
subordinated excess cash flows results in the $2
Spread accounts that function as credit- asset being treated as a credit-enhancing interest-
enhancing interest-only strips. A spread account only strip, a subset of residual interests.
is an on-balance-sheet asset that functions as a The face amount of all of the bank’s credit-
credit enhancement and that can represent an enhancing interest-only strips is first subject to a
interest in expected interest and fee cash flows 25 percent of tier 1 capital concentration limit.

Page 25
Any portion of this face amount that exceeds spread-related assets as credit-enhancing I/O
25 percent of tier 1 capital is deducted from tier strips on a case-by-case basis. For example,
1 capital. This limit will affect both a bank’s including some principal payments with interest
risk-based and leverage capital ratios. The and fee cash flows will not otherwise negate the
remaining face amount of the bank’s credit- regulatory capital treatment of that asset as a
enhancing interest-only strips, as well as the credit-enhancing I/O strip. Credit-enhancing I/O
face amount of the spread-account receivable strips include both purchased and retained
for cash already held in the trust, is subject to the interest-only strips that serve in a credit-
dollar-for-dollar capital requirement established enhancing capacity, even though purchased I/O
for residual interests, which affects only the strips generally do not result in the creation of
risk-based capital ratios. capital on the purchaser’s balance sheet.
Credit-enhancing interest-only strips. A credit- Loan-servicing arrangements. The definitions

enhancing interest-only (I/O) strip is an of recourse and direct-credit substitute cover
on-balance-sheet asset that, in form or substance, loan-servicing arrangements if the bank, as ser-
(1) represents the contractual right to receive vicer, is responsible for credit losses associated
some or all of the interest due on transferred with the serviced loans. However, cash advances
assets and (2) exposes the bank to credit risk that made by residential mortgage servicers to ensure
exceeds its pro rata claim on the underlying an uninterrupted flow of payments to investors
assets, whether through subordination provi- or the timely collection of the mortgage loans
sions or other credit-enhancing techniques. Thus, are specifically excluded from the definitions of
credit-enhancing I/O strips include any balance- recourse and direct-credit substitute, provided
sheet asset that represents the contractual right the residential mortgage servicer is entitled to
to receive some or all of the remaining interest reimbursement for any significant advances and
cash flow generated from assets that have been this reimbursement is not subordinate to other
transferred into a trust (or other special-purpose claims. To be excluded from recourse and direct-
entity), after taking into account trustee and credit-substitute treatment, the bank, as servicer,
other administrative expenses, interest payments should make an independent credit assessment
to investors, servicing fees, reimbursements to of the likelihood of repayment of the servicer
investors for losses attributable to the beneficial advance before advancing funds, and should
interests they hold, and reinvestment income only make such an advance if prudent lending
and ancillary revenues26 on the transferred assets. standards are met. Risk-based capital is assessed
Credit-enhancing I/O strips are generally carried only against the amount of the cash advance,
on the balance sheet at the present value of the and the advance is assigned to the risk-weight
expected net cash flow that the banking organi- category appropriate to the party obligated to
zation reasonably expects to receive in future reimburse the servicer.
periods on the assets it has securitized, adjusted If a residential mortgage servicer is not entitled
for some level of prepayments if relevant to that to full reimbursement, then the maximum pos-
asset class, and discounted at an appropriate sible amount of any nonreimbursed advances on
market interest rate. Typically, when assets are any one loan must be contractually limited to an
transferred in a securitization transaction that is insignificant amount of the outstanding principal
accounted for as a sale under GAAP, the account- on that loan. Otherwise, the servicer’s obligation
ing recognition given to the credit-enhancing to make cash advances will not be excluded
I/O strip on the seller’s balance sheet results in from the definitions of recourse and direct-credit
the recording of a gain on the portion of the substitute. Banks that act as servicers should
transferred assets that has been sold. This gain is establish policies on servicer advances and use
recognized as income, thus increasing the bank’s discretion in determining what constitutes an
capital position. The economic substance of a ‘‘insignificant’’ servicer advance. The Federal
transaction will be used to determine whether a Reserve will exercise its supervisory authority
particular interest cash flow functions as a credit- to apply recourse or direct-credit-substitute treat-
enhancing I/O strip, and the Federal Reserve ment to servicer cash advances that expose a
reserves the right to identify other cash flows or bank, acting as servicer, to excessive levels of
credit risk.
26. According to FAS 140, ancillary revenues include such
revenues as late charges on the transferred assets. Liquidity facility. A liquidity facility refers to a

Page 26
legally binding commitment to provide liquidity ing the third-party enhancement. Second mort-
support to ABCP by lending to, or purchasing gages or home equity loans generally will not be
assets from, any structure, program, or conduit considered recourse arrangements unless they
in the event that funds are required to repay actually function as credit enhancements.
maturing ABCP. Third-party enhancements (for example,
insurance protection) purchased by the origina-
Mortgage-servicer cash advance. A mortgage- tor of a securitization for the benefit of investors
servicer cash advance represents funds that a also do not generally constitute recourse. The
residential mortgage loan servicer advances to purchase of enhancements for a securitization,
ensure an uninterrupted flow of payments, when the bank is completely removed from any
including advances made to cover foreclosure credit risk, will not, in most instances, constitute
costs or other expenses to facilitate the timely recourse. However, if the purchase or premium
collection of the loan. price is paid over time and the size of the
A mortgage-servicer cash advance is not a payment is a function of the third-party’s loss
recourse obligation or a direct-credit substitute experience on the portfolio, such an arrange-
if— ment indicates an assumption of credit risk and
would be considered recourse.
• the servicer is entitled to full reimbursement Recourse may also exist implicitly if a bank
and this right is not subordinated to other provides credit enhancement beyond any con-
claims on the cash flows from the underlying tractual obligation to support assets it has sold.
asset pool; or The following are examples of recourse arrange-
• for any one loan, the servicer’s obligation to ments:
make nonreimbursable advances is contractu-
ally limited to an insignificant amount of the • credit-enhancing representations and warran-
outstanding principal balance of that loan. ties made on the transferred assets
• loan-servicing assets retained pursuant to an
Nationally recognized statistical rating organi- agreement under which the bank will be
zation (NRSRO). An NRSRO is an entity that is responsible for credit losses associated with
recognized by the Division of Market Regula- the loans being serviced (mortgage-servicer
tion of the Securities and Exchange Commission cash advances that meet the conditions of
(or any successor division) (the commission) as section III.B.3.a.x. of the guidelines (12 CFR
a nationally recognized statistical rating organi- 208, appendix A) are not recourse
zation for various purposes, including the com- arrangements)
mission’s uniform net capital requirements for • retained subordinated interests that absorb
brokers and dealers. more than their pro rata share of losses from
the underlying assets
Recourse. Recourse means the retention by a • assets sold under an agreement to repurchase,
bank, in form or in substance, of any credit risk if the assets are not already included on the
directly or indirectly associated with an asset it balance sheet
has transferred that exceeds a pro rata share of • loan strips sold without contractual recourse,
the bank’s claim on the asset. If a bank has no when the maturity of the transferred loan is
claim on a transferred asset, then the retention of shorter than the maturity of the commitment
any risk of credit loss is recourse. A recourse under which the loan is drawn
obligation typically arises when a bank transfers • credit derivatives issued that absorb more than
assets and retains an explicit obligation to repur- the bank’s pro rata share of losses from the
chase the assets or absorb losses due to a default transferred assets
on the payment of principal or interest or any • clean-up calls at inception that are greater than
other deficiency in the performance of the under- 10 percent of the balance of the original pool
lying obligor or some other party. The definition of transferred loans (clean-up calls that are
of recourse is consistent with the banking agen- 10 percent or less of the original pool balance
cies’ long-standing use of this term, and incor- that are exercisable at the option of the bank
porates existing agency practices regarding reten- are not recourse arrangements)
tion of risk in asset sales. • liquidity facilities that provide liquidity sup-
Second-lien positions do not, in most circum- port to ABCP (other than eligible ABCP
stances, constitute recourse for the bank receiv- liquidity facilities)

Page 27
Residual interests. Residual interests are defined future credit losses within the loan pools that
as any on-balance-sheet asset (1) that represents they support, and thus are subject to valuation
an interest (including a beneficial interest) inaccuracies. Spread accounts and overcollater-
created by a transfer that qualifies as a sale (in alizations that do not meet the definition of
accordance with GAAP) of financial assets, credit-enhancing I/O strips generally do not
whether through a securitization or otherwise, expose a bank to the same level of risk as
and (2) that exposes a bank to credit risk directly credit-enhancing I/O strips, and thus are excluded
or indirectly associated with the transferred from the concentration limit.
assets that exceeds a pro rata share of The capital treatment for a residual interest
the bank’s claim on the asset, whether through applies when a bank effectively retains the risk
subordination provisions or other credit- associated with that residual interest, even if the
enhancement techniques. Residual interests gen- residual is sold. The economic substance of the
erally do not include interests purchased from a transaction will be used to determine whether
third party, except for credit-enhancing I/O strips. the bank has transferred the risk associated with
Examples of residual interests (assets) include the residual-interest exposure. Banks that trans-
credit-enhancing I/Os; spread accounts; cash- fer the risk on residual interests, either directly
collateral accounts; retained subordinated inter- through a sale or indirectly through guarantees
ests; accrued but uncollected interest on trans- or other credit-risk-mitigation techniques, and
ferred assets that, when collected, will be then reassume this risk in any form will be
available to serve in a credit-enhancing capac- required to hold risk-based capital as though the
ity; and similar on-balance-sheet assets that residual interest remained on the bank’s books.
function as a credit enhancement. The functional- For example, if a bank sells an asset that is an
based definition reflects the fact that securitiza- on-balance-sheet credit enhancement to a third
tion structures vary in the way they use certain party and then writes a credit derivative to cover
assets as credit enhancements. Residual interests the credit risk associated with that asset, the
therefore include any retained on-balance-sheet selling bank must continue to risk-weight, and
asset that functions as a credit enhancement in a hold capital against, that asset as a residual
securitization, regardless of how a bank refers to interest as if the asset had not been sold.
the asset in financial or regulatory reports.
In general, the definition of residual interests Risk participation. Risk participation means a
includes only an on-balance-sheet asset that participation in which the originating party
represents an interest created by a transfer of remains liable to the beneficiary for the full
financial assets treated as a sale under GAAP, in amount of an obligation (for example, a direct-
accordance with FAS 140. Interests retained in a credit substitute) notwithstanding that another
securitization or transfer of assets accounted for party has acquired a participation in that
as a financing under GAAP are generally obligation.
excluded from the definition of residual interest.
In the case of GAAP financings, the transferred Securitization. Securitization is the pooling and
assets remain on the transferring bank’s balance repackaging by a special-purpose entity of assets
sheet and are, therefore, directly included in or other credit exposures into securities that can
both the leverage and risk-based capital calcu- be sold to investors. Securitization includes
lations. Further, when a transaction is treated as transactions that create stratified credit-risk posi-
a financing, no gain is recognized from an tions whose performance is dependent on an
accounting standpoint. underlying pool of credit exposures, including
Sellers’ interests generally do not function as loans and commitments.
a credit enhancement. Thus, if a seller’s interest
shares losses on a pro rata basis with investors, Sponsor. A sponsor refers to a bank that estab-
such an interest would not be considered a lishes an ABCP program; approves the sellers
residual interest. However, banks should recog- permitted to participate in the program; approves
nize that sellers’ interests that are structured to the asset pools to be purchased by the program;
absorb a disproportionate share of losses will be or administers the program by monitoring the
considered residual interests. assets, arranging for debt placement, compiling
The definition of residual interest also includes monthly reports, or ensuring compliance with
overcollateralization and spread accounts because the program documents and with the program’s
these accounts are susceptible to the potential credit and investment policy.

Page 28
Structured finance program. A structured finance Risk-Weight Factor for Off-Balance-Sheet

program refers to a program where receivable Recourse Obligations and Direct-Credit
interests and asset-backed securities issued by Substitutes
multiple participants are purchased by a special-
purpose entity that repackages those exposures To determine the bank’s risk-weight factor for
into securities that can be sold to investors. off-balance-sheet recourse obligations and direct-
Generally, structured finance programs allocate credit substitutes, the credit-equivalent amount
credit risks between the participants and the is assigned to the risk category appropriate to
credit enhancement provided to the program. the obligor in the underlying transaction, after
considering any associated guarantees or collat-
eral. For a direct-credit substitute that is an
on-balance-sheet asset (for example, a pur-
Recourse Obligations, Direct-Credit chased subordinated security), a bank must cal-
Substitutes, Residual Interests, and culate risk-weighted assets using the amount of
Asset- and Mortgage-Backed the direct-credit substitute and the full amount
Securities of the assets it supports, that is, all the more
senior positions in the structure. Direct-credit
substitutes that have been syndicated or in
The risk-based capital treatment for recourse
which risk participations have been conveyed or
obligations, direct-credit substitutes, and asset-
acquired are considered off-balance-sheet items
and mortgage-backed securities in connection
that are converted at a 100 percent conversion
with asset securitizations and structured financ-
factor. (See section III.D.1. of the guidelines (12
ings is described below. The capital treatment
CFR 208, appendix A) for more capital-treatment
described in this subsection applies to the bank’s
details.)
own positions.27
For banks that comply with the market-risk
rules, except for liquidity facilities supporting Ratings-Based Approach—Externally
ABCP (in form or in substance), positions in the Rated Positions
trading book that arise from asset securitiza-
tions, including recourse obligations, residual Each loss position in an asset-securitization
interests, and direct-credit substitutes, should be structure functions as a credit enhancement for
treated according to the market-risk rules. How- the more senior loss positions in the structure. A
ever, these banks remain subject to the 25 per- multilevel ratings-based approach is used to
cent concentration limit for credit-enhancing I/O assess capital requirements on recourse obliga-
strips. tions, residual interests (except credit-enhancing
I/O strips), direct-credit substitutes, and senior
and subordinated securities in asset securitiza-
Credit-Equivalent Amount tions. The approach uses credit ratings from the
rating agencies to measure relative exposure to
The credit-equivalent amount for a recourse credit risk and determine the associated risk-
obligation or a direct-credit substitute is the full based capital requirement. Using these credit
amount of the credit-enhanced assets for which ratings provides a way to use determinations of
the bank directly or indirectly retains or assumes credit quality that are relied on by investors and
credit risk, multiplied by a 100 percent conver- other market participants to differentiate the
sion factor. This treatment, however, does not regulatory capital treatment for loss positions
apply to externally rated positions, senior posi- representing different gradations of risk.
tions not externally rated, residual interests, Under the ratings-based approach, the capital
certain internally rated positions, and certain requirement for a position is computed by mul-
small-business loans and leases on personal tiplying the face amount of the position by the
property transferred with recourse. appropriate risk weight, determined in accor-
dance with the following tables.28 Table 2 maps
28. The rating designations (for example, AAA, BBB, A-1,

27. The treatment also applies to banks that hold positions and P-1) used in the tables are illustrative only and do not
in their trading book but that are not otherwise subject to the indicate any preference for, or endorsement of, any particular
market-risk rules. rating-agency designation system.

Page 29
Table 2—Risk-Weight Assignments for Externally Rated Long-Term Positions

Rating-designation
Long-term rating category examples Risk weight
Highest or second-highest investment grade AAA, AA 20 percent
Third-highest investment grade A 50 percent
Lowest investment grade BBB 100 percent
One category below investment grade BB 200 percent
Table 3—Risk-Weight Assignments for Externally Rated Short-Term Positions

Rating-designation
Short-term rating category examples Risk weight
Highest investment grade A-1, P-1 20 percent
Second-highest investment grade A-2, P-2 50 percent
Lowest investment grade A-3, P-3 100 percent
long-term ratings to the appropriate risk weights. enhancing I/O strips) retained, assumed, or issued
Table 3 maps short-term ratings for asset-backed in connection with a securitization or structured
commercial paper to the appropriate risk weights. finance program qualify for the ratings-based
The Federal Reserve has the authority, however, approach.
to override the use of certain ratings or the Corporate debt instruments, municipal bonds,
ratings on certain instruments, either on a case- and other securities that are not related to a
by-case basis or through broader supervisory securitization or structured finance program do
policy, if necessary or appropriate to address the not meet these definitions, and thus do not
risk that an instrument poses to a bank. qualify for the ratings-based approach.
The ratings-based approach can be used for
certain designated asset-backed securities
(including asset-backed commercial paper),
recourse obligations, direct-credit substitutes, Traded Positions
and residual interests (other than credit-
enhancing I/O strips). Credit-enhancing I/O strips A traded position is only required to be rated by
have been excluded from the ratings-based one rating agency. A traded position is defined
approach because of their high risk profile. as a position that is externally rated and is
While the ratings-based approach is available retained, assumed, or issued in connection with
for both traded and untraded positions, the an asset securitization, where there is a reason-
approach applies different requirements to each able expectation that, in the near future, the
type of position. rating will be relied on by unaffiliated investors
to purchase the position or will be relied on by
an unaffiliated third party to enter into a trans-
action involving the position, such as a pur-
Ratings-Based Qualification for chase, loan, or repurchase agreement.
Corporate Bonds or Other Securities For a traded position that has received an
external rating on a long-term position that is
Corporate bonds or other securities not related one grade below investment grade or better, or
in any way to a securitization or structured that has received a short-term rating that is
finance program do not qualify for the ratings- investment grade, the bank multiplies the face
based approach. Only mortgage- and asset-backed amount of the position by the appropriate risk
securities, recourse obligations, direct-credit sub- weight, determined in accordance with tables 2
stitutes, and residual interests (except credit- and 3. Stripped mortgage-backed securities and

Page 30
other similar instruments, such as interest-only lower. Similarly, if a portion of an instrument is

or principal-only strips that are not credit unrated, the entire position will be treated as if it
enhancements, must be assigned to the 100 per- was unrated. In addition to this regulatory capi-
cent risk category. If a traded position has tal treatment, the Federal Reserve may also, as
received more than one external rating, the appropriate, adversely classify and require write-
lowest single rating will apply. Moreover, if a downs for an other-than-temporary impairment
rating changes, the bank must use the new on unrated and below-investment-grade securi-
rating. ties, including split or partially rated securities.
Table 3, for short-term ratings, is not identical (See SR-02-16.)
to table 2, for long-term ratings, because the
rating agencies do not assign short-term ratings
using the same methodology as they use for Senior Positions Not Externally Rated
long-term ratings. Each short-term rating cate-
gory covers a range of longer-term rating cate- A position that is not externally rated (an
gories.29 For example, a P-1 rating could map to unrated position), but that is senior or preferred
a long-term rating that is as high as Aaa or as in all respects (including collateralization and
low as A3. maturity) to a rated position that is traded, is
treated as if it had the rating assigned to the
rated position. The bank must satisfy the Federal
Externally Rated, Nontraded Positions Reserve that such treatment is appropriate. Senior
unrated positions qualify for the risk weighting
For a rated, but untraded, position to be eligible of the subordinated rated positions in the same
for the ratings-based approach, it must meet securitization transaction as long as the subor-
certain conditions. To qualify, the position dinated rated position (1) is traded and (2) remains
(1) must be rated by more than one rating outstanding for the entire life of the unrated
agency; (2) must have received an external position, thus providing full credit support until
rating on a long-term position that is one grade the unrated position matures.
below investment grade or better or, for Recourse obligations and direct-credit substi-
a short-term position, a rating that is investment tutes (other than residual interests) that do not
grade or better by all rating agencies providing a qualify for the ratings-based approach (or for the
rating; (3) must have ratings that are publicly internal-ratings, program-ratings, or computer-
available; and (4) must have ratings that are program-ratings approaches outlined below)
based on the same criteria used to rate traded receive ‘‘gross-up’’ treatment, that is, the bank
securities. If the ratings are different, the lowest holding the position must hold capital against
single rating will determine the risk- the amount of the position, plus all more senior
weight category to which the position will be positions, subject to the low-level-exposure
assigned. This treatment does not apply to a requirement.30 This grossed-up amount is placed
credit-enhancing I/O strip. into a risk-weight category according to the
obligor or, if relevant, according to the guarantor
or nature of the collateral. The grossed-up
Split or Partially Rated Instruments amount multiplied by both the risk weight and
8 percent is never greater than the full capital
For instruments that have been assigned sepa- charge that would otherwise be imposed on the
rate ratings for principal and interest (split or
partially rated instruments), the Federal Reserve 30. Gross-up treatment means that a position is combined
will apply to the entire instrument the risk with all more senior positions in the transaction. The result is
weight that corresponds to the lowest compo- then risk-weighted based on the obligor or, if relevant, the
nent rating. For example, a purchased subordi- guarantor or the nature of the collateral. For example, if a bank
retains a first-loss position (other than a residual interest) in a
nated security whose principal component is pool of mortgage loans that qualify for a 50 percent risk
rated BBB, but whose interest component is weight, the bank would include the full amount of the assets
rated B, is subject to the gross-up treatment in the pool, risk-weighted at 50 percent, in its risk-weighted
accorded to direct-credit substitutes rated B or assets for purposes of determining its risk-based capital ratio.
The low-level-exposure rule provides that the dollar amount
of risk-based capital required for assets transferred with
29. See, for example, Moody’s Global Ratings Guide, June recourse should not exceed the maximum dollar amount for
2001, p.3. which a bank is contractually liable.

Page 31
assets if they were on the banking organization’s Transactions that, in substance, result in the
balance sheet.31 retention of credit risk associated with a trans-
ferred residual interest will be treated as if the
residual interest was retained by the bank and
Residual Interests not transferred.
When the aggregate capital requirement for
Credit-Enhancing I/O Strips residual interests and other recourse obligations
in connection with the same transfer of assets
After applying the concentration limit to credit- exceeds the full risk-based capital requirement
enhancing I/O strips (both purchased and for those assets, a bank must maintain risk-based
retained), a bank must maintain risk-based capi- capital equal to the greater of the risk-based
tal for a credit-enhancing I/O strip (both pur- capital requirement for the residual interest or
chased and retained), regardless of the external the full risk-based capital requirement for the
rating on that position, equal to the remaining assets transferred.
amount of the credit-enhancing I/O strip (net of
any existing associated deferred tax liability),
even if the amount of risk-based capital required
to be maintained exceeds the full risk-based Accrued Interest Receivables Held on
capital requirement for the assets transferred. Credit Card Securitizations
Transactions that, in substance, result in the
retention of credit risk associated with a trans- In a typical credit card securitization, an insti-
ferred credit-enhancing I/O strip will be treated tution transfers a pool of credit card receivables
as if the credit-enhancing I/O strip was retained to a trust, as well as the rights to receive future
by the bank and not transferred. payments of principal, interest, and fee income
from those receivables. If a securitization trans-
action qualifies as a sale under FAS 140, the
Other Residual Interests selling institution removes the receivables that
were sold from its reported assets and continues
Residual interests that are not eligible for the to carry any retained interests in the transferred
ratings-based approach receive dollar-for-dollar receivables on its balance sheet; the right to
treatment. Dollar-for-dollar treatment means, these future cash flows should be reported as an
effectively, that one dollar in total risk-based accrued interest receivable (AIR) asset.33 ,34 Any
capital must be held against every dollar of a accrued amounts (cash flows) the institution
residual interest retained on the balance sheet collects (for example, accrued fees and finance
(net of any existing associated deferred tax charges) generally must be transferred to the
liability), even if the amount of risk-based trust and will be used first by the trustee for the
capital required to be maintained exceeds the benefit of third-party investors to satisfy more
full risk-based capital requirement for the assets senior obligations and for the payment of trust
transferred. This capital treatment applies to all expenses (such as servicing fees, investor-
residual interests, except for credit-enhancing certificate interest, and investor-principal charge-
I/O strips that have already been deducted from offs). Any remaining excess fee and finance
tier 1 capital under the concentration limit.32 charges will flow back to the seller.
Because the AIR asset constitutes a subordi-
31. For assets that are assigned to the 100 percent risk- nated residual (retained) interest in the trans-
weight category, the minimum capital charge is 8 percent of
the amount of assets transferred, and banking organizations
are required to hold 8 cents of capital for every dollar of assets
transferred with recourse. For assets that are assigned to the 33. The AIR represents fees and finance charges that have
50 percent risk-weight category, the minimum capital charge been accrued on receivables that the institution has securitized
is 4 cents of capital for every dollar of assets transferred with and sold to other investors. For example, in credit card
recourse. securitizations, this accrued interest receivable asset may
32. Residual interests that are retained or purchased credit- include both finance charges billed but not yet collected and
enhancing I/O strips are first subject to a capital concentration finance charges accrued but not yet billed on the securitized
limit of 25 percent of tier 1 capital. For risk-based capital receivables.
purposes (but not for leverage capital purposes), once this 34. Some institutions may categorize part or all of this
concentration limit is applied, a banking organization must receivable as a loan, a ‘‘due from trust’’ account, a retained
then hold dollar-for-dollar capital against the face amount of interest in the trust, or as part of an interest-only strip
credit-enhancing I/O strips remaining. receivable.

Page 32
ferred securitized assets, it meets the definition these approaches, the bank must satisfy the
of recourse exposure for risk-based capital pur- Federal Reserve that the use of the approach is
poses. Recourse exposures (such as the AIR appropriate for the particular bank and for the
asset) require risk-based capital against the full, exposure being evaluated. The risk weight that
risk-weighted amount of the assets transferred may be applied to an exposure under these
with recourse, subject to the low-level-recourse alternative approaches is limited to a minimum
rule.35 The AIR asset serves as a credit of 100 percent.
enhancement to protect third-party investors in
the securitization from credit losses, and it meets
the definition of a residual interest under the Internal Risk-Rating Systems for
risk-based capital adequacy rules for the treat- Asset-Backed Commercial Paper
ment of recourse arrangements. Under those Programs
rules, an institution must hold dollar-for-dollar
capital against residual interests, even if that A bank that has a qualifying internal risk-rating
amount exceeds the full equivalent risk-based system can use that system to apply the ratings-
capital charge on the transferred assets.36 The based approach to its unrated direct-credit sub-
institution is expected to hold risk-based capital stitutes in asset-backed commercial paper pro-
in an amount consistent with the subordinated grams. Internal risk ratings could be used to
nature of the AIR asset. qualify such a credit enhancement for a risk
In accounting for the sale, the AIR asset is weight of 100 percent or 200 percent under the
treated as a subordinated retained interest of ratings-based approach, but not for a risk weight
credit card receivables when computing the gain of less than 100 percent.
or loss on sale. Consistent with GAAP, this Most sophisticated banking organizations that
means that the value of the AIR, at the date of participate extensively in the asset-securitization
transfer, must be adjusted based on its relative business assign internal risk ratings to their
fair (market) value. This adjustment will typi- credit exposures, regardless of the form of the
cally result in the carrying amount of the AIR exposure. Usually, internal risk ratings more
being lower than its book (face) value prior to finely differentiate the credit quality of a bank-
securitization. The AIR should be reported in ing organization’s exposures than the categories
regulatory reports as ‘‘Other Assets’’ and not as the banking agencies use to evaluate credit risk
a loan receivable. (See SR-02-12 and SR-02-22). during bank examinations (pass, substandard,
doubtful, or loss). An individual bank’s internal
risk ratings may be associated with a certain
Other Unrated Positions probability of default, loss in the event of
default, and loss volatility.
A position (but not a residual interest) main- The credit enhancements that sponsors obtain
tained in connection with a securitization and for their commercial paper conduits are rarely
that is not rated by a rating agency may be rated or traded. If an internal risk-ratings
risk-weighted based on the bank’s internal approach were not available for these unrated
determination of the credit rating of the position, credit enhancements, the provider of the
as specified in table 4, multiplied by the face enhancement would have to obtain two ratings
amount of the position. The bank may use three solely to avoid the gross-up treatment that would
approaches to determine the capital require- otherwise apply to nontraded positions in asset
ments for certain unrated direct-credit substi- securitizations for risk-based capital purposes.
tutes and recourse obligations. Under each of However, before a provider of an enhancement
decides whether to provide a credit enhance-
ment for a particular transaction (and at what
35. The low-level-recourse rule limits the maximum risk- price), the provider will generally perform its
based capital requirement to the lesser of a banking organi-
zation’s maximum contractual exposure or the full capital
own analysis of the transaction to evaluate the
charge against the outstanding amount of assets transferred amount of risk associated with the enhancement.
with recourse. An internal risk-ratings approach, therefore, is
36. For a complete description of the appropriate capital potentially less costly than a ratings-based
treatment for recourse, residual interests, and credit-enhancing
interest-only strips, see ‘‘Recourse, Direct Credit Substitutes,
approach that relies exclusively on ratings by
and Residual Interests in Asset Securitizations,’’ 66 Fed. Reg. the rating agencies for the risk weighting of
59614 (November 29, 2001). these positions.

Page 33
Table 4—Risk-Weight Assignments for Unrated Positions Using the

Alternative Approaches1
Rating-designation
Rating category examples Risk weight
Highest or second-highest investment grade AAA, AA 100 percent
Third-highest investment grade A 100 percent
Lowest investment grade BBB 100 percent
One category below investment grade BB 200 percent
1. such as the internal ratings approach
Internal risk ratings that correspond to the ers, as well as the risk associated with the
rating categories of the rating agencies can be specific positions in a securitization transaction.
mapped to risk weights under the Federal • The ratings identify gradations of risk among
Reserve’s capital standards. This mapping can ‘‘pass’’ assets, and not just among assets that
be done in a way that would make it possible to have deteriorated to the point that they fall
differentiate the riskiness of various unrated into ‘‘watch’’ grades. Although it is not nec-
direct-credit substitutes in asset-backed commer- essary for a bank to use the same categories as
cial paper programs based on credit risk. The the rating agencies, its internal ratings must
use of internal risk ratings, however, may raise correspond to the ratings of the rating agen-
concerns about the accuracy and consistency of cies so that the Federal Reserve can determine
the ratings, especially because the mapping of which internal risk rating corresponds to each
ratings to risk-weight categories will give banks rating category of the rating agencies. A bank
an incentive to rate their risk exposures in a way would be responsible for demonstrating, to the
that minimizes the effective capital requirement. satisfaction of the Federal Reserve, how these
A bank engaged in asset-backed commercial ratings correspond with the rating-agency stan-
paper securitization activities that wishes to use dards that are used as the framework for the
the internal risk-ratings approach must therefore asset-securitization portion of the risk-based
be able to demonstrate to the satisfaction of the capital rule. This correlation is necessary so
Federal Reserve, before relying on its internal that the mapping of credit ratings to risk-
ratings, that the bank’s internal credit-risk rating weight categories in the ratings-based approach
system is adequate. Adequate internal risk- can be applied to internal ratings.
rating systems usually have the following • The ratings classify assets into each risk grade
characteristics: using clear, explicit criteria, even for subjec-
tive factors.
• The internal risk ratings are an integral part of • Independent credit-risk-management or loan-
an effective risk-management system that review personnel assign or review the credit-
explicitly incorporates the full range of risks risk ratings. These personnel should have
arising from the bank’s participation in secu- adequate training and experience to ensure
ritization activities. The system must also that they are fully qualified to perform this
fully take into account the effect of such function.
activities on the bank’s risk profile and capital • An internal audit procedure periodically veri-
adequacy. fies that internal risk ratings are assigned
• The ratings link to measurable outcomes, such in accordance with the bank’s established
as the probability that a position will experi- criteria.37
ence any losses, the expected losses on that
position in the event of default, and the degree 37. The audit may be performed by any group within the
of variance in losses given default on that organization that is qualified to audit the system and is
position. independent of both the group that makes the decision to
extend credit to the asset-backed commercial paper program
• The ratings separately consider the risk asso- and the groups that develop and maintain the internal credit-
ciated with the underlying loans and borrow- risk rating system. (See SR-02-16.)

Page 34
• The performance of internal ratings is tracked rating obtained by the sponsor of the program.
over time to evaluate how well risk grades are Banks with limited involvement in securitiza-
being assigned, make adjustments to the rat- tion activities may find the above alternative to
ing system when the performance of the rated be useful. In addition, some banks extensively
positions diverges from assigned ratings, and involved in securitization activities already rely
adjust individual ratings accordingly. on ratings of the credit-risk positions under their
• Credit-risk rating assumptions are consistent securitization programs as part of their risk-
with, or more conservative than, the credit- management practices. Such banks can rely on
risk rating assumptions and methodologies of these ratings for regulatory capital purposes if
the rating agencies. the ratings are part of a sound overall risk-
management process and the ratings reflect the
If it determines that a bank’s rating system is risk of nontraded positions to the banks.
not adequate, the Federal Reserve may preclude This approach in a structured financing pro-
the bank from applying the internal risk-ratings gram can be used to qualify a direct-credit
approach to new transactions for risk-based substitute or recourse obligation (but not a
capital purposes until the deficiencies have been residual interest) for a risk weight of 100 percent
remedied. Additionally, depending on the sever- or 200 percent of the face value of the position
ity of the problems identified, the Federal under the ratings-based approach, but not for a
Reserve may decline to rely on the internal risk risk weight of less than 100 percent.
ratings that the bank had applied to previous
transactions for purposes of determining its
regulatory capital requirements. Credit-Assessment Computer Programs
A bank (particularly a bank with limited involve-
Ratings of Specific Unrated Positions in ment in securitization activities) may use an
Structured Financing Programs internal ratings-based approach if it is using an
acceptable credit-assessment computer pro-
A bank may also use a rating obtained from a gram, developed by a rating agency, to deter-
rating agency for an unrated direct-credit sub- mine the rating of a direct-credit substitute or a
stitute or recourse obligation (other than a recourse obligation (but not a residual interest)
residual interest) that is assumed or retained in issued in connection with a structured finance
connection with a structured finance program, if program. To be used by a bank for risk-based
a rating agency has reviewed the terms of the capital purposes, a computer program must have
program (according to the specifications set by been developed by a rating agency. Further, the
the rating agency) and stated a rating for posi- bank must demonstrate to the satisfaction of the
tions associated with the program. If the pro- Federal Reserve that the computer program’s
gram has options for different combinations of credit assessments correspond credibly and reli-
assets, standards, internal credit enhancements, ably to the rating standards of the rating agen-
and other relevant factors, and if the rating cies for traded positions in securitizations and
agency specifies ranges of rating categories to with the rating of traded positions in the finan-
them, the bank may apply the rating category cial markets. The latter would generally be
that corresponds to the bank’s position. To rely shown if investors and other market participants
on a program rating, the bank must demonstrate significantly used the computer program for
to the Federal Reserve’s satisfaction that the risk-assessment purposes. In addition, the bank
credit-risk rating assigned to the program meets must demonstrate to the Federal Reserve’s sat-
the same standards generally used by rating isfaction that the program was designed to apply
agencies for rating traded positions. to its particular direct-credit substitute or recourse
The bank must also demonstrate to the Fed- exposure and that it has properly implemented
eral Reserve’s satisfaction that the criteria under- the computer program. In general, sophisticated
lying the rating agency’s assignment of ratings banks with extensive securitization activities
for the structured financing program are satisfied should use this approach only if the computer
for the particular position. If a bank participates program is an integral part of their risk-
in a securitization sponsored by another party, management systems and if the bank’s systems
the Federal Reserve may authorize the bank to fully capture the risks from its securitization
use this approach based on a programmatic activities. This computer-program approach can

Page 35
be used to qualify a direct-credit substitute or similar arrangements with embedded recourse

recourse obligation (but not a residual interest) obligations or direct-credit substitutes, both the
for a risk weight of 100 percent or 200 percent on-balance-sheet assets and the related recourse
of the face value of the position under the obligations and direct-credit substitutes must be
ratings-based approach, but not for a risk weight separately risk-weighted and incorporated into
of less than 100 percent. the risk-based capital calculation.
Asset-Backed Commercial Paper Program

Limitations on Risk-Based Capital Assets and Related Minority Interests
Requirements
An asset-backed commercial paper (ABCP) pro-
gram typically is a program through which a
Low-Level Exposure bank provides funding to its corporate custom-
ers by sponsoring and administering a
If a bank’s maximum contractual exposure to
bankruptcy-remote special-purpose entity that
loss retained or assumed in connection with a
purchases asset pools from, or extends loans to,
recourse obligation or a direct-credit substitute,
those customers.38 The asset pools in an ABCP
except for a residual interest, is less than the
program might include, for example, trade
effective risk-based capital requirement for the
receivables, consumer loans, or asset-backed
enhanced assets, the risk-based capital require-
securities. The ABCP program raises cash to
ment is limited to the maximum contractual
provide funding to the bank’s customers, prima-
exposure, less any recourse liability account
rily (that is, more than 50 percent of the ABCP’s
established in accordance with GAAP. This
issued liabilities) through the issuance of exter-
limitation does not apply when a bank provides
nally rated commercial paper into the market.
credit enhancement beyond any contractual obli-
Typically, the sponsoring bank provides liquid-
gation to support assets it has sold.
ity and credit enhancements to the ABCP pro-
gram. These enhancements aid the program in
Mortgage-Related Securities or obtaining high credit ratings that facilitate the
Participation Certificates Retained in a issuance of the commercial paper.39
Mortgage Loan Swap Under the Board’s risk-based capital rule, a
bank that qualifies as a primary beneficiary and
If a bank holds a mortgage-related security or a must consolidate an ABCP program that is
participation certificate as a result of a mortgage defined as a variable interest entity under GAAP
loan swap with recourse, capital is required to may exclude the consolidated ABCP program’s
support the recourse obligation plus the percent- assets from risk-weighted assets provided that
age of the mortgage-related security or partici- the bank is the sponsor of the ABCP program. If
pation certificate that is not covered by the a bank excludes such consolidated ABCP pro-
recourse obligation. The total amount of capital gram assets, the bank must assess the appropri-
required for the on-balance-sheet asset and the ate risk-based capital charge against any expo-
recourse obligation, however, is limited to the sures of the bank arising in connection with such
capital requirement for the underlying loans, ABCP programs, including direct-credit substi-
calculated as if the bank continued to hold the tutes, recourse obligations, residual interests,
loans as on-balance-sheet assets. liquidity facilities, and loans, in accordance with
38. The definition of ABCP program generally includes

Related On-Balance-Sheet Assets structured investment vehicles (entities that earn a spread by
issuing commercial paper and medium-term notes and using
If a recourse obligation or a direct-credit substi- the proceeds to purchase highly rated debt securities) and
securities arbitrage programs.
tute also appears as a balance-sheet asset, the 39. A bank is considered the sponsor of an ABCP program
balance-sheet asset is not included in a bank’s if it establishes the program; approves the sellers permitted to
risk-weighted assets to the extent the value of participate in the program; approves the asset pools to be
the balance-sheet asset is already included in the purchased by the program; or administers the program by
monitoring the assets, arranging for debt placement, compil-
off-balance-sheet credit-equivalent amount for ing monthly reports, or ensuring compliance with the program
the recourse obligation or direct-credit substi- documents and with the program’s credit and investment
tute. In the case of loan-servicing assets and policy.

Page 36
sections III.B.5., III.C., and III.D. of the risk- ABCP constitutes less than 50 percent of the
based capital rule (12 CFR 208, appendix A). securities issued by the program, thus causing
When calculating the bank’s tier 1 and total the issuing structure not to meet the rule’s
capital, any associated minority interests must definition of an ABCP program. However, if a
also be excluded from tier 1 capital. As a result bank (1) does not meet this definition and must
of FIN 46-R, banks are to include all assets of include the program’s assets in its risk-weighted
consolidated ABCP programs as part of their asset base or (2) otherwise chooses to include
on-balance-sheet assets, for purposes of calcu- the program’s assets in risk-weighted assets,
lating the tier 1 leverage capital ratio. then no risk-based capital requirement will be
A bank is able to exclude ABCP program assessed against any liquidity facilities provided
assets from its risk-weighted asset base only by the bank that support the program’s ABCP.
with respect to those programs for which it is the Ineligible liquidity facilities will be treated as
sponsor and that meet the rule’s definition of an recourse obligations or direct-credit substitutes
ABCP program. Thus, a bank sponsoring a for the purposes of the Board’s risk-based capi-
program issuing ABCP that does not meet the tal guidelines.
rule’s definition of an ABCP program must The resulting credit-equivalent amount would
continue to include the program’s assets in the then be risk-weighted according to the under-
institution’s risk-weighted asset base. lying assets or the obligor, after considering any
collateral or guarantees, or external credit rat-
Liquidity facilities supporting ABCP. Liquidity ings, if applicable. For example, if an eligible
facilities supporting ABCP often take the form short-term liquidity facility providing liquidity
of commitments to lend to, or purchase assets support to ABCP covered an asset-backed secu-
from, the ABCP programs in the event that rity (ABS) externally rated AAA, then the
funds are needed to repay maturing commercial notional amount of the liquidity facility would
paper. Typically, this need for liquidity is due to be converted at 10 percent to an on-balance-
a timing mismatch between cash collections on sheet credit-equivalent amount and assigned to
the underlying assets in the program and sched- the 20 percent risk-weight category appropriate
uled repayments of the commercial paper issued for AAA-rated ABS.40
by the program.
A bank that provides liquidity facilities to Overlapping exposures to an ABCP program. A
ABCP is exposed to credit risk regardless of the bank may have multiple overlapping exposures
term of the liquidity facilities. For example, an to a single ABCP program (for example, both a
ABCP program may require a liquidity facility program-wide credit enhancement and multiple
to purchase assets from the program at the first pool-specific liquidity facilities to an ABCP
sign of deterioration in the credit quality of an program that is not consolidated for risk-based
asset pool, thereby removing such assets from capital purposes). A bank must hold risk-based
the program. In such an event, a draw on the capital only once against the assets covered by
liquidity facility exposes the bank to credit risk. the overlapping exposures. Where the overlap-
Short-term commitments with an original ping exposures are subject to different risk-
maturity of one year or less expose banks to a based capital requirements, the bank must apply
lower degree of credit risk than longer-term the risk-based capital treatment that results in
commitments. This difference in the degree of the highest capital charge to the overlapping
credit risk is reflected in the risk-based capital portion of the exposures.
requirement for the different types of exposure. For example, assume a bank provides a
The Board’s capital guidelines impose a 10 per- program-wide credit enhancement that would
cent credit-conversion factor on eligible short- absorb 10 percent of the losses in all of the
term liquidity facilities supporting ABCP. A underlying asset pools in an ABCP program and
50 percent credit-conversion factor applies to pool-specific liquidity facilities that cover
eligible long-term ABCP liquidity facilities. 100 percent of each of the underlying asset
These credit-conversion factors apply regardless pools. The bank would be required to hold
of whether the structure issuing the ABCP meets capital against 10 percent of the underlying asset
the rule’s definition of an ABCP program. For
example, a capital charge would apply to an 40. See section 4030.1 and also the Board staff’s October
eligible short-term liquidity facility that pro- 12, 2007, legal interpretation regarding the risk-based capital
vides liquidity support to ABCP where the treatment of ABCP liquidity facilities.

Page 37
pools because it is providing the program-wide rities will be considered either recourse obliga-
credit enhancement. The bank would also be tions or direct-credit substitutes. However, the
required to hold capital against 90 percent of ‘‘investment-grade’’ limitation is not applied in
the liquidity facilities it is providing to each of the asset-quality test with respect to assets that
the underlying asset pools. are conditionally or unconditionally guaranteed
If different banks have overlapping exposures by the U.S. government or its agencies or by
to an ABCP program, however, each organiza- another OECD central government. If the asset-
tion must hold capital against the entire maxi- quality tests are not met (that is, if a bank
mum amount of its exposure. As a result, while actually funds through the liquidity facility assets
duplication of capital charges will not occur for that do not satisfy the facility’s asset-quality
individual banks, some systemic duplication tests), the liquidity facility will be considered a
may occur where multiple banking organiza- recourse obligation or a direct-credit substitute
tions have overlapping exposures to the same and generally will be converted at 100 percent.
ABCP program.
Asset-quality test. For a liquidity facility, either Risk-Based Capital Treatment of

short- or long-term, that supports ABCP not Certain Off-Balance-Sheet Items and
to be considered a recourse obligation or a Certain Other Types of Transactions
direct-credit substitute, it must meet the rule’s
definition of an eligible ABCP liquidity facil-
ity. An eligible ABCP liquidity facility must Distinction Between Financial and
meet a reasonable asset-quality test that, among Performance Standby Letters of Credit
other things, precludes funding assets that are
For risk-based capital purposes, the vast major-
90 days or more past due or in default. When
ity of standby letters of credit a bank issues are
assets are 90 days or more past due, they
considered financial in nature. On the one hand,
typically have deteriorated to the point where
in issuing a financial standby letter of credit, a
there is an extremely high probability of default.
bank guarantees that the account party will
Assets that are 90 days past due, for example,
fulfill a contractual financial obligation that
often must be placed on nonaccrual status in
involves payment of money. On the other hand,
accordance with the agencies’ Uniform Retail
in issuing a performance standby letter of credit,
Credit Classification and Account Management
a bank guarantees that the account party will
Policy.41 Further, they generally must also be
fulfill a contractual nonfinancial obligation, that
classified substandard under that policy.
is, an obligation that does not entail the payment
The rule’s asset-quality test specifically allows
of money. For example, a standby letter of credit
a bank to reflect certain guarantees providing
that guarantees that an insurance company will
credit protection to the bank providing the
pay as required under the terms of a policy is
liquidity facility. In particular, the ‘‘days-past-
deemed to be financial and is converted at
due limitation’’ is not applied with respect to
100 percent, while a letter of credit that guaran-
assets that are either conditionally or uncondi-
tees a contractor will pave a street according to
tionally guaranteed by the U.S. government or
certain specifications is deemed to be perfor-
its agencies or by another OECD central gov-
mance related and is converted at 50 percent.
ernment. To qualify as an eligible ABCP liquid-
Financial standby letters of credit have a higher
ity facility, if the assets covered by the liquidity
conversion factor in large part because, unlike
facility are initially externally rated (at the time
performance standby letters of credit, they tend
the facility is provided), the facility can be used
to be drawn down only when the account party’s
to fund only those assets that are externally rated
financial condition has deteriorated.
investment grade at the time of funding.
The practice of purchasing assets that are
externally rated below investment grade out of Participations of Off-Balance-Sheet
an ABCP program is considered the equivalent Transactions
of providing credit protection to the commercial
paper investors. Thus, liquidity facilities permit- If a standby letter of credit or commitment has
ting purchases of below-investment-grade secu- been participated to other institutions in the
form of a syndication, as defined in the instruc-
41. See 65 Fed. Reg. 36904 (June 12, 2000). tions to the Call Report, that is, if each bank is

Page 38
responsible only for its pro rata share of loss and other form of consideration. Commitments are
there is no recourse to the originating bank, each included in weighted-risk assets regardless of
bank includes only its pro rata share of the whether they contain ‘‘material adverse change’’
standby or commitment in its risk-based capital clauses or other provisions that are intended to
calculation. relieve the issuer of its funding obligation under
The treatment differs, however, if the partici- certain conditions. In the case of commitments
pation takes the form of a conveyance of a risk structured as syndications, where the bank is
participation. In such a participation, the origi- obligated solely for its pro rata share, only the
nating bank remains liable to the beneficiary for bank’s proportional share of the syndicated
the full amount of the standby or commitment if commitment is taken into account in calculating
the institution that has acquired the participation the risk-based capital ratio.
fails to pay when the instrument is drawn. Under
this arrangement, the originating bank is exposed Commitments to make off-balance-sheet trans-
to the credit risk of the institution that has actions. As specified in the instructions to the
acquired the conveyance rather than that of the Call Report, a commitment to make a standby
account party. Accordingly, for risk-based capi- letter of credit is considered to be a standby
tal purposes, the originating bank should con- letter of credit. Accordingly, such a commitment
vert the full amount of the standby or commit- should be converted to an on-balance-sheet
ment to an on-balance-sheet credit-equivalent credit-equivalent amount at 100 percent if it is
amount. The credit-equivalent amount of the a commitment to make a financial standby let-
portion of the credit that has not been conveyed ter of credit or at 50 percent if it is a commit-
is assigned to the risk category appropriate to ment to make a performance standby letter of
the obligor, after giving effect to any collateral credit.
or guarantees. The portion that has been con- A commitment to make a commitment is
veyed is assigned either to the same risk cate- treated as a single commitment whose maturity
gory as the obligor or to the risk category is the combined maturity of the two commit-
appropriate to the institution acquiring the par- ments. For example, a 6-month commitment to
ticipation, whichever category carries the lower make a 1-year commitment is considered to be a
risk weight. Any remainder is assigned to the single 18-month commitment. Since the matu-
risk category appropriate to the obligor, guaran- rity is over one year, such a commitment would
tor, or collateral. For example, the pro rata share receive the 50 percent conversion factor appro-
of the full amount of the assets supported, in priate to long-term commitments, rather than the
whole or in part, by a direct-credit substitute zero percent conversion factor that would be
conveyed as a risk participation to a U.S. domes- accorded to separate unrelated short-term com-
tic depository institution or foreign bank is mitments of six months and one year.
assigned to the 20 percent risk category. Risk A commitment to make a commercial letter of
participations with a remaining maturity of over credit may be treated either as a commitment or
one year that are conveyed to non-OECD banks as a commercial letter of credit, whichever
are to be assigned to the 100 percent risk results in the lower conversion factor. Normally,
category, unless a lower risk category is appro- this would mean that a commitment under one
priate to the obligor, guarantor, or collateral. year to make a commercial letter of credit would
be treated as a commitment and converted at
zero percent, while a similar commitment of
Commitments over one year would be treated as a commercial
letter of credit and converted at 20 percent.
Commitments are defined as any legally binding If a commitment facility is structured so that
arrangements that obligate a bank to extend it can be drawn down in several forms, such as
credit in the form of loans or leases; to purchase a standby letter of credit, a loan, or a commer-
loans, securities, or other assets; or to participate cial letter of credit, the entire facility should be
in loans and leases. Commitments also include treated as a commitment to extend credit in the
overdraft facilities, revolving credit, home equity form that incurs the highest capital charge.
and mortgage lines of credit, eligible ABCP Thus, if a facility could be drawn down in any of
liquidity facilities, and similar transactions. Nor- the three forms just cited, the entire facility
mally, commitments involve a written contract would be treated as a commitment to issue a
or agreement and a commitment fee, or some standby letter of credit and would be converted

Page 39
at 100 percent, rather than treated as a commit- advance notice of cancellation to the obligor or
ment to make a loan or commercial letter of which permit the commitment to roll over auto-
credit, which would have a lower conversion matically (that is, on the same terms and without
factor. a thorough credit review) unless the bank gives
notice otherwise, are not unconditionally can-
Unused commitments. Except for eligible ABCP celable. Thus, any such commitment whose
liquidity facilities,42 unused portions of commit- term from date of issuance could exceed one
ments, including underwriting commitments, and year is subject to the 50 percent conversion
commercial and consumer credit commitments factor.
that have an original maturity of one year or less A bank may issue a commitment that expires
are converted at zero percent. within one year, with the understanding that the
Unused commitments that have an original commitment will be renewed upon expiration
maturity of over one year are converted at subject to a thorough credit review of the
50 percent. For this purpose, original maturity is obligor. Such a commitment may be converted
defined as the length of time between the date at zero percent only if (1) the renegotiation
the commitment is issued and the earliest date process is carried out in good faith, involves a
on which (1) the bank has the permanent ability full credit assessment of the obligor, and allows
to, at its option, unconditionally cancel43 (with- the bank flexibility to alter the terms and con-
out cause) the commitment44 and (2) the bank is ditions of the new commitment; (2) the bank has
scheduled to (and as a normal practice actually absolute discretion to decline renewal or exten-
does) review the facility to determine whether sion of the commitment; and (3) the renegoti-
the unused commitment should be extended. (It ated commitment expires within 12 months
should be noted that the term of any loan from the time it is made. Some commitments
advances that can be made under a commitment contain unusual renegotiation arrangements that
is not taken into account in determining the would give the borrower a considerable amount
commitment’s maturity.) Under this definition of advance notice that a commitment would not
of original maturity, commitments with a nomi- be renewed. Provisions of this kind can have the
nal original maturity of more than one year can effect of creating a rolling commitment arrange-
be treated as having a maturity of one year or ment that should be treated for risk-based capital
less for risk-based capital purposes only if the purposes as a long-term commitment and should
issuing bank (1) has full and unconditional therefore be converted to a credit-equivalent
discretion to cancel the commitment without amount at 50 percent. Normally, the renegotia-
cause and without notice on each and every day tion process should take no more than six to
after the first year and (2) conducts at least eight weeks, and in many cases it should take a
annually a formal credit review of the commit- shorter period of time. The renegotiation period
ment, including an assessment of the credit should immediately precede the expiration date
quality of the obligor. of the commitment and should be reasonably
It should be noted that a bank is not deemed short and appropriate to the complexity of the
able to unconditionally cancel a commitment transaction. The reasons for provisions in a
if it is required to give, or is presumed to be commitment arrangement that would appear to
required to give, any advance notice of cancel- allow for a protracted renegotiation period should
lation. Accordingly, so-called evergreen com- be thoroughly documented by the bank and
mitments, which require the bank to give reviewed by the examiner.
As mentioned above, a commitment to make
42. Unused portions of eligible ABCP liquidity facilities
a commitment is treated as a single commitment
with an original maturity of one year of less are converted at whose maturity is the combined maturity of the
10 percent. two commitments. Although such commitments
43. A bank’s option to cancel a commitment under a whose combined maturity is in excess of one
material adverse change clause is not considered to be an
option to unconditionally cancel a commitment.
year are generally considered long-term, if the
44. In the case of consumer home equity or mortgage lines customer has a bona fide business reason for
of credit secured by liens on one- to four-family residential requesting a new commitment to supersede the
properties, the bank is deemed able to unconditionally cancel unexpired one, such as an unanticipated increase
the commitment for the purpose of this criterion if, at its
option, it can prohibit additional extensions of credit, reduce
in the volume of business or a change in the
the credit lines, and terminate the commitment to the full customer’s cash flow and credit needs, then the
extent permitted by relevant federal law. commitment would not automatically be consid-

Page 40
ered long-term. However, if the bank exhibits a following off-balance-sheet contracts:

pattern and practice of extending short-term
commitments before their expiration—either for • interest-rate contracts
one customer or more broadly within the bank— — single-currency interest-rate swaps
then such extended commitments would be — basis swaps
viewed as long-term. This treatment generally — forward rate agreements
would apply to all commitments, including tra- — interest-rate options purchased (includ-
ditional commercial paper liquidity lines. ing caps, collars, and floors purchased)
Other criteria for determining whether a — any other instrument linked to interest
facility is short- or long-term include the actual rates that gives rise to similar credit risks
level of risk associated with the transaction and (including when-issued securities and for-
whether that level of risk is more characteristic ward deposits accepted)
of a long-term (as opposed to a short-term) • exchange-rate contracts
commitment. Liquidity facilities issued in con- — cross-currency interest-rate swaps
nection with asset-backed commercial paper — forward foreign-exchange-rate contracts
programs, when judged by these criteria, seem — currency options purchased
to possess risk characteristics that are less than — any other instrument linked to exchange
those associated with typical short-term com- rates that gives rise to similar credit risks
mercial loan commitments. One of these char- • equity derivative contracts
acteristics is the short-term nature of the secu- — equity-linked swaps
ritized receivables. The receivables that are — equity-linked options purchased
securitized in asset-backed commercial paper — forward equity-linked contracts
programs tend to be of very short average — any other instrument linked to equities
maturity—often in the range of 30 to 60 days. that gives rise to similar credit risks
Advances under asset-backed commercial paper • commodity (including precious metal) deriva-
liquidity facilities generally are very rare, and tive contracts
when such advances are made, it is against pools — commodity-linked swaps
of very high-quality performing receivables that — commodity-linked options purchased
would generally liquidate very quickly. These — forward commodity-linked contracts
facilities are further protected against credit risk — any other instrument linked to commodi-
by significant amounts of overcollateralization, ties that gives rise to similar credit risks
as well as other credit enhancements. • credit derivatives
A series of short-term commitments would — credit-default swaps
generally be treated as a single commitment — total-rate-of-return swaps
whose original maturity is the combined matu- — other types of credit derivatives
rities of the individual commitments in the
series. Also, a commitment may be structured to Exceptions. Exchange-rate contracts with an
be drawn down in a number of tranches, some original maturity of 14 or fewer calendar days
exercisable in one year or less and others exer- and derivative contracts traded on exchanges
cisable in over one year. The full amount of such that require daily receipt and payment of cash-
a commitment is deemed to be over one year variation margin may be excluded from the
and converted at 50 percent. Some long-term risk-based ratio calculation. Gold contracts are
commitments may permit the customer to draw accorded the same treatment as exchange-rate
down varying amounts at different times to contracts, except that gold contracts with an
accommodate, for example, seasonal borrowing original maturity of 14 or fewer calendar days
needs. The 50 percent conversion factor should are included in the risk-based ratio calculation.
be applied to the maximum amount that could Over-the-counter options purchased are included
be drawn down under such commitments. and treated in the same way as other derivative
contracts.
Credit-Equivalent Computations for Calculation of credit-equivalent amounts. The

Derivative Contracts credit-equivalent amount of a derivative con-
tract (excluding credit derivatives) that is not
Applicable derivative contracts. Credit- subject to a qualifying bilateral netting contract
equivalent amounts are computed for each of the is equal to the sum of—

Page 41
Table 5—Conversion-Factor Matrix

Other
Foreign- Precious commodity
exchange- metals (excluding
Interest- rate (excluding precious
Remaining maturity rate and gold Equity gold) metals)
One year or less 0.0 1.0 6.0 7.0 10.0

Over one to five years 0.5 5.0 8.0 7.0 12.0
Over five years 1.5 7.5 10.0 8.0 15.0
• the current exposure (sometimes referred to as tract. A derivative contract not included in the
the replacement cost) of the contract, and definitions of interest-rate, exchange-rate, equity,
• an estimate of the potential future credit or commodity contracts is included in the risk-
exposure of the contract. based capital calculation and is subject to the
same conversion factors as a commodity, exclud-
The current exposure is determined by the ing precious metals.
mark-to-market value of the contract. If the No potential future credit exposure is calcu-
mark-to-market value is positive, then the cur- lated for a single-currency interest-rate swap in
rent exposure is equal to that mark-to-market which payments are made based on two floating-
value. If the mark-to-market value is zero or rate indexes, so-called floating/floating or basis
negative, then the current exposure is zero. swaps. The credit exposure on these contracts is
Mark-to-market values are measured in dollars, evaluated solely on the basis of their mark-to-
regardless of the currency or currencies speci- market values.
fied in the contract, and should reflect changes in
the underlying rates, prices, and indexes, as well Avoidance of double-counting. In certain cases,
as in counterparty credit quality. credit exposures arising from derivative con-
The potential future credit exposure of a tracts may be reflected, in part, on the balance
contract, including a contract with a negative sheet. To avoid double counting these exposures
mark-to-market value, is estimated by multiply- in the assessment of capital adequacy and,
ing the notional principal amount of the contract perhaps, assigning inappropriate risk weights,
by a credit-conversion factor. Banks should use, examiners may need to exclude counterparty
subject to examiner review, the effective rather credit exposures arising from the derivative
than the apparent or stated notional amount in instruments covered by the guidelines from
this calculation. The conversion factors (in per- balance-sheet assets when calculating a bank’s
cent) are in table 5. The Board has noted that risk-based capital ratios. This exclusion will
these conversion factors, which are based on eliminate the possibility that an organization
observed volatilities of the particular types of could be required to hold capital against both an
instruments, are subject to review and modifi- off-balance-sheet and on-balance-sheet amount
cation in light of changing volatilities or market for the same item. This treatment is not accorded
conditions. to margin accounts and accrued receivables
For a contract that is structured such that related to interest-rate and exchange-rate
on specified dates any outstanding exposure is contracts.
settled and the terms are reset so that the mar- The aggregate on-balance-sheet amount
ket value of the contract is zero, the remaining excluded from the risk-based capital calculation
maturity is equal to the time until the next reset is equal to the lower of—
date. Such resetting interest-rate contracts must
have a minimum conversion factor of • each contract’s positive on-balance-sheet
0.5 percent. amount, or
For a contract with multiple exchanges of • its positive market value included in
principal, the conversion factor is multiplied by the off-balance-sheet risk-based capital
the number of remaining payments in the con- calculation.

Page 42
For example, a forward contract that is marked lent location in the case of noncorporate
to market will have the same market value on entities, and if a branch of the counter-
the balance sheet as is used in calculating the party is involved, then also under the law
credit-equivalent amount for off-balance-sheet of the jurisdiction in which the branch is
exposures under the guidelines. Therefore, the located;
on-balance-sheet amount is not included in the — the law that governs the individual con-
risk-based capital calculation. When either the tracts covered by the netting contract;
contract’s on-balance-sheet amount or its mar- and
ket value is negative or zero, no deduction from — the law that governs the netting contract;
on-balance-sheet items is necessary for that • the bank establishes and maintains procedures
contract. to ensure that the legal characteristics of
If the positive on-balance-sheet asset amount netting contracts are kept under review in light
exceeds the contract’s market value, the excess of possible changes in relevant law; and
(up to the amount of the on-balance-sheet asset) • the bank maintains documentation in its files
should be included in the appropriate risk- that is adequate to support the netting of rate
weight category. For example, a purchased contracts, including a copy of the bilateral
option will often have an on-balance-sheet netting contract and necessary legal opinions.
amount equal to the fee paid until the option
expires. If that amount exceeds market value, A contract containing a walkaway clause is not
the excess of carrying value over market value eligible for netting for purposes of calculating
would be included in the appropriate risk-weight the credit-equivalent amount.
category for purposes of the on-balance-sheet By netting individual contracts for the pur-
portion of the calculation. pose of calculating credit-equivalent amounts of
derivative contracts, a bank represents that it has
Netting of swaps and similar contracts. Netting met the requirements of the risk-based measure
refers to the offsetting of positive and negative of the capital adequacy guidelines for bank
mark-to-market values in the determination of a holding companies and that all the appropriate
current exposure to be used in the calculation of documents are in the organization’s files and
a credit-equivalent amount. Any legally enforce- available for inspection by the Federal Reserve.
able form of bilateral netting (that is, netting The Federal Reserve may determine that a
with a single counterparty) of derivative con- bank’s files are inadequate or that a netting
tracts is recognized for purposes of calculating contract, or any of its underlying individual
the credit-equivalent amount provided that— contracts, may not be legally enforceable. If
such a determination is made, the netting con-
• the netting is accomplished under a written tract may be disqualified from recognition for
netting contract that creates a single legal risk-based capital purposes, or underlying indi-
obligation, covering all included individual vidual contracts may be treated as though they
contracts, with the effect that the organization are not subject to the netting contract.
would have a claim to receive, or an obliga- The credit-equivalent amount of contracts
tion to receive or pay, only the net amount of that are subject to a qualifying bilateral netting
the sum of the positive and negative mark-to- contract is calculated by adding—
market values on included individual con-
tracts if a counterparty, or a counterparty to • the current exposure of the netting contract
whom the contract has been validly assigned, (net current exposure), and
fails to perform due to default, insolvency, • the sum of the estimates of the potential future
liquidation, or similar circumstances; credit exposures on all individual contracts
• the bank obtains written and reasoned legal subject to the netting contract (gross potential
opinions that in the event of a legal challenge— future exposure), adjusted to reflect the effects
including one resulting from default, insol- of the netting contract.
vency, liquidation, or similar circumstances—
the relevant court and administrative authorities The net current exposure of the netting con-
would find the bank’s exposure to be such a tract is determined by summing all positive and
net amount under— negative mark-to-market values of the indi-
— the law of the jurisdiction in which the vidual contracts included in the netting contract.
counterparty is chartered or the equiva- If the net sum of the mark-to-market values is

Page 43
positive, then the current exposure of the netting ing bilateral netting contract to determine the
contract is equal to that sum. If the net sum of adjusted add-on for that netting contract.
the mark-to-market values is zero or negative, In the event a netting contract covers con-
then the current exposure of the netting contract tracts that are normally excluded from the risk-
is zero. The Federal Reserve may determine that based ratio calculation—for example, exchange-
a netting contract qualifies for risk-based capital rate contracts with an original maturity of 14 or
netting treatment even though certain individual fewer calendar days or instruments traded on
contracts may not qualify. In these instances, the exchanges that require daily payment and receipt
nonqualifying contracts should be treated as of cash-variation margin—an institution may
individual contracts that are not subject to the elect to either include or exclude all mark-to-
netting contract. market values of such contracts when determin-
Gross potential future exposure (Agross) is ing net current exposure, provided the method
calculated by summing the estimates of poten- chosen is applied consistently.
tial future exposure for each individual contract Examiners should review the netting of off-
subject to the qualifying bilateral netting con- balance-sheet derivative contracts used by banks
tract. The effects of the bilateral netting contract when calculating or verifying risk-based capital
on the gross potential future exposure are rec- ratios to ensure that the positions of such con-
ognized through the application of a formula tracts are reported gross, unless the net positions
that results in an adjusted add-on amount (Anet). of those contracts reflect netting arrangements
The formula, which employs the ratio of net that comply with the netting requirements listed
current exposure to gross current exposure previously.
(NGR), is expressed as—
Anet = (0.4 × Agross) + 0.6(NGR × Agross) Credit Derivatives
The NGR may be calculated in accordance with Credit derivatives are off-balance-sheet arrange-
either the counterparty-by-counterparty approach ments that allow one party (the beneficiary) to
or the aggregate approach. Under the transfer credit risk of a reference asset—which
counterparty-by-counterparty approach, the NGR the beneficiary may or may not own—to another
is the ratio of the net current exposure for a party (the guarantor).45 Many banks increas-
netting contract to the gross current exposure of ingly use these instruments to manage their
the netting contract. The gross current exposure overall credit-risk exposure. In general, credit
is the sum of the current exposures of all derivatives have three distinguishing features:
individual contracts subject to the netting con-
tract. Net negative mark-to-market values for • the transfer of the credit risk associated with a
individual netting contracts with the same coun- reference asset through contingent payments
terparty may not be used to offset net positive based on events of default and, usually, the
mark-to-market values for other netting con- prices of instruments before, at, and shortly
tracts with the same counterparty. after default (reference assets most often take
Under the aggregate approach, the NGR is the the form of traded sovereign and corporate
ratio of the sum of all the net current exposures debt instruments or syndicated bank loans)
for qualifying bilateral netting contracts to the • the periodic exchange of payments or the
sum of all the gross current exposures for those payment of a premium rather than the pay-
netting contracts (each gross current exposure is ment of fees customary with other off-balance-
calculated in the same manner as in the sheet credit products, such as letters of credit
counterparty-by-counterparty approach). Net • the use of an International Swap Derivatives
negative mark-to-market values for individual Association (ISDA) master agreement and the
counterparties may not be used to offset legal format of a derivatives contract
net positive current exposures for other
counterparties.
A bank must consistently use either the 45. Credit derivatives generally fall into three basic trans-
counterparty-by-counterparty approach or the action types: total-rate-of-return swaps, credit-default swaps,
and credit-default or credit-linked notes. For a more in-depth
aggregate approach to calculate the NGR. description of these types of credit derivatives, see the Federal
Regardless of the approach used, the NGR Reserve’s Trading and Capital-Markets Activities Manual,
should be applied individually to each qualify- section 4350.1, ‘‘Credit Derivatives,’’ as well as SR-96-17.

Page 44
For risk-based capital purposes, total-rate-of- A bank providing a guarantee through a credit
return swaps and credit-default swaps generally derivative may mitigate the credit risk associ-
should be treated as off-balance-sheet direct- ated with the transaction by entering into an
credit substitutes.46 The notional amount of a offsetting credit derivative with another
contract should be converted at 100 percent to counterparty—a so-called back-to-back posi-
determine the credit-equivalent amount to be tion. A bank that has entered into such a position
included in the risk-weighted assets of a guar- may treat the first credit derivative as being
antor.47 A bank that provides a guarantee through guaranteed by the offsetting transaction for risk-
a credit derivative transaction should assign its based capital purposes. Accordingly, the notional
credit exposure to the risk category appropriate amount of the first credit derivative may be
to the obligor of the reference asset or any assigned to the risk category appropriate to the
collateral. On the other hand, a bank that owns counterparty providing credit protection through
the underlying asset upon which effective credit the offsetting credit derivative arrangement (for
protection has been acquired through a credit example, the 20 percent risk category if the
derivative may, under certain circumstances, counterparty is an OECD bank).
assign the unamortized portion of the underlying In some instances, the reference asset in the
asset to the risk category appropriate to the credit derivative transaction may not be identi-
guarantor (for example, the 20 percent risk cal to the underlying asset for which the bene-
category if the guarantor is an OECD bank). ficiary has acquired credit protection. For exam-
Whether the credit derivative is considered an ple, a credit derivative used to offset the credit
eligible guarantee for purposes of risk-based exposure of a loan to a corporate customer may
capital depends on the actual degree of credit use as the reference asset a publicly traded
protection. The amount of credit protection corporate bond of that customer, with the credit
actually provided by a credit derivative may be quality of the bond serving as a proxy for the
limited depending on the terms of the arrange- on-balance-sheet loan. In such a case, the under-
ment. In this regard, for example, a relatively lying asset would still generally be considered
restrictive definition of a default event or a guaranteed for capital purposes, as long as both
materiality threshold that requires a comparably the underlying asset and the reference asset are
high percentage of loss to occur before the obligations of the same legal entity and have the
guarantor is obliged to pay could effectively same level of seniority in bankruptcy. In addi-
limit the amount of credit risk actually trans- tion, a bank offsetting credit exposure in this
ferred in the transaction. If the terms of the manner would be obligated to demonstrate to
credit derivative arrangement significantly limit examiners that (1) there is a high degree of
the degree of risk transference, then the benefi- correlation between the two instruments; (2) the
ciary bank cannot reduce the risk weight of the reference instrument is a reasonable and suffi-
‘‘protected’’ asset to that of the guarantor bank. ciently liquid proxy for the underlying asset so
On the other hand, even if the transfer of credit that the instruments can be reasonably expected
risk is limited, a bank providing limited credit to behave in a similar manner in the event of
protection through a credit derivative should default; and (3) at a minimum, the reference
hold appropriate capital against the underlying asset and underlying asset are subject to mutual
exposure while it is exposed to the credit risk of cross-default provisions. A bank that uses a
the reference asset. credit derivative that is based on a reference
asset that differs from the protected underlying
asset must document the credit derivative being
used to offset credit risk, and must link it
46. Unlike total-rate-of-return swaps and credit-default directly to the asset or assets whose credit risk
swaps, credit-linked notes are on-balance-sheet assets or the transaction is designed to offset. The docu-
liabilities. A guarantor bank should assign the on-balance- mentation and the effectiveness of the credit
sheet amount of the credit-linked note to the risk category
appropriate to either the issuer or the reference asset, which-
derivative transaction are subject to examiner
ever is higher. For a beneficiary bank, cash consideration review. A bank providing credit protection
received in the sale of the note may be considered as collateral through such an arrangement must hold capital
for risk-based capital purposes. against the risk exposures that are assumed.
47. A guarantor bank that has made cash payments repre-
senting depreciation on reference assets may deduct such
Some credit derivative transactions provide
payments from the notional amount when computing credit- credit protection for a group or basket of refer-
equivalent amounts for capital purposes. ence assets and call for the guarantor to absorb

Page 45
losses on only the first asset in the group that facilities, letters of credit, banker’s acceptances,
defaults. Once the first asset in the group defaults, or other asset-backed securities. In a typical
the credit protection for the remaining assets CLO transaction, the sponsoring banking orga-
covered by the credit derivative ceases. If nization (SBO) transfers the loans and other
examiners determine that the credit risk for the assets to a bankruptcy-remote special-purpose
basket of assets has effectively been transferred vehicle (SPV), which then issues asset-backed
to the guarantor and the beneficiary banking securities consisting of one or more classes of
organization owns all of the reference assets debt. This type of transaction represents a
included in the basket, then the beneficiary may so-called cash-flow CLO. It enables the spon-
assign the asset with the smallest dollar amount soring institution (SI) to reduce its leverage and
in the group—if less than or equal to the risk-based capital requirements, improve its
notional amount of the credit derivative—to the liquidity, and manage credit concentrations.
risk category appropriate to the guarantor. Con- The first synthetic CLO (issued in 1997) used
versely, a bank extending credit protection credit-linked notes (CLNs).49 Rather than trans-
through a credit derivative on a basket of assets ferring assets to the SPV, the sponsoring bank
must assign the contract’s notional amount of issued CLNs to the SPV, individually referenc-
credit exposure to the highest risk category ing the payment obligation of a particular com-
appropriate to the assets in the basket. pany, or ‘‘reference obligor.’’ The notional
In addition to holding capital against credit amount of the CLNs issued equaled the dollar
risk, a bank that is subject to the market-risk rule amount of the reference assets the sponsor was
(see ‘‘Market-Risk Measure’’ earlier in this hedging on its balance sheet. Other structures
section) must hold capital against market risk have evolved that use credit-default swaps to
for credit derivatives held in its trading account. transfer credit risk and create different levels of
(For a description of market-risk capital require- risk exposure, but that hedge only a portion of
ments for credit derivatives, see SR-97-18.) the notional amount of the overall reference
portfolio.50
Traditional CLO structures usually transfer
Using Credit Derivatives assets into the SPV. In synthetic securitizations,
to Synthetically Replicate Collateralized the underlying exposures that make up the
Loan Obligations reference portfolio remain in the institution’s
banking book.51 The credit risk is transferred
Credit derivatives can be used to synthetically into the SPV through credit-default swaps or
replicate collateralized loan obligations (CLOs). CLNs. The institution is thus able to maintain
Banking organizations (BOs) can use CLOs and client confidentiality and avoid sensitive
their synthetic variants to manage their balance client-relationship issues that arise from loan-
sheets and, in some instances, transfer credit risk transfer-notification requirements, loan-
to the capital markets. Such transactions allow assignment provisions, and loan-participation
economic capital to be more efficiently allo- restrictions.
cated, resulting in, among other things, improved Corporate credits are assigned to the 100 per-
shareholders’ returns. cent risk-weighted asset category. In the case of
The issue for BOs is how synthetic CLOs high-quality investment-grade corporate expo-
should be treated under the risk-based and sures, the associated 8 percent capital require-
leverage capital guidelines.48 Supervisors and ment may exceed the economic capital that the
examiners need to fully understand these com- sponsoring bank sets aside to cover the credit
plex structures and identify the relative degree
of transference and retention of the securitized 49. CLNs are obligations whose principal repayment is
portfolio’s credit risk. They must determine conditioned upon the performance of a referenced asset or
whether the institution’s regulatory capital is portfolio. The assets’ performance may be based on a variety
of measures, such as movements in price or credit spread, or
adequate given the retained credit exposures. the occurrence of default.
A CLO is an asset-backed security that is 50. A credit-default swap is similar to a financial standby
usually supported by a variety of assets, includ- letter of credit in that the institution writing the swap provides,
ing whole commercial loans, revolving-credit for a fee, credit protection against credit losses associated with
a default on a specified reference asset or pool of assets.
51. ‘‘Banking book’’ refers to nontrading accounts. See the
48. See SR-99-32 and its November 15, 1999, attachment, definition of ‘‘trading accounts’’ in the glossary for the
an FRB-OCC capital interpretation on synthetic CLOs. instructions to the bank Call Report.

Page 46
Figure 1—Transaction 1
Bank SPV $1.5 billion

$1.5 billion cash cash proceeds
$1.5 billion proceeds Holds portfolio
credit portfolio of CLNs
$1.5 billion
of CLNs
issued by
bank
$1.5 billion
of notes
X-year Y-year
notes notes
risk of the transaction. Therefore, one of the In the example shown in figure 1, this amount is
apparent motivations behind CLOs and other $1.5 billion.
securitizations is to more closely align the SI’s If any obligor linked to a CLN in the SPV
regulatory capital requirements with the eco- defaults, the SI will call the individual CLN and
nomic capital required by the market. redeem it based on the repayment terms speci-
Synthetic CLOs can raise questions about fied in the note agreement. The term of each
their capital treatment when calculating the CLN is set so that the credit exposure (to which
risk-based and leverage capital ratios. Capital it is linked) matures before the maturity of the
treatments for three synthetic CLO transactions CLN, which ensures that the CLN will be in
follow. They are discussed from the perspective place for the full term of the exposure to which
of the investors and the SBOs. it is linked.
An investor in the notes issued by the SPV is
Transaction 1—Entire notional amount of the exposed to the risk of default of the underlying
reference portfolio is hedged. In the first type of reference assets, as well as to the risk that the SI
synthetic securitization, the SBO, through a will not repay principal at the maturity of the
synthetic CLO, hedges the entire notional amount notes. Because of the linkage between the credit
of a reference-asset portfolio. An SPV acquires quality of the SI and the issued notes, a down-
the credit risk on a reference portfolio by pur- grade of the sponsor’s credit rating most likely
chasing CLNs issued by the SBO. The SPV will result in the notes also being downgraded.
funds the purchase of the CLNs by issuing a Thus, a BO investing in this type of synthetic
series of notes in several tranches to third-party CLO should assign the notes to the higher of the
investors. The investor notes are in effect col- risk categories appropriate to the underlying
lateralized by the CLNs. Each CLN represents reference assets or the issuing entity.
one obligor and the bank’s credit-risk exposure For purposes of risk-based capital, the SBOs
to that obligor, which could take the form of may treat the cash proceeds from the sale of
bonds, commitments, loans, and counterparty CLNs that provide protection against underlying
exposures. Since the noteholders are exposed to reference assets as cash collateralizing these
the full amount of credit risk associated with the assets.52 This treatment would permit the refer-
individual reference obligors, all of the credit
risk of the reference portfolio is shifted from the
52. The CLNs should not contain terms that would signifi-
sponsoring bank to the capital markets. The cantly limit the credit protection provided against the under-
dollar amount of notes issued to investors equals lying reference assets, for example, a materiality threshold
the notional amount of the reference portfolio. that requires a relatively high percentage of loss to occur

Page 47
ence assets, if carried on the SI’s books, to be In the structure illustrated in figure 2, the
assigned to the zero percent risk category to the SBO purchases default protection from an SPV
extent that their notional amount is fully collat- for a specifically identified portfolio of banking-
eralized by cash. This treatment may be applied book credit exposures, which may include let-
even if the cash collateral is transferred directly ters of credit and loan commitments. The credit
into the general operating funds of the institu- risk on the identified reference portfolio (which
tion and is not deposited in a segregated account. continues to remain in the sponsor’s banking
The synthetic CLO would not confer any bene- book) is transferred to the SPV through the use
fits to the SBO for purposes of calculating its of credit-default swaps. In exchange
tier 1 leverage ratio because the reference assets for the credit protection, the SI pays the SPV
remain on the organization’s balance sheet. an annual fee. The default swaps on each of the
obligors in the reference portfolio are struc-
Transaction 2—High-quality, senior risk posi- tured to pay the average default losses on all
tion in the reference portfolio is retained. In the senior unsecured obligations of defaulted
second type of synthetic CLO transaction, the borrowers.
SBO hedges a portion of the reference portfolio To support its guarantee, the SPV sells CLNs
and retains a high-quality, senior risk position to investors and uses the cash proceeds to
that absorbs only those credit losses in excess of purchase U.S. government Treasury notes. The
the junior-loss positions. In some recent syn- SPV then pledges the Treasuries to the SBO to
thetic CLOs, the SBO has used a combination of cover any default losses.53 The CLNs are often
credit-default swaps and CLNs to essentially issued in multiple tranches of differing seniority
transfer to the capital markets the credit risk of and in an aggregate amount that is significantly
a designated portfolio of the organization’s credit less than the notional amount of the reference
exposures. Such a transaction allows the SI to portfolio. The amount of notes issued typically
allocate economic capital more efficiently and to is set at a level sufficient to cover some multiple
significantly reduce its regulatory capital of expected losses, but well below the notional
requirements. amount of the reference portfolio being hedged.
before CLN payments are adversely affected, or a structuring 53. The names of corporate obligors included in the refer-
of CLN post-default payments that does not adequately pass ence portfolio may be disclosed to investors in the CLNs.
through credit-related losses on the reference assets to inves-
tors in the CLNs.
Default payment and

pledge of Treasuries
Bank SPV
$5 billion Holds $400 million

credit portfolio $5 billion of credit-default swaps of pledged Treasuries
and annual fee
$400 million $400 million

of CLNs of cash
Senior
notes
Junior
notes

Page 48
There may be several levels of loss in this tion of its retained senior position in the refer-
type of synthetic securitization. The first-loss ence portfolio to the 20 percent risk weight.
position may consist of a small cash reserve, However, to the extent that the reference port-
sufficient to cover expected losses. The cash folio includes loans and other on-balance-sheet
reserve accumulates over a period of years and assets, an SBO involved in such a synthetic
is funded from the excess of the SPV’s income securitization would not realize any benefits in
(that is, the yield on the Treasury securities plus the determination of its leverage ratio.
the credit-default-swap fee) over the interest In addition to the three stringent minimum
paid to investors on the notes. The investors in conditions, the Federal Reserve may impose
the SPV assume a second-loss position through other requirements as it deems necessary to
their investment in the SPV’s senior and junior ensure that the SI has virtually eliminated all of
notes, which tend to be rated AAA and BB, its credit exposure. Furthermore, the Federal
respectively. Finally, the SBO retains a high- Reserve retains the discretion to increase the
quality, senior risk position that would absorb risk-based capital requirement assessed against
any credit losses in the reference portfolio that the retained senior exposure in these structures,
exceed the first- and second-loss positions. if the underlying asset pool deteriorates
Typically, no default payments are made until significantly.
the maturity of the overall transaction, regard- Federal Reserve staff will make a case-by-
less of when a reference obligor defaults. While case determination, based on a qualitative review,
operationally important to the SBO, this feature as to whether the senior retained portion of an
has the effect of ignoring the time value of SBO’s synthetic securitization qualifies for the
money. Thus, the Federal Reserve expects that 20 percent risk weight. The SI must be able to
when the reference obligor defaults under the demonstrate that virtually all the credit risk of
terms of the credit derivative and when the the reference portfolio has been transferred from
reference asset falls significantly in value, the the banking book to the capital markets. As they
SBO should, in accordance with GAAP, make do when BOs are engaging in more traditional
appropriate adjustments in its regulatory reports securitization activities, examiners must care-
to reflect the estimated loss that takes into fully evaluate whether the institution is fully
account the time value of money. capable of assessing the credit risk it retains in
For risk-based capital purposes, BOs invest- its banking book and whether it is adequately
ing in the notes must assign them to the risk capitalized given its residual risk exposure. The
weight appropriate to the underlying reference Federal Reserve will require the SBO to main-
assets.54 The SBO for such transactions must tain higher levels of capital if it is not deemed to
include in its risk-weighted assets its retained be adequately capitalized given the retained
senior exposure in the reference portfolio, to the residual risks. In addition, an SI involved in
extent these underlying assets are held in its synthetic securitizations must adequately dis-
banking book. The portion of the reference close to the marketplace the effect of the trans-
portfolio that is collateralized by the pledged action on its risk profile and capital adequacy.
Treasury securities may be assigned a zero The Federal Reserve may consider an SBO’s
percent risk weight. Unless the SBO meets the failure to require the investors in the CLNs to
stringent minimum conditions for transaction 2 absorb the credit losses that they contractually
that are outlined in the minimum conditions agreed to assume to be an unsafe and unsound
explanation below, the remainder of the port- banking practice. In addition, such a failure
folio should be risk-weighted according to the generally would constitute ‘‘implicit recourse’’
obligor of the exposures. or support to the transaction, which would result
When the SI has virtually eliminated its in the SBO’s losing preferential capital treat-
credit-risk exposure to the reference portfolio ment on its retained senior position.
through the issuance of CLNs, and when the If an SBO of a synthetic securitization does
other stringent minimum conditions are met, the not meet the stringent minimum conditions, it
institution may assign the uncollateralized por- may still reduce the risk-based capital require-
ment on the senior risk position retained in the
54. Under this type of transaction, if a structure exposes banking book by transferring the remaining
investing BOs to the creditworthiness of a substantive issuer,
for example, the SI, then the investing institutions should
credit risk to a third-party OECD bank through
assign the notes to the higher of the risk categories appropriate the use of a credit derivative. Provided the credit
to the underlying reference assets or the SI. derivative transaction qualifies as a guarantee

Page 49
under the risk-based capital guidelines, the risk other credit enhancements—which effec-
weight on the senior position may be reduced tively must be deducted from capital—is
from 100 percent to 20 percent. Institutions may no greater than a reasonable estimate of
not enter into nonsubstantive transactions that expected losses on the reference portfolio;
transfer banking-book items into the trading and
account to obtain lower regulatory capital — ensure that the SI does not reassume any
requirements.55 credit risk beyond the first-loss position
through another credit derivative or any
Minimum conditions. The following stringent other means.
minimum conditions are those that SIs must • Condition 2—Demonstration of ability to
meet to use the synthetic securitization capital evaluate remaining banking-book risk expo-
treatment for transaction 2. The Federal Reserve sures and provide adequate capital support.
may impose additional requirements or condi- To ensure that the SI has adequate capital for
tions as deemed necessary to ascertain that the the credit risk of its unhedged exposures, an
SBO has sufficiently isolated itself from the institution is expected to have adequate sys-
credit-risk exposure of the hedged reference tems that fully account for the effect of those
portfolio. transactions on its risk profiles and capital
adequacy. In particular, its systems should be
• Condition 1—Demonstration of transfer of capable of fully differentiating the nature and
virtually all of the risk to third parties. Not all quality of the risk exposures an institution
transactions structured as synthetic securitiza- transfers from the nature and quality of the
tions transfer the level of credit risk needed to risk exposures it retains. Specifically, to gain
receive the 20 percent risk weight on the capital relief institutions are expected to—
retained senior position. To demonstrate that a — have a credible internal process for grad-
transfer of virtually all of the risk has been ing credit-risk exposures, including
achieved, institutions must— (1) adequate differentiation of risk among
— produce credible analyses indicating a risk grades, (2) adequate controls to
transfer of virtually all of the credit risk to ensure the objectivity and consistency of
substantive third parties; the rating process, and (3) analysis or
— ensure the absence of any early- evidence supporting the accuracy or
amortization or other credit performance– appropriateness of the risk-grading system;
contingent clauses;56 — have a credible internal economic capital-
— subject the transaction to market discipline assessment process that defines the insti-
through the issuance of a substantive tution to be adequately capitalized at an
amount of notes or securities to the capital appropriate insolvency probability and that
markets; readjusts, as necessary, its internal eco-
— have notes or securities rated by a nation- nomic capital requirements to take into
ally recognized credit rating agency; account the effect of the synthetic-
— structure a senior class of notes that securitization transaction. In addition, the
receives the highest possible investment- process should employ a sufficiently long
grade rating, for example, AAA, from a time horizon to allow necessary adjust-
nationally recognized credit rating agency; ments in the event of significant losses.
— ensure that any first-loss position retained The results of an exercise demonstrating
by the SI in the form of fees, reserves, or that the organization is adequately capital-
ized after the securitization transaction
55. For instance, a lower risk weight would not be applied must be presented for examiner review;
to a nonsubstantive transaction in which the SI (1) enters into — evaluate the effect of the transaction on the
a credit derivative transaction to pass the credit risk of the nature and distribution of the nontrans-
senior retained portion held in its banking book to an OECD
bank and then (2) enters into a second credit derivative
ferred banking-book exposures. This analy-
transaction with the same OECD bank, in which it reassumes sis should include a comparison of the
into its trading account the credit risk initially transferred. banking book’s risk profile and economic
56. Early-amortization clauses may generally be defined as capital requirements before and after the
features that are designed to force a wind-down of a securi-
tization program and rapid repayment of principal to asset-
transaction, including the mix of expo-
backed securities investors if the credit quality of the under- sures by risk grade and business or eco-
lying asset pool deteriorates significantly. nomic sector. The analysis should also

Page 50
identify any concentrations of credit risk 10-K and annual reports, SIs must adequately
and maturity mismatches. Additionally, disclose to the marketplace the accounting,
the bank must adequately manage and economic, and regulatory consequences of
control the forward credit exposure that synthetic CLO transactions. In particular,
arises from any maturity mismatch. The institutions are expected to disclose—
Federal Reserve retains the flexibility to — the notional amount of loans and commit-
require additional regulatory capital if the ments involved in the transaction;
maturity mismatches are substantive — the amount of economic capital shed
enough to raise a supervisory concern. through the transaction;
Moreover, as stated above, the SBO must — the amount of reduction in risk-weighted
demonstrate that it meets its internal eco- assets and regulatory capital resulting from
nomic capital requirement subsequent to the transaction, both in dollar terms and in
the completion of the synthetic securitiza- terms of the effect in basis points on the
tion; and risk-based capital ratios; and
— perform rigorous and robust forward- — the effect of the transaction on the distri-
looking stress testing on nontransferred bution and concentration of risk in the
exposures (remaining banking-book loans retained portfolio by risk grade and sector.
and commitments), transferred exposures,
and exposures retained to facilitate trans- Transaction 3—Retention of a first-loss position.
fers (credit enhancements). The stress tests In the third type of synthetic transaction, the
must demonstrate that the level of credit SBO may retain a subordinated position that
enhancement is sufficient to protect the absorbs first losses in a reference portfolio. The
sponsoring bank from losses under SBO retains the credit risk associated with a
scenarios appropriate to the specific first-loss position and, through the use of credit-
transaction. default swaps, passes the second- and senior-
• Condition 3—Provide adequate public disclo- loss positions to a third-party entity, most often
sures of synthetic CLO transactions regarding an OECD bank. The third-party entity, acting as
their risk profile and capital adequacy. In their an intermediary, enters into offsetting credit-
Credit-default-swap
fee (basis points per year)
SPV
Intermediary
OECD Bank Holds $400 million
Default payment and of pledged Treasuries
pledge of Treasuries
Default payment
$400 million $400 million
and pledge of
of CLNs of cash
Treasuries equal
Credit-default-
to $400 million to
swap fee
cover losses above
1% of the Senior
reference assets notes
Sponsoring
Bank
Junior
$5 billion credit notes
portfolio

Page 51
default swaps with an SPV, thus transferring its It is possible that the second approach may
credit risk associated with the second-loss posi- result in a higher risk-based capital requirement
tion to the SPV.57 The SPV then issues CLNs to than the dollar-for-dollar capital charge imposed
the capital markets for a portion of the reference by the first approach. This depends on whether
portfolio and purchases Treasury collateral to the reference portfolio consists primarily of
cover some multiple of expected losses on the loans to private obligors or of undrawn long-
underlying exposures. (See figure 3.) term commitments, which generally have an
Two alternative approaches could be used to effective risk-based capital requirement that is
determine how the SBO should treat the overall one-half of the requirement for loans, since such
transaction for risk-based capital purposes. The commitments are converted to an on-balance-
first approach employs an analogy to the low- sheet credit-equivalent amount using the 50 per-
level capital rule for assets sold with recourse. cent conversion factor. If the reference pool
Under this rule, a transfer of assets with recourse consists primarily of drawn loans to private
that contractually is limited to an amount less obligors, then the capital requirement on the
than the effective risk-based capital require- senior loss position would be significantly higher
ments for the transferred assets is assessed a than if the reference portfolio contained only
total capital charge equal to the maximum undrawn long-term commitments. As a result,
amount of loss possible under the recourse the capital charge for the overall transaction
obligation. If this rule was applied to an SBO could be greater than the dollar-for-dollar capi-
retaining a 1 percent first-loss position on a tal requirement set forth in the first approach.
synthetically securitized portfolio that would SIs will be required to hold capital against a
otherwise be assessed 8 percent capital, the SBO retained first-loss position in a synthetic securi-
would be required to hold dollar-for-dollar capi- tization equal to the higher of the two capital
tal against the 1 percent first-loss risk position. charges resulting from application of the first
The SI would not be assessed a capital charge and second approaches, as discussed above.
against the second and senior risk positions.58 Further, although the SBO retains only the credit
The second approach employs a literal read- risk associated with the first-loss position, it still
ing of the capital guidelines to determine the should continue to monitor all the underlying
SBO’s risk-based capital charge. In this instance, credit exposures of the reference portfolio to
the one percent first-loss position retained by the detect any changes in the credit-risk profile of
SI would be treated as a guarantee, that is, a the counterparties. This is important to ensure
direct-credit substitute, which would be assessed that the institution has adequate capital to pro-
an 8 percent capital charge against its face value tect against unexpected losses. Examiners should
of one percent. The second-loss position, which determine whether the sponsoring bank has the
is collateralized by Treasury securities, would capability to assess and manage the retained risk
be viewed as fully collateralized and subject to a in its credit portfolio after the synthetic securi-
zero percent capital charge. The senior-loss tization is completed. For risk-based capital
position guaranteed by the intermediary bank purposes, BOs investing in the notes must assign
would be assigned to the 20 percent risk cate- them to the risk weight appropriate to the
gory appropriate to claims guaranteed by OECD underlying reference assets.60
banks.59
57. Because the credit risk of the senior position is not

Reservation of Authority
transferred to the capital markets but remains with the
intermediary bank, the SBO should ensure that its counter- The Federal Reserve reserves its authority to
party is of high credit quality, for example, at least investment determine, on a case-by-case basis, the appro-
grade. priate risk weight for assets and credit-equivalent
58. A BO that sponsors this type of synthetic securitization
would not realize any benefits with respect to the determina-
tion of its leverage ratio since the reference assets remain on
the SI’s balance sheet. would be subject to the standardized specific-risk capital
59. If the intermediary is a BO, then it could place both sets charge.
of credit-default swaps in its trading account and, if subject to 60. Under this type of transaction, if a structure exposes
the Federal Reserve’s market-risk capital rules, use its general- investing BOs to the creditworthiness of a substantive issuer,
market-risk model and, if approved, specific-risk model to for example, the SI, then the investing institutions should
calculate the appropriate risk-based capital requirement. If the assign the notes to the higher of the risk categories appropriate
specific-risk model has not been approved, then the SBO to the underlying reference assets or the SI.

Page 52
amounts and the appropriate credit-conversion Certain agency securities-lending arrangements

factor for off-balance-sheet items. The Federal (May 2003 exception for ‘‘cash-collateral trans-
Reserve’s exercise of this authority may result actions’’). In response to a bank’s inquiry, the
in a higher or lower risk weight for an asset Board issued a May 14, 2003, interpretation for
or credit-equivalent amount, or in a higher or the risk-based capital treatment of certain Euro-
lower credit-conversion factor for an off- pean agency securities’ lending arrangements in
balance-sheet item. This reservation of authority which the bank, acting as agent, lends securities
explicitly recognizes that the Federal Reserve of a client and receives cash collateral from the
retains sufficient discretion to ensure that banks, borrower. The transaction is marked-to-market
as they develop novel financial assets, will daily and a positive margin of cash collateral
be treated appropriately under the regulatory relative to the market value of the securities lent
capital standards. Under this authority, the Fed- is maintained at all times. If the borrowing
eral Reserve reserves its right to assign risk counterparty defaults on the securities loaned
positions in securitizations to appropriate risk through, for example, failure to post margin
categories on a case-by-case basis, if the credit when required, the transaction is immediately
rating of the risk position is determined to be terminated and the cash collateral is used by the
inappropriate. bank to repurchase in the market the securities
lent in order to restore them to the client. The
bank indemnifies its client against the risk that,
in the event of counterparty default, the amount
Board Approved Exceptions to Risk-Based of cash collateral may be insufficient to repur-
Capital Guidelines (Reservation of chase the amount of securities lent. Thus, the
Authority) Involving Securities Lending indemnification is limited to the difference
between the value of the cash collateral and the
Securities lent by a bank are treated in one of repurchase price of the replacement securities.
two ways, depending upon whether the lender In addition, the bank, again acting as agent,
is at risk of loss. If a bank, as agent for a cus- reinvests, on the client’s behalf, the cash collat-
tomer, lends the customer’s securities and does eral received from the borrower. The reinvest-
not indemnify the customer against loss, then ment transaction takes the form of a cash loan to
the transaction is excluded from the risk-based a counterparty that is fully collateralized by
capital calculation. Alternatively, if a bank government or corporate securities (through, for
lends its own securities or, acting as agent for a example, a reverse repurchase agreement). Like
customer, lends the customer’s securities and the first transaction, the reinvestment transaction
indemnifies the customer against loss, the is subject to daily marking-to-market and remar-
transaction is converted at 100 percent and gining and is immediately terminable in the
assigned to the risk-weight category appropri- event of counterparty default. The bank issues
ate to the obligor, or, if applicable, to any col- an indemnification to the client against the
lateral delivered to the lending bank or the reinvestment risk, which is similar to the indem-
independent custodian acting on the lending nification the bank gives on the original
bank’s behalf. When a bank is acting as agent securities-lending transaction.
for a customer in a transaction involving the The Federal Reserve Board’s current risk-
lending or sale of securities that is collateral- based capital guidelines treat indemnifications
ized by cash delivered to the bank, the transac- issued in connection with agency securities-
tion is deemed to be collateralized by cash on lending activities as off-balance-sheet guaran-
deposit for purposes of determining the appro- tees that are subject to capital charges. Under the
priate risk-weight category, provided that guidelines, the bank’s first indemnification would
(1) any indemnification is limited to no more receive the risk weight of the securities-
than the difference between the market value of borrowing counterparty because of the bank’s
the securities and the cash collateral received indemnification of the client’s reinvestment risk
and (2) any reinvestment risk associated with on the cash collateral. (See 12 CFR 208, appen-
that cash collateral is borne by the customer. dix A, section III.D.1.c.) The bank’s second
See the ‘‘Risk-Weighting Process’’ discussion indemnification would receive the lower of the
in this section and also the discussion in sec- risk weight of the reverse repurchase counter-
tion 2030.1 on bank dealer securities-lending or party or the collateral, unless it was fully collat-
-borrowing transactions. eralized with margin by OECD government

Page 53
securities, which would qualify for a zero per- unsecured loan equivalent amount will be
cent risk weight. (See 12 CFR 208, appendix A, assigned the risk weight appropriate to the
sections III.D.1.a. and b.) counterparty.
The bank inquired about the possibility of To determine the unsecured loan equivalent
assigning a zero percent risk weight for both amount, the bank must add together its current
indemnifications, given the low risk they pose to exposure to the counterparty and a measure for
the bank. The Board approved an exception to potential future exposure (PFE) to the counter-
its risk-based capital guidelines for the bank’s party. The current exposure is the sum of the
agency securities-lending transactions. The Board market value of all securities and cash lent to the
approved this exception under the reservation of counterparty under the bank’s indemnified
authority provision contained in the guidelines. arrangements, less the sum of all securities and
This provision permits the Board, on a case-by- cash received from the counterparty as collateral
case basis, to determine the appropriate risk under the indemnified arrangements. The PFE
weight for any asset or off-balance-sheet item calculation is to be based on the market volatili-
that imposes risks on a bank that are incommen- ties of the securities lent and the securities
surate with the risk weight otherwise specified received, as well as any foreign exchange rate
in the guidelines. (See 12 CFR 208, appendix A, volatilities associated with any cash or securities
section III.A.) lent or received.
This exception applies to the bank’s agency The Board considered two methods for incor-
securities-lending transactions collateralized by porating market volatilities into the PFE calcu-
cash where the bank indemnifies its client lation: (1) the bank’s own estimates of those
against (1) the risk that, in the event of default volatilities based on a year’s historical observa-
by the securities borrower, the amount of cash tion of market prices with no recognition of
collateral may be insufficient to repurchase the correlation effects or (2) a value-at-risk (VaR)
amount of securities lent and (2) the reinvest- type model. The bank was calculating daily,
ment risk associated with lending the cash counterparty VAR estimates for its agency lend-
collateral in a transaction fully collateralized by ing transactions and it had a VaR model that had
securities (for example, in a reverse repur- been approved for purposes of the Board’s
chase transaction). market risk rule. The Board determined that the
The capital treatment the Board approved for bankt could use a VaR model to calculate the
these transactions relies upon an economic mea- PFE for each of its counterparties.
surement of the amount of risk exposure the The bank must calculate the VaR using a
bank has to each of its counterparties. Under this five-day holding period and a 99th percentile
approved approach, the bank does not use the one-tailed confidence interval based on market
notional amount of underlying transactions that price data over a one-year historical observa-
are subject to client indemnifications as the tion period. The data set used should be updated
exposure amount for risk-based capital pur- no less frequently than once every three months
poses. Rather, the bank must use an economic and should be reassessed whenever market
exposure amount that takes into account the prices are subject to material changes. For each
market value of collateral and the market price counterparty, the bank is required to calculate
volatilities of (1) the instruments delivered by daily an unsecured loan equivalent amount,
the bank to the counterparty and (2) the instru- including the VaR PFE component. These
ments received by the bank from the counter- calculations will be subject to supervisory
party. This approach builds on best practices of review to ensure they are in line with the
banks for measuring their credit exposure quarter-end calculations used to determine
amounts for purposes of managing internal regulatory capital requirements.
single-borrower exposure limits, as well as upon To qualify for the capital treatment outlined
existing concepts incorporated in the Basel above, the securities-lending and cash loan trans-
Accord and the Board’s risk-based capital and actions covered by the bank’s indemnification
market risk rules. The bank, under this excep- must meet the following conditions:
tion, is required to determine an unsecured loan
equivalent amount for each of the counterparties • the transactions are fully collateralized
to which, as agent, the bank lends securities • any securities lent or taken as collateral are
collateralized by cash or lends cash collateral- eligible for inclusion in the trading book and
ized by securities. As described below, the are liquid and readily marketable

Page 54
• any securities lent or taken as collateral are request and receive Board approval for such
marked-to-market daily treatment.
• the transactions are subject to a daily margin
maintenance requirement Certain agency securities-lending arrangements
(August 2006 exception for ‘‘securities-collateral
Further, the transactions must be executed transactions’’). In response to an inquiry made
under a bilateral netting agreement or an equiva- by a bank, a Board interpretation was issued on
lent arrangement. These arrangements must August 15, 2006, which discussed the regulatory
(1) provide the non-defaulting party the right to capital treatment of certain securities-lending
promptly terminate and close out all transactions transactions. In these transactions, the bank,
under the agreement upon an event of default, acting as agent for its clients, lends its clients’
including insolvency or bankruptcy of the coun- securities and receives liquid securities collat-
terparty; (2) provide for the netting of gains and eral in return (the securities-collateral transac-
losses on transactions (including the value of tions).61 Each securities loan is marked-to-
any collateral) terminated and closed out under market daily, and the bank calls for additional
the agreement so that a single net amount is margin as needed to maintain a positive margin
owed by one party to the other; (3) allow for the of collateral relative to the market value of the
prompt liquidation or setoff of collateral upon securities lent at all times. The bank also agrees
the occurrence of an event of default; (4) be to indemnify its clients against the risk that, in
conducted, together with the rights arising from the event of borrower default, the market value
the conditions required in provisions 1 and 3 of the securities collateral is insufficient to
above, under documentation that is legally bind- repurchase the amount of securities lent.
ing on all parties and legally enforceable in each If the borrower were to default, the bank
relevant jurisdiction upon the occurrence of an would be in a position to terminate a securities-
event of default and regardless of the counter- collateral transaction and sell the collateral in
party’s insolvency or bankruptcy; and (5) be order to purchase securities to replace the secu-
conducted under documentation for which the rities that were originally lent. The bank’s expo-
bank has completed sufficient legal review to sure under a securities-collateral transaction
verify it meets provision 4 above and for which would be limited to the difference between the
the bank has a well-founded legal basis for purchase price of the replacement securities and
reaching this conclusion. the market value of the securities collateral.
With regard to the counterparty VaR model The bank requested that the Federal Reserve
that the bank uses, the bank is required to Board approve another exception to the capital
conduct regular and rigorous backtesting proce- guidelines that would permit the bank to mea-
dures, subject to supervisory review, to ensure sure its exposure amounts for risk-based capital
the validity of the correlation factors used by the purposes with respect to the securities-collateral
bank and the stability of these factors over time. transactions under the methodology of the bank’s
The bank was not subject to a formal backtest- prior May 14, 2003, approval (the prior approval).
ing procedure requirement at the time the letter The Board, again, determined that, under its
was issued. However, if supervisory review current risk-based capital guidelines, the capital
determines that the bank’s counterparty VaR charges for these securities-lending arrange-
model or its backtesting procedures have mate- ments would exceed the amount of economic
rial deficiencies and the bank does not take risk posed to the bank, which would result in
appropriate and expeditious steps to rectify those capital charges that would be significantly out of
deficiencies, supervisors may take action to proportion to the risk posed. The Board there-
adjust the bank’s capital calculations. Such action fore approved an August 15, 2006, exception to
could range from imposing a multiplier on the its risk-based capital guidelines according to the
VaR estimates of PFE calculated by the bank to prior approval, allowing the bank to compute its
disallowing the use of its counterparty VaR regulatory capital for these transactions using a
model and requiring use of the own estimates loan-equivalent methodology. In so doing, the
approach to determine the PFE component of bank would assign the risk weight of the coun-
the unsecured loan equivalent amounts. terparty to the exposure amount of all such
The capital treatment that the Board ap-
proved in the letter has been and will be made 61. The liquid securities collateral includes government
agency, government-sponsored entity, corporate debt or equity,
available to similarly situated institutions that or asset-backed or mortgage-backed securities.

Page 55
transactions with the counterparty. Specifically, ment, funding sources, capital formation, man-
the Board granted the bank its request to use an agement, marketing, operations, and informa-
unsecured loan equivalent amount (calculated as tion systems to achieve success. Strategic
current exposure plus a VaR-modeled PFE) for planning helps the organization more effectively
the securities-collateral transactions for risk- anticipate and adapt to change. Management
based capital purposes. The Board approved the must also ensure that planning information as
exception under the reservation authority provi- well as corporate goals and objectives are effec-
sion contained in its capital guidelines. tively communicated throughout the organiza-
tion. Effective strategic planning allows the
institution to be more proactive than reactive in
shaping its own future. The strategic plan should
Overall Assessment of Capital clearly outline the bank’s capital base, antici-
Adequacy pated capital expenditures, desirable capital level,
and external capital sources. Each of these areas
The following factors should be taken into should be evaluated in consideration of the
account in assessing the overall capital ade- degree and type of risk that management and the
quacy of a bank. board of directors are willing to accept.
Capital Ratios Growth. Capital is necessary to support a bank’s

growth; however, it is the imposition of required
Capital ratios should be compared with regula- capital ratios that controls growth. Because a
tory minimums and with peer-group averages. bank has to maintain a minimum ratio of capital
Banks are expected to have a minimum total to assets, it will only be able to grow so fast. For
risk-based capital ratio of 8 percent. However, example, a rapid growth in a bank’s loan port-
because risk-based capital does not take explicit folio may be a cause of concern, for it could
account of the quality of individual asset port- indicate that a bank is altering its risk profile by
folios or the range of other types of risks to reducing its underwriting standards.
which banks may be exposed, such as interest-
rate, liquidity, market, or operational risks, banks Dividends. Examiners should review historical
are generally expected to operate with capital and planned cash-dividend payout ratios to deter-
positions above the minimum ratios. Institutions mine whether dividend payments are impairing
with high or inordinate levels of risk are also capital adequacy.62 Excessive dividend payouts
expected to maintain capital well above the may result from several sources:
minimum levels.
The minimum tier 1 leverage ratio is 3 per- • If the bank is owned by a holding company,
cent. However, an institution operating at or the holding company may be requiring exces-
near these levels is expected to have well- sive dividend payments from the bank to fund
diversified risk, including no undue interest-rate the holding company’s debt-repayment pro-
risk exposure, excellent asset quality, high gram, expansion goals, or other cash needs.
liquidity, and good earnings, and to generally be • The bank’s board of directors may be under
considered a strong banking organization, rated pressure from individual shareholders to pro-
composite 1 under the CAMELS rating system vide funds to repay bank stock debt or to use
of banks. For all but the most highly rated banks for other purposes.
meeting the above conditions, the minimum • Dividends may be paid or promised to support
tier 1 leverage ratio is 3 percent plus an addi- a proposed equity offering.
tional cushion of at least 100 to 200 basis points.
Access to additional capital. Banks that do not
generate sufficient capital internally may require
Impact of Management external sources of capital. Large, independent
institutions may solicit additional funding from
Strategic planning. One of management’s most the capital markets. Smaller institutions may
important functions is to lead the organization rely on a bank holding company or a principal
by designing, implementing, and supporting an shareholder or control group to provide addi-
effective strategic plan. Strategic planning is a
long-term approach to integrating asset deploy- 62. See also ‘‘Dividends,’’ section 4070.1.

Page 56
tional funds, or on the issuance of new capital a bank generating losses is incapable of replen-
instruments to existing or new investors. Cur- ishing its capital accounts internally.
rent shareholders may resist efforts to obtain
additional capital by issuing new capital instru- Funds management. A bank with undue levels
ments because of the diluting effect of the new of interest-rate risk should be required to
capital. In deciding whether to approve obtain- strengthen its capital positions, even though it
ing additional capital in this manner, sharehold- may meet the minimum risk-based capital stan-
ers must weigh the dilution against the possibil- dards. Assessments of capital adequacy should
ity that, without the additional funds, the reflect banks’ appropriate use of hedging instru-
institution may fail. ments. Other things being equal, banks that have
Under Federal Reserve policy, a bank holding appropriately hedged their interest-rate exposure
company is expected to serve as a source of will be permitted to operate with lower levels of
strength to its subsidiary banks. A bank holding capital than those banks that are vulnerable to
company can fulfill this obligation by having interest-rate changes. While the Federal Reserve
enough liquidity to inject funds into the bank or does not want to discourage the use of legitimate
by having access to the same sources of addi- hedging vehicles, some instruments, in particu-
tional capital, that is, current or existing share- lar interest-only strips (IOs) and principal-only
holders, as outlined above. strips (POs), raise concerns. IOs and POs have
highly volatile price characteristics as interest
rates change, and they are generally not consid-
Financial Considerations ered appropriate investments for most banks.
However, some sophisticated banks may have
Capital levels and ratios should be evaluated in the expertise and systems to appropriately use
view of the bank’s overall financial condition, IOs and POs as hedging vehicles.
including the following areas.
Off-balance-sheet items and activities. Once
Asset quality. The final supervisory judgment on funded, off-balance-sheet items become subject
a bank’s capital adequacy may differ signifi- to the same capital requirements as on-balance-
cantly from conclusions that may be drawn sheet items. A bank’s capital levels should be
solely from the level of a bank’s risk-based sufficient to support the quality and quantity of
capital ratio. Generally, the main reason for this assets that would result from a significant por-
difference is the evaluation of asset quality. tion of these items being funded within a short
Final supervisory judgment of a bank’s capital time.
adequacy should take into account examination
findings, particularly those on the severity of
problem and classified assets and investment or Adequacy of and Compliance with
loan portfolio concentrations, as well as on the Capital-Improvement Plans
adequacy of the bank’s allowance for loan and
lease losses. Capital-improvement plans are required for
banks operating with capital ratios below regu-
Balance-sheet composition. A bank whose earn- latory minimums as required by the prompt-
ing assets are not diversified or whose credit corrective-action part of the Federal Deposit
culture is more risk-tolerant is generally expected Insurance Act, as well as for some banks oper-
to operate with higher capital levels than a ating under supervisory actions. Examiners
similar-sized institution with well-diversified, should review any such plans and determine
less-risky investments. their adequacy and reasonableness, keeping in
mind that banks may meet required capital-to-
Earnings. An adequately capitalized, growing asset ratios in three ways:
bank should have a consistent pattern of capital
augmentation by earnings retention. Poor earn- • They may issue more capital. In doing so,
ings can have a negative effect on capital banks must weigh the need for additional
adequacy in two ways. First, any losses absorbed capital against the dilution of market value
by capital reduce the ability of the remaining that will result.
capital to fulfill that function. Second, the impact • They may retain earnings rather than paying
of losses on capital is magnified by the fact that them out as dividends.

Page 57
• They may sell assets. By reducing the amount included in tier 2 capital is limited to 50 percent
of total assets, a bank reduces the amount of of tier 1 capital. Amounts issued or outstanding
capital necessary to meet the required ratios. in excess of this limit are not included in the
risk-based capital calculation but should be
taken into consideration when assessing the
bank’s funding and financial condition.
Inadequate Allowance for Loan and
Lease Losses
Unrealized Asset Values
An inadequate allowance for loan and lease
losses (ALLL) will require an additional charge Banks often have assets on their books that are
to current income. Any charge to current income carried at significant discounts below current
will reduce the amount of earnings available to market values. The excess of the market value
supplement tier 1 capital. Because the amount of over the book value (historical cost or acquisi-
the ALLL that can be included in tier 2 capital is tion value) of assets such as investment securi-
limited to 1.25 percent of gross risk-weighted ties or banking premises may represent capital
assets, an additional provision may increase the to the bank. These unrealized asset values are
ALLL level above this limit, thereby resulting in not included in the risk-based capital calculation
the excess portion being excluded from tier 2 but should be taken into consideration when
capital. assessing capital adequacy. Particular attention
should be given to the nature of the asset, the
reasonableness of its valuation, its marketability,
Ineligible Collateral and Guarantees and the likelihood of its sale.
The risk-based capital guidelines recognize only

limited types of collateral and guarantees. Other Accounting for Defined Benefit Pension
types of collateral and guarantees may support and Other Postretirement Plans
the asset mix of the bank, particularly within its
loan portfolio. Such collateral or guarantees In September 2006, the Financial Accounting
may serve to substantially improve the overall Standards Board adopted the Statement of Finan-
quality of a loan portfolio and other credit cial Accounting Standard No. 158, ‘‘Employers
exposures, and should be considered in the Accounting for Defined Benefit Pension and
overall assessment of capital adequacy. Other Postretirement Plans’’ (FAS 158). The
standard requires, as early as December 31,
2006, that a bank, bank holding company, or
other banking or thrift organization that spon-
Market Value of Bank Stock
sors a single-employer defined benefit postre-
Examiners should review trends in the market tirement plan—such as a pension plan or health
price of the bank’s stock and whether stock is care plan—to recognize the overfunded or under-
trading at a reasonable multiple of earnings or a funded status of each such plan as an asset or
reasonable percentage (or multiple) of book liability on its balance sheet with corresponding
value. A bank’s low stock price may merely be adjustments recognized in accumulated other
an indication that it is undervalued, or it may be comprehensive income (AOCI), a component of
indicative of regional or industry-wide prob- equity capital. After a banking organization
lems. However, a low-valued stock may also initially applies FAS 158, changes in the benefit
indicate that investors lack confidence in the plan asset or liability reported on the organiza-
institution; such lack of support could impair the tion’s balance sheet will be recognized in the
bank’s ability to raise additional capital in the year in which the changes occur and will result
capital markets. in an increase or decrease in AOCI. Postretire-
ment plan amounts carried in AOCI are adjusted
as they are subsequently recognized in earnings
Subordinated Debt in Excess of Limits as components of the plans’ net periodic benefit
cost.
The total of term subordinated debt and The Federal Reserve Board, along with other
intermediate-term preferred stock that may be federal bank and thrift regulatory agencies (the

Page 58
Agencies63), issued a joint press release on will; amounts of mortgage-servicing assets,

December 14, 2006, in which they announced nonmortgage-servicing assets, and purchased
that FAS 158 will not affect a banking organi- credit-card relationships that, in the aggregate,
zations’ regulatory capital. The agencies decided, are in excess of 100 percent of tier 1 capital;
until they can determine otherwise through a amounts of nonmortgage-servicing assets and
rulemaking, that banks should exclude from purchased credit-card relationships that, in the
regulatory capital any amounts recorded in AOCI aggregate, are in excess of 25 percent of tier 1
resulting from the adoption and application of capital; amounts of credit-enhancing interest-
FAS 158. The purpose of this exclusion is to only strips that are in excess of 25 percent of tier
neutralize the effect of the application of FAS 1 capital; all other identifiable intangible assets;
158 on regulatory capital, including the report- any investments in subsidiaries or associated
ing of the risk-based and leverage capital companies that the Federal Reserve determines
measures. should be deducted from tier 1 capital; deferred
tax assets that are dependent on future taxable
income, net of their valuation allowance, in
TIER 1 LEVERAGE RATIO FOR excess of the limitations set forth in section II.B.
of appendix A of Regulation H; and the amount
STATE MEMBER BANKS of the total adjusted carrying value of nonfinan-
The Federal Reserve has adopted a minimum cial equity investments that is subject to a
ratio of tier 1 capital to average total assets to deduction from tier 1 capital.
assist in the assessment of the capital adequacy Under the tier 1 leverage ratio guidelines, the
of state member banks. The principal objective minimum level of tier 1 capital to total assets for
of this measure (which is intended to be used as strong state member banks is 4 percent, unless
a supplement to the risk-based capital measure) they are rated composite 1 under the UFIRS
is to place a constraint on the maximum degree (CAMELS) rating system of banks. Institutions
to which a state member bank can leverage its not meeting these characteristics, as well as
equity capital base. institutions with supervisory, financial, or opera-
The guidelines implementing the tier 1 lever- tional weaknesses, are expected to operate well
age ratio are found in Regulation H (12 CFR above minimum capital standards. Institutions
208), appendix B, and apply to all state member experiencing or anticipating significant growth
banks on a consolidated basis. The ratio is to be are also expected to maintain capital ratios,
used in the examination and supervisory pro- including tangible capital positions, well above
cess, as well as in the analysis of applications the minimum levels. Moreover, higher capital
acted on by the Federal Reserve. ratios may be required for any banking institu-
A bank’s tier 1 leverage ratio is calculated by tion if warranted by its particular circumstances
dividing its tier 1 capital (the numerator of the or risk profile. In all cases, institutions should
ratio) by its average total consolidated assets hold capital commensurate with the level and
(the denominator of the ratio). For purposes of nature of the risks, including the volume and
calculating this ratio during an examination, severity of problem loans, to which they are
examiners may use the bank’s average total exposed.
assets as of the last Call Report date. The ratio A bank that does not have a 4 percent
will be calculated using period-end assets when- leverage ratio (3 percent if it is rated a compos-
ever necessary, on a case-by-case basis. For the ite CAMELS 1) is considered undercapitalized
purpose of this leverage ratio, the definition of under the prompt-corrective-action framework
tier 1 capital as set forth in the risk-based capital and must file a capital-restoration plan that
guidelines in appendix A of the Federal Reserve’s meets certain requirements.
Regulation H is used. Average total consolidated
assets are defined as the quarterly average total
assets (defined net of the allowance for loan and
lease losses) reported on the bank’s Reports of
De Novo Banks
Condition and Income (Call Reports), less good-
Initial capital in a de novo state member bank
63. The Office of the Comptroller of the Currency, the
should be reasonable in relation to the bank’s
Federal Deposit Insurance Corporation, and the Office of location, business plan, competitive environ-
Thrift Supervision. ment, and state law. At a minimum, however, a

Page 59
de novo bank must maintain a tangible tier 1 reliance on additional capital injections. Even
leverage ratio (core capital elements minus all though a 9 percent tangible leverage ratio is not
intangible assets divided by average total assets required after the third year, de novo banks are
minus all intangible assets) of 9 percent for the expected to maintain capital ratios that are
first three years of operations. The applicant commensurate with ongoing safety-and-
must provide projections of asset growth and soundness concerns and that are generally well
earnings performance that reasonably support in excess of regulatory minimums. (See SR-
the bank’s ability to maintain this ratio without 91-17.)

Page 60
1. To determine the adequacy of capital. leverage capital guidelines, as well as exist-

2. To determine compliance with the risk- ing conditions and future plans.
based and tier 1 leverage capital adequacy 6. To initiate corrective action when policies,
guidelines. procedures, or capital are deficient.
3. To determine if the policies, practices, and 7. To evaluate whether—
procedures with regard to the capital ade- a. the institution is fully capable of assessing
quacy guidelines are adequate. the credit risk associated with the collat-
4. To determine if the bank’s officers and eralized loan obligations (CLOs) it retains
employees are operating in conformity with in its banking book (nontrading accounts);
the Board’s established capital adequacy and
guidelines. b. the institution is adequately capitalized
5. To evaluate the propriety and consistency of given its residual risk exposure involving
the bank’s present and planned level of CLOs.
capitalization in light of the risk-based and

Page 1
VERIFICATION OF THE — any issuer-redemption feature must

RISK-BASED CAPITAL RATIO be subject to prior Federal Reserve
approval
Examiners should verify that the bank has — noncumulative
adequate systems in place to compute and docu- — fixed rate or traditional floating or
ment its risk-based capital ratios. Small banks adjustable rate
with capital ratios well in excess of established — must not contain features that would
minimums may not have a system explicitly require or create an incentive for
designed to capture risk-based capital informa- the issuer to redeem or repurchase
tion. In addition, depending on a bank’s current the instrument, such as an ‘‘explod-
capital structure and ratios, all procedures may ing rate,’’ an auction-rate pricing
not apply. mechanism, or a feature that allows
the stock to be converted into
1. Verify that the bank is correctly reporting increasing numbers of common
the risk-based capital information requested shares
on the Reports of Condition and Income. • Perpetual preferred stock, includable
within tier 2 capital without a sublimit,
For the qualifying components of capital (the must have the characteristics listed
ratio’s numerator): above for tier 1 perpetual preferred
stock, but perpetual preferred stock
2. Determine if management is adhering to the does not otherwise qualify for inclu-
underlying terms of any currently outstand- sion in tier 1 capital. For example,
ing stock issues. cumulative or auction-rate perpetual
3. Review common stock to ensure that the preferred stock, which does not qualify
bank is in compliance with the terms of any for tier 1 capital, may be includable in
underlying agreements and to determine if tier 2 capital.
more than one class exists. When more than 5. Verify that minority interest in equity
one class exists, review the terms for any accounts of consolidated subsidiaries
preference or nonvoting features. If the included in tier 1 capital consists only of
terms include such features, determine qualifying tier 1 capital elements. Deter-
whether the class of common stock qualifies mine whether any perpetual preferred stock
for inclusion in tier 1 capital. of a subsidiary that is included in minority
4. Review any perpetual and long-term pre- interest is secured by the subsidiary’s assets;
ferred stock for the following: if so, that stock may not be included in
a. Compliance with terms of the underlying capital.
agreements carefully noting— 6. Review the intermediate-term preferred
• adherence to the cumulative or non- stock and subordinated debt instruments
cumulative nature of the stock and included in capital for the following:
• adherence to any conversion rights. a. Compliance with terms of the underlying
b. Proper categorization as tier 1 or tier 2 agreements, noting that subordinated debt
for capital adequacy purposes, noting the containing the following terms may not
following requirements: be included in capital:
• Tier 1 perpetual preferred stock must • interest payments tied to the bank’s
have the following characteristics: financial condition
— no maturity date • acceleration clauses or broad condi-
— cannot be redeemed at the option tions of events of default that are
of the holder inconsistent with safe and sound bank-
— unsecured ing practices
— ability to absorb losses b. Compliance with restrictions on the
— ability and legal right for issuer to inclusion of such instruments in capital
defer or eliminate dividends by verifying that the aggregate amount

Page 1
3020.3 Assessment of Capital Adequacy: Examination Procedures
of both types of instruments does not 9. Verify that the amount of the allowance for
exceed 50 percent of tier 1 capital (net of loan and lease losses included in tier 2
goodwill) and that the portions includ- capital has been properly calculated and
able in tier 2 capital possess the follow- disclosed, and verify that the supporting
ing characteristics: computations of that amount have been
• unsecured adequately documented.
• minimum five-year original weighted
average maturity For the calculation of risk-weighted assets
• in the case of subordinated debt, con- (the ratio’s denominator):
tains terms stating that the debt (1) is
not a deposit, (2) is not insured by 10. Determine whether the bank consolidates,
a federal agency, (3) cannot be in accordance with the Financial Account-
redeemed without prior approval from ing Standards Board’s FIN 46-R, the assets
the Federal Reserve, and (4) is sub- of any asset-backed commercial paper
ordinated to depositors and general (ABCP) program that it sponsors.
creditors a. Determine whether the bank’s ABCP
c. Appropriate amortization, if the instru- program meets the definition of a spon-
ments have a remaining maturity of less sored ABCP program under the Federal
than five years. Reserve’s risk-based capital guidelines.
7. Determine, through review of minutes of If the bank does consolidate the assets of
board of directors meetings, if a stock an ABCP program, review the documen-
offering or subordinated debt issue is being tation of its risk-based capital ratio cal-
considered. If so, determine that manage- culations, and determine whether the
ment is aware of the risk-based capital associated ABCP program’s assets and
requirements for inclusion in capital. minority interests were excluded from
8. Review any mandatory convertible debt the bank’s risk-weighted asset base (and
securities for the following: also if they were excluded from tier 1
a. Compliance of the terms with the criteria capital—the ratio’s numerator). See sec-
set forth in 12 CFR 225 (Regulation Y), tion III.B.6. of the risk-based capital
appendix B. guidelines (12 CFR 208, appendix A).
b. Notification in the terms of agreement b. Determine whether any of the bank’s
that the redemption or repurchase of liquidity facilities meet the definition and
such securities before maturity is subject requirements of an eligible ABCP liquid-
to prior approval from the Federal ity facility under the Federal Reserve’s
Reserve. risk-based capital guidelines. See section
c. The treatment of the portions of such III.B.3.a.iv. of the risk-based capital
securities covered by the issuance of guidelines (12 CFR 208, appendix A).
common or perpetual preferred stock c. Determine from the bank’s supporting
dedicated to the repayment of the secu- documentation of its risk-based capital
rities, bearing in mind the following: ratios whether the bank held risk-based
• The amount of the security covered by capital against its eligible ABCP liquid-
dedicated stock should be treated as ity facilities.
subordinated debt and is subject, d. Determine whether the bank applied the
together with other subordinated debt correct conversion factors to the eligible
and intermediate-term preferred stock, ABCP liquidity facilities when it deter-
to a sublimit within tier 2 capital of mined the amount of risk-weighted assets
50 percent of tier 1 capital, as well as for its risk-based capital ratios. See sec-
to amortization in the last five years of tion III.D. of the risk-based capital guide-
life. lines (12 CFR 208, appendix A).
• The portion of a mandatory convert- • For those eligible ABCP liquidity
ible security that is not covered by facilities having an original maturity of
dedication qualifies for inclusion in one year or less, determine if a 10 per-
tier 2 capital without any sublimit and cent credit-conversion factor was used.
without being subject to amortization • For those eligible ABCP liquidity
in the last five years of life. facilities having an original maturity

Page 2
Assessment of Capital Adequacy: Examination Procedures 3020.3
exceeding one year, determine if a or that are otherwise considered to lack

50 percent credit-conversion factor sufficient capital to support their activities,
should have been used. examine the bank’s capital plans for achiev-
e. Determine if ineligible ABCP liquidity ing adequate levels of capital. In conjunc-
facilities were treated as direct-credit tion with management of the appropriate
substitutes or as recourse obligations, as Reserve Bank, determine whether the plans
required by the risk-based capital guide- are acceptable to the Federal Reserve.
lines. Review and comment on these plans and
11. Verify that each on- and off-balance-sheet any progress achieved in meeting the
item has been assigned to the appropriate requirements.
risk category in accordance with the risk- 2. The review processes discussed in ‘‘Overall
based capital guidelines. Close attention Conclusions Regarding Condition of the
should be paid to the underlying obligor, Bank,’’ section 5020.1, require an evalua-
collateral, and guarantees, and to assign- tion of the propriety and consistency of the
ment to a risk category based on the terms bank’s present and planned level of capitali-
of a claim. The claim should be assigned to zation in light of existing conditions and
the risk category appropriate to the highest future plans. In this regard, the examiner
risk option available under the terms of the assigned to assessing capital adequacy
transaction. Verify that the bank’s documen- should do the following:
tation supports the assignment of preferen- a. Using the latest Uniform Bank Perfor-
tial risk weights. If necessary, recalculate mance Report (UBPR), analyze applica-
the value of risk-weighted assets. ble ratios involving capital funds, com-
12. Verify that all off-balance-sheet items have paring these ratios with those of the
been converted properly to credit-equivalent bank’s peer group and investigating
amounts based on the risk-based capital trends or significant variations from peer-
guidelines. Close attention should be paid to group averages.
the proper reporting of assets sold with b. Determine, with regard to the bank’s
recourse, financial and performance standby overall financial condition, that the bank’s
letters of credit, participations of off-balance- capital is sufficient to compensate for
sheet transactions, and commitments. any instabilities or deficiencies in the
asset and liability mix and in quality, as
described in the ‘‘Funds Management’’
paragraph (‘‘Financial Considerations’’
VERIFICATION OF THE TIER 1 subsection of section 3020.1).
LEVERAGE RATIO c. Determine if the bank’s earnings perfor-
mance enables it to fund its expansion
1. Verify that the bank has correctly calculated
adequately, to remain competitive in the
tier 1 capital in accordance with the defini-
market, and to replenish or increase its
tion of tier 1 capital, as set forth in the
capital funds as needed.
risk-based capital guidelines.
d. Analyze trends in the bank’s deposit and
2. Verify that the bank has properly calculated
borrowed funds structure to determine
average total consolidated assets, which are
whether capital is maintained at a level
defined as the quarterly average total assets
sufficient to sustain depositor and lender
as reported on the Call Report, less good-
confidence.
will and any other intangible assets and any
e. If the allowance for loan and lease losses
investments in subsidiaries that the Federal
is determined to be inadequate, analyze
Reserve determines should be deducted from
the impact of current and potential losses
tier 1 capital.
on the bank’s capital structure. See ‘‘Ana-
lytical Review and Income and Expense,’’
section 4010.1.
OVERALL ASSESSMENT OF f. Consider the impact of any management
CAPITAL ADEQUACY deficiencies on present and projected
capital.
1. For banks that do not meet the minimum g. Determine if there are any assets or
risk-based tier 1 leverage capital standards contingent accounts whose quality rep-

Page 3
3020.3 Assessment of Capital Adequacy: Examination Procedures
resents an actual or potential serious minimum conditions have been met for
weakening of capital. that treatment.
h. Consider the potential impact of any 3. Review capital adjustments such as good-
proposed changes in controlling owner- will and intangible assets by performing the
ship (if approved) on the projected capi- following procedures:
tal position. a. Verify the existence of adequate docu-
i. Analyze assets that are considered mentation concerning book and fair
undervalued on the balance sheet and values and the amortization method.
carried at below-market values. The b. Verify that intangibles are being reduced
excess of fair value over cost may rep- in accordance with the amortization
resent an additional cushion to the bank. method. If the book carrying amount
j. Consider the cushion for absorbing losses exceeds the fair value, the intangible
that may be provided by any subordi- should be written down or off.
nated debt or intermediate-term pre- c. Determine if the bank is performing a
ferred stock not included in tier 2 capital quarterly review of the book and fair
because of the 50 percent of tier 2 capital values and the quality of all intangibles.
limitation, or that is not included in d. Verify that goodwill and other nonquali-
capital for tier 1 leverage ratio purposes. fying identifiable intangibles are deducted
k. Analyze any collateral and guarantees from tier 1 capital.
supporting assets that may not be taken e. Determine the proper inclusion of other
into account for risk-based or tier 1 identifiable intangibles included in tier 1
leverage capital purposes, and consider capital by verifying that the criteria and
these collateral and guarantees in the limitations outlined in the risk-based capi-
overall assessment of capital adequacy. tal guidelines are met.
l. Evaluate the bank’s overall asset quality, 4. In light of the analysis conducted in step 2
and determine whether the bank needs to (under ‘‘Overall Assessment of Capital
strengthen its capital position based on Adequacy’’), and in accordance with the
the following: Federal Reserve’s capital adequacy guide-
• the severity of problem and classified lines, determine any appropriate supervi-
assets sory action with regard to the bank’s capital
• investment or loan- portfolio con- adequacy.
centrations 5. Review the following items with the
• the adequacy of loan-loss reserves examiner-in-charge in preparation for dis-
m. Analyze the bank’s interest-rate risk and cussion with appropriate management:
use of hedging instruments. Determine if a. all deficiencies noted with respect to the
the bank should strengthen its capital capital accounts
position because of undue levels of risk. b. the adequacy of present and projected
Review hedging instruments for the use capital
of interest-only strips (IOs) and principal- 6. Ascertain through minutes, reports, etc., or
only strips (POs) (which raise concerns), through discussions with management, how
and review management’s expertise in the future plans of the bank (for example,
using hedging instruments. growth through commercial lending, retail
n. Determine whether the sponsoring bank operations, etc.) will affect the bank’s asset
is able to assess and manage the retained quality, capital position, and other areas of
risk in its credit portfolio after the issu- its balance sheet.
ance of synthetic collateralized loan 7. Prepare comments for the examination report
obligations (CLOs). on the bank’s capital position, including any
o. If the bank has used the special risk- deficiencies noted.
based regulatory capital treatment for 8. Update the workpapers with any informa-
synthetic CLOs, verify that the stringent tion that will facilitate future examinations.

Page 4
Review the bank’s internal controls, policies, *4. Are capital transactions verified by more
practices, and procedures concerning capital. than one person before stock certificates
The bank’s system should be documented in a are issued?
complete and concise manner and should include, *5. Are stock certificates and debentures han-
where appropriate, narrative descriptions, flow- dled by persons who do not also record
charts, copies of forms used, and other pertinent those transactions?
information. Items marked with an asterisk *6. Does the bank maintain a stock certificate
require substantiation by observation or testing. book with certificates serially numbered
by the printer?
*7. Is the stock certificate book maintained
GENERAL under dual control?
*8. Does the bank’s policy prohibit the sign-
1. Has the bank established procedures to ing of blank stock certificates?
ensure that— *9. Does the bank maintain a shareholders’
a. all components of capital are accurately ledger that shows the total number of
categorized and reported for purposes shares owned by each stockholder?
of the risk-based and leverage capital *10. Does the bank maintain a stock transfer
measures? journal disclosing names, dates, and
b. all on-and off-balance-sheet items are amounts of transactions?
accurately risk-weighted and reported *11. Does the bank cancel surrendered stock
for purposes of the risk-based capital certificates?
measures? *12. Are inventories of unissued notes or
c. categorization of on- and off-balance- debentures—
sheet items and capital for purposes of a. maintained under dual control?
the risk-based capital measures is ade- b. counted periodically by someone other
quately documented? than the person responsible for their
d. the bank is in compliance with the custody?
terms of any contractual agreements *13. When transfers are made—
underlying capital instruments? a. are notes or debentures surrendered and
e. management and the board of directors promptly cancelled?
consider the requirements of the risk- b. are surrendered notes or debentures
based capital guidelines for inclusion inspected to determine that proper
in capital of stock or debt prior to assignment has been made and that new
issuance? notes or debentures agree in amount?
2. Does the bank prepare a periodic analysis
of its risk-based and leverage capital posi-
tions to assess capital adequacy for both CONCLUSION
current and anticipated needs?
*3. Has the board of directors authorized spe- 14. Indicate additional procedures used in
cific bank officers to— arriving at conclusions.
a. sign stock certificates? 15. Are internal controls of capital adequate
b. maintain custody of unissued stock based on a composite evaluation, as
certificates? evidenced by answers to the foregoing
c. maintain stock journals and records? questions?

Page 1
Assessing Risk-Based Capital—Direct-Credit Substitutes
The Federal Reserve Board and the other federal internal-ratings approach to their unrated direct-
banking agencies (the agencies)1 amended their credit substitutes extended to ABCP programs4
risk-based capital standards on November 29, that they sponsor by mapping internal risk
2001, to adopt a new capital framework for ratings to external rating equivalents. These
banking organizations (includes bank holding external credit rating equivalents are organized
companies) engaged in securitization activities into three ratings categories: investment-grade
(the securitization capital rule).2 In March 2005, (BBB and above) credit risk, high non-
the agencies issued interagency guidance that investment-grade (BB+ through BB-) credit risk,
clarifies how banking organizations are to use and low non-investment-grade (below BB-)
internal ratings that they assign to asset pools credit risk. These rating categories can then be
purchased by their asset-backed commercial used to determine whether a direct-credit sub-
paper (ABCP) programs in order to appropri- stitute provided to an ABCP program should be
ately risk-weight any direct-credit substitutes (1) assigned to a risk weight of 100 percent or
(for example, guarantees) extended to such pro- 200 percent or (2) subject to the ‘‘gross-up’’
grams. For state member bank examination treatment, as summarized in the table on the
purposes, the interagency guidance has been next page.5 (See appendix A for a more detailed
reformatted for examiner use as examination description of ABCP programs.)
objectives, examination procedures, and an inter- As the table indicates, the minimum risk
nal control questionnaire. The guidance uses the weight available under the internal risk-ratings
term ‘‘banking organization.’’ In this section, the approach is 100 percent, regardless of the inter-
guidance should be interpreted to mean the nal rating.6 Conversely, positions rated below
application of the risk-based capital guidelines BB- receive the gross-up treatment. That is, the
to all state member banks on a consolidated banking organization holding the position must
basis. maintain capital against the amount of the posi-
The guidance sets forth an analytical frame- tion plus all more senior positions.7 Application
work for assessing the broad risk characteristics of gross-up treatment, in many cases, will result
of direct-credit substitutes3 that a banking orga- in a full dollar-for-dollar capital charge (the
nization provides to an ABCP program it spon- equivalent of a 1,250 percent risk weight) on
sors. The guidance provides specific informa- direct-credit substitutes that fall into the low
tion on evaluating direct-credit substitutes issued non-investment-grade category. In addition, the
in the form of program-wide credit enhance- risk-based capital requirement applied to a direct-
ments, as well as an approach to determine the credit substitute is subject to the low-level-
risk-based capital charge for these enhance- exposure rule. Under the rule, the amount of
ments. (See SR-05-6 and its attachment. Also, required risk-based capital would be limited to
see sections 3020.1, ‘‘Assessment of Capital the lower of a full dollar-for-dollar capital charge
Adequacy,’’ and 4030.1, ‘‘Asset Securitization.’’) against the direct-credit substitute or the effec-
The securitization capital rule permits bank- tive risk-based capital charge (for example,
ing organizations with qualifying internal risk- 8 percent) for the entire amount of assets in the
rating systems to use those systems to apply the
4. ABCP programs include multiseller ABCP conduits,
1. The Office of the Comptroller of the Currency, the credit arbitrage ABCP conduits, and structured investment
Federal Deposit Insurance Corporation, and the Office of vehicles.
Thrift Supervision. 5. The rating designations (for example, ‘‘BBB-’’ and
2. See 66 Fed. Reg. 59614 (November 29, 2001). See also ‘‘BB+’’) used in the table are illustrative only and do not
12 C.F.R. 208, appendix A, section III.B.3. indicate any preference for, or endorsement of, any particular
3. Direct-credit substitute means an arrangement in which rating designation system.
a banking organization assumes, in form or in substance, 6. Exposures externally rated by a nationally recognized
credit risk associated with an on- or off-balance-sheet credit statistical rating organization (NRSRO) above BBB+ are
exposure that it did not previously own (that is, a third-party eligible for lower risk weights (that is, 20 percent for AAA
asset) and the risk it assumes exceeds the pro rata share of its and AA, 50 percent for A).
interest in the third-party asset. If the banking organization has 7. Gross-up treatment means that a position is combined
no claim on the third-party asset, then the organization’s with all more senior positions in the transaction. The resulting
assumption of any credit risk with respect to the third-party amount is then risk-weighted based on the obligor or, if
asset is a direct-credit substitute. relevant, the guarantor or the nature of the collateral.

Page 1
3030.1 Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs
Internal risk-rating
equivalent Ratings category Risk weighting
BBB- or better Investment grade 100%
BB+ to BB- High non-investment 200%
grade
Below BB- Low non-investment Gross-up treatment
grade
ABCP program.8 A process is provided that is designed to aid

The use of internal risk rattings under the in determining the regulatory capital treatment
securitization capital rule is limited to determin- for program-wide credit enhancements, pro-
ing the risk-based capital charge for unrated vided to an ABCP program. The key underlying
direct-credit substitutes that banking organiza- principles are as follows:
tions provide to ABCP programs. Thus, banking
organizations may not use the internal-ratings 1. The determination of the credit quality of the
approach to derive the risk-based capital require- program-wide credit enhancement shall be
ment for unrated direct-credit substitutes ex- based on the risk of draw and subsequent
tended to other transactions. Approved use of loss, which depends directly on the quality of
the internal rating-based approach for ABCP the credit-enhanced assets funded through
programs under the securitization capital rule the ABCP program.
will have no bearing on the overall appropriate- 2. An estimate of the risk of draw for the
ness of a banking organization’s internal risk- program-wide credit enhancement is derived
rating system for other purposes. from the quality (rating) of the riskiest cred-
Most rated commercial paper issued out of an it(s) within the ABCP program, which is
ABCP program is supported by program-wide often indicated by the internal rating a bank-
credit enhancement, which is a direct-credit ing organization assigns to a transaction’s
substitute. Often the sponsoring banking orga- pool-specific liquidity facility. Other credit
nization provides, in whole or in part, program- risks (for example, seller/servicer risk) to the
wide credit enhancement to the ABCP program. program-wide credit enhancement may also
Program-wide credit enhancement may take a be considered.
number of different forms, including an irrevo- 3. The weakest-link approach assigns risk-
cable loan facility, a standby letter of credit, a based capital against the program-wide credit
financial guarantee, or a subordinated debt. enhancement in rank order of the internal
The interagency guidance also discusses the ratings starting with the lowest-rated posi-
weakest-link approach. This approach is used tions supported by the program-wide credit
for calculating the risk-based capital require- enhancement. Therefore, if all of the posi-
ment and assumes that the risk of the program- tions supported by the program-wide credit
wide credit enhancement is directly dependent enhancement are internally rated investment
on the quality (that is, internal rating) of the grade, the banking organization would risk-
riskiest transaction(s) within the ABCP weight the notional amount of the program-
program. (See step 9 of the examination wide credit enhancement at 100 percent and
procedures, section 3030.3.) More specifically, there would be no need to proceed further.
the weakest-link concept presupposes the prob- However, for positions supported by the
ability that the program-wide credit enhance- program-wide credit enhancement that are
ment that will be drawn is equal to the prob- non-investment grade, banking organizations
ability of default of the transaction(s) with the can use the formula-driven weakest-link
weakest transaction risk rating. approach illustrated in step 9 of the exami-
nation procedures to generate the appropriate
amount of risk-based capital to be assessed
8. The low-level-exposure rule provides that the dollar against an unrated position.
amount of risk-based capital required for a recourse obligation
or direct-credit substitute should not exceed the maximum
dollar amount for which a banking organization is contractu-
ally liable. (See 12 C.F.R 208, appendix A, section III.B.3.g.i.)

Page 2
Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs 3030.1
Asset Pools
Pool-Specific Credit Pool-Specific
Enhancement Liquidity Facility
ABCP Conduit
Program Manager/ Program-Wide

Sponsor Liquidity Facility
Commercial Program-Wide
Paper Investors Credit Enhancement
ASSESSMENT OF INTERNAL APPENDIX A—OVERVIEW OF

RATING SYSTEMS ABCP PROGRAMS
The guidance is organized in the form of a ABCP programs provide a means for corpora-
decision tree that (1) provides an outline of the tions to obtain relatively low-cost funding by
key decisions that examiners and sponsoring selling or securitizing pools of homogenous
banking organizations should consider when assets (for example, trade receivables) to
reviewing internal risk-rating systems for ABCP special-purpose entities (SPEs/ABCP
programs and (2) provides supervisors with programs). The ABCP program raises funds for
more-specific information on how to assess the purchase of these assets by issuing commercial
adequacy of these systems. Many of the quali- paper into the marketplace. The commercial
tative and quantitative factors used to evaluate paper investors are protected by structural
risk in this guidance are comparable with rating enhancements provided by the seller (for
agency criteria (for example, criteria from S&P, example, overcollateralization, spread ac-
Moody’s, and Fitch) because the ABCP pro- counts, early-amortization triggers, etc.) and by
gram sponsors generally use the rating method- credit enhancements (for example, subordinated
ologies of nationally recognized statistical rating loans or guarantees) provided by banking
organizations (NRSROs) when assessing the organization sponsors of the ABCP program
credit quality of their risk exposures to ABCP and by other third parties. In addition, liquid-
programs. The guidance has two primary goals:
ity facilities are also present to ensure the rapid
and orderly repayment of commercial paper
• provide information to banking organizations
should cash-flow difficulties emerge. ABCP
to ensure the accuracy and consistency of the
programs are nominally capitalized SPEs that
ratings assigned to transactions in an ABCP
program issue commercial paper. A sponsoring banking
• assist supervisors in assessing the adequacy of organization establishes the ABCP program but
a banking organization’s internal risk-rating usually does not own the conduit’s equity,
system based on the nine key criteria set forth which is often held by unaffiliated third-party
in the securitization capital rule9 management companies that specialize in own-
ing such entities, and are structured to be
bankruptcy remote.
9. 12 C.F.R. 208, appendix A, III.B.3.f.i.

Page 3
Typical Structure or higher. SIVs operate on a market-value basis

similar to market value CDOs in that they must
ABCP programs are funding vehicles that bank- maintain a dynamic overcollateralization ratio
ing organizations and other intermediaries estab- determined by analysis of the potential price
lish to provide an alternative source of funding volatility on securities held in the portfolio.
to themselves or their customers. In contrast to SIVs are monitored daily and must meet strict
term securitizations, which tend to be amortiz- liquidity, capitalization, leverage, and concentra-
ing, ABCP programs are ongoing entities that tion guidelines established by the rating agencies.
usually issue new commercial paper to repay
maturing commercial paper. The majority of
ABCP programs in the capital markets are Key Parties and Roles
established and managed by major international
commercial banking organizations. As with tra- Key parties for an ABCP program include the
ditional commercial paper, which has a maxi- following:
mum maturity of 270 days, ABCP is short-term
debt that may either pay interest or be issued at • program management/administrators
a discount. • credit-enhancement providers
• liquidity-facility providers
• seller/servicers
Types of ABCP Programs • commercial paper investors
Multiseller programs generally provide working Program Management

capital financing by purchasing or advancing
against receivables generated by multiple cor- The sponsor of an ABCP program initiates the
porate clients of the sponsoring banking organi- creation of the program but typically does not
zations. These programs are generally well diver- own the equity of the ABCP program, which is
sified across both sellers and asset types. provided by unaffiliated third-party investors.
Despite not owning the equity of the ABCP
Single-seller programs are generally established program, sponsors usually retain a financial
to fund one or more types of assets originated by stake in the program by providing credit
a single seller. The lack of diversification is enhancement, liquidity support, or both, and
generally compensated for by increased program- they play an active role in managing the pro-
wide credit enhancement. gram. Sponsors typically earn fees—such as
credit-enhancement, liquidity-facility, and
Loan-backed programs fund direct loans to program-management fees—for services pro-
corporate customers of the ABCP program’s vided to their ABCP programs.
sponsoring banking organization. These loans Typically, an ABCP program makes arrange-
are generally closely managed by the banking ments with various agents/servicers to conduct
organization and have a variety of covenants the administration and daily operation of the
designed to reduce credit risk. ABCP program. This includes such activities as
purchasing and selling assets, maintaining oper-
Securities-arbitrage programs invest in securi- ating accounts, and monitoring the ongoing
ties that generally are rated AA- or higher. They performance of each transaction. The sponsor is
generally have no additional credit enhancement also actively engaged in the management of the
at the seller/transaction level because the secu- ABCP program, including underwriting the
rities are highly rated. These programs are assets purchased by the ABCP program and the
typically well diversified across security types. type/level of credit enhancements provided to
The arbitrage is mainly due to the difference the ABCP program.
between the yield on the securities and the
funding cost of the commercial paper.
Credit-Enhancement Providers
Structured investment vehicles (SIVs) are a form
of a securities-arbitrage program. These ABCP The sponsoring banking organization typically
programs invest in securities typically rated AA- provides pool-specific and program-wide backup

Page 4
liquidity facilities, and program-wide credit can purchase the ABCP from the conduit if the
enhancements, all of which are usually unrated commercial paper cannot be issued. Pool-
(pool-specific credit enhancement, such as over- specific and program-wide credit enhance-
collateralization, is provided by the seller of the ments also protect commercial paper investors
assets). These enhancements are fundamental from deterioration of the underlying asset pools.
for obtaining high investment-grade ratings on
the commercial paper issued to the market by
the ABCP program. Seller-provided credit The Loss Waterfall
enhancement may exist in various forms and is
generally sized based on the type and credit The loss waterfall diagram (on the next page)
quality of the underlying assets as well as the for the exposures of a typical ABCP program
quality and financial strength of seller/servicers. generally has four legally distinct layers.
Higher-quality assets may only need partial However, most legal documents do not specify
support to achieve a satisfactory rating for the which form of credit or liquidity enhancement is
commercial paper. Lower-quality assets may in a priority position after pool-specific credit
need full support. enhancement is exhausted due to defaults. For
example, after becoming aware of weakness in
the seller/servicer or in asset performance, an
Liquidity-Facility Providers ABCP program sponsor may purchase assets
out of the conduit using pool-specific liquidity.
The sponsoring banking organization and in Liquidity agreements must be subject to a valid
some cases, unaffiliated third parties, provide asset-quality test that prevents the purchase of
pool-specific or program-wide liquidity facili- defaulted or highly delinquent assets. Liquidity
ties. These backup liquidity facilities ensure the facilities that are not limited by such an asset-
timely repayment of commercial paper under quality test are to be viewed as credit enhance-
certain conditions, such as financial market ment and are subject to the risk-based capital
disruptions or if cash-flow timing mismatches requirements applicable to direct-credit
occur, but generally not under conditions associ- substitutes.
ated with the credit deterioration of the underly-
ing assets or the seller/servicer to the extent that
such deterioration is beyond what is permitted Pool-Specific Credit Enhancement
under the related asset-quality test.
The form and size of credit enhancement for
each particular asset pool is dependent upon the
Commercial Paper Investors nature and quality of the asset pool and the
seller/servicer’s risk profile. In determining the
Commercial paper investors are typically level of credit enhancement, consideration is
institutional investors, such as pension funds, given to the seller/servicer’s financial strength,
money market mutual funds, bank trust depart- quality as a servicer, obligor concentrations, and
ments, foreign banks, and investment obligor credit quality, as well as the historic
companies. Commercial paper maturities range performance of the asset pool. Credit enhance-
from 1 day to 270 days, but most frequently are ment is generally sized to cover a multiple level
issued for 30 days or less. There is a limited of historical losses and dilution for the particular
secondary market for commercial paper since asset pool. Pool-specific credit enhancement can
issuers can closely match the maturity of the take several forms, including overcollateraliza-
paper to the investors’ needs. Commercial paper tion, cash reserves, seller/servicer guarantees
investors are generally repaid from the reissu- (for only highly rated seller/servicers), and sub-
ance of new commercial paper or from cash ordination. Credit enhancement can either be
flows stemming from the underlying asset pools dynamic (that is, increases as the asset pool’s
purchased by the program. In addition, to ensure performance deteriorates) or static (that is, fixed
timely repayment in the event that new com- percentage). Pool-specific credit enhancement is
mercial paper cannot be issued or if anticipated generally provided by the seller/servicer (or
cash flows from the underlying assets do not oc- carved out of the asset pool in the case of
cur, ABCP programs utilize backup liquidity overcollateralization) but may be provided by
facilities. In addition, the banking organization other third parties.

Page 5
The Loss Waterfall
Last Loss
Program-
Wide
Liquidity
Pool-Specific
Liquidity
Program-Wide Credit
Enhancement
Pool-Specific Credit
Enhancement
First Loss
The ABCP program sponsor or administrator specific credit enhancement and other structur-
will generally set strict eligibility requirements ing protections.
for the receivables to be included in the pur-
chased asset pool. For example, receivable eli-
gibility requirements will establish minimum Program-Wide Credit Enhancement
credit ratings or credit scores for the obligors
and the maximum number of days the receivable The second level of contractual credit protection
can be past due. is the program-wide credit enhancement, which
Usually the purchased asset pools are struc- may take the form of an irrevocable loan facility,
tured (credit-enhanced) to achieve a credit- a standby letter of credit, a surety bond from a
quality equivalent of investment grade (that is, monoline insurer, or an issuance of subordinated
BBB or higher). The sponsoring banking orga- debt. Program-wide credit enhancement protects
nization will typically utilize established rating commercial paper investors if one or more of the
agency criteria and structuring methodologies to underlying transactions exhaust the pool-specific
achieve the desired internal rating level. In credit enhancement and other structural protec-
certain instances, such as when ABCP programs tions. The sponsoring banking organization or
purchase ABS, the pool-specific credit enhance- third-party guarantors are providers of this type
ment is already built into the purchased ABS of credit protection. The program-wide credit
and is reflected in the security’s credit rating. enhancement is generally sized by the rating
The internal rating on the pool-specific liquidity agencies to cover the potential of multiple
facility provided to support the purchased asset defaults in the underlying portfolio of transac-
pool will reflect the inclusion of the pool- tions within ABCP conduits and takes into

Page 6
account concentration risk among seller/servicers defaults that would require a draw against the
and industry sectors. program-wide credit enhancement.11 While the
liquidity banking organization is exposed to the
credit risk of the underlying asset pool, the risk
Pool-Specific Liquidity is mitigated by the seller-provided credit en-
hancement and the asset-quality test.12 At the
Pool-specific liquidity facilities are an important time that the asset pool is put to the liquidity
structural feature in ABCP programs because banking organization, the facility is usually fully
they ensure investors of timely payments on the drawn because the entire amount of the pool that
issued commercial paper by smoothing timing qualifies under the asset-quality test is pur-
differences in the payment of interest and prin- chased by the banking organization. However,
cipal on the pooled assets and ensuring pay- with respect to revolving transactions (such as
ments in the event of market disruptions. The credit card securitizations) it is possible to
types of liquidity facilities may differ among average less than 100 percent of the commitment.
various ABCP programs and may even differ
among asset pools purchased by a single ABCP
program. For instance, liquidity facilities may Program-Wide Liquidity
be structured either in the form of (1) an
asset-purchase agreement, which provides liquid- The senior-most position in the waterfall,
ity to the ABCP program by purchasing nonde- program-wide liquidity, is provided in an amount
faulted assets from a specific asset pool, or (2) a sufficient to support that portion of the face
loan to the ABCP program, which is repaid amount of all the commercial paper that is
solely by the cash flows from the underlying issued by the ABCP program that is necessary to
assets.10 Some older ABCP programs may have achieve the desired external rating on the issued
both pool-specific liquidity and program-wide paper. Progam-wide liquidity also provides
liquidity coverage, while more-recent ABCP liquidity in the event of a short-term disruption
programs tend to utilize only pool-specific facili- in the commercial paper market. In some cases,
ties. Typically, the seller-provided credit enhance- a liquidity banking organization that extends a
ment continues to provide credit protection on direct liquidity loan to an ABCP program may
an asset pool that is purchased by a liquidity be able to access the program-wide credit
banking organization so that the institution is enhancement to cover losses while funding the
protected against credit losses that may arise due underlying asset pool.
to subsequent deterioration of the pool.
Pool-specific liquidity, when drawn prior to
the ABCP program’s credit enhancements, is APPENDIX B—CREDIT-
subject to the credit risk of the underlying asset
pool. However, the liquidity facility does not
APPROVAL MEMORANDUM
provide direct-credit enhancement to the com- The credit-approval memorandum typically
mercial paper holders. Thus, the pool-specific should include a description of the following:
liquidity facility generally is in an economic
second-loss position after the seller-provided 1. Transaction structure. In the beginning of the
credit enhancements and prior to the program- credit-approval memorandum, the sponsor-
wide credit enhancement even when the legal ing banking organization will outline the
documents state that the program-wide credit structure of the transaction, which includes a
enhancement would absorb losses prior to the
pool-specific liquidity facilities. This is because 11. In fact, according to the contractual provisions of some
the sponsor of the ABCP program would most conduits, a certain level of draws on the program-wide credit
likely manage the asset pools in such a way that enhancement is a condition for unwinding the conduit pro-
gram, which means that this enhancement is never meant to be
deteriorating portfolios or assets would be put to used.
the liquidity banking organizations prior to any 12. An asset-quality test or liquidity-funding formula deter-
mines how much funding the liquidity banking organization
10. Direct-liquidity loans to an ABCP program may be will extend to the conduit based on the quality of the
termed a commissioning agreement (most likely in a foreign underlying asset pool at the time of the draw. Typically,
bank program) and may share in the security interest in the liquidity banking organizations will fund against the conduit’s
underlying assets when commercial paper ceases to be issued purchase price of the asset pool less the amount of defaulted
due to deterioration of the asset pool. assets in the pool.

Page 7
discussion of the asset type that would be tion summary. For certain types of assets,
purchased by the ABCP program and the such as auto loans, the sponsoring banking
liquidity facilities (and possibly credit organization should consider the seller’s use
enhancements) that the sponsoring banking of credit scoring and the minimum accept-
organization is providing to the transaction. able loan score that may be included in the
Generally, the sponsoring banking organiza- asset pool. In addition, the credit-approval
tion indicates the type and dollar volume of memorandum may include an indication of
the liquidity facility that the institution is whether the underwriting standards have
seeking to extend to the transaction, such as remained relatively constant over time or
a $250 million short-term pool-specific liquid- whether there has been a recent tightening or
ity facility, as well as the type of first-loss loosening.
credit enhancement that is provided by the 4. Asset-eligibility criteria. In order to reduce
seller, such as overcollateralization. The asset the ABCP program’s exposure to higher-
purchase by the ABCP conduit from the risk assets, an ABCP program generally
seller may be described as a two-step sale specifies minimum asset-eligibility criteria.
that first involves the sale of the assets (for This is particularly true for revolving
example, trade receivables) to an SPV on a transactions since the seller’s underwriting
true-sale basis and then involves the sale of standards may change so that the credit qual-
the assets by the SPV to the ABCP program. ity of the assets purchased by the ABCP
Other features of the structure should be program can be adversely affected. While
described, such as if the transaction is a eligibility criteria may be designed for
revolving transaction with a one-year revolv- specific transactions, there is a common set
ing period. of criteria that are generally applicable,
In addition, the sponsoring banking orga- including those that exclude the purchase of
nization typically obtains true-sale and non- defaulted assets or assets past due more than
consolidation opinions from the seller’s a specified number of days appropriate for
external legal counsel. The opinions should the specific transaction; limiting excess
identify the various participants in the concentration to an individual obligor;
transaction—including the seller, servicer, excluding the purchase of assets of obligors
and trustee—as appropriate. For instance, the that are affiliates of the seller; or limiting the
seller of the assets is identified as the party tenor of the assets to be purchased. Other
that would act as the servicer of the assets and criteria also may require that the obligor be a
who is responsible for all the representa- resident of a certain country and that the
tions and warranties associated with the sold asset is payable in a particular currency. All
assets. of these criteria are intended to reduce the
2. Asset seller’s risk profile. The assessment of credit risk inherent in the asset pool to be
the asset seller’s risk profile should consider purchased by the ABCP program. A strong
its past and expected future financial perfor- set of eligibility criteria may reduce the
mance, its current market position and necessary credit enhancement provided by
expected competitiveness going forward, as the selling organization.
well as its current debt ratings. For example, 5. Collection process. Often, if the seller/
the sponsor may review the seller’s leverage, servicer has a senior unsecured debt rating of
generation of cash flow, and interest cover- at least BBB-, cash collections may be com-
age ratios, and whether the seller is at least mingled with the seller/servicer’s cash until
investment grade. Also, the sponsoring bank- such time as periodic payments are required
ing organization may attempt to anticipate to be made to the ABCP program. Documen-
the seller’s ability to continue to perform tation should provide an ABCP program with
under more-adverse economic conditions. In the ability to take steps to control the cash
addition, some sponsors may take other infor- flows when necessary and include covenants
mation into account, such as KMV ratings, to to redirect cash flows or cause the segrega-
confirm their internal view of the seller’s tion of funds into a bankruptcy-remote SPE
financial strength. upon the occurrence of certain triggers. A
3. Underwriting standards. A discussion of the description of how checks, cash, and debit
seller’s current and historical underwriting payments are to be handled may be dis-
standards should be included in the transac- cussed. For instance, documentation may

Page 8
state that payments by check must be pro- ABCP program.

cessed on the same day they are received by 8. Historical performance. As a prelude to siz-
the lockbox and that after the checks clear, ing the pool-specific credit enhancement pro-
the cash is deposited in a segregated collec- vided by the seller, the sponsoring banking
tion account at the sponsoring banking orga- organization will review the historical per-
nization. Also, the documents may describe formance of the seller’s portfolio, including
the types of eligible investments in which the consideration of losses (that is, loss rate and
cash may be invested, which are usually loss severity), delinquencies, dilutions, and
highly rated, liquid investments such as gov- the turnover rate.13 An indication of the
ernment securities and A1/P1+ commercial direction of losses and delinquencies, and the
paper. reasons behind any increase or decrease are
6. Assets’ characteristics. Usually, a transaction often articulated. For instance, an increase in
summary will provide a description of the losses may reflect losses due to specific
assets that will be sold into the program and industry-related problems and general eco-
outline relevant pool statistics. For instance, nomic downturns. Typically, the rating agen-
there likely will be a discussion of the cies prefer at least three years’ worth of
weighted average loan balance, weighted historical information on the performance of
average credit score (if appropriate), weighted the seller’s asset pools, although the rating
average original term, and weighted average agencies periodically permit transactions to
coupon, as well as the ranges of each char- have less information. As a result, a sponsor-
acteristic. In addition, the portfolio may be ing banking organization likely will require
segmented by the sponsoring banking orga- the same degree of information as a rating
nization’s internal-rating grades to give an agency whether this is a full three-year his-
indication of each segment’s average credit tory or a lesser amount, as appropriate, when
quality (as evidenced by an average credit assessing the credit quality of its liquidity
score) and share of the portfolio’s balances. and credit-enhancement exposures.
Many times, the sponsor will identify con- 9. Termination events. ABCP programs usually
centrations to individual obligors or geo- incorporate commercial paper stop-issuance
graphic areas, such as states. or wind-down triggers to mitigate losses that
7. Dilution. Certain asset types (for example, may result from a deteriorating asset pool or
trade receivables) purchased by ABCP pro- some event that may hinder the ABCP pro-
grams may be subject to dilution, which is grams’ ability to repay maturing commercial
the evaporation of the asset due to customer paper. Such triggers may be established at
returns of sold goods, warranty claims, dis- either the pool level or program-wide level,
putes between the seller and its customers, as and may, if hit, require the ABCP program to
well as other factors. For instance, the seller immediately stop issuing commercial paper
of the assets to the ABCP program may to fund (1) new purchases from a particular
permit its customers to return goods, at seller or (2) any new purchases regardless of
which point the receivables cease to exist. the seller. In addition, such triggers may
The likelihood of this risk varies by asset require the ABCP program to begin liquidat-
type and is typically addressed in the trans- ing specific asset pools or its entire portfolio.
action summary. For instance, in sales of The rating agencies consider these struc-
credit card receivables to an ABCP program, tural safeguards, which are designed to pro-
the risk of dilution is small due to the tect the ABCP program from credit deterio-
underlying diversity of the obligors and mer- ration over time, in determining the rating on
chants. While the pool-specific liquidity an ABCP program’s commercial paper. In
facilities often absorb dilution initially, the many ABCP programs, there may be a pro-
seller generally is required to establish a vision that requires the program to wind
reserve to cover a multiple of expected dilu- down if a certain percentage of the program-
tion, which is based on historical informa- wide credit enhancement has been used to
tion. The adequacy of the dilution reserve is
reviewed at the inception of the transaction 13. The turnover rate of a receivables portfolio is a
measure of how fast the outstanding assets are paid off. For
and may or may not be incorporated in the example, if a seller had sales of $4,000 in the prior year and
seller-provided credit enhancement that is an average portfolio balance of $1,000, then the turnover rate
provided on the pool of assets sold to the of the portfolio is four.

Page 9
cover losses (for example, 25 percent). above predetermined levels. Program-wide

Examples of pool-specific triggers include triggers may include (1) the ABCP pro-
the insolvency or bankruptcy of the seller/ gram’s failure to repay maturing commercial
servicer; downgrade of the seller’s credit paper or (2) when draws reduce the program-
rating below a specific rating grade; or dete- wide credit enhancement below a stated
rioration of the asset pool to the point where threshold.
charge-offs, delinquencies, or dilution rises

Page 10
Assessing Risk-Based Capital (RBC)—Direct-Credit
Substitutes Extended to ABCP Programs
Unless otherwise specified, examiners should by the ABCP programs is rated by one or
weigh the importance and significance of the more nationally recognized statistical rating
objectives being assessed when he or she deter- organizations (NRSROs).
mines a final conclusion. 2. To verify that NRSROs are monitoring the
ABCP programs in order to ensure the main-
tenance of minimum standards for the respec-
INTERNAL RISK-RATING tive ABCP program’s rating.
SYSTEM
1. To determine if the banking organization has UNDERWRITING STANDARDS
a robust internal risk-rating system. AND MANAGEMENT OVERSIGHT
2. To determine if the banking organization
generally has sound risk-management prac- 1. To assess the quality and robustness of the
tices and principles. underwriting process.
INTERNAL RISK-RATING
SYSTEM FOR ABCP INTERNAL-RATING
SECURITIZATION EXPOSURES CONSISTENCY WITH
RATINGS ISSUED BY THE
1. To determine the extent to which the banking RATING AGENCIES
organization integrates its ABCP internal
risk-rating process with its credit-risk man- 1. To confirm that whenever ABCP program
agement framework. transactions are externally rated, internal rat-
2. To qualitatively assess the suitability of the ings are consistent with, or more conserva-
banking organization’s risk-rating process tive than, those issued by NRSROs.
relative to the transactions and type of assets
securitized.
3. To assess the adequacy of the credit-approval FIRST-LOSS POSITION FOR
process. PROGRAM-WIDE CREDIT
ENHANCEMENT
INTERNALLY RATED 1. To assertain the rank order, if possible, of the
EXPOSURES risk assumed by the various direct-credit
substitutes and liquidity facilities in the ABCP
1. To determine whether the banking organiza- program—determining the order in which
tion applies its internal risk-rating system to various exposures would absorb losses.
liquidity facilities and credit enhancements 2. To determine if third-party investors provide
extended to ABCP programs. program-wide credit enhancement to the
2. To determine whether the assigned internal ABCP conduit.
ratings incorporate all of the risks associated 3. To determine if the spread that third-party
with rated exposures extended to ABCP investors or the banking organization charges
programs. for taking program-wide credit-enhancement
risk is generally within the market’s
investment-grade pricing range.
MONITORING OF ABCP
PROGRAMS BY RATING
AGENCIES
1. To confirm that the commercial paper issued

Page 1
3030.2 RBC—Direct-Credit Substitutions Extended to ABCP Programs: Examination Objectives
CONCENTRATIONS OF mine the banking organization’s assessment

NON-INVESTMENT GRADE of the credit quality of the risk exposure.
SELLER/SERVICERS 2. To rank-order the underlying transactions in
the ABCP program on the basis of internal
1. To determine if the sponsoring banking orga- risk ratings in order to determine the notional
nization is exposed to an inordinate amount amount of transactions falling in each of the
of seller/servicer risk. three ratings categories: investment grade
(BBB- or better), high non-investment grade
(BB+ to BB-), and low non-investment grade
UNDERLYING ASSETS OF THE (below BB-).
ABCP PROGRAM STRUCTURED 3. To determine a risk-based capital require-
TO INVESTMENT-GRADE RISK ment for the program-wide credit
enhancement.
1. To obtain the internal rating for the program-
wide credit enhancement in order to deter-

Page 2
Assessing Risk-Based Capital (RBC)—Direct-Credit
Substitutes Extended to ABCP Programs
DECISION TREE the internal-ratings approach for exposures to

ABCP programs is inappropriate for purposes of
The decision tree is intended to assist examiners the respective provisions of the risk-based capi-
in determining the adequacy of the internal tal rule.
rating systems used for rating direct-credit sub- While this guidance has been designed to
stitutes extended to asset-backed commercial address common industry underwriting and risk-
paper (ABCP) programs. If examiners consider management practices, it may not sufficiently
a banking organization’s internal rating system address all circumstances. For unique cases not
adequate, then the institution may use the inter- adequately addressed by the guidance, examin-
nal ratings assigned to calculate the risk-based ers should review the specific facts and circum-
capital charge for unrated direct-credit substi- stances with the responsible Reserve Bank man-
tutes, including program-wide credit enhance- agement in conjunction with the Board’s Banking
ments. The determination process can essen- Supervision and Regulation staff before render-
tially be broken down into individual steps that ing a final conclusion.
start by answering broad fundamental risk ques-
tions and end with examining more-detailed
ABCP program-specific characteristics. Organizing the Examination Process
The first six steps (1–6) of the process focus
When organizing the examination, examiners
on evaluating the banking organization’s risk-
should note if the banking organization operates
rating system, while the final three steps (7–9)
multiple ABCP conduits. In some cases, a bank-
are used to determine the amount of risk-based
ing organization may manage individual ABCP
capital to be assessed against program-wide
conduits out of different legal entities or lines of
credit enhancements.
business, and each conduit may focus on differ-
ent business strategies.
PERFORMING THE 1. Before initiating the examination process,

EXAMINATION PROCEDURES determine—
a. the number of ABCP conduits sponsored
Examiners should be mindful that evaluating the by the banking organization,
adequacy of internal risk-rating systems gener- b. which ABCP conduits have direct-credit
ally depends on both subjective judgments and substitutes provided by the banking orga-
objective information generated in each step of nization, and
the process. When performing the examination c. from what areas within the organization
procedures, the examiner may determine that these activities are conducted.
certain observed weaknesses in meeting specific 2. When multiple ABCP conduits exist, assess
supervisory expectations may not necessarily be whether the banking organization applies the
severe enough to conclude that the internal internal risk-rating system consistently to
risk-rating system is inadequate. In some cases, each program with identical policies, proce-
compensating strengths in components of the dures, and controls.
risk-rating system may offset observed weak- 3. If the banking organization operates ABCP
nesses. However, examiners should take such program activities out of different legal enti-
weaknesses into consideration in formulating ties or lines of business, or if the application
their overall conclusion and consider them when of an internal rating system varies from
developing recommendations to improve the program to program, evaluate the adequacy
internal risk-rating process. Failure to meet the of each unique application.
regulatory requirements and follow the supervi- 4. Consider limiting any Federal Reserve
sory guidance typically is an indication of unsafe approval of the use of internal ratings to
and unsound banking practices in the risk man- those programs that have been examined and
agement of ABCP programs. Where failures are determined to meet the requirements outlined
observed, examiners should conclude that use of in this guidance.

Page 1
3030.3 RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures
Assessment of Internal Risk-Rating System Assessment of Program-wide Credit Enhancement
Begin
Step 1 Step 7
Program-wide
Exposure Is
Acceptable No Yes Credit
in the First
Risk-Rating May Require
Use of Internal Loss
System? Gross-Up
Risk-Rating Position?
Treatment
System Should
Not be Approved
Yes No
Step 2 Step 8
Established Is Seller/
Rating System No Yes
Service
for ABCP Risk High?
Exposure?
Yes No
Step 3 Step 9
Are All Risk-weight
Relevant Underlying Yes Program-wide
Exposures No Exposures Credit
Internally Investment Enhancement
Rated? Grade? at 100%
Yes No
Step 4
Determine
Exposures Risk-Based Capital
Monitored by No Requirement Using
Rating Weakest-Link
Agencies? Formula
Yes
Step 5
Sufficient
Underwriting No
Standards &
Oversight?
Yes
Step 6
Internal &
External No
Ratings are
Consistent?
Yes
Use of Internal Risk-

Rating System is
Approved

Page 2
RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures 3030.3
Banking organizations may have estab- enhancement to maintain an internal risk

lished ABCP lines of business from which rating.
they coordinate client relationships, 6. The transactional due-diligence, approval,
transaction-origination activities, funding or execution documentation is poorly
activities, and ABCP conduit management. prepared.
An inspection of such ‘‘front-office’’ opera- 7. A significant number of problem transac-
tions can provide important insight into the tions are taken out of the ABCP program
unique characteristics of the banking organi- through liquidity draws.
zation’s ABCP program. Examiners should 8. There is no independent review or oversight
focus the examination’s review on the areas of the internal rating system or the assigned
of the organization where credit decisions transaction ratings. A review conducted by
and credit-risk management are housed and internal parties within the sponsoring/
where oversight of the internal risk-rating administrating banking organization may
system is maintained. still be considered independent so long as
5. Consider the factors listed below while con- the business unit conducting the review
ducting the banking organization’s examina- does not report to the unit that is responsible
tion. When any of these factors are observed, for the ABCP program’s transactions.
perform a more thorough review of its inter- 9. The transaction-underwriting and risk-
nal controls, risk management, and potential management functions of an ABCP pro-
weaknesses before approving the banking gram sponsor/administrator, other than rou-
organization’s internal risk-rating system. tine outside audit reviews, are delegated to
Although observation of a single factor unaffiliated third parties.
may not be compelling enough for withhold- 10. The ABCP conduit commercial paper is not
ing approval, the examiner’s observation of rated lower than A-2/P2 on an ongoing
one or more of these factors should result in basis by the rating agencies.
the adoption of a more conservative bias as
the examination procedures are performed. If examiners observe either of the following
two factors, the banking organization should
If a combination of the risk factors identified not receive Federal Reserve approval to use
below is observed during the examination the internal-ratings approach. (See the
process, the examiner may determine that the examination procedures for more detail.)
internal risk-rating system should not be
relied upon for assessing the risk-based capi- 11. The banking organization does not have, in
tal treatment for direct-credit substitutes pro- the examiner’s view, an established or
vided to ABCP programs. acceptable internal risk-rating system to
assess the credit quality of its exposures to
The following factors should be considered: its ABCP programs.
12. Relevant direct-credit substitutes or liquid-
1. The sponsoring banking organization has a ity facilities are not internally risk rated.
short track record and is inexperienced in
the management of an ABCP program.
2. The transaction-specific credit enhancement
is solely in the form of excess spread. Step 1—Acceptable Internal
3. Significantly higher ABCP program costs Risk-Rating Systems
exist for program-wide credit enhancement
as compared with the internal and external 1. Determine if the banking organization is able
benchmarks for investment-grade risk. to satisfactorily demonstrate how its internal
4. The sponsoring banking organization fails risk-rating system corresponds to the rating
to maintain historical ratings-migration data agencies’ standards used as the framework
or the migration data of required credit- for complying with the securitization require-
enhancement levels. ments in the risk-based capital rule. Ascer-
5. There is an excessive number of transaction- tain whether the credit ratings map to the
rating migrations (both internal and exter- risk-weight categories in the ratings-based
nal), or excessive collateral calls are neces- approach so they can be applied to internal
sary to enhance transaction-level credit ratings.

Page 3
2. If a separate supervisory team has conducted credit-risk management or loan-review

a detailed evaluation of the robustness and personnel assigning or reviewing the
effectiveness of the banking organization’s credit-risk ratings.
overall internal ratings system, use the inspec- g. The banking organization has an internal
tion work to assess the application of internal audit procedure that periodically verifies
ratings specific to the banking organization’s that internal risk ratings are assigned in
ABCP programs. Consider reducing the pro- accordance with the organization’s estab-
cedures to a quick review of the previous lished criteria.
examination’s findings. h. The banking organization (1) monitors the
3. If there was no previous evaluation of the performance of the internal credit-risk
banking organization’s risk-rating system or ratings assigned to nonrated, nontraded
if documentation of the evaluation findings is direct-credit substitutes over time to deter-
unavailable, perform a full review of the mine the appropriateness of the initial
organization’s risk-rating system. credit-risk rating assignment and (2) adjusts
4. Ascertain whether the banking organiza- individual credit-risk ratings, or the over-
tion’s overall risk-rating process is generally all internal credit-risk ratings system, as
consistent with the fundamental elements of needed.
sound risk management and with the rating i. The internal credit-risk system makes
assumptions and methodologies of the rating credit-risk rating assumptions that are con-
agencies. sistent with, or more conservative than,
a. Determine if the internal ratings are incor- the credit-risk rating assumptions and
porated into the credit-approval process methodologies of the nationally recog-
and are considered in the pricing of credit. nized statistical rating organizations
b. Find out if the internal lending and expo- (NRSROs).
sure limits are linked to internal ratings.
5. Verify that the internal risk-rating system for If all of the above supervisory guidance is
ABCP programs contains the following nine not adhered to, the use of internal ratings
criteria: under the risk-based capital rule should not
a. The internal credit-risk system is an inte- be approved.
gral part of the banking organization’s
risk-management system, which explicitly
incorporates the full range of risks arising Step 2—Use of an Established
from its participation in securitization Internal Risk-Rating System Tailored
activities. to ABCP Securitization Exposures
b. Internal credit ratings are linked to mea-
surable outcomes, such as the probability 1. Determine if an internal rating system exists
that the position will experience any loss, that assesses exposures (for example, liquid-
the position’s expected loss given default, ity facilities) provided to ABCP programs.
and the degree of variance in losses given 2. Ascertain whether there is evidence that the
default on that position. ABCP internal risk-rating process is an inte-
c. The banking organization’s internal credit- grated component of the enterprise-wide
risk system separately considers (1) the credit-risk management process. This
risk associated with the underlying loans includes—
or borrowers and (2) the risk associated a. risk ratings that are a fundamental portfo-
with the structure of a particular securiti- lio management tool and
zation transaction. b. internal ratings that are considered in
d. The banking organization’s internal credit- credit and pricing decisions.
risk system identifies gradations of risk 3. Evaluate whether the management team and
among ‘‘pass’’ assets and other risk staff are experienced with the types of assets
positions. and facilities internally rated for the ABCP
e. The banking organization has clear, explicit program.
criteria, including subjective factors, that 4. Determine if there is meaningful differentia-
are used to classify assets into each inter- tion of risk. Verify that—
nal risk grade. a. separate ratings are applied to borrowers
f. The banking organization has independent and facilities that separately consider the

Page 4
risk associated with the underlying loans the ABCP program has been rated in the
and borrowers, as well as the risk associ- second-highest short-term rating category
ated with the specific positions in a secu- (A2, P2, or F2) or higher.
ritization transaction, and 2. Confirm that there is evidence that rating
b. a distinct set of rating criteria exists for agencies are actively monitoring the structur-
each grade. The banking organization ing methodologies and credit quality of the
should have classified its assets into each transactions purchased by the ABCP conduit.
risk grade using clear, explicit criteria, a. Prescreened programs. Confirm that
even for subjective factors. NRSROs are prescreening each new trans-
5. Verify that the risk-ratings criteria for ABCP action placed in the ABCP program.
transactions are documented with specific b. Post-review programs. Find out if ABCP
methodologies detailed for different asset program transactions are monitored by the
types. NRSROs via monthly or quarterly reports.
6. Find out if the banking organization includes Determine if the banking organization is
a transaction summary1 as part of its credit- promptly forwarding information on new
approval process. The transaction summary transactions and transactions experiencing
should include a description of the following: deterioration to the NRSROs (for example,
transaction structure, seller/servicer’s risk pro- through monthly reports).
file,2 relevant underwriting criteria, asset-
eligibility criteria, collection process, asset
characteristics, dilution and historical loss
rates, and trigger and termination events. Step 5—Sufficient Underwriting
(See appendix B of section 3030.1 for a more Standards and Management Oversight
detailed description of the above transaction-
summary categories.) 1. Determine if the banking organization has
7. Before reaching a final assessment, consult internal policies addressing underwriting
with the other examiners who have con- standards that are applicable to ABCP
ducted reviews of the banking organization’s programs.
other risk-rating systems, including the cor- 2. For each ABCP transaction, ascertain
porate risk-rating system. whether the institution applies the following
factors in its underwriting process:
Step 3—Relevant Internally Rated a. General Portfolio Characteristics:

Exposures
• an understanding of the operations of
1. Verify that the banking organization inter- the businesses that originates the
nally rates all relevant exposures to ABCP assets being securitized
programs, such as pool-specific liquidity • a review of the general terms offered
facilities. to the customer
2. Ascertain if the banking organization maps • a determination of the quality of assets
its internal ratings to the full scale of external and from which legal entity assets are
ratings provided by the NRSROs. originated
• a determination of customer, indus-
try, and geographic concentrations
Step 4—ABCP Program Monitored
• an understanding of the recent trends
by Rating Agencies in the business that may affect any
historical information about the assets
1. Verify that the commercial paper issued by
1. The transaction summary may not be specifically iden- b. Legal Structure of the
tified, but its elements would be part of the credit-approval Transaction:
process.
2. The seller/servicer’s risk profile may be developed by a
group within the banking organization other than the ABCP
• A general structuring of transactions
program group and incorporated into the transaction summary as ‘‘bankruptcy-remote’’ via a legal
by reference. ‘‘true sale’’ of assets rather than as

Page 5
secured loans. (This reduces the like- Reserves may take a number of differ-
lihood that a creditor of the seller can ent forms, including recourse to the
successfully challenge the security seller (if the seller is of high credit
interest in the asset pool in the event quality), funded cash reserves, and over-
of seller insolvency.) Determine if the collateralization.
banking organization maintains cop- (1) Determine if the credit-approval
ies of true-sale opinions in the facility chain carefully scrutinizes transac-
file or as a part of the facility’s legal tions in which reserves are in the
documents. form of recourse to a seller with
• An appropriate management level in weak credit quality.
the credit-approval hierarchy that is (2) Ascertain if the banking organiza-
responsible for reviewing transaction’s criteria for structuring the
tions that do not have a bankruptcy- appropriate reserve levels are gen-
remote ‘‘true-sale’’ structure. erally consistent with rating agency
• Uniform commercial code (UCC) fil- criteria for a particular asset class.
ings and searches on securitized (3) Review and consider the relevant
assets. (UCC filings are often needed rating agency methodology when
to ensure that asset transfers resist evaluating reserves for any particu-
third-party attack [that is, are ‘‘per- lar transaction.
fected’’]). UCC searches often ensure
that asset transfers are not subject to a
higher-priority security interest (that
d. Eligibility Criteria
is, that the banking organization’s Eligibility criteria are structured into
interests are ‘‘first priority’’). If such securitization transactions to restrict (or
filings and searches have not been limit) the inclusion of certain categories
performed, examiners should make of receivables as appropriate to the
further inquiry. There may be a satis- particular transaction. Examples of such
factory reason for not using the UCC restricted categories may include:
filing system.
• delinquent receivables (based on a
• Transactions that include a contrac- stated aging policy, such as 30 days
tual representation or a legal opinion past due)
ensuring that there are no provisions, • receivables of bankrupt obligors
such as negative pledges or limita- • foreign receivables
tions on the sale of assets, that would
• affiliate receivables
prohibit the securitization transaction.
• receivables of obligors with delin-
quent balances above a certain amount
c. Transaction-Specific Credit • bill and hold receivables
Enhancements • unearned receivables
• non-U.S.-dollar-denominated receiv-
Transaction-specific credit enhance- ables
ment takes a variety of forms depend- • receivables subject to offset
ing upon the asset type. For instance, • disputed receivables
credit enhancement relating to trade • receivables with a payment date
receivables may consist of the follow- beyond a specified time horizon
ing types of reserves: • post-petition receivables
• loss reserve—reserves related to obli-
gor default risk The above list is illustrative and should
• dilution reserve—reserves related to not be considered comprehensive.
non-cash reductions of balances
• servicing reserve—reserves related to (1) Conduct further analysis when there
fees for servicing and trustees is a lack of any specific eligibility
criteria (for example, those listed
The loss and dilution reserves typically above) that warrants a further deter-
account for most of the reserves. mination as to whether the banking

Page 6
organization has taken appropriate g. Due-Diligence Reviews

measures to alleviate any particular
risk arising from the lack of a (1) Ascertain if the banking organiza-
specific feature. tion conducts due-diligence reviews
prior to closing its ABCP transac-
tions. Determine if such reviews
e. Concentrations were tailored to the asset type being
securitized and the availability of
(1) Analyze obligor, industry, and geo- audit information. A frequent pub-
graphic concentrations. lic asset-backed securities (ABS)
(2) Ascertain if the appropriate concen- issuer that accesses conduit funding
tration limits have been established or a seller that has strong credit
within transaction documents, often quality may be eligible for a post-
within the eligibility criteria. closing review, provided recent
audit results are obtained. If not, it
should be subject to pre-closing
f. Trigger Events and Termination review. For example, a review tai-
Events lored to trade receivables should
focus on most of the following:
The inclusion of trigger and termination • Confirming the receivable infor-
events plays a critical role in securiti- mation (balances, sales, dilution,
zation structures. It is standard practice write-offs, etc.) previously pro-
to have trigger or termination events vided by the seller, with the sell-
related to the performance of the assets er’s books and records over at
and, depending upon the asset type, to least two reporting periods. Such
the seller/servicer. Trigger events are a review might be performed by a
comparable to performance covenants third-party auditor.
in corporate debt and provide a lender • Sampling invoices against the
with the ability to accelerate a transac- seller’s aged trial balance to test
tion, when appropriate. In addition, such the accuracy of agings.
triggers create incentives that allow the • Sampling past invoices to deter-
seller and the banking organization to mine ultimate resolution (paid,
negotiate higher levels of credit enhance- credited, written-off, etc.)
ment or add further restrictions to eli- • Sampling credits against their
gibility criteria when the receivables’ respective invoices to test the
performance metrics indicate deteriora- dilution horizon.
tion beyond an established trigger level. • Sampling write-offs to determine
In a similar way, termination events are timing and reasons for write-offs.
established to begin the early termina- • Reviewing significant customer
tion of the transaction when the receiv- concentrations, including delin-
able performance deteriorates. Typical quent balances.
trigger events are based on one or more • Determining systems capability
of the following performance metrics: with respect to transaction report-
• asset coverage ratio ing and compliance.
• Reviewing credit files for com-
• delinquencies pleteness and conformity with
• losses credit policies.
• dilution • Reviewing collection systems and
determining the portion of cash
Termination events may include these going into segregated lockboxes
same metrics but may also include the or bank accounts.
bankruptcy, insolvency, change of con- • Reviewing internal and external
trol of the seller/servicer, or the failure auditor reports to the extent that
of the servicer to perform its responsi- such documents are available for
bilities in full. review.

Page 7
• Noting any unusual items that should be required in the monthly report.
may complicate the receivable
transaction. (1) Determine if quarterly, or more fre-
(2) Determine if ABCP transactions are quent, reports for a trade receivable
reviewed at least annually. transaction include the following:
• Confirm that the banking organi- • beginning balances
zation verifies the accuracy of the • sales
monthly servicer’s transaction • cash collections
reports, including compliance • dilution or credits
with sale and servicing require- • write-offs
ments. • ending balances
• Determine if an increased review • delinquencies by aging bucket
frequency is needed for any issues • ineligible assets
raised in prior reviews, transac- • total eligible receivables
tions with higher-risk sellers, and • excess concentrations
transactions serviced out of mul- • net receivable balance
tiple locations. • conduit investment
• conduit’s purchased interest
• calculation of receivable perfor-
h. Cash Management mance termination events
• top 10 obligor concentrations
(1) Assess a seller’s cash-management
(2) Ascertain if the banking organiza-
practices. Commingling of cash col-
tion has established other special
lections can cause a loss in the
reporting requirements based on the
perfected security interest of cash
particular pool of receivables being
flows, particularly in the event of
securitized.
seller insolvency.
• Determine if, preferably, the bank-
ing organization requires that all j. Receivable Systems
payment collections flow into a
single, segregated lockbox (1) Because of the significant reporting
account to minimize cash- requirements in a securitization
commingling risk. transaction, verify that the banking
• For trade receivables, find out if organization assesses—
the banking organization requires • the seller’s receivable systems to
that the cash collections be rein- determine if they will be suffi-
vested in new receivables to cient to provide the required
eliminate cash-commingling risk. information and
(2) For higher-risk sellers, determine if • the seller’s data backup and disas-
the banking organization— ter recovery systems.
• establishes an account in the name
of the trust or special-purpose
vehicle (SPV) into which collec- k. Quality of Seller/Servicer
tions could be swept on a daily
(1) Verify that the banking organiza-
basis or
tion performs an assessment of the
• requires that settlement be done
creditworthiness of the seller that is
weekly, or daily, ensuring that
conducted from the relationship
there are always sufficient receiv-
side.
ables to cover investments and
(2) Determine if the banking organiza-
reserves.
tion conducts a more focused as-
sessment on the seller/servicer’s
i. Reporting management team that is involved
in the day-to-day receivables opera-
When underwriting a portfolio, it is tion (that is, credit, accounting,
important to decide what information sales, servicing, etc.).

Page 8
l. Performance Monitoring (2) Evaluate the robustness of the

underwriting process and deter-
(1) Find out whether the banking orga- mine if it is comparable to stated
nization has developed and uses a rating agency criteria. If weak-
performance-monitoring plan that nesses in the underwriting process
periodically monitors the portfolio. are found, determine if there are
• Determine if there is appropriate any existing compensating strengths
monitoring that allows the desig- and any other relevant factors to be
nated administrator to review rel- considered when determining its
evant pool performance to evalu- overall assessment.
ate the level of available funding (3) If the examiner determines that the
under the asset-quality tests in supervisory expectations generally
the related liquidity facility. are not met, he or she should not
• Determine if the banking organi- recommend to the appropriate
zation tests these conditions when Reserve Bank supervisory official
the seller reports performance that the use of internal ratings,
data relating to an underlying under the securitization capital rule,
transaction (usually monthly or be approved.
quarterly).
Typically, a liquidity facility has a fund- Step 6—Consistency of Internal

ing condition based on asset quality Ratings of ABCP Program’s
whereby the liquidity provider will not
advance against any receivable that is
Exposures with Ratings Issued
considered defaulted. A performance- by the Rating Agencies
monitoring plan may entail monitoring the
run rate of defaulted assets so that the 1. Find out if any underlying transactions funded
potential losses do not exceed the loss through ABCP programs are externally rated
protection. by one or more rating agencies.
2. Confirm if the mapping of the internal ratings
assigned to these transactions is consistent
m. Post-Closing Monitoring with, or more conservative than, those issued
by NRSROs.
(1) Determine if the banking organiza- 3. When the underlying transactions are split-
tion’s underwriting team assists the rated by two or more rating agencies, deter-
portfolio management team in mine if the internal ratings are consistent
developing all of the items that with the most conservative (lowest) external
should be tracked on the transac- rating.
tion, including the development of 4. Ascertain that the above exceptions do not
a spreadsheet that ensures the cap- represent more than a small fraction of the
ture and calculation of the appro- total number of transactions that are exter-
priate information. nally rated. If such exceptions exist, deter-
mine if there are generally an equal or larger
n. Underwriting Exceptions percentage of externally rated transactions
where internal ratings are more conservative
(1) If a banking organization approves than the external rating.
a transaction after it has agreed to
an exception from standard under- If supervisory expectations are not met, then
writing procedures, find out if the the internal risk-rating system may not be
banking organization closely moni- appropriately mapped to the external ratings
tors and periodically evaluates the of an NRSRO. In such cases, further review
policy exception. of the adequacy of the banking organiza-
tion’s risk-rating system must be undertaken
Banking organizations may utilize variations of before the use of internal ratings under the
the above-listed underwriting standards. securitization capital rule can be approved.

Page 9
Determine Adequacy of Internal Ratings ranges of non-investment-grade and

Systems investment-grade exposures of the spon-
soring banking organization, the loan syn-
If, through the examination process, the internal dication market, and the bond market.
risk-rating system utilized for ABCP exposures This may be a gauge as to whether a third
is found to be inadequate, then the banking party considers the risk as investment
organization may not apply the internal risk- grade or non-investment grade.
ratings approach to ABCP exposures for risk- b. Reference such sources for reviewing mar-
based capital purposes until the organization has ket pricing as Loan Pricing Corporation’s
remedied the deficiencies. Banking organiza- Gold Sheets and Bloomberg (for bond
tions that have adequate risk-rating systems that spreads). A range or average pricing for
are well integrated into risk-management pro- both investment-grade and non-investment-
cesses applied to ABCP programs may be grade syndicated loans can be found in the
approved for use of the internal risk-ratings Gold Sheets.
approach. c. Similarly, review also the price the sponsor/
Once a banking organization’s internal rating banking organization is charging for its
system is deemed adequate, the organization respective portion of the program-wide
may use its internal ratings to slot ABCP expo- credit enhancement.
sures, including pool-specific liquidity facilities,
into the appropriate rating category (investment
grade, high non-investment grade, and low non-
investment grade), and apply the corresponding
Step 8—Risk Levels
risk weights. However, due to the unique nature Posed by Concentrations of
of program-wide credit enhancements, further Non-Investment-Grade
guidance is provided in steps 7 through 9 to help Seller/Servicers
establish the appropriate capital requirement.
1. Confirm that the banking organization’s inter-
nal risk-rating systems properly account for
the existence of seller/servicer risk.
Step 7—Determination of Whether An asset originator (that is, the entity
Program-Wide Credit Enhancements selling the assets to the ABCP program)
Are in the First-Loss Position typically is the servicer and essentially acts
as the portfolio manager for the ABCP pro-
1. Determine if the ABCP program documenta- gram’s investment. The servicer identifies
tion confirms that the program-wide credit receivables eligible for the ABCP program
enhancement is not the first-loss credit and manages to preserve the investment on
enhancement for any transaction in the ABCP behalf of the banking organization sponsor-
program and is, at worst, in the second- ing the ABCP program. As previously dis-
economic-loss position, usually after cussed, servicer risk can be partially miti-
transaction-specific credit enhancements. gated through seller allocation and structuring
2. Verify if the spread charged for the program- payments to protect against commingling of
wide credit enhancement is the spread range cash.
of investment-grade exposures of a term 2. Determine if the banking organization has
securitization. Consider other factors that specific transaction structures, such as a
may influence pricing, such as availability of backup servicer, in place to mitigate servicer
the credit enhancement. risk.
3. Find out if the financial guarantee providers, 3. Ascertain if exposure to an excessive number
such as AMBAC, FSA, and FGIC, partici- of non-investment-grade servicers adversely
pate in a program-wide credit-enhancement affects the overall credit quality of the ABCP
tranche either on a senior position or on a program, exposing the conduit to the higher
pari-passu position with other providers. The bankruptcy risk that inherently exists with
risk taken by these institutions is usually non-investment-grade obligors.
investment grade. 4. Use the benchmarks below to assess the
a. Compare the price of the guarantee banking organization’s potential exposures
charged by these institutions to the pricing to non-investment-grade seller/servicer con-

Page 10
centrations in its ABCP program. Depending tions are internally rated below invest-
on the circumstances, concentrations exceed- ment grade, then consider using the fol-
ing these benchmarks may be considered as lowing weakest-link approach to calculate
unsafe and unsound banking practices. an appropriate risk-based capital charge
a. Determine, based on the grid below, the for the program-wide credit enhancement.
percentage of securitized assets from non- The approach takes into account the
investment-grade servicers to the total internal ratings assigned to each underly-
outstandings of an ABCP program that ing transaction in an ABCP program.
has a lower weighted average rating of all These transaction-level ratings are typi-
the transactions in the program. For cally based on the internal assessment of a
example, if the ABCP program transac- transaction’s pool-specific liquidity facil-
tions have a weighted average rating ity and the likelihood of its being drawn.
equivalent to ‘‘BBB,’’ no more than 30 per- The transactions are rank-ordered by their
cent of the total outstandings of the ABCP internal rating and then bucketed into the
program should be represented by non- three ratings categories: investment grade,
investment-grade seller/servicers. How- high non-investment grade, and low non-
ever, an ABCP program that has transac- investment grade. The program-wide credit
tions structured to a higher weighted enhancement is then assigned an appropri-
average rating, such as a single ‘‘A’’ ate risk weight based upon the notional
equivalent, could have up to 60 percent of amount of transactions in each ratings
the outstandings originated by non- bucket.
investment-grade seller/servicers without Under the weakest-link approach, the
causing undue concerns. risk of loss corresponds first to the weak-
est transactions to which the program-
Weighted Servicer wide credit enhancement is exposed. Bank-
average rating percentage ing organizations should begin with the
lowest bucket (low non-investment grade)
equivalent below and then move to the next-highest rating
of transactions investment grade bucket until the entire amount of the
AA 90% program-wide credit enhancement has
AA– 80% been assigned. The assigned risk weights
A+ 70% and their associated capital charges are
A 60% then aggregated. However, if the risk-
A– 50% based capital charge for the non-
BBB+ 40% investment-grade asset pools equals or
BBB 30% exceeds the 8 percent charge against the
BBB– 20% entire amount of assets in the ABCP
BB+ 10% program, then the risk-based capital charge
is limited to the 8 percent against the
program’s assets.
Banking organizations that sponsor
Step 9—The Portion of Underlying ABCP programs may have other method-
Assets of the ABCP Program ologies to quantify risk across multiple
Structured to Investment-Grade Risk exposures. For example, collateralized debt
obligation (CDO) ratings methodology
1. Determine the appropriate amount of risk- takes into account both the probability of
based capital that should be assessed against loss on each underlying transaction and
the program-wide credit enhancement based correlations between the underlying trans-
on the internal risk ratings of the underlying actions. This and other methods may gen-
transactions in the ABCP program. erate capital requirements equal to or
a. If all underlying transactions are rated more conservative than those arrived at
investment grade, risk-weight the notional via the weakest-link method. Regardless
amount of the program-wide credit of the approach used, well-managed insti-
enhancement at 100 percent. tutions should be able to support their
b. If one or more of the underlying transac- risk-based capital calculations.

Page 11
Weakest-Link Formula
IF [(0.16 * NI1) + NI2**] ≥ (0.08 * PROG), THEN RBC = (0.08 x PROG)
Else
Capital = [0.08 * (PWC Ø (NI1 + NI2))] + 0.16 * NI1] + [NI2**]
**Although the term NI2 should reflect a gross-up charge under the securitization capital rule
(that is, an effective 1,250 percent risk weight), for the sake of simplicity a dollar-for-dollar
charge is used here. The reason for using dollar-for-dollar is based on the assumption that the
NI2 portion of an ABCP pool is typically smaller than the gross-up charge would be on the
entire pool. Thus, instead of grossing-up the NI2 portion and then applying the low-level-
exposure rule (which, if NI2 is less than the gross-up charge, will yield a dollar-for-dollar
capital charge), the term just assumes the dollar-for-dollar amount.
In any event, the risk-based capital charge on the program-wide credit enhancement will
never exceed the maximum contractual amount of that program-wide credit enhancement
(that is, the low-level-exposure rule).
RBC = Risk-based capital

PROG = Notional amount of all underlying exposures in the program
PWC = Notional amount of program-wide credit enhancement
IG = Notional amount of exposures rated BBB- or better
NI1 = Notional amount of exposures rated between BB+ and BB-
NI2 = Notional amount of exposures rated below BB-
Example 1 Example 2
ABCP program size (PROG) = $1,000 MM ABCP program size (PROG) = $1,000 MM
Program-wide credit enhancement (PWC) = Program-wide credit enhancement (PWC) =
$100 MM $150 MM
Total amount of investment grade (IG) = Total amount of investment grade (IG) =
$995 MM $940 MM
Total amount of high non-investment grade Total amount of high non-investment grade
(NI1) = $4 MM (NI1) = $50 MM
Total amount of low non-investment grade Total amount of low non-investment grade
(NI2) = $1 MM (NI2) = $10 MM
Weakest Link Weakest Link

RBC = IF [(0.16 * 4) + 1] ≥ (0.08 * 1,000), then RBC = IF [(0.16 * 50) + 10] ≥ (0.08 * 1,000),
RBC = (0.08 * 1,000) then RBC = (0.08 * 1,000) = $18 MM
= $1.64 MM < $80 MM < $80 MM
Else Else
RBC = [(0.08 * (100 Ø (4 + 1))] + (0.16 * 4) + RBC = [(0.08 * (150 Ø (50+10))] + (0.16 * 50)
(1) + (10)
RBC = (7.60) + (0.64) + (1) RBC = (7.20) + (8.00) + (10)
= $ 9.24 MM = $25.2MM

Page 12
Example 3 too much risk-based capital being assessed. If

this situation arises, banking organizations
ABCP program size (PROG) = $1,000 MM should first apply the gross-up treatment to the
Program-wide credit enhancement (PWC) = NI2 asset pools and then assess 16 percent
$150 MM risk-based capital against an amount of the NI1
Total amount of investment grade (IG) = asset pools that, when added with the NI2 asset
$0 MM pools, would equal the amount of the program-
Total amount of high non-investment grade wide credit enhancement. For example, if the
(NI1) = $500 MM program-wide credit enhancement is $100 on
Total amount of low non-investment grade underlying transactions totaling $1,000, and the
(NI2) = $500 MM underlying exposures are $10 low non-
investment grade, $100 high non-investment
grade, and $890 investment grade, then risk
Weakest Link weighting will be based on the gross-up approach
for $10 and assigning the remaining $90 to the
RBC = IF [(0.16 * 500) + 500] ≥ (0.08 * 1,000), 200 percent risk-weight category, as shown
THEN RBC = (0.08 * 1,000) = $580 MM > below:
$80 MM
Therefore, $10 * 1,250% * 8% = $10.00
$90 * 200% * 8% = $14.40
RBC = (0.08 * 1,000) = $80 MM
Total $24.40
Because $580 MM is greater than the $80 MM
capital charge that would apply if all of the Finally, the aggregate capital charge, $24.40
assets supported by the PWC were on-balance- in this case, is then compared to the capital
sheet, the maximum risk-based capital charge is charge imposed on the underlying transactions if
$80 MM. all the program assets were on the banking
When the sum of all non-investment-grade organization’s balance sheet (that is, 0.08 *
asset pools (that is, NI1 + NI2) exceeds the $1,000 = $80); the lower amount prevails. This
amount of the program-wide credit enhance- establishes the capital charge for the program-
ment, the weakest-link formula would result in wide credit enhancement.

Page 13
Assessing Risk-Based Capital—Direct-Credit Substitutes
1. Does the banking organization have an sures consistent with ratings issued by the
acceptable risk-rating system? rating agencies?
2. Does the banking organization use an estab- 7. Is program-wide credit enhancement in the
lished internal risk-rating system tailored to first-loss position?
ABCP securitization exposures?
3. Are the relevant exposures internally rated? 8. Do concentrations of non-investment-grade
4. Are the ABCP programs monitored by rating seller/services pose an excessive level of
agencies? risk?
5. Are there sufficient underwriting standards 9. What portion of the underlying assets of the
and management oversight? ABCP programs is structured to investment-
6. Are internal ratings of ABCP program expo- grade risk?

Page 1
Section 4000.1
[Reserved]

Page 1
Analytical Review and Income and Expense
INTRODUCTION Control,’’ section 1010, for a discussion of

procedures to use in reviewing the audit work of
This section is designed to help the examiner others.)
develop an overview of a bank’s financial con-
dition and results of operations through the use
of analytical review techniques. It also provides ANALYTICAL REVIEW
procedures to assist in evaluating the reasonable-
ness and reliability of the bank’s income and Analytical review involves a comparison of
expense accounts. (However, no analytical view detail balances or statistical data on a period-to-
of a bank’s operating results is complete without period basis in an effort to substantiate reason-
due consideration of the stability and probable ableness without systematic examination of the
continuity of the earnings. In this regard, the transactions that make up the account balances.
examiner must remain cognizant of the inextri- Analytical review is based on the assumption
cable links between liquidity and earnings and that comparability of period-to-period balances
the implications of a bank’s funds-management and ratios shows them to be free from significant
decisions, particularly those dealing with interest- error. A well-performed analytical review not
rate risk. only benefits the examination by providing an
understanding of the bank’s operations, but also
highlights matters of interest and potential prob-
lem situations which, if detected early, might
GENERAL EXAMINATION avert more serious problems.
APPROACH
The review and analysis of the bank’s financial Analytical Tools
condition and results of operations should begin
during the pre-examination analysis of the bank The basic analytical tools available to the exam-
(see ‘‘Examination Strategy and Risk-Focused iner are the UBPR and the bank’s financial
Examinations,’’ section 1000). Pre-examination statements. Internally prepared statements and
analysis is meant to determine potential problem supplemental schedules, if available, are excel-
areas so that proper staff levels and appropriate lent additions to an in-depth analytical review.
examination procedures can be used. The analy- The information from those schedules may give
sis will be performed using the most recent the examiner considerable insight into the inter-
Uniform Bank Performance Report (UBPR). pretation of the bank’s basic financial state-
(See ‘‘Federal Reserve System Surveillance Pro- ments. However, internally prepared informa-
gram,’’ section 1020.) tion alone is not sufficient to adequately analyze
Questions raised during the preliminary review the financial condition of the bank. To properly
should be answered and substantiated soon after understand and interpret financial and statistical
commencing the examination, while performing data, the examiner should be familiar with
the more comprehensive analytical review. The current economic conditions and with any secu-
analytical review should use the UBPR financial lar, cyclical, or seasonal factors in the nation,
statements and reports, detail trial balances, region, and local area, including general indus-
analyses of accounts, financial budgets, statisti- try conditions. Economic and industry informa-
cal information, and any other relevant data tion, reports, and journals are an important
available at the bank. Explanations for unusual source for knowledge of industry conditions.
conditions identified during the review, and Finally, the examiner should be knowledgeable
work performed to substantiate such explana- about new banking laws and pending legislation
tions, should be documented in the examination that could have a material impact on financial
workpapers. institutions.
If internal or external auditors have not per-
formed adequate audit procedures relating to Review of Financial Statements
income and expenses, the examiner should test
check computations for accuracy and trace An analytical review of a bank’s financial state-
entries to appropriate accounts. (See ‘‘Internal ments requires professional judgment and an

Page 1
4010.1 Analytical Review and Income and Expense
inquiring attitude. During the analysis, the the income stream and its possible future
examiner should avoid details not specifically variability.
related to his or her objective so that excessive In addition to UBPR analysis and review of
time is not spent analyzing relatively immaterial bank financial statements, the examiner should
amounts. incorporate a review of management’s budget
Generally, it is more efficient to review finan- and/or projections into his or her analysis. A
cial data that have been rounded to the nearest review of projections and individual variances
thousand. Undue precision in computing and from the operating budget can often provide
reviewing ratios should be avoided. An evalua- valuable insight into an institution’s prior and
tion of the meaning of the ratios and amounts future earnings. The examiner should also verify
being compared is important; little can be gained the reasonableness of the budgeted amounts,
by computing ratios for totally unrelated items. frequency of budget review by bank manage-
When comparing bank data to peer-group data, ment and the board of directors, and level of
the examiner should consider whether the bank involvement of key bank personnel in the bud-
is typical of its peer group (a group of banks of get process.
similar size and reporting characteristics). For The primary source of information used to
example, the bank might be of comparable size prepare UBPRs are the Consolidated Reports of
to its peers, but still be atypical because its Condition and Income, which are filed quarterly.
earning assets are composed principally of The content and frequency of these reports are
agricultural loans or mortgage loans. The age of sufficient to allow the reviewer of the UBPR to
the institution should also be taken into account detect unusual or significantly changed circum-
when using peer-group data, as newly chartered stances within a bank, and they normally will be
de novo banks tend to produce distorted ratios adequate for the purposes of analytical review.
(versus the peer group). Accordingly, the examiner must check these
Alternative accounting treatments for similar consolidated reports to ensure the resulting
transactions among peer banks also should be accuracy of the UBPRs.
considered because they may produce signifi- Frequently, the examiner may be interested in
cantly different results. The analytical review a more detailed and current review of the bank
must be based on figures derived under valid than that provided by the UBPR system. Under
accounting practices consistently applied, par- certain circumstances, UBPR procedures may
ticularly in the accrual areas. Accordingly, dur- need to be supplemented because—
ing the analytical review, the examiner should
determine any material inconsistencies in the • asset-quality information must be linked to the
application of accounting principles. income stream;
The examiner also should be aware of the • more detailed information is necessary on
difficulty of interpreting the cash basis account- asset-liability maturities and matching;
ing method. Any required adjustments should be • more detailed information is necessary on
documented and explained in the workpapers other liquidity aspects, as they may affect
and examination report. earnings;
• yield or cost information, which may be
difficult to interpret from the report, is needed;
UBPR • certain income or expense items may need
clarification, as well as normal examination
Another analytical tool available to the exam- validation;
iner is the UBPR. The user’s guide for the • volume information, such as the number of
UBPR explains how a structured approach to demand deposits, certificates of deposit, and
financial analysis should be followed. This other accounts, is not reported, and vulnerabil-
approach breaks down the income stream into ity in a bank subject to concentrations nor-
its major components of interest margin perfor- mally should be considered;
mance, overhead, noninterest income, loan-loss • components of interest and fees on loans are
provisions, tax factors, and extraordinary items. not reported separately by category of loan;
These major components can then be broken thus, adverse trends in the loan portfolio may
down into various subcomponents. Also, the not be detected (For example, the yield of a
balance-sheet composition, along with eco- particular bank’s loan portfolio may be similar
nomic conditions, must be analyzed to explain to those of its peer group, but the examiner

Page 2
Analytical Review and Income and Expense 4010.1
may detect an upward trend in yields for a the various earnings components (This may
specific category of loans. That upward trend include a discussion of balance-sheet compo-
might be partially or wholly offset by a sition, particularly the volume and type of
downward trend of yields in another category earning assets and off-balance-sheet items, if
of loans, and the examiner should consider applicable.);
further investigating the circumstances appli- • peer-group comparisons;
cable to each of those loan categories. A • vulnerability to interest-rate and other market
change in yields could be a result of a change or price risks;
in the bank’s ‘‘appetite’’ for certain types of • income and expense accounts, and their relia-
loans or may indicate a change in loan under- bility, including applicable accounting prac-
writing standards.); or tices, internal controls, and audit methods;
• income or expense resulting from a change in • compliance with laws and regulations relating
the bank’s operations, such as the opening of to earnings and dividends; and
a new branch or starting of a mortgage bank- • budgeting process and the levels of manage-
ing activity or trust department, may skew ment involved in it.
performance ratios. (When there has been a
significant change in a bank’s operations, the Examiners should consider the adequacy of
examiner should analyze the potential impact provisions to the loan-loss reserve. If the exam-
of the change on future bank earnings.) iners conducting the asset quality review deter-
mine that the loan-loss reserve is inadequate, the
bank’s earnings are inflated and should be
Written Analysis restated accordingly. In turn, this determination
should be factored into the examiner’s assess-
After the examiner has completed the analytical ment of management, including its responsibil-
review of income and expense, he or she should ity to maintain an adequate loan-loss reserve.
prepare a written analysis to be submitted to the Consideration should also be given to the
examiner-in-charge. This evaluation should interrelationships that exist between the dividend-
include, but is not limited to, a review of the payout ratio, the rate of growth of retained
bank’s— earnings, and the adequacy of bank capital.
Examiners should consider the extent to which
• quality and future prospects for core income; extraordinary items, securities transactions, and
• ability to cover losses and maintain adequate taxes affect net income. The links between
capital, including compliance with the mini- earnings and liquidity and the implications of a
mum capital standard; bank’s funds management decisions, particu-
• earnings levels and trends; larly with respect to interest-rate sensitivity,
• composition of earnings and sustainability of should also be fully analyzed.

Page 3
1. To detect significantly changed circum- 4. To determine if accounting policies, prac-

stances before or as early as possible during tices, procedures, and internal controls relat-
the examination so that any impact on the ing to income and expenses are adequate.
determination of the scope and conduct of the 5. To determine the scope and adequacy of the
examination may be assessed. audit function.
2. To analyze the financial position and opera- 6. To determine compliance with laws and regu-
tions of the bank and to investigate any lations relating to income and expenses to the
unusual fluctuations. extent that such compliance is not covered
3. To assist in determining the reliability of the elsewhere in the examination.
bank’s financial information and the consis- 7. To initiate corrective action when deficien-
tency of the application of accounting cies or violations of law or regulation have
principles. been discovered.

Page 1
1. Obtain the Uniform Bank Performance • Loan losses are increasing.
Report and, through a general review of it, • Provisions for loan losses are sufficient to
note any conditions of interest particularly cover loan losses and maintain reserves at
significant changes in trends and levels of an adequate level.
income and expense categories that would • There is evidence that sources of interest
indicate present problems or shifts in busi- and other revenues have changed since
ness emphasis including new directions or the last examination.
activities undertaken. • Earnings are deemed inadequate to pro-
2. Determine early in the examination if any vide increased capitalization commensu-
significant changes have occurred in: rate with the bank’s growth.
• Operations.
7. Obtain and review the bank’s formalized
• Accounting practices or records.
planning procedures, profit plans, budgets,
• Financial reporting.
mid- and long-range financial plans, eco-
• General business conditions.
nomic advisory reports, and any progress
3. If selected for implementation complete or
reports related to any of those and:
update the Income and Expense section of
the Internal Control Questionnaire. a. Compare actual results to budgeted
4. Based on the evaluation of internal controls, amounts.
the work performed by internal/external b. Determine the impact of any broad and
auditors and the results of performing the important specific goals which have been
above procedures, determine the scope of set.
the examination. c. Determine the frequency of planning
5. Test for compliance with policies, practices, revisions.
procedures and internal controls in conjunc- d. Determine what triggers a specific plan
tion with performing the remaining exami- revision.
nation procedures. e. Determine who initiates plan revisions.
6. Obtain the bank’s current financial state- f. Determine whether explanations are
ments, internal operating reports, interim required for significant variations and
financial statements, reports filed with the whether causes are ascertained in imple-
Federal Reserve and daily statements of mentating corrective action.
condition or other available financial infor- g. Determine the sources of input for fore-
mation, then review balances and amounts casts, plans and budgets.
relative to information in the UBPR staying
h. Extract any information considered rele-
alert for the development or continuation of
vant to the completion of ‘‘Management
adverse trends and other significant or un-
Assessment’’ and ‘‘Overall Conclusions
usual trends or fluctuations. Primary consid-
Regarding Condition of the Bank.’’
erations should include whether:
• Significant structural changes are occur- 8. Scan ledger accounts for unusual entries, as
ring in the bank that may impact the considered necessary. Examples of such
earnings stream. items include:
• The bank is making use of tax carrybacks • Significant deviations from the normal
or carryforwards. amounts of recurring entries.
• Earnings are static or declining as a per- • Unusual debit entries in income accounts
centage of total resources. or unusual credit entries in expense
• Income before securities gains and losses accounts.
is decreasing as a percentage of total • Significant entries from an unusual source,
revenues. such as a journal entry.
• The ratio of operating expense to operat- • Significant entries in ‘‘other income’’ or
ing revenue is increasing. ‘‘other expense’’ which may indicate fees
• Earnings trends are inconsistent. or service losses on an off balance sheet
• The spread between interest earned and activity (i.e., financial advisory or under-
interest paid is decreasing. writing services).

Page 1
4010.3 Analytical Review and Income and Expense: Examination Procedures
9. Investigate, as appropriate, conditions of f. Reaching a conclusion as to the reason-

interest disclosed by the procedures in steps ableness of any explanations offered
1 and 2 and 6 through 8 by: by other examiners or management and
a. Discussing exceptions or questionable deciding whether extensions of exam-
findings with the examiner responsible ination or verification procedures are
for conducting those aspects of the necessary.
examination which are most closely re- 10. Determine compliance with appropriate laws
lated to the item of interest, to determine and regulations.
if a satisfactory explanation already has 11. Review with officers of the bank and pre-
been obtained. pare, in appropriate report format, listings
b. Reviewing copies of work papers pre- of:
pared by internal auditors or manage- a. Deficiencies in and deviations from,
ment that explain account fluctuations policies, practices, procedures, and inter-
from prior periods or from budgeted nal controls.
amounts.
b. Violations of law.
c. Discussing unresolved items with
management. c. Adverse trends.
d. Reviewing underlying supporting data d. Any UBPR peer group or local con-
and records, as necessary, to substantiate structed peer group data which should be
explanations advanced by management. brought to the attention of management.
e. Performing any other procedures consid- e. Comments on earnings.
ered necessary to substantiate the authen- 12. Update workpapers with any information
ticity of the explanations given. that will facilitate future examinations.

Page 2
Review the bank’s internal controls, policies, PURCHASES

practices and procedures over income and
expenses. The bank’s system should be docu- *13. If the bank has a separate purchasing
mented in a complete and concise manner and department, is it independent of the account-
should include, where appropriate, narrative ing and receiving departments?
descriptions, flowcharts, copies of forms used *14. Are purchases made only on the basis
and other pertinent information. Items marked of requisitions signed by authorized
with an asterisk require substantiation by obser- individuals?
vation or testing. *15. Are all purchases routed through a pur-
chasing department or personnel function-
ing in that capacity?
GENERAL 16. Are all purchases made by means of pre-
numbered purchase orders sent to
1. Does the bank have a budget? If so: vendors?
a. Is it reviewed and approved by mana- 17. Are all invoices received checked against
gerial personnel and/or the board of purchase orders and receiving reports?
directors? 18. Are all invoices tested for clerical accuracy?
b. Is it periodically reviewed and updated 19. Are invoice amounts credited to their
for changed conditions? respective accounts and tested periodically
c. Are periodic statements compared to for accuracy?
budget and are explanations of vari-
ances reviewed by managment?
d. Is a separate budget prepared by the
manager of each department or division?
DISBURSEMENTS
2. Does the bank’s accounting system provide
*20. Is the payment for all purchases, except
sufficiently detailed breakdowns of ac-
minor items, made by official checks?
counts to enable it to analyze fluctuations?
*21. Does the official signing the check review
*3. Are the general books of the bank main-
all supporting documents?
tained by someone who does not have
*22. Are supporting vouchers and invoices can-
access to cash?
celled to prevent re-use?
4. Are all general ledger entries processed
*23. Are duties and responsibilities in the fol-
through the proof department?
lowing areas segregated?
5. Are all entries to the general ledger sup-
a. Authorization to issue expense checks?
ported by a general ledger ticket?
b. Preparation of expense checks?
6. Do general ledger tickets, both debit and
c. Signing of expense checks?
credit, bear complete approvals, descrip-
d. Sending of expense checks?
tions and an indication of the offset?
e. Use and storage of facsimile signa-
*7. Are all general ledger entries approved by
tures?
a responsible person other than the general
f. General ledger posting?
ledger bookkeeper or person associated
g. Subsidiary ledger posting?
with its preparation?
8. Is the general ledger posted daily?
9. Is a daily statement of condition prepared?
*10. Are corrections to ledgers made by posting PAYROLL
a correcting entry and not by erasing
(manual system) or deleting (computer- 24. Is the payroll department separate from the
ized system) the incorrect entry? personnel department?
11. Are supporting worksheets or other records 25. Are signed authorizations on file for all
maintained on accrued expenses and taxes? payroll deductions including W-4s for
12. Are those supporting records periodically withholding?
reconciled with the appropriate general 26. Are salaries authorized by the board of
ledger controls? directors or its designated committee?

Page 1
4010.4 Analytical Review and Income and Expense: Internal Control Questionnaire
27. Are individual wage rates authorized in ment of the bank reported promptly, in
writing by an authorized officer? writing, to the payroll department?
28. Are vacation and sick leave payments 36. Are payroll expense distributions recon-
fixed or authorized? ciled with the general payroll payment
29. Are payrolls paid from a special bank records?
account or directly credited to the employ-
ee’s demand deposit account?
30. Are time records reviewed and signed by
CONCLUSION
the employee’s supervisor?
31. Are double checks made of hours, rates, basis for evaluating internal control in that
deductions, extension, and footings? there are no significant deficiencies in
32. Are payroll signers independent of the areas not covered in this questionnaire that
persons approving hours worked and prep- impair any controls? Explain negative
aration of the payroll? answers briefly, and indicate any addi-
33. If a check signing machine is used, are tional examination procedures deemed
controls over its use adequate (such as a necessary.
dual control)? 38. Based on a composite evaluation, as evi-
34. Are payrolls subject to final officer denced by answers to the foregoing ques-
approval? tions, internal control is considered (ade-
35. Are the names of persons leaving employ- quate, inadequate).

Page 2
Asset/Liability Management
Funds management is at the core of sound bank the collapse of a floating-rate-note market).
planning and financial management. Although Internal liquidity risk relates largely to how an
funding practices, techniques, and norms have institution is perceived in its various markets:
been revised substantially in recent years, funds local, regional, national, or international.
management is not a new concept. It is the An analysis of the following factors will help
process of managing the spread between interest to determine the adequacy of a bank’s liquidity
earned and interest paid while ensuring adequate position:
liquidity. Therefore, funds management has two
components—liquidity and interest-rate risk • historical funding requirements
management. • current liquidity position
To evaluate a bank’s funds management, an • anticipated future funding needs
understanding of the bank, its customer mix, the • sources of funds
nature of its assets and liabilities, and its eco- • options for reducing funding needs or attract-
nomic and competitive environment is required. ing additional funds
No single theory can be applied universally to • current and anticipated asset quality
all banks. • current and future earnings capacity
• current and planned capital position
To satisfy its funding needs, a bank must per-

LIQUIDITY form one or a combination of the following:
Liquidity is the ability to accommodate decreases • dispose of liquid assets

in liabilities and to fund increases in assets. A • increase short-term borrowings (or issue addi-
bank has adequate liquidity when it can obtain tional short-term deposit liabilities)
sufficient funds, either by increasing liabilities • decrease holdings of less-liquid assets
or converting assets, promptly and at a reason- • increase liabilities of a term nature
able cost. Liquidity is essential in all banks to • increase capital funds
compensate for expected and unexpected balance-
sheet fluctuations and to provide funds for All banks are affected by changes in the
growth. The price of liquidity is a function of economic climate, so the monitoring of eco-
market conditions and the market’s perception nomic and money market trends is key to
of risks, both interest-rate and credit, as reflected liquidity planning. Sound financial management
in the bank’s on-balance-sheet and off-balance- can minimize the negative effects of these trends
sheet activities. Additionally, market percep- while accentuating the positive ones. Factors
tions of a bank’s management and strategic that management should consider in liquidity
direction can be critical to the price of liquidity. planning include—
To the extent that liquidity needs are met through
holdings of high-quality short-term assets, the • internal costs of funds,
price of liquidity is the income sacrificed by not • maturity and repricing mismatches in the
holding longer-term or lower-quality assets. If balance sheet,
liquidity needs are not met through liquid asset • anticipated funding needs,
holdings, a bank may be forced to restructure or • economic and market forecasts, and
acquire additional liabilities under adverse mar- • the need to maintain a plan that ensures
ket conditions. adequate access to a diversified array of readily
Liquidity exposure can stem from both inter- accessible, confirmed funding sources, includ-
nally (institution-specific) and externally gener- ing liquid assets such as high-grade invest-
ated factors. Sound liquidity-risk management ment securities and a diversified mix of whole-
should address both types of exposure. External sale and retail borrowings.
liquidity risks can be geographic (such as the
premiums required on deposits within a certain Management must have an effective contin-
state), systemic (such as the adverse effects on gency plan that identifies minimum and maxi-
several large banks of the near failure of a large mum liquidity needs and weighs alternative
regional bank), or instrument-specific (such as courses of action designed to meet those needs.

Page 1
4020.1 Asset/Liability Management
Some factors that may affect a bank’s liquidity designed and should span a broad range of
include— potential liquidity events that are tailored to an
institution’s specific business lines and
• a decline in earnings, liquidity-risk profile.)
• an increase in nonperforming assets,
• deposit concentrations, Adequate liquidity contingency planning is criti-
• a downgrading by a rating agency, cal to the ongoing maintenance of the safety and
• expanded business opportunities, soundness of any depository institution. Contin-
• acquisitions, and gency planning starts with an assessment of the
• new tax initiatives. possible liquidity events that an institution might
encounter. The types of potential liquidity events
Once liquidity needs have been determined, considered should range from high-probability/
management must decide how to meet them low-impact events that can occur in day-to-day
through asset management, liability manage- operations to low-probability/high-impact events
ment, or a combination of both. that can arise through institution-specific or
See also the ‘‘Liquidity Risk’’ sections (3005.1 systemic market or operational circumstances.
to 3005.5) of the Federal Reserve System’s Responses to these events should be assessed in
Trading and Capital-Markets Activities Manual the context of their implications for an institu-
for additional guidance on evaluating an insti- tion’s short-term, intermediate-term, and long-
tution’s liquidity management. term liquidity profile. A fundamental principle
in designing contingency plans for each of these
liquidity tenors is to ensure adequate diversifi-
Sound Liquidity-Risk Management cation in the potential sources of funds that
could be used to provide liquidity. Such diver-
Sound liquidity-risk management requires the sification should not only focus on the number
following four elements.1 of potential funds providers but on the underly-
ing stability, availability, and flexibility of funds
• Well-established strategies, policies, and pro- sources in the context of the type of liquidity
cedures for managing both the sources and event they are expected to address.
uses of an institution’s funds across various
tenors or time frames. (This includes assess-
ing and planning for short-term, intermediate- Liquidity-Risk Management Using the
term, and long-term liquidity needs.) Federal Reserve’s Primary Credit
• Liquidity-risk measurement systems that are Program
appropriate for the size and complexity of the
institution. (Depending upon the institution, The Federal Reserve’s primary credit program
such measurement systems can range from (discount window) offers depository institutions
simple gap-derived cash-flow measures to an additional source of available funds (at a rate
very sophisticated cash-flow simulation above the target federal funds rate) for manag-
models.) ing short-term liquidity risks.2 Management
• Adequate internal controls and internal audit should fully assess the potential role that the
processes. (Internal controls and internal audit Federal Reserve’s primary credit program might
reviews are needed to ensure compliance with play in managing their institution’s liquidity.
internal liquidity-management policies and The primary credit program can be a viable
procedures.) source of very short-term backup funds. Man-
• Comprehensive liquidity contingency plan- agement may find it appropriate to incorporate
ning. (Contingency plans need to be well the availability of the primary credit program
into their institution’s diversified liquidity-
management policies, procedures, and contin-
1. See the July 23, 2003, Interagency Advisory on the Use gency plans. The primary credit program has the
of the Federal Reserve’s Primary Credit Program in Effective
Liquidity Management, issued by the federal financial insti- following attributes that make the discount win-
tution regulatory agencies. The interagency advisory supple-
ments and does not replace existing agency guidance or 2. See section 3010.1 for further discussion of the Federal
policy. See also section 4010.0 of the Bank Holding Company Reserve’s credit programs that are available to qualifying
Supervision Manual. institutions.

Page 2
Asset/Liability Management 4020.1
dow a viable source of backup or contingency tion were to deteriorate, primary credit may not
funding for short-term purposes: be available. Under those scenarios, secondary
credit may be available.
• Primary credit provides a simpler, less- Another critical element of liquidity manage-
burdensome administrative process and a more ment is an appropriate assessment of the costs
accessible source of backup, short-term and benefits of various sources of potential
funding. liquidity. This assessment is particularly impor-
• Primary credit can enhance diversification in tant in managing short-term and day-to-day
short-term funding contingency plans. sources and uses of funds. Given the above-
• Borrowings can be secured with an array of market rates charged on primary credit, institu-
collateral, including consumer and commer- tions should ensure that they adequately assess
cial loans. the higher costs of this form of credit relative to
• Requests for primary credit advances can be other available sources. Extended use of any
made anytime during the day.3 type of relatively expensive source of funds can
• There are no restrictions on the use of short- give rise to significant earnings implications
term primary credit. which, in turn, may lead to supervisory concerns.
It is also important to note that the Federal
If an institution incorporates primary credit Reserve’s primary credit facility is only one of
into its contingency plans, the institution should many tools institutions may use in managing
ensure that it has in place with the appropriate their liquidity-risk profiles. An institution’s man-
Reserve Bank the necessary collateral arrange- agement should ensure that the institution main-
ments and documentation. This is particularly tains adequate access to a diversified array of
important when the intended collateral consists readily available and confirmed funding sources,
of loans or other assets that may involve signifi- including liquid assets such as high-grade invest-
cant processing or lead time for pledging to the ment securities and a diversified mix of whole-
Reserve Bank. sale and retail borrowings. (See SR-03-15.)
It is a long-established sound practice for
institutions to periodically test all sources of
contingency funding. Accordingly, if an institu- Supervisory and Examiner Considerations
tion incorporates primary credit in its contin-
gency plans, management should occasionally Because primary credit can serve as a viable
test the institution’s ability to borrow at the source of backup, short-term funds, supervisors
discount window. The goal of such testing is to and examiners should view the occasional use of
ensure that there are no unexpected impedi- primary credit as appropriate and unexceptional.
ments or complications in the case that such At the same time, however, supervisors and
contingency lines need to be used. examiners should be cognizant of the implica-
Institutions should ensure that any planned tions that too-frequent use of this source of
use of primary credit is consistent with the relatively expensive funds may have for the
stated purposes and objectives of the program. earnings, financial condition, and overall safety
Under the primary credit program, the Federal and soundness of the institution. Overreliance
Reserve generally expects to extend funds on a on primary credit borrowings, or any one source
very short-term basis, usually overnight. There- of short-term contingency funds, regardless of
fore, as with any other type of short-term the relative costs, may be symptomatic of deeper
contingency funding, institutions should ensure operational or financial difficulties. Importantly,
that any use of primary credit facilities for the use of primary credit, as with the use of any
short-term liquidity contingencies is accompa- potential sources of contingency funding, is a
nied by viable take-out or exit strategies to management decision that must be made in the
replace this funding expeditiously with other context of safe and sound banking practices.
sources of funding. Institutions should factor
into their contingency plans an analysis of their
eligibility for primary credit under various sce- ASSET MANAGEMENT
narios, recognizing that if their financial condi-
Liquidity needs may be met by manipulating the
3. Advances generally are booked at the end of the busi- bank’s asset structure through the sale or planned
ness day. runoff of a reserve of readily marketable assets.

Page 2.1
Because many banks (primarily the smaller assets are in terms of both time and cost, is of
ones) tend to have little influence over the size primary importance in asset management. To
of their total liabilities, liquid assets enable a maximize profitability, management must care-
bank to provide funds to satisfy increased loan fully weigh the full return on liquid assets (yield
demand. plus liquidity value) against the higher return
Banks that rely solely on asset management associated with less-liquid assets. Income derived
concentrate on adjusting the price and availabil- from higher-yielding assets may be offset if a
ity of credit and the level of liquid assets held in forced sale, at less than book value, is necessary
response to a change in customer asset and because of adverse balance-sheet fluctuations.
liability preferences. However, assets that are Seasonal, cyclical, or other factors may cause
often assumed to be liquid are sometimes diffi- aggregate outstanding loans and deposits to
cult to liquidate. For example, investment secu- move in opposite directions and result in loan
rities may be pledged against public deposits or demand that exceeds available deposit funds. A
repurchase agreements or may be heavily depre- bank relying strictly on asset management would
ciated because of interest-rate changes. Trading restrict loan growth to a level that could be
accounts cannot be reduced materially if banks supported by available deposits. As an alterna-
must maintain adequate inventories for their tive, liquidity needs may be met through liabil-
customers. Furthermore, the holding of liquid ity sources, such as federal funds purchased and
assets for liquidity purposes is less attractive the sale of securities under agreements to repur-
because of their thin profit spreads. chase, which would allow the bank to meet the
Management must also consider the cost of loan demand of its trade area. If short-term
maintaining liquidity. An institution that main- funding is not readily available in the market-
tains a strong liquidity position may do so at the place, the bank may qualify for borrowings from
opportunity cost of generating higher earnings. the local Federal Reserve Bank. The decision
The amount of liquid assets a bank should whether to use liability sources should be based
hold depends on the stability of its deposit on a complete analysis of seasonal, cyclical, and
structure and the potential for rapid expansion of other factors and on the costs involved. In
its loan portfolio. If deposit accounts are com- addition to supplementing asset liquidity, liabil-
posed primarily of small stable accounts, a ity sources of liquidity may be an alternative
relatively low allowance for liquidity is neces- even when asset sources are available. The
sary. Additionally, management must consider number of banks relying solely on manipulation
the current and expected ratings by regulatory of the asset structure to meet liquidity needs is
and rating agencies when planning liquidity declining rapidly.
needs. A higher allowance for liquidity is
required when—
• high interest rates increase the potential for

deposit disintermediation,
• recent trends show a substantial increase or
reduction in large deposits or borrowings,
• a significant portion of deposits are short-term
municipal special assessment–type accounts,
• a substantial portion of the loan portfolio
consists of large static loans with little likeli-
hood of reduction,
• large unused lines of credit or commitments to
lend are expected to be used in the near term,
• a strong relationship exists between individual
deposit accounts and principal employers in
the trade area who have financial problems, or
• a concentration of credit has been extended to
industries with current or anticipated financial
problems.
Asset liquidity, or how ‘‘salable’’ the bank’s

Page 2.2
LIABILITY MANAGEMENT expanding customer loan demand, misuse or

improper implementation of liability manage-
Liquidity needs can be met through the discre- ment can have severe consequences. Further,
tionary acquisition of funds on the basis of liability management is not riskless. For example,
interest rate competition. This does not preclude
the option of selling assets to meet funding • Purchased funds may not always be available
needs, and conceptually, the availability of asset at a reasonable cost when needed. If the
and liability options should result in a lower market loses confidence in a bank, the
liquidity maintenance cost. The alternative costs availability of purchased funds may be
of available discretionary liabilities can be com- threatened.
pared to the opportunity cost of selling various • Concentrations in funding sources increase
assets. The major difference between liquidity in liquidity risk. For example, a bank relying
larger banks and in smaller banks is that larger heavily on foreign interbank deposits will
banks are better able to control the level and experience funding problems if overseas mar-
composition of their liabilities and assets. When kets perceive instability in U.S. banks or the
funds are required, larger banks have a wider economy. Replacing foreign source funds
variety of options from which to select the least might be difficult and costly because the
costly method of generating funds. In addition, domestic market may view the bank’s sudden
discretionary access to the money markets should need for funds negatively.
reduce the size of the liquid asset ‘‘buffer’’ that • Over-reliance on liability management may
would be needed if the bank were solely depen- cause a tendency to minimize holdings of
dent upon asset management to obtain funds. short-term securities, relax asset liquidity stan-
The ability to obtain additional liabilities dards, and result in a large concentration of
represents liquidity potential. The marginal cost short-term liabilities supporting assets of
of liquidity, the cost of incremental funds longer maturity. During times of tight money,
acquired, is of paramount importance in evalu- this could cause an earnings squeeze and an
ating liability sources of liquidity. Consideration illiquid condition.
must be given to such factors as the frequency
• If rate competition develops in the money
with which the banks must regularly refinance
market, a bank may incur a high cost of funds
maturing purchased liabilities, as well as an
and may elect to lower credit standards to
evaluation of the bank’s ongoing ability to
book higher yielding loans and securities. If a
obtain funds under normal market conditions.
bank is purchasing liabilities to support assets
The obvious difficulty in estimating the latter is
which are already on its books, the higher cost
that, until the bank goes to the market to borrow,
of purchased funds may result in a negative
it cannot determine with complete certainty that
yield spread.
funds will be available and/or at a price which
will maintain a positive yield spread. Changes in • When national monetary tightness occurs,
money market conditions may cause a rapid heightened interest rate discrimination, or
deterioration in a bank’s capacity to borrow at a tiering, may develop, and may make the cost
favorable rate. In this context, liquidity repre- of purchased funds prohibitive to all but a
sents the ability to attract funds in the market small number of money center banks. There-
when needed, at a reasonable cost vis-à-vis asset fore, banks with limited funding sources
yield. should avoid heavy reliance on purchased
As previously noted the access of a large bank funds.
to discretionary funding sources is a function of • Preoccupation with obtaining funds at the
its position and reputation in the money mar- lowest possible cost, without considering
kets. Although smaller institutions do not have a maturity distribution, greatly intensifies a
‘‘name’’ in those markets, they are not pre- bank’s exposure to the risk of interest rate
cluded from liability management. The scope fluctuations.
and volume of smaller institution’s operations is
somewhat limited, however, particularly as they In all banks, and particularly those relying on
attempt to access the brokered or purchased CD wholesale funding sources, management must
market. constantly be aware of the composition, charac-
Although the acquisition of funds at a com- teristics, and diversification of its funding
petitive cost has enabled many banks to meet sources.

Page 3
Real or perceived deterioration in the finan- methods chosen to manage a bank’s liquidity
cial condition of a bank because of weak asset position, it is of key importance that the bank
quality, fraud, or external economic develop- formulate a policy and develop a measurement
ments will adversely affect wholesale and retail system to ensure that liquidity requirements are
funding. The extent of market reaction depends monitored and met on an ongoing basis. This
on the composition and risk tolerance of the should be done in anticipation of future occur-
bank’s funding base. (Risk tolerance is the rences, both expected and unexpected. It should
willingness and ability of an individual or insti- also reflect the bank’s strategy for managing its
tution to borrow/lend money for a given risk and investment portfolio and the potential for those
reward). investments to provide liquidity to the bank.
Many factors affect the risk tolerance of funds Such a policy should recognize the unique
providers, including these: characteristics of the bank and should reflect its
goals. The scope of the policy will vary with the
• Obligations to fiduciary investors, such as sophistication of the institution.
money market funds, trust funds and pensions. The policy should provide for coordination
• Reliance on rating firms—bylaws or internal between concerned bank departments and should
guidelines may prohibit placing funds in banks establish clear responsibility for decisions affect-
that have low ratings. ing liquidity. Senior management should be
• Obligations to disclose information on invest- apprised regularly of liquidity conditions. Fur-
ment holdings. thermore, the policy should set forth guidelines
• Self-interest in maintaining an orderly market- delineating appropriate levels of liquidity.
place—for this reason major banks are slow in Examples of some typical guidelines are listed
eliminating funding to other banks. below:
• Having a personal contact at the bank to
provide timely and accurate information about • A limit on the loan to deposit ratio.
its financial condition. • A limit on the loan to capital ratio.
• A general limit on the relationship between
The following common fund providers are anticipated funding needs and available sources
ranked generally (while subject to change) from for meeting those needs (for example: the
the least to the most risk tolerant: ratio of anticipated needs/primary sources shall
not exceed percent).
• Money market funds. • Primary sources for meeting funding needs
• Trust funds. should be quantified.
• Pension funds. • Flexible limits on the percentage reliance on a
• Money market brokers-dealers particular liability category (for example:
— small denomination certificates of deposit negotiable certificates of deposit should not
(under $100,000) sold through broker- account for more than percent of total
dealers; and liabilities).
— large denomination certificates of deposit • Limits on the dependence on individual cus-
($100,000 and over) sold through brokers- tomers or market segments for funds in liquid-
dealers ity position calculations.
• Regional banks. • Flexible limits on the minimum/maximum
• Government agencies. average maturity for different categories of
• Community banks. liabilities (for example: the average maturity
• Insurance companies. of negotiable certificates of deposit shall not
• Corporations. be less than months).
• Multinational banks. • Minimum liquidity provision to be maintained
• Individuals. to sustain operations while necessary longer-
term adjustments are made.
A workable management information system

POLICY/MANAGEMENT is integral to making sound funds management
REPORTING SYSTEMS decisions. Reports containing certain basic
information should be prepared and reviewed
Regardless of the method or combination of regularly. Report content and format will vary

Page 4
from bank to bank depending on the character- expected funding of commitments would prove
istics of the bank and the funds management useful in preparing this report.) Additionally,
methods and practices used. Normally, a good policies should establish, and the management
management information system will contain information system should be able to track,
reports detailing liquidity needs and the sources contingency liquidity plans for use in a variety
of funds available to meet those needs. (The of emergency funding situations.
maturity distribution of assets and liabilities and

Page 5
1. To evaluate the management of the bank’s informed liquidity decisions and for moni-
assets, liabilities, and off-balance-sheet posi- toring the results of those decisions.
tion to determine if management is planning 4. To urge corrective action when liquidity
adequately for liquidity needs, and if the policies, practices, or procedures are
bank can effectively meet anticipated and deficient.
potential liquidity needs. 5. To determine if guidelines and procedures
have been developed to assess the adequacy
2. To determine if reasonable parameters have
of the following: a formal contingency plan;
been established for the bank’s liquidity
the level of liquid assets; the ability of the
position and if the bank is operating within
bank to liquidate the loan and investment
those established parameters.
portfolios; the level of term deposits and
3. To determine if internal management reports funding lines; and whether committed funds
provide the necessary information for lines are needed.

Page 1
1. If internal controls or the internal audit appropriate planning period;

function is determined to be inadequate, b. ascertain if management has planned the
complete or update the internal control future direction of the bank, noting the
questionnaire, and prepare a brief descrip- projected growth, source of funding for
tion of the bank’s liquidity policies and the growth, and any projected changes in
practices. asset or liability mix;
2. Review the UBPR interim financial state- c. evaluate future plans regarding liquidity
ments and internal management reports to needs, ascertaining whether the bank can
assess the asset/liability mix and trends, reasonably achieve the amounts and types
paying particular attention to— of funding projected and can achieve the
a. deposit composition and stability, amounts and types of asset growth pro-
b. the ratios of loan commitments to total jected; and
loans and of standby letters of credit to d. ascertain whether the appropriate interest-
total loans, rate sensitivity concerns have been
c. the loan-to-deposit ratio (at community addressed in planning long-term funding
banks), strategies.
d. the ratio of temporary investments to 5. Assess the reasonableness of bank-
volatile liabilities, and established parameters for the use of vola-
e. the ratio of pledged securities to total tile liabilities.
securities. a. Does the liquidity policy incorporate lim-
When performing steps 3 through 9, its on both the volume and intended use
evaluate the effectiveness of internal man- of such liabilities?
agement reporting systems in providing for b. Does the policy establish permissible
adequate liquidity management. ranges for maturity mismatches between
3. Determine if management has properly volatile liabilities and assets being sup-
planned for liquidity needs. ported by these liabilities?
a. Are well-established strategies, policies, 6. Review the adequacy of the bank’s contin-
and procedures for managing both the gency liquidity plan.
sources and uses of an institution’s funds a. Does management’s plan ensure adequate
across various tenors or time frames in access to a diversified array of readily
place, and do these strategies include accessible confirmed funding sources,
assessing and planning for short-term, including liquid assets such as high-
intermediate-term, and long-term liquid- grade investment securities and a diver-
ity needs? sified mix of wholesale and retail
b. Are there liquidity-risk measurement sys- borrowings?
tems appropriate for the size and com- b. Has management determined what poten-
plexity of the institution? tial funding losses could occur if unex-
c. Are the short-term sources of funds to pected financial or operational problems
meet anticipated or potential needs arise?
adequate? c. Have alternative funding sources or assets
d. Has management— that could be sold to cover such losses
• reviewed the internal management been identified?
report detailing liquidity requirements d. Is the contingency plan well designed,
and sources of liquidity, and and does it span a broad range of poten-
• evaluated the bank’s ability to meet tial liquidity events that are tailored to an
anticipated or potential needs? institution’s specific business lines and
4. To determine if management is adequately liquidity-risk profile?
planning for intermediate-term and longer- 7. Does the liquidity policy restrict borrow-
term liquidity or funding needs— ings from affiliated banks to reasonable
a. discuss with management or review the levels?
bank’s budget projections for the 8. Does the liquidity policy provide appropri-

Page 1
4020.3 Asset/Liability Management: Examination Procedures
ate control and supervision of the volume of meet liquidity needs and the current
loan commitments and other off-balance- ability of the bank to meet anticipated
sheet activities? and potential liquidity needs
9. Are adequate internal controls and internal b. the quality of administrative control and
audit processes in place? Do the internal internal management reporting systems
controls and internal audit reviews ensure c. where appropriate, the effect of liquidity
compliance with internal liquidity- management decisions on earnings
management policies and procedures? 11. Update the workpapers with any informa-
10. Discuss the following issues with manage- tion that will facilitate future examinations.
ment, and summarize your findings in the Discuss with senior management the find-
report: ings of the examination of their liquidity
a. the quality of the bank’s planning to policies and practices.

Page 2
1. Has the board of directors, consistent with its 4. Are internal management reports concerning
duties and responsibilities, reviewed and rati- liquidity needs and sources of funds to meet
fied funds-management policies, practices and those needs prepared regularly and reviewed
procedures that include— as appropriate by senior management and the
a. lines of authority and responsibility for board of directors?
liquidity management decisions? 5. Is the information obtained in questions 1–4
b. a formal mechanism to coordinate asset an adequate basis for evaluating internal
and liability management decisions? controls over asset/liability management in
c. a method to identify liquidity needs and that there are no significant additional defi-
the means to meet those needs? ciencies that impair any control? Explain
d. guidelines for the level of liquid assets negative answers briefly, and indicate any
and other sources of funds in relationship additional examination procedures deemed
to anticipated and potential needs? necessary.
2. Does the planning and budgeting function 6. On the basis of a composite evaluation, as
consider liquidity requirements? evidenced by answers to the foregoing ques-
3. Have provisions been made for the prepara- tions, are the internal controls and internal
tion of internal management reports that are audit procedures considered adequate? Do
an adequate basis for ongoing liquidity man- the internal controls and internal audit reviews
agement decisions and for monitoring the ensure compliance with internal liquidity
results of the decisions? management policies and procedures?

Page 1
Asset Securitization
Many banking organizations (BOs) have essentially five benefits that can be derived from
substantially increased their securitization securitized transactions. First, the sale of assets
activities. Asset securitization typically involves may reduce regulatory costs. The removal of an
the transfer of potentially illiquid on-balance- asset from an institution’s books reduces capital
sheet assets (for example, loans, leases, and requirements and reserve requirements on the
other assets) to a third party or trust. In turn, the deposits funding the asset. Second, securitiza-
third party or trust issues certificates or notes to tion provides originators with an additional
investors. The cash flow from the transferred source of funding or liquidity. The process of
assets supports repayment of the certificates or securitization basically converts an illiquid asset
notes. BOs use asset securitization to access into a security with greater marketability. Secu-
alternative funding sources, manage concentra- ritized issues often require a credit enhance-
tions, improve financial-performance ratios, and ment, which results in a higher credit rating than
more efficiently meet customer needs. Assets what would normally be obtainable by the
typically securitized include credit card institution itself. Consequently, these issues may
receivables and automobile receivable paper, provide the institution with a cheaper form of
commercial and residential first mortgages, funding. Third, securitization may be used to
commercial loans, home-equity loans, and reduce interest-rate risk by improving the insti-
student loans. tution’s asset-liability mix. This is especially
Managing the risks of securitization activities true if the institution has a large investment in
poses increasing challenges, which may be less fixed-rate, low-yield assets. Fourth, by remov-
obvious and more complex than the risks of ing assets, the institution enhances its return on
traditional lending activities. Securitization can equity and assets. Finally, the ability to sell these
involve credit, liquidity, operational, legal, and securities worldwide diversifies the institution’s
reputational risks in concentrations and forms funding base, which reduces the bank’s depen-
that may not be fully recognized by bank man- dence on local economies.
agement or adequately incorporated into an While securitization activities can enhance
institution’s risk-management systems. In review- both credit availability and bank profitability, the
ing these activities, examiners should assess risks of these activities must be known and
whether BOs fully understand and adequately managed. Accordingly, BOs should ensure that
manage the full range of risks involved in their overall risk-management process explicitly
securitization activities. incorporates the full range of risks involved in
BOs have been involved with asset-backed their securitization activities, and examiners
securities (ABS), both as investors in them and should assess whether institutions fully under-
as major participants in the securitization pro- stand and adequately manage these risks.
cess. The federal government encourages the Specifically, examiners should determine whether
securitization of residential mortgages. In 1970, institutions are recognizing the risks of securiti-
the Government National Mortgage Association zation activities by (1) adequately identifying,
(GNMA or Ginnie Mae) created the first pub- quantifying, and monitoring these risks;
licly traded mortgage-backed security. Shortly (2) clearly communicating the extent and depth
thereafter, the Federal National Mortgage Asso- of these risks in reports to senior management
ciation (Fannie Mae) and the Federal Home and the board of directors and in regulatory
Loan Mortgage Corporation (Freddie Mac), both reports; (3) conducting ongoing stress testing to
government-sponsored agencies, also developed identify potential losses and liquidity needs
mortgage-backed securities. The guarantees on under adverse circumstances; and (4) setting
the securities that these government or adequate minimum internal standards for allow-
government-sponsored entities provide ensure ances or liabilities for losses, capital, and
investors of the payment of principal and inter- contingency funding. Incorporating asset-
est. These guarantees have greatly facilitated the securitization activities into BO’s risk-
securitization of mortgage assets. Banks also management systems and internal capital-
securitize other types of assets, such as nonper- adequacy allocations is particularly important
forming loans and lease receivables. since the current regulatory capital rules may not
While the objectives of securitization may fully capture the economic substance of the risk
vary from institution to institution, there are exposures arising from many of these activities.

Page 1
4030.1 Asset Securitization
Senior management and directors must have resent an excessive concentration of the spon-
the requisite knowledge of the effect of securi- soring institution’s capital, the institution’s
tization on the BO’s risk profile, and they must demise.
be fully aware of the accounting, legal, and An institution’s failure to adequately under-
risk-based capital nuances of this activity. BOs stand the risks inherent in its securitization
must fully and accurately distinguish and mea- activities and to incorporate risks into its risk-
sure the risks that are transferred versus those management systems and internal capital allo-
that are retained, and they must adequately cations may constitute an unsafe and unsound
manage the retained portion. It is essential that banking practice. Furthermore, retained interests
BOs engaging in securitization activities have that lack objectively verifiable support or that
appropriate front- and back-office staffing; inter- fail to meet these supervisory standards will be
nal and external accounting and legal support; classified as loss and disallowed for inclusion as
audit or independent-review coverage; informa- assets of the institution for regulatory capital
tion systems capacity; and oversight mecha- purposes. (See SR-99-37.) Accordingly, for those
nisms to execute, record, and administer these institutions involved in asset securitization or
transactions correctly. providing credit enhancements in connection
Appropriate valuation and modeling method- with loan sales and securitization, examiners
ologies must be used. They must be able to should assess whether the institutions’ systems
determine the initial and ongoing fair value of and processes adequately identify, measure,
retained interests. Accounting rules (generally monitor, and control all the risks involved in its
accepted accounting principles, or GAAP) pro- securitization activities. Examiners also will
vide a method to recognize an immediate gain review an institution’s valuation of retained
(or loss) on the sale through booking a ‘‘retained interests and the concentration of these assets
interest.’’ The carrying value, however, of that relative to capital. Consistent with existing
interest must be fully documented, based on supervisory authority, BOs may be required, on
reasonable assumptions, and regularly analyzed a case-by-case basis, to hold additional capital
for any subsequent impairment in value. The commensurate with their risk exposures.2 An
best evidence of fair value is a quoted market excessive dependence on securitizations for day-
price in an active market. When quoted market to-day core funding can present significant
prices are not available, accounting rules allow liquidity problems during times of market tur-
fair value to be estimated. This estimate must be bulence or if there are difficulties specific to the
based on the ‘‘best information available in the BO.
circumstances.’’1 An estimate of fair value must Traditional lending activities are generally
be supported by reasonable and current assump- funded by deposits or other liabilities, with both
tions. If a best estimate of fair value is not the assets and related liabilities reflected on the
practicable, the asset is to be recorded at zero in balance sheet. Liabilities must generally increase
financial and regulatory reports. in order to fund additional loans. In contrast, the
Unforeseen market events that affect the dis- securitization process generally does not increase
count rate or performance of receivables sup- on-balance-sheet liabilities in proportion to the
porting a retained interest can swiftly and dra- volume of loans or other assets securitized. As
matically alter its value. Without appropriate discussed more fully below, when banking
internal controls and independent oversight, an organizations securitize their assets and these
institution that securitizes assets may inappro- transactions are treated as sales, both the assets
priately generate ‘‘paper profits’’ or mask actual and the related ABS (liabilities) are removed
losses through flawed loss assumptions, inaccu- from the balance sheet. The cash proceeds from
rate prepayment rates, and inappropriate dis- the securitization transactions are generally used
count rates. Liberal and unsubstantiated assump- to originate or acquire additional loans or other
tions can result in material inaccuracies in assets for securitization, and the process is
financial statements; substantial write-downs of
retained interests; and, if retained interests rep-
1. See Financial Accounting Standards Board (FASB) 2. For instance, an institution that has high concentrations
Statement of Financial Accounting Standards No. 140 (FAS of retained interests relative to its capital or is otherwise at risk
140), ‘‘Accounting for Transfers and Servicing of Financial from impairment of these assets may be subject to this
Assets and Extinguishments of Liabilities.’’ requirement.

Page 2
Asset Securitization 4030.1
repeated. Thus, for the same volume of loan the activities of the servicer to ensure that it
originations, securitization results in lower assets properly fulfills its role.
and liabilities compared with traditional lending A guarantor may also be involved to ensure
activities. that principal and interest payments on the
securities will be received by investors on a
timely basis, even if the servicer does not collect
THE SECURITIZATION PROCESS these payments from the obligors of the under-
lying assets. Many issues of mortgage-backed
As depicted in figure 1, the asset-securitization securities are either guaranteed directly by
process begins with the segregation of loans or GNMA, which is backed by the full faith and
leases into pools that are relatively homoge- credit of the U.S. government, or by Fannie Mae
neous with respect to credit, maturity, and or Freddie Mac, which are government-
interest-rate risks. These pools of assets are then sponsored agencies that are perceived by the
transferred to a trust or other entity known as an credit markets to have the implicit support of the
issuer because it issues the securities or owner- federal government. Privately issued mortgage-
ship interests that are acquired by investors. backed securities and other types of ABS gen-
These ABS may take the form of debt, certifi- erally depend on some form of credit enhance-
cates of beneficial ownership, or other instrument provided by the originator or third party to
ments. The issuer is typically protected from insulate the investor from a portion of or all
bankruptcy by various structural and legal credit losses. Usually, the amount of the credit
arrangements. A sponsor that provides the assets enhancement is based on several multiples of
to be securitized owns or otherwise establishes the historical losses experienced on the particu-
the issuer. lar asset backing the security.
Each issue of ABS has a servicer that is The structure of an asset-backed security and
responsible for collecting interest and principal the terms of the investors’ interest in the collat-
payments on the loans or leases in the under- eral can vary widely depending on the type of
lying pool of assets and for transmitting these collateral, the desires of investors, and the use of
funds to investors (or a trustee representing credit enhancements. Securitizations typically
them). A trustee is responsible for monitoring carve up the risk of credit losses from the
Figure 1—Pass-through, asset-backed securities: structure and cash flows
Obligors Forwards ‘‘Passes through’’ principal and

principal and interest payments
interest Trustee
Remit payments
principal and
interest
Initial cash Initial Initial
payments
proceeds proceeds purchase
Originator/ from from of
securities securities securities
Sponsor/ Trust Underwriter Investors
Servicer Issues Distributes
Transfers
loans on securities securities
Purchases receivables Provides credit
credit enhancement for the
enhancement asset pool, for example,
by a letter of credit
Credit
Enhancer Cash flows
Structure

Page 3
underlying assets and distribute it to different zation. If the third-party enhancement is pro-
parties. The first-dollar, or most subordinate, vided by another bank, the other bank assumes
loss position is first to absorb credit losses, and some portion of the assets’ credit risk. All forms
the most senior investor position is last to of third-party enhancements, that is, all arrange-
absorb losses; there may also be one or more ments in which a bank assumes credit risk from
loss positions in between (second-dollar loss third-party assets or other claims that it has not
positions). Each loss position functions as a transferred, are referred to as direct-credit sub-
credit enhancement for the more senior posi- stitutes. The economic substance of a bank’s
tions in the structure. In other words, when ABS credit risk from providing a direct-credit substi-
reallocate the risks in the underlying collateral tute can be identical to its credit risk from
(particularly credit risk), the risks are moved retaining recourse on assets it has transferred.
into security tranches that match the desires of Third-party credit enhancements include standby
investors. For example, senior-subordinated letters of credit, collateral or pool insurance, or
security structures give holders of senior tranches surety bonds from third parties. Many asset
greater credit-risk protection—albeit at lower securitizations use a combination of recourse
yields—than holders of subordinated tranches. and third-party enhancements to protect inves-
Under this structure, at least two classes of tors from credit risk. When third-party enhance-
asset-backed securities, a senior and a junior or ments are not provided, the selling bank ordi-
subordinated class, are issued in connection narily retains virtually all of the credit risk on
with the same pool of collateral. The senior class the assets transferred.
is structured so that it has a priority claim on the Some ABS, such as those backed by credit
cash flows from the underlying pool of assets. card receivables, typically use a spread account.
The subordinated class must absorb credit losses This account is actually an escrow account. The
on the collateral before losses can be charged to funds in this account are derived from a portion
the senior portion. Because the senior class has of the spread between the interest earned on the
this priority claim, cash flows from the under- assets in the underlying pool and the lower
lying pool of assets must first satisfy the require- interest paid on securities issued by the trust.
ments of the senior class. Only after these The amounts that accumulate in the account are
requirements have been met will the cash flows used to cover credit losses in the underlying
be directed to service the subordinated class. asset pool up to several multiples of historical
losses on the particular asset collateralizing the
securities. Overcollateralization, a form of credit
Credit Enhancement enhancement covering a predetermined amount
of potential credit losses, occurs when the
ABS can use various forms of credit enhance- value of the underlying assets exceeds the face
ments to transform the risk-return profile of value of the securities.
underlying collateral. These include third-party A similar form of credit enhancement is the
credit enhancements, recourse provisions, over- cash-collateral account, which is established
collateralization, and various covenants and when a third party deposits cash into a pledged
indentures. The sponsor of the asset securitiza- account. The use of cash-collateral accounts,
tion may provide a portion of the total credit which are considered by enhancers to be loans,
enhancement internally, as part of the securiti- grew as the number of highly rated banks and
zation structure, through the use of excess spread other credit enhancers declined in the early
accounts, overcollateralization, retained subor- 1990s. Cash-collateral accounts eliminate event
dinated interests, or other similar on-balance- risk, or the risk that the credit enhancer will have
sheet assets. When these or other on-balance- its credit rating downgraded or that it will not be
sheet internal enhancements are provided, the able to fulfill its financial obligation to absorb
enhancements are ‘‘residual interests’’ and are a losses and thus provide credit protection to
form of recourse.3 investors in a securitization.
A seller may also arrange for a third party to An investment banking firm or other organi-
provide credit enhancement in an asset securitization generally serves as an underwriter for
ABS. In addition, for asset-backed issues that
are publicly offered, a credit-rating agency will
3. Purchased credit-enhancing interest-only strips are also analyze the policies and operations of the origi-
considered ‘‘residual interests.’’ nator and servicer, as well as the structure,

Page 4
underlying pool of assets, expected cash flows, pay-through structure resulted from the desire to
and other attributes of the securities. Before broaden the marketability of these securities to
assigning a rating to the issue, the rating agency investors who were interested in maturities other
will also assess the extent of loss protection than those generally associated with pass-
provided to investors by the credit enhance- through securities.
ments associated with the issue. Multiple-class ABS may also be issued as
derivative instruments, such as ‘‘stripped’’ secu-
rities. Investors in each class of a stripped
TYPES OF ASSET-BACKED security will receive a different portion of the
SECURITIES principal and interest cash flows from the under-
lying pool of assets. In their purest form, stripped
Asset securitization involves different types of securities may be issued as interest-only (IO)
capital-market instruments. (For more informa- strips, for which the investor receives 100 per-
tion, see the Trading and Capital-Markets cent of the interest from the underlying pool of
Activities Manual, section 4105.1, ‘‘Asset- assets, and as principal-only (PO) strips, for
Backed Securities and Asset-Backed Commer- which the investor receives all of the principal.
cial Paper,’’ and section 4110.1, ‘‘Residential In addition to these securities, other types of
Mortgage–Backed Securities.’’) These instru- financial instruments may arise as a result of
ments may be structured as ‘‘pass-throughs’’ or asset securitization, as follows:
‘‘pay-throughs.’’ Under a pass-through struc-
ture, the cash flows from the underlying pool of • Servicing assets. These assets become a dis-
assets are passed through to investors on a pro tinct asset recorded on the balance sheet when
rata basis. This type of security may be a contractually separated from the underlying
single-class instrument, such as a GNMA pass- assets that have been sold or securitized and
through, or a multiclass instrument, such as a when the servicing of those assets is retained.
real estate mortgage investment conduit (See FAS 140 for more information.) In addi-
(REMIC).4 tion, servicing assets are created when orga-
The pay-through structure, with multiple nizations purchase the right to act as servicers
classes, combines the cash flows from the under- for loan pools. The value of the servicing
lying pool of assets and reallocates them to two assets is based on the contractually specified
or more issues of securities that have different servicing fees, net of servicing costs.
cash-flow characteristics and maturities. An • Interest-only strips receivables. These cash
example is the collateralized mortgage obliga- flows are accounted for separately from ser-
tion (CMO), which has a series of bond classes, vicing assets and reflect the right to future
each with its own specified coupon and stated interest income from the serviced assets in
maturity. In most cases, the assets that make up excess of the contractually specified servicing
the CMO collateral pools are pass-through fees.
securities. Scheduled principal payments and • ABS residuals. These residuals (sometimes
any prepayments from the underlying collateral referred to as ‘‘residuals,’’ ‘‘residual inter-
go first to the earliest maturing class of bonds. ests,’’ or ‘‘retained interests’’ represent claims
This first class of bonds must be retired before on any cash flows that remain after all obli-
the principal cash flows are used to retire the gations to investors and any related expenses
later bond classes. The development of the have been met. The excess cash flows may
arise as a result of overcollateralization or
from reinvestment income. Residuals can be
4. In the early 1980s, collateralized mortgage obligations retained by sponsors or purchased by inves-
(CMOs), or multiple-class securities, were introduced to help tors in the form of securities.
minimize the reinvestment and interest-rate risks inherent in
the traditional fixed-rate mortgage-backed security. As a result
of the Tax Reform Act of 1986, the REMIC was created. The
REMIC is a more flexible mortgage security that expanded the
appeal of the CMO structure to a wider investor base and RISKS ASSOCIATED WITH ASSET
offered preferred tax status to both investors and issuers. SECURITIZATION
Today, almost all CMOs are issued in REMIC form. (‘‘The
ABCs of CMOs, REMICs and IO/POs: Rocket Science
Comes to Mortgage Finance,’’ Journal of Accountancy, April While clear benefits accrue to banking organi-
1991, p. 41.) zations that engage in securitization activities

Page 5
and invest in ABS, these activities have the Issuer-Specific Risks

potential to increase the overall risk profile of
the banking organization if they are not carried Banking organizations that issue ABS may be
out prudently. For the most part, the types of subject to pressures to sell only their best assets,
risks that financial institutions encounter in the thus reducing the quality of their own loan
securitization process are identical to those that portfolios. On the other hand, some banking
they face in traditional lending transactions, organizations may feel pressures to relax their
including credit risk, concentration risk, interest- credit standards because they can sell assets
rate risk (including prepayment risk), opera- with higher risk than they would normally want
tional risk, liquidity risk, moral-recourse risk, to retain for their own portfolios.
and funding risk. However, since the securitiza- To protect their name in the market, issuers
tion process separates the traditional lending may face pressures to provide ‘‘moral recourse’’
function into several limited roles, such as by repurchasing securities backed by loans or
originator, servicer, credit enhancer, trustee, and leases they have originated that have deterio-
investor, the types of risks that a bank will rated and become nonperforming. Funding risk
encounter will differ depending on the role it may also be a problem for issuers when market
assumes. aberrations do not permit the issuance of asset-
backed securities that are in the securitization
pipeline.
Servicer-Specific Risks
Investor-Specific Risks
Banking organizations that service securitiza-
Investors in ABS will be exposed to varying tion issues must ensure that their policies,
degrees of credit risk, that is, the risk that operations, and systems will not permit break-
obligors will default on principal and interest downs that may lead to defaults. Substantial fee
payments. Like the investors in the direct invest- income can be realized by acting as a servicer.
ments of the underlying assets, ABS investors An institution already has a fixed investment in
are also subject to the risk that the various its servicing systems, and achieving economies
parties in the securitization structure, for exam- of scale relating to that investment is in its best
ple, the servicer or trustee, will be unable to interest. The danger, though, lies in overload-
fulfill their contractual obligations. Moreover, ing the system’s capacity, thereby creating
investors may be susceptible to concentrations enormous out-of-balance positions and cost
of risks across various asset-backed security overruns. Servicing problems may precipitate
issues (1) through overexposure to an organiza- a technical default, which in turn could lead
tion that performs various roles in the securiti- to the premature redemption of the security. In
zation process or (2) as a result of geographic addition, expected collection costs could exceed
concentrations within the pool of assets provid- fee income. (For further guidance, examin-
ing the cash flows for an individual issue. Also, ers should see section 2040.3, ‘‘Loan Portfolio
since the secondary markets for certain ABS are Management: Examination Procedures,’’ under
limited, investors may encounter greater than the ‘‘Loan Portfolio Review and Analysis’’
anticipated difficulties (liquidity risk) when seek- heading.)
ing to sell their securities. Furthermore, certain
derivative instruments, such as stripped asset- ACCOUNTING ISSUES
backed securities and residuals, may be extremely
sensitive to interest rates and exhibit a high Sale or Borrowing Treatment
degree of price volatility. Therefore, they may
dramatically affect the risk exposure of investors Asset-securitization transactions are frequently
unless used in a properly structured hedging structured to obtain certain accounting treat-
strategy. Examiner guidance in the Trading and ments, which in turn affect reported measures of
Capital-Markets Activities Manual, section profitability and capital adequacy. In transfer-
3000.1, ‘‘Investment Securities and End-User ring assets into a pool to serve as collateral for
Activities,’’ is directly applicable to ABS held as ABS, a key question is whether the transfer
investments. should be treated as a sale of the assets or as a

Page 6
collateralized borrowing, that is, a financing analyses include prepayment or payment rates,
transaction secured by assets. Treating these default rates, loss-severity factors, and discount
transactions as a sale of assets results in their rates. Institutions are expected to take a logical
being removed from the banking organization’s and conservative approach when developing
balance sheet, thus reducing total assets relative securitization assumptions and capitalizing future
to earnings and capital, and thereby producing income flows. It is important that management
higher performance and capital ratios.5 Treating quantifies the assumptions at least quarterly on a
these transactions as financings, however, means pool-by-pool basis and maintains supporting
that the assets in the pool remain on the balance documentation for all changes to the assump-
sheet and are subject to capital requirements and tions as part of the valuation. Policies should
the related liabilities-to-reserve requirements.6 define the acceptable reasons for changing
assumptions and require appropriate manage-
ment approval.
Valuation and Modeling Processes for An exception to this pool-by-pool valuation
analysis may be applied to revolving-asset trusts
Retained Interests if the master-trust structure allows excess cash
The methods and models BOs use to value flows to be shared between series. In a master
retained interests and the difficulties in manag- trust, each certificate of each series represents an
ing exposure to these volatile assets can raise undivided interest in all of the receivables in the
supervisory concerns. Under GAAP, a BO rec- trust. Therefore, valuations are appropriate at
ognizes an immediate gain (or loss) on the sale the master-trust level.
of assets by recording its retained interest at fair To determine the value of the retained interest
value. The valuation of the retained interest is at inception, and to make appropriate adjust-
based on the present value of future cash flows ments going forward, the institution must imple-
in excess of the amounts needed to service the ment a reasonable modeling process to comply
bonds and cover credit losses and other fees of with FAS 140. Management is expected to
the securitization vehicle.7 employ reasonable and conservative valuation
Determinations of fair value should be based assumptions and projections, and to maintain
on reasonable, conservative assumptions about verifiable objective documentation of the fair
factors such as discount rates, projected credit value of the retained interest. Senior manage-
losses, and prepayment rates. Bank supervisors ment is responsible for ensuring that the valua-
expect retained interests to be supported by tion model accurately reflects the cash flows
verifiable documentation of fair value in accor- according to the terms of the securitization’s
dance with GAAP. In the absence of such structure. For example, the model should account
support, the retained interests should not be for any cash collateral or overcollateralization
carried as assets on an institution’s books, but triggers, trust fees, and insurance payments if
should be charged off. Other supervisory con- appropriate. The board and management are
cerns include failure to recognize and hold accountable for the model builders’ possessing
sufficient capital against recourse obligations the necessary expertise and technical profi-
generated by securitizations, and the absence of ciency to perform the modeling process. Senior
an adequate and independent audit function. management should ensure that internal controls
The method and key assumptions used to are in place to provide for the ongoing integrity
value the retained interests and servicing assets of management information systems (MIS)
or liabilities must be reasonable and fully docu- associated with securitization activities.
mented. The key assumptions in all valuation As part of the modeling process, the risk-
management function should ensure that peri-
odic validations are performed to reduce vulner-
5. See FAS 140 for criteria that must be met for the ability to model risk. Validation of the model
securitization of assets to be accounted for as a sale.
6. Note, however, that the Federal Reserve’s Regulation D
includes testing the internal logic, ensuring
(12 CFR 204) defines what constitutes a reservable liability of empirical support for the model assumptions,
a depository institution. Thus, although a given transaction and back-testing the models using actual cash
may qualify as an asset sale for call report purposes, it flows on a pool-by-pool basis. The validation
nevertheless could result in a reservable liability under Regu-
lation D. See the call report instructions for further guidance.
process should be documented to support con-
Also, see section 3020.1, ‘‘Assessment of Capital Adequacy.’’ clusions. Senior management should ensure the
7. See FAS 140. validation process is independent from line man-

Page 7
agement and from the modeling process. The of sound disclosures include—
audit scope should include procedures to ensure
that the modeling process and validation mecha- • accounting policies for measuring retained
nisms are both appropriate for the institution’s interests, including a discussion of the impact
circumstances and executed consistently with its of key assumptions on the recorded value;
asset-securitization policy. • the process and methodology used to adjust
the value of retained interests for changes in
key assumptions;
Use of Outside Parties • risk characteristics, both quantitative and quali-
tative, of the underlying securitized assets;
Third parties are often engaged to provide pro- • the role of retained interests as credit enhance-
fessional guidance and support regarding an ments to special-purpose entities and other
institution’s securitization activities, transac- securitization vehicles, including a discussion
tions, and valuing of retained interests. The use of techniques used for measuring credit risk;
of outside resources does not relieve directors of and
their oversight responsibility, nor does it relieve • sensitivity analyses or stress testing conducted
senior management of its responsibilities to by the BO, showing the effect of changes in
provide supervision, monitoring, and oversight key assumptions on the fair value of retained
of securitization activities, particularly the man- interests.
agement of the risks associated with retained
interests. Management is expected to have the
experience, knowledge, and abilities to dis-
charge its duties; understand the nature and CAPITAL ADEQUACY
extent of the risks that retained interests present;
and have the policies and procedures necessary As with all risk-bearing activities, institutions
to implement an effective risk-management sys- should fully support the risk exposures of their
tem to control such risks. Management must securitization activities with adequate capital.
have a full understanding of the valuation tech- Banking organizations should ensure that their
niques employed, including the basis and rea- capital positions are sufficiently strong to sup-
sonableness of underlying assumptions and port all the risks associated with these activities
projections. on a fully consolidated basis and should main-
tain adequate capital in all affiliated entities
engaged in these activities. The Federal Reserve’s
risk-based capital guidelines establish minimum
Market Discipline and Disclosures capital ratios, and those banking organizations
exposed to high or above-average degrees of
Transparency through public disclosure is cru- risk are expected to operate significantly above
cial to effective market discipline and can rein- the minimum capital standards.
force supervisory efforts to promote high stan- The current regulatory capital rules may not
dards in risk management. Timely and adequate fully incorporate the economic substance of the
information on the institution’s asset- risk exposures involved in many securitization
securitization activities should be disclosed. The activities. Therefore, when evaluating capital
information in the disclosures should be com- adequacy, examiners should ensure that banking
prehensive; however, the amount of disclosure organizations that (1) sell assets with recourse,
that is appropriate will depend on the volume of (2) assume or mitigate credit risk through the
securitizations and complexity of the BO. Well- use of credit derivatives, or (3) provide direct-
informed investors, depositors, creditors, and credit substitutes and liquidity facilities to secu-
other counterparties can provide a BO with ritization programs are accurately identifying
strong incentives for maintaining sound risk- and measuring these exposures and maintaining
management systems and internal controls. capital at aggregate levels sufficient to support
Adequate disclosure allows market participants the associated credit, market, liquidity, reputa-
to better understand the BO’s financial condition tional, operational, and legal risks.
and apply market discipline, thus creating incen- Examiners should review the substance of
tives to reduce inappropriate risk-taking or securitizations when assessing underlying risk
inadequate risk-management practices. Examples exposures. For example, partial, first-loss direct-

Page 8
credit substitutes providing credit protection to a exposures. However, the specific capital require-
securitization transaction can, in substance, ment will depend on the amount of recourse
involve the same credit risk as would be involved retained by the transferring institution and the
in holding the entire asset pool on the institu- type of asset sold with recourse. Third, banking
tion’s balance sheet. Examiners should ensure organizations that provide credit enhancement
that banks have implemented reasonable meth- to asset-securitization issues through standby
ods for allocating capital against the economic letters of credit or by other means must hold
substance of credit exposures arising from early- capital against the related off-balance-sheet credit
amortization events and liquidity facilities asso- exposure.
ciated with securitized transactions. These
liquidity facilities are usually structured as short-
term commitments in order to avoid a risk-based
capital requirement, even though the inherent Assigning Risk Weights
credit risk may be similar to that of a guarantee.8
If, in the examiner’s judgment, an institu- The risk weights assigned to an asset-backed
tion’s capital level is not sufficient to provide security generally depend on the issuer and on
protection against potential losses from the above whether the assets that compose the collateral
credit exposures, this deficiency should be pool are mortgage-related assets or assets guar-
reflected in the banking organization’s CAMELS anteed by a U.S. government agency. ABS
rating. Furthermore, examiners should discuss issued by a trust or single-purpose corporation
the capital deficiency with the institution’s man- and backed by nonmortgage assets generally are
agement and, if necessary, its board of directors. to be assigned a risk weight of 100 percent.
Such an institution will be expected to develop Securities guaranteed by U.S. government
and implement a plan for strengthening the agencies and those issued by U.S. government–
organization’s overall capital adequacy to levels sponsored agencies are assigned risk weights of
deemed appropriate given all the risks to which 0 percent and 20 percent, respectively, because
it is exposed. of the low degree of credit risk. Accordingly,
mortgage pass-through securities guaranteed by
GNMA are placed in the risk category of 0 per-
cent. In addition, securities such as participation
RISK-BASED CAPITAL certificates and CMOs issued by Fannie Mae or
PROVISIONS AFFECTING ASSET Freddie Mac are assigned a 20 percent risk
SECURITIZATION weight.
However, several types of securities issued by
The risk-based capital framework assigns risk Fannie Mae and Freddie Mac are excluded from
weights to loans, ABS, off-balance-sheet credit the lower risk weight and slotted in the 100 per-
enhancements, and other assets related to secu- cent risk category. Residual interests (for exam-
ritization.9 Second, banks that transfer assets ple, CMO residuals) and subordinated classes of
with recourse to the seller as part of the securi- pass-through securities or CMOs that absorb
tization process are explicitly required to hold more than their pro rata share of loss are
capital against their off-balance-sheet credit assigned to the 100 percent risk-weight cate-
gory. Furthermore, high-risk mortgage-derivative
8. For further guidance on distinguishing, for risk-based securities and all stripped, mortgage-backed
capital purposes, whether a facility is a short-term commit- securities, including IOs, POs, and similar
ment or a direct-credit substitute, see SR-92-11, ‘‘Asset- instruments, are assigned to the 100 percent
Backed Commercial Paper Programs.’’ Essentially, facilities
that provide liquidity, but which also provide credit protection risk-weight category because of their high price
to secondary-market investors, are to be treated as direct- volatility and market risk.
credit substitutes for purposes of risk-based capital. A privately issued mortgage-backed security
9. In addition to being subject to risk-based capital require-
ments, servicing assets are also subject to capital limitations.
that meets the criteria listed below is considered
The total amount of servicing assets (including both mortgage- a direct or indirect holding of the underlying
servicing assets and nonmortgage-servicing assets) and pur- mortgage-related assets and is generally assigned
chased credit-card relationships that may be included in a to the same risk category as those assets (for
bank’s capital may not, in the aggregate, exceed 100 percent
of tier 1 capital. The total amount of nonmortgage-servicing
example, U.S. government agency securities,
assets and purchased credit-card relationships is subject to a U.S. government–sponsored agency securities,
separate aggregate sublimit of 25 percent of tier 1 capital. FHA- and VA-guaranteed mortgages, and con-

Page 9
ventional mortgages). However, under no cir- guaranteed portion of the student loans is eli-
cumstances will a privately issued mortgage- gible for the 20 percent risk category. Therefore,
backed security be assigned to the 0 percent risk senior ABS that are supported solely by student
category. Therefore, private issues that are loans that are conditionally guaranteed by the
backed by GNMA securities will be assigned to Department of Education and that meet the four
the 20 percent risk category as opposed to the criteria listed above may be assigned to the
0 percent category appropriate to the underlying 20 percent risk category to the extent they are
GNMA securities. The criteria that a privately guaranteed. As with mortgage-backed securi-
issued mortgage-backed security must meet to ties, subordinated student loan–backed securi-
be assigned the same risk weight as the under- ties and securities backed by pools of condition-
lying assets are as follows: ally guaranteed and nonguaranteed student loans
would be assigned to the 100 percent risk
• The underlying assets are held by an indepen- category.
dent trustee, and the trustee has a first-priority, Banks report their activities in accordance
perfected security interest in the underlying with GAAP, which permits asset-securitization
assets on behalf of the holders of the security. transactions to be treated as sales when certain
• The holder of the security has an undivided criteria are met even when there is recourse to
pro rata ownership interest in the underlying the seller. In accordance with the RBC guide-
mortgage assets, or the trust or single-purpose line, banks are required to hold capital against
entity (or conduit) that issues the security has the off-balance-sheet credit exposure arising
no liabilities unrelated to the issued securities. from the contingent liability associated with the
• The cash flow from the underlying assets of recourse provisions. This exposure, generally
the security in all cases fully meets the cash- the outstanding principal amount of the assets
flow requirements of the security without sold with recourse, is considered a direct-credit
undue reliance on any reinvestment income. substitute that is converted at 100 percent to an
• No material reinvestment risk is associated on-balance-sheet credit-equivalent amount for
with any funds awaiting distribution to the appropriate risk weighting.
holders of the security.
Those privately issued mortgage-backed securi- Recourse Obligations

ties that do not meet the above criteria are to be
assigned to the 100 percent risk category. For regulatory purposes, recourse is generally
If the underlying pool of mortgage-related defined as an arrangement in which an institu-
assets is composed of more than one type of tion retains the risk of credit loss in connection
asset, then the entire class of mortgage-backed with an asset transfer, if the risk of credit loss
securities is assigned to the category appropriate exceeds a pro rata share of its claim on the
to the highest risk-weighted asset in the asset assets.10 In addition to broad contractual lan-
pool. For example, if the security is backed by a guage that may require the seller to support a
pool consisting of U.S. government–sponsored securitization, recourse can arise from retained
agency securities (for example, Freddie Mac interests, retained subordinated security inter-
participation certificates) that qualify for a ests, the funding of cash-collateral accounts, or
20 percent risk weight and conventional mort- other forms of credit enhancements that place a
gage loans that qualify for the 50 percent risk BO’s earnings and capital at risk. These enhance-
category, then the security would receive the ments should generally be aggregated to deter-
50 percent risk weight. mine the extent of a BO’s support of securitized
While not set forth specifically in the risk- assets. Although an asset securitization qualifies
based capital guidelines, securities backed by for sales treatment under GAAP, the underlying
student loans that meet the above-mentioned assets may still be subject to regulatory risk-
criteria may also be considered an indirect
holding of the underlying assets and assigned to
the same risk category as those assets. For 10. See the risk-based capital treatment for sales with
instance, the U.S. Department of Education recourse at 12 CFR 3, appendix A, section (3)(b)(1)(iii) (for
the OCC), and 12 CFR 567.6(a)(2)(i)(c) (for the OTS). For a
conditionally guarantees banks originating stu- further explanation of recourse, see the glossary of the call
dent loans for 98 percent of each loan under the report instructions at ‘‘sales of assets for risk-based capital
Federal Family Education Loan Program. The purposes.’’

Page 10
based capital requirements. Assets sold with for credit losses associated with the loans
recourse should generally be risk-weighted as if being serviced (mortgage-servicer cash
they had not been sold. advances that meet the conditions of section
III.B.3.a.viii. of the capital adequacy guide-
lines (12 CFR 208, appendix A) are not
Credit-Equivalent Amounts and Risk recourse arrangements)
Weights of Recourse Obligations and • retained subordinated interests that absorb
Direct-Credit Substitutes more than their pro rata share of losses from
the underlying assets
The credit-equivalent amount for a recourse • assets sold under an agreement to repurchase,
obligation or direct-credit substitute is the full if the assets are not already included on the
amount of the credit-enhanced assets for which balance sheet
the bank directly or indirectly retains or assumes • loan strips sold without contractual recourse
credit risk, multiplied by a 100 percent conver- when the maturity of the transferred loan is
sion factor. A bank that extends a partial direct- shorter than the maturity of the commitment
credit substitute, for example, a financial standby under which the loan is drawn
letter of credit that absorbs the first 10 percent of • credit derivatives issued that absorb more than
loss on a transaction, must maintain capital the bank’s pro rata share of losses from the
against the full amount of the assets being transferred assets
supported. • clean-up calls at inception that are greater than
To determine the bank’s risk-weighted assets 10 percent of the balance of the original pool
for an off-balance-sheet recourse obligation, a of transferred loans (clean-up calls that are
third-party direct-credit substitute, or a letter of 10 percent or less of the original pool balance
credit, the credit-equivalent amount is assigned and that are exercisable at the option of the
to the risk category appropriate to the obligor in bank are not recourse arrangements)
the underlying transaction, after considering any
associated guarantees or collateral. For a direct- The risk-based capital treatment for asset
credit substitute that is an on-balance-sheet asset, securitizations is discussed in detail in section
for example, a purchased subordinated security, 3020.1. In general, a multilevel, ratings-based
a bank must calculate risk-weighted assets using approach is used to assess the capital require-
the amount of the direct-credit substitute and the ments on recourse obligations, residual interests
full amount of the assets it supports, that is, all (except credit-enhancing interest-only (I/O)
the more senior positions in the structure. This strips), direct-credit substitutes, and senior and
treatment is subject to the low-level-exposure subordinated securities in asset securitizations,
rule discussed below. (The risk-based capital based on their relative exposure to credit risk.
treatment for asset securitizations is discussed in Credit ratings from rating agencies are used to
more detail in section 3020.1.) measure relative exposure to credit risk and to
If a bank has no claim on a transferred asset, determine the associated risk-based capital re-
then the retention of any risk of credit loss is quirement. The Federal Reserve is relying on
recourse. A recourse obligation typically arises these credit ratings to make determinations of
when a bank transfers assets and retains an credit quality for the regulatory capital treatment
explicit obligation to repurchase the assets or for loss positions that represent different grada-
absorb losses due to a default on the payment of tions of credit risk, the same as investors and
principal or interest, or due to any other defi- other market participants. As discussed later in
ciency in the performance of the underlying this section, residual interests are subject to (1) a
obligor or some other party. Recourse may also dollar-for-dollar capital charge and (2) a 25 per-
exist implicitly if a bank provides credit enhance- cent of tier 1 capital concentration limit on a
ment beyond any contractual obligation to sup- subset of residual interests, credit-enhancing I/O
port assets it has sold. The following are strips.
examples of recourse arrangements:
• credit-enhancing representations and warran- Implicit Recourse Provided to Asset

ties made on the transferred assets Securitizations
• loan-servicing assets retained under an agree-
ment that requires the bank to be responsible Implicit recourse arises when a bank provides

Page 11
credit support to one of more of its securitiza- which receivables generated by the lines are
tions beyond its contractual obligation. Implicit sold into the securitizations. These securitiza-
recourse, like contractual recourse, exposes an tions typically provide that, when certain per-
institution to the risk of loss arising from dete- formance criteria hit specified thresholds, no
rioration in the credit quality of the underlying new receivables can be sold into the securitiza-
assets of the securitization. Implicit recourse is tion, and the principal on the bonds issued will
of supervisory concern because it demonstrates begin to pay out. These early-amortization events
that the securitizing institution is reassuming are intended to protect investors from further
risk associated with the securitized assets—risk deterioration in the underlying asset pool. Once
that the institution initially transferred to the an early-amortization event has occurred, the
marketplace. For risk-based capital purposes, bank could have difficulties using securitization
banks deemed to be providing implicit recourse as a continuing source of funding and, at the
are generally required to hold capital against the same time, have to fund the new receivables
entire outstanding amount of assets sold, as generated by the lines of credit on its balance
though the assets remained on the bank’s books. sheet. Thus, banks have an incentive to avoid
Banks have typically provided implicit early amortization by providing implicit support
recourse in situations where the originating bank to the securitization.
perceived that the failure to provide this support, Examiners should be alert for securitizations
even though not contractually required, would that are approaching early-amortization triggers,
damage its future access to the asset-backed such as a decrease in the excess spread 10b below
securities market. An originating bank can pro- a certain threshold or an increase in delinquen-
vide implicit recourse in a variety of ways. The cies beyond a certain rate. Providing implicit
ultimate determination as to whether implicit recourse can pose a degree of risk to a bank’s
recourse exists depends on the facts. The fol- financial condition and to the integrity of its
lowing actions point to a finding of implicit regulatory and public financial statements and
recourse: reports. Examiners should review securitization
documents (for example, pooling and servicing
• selling assets to a securitization trust or other agreements) to ensure that the selling institution
special-purpose entity (SPE) at a discount limits any post-sale support to that specified in
from the price specified in the securitization the terms and conditions in the securitization
documents, which is typically par value documents. Examiners should also review a
• purchasing assets from a trust or other SPE at sample of receivables transferred between the
an amount greater than fair value seller and the trust to ensure that these transfers
• exchanging performing assets for nonperform- were conducted in accordance with the contrac-
ing assets in a trust or other SPE tual terms of the securitization, particularly in
• funding credit enhancements 10a beyond con- cases where the overall credit quality of the
tractual requirements securitized loans or receivables has deteriorated.
While banks are not prohibited from providing
By providing implicit recourse, a bank signals implicit recourse, such support will generally
to the market that it still holds the risks inherent result in higher capital requirements.
in the securitized assets, and, in effect, the risks Examiners should recommend that prompt
have not been transferred. Accordingly, exam- supervisory action be taken when implicit
iners must be attentive to banks that provide recourse is identified. To determine the appro-
implicit support, given the risk these actions priate action, examiners need to understand the
pose to a bank’s financial condition. Increased bank’s reasons for providing support and the
attention should be given to situations where a extent of the impact of this support on the
bank is more likely to provide implicit support. bank’s earnings and capital. As with contractual
Particular attention should be paid to revolv- recourse, actions involving noncontractual post-
ing securitizations, such as those used for credit sale credit enhancement generally result in the
card lines and home equity lines of credit, in requirement that the bank hold risk-based capi-
tal against the entire outstanding amount of the
10a. Credit enhancements include retained subordinated
interests, asset-purchase obligations, overcollateralization, 10b. Excess spread generally is defined as finance-charge
cash-collateral accounts, spread accounts, and interest-only collections minus certificate interest, servicing fees, and
strips. charge-offs allocated to the series.

Page 12
securitized assets. Supervisors may require the that are due from customers located in the
bank to bring all assets in existing securitiza- geographic areas where the bank lacks a signifi-
tions back on the balance sheet for risk-based cant market presence, and it will remove all such
capital purposes, as well as require the bank to receivables from the trust.
increase its minimum capital ratios. Supervisors
may also prevent a bank from removing assets Analysis. The removal of the above-described
from its risk-weighted asset base on future receivables from the trust does not constitute
transactions until the bank demonstrates its intent implicit recourse for regulatory capital pur-
and ability to transfer risk to the marketplace. In poses. Supporting factors for this conclusion
addition, supervisors may consider other actions include the following:
to ensure that the risks associated with implicit
recourse are adequately reflected in the capital • The bank’s earnings and capital are not
ratios. For example, supervisors may require the exposed to actual or potential risk of loss as a
bank to deduct residual interests from tier 1 result of removing the receivables from the
capital as well as hold risk-based capital on the trust.
underlying assets. • There is no indication that the receivables are
The following examples illustrate post-sale removed from the trust because of perfor-
actions that banks have taken on assets they mance concerns.
have securitized. These examples are intended • The bank is removing the receivables from the
to provide guidance on whether these actions trust for a legitimate business purpose other
would be considered implicit recourse for risk- than to systematically improve the quality of
based capital and other supervisory purposes. A the trust’s assets. The legitimate business
key factor in each scenario and analysis is the purpose is evidenced by the bank’s prear-
potential risk of loss the bank’s earnings and ranged, arm’s-length sale agreement that
capital may be exposed to as a result of its facilitates exiting the business in identified
actions. geographic locations.
Account removal: Example 1a Examiners should review the terms and con-
ditions of the transaction to ensure that the
Facts. A bank originates and services credit card market value of the receivables is documented
receivables throughout the country. The bank and well supported before concluding that this
decides to divest those credit card accounts of transaction does not represent implicit recourse.
customers who reside in specific geographic Examiners should also ensure that the selling
areas where the bank lacks a significant market bank has not provided the purchaser with any
presence. To achieve the maximum sales price, guarantees or credit enhancements on the sold
the sale must include both the credit card rela- receivables.
tionships and the receivables. Because many of
the credit card receivables are securitized through Account removal: Example 1b
a master-trust structure, the bank needs to remove
the receivables from the trust. The affected Facts. After the establishment of a master trust
receivables are not experiencing any unusual for a pool of credit card receivables, the receiv-
performance problems. In that respect, the ables in the trust begin to experience adverse
charge-off and delinquency ratios for the receiv- performance. A combination of lower-than-
ables to be removed from the trust are substan- expected yields and higher-than-anticipated
tially similar to those for the trust as a whole. charge-offs on the pool causes spreads to com-
The bank enters into a contract to sell the press significantly (although not to zero). The
specified credit card accounts before the receiv- bank’s internally generated forecasts indicate
ables are removed from the trust. The terms of that spreads will likely become negative in the
the transaction are arm’s length, wherein the near future.
bank will sell the receivables at market value. Management takes action to support the trust
The bank separately agrees to purchase the by purchasing the low-quality (delinquent)
receivables from the trust at this same price. receivables from the trust at par, although their
Therefore, no loss is incurred as a result of market value is less than par. The receivables
removing the receivables from the trust. The purchased from the trust represent approxi-
bank will only remove receivables from the trust mately one-third of the trust’s total receivables.

Page 13
This action improves the overall performance of and the affinity client subsequently revised the
the trust and avoids a potential early-amortization terms of their contract, enabling the affinity
event. accounts to meet the selection criteria and be
included in future securitization transactions.
Analysis. The purchase of low-quality receiv- Later, rising charge-offs within the pool of
ables from a trust at par constitutes implicit receivables held by the trust caused spread
recourse for regulatory capital purposes. The compression in the trust. To improve the perfor-
purchase of low-quality receivables at an above- mance of the assets in the trust, the bank begins
market price exposes the bank’s earnings and to include the better-performing and now-
capital to potential future losses from assets that eligible receivables from the affinity accounts
had previously been sold. Accordingly, the bank among the receivables sold to the trust. This
is required to hold risk-based capital for the action improves the trust’s performance, includ-
remaining assets in the trust as if they were ing its spread levels and charge-off ratios. How-
retained on the balance sheet, as well as hold ever, the replacement assets were sold at par in
capital for the assets that were repurchased. accordance with the terms of the trust agree-
ment, so no current or future charge to the
Additions of future assets or receivables: bank’s earnings or capital will result from these
Example 2a asset sales. As another result of this action, the
performance of the trust’s assets closely tracks
Facts. Months after the issuance of credit card the credit card receivables that remain on the
asset-backed securities, charge-offs and delin- bank’s balance sheet.
quencies on the underlying pool of receivables
rise dramatically. A rating agency places the Analysis. The actions described above do not
securities on watch for a potential rating down- constitute implicit recourse for regulatory capi-
grade, causing the bank to negotiate additional tal purposes. The bank did not incur any addi-
credit support for the securitized assets. The tional risk to earnings or capital after the affinity
securitization documents require the bank to accounts met the selection criteria for replace-
transfer new receivables to the securitization ment assets and after the associated receivables
trust at par value. However, to maintain the were among the receivables sold to the trust.
rating on the securities, the bank begins to sell The replacement assets were sold at par in
replacement receivables into the trust at a dis- accordance with the terms of the trust agree-
count from par value. ment, so no future charge to earnings or capital
will result from these asset sales. The sale of
Analysis. The sale of receivables to the trust at a replacement assets into a master-trust structure
discount constitutes implicit recourse for regu- is part of normal trust management.
latory capital purposes. The sale of assets at a In this example, the credit card receivables
discount from the price specified in the securi- that remain on the bank’s balance sheet closely
tization documents, par value in this example, track the performance of the trust’s assets.
exposes earnings and capital to future losses. Nevertheless, examiners should ascertain whether
The bank must hold regulatory capital against a securitizing bank sells disproportionately
the outstanding assets in the trust. higher-quality assets into securitizations while
retaining comparatively lower-quality assets on
Additions of future assets or receivables: its books; if so, examiners should consider the
Example 2b effect of this practice on the bank’s capital
adequacy.
Facts. A bank established a credit card master
trust. The receivables from the accounts placed Additions of future assets or receivables:
in the trust were, on average, of lesser quality Example 2c
than the receivables from accounts retained on
the bank’s balance sheet. Under the criteria for Facts. A bank establishes a credit card master
selecting the receivables to be transferred to the trust composed of receivables from accounts
master trust, the bank was prevented from includ- that were generally of lower quality than the
ing the better-performing affinity accounts in the receivables retained on the bank’s balance sheet.
initial pool of accounts because the affinity- The difference in the two portfolios is primarily
relationship contract was expiring. The bank due to logistical and operational problems that

Page 14
prevent the bank from including certain better- bank increased the spread accounts beyond its
quality affinity accounts in the initial pool from contractual obligation under the securitization
which accounts were selected for securitization. documents in order to provide additional protec-
Rising charge-offs and other factors later result tion to investors, this action would be consid-
in margin compression on the assets in the ered a form of implicit recourse. None of the
master trust, which causes some concern in the other actions the bank took would affect the
market regarding the stability of the outstanding bank’s earnings or capital:
asset-backed securities. A rating agency places
several securities on its watch list for a potential • Like other additions to credit card trusts, the
rating downgrade. In response to the margin additions of receivables from the new affinity
compression, as part of the bank’s contractual accounts were made at par value, in accor-
obligations, spread accounts are increased for all dance with the securitization documents.
classes by trapping excess spread in conform- Therefore, the addition of receivables to the
ance with the terms and conditions of the new affinity accounts would not affect the
securitization documents. To stabilize the qual- bank’s earnings or capital.
ity of the receivables in the master trust as well • The trust’s policy on the timing of charge-offs
as to preclude a downgrade, the bank takes on accounts of cardholders who have filed for
several actions beyond its contractual obligations: bankruptcy was changed to meet the less-
stringent standards of the industry and those
• Affinity accounts are added to the pool of required under the Federal Reserve’s policy to
receivables eligible for inclusion in the trust. improve trust performance, at least tempo-
This change results in improved overall trust rarily. Nonetheless, this would not affect the
performance. However, these receivables are bank’s earnings or capital.
sold to the trust at par value, consistent with
the terms of the securitization documents, so • In accordance with the securitization docu-
no current or future charge to the bank’s ments, proceeds from recoveries on charged-
earnings or capital will result from these asset off accounts are the property of the trust.
sales. These and other proceeds would continue to
• The charge-off policy for cardholders that be paid out in accordance with the pooling and
have filed for bankruptcy is changed from servicing agreement. No impact on the bank’s
criteria that were more conservative than earnings or capital would result.
industry standards and the FFIEC Uniform
Retail Credit Classification and Account Man- Modification of loan-repayment terms:
agement Policy to criteria that conform to Example 3
industry standards and the FFIEC’s policy.
• Charged-off receivables held by the trust are Facts. In performing the role of servicer for its
sold to a third party. The funds generated by securitization, a bank is authorized under its
this sale, effectively accelerating the recovery pooling and servicing agreement to modify loan-
on these receivables, improve the trust’s spread repayment terms when it appears that this action
performance. will improve the likelihood of repayment on the
loan. These actions are part of the bank’s
Analysis. The actions described above do not process of working with customers who are
constitute implicit recourse for regulatory capi- delinquent or otherwise experiencing temporary
tal purposes. None of the noncontractual actions financial difficulties. All of the modifications are
results in a loss or exposes the bank’s earnings consistent with the bank’s internal loan policy.
or capital to the risk of loss. Because of the However, in modifying the loan terms, the
margin compression, the bank is obligated to contractual maturity of some loans may be
increase the spread accounts in conformance extended beyond the final maturity date of the
with the terms and conditions of the securitiza- most junior class of securities sold to investors.
tion documents. To the extent this results in an When this occurs, the bank repurchases these
increase in the value of the subordinated spread loans from the securitization trust at par.
accounts (residual interests) on the bank’s bal-
ance sheet, the bank will need to hold additional Analysis. The modification of terms and repur-
capital on a dollar-for-dollar basis for the addi- chase of loans held by the trust constitutes
tional credit risk it retains. In contrast, if the implicit recourse for regulatory capital pur-

Page 15
poses. The combination of the loan-term modi- The third party initially covers actual losses that
fication for securitized assets and the subsequent occur in the underlying asset pool in accordance
repurchase constitutes implicit recourse. While with its contractual commitment under the letter
the modification of loan terms is permitted of credit. Later, the selling bank agrees not only
under the pooling and servicing agreement, the to pay the credit enhancer the annual premium
repurchase of loans with extended maturities at on the credit enhancement, but also to reimburse
par exposes the bank’s earnings and capital to the credit enhancer for the losses it absorbed
potential risk of loss. during the preceding year. This reimbursement
for actual losses was not originally provided for
Servicer’s payment of deficiency balances: in the contractual arrangement between the bank
Example 4 and the credit-enhancement provider.
Facts. A wholly owned subsidiary of a bank Analysis. The selling bank’s subsequent reim-
originates and services a portfolio of home bursement of the credit-enhancement provider’s
equity loans. After liquidation of the collateral losses constitutes implicit recourse because the
for a defaulted loan, the subsidiary makes the bank’s reimbursement of losses went beyond its
trust whole in terms of principal and interest if contractual obligations. Furthermore, the Fed-
the proceeds from the collateral are not suffi- eral Reserve would consider any requirement
cient. However, there is no contractual commit- contained in the original credit-enhancement
ment that requires the subsidiary to support the contract that obligates the bank to reimburse the
pool in this manner. The payments made to the credit-enhancement provider for its losses to be
trust to cover deficient balances on the defaulted a recourse arrangement.
loans are not recoverable under the terms of the
pooling and servicing agreement.
Low-Level Exposure
Analysis. The subsidiary’s action constitutes
implicit recourse to the bank for regulatory Securitization transactions involving recourse
capital purposes. This action is considered may be eligible for ‘‘low-level-recourse’’
implicit recourse because it adversely affects the treatment.11 A bank that contractually limits its
bank’s earnings and capital since the bank maximum off-balance-sheet recourse obligation
absorbs losses on the loans resulting from the or direct-credit substitute (except credit-
actions taken by its subsidiary. Further, no enhancing I/O strips) to an amount less than the
mechanism exists to provide for, and ensure effective risk-based capital requirement for the
that, the subsidiary will be reimbursed for the enhanced assets is required to hold risk-based
payments made to the trust. In addition, exam- capital equal to the maximum contractual expo-
iners will consider any servicer advance a credit sure, 12 less any recourse liability established in
enhancement if the servicer is not entitled to full accordance with GAAP. The low-level-recourse
reimbursement 10c or if the reimbursement is capital treatment thus applies to transactions
subordinate to other claims. accounted for as sales under GAAP. The low-
level-exposure rule provides that the dollar
Reimbursement of credit enhancer’s actual amount of risk-based capital required for assets
losses: Example 5 transferred with recourse should not exceed the
maximum dollar amount for which a bank is
Facts. A bank sponsoring a securitization contractually liable, less any recourse liability
arranges for an unrelated third party to provide a account established in accordance with GAAP.
first-loss credit enhancement, such as a financial The limitation does not apply when the bank
standby letter of credit that will cover losses up provides credit enhancement beyond any con-
to the first 10 percent of the securitized assets.
The bank agrees to pay a fixed amount as an 11. See the Federal Reserve’s Regulation H, appendix A.
annual premium for this credit enhancement. See also 60 Fed. Reg. 17986, April 10, 1995 (OCC); 60 Fed.
Reg. 8177, February 13, 1995 (FRB); and 60 Fed. Reg. 15858,
March 28,1995 (FDIC). The OTS low-level-recourse rule is
10c. A servicer advance will also be considered a form of found at 12 CFR 567.6(a)(2)(i)(c).
credit enhancement if, for any one loan, nonreimbursable 12. For example, the effective risk-based capital require-
advances are not contractually limited to an insignificant ment generally would be 4 percent for residential mortgages
amount of that loan’s outstanding principal. and 8 percent for commercial loans.

Page 16
tractual obligation to support assets it has sold. establish, pursuant to GAAP, a noncapital reserve
The low-level capital treatment applies to low- sufficient to meet the reasonably estimated lia-
level-recourse transactions involving all types of bility under their recourse arrangements.
assets, including commercial loans and residen- Banking organizations will be considered
tial mortgages. qualifying institutions for the purpose of treat-
Low-level-recourse transactions can arise ment of recourse for small-business organiza-
when a bank sells or securitizes assets and uses tions if, pursuant to the Board’s prompt-
contractual cash flows, such as spread accounts corrective-action regulation (12 CFR 208.40),
and I/O strips receivables, as a credit enhance- they are well capitalized or, by order of the
ment for the sold or securitized assets. A spread Board, adequately capitalized.13 To qualify, an
account is an escrow account that a bank typi- institution must be determined to be well capi-
cally establishes to absorb losses on receivables talized or adequately capitalized without taking
it has sold in a securitization, thereby providing into account the preferential capital treatment
credit enhancement to investors in the securities for any previous transfers of small-business
backed by the receivables, for example, credit obligations with recourse. The total outstanding
card receivables. As defined in paragraph 14 of amount of recourse retained by a qualifying BO
FAS 140, an I/O strip receivable is the contrac- on transfers of small-business obligations receiv-
tual right to receive some or all of the interest ing the preferential capital treatment cannot
due on a bond, a mortgage loan, or other exceed 15 percent of the institution’s total risk-
interest-bearing financial assets. I/O strips are to based capital.
be measured at fair value with gains or losses
recognized either in earnings (if classified as
trading) or a separate component of sharehold- Standby Letters of Credit
ers’ equity (if classified as available-for-sale).
Paragraph 14 of FAS 140 states that I/O strips, Banking organizations that issue standby letters
retained interests in securitizations, loans, other of credit as credit enhancements for ABS issues
receivables, or other financial assets that can must hold capital against these contingent liabili-
contractually be prepaid or otherwise settled in ties under the risk-based capital guidelines.
such a way that the holder would not recover According to the guidelines, financial standby
substantially all of its recorded investment letters of credit are direct-credit substitutes. A
(except for instruments that are within the scope direct-credit substitute is an arrangement in
of Statement of Financial Accounting Standards which a bank assumes, in form or substance,
No. 133 (FAS 133), ‘‘Accounting for Derivative credit risk associated with an on- or off-balance-
Instruments and Hedging Activities,’’ shall be sheet credit exposure that it did not previously
subsequently measured like investments in debt own (a third-party asset), and the risk assumed
securities classified as available-for-sale or trad- by the bank exceeds the pro rata share of its
ing under Statement of Financial Accounting interest in the third-party asset. If the bank has
Standards No. 115 (FAS 115), ‘‘Accounting for no claim on the third-party asset, then its
Certain Investments in Debt and Equity Securi-
ties.’’ Retained interests that lack objectively 13. Under 12 CFR 208.43, a state member bank is deemed
to be well capitalized if it (1) has a total risk-based capital
verifiable support or that fail to meet the super- ratio of 10.0 percent or greater; (2) has a tier 1 risk-based
visory standards (discussed previously in this capital ratio of 6.0 percent or greater; (3) has a leverage ratio
section) will be classified as loss and disallowed of 5.0 percent or greater; and (4) is not subject to any written
as assets of the BO for regulatory capital agreement, order, capital directive, or prompt-corrective-
action directive issued by the Board pursuant to section 8 of
purposes. the FDI Act, the International Lending Supervision Act of
Another divergence from the general risk- 1983, or section 38 of the FDI Act or any regulation
based capital treatment for assets sold with thereunder to meet and maintain a specific capital level for any
recourse concerns small-business obligations. capital measure.
A state member bank is deemed to be adequately capital-
Qualifying institutions that transfer small- ized if it (1) has a total risk-based capital ratio of 8.0 or
business obligations with recourse are required, greater, (2) has a tier 1 risk-based capital ratio of 4.0 percent
for risk-based capital purposes, to maintain or greater, (3) has a leverage ratio of 4.0 percent or greater or
capital against only the amount of recourse a leverage ratio of 3.0 percent or greater if the bank is rated
composite 1 under the CAMELS rating system in its most
retained, provided two conditions are met. First, recent examination and is not experiencing or anticipating
the transactions must be treated as a sale under significant growth, and (4) does not meet the definition of a
GAAP. Second, the transferring institutions must well-capitalized bank.

Page 17
assumption of any credit risk with respect to the disallowed purchased credit-card relationships,
third-party asset is a direct-credit substitute. disallowed credit-enhancing I/O strips, disal-
Direct-credit substitutes are converted in their lowed deferred tax assets, and amounts of
entirety to credit-equivalent amounts. The credit- nonfinancial equity investments required to be
equivalent amounts are then risk-weighted deducted). To determine the amount of credit-
according to their credit rating, like other direct- enhancing I/O strips that fall within the concen-
credit substitutes, and the risk weight for the tration limit, the bank would multiply the tier 1
corresponding credit rating. capital of $320 by 25 percent, which is $80.
The amount of credit-enhancing I/O strips that
exceeds the concentration limit, in this case
$20, is deducted from tier 1 capital for risk-
Concentration Limits Imposed on based and leverage capital calculations and from
Residual Interests assets.
Credit-enhancing I/O strips that are not
The creation of a residual interest (the debit) deducted from tier 1 capital (that is, the remain-
typically results in an offsetting gain on sale (the ing $80 in the above example), along with all
credit), and thus the generation of an asset. other residual interests not subject to the con-
Banking organizations that securitize high- centration limit, are subject to a dollar-for-dollar
yielding assets with long durations may create a capital requirement. Banks are not required to
residual-interest asset value that exceeds the hold capital for more than 100 percent of the
risk-based capital charge that would be in place amount of the residual interest. Credit-enhancing
if it had not sold the assets. Serious pro- I/O strips are not aggregated with any servicing
blems can arise for those banking organiza- assets or purchased credit-card relationships for
tions that distribute earnings too generously, purposes of calculating the 25 percent concen-
only to be faced later with a downward valua- tration limit.
tion and charge-off of part or all of the residual Continuing the above illustration, once a bank
interests. deducts the $20 in disallowed credit-enhancing
Under the Federal Reserve’s capital adequacy I/O strips, it must hold $80 in total capital for the
guidelines, there is a dollar-for-dollar capital $80 that represents the credit-enhancing I/O
charge on residual interests and a concentration strips not deducted from tier 1 capital. The $20
limit on a subset of residual interests, credit- deducted from tier 1 capital, plus the $80 in total
enhancing I/O strips. These strips include any risk-based capital required under the dollar-for-
on-balance-sheet assets that represent a con- dollar treatment, equals $100, the face amount
tractual right to receive some or all of the of the credit-enhancing I/O strips. Banks may
interest due on transferred assets, after taking apply a net-of-tax approach to any credit-
into account trustee and other administra- enhancing I/O strips that have been deducted
tive expenses, interest payments to investors, from tier 1 capital, as well as to the remaining
servicing fees, reimbursements to investors for residual interests subject to the dollar-for-
losses attributable to beneficial interests they dollar treatment. A bank is permitted, but not
hold, and reinvestment income and ancillary required, to net the deferred tax liabilities
revenues (for example, late fees) on the trans- recorded on its balance sheet, if any, that are
ferred assets. Credit-enhancing I/O strips expose associated with the residual interests. This net-
the bank to more than its pro rata share of credit ting of the deferred tax liabilities may result in a
risk and are limited to 25 percent of tier 1 bank’s holding less than 100 percent capital
capital, whether they are retained or purchased. against residual interests.
Any amount of credit-enhancing I/O strips that Normally, a sponsor will eventually receive
exceeds the 25 percent limit will be deducted any excess cash flow remaining from securitiza-
from tier 1 capital and assets. An example of the tions after investor interests have been met. As
concentration calculation required for banks that previously stated, residual interests are vulner-
hold credit-enhancing I/O strips is described able to sudden and sizeable write-downs that
below. can hinder a bank’s access to the capital mar-
A bank has purchased and retained on its kets; damage its reputation in the marketplace;
balance sheet credit-enhancing I/O strips with a and, in some cases, threaten its solvency. An
face amount of $100, and it has tier 1 capital of institution’s board of directors and management
$320 (before any disallowed servicing assets, are expected to develop and implement policies

Page 18
that limit the amount of residual interests that bankruptcy-remote special-purpose entity that
may be carried as a percentage of total equity purchases asset pools from, or extends loans to,
capital, based on the results of their valuation those customers.15 The asset pools in an ABCP
and modeling processes. Well-constructed inter- program might include, for example, trade
nal limits also lessen the incentives for an receivables, consumer loans, or ABS. The ABCP
institution’s personnel to engage in activities program raises cash to provide funding to the
designed to generate near-term ‘‘paper profits’’ bank’s customers through the issuance of exter-
that may be at the expense of the institution’s nally rated commercial paper into the market.
long-term financial position and reputation. Typically, the sponsoring bank provides liquid-
ity and credit enhancements to the ABCP pro-
gram. These enhancements aid the program in
Asset-Backed Commercial Paper obtaining high credit ratings that facilitate the
issuance of the commercial paper.16
Programs
In January 2003, the Financial Accounting
Although banks’ involvement in the securitiza- Standards Board (FASB) issued FASB Interpre-
tion of commercial paper has increased signifi- tation No. 46, ‘‘Consolidation of Variable Inter-
cantly over time, asset-backed commercial paper est Entities’’ (FIN 46), which was effective the
programs differ from other methods of securiti- first annual reporting period after June 15, 2003.
zation. One difference is that more than one type FIN 46 required, for the first time, the consoli-
of asset may be included in the receivables dation of variable interest entities (VIEs) onto
pool.14 Moreover, in certain cases, the cash flow the balance sheets of companies deemed to be
from the receivables pool may not necessarily the primary beneficiaries of those entities. FASB
match the payments to investors because the revised FIN 46 in December 2003 as FIN 46-R
maturity of the underlying asset pool does not (effective for publicly owned banking organiza-
always parallel the maturity of the structure of tions by March 31, 2004). FIN 46-R requires the
the commercial paper. Consequently, when the consolidation of many ABCP programs onto the
paper matures, it is usually rolled over or funded balance sheets of BOs. Banks that are required
by another issue. In certain circumstances, a to consolidate ABCP program assets must
maturing issue of commercial paper cannot be include all of the program assets (mostly receiv-
rolled over. To address this problem, many ables and securities) and liabilities (mainly com-
banks have established backup liquidity facili- mercial paper) on their balance sheets for pur-
ties. Certain banks have classified these backup poses of the bank Reports of Condition and
facilities as pure liquidity facilities, despite the Income (Call Reports).
credit-enhancement element present in them, Sponsoring BOs generally face limited risk
and, as a result, have incorrectly assessed the exposure to ABCP programs. This risk usually
risks associated with these facilities. In these is confined to the credit enhancements and
cases, the backup liquidity facilities have been liquidity-facility arrangements that sponsoring
more similar to direct-credit substitutes than to BOs provide to these programs. In addition,
loan commitments. operational controls and structural provisions,
along with overcollateralization or other credit
enhancements provided by the companies that
sell assets into ABCP programs, mitigate the
Risk-Based Capital Exclusion of
risks to which sponsoring BOs are exposed.
Asset-Backed Commercial Paper Program
Assets and Related Minority Interests
15. The definition of ABCP program generally includes
An asset-backed commercial paper (ABCP) pro- structured investment vehicles (entities that earn a spread by
issuing commercial paper and medium-term notes and using
gram typically is a program through which a the proceeds to purchase highly rated debt securities) and
bank provides funding to its corporate custom- securities arbitrage programs.
ers by sponsoring and administering a 16. A bank is considered the sponsor of an ABCP program
if it establishes the program; approves the sellers permitted to
participate in the program; approves the asset pools to be
14. See the Federal Reserve System’s Supervision and purchased by the program; or administers the program by
Regulation Task Force on Securitization, ‘‘An Introduction to monitoring the assets, arranging for debt placement, compil-
Asset Securitization,’’ issued as an attachment to SR-90-16. ing monthly reports, or ensuring compliance with the program
See also ‘‘Asset-Backed Commercial Paper Programs,’’ Fed- documents and with the program’s credit and investment
eral Reserve Bulletin, February 1992. policy.

Page 19
Because of the limited risks, the agencies17 a timing mismatch between cash collections on
adopted on July 17, 2004 (effective September the underlying assets in the program and sched-
30, 2004) a revised rule that permits sponsoring uled repayments of the commercial paper issued
BOs to exclude from risk-weighted assets (for by the program.
purposes of calculating the risk-based capital A bank that provides liquidity facilities to
ratios) ABCP program assets that require con- ABCP is exposed to credit risk, regardless of the
solidation under FIN 46-R (subject to certain term of the liquidity facilities. For example, an
requirements). ABCP program may require a liquidity facility
Under the Board’s risk-based capital rule, a to purchase assets from the program at the first
bank that must consolidate an ABCP program sign of deterioration in the credit quality of an
that is defined as a VIE under GAAP may asset pool, thereby removing such assets from
exclude the consolidated ABCP program assets the program. In such an event, a draw on the
from risk-weighted assets, provided that the liquidity facility exposes the bank to credit risk.
bank is the sponsor of the ABCP program. If a Short-term commitments with an original
bank excludes such consolidated ABCP pro- maturity of one year or less expose banks to a
gram assets, the bank must assess the appropri- lower degree of credit risk than longer-term
ate risk-based capital charge against any expo- commitments. This difference in the degree of
sures of the bank arising in connection with such credit risk is reflected in the risk-based capital
ABCP programs, including direct-credit substi- requirement for the different types of exposures
tutes, recourse obligations, residual interests, through liquidity facilities.
liquidity facilities, and loans, in accordance with The Board’s risk-based capital guidelines
sections III.B.5., III.C., and III.D. (12 CFR 208, impose a 10 percent credit-conversion factor on
appendix A) of the risk-based capital rule. When unused portions of eligible short-term liquidity
calculating the bank’s tier 1 and total capital, facilities supporting ABCP. Under the risk-
any associated minority interests must also be based capital guidelines and the Board’s inter-
excluded from tier 1 capital. As a result of FIN pretations thereof, the credit conversion factor
46-R, banks are to include all assets of consoli- for an eligible ABCP liquidity facility is based
dated ABCP programs as part of their on-balance- on whether the facility has an original maturity
sheet assets for purposes of calculating the tier 1 of one year or less.18 A 50 percent credit-
leverage capital ratio. conversion factor applies to eligible ABCP
A bank is able to exclude ABCP program liquidity facilities having a maturity greater than
assets from its risk-weighted asset base only one year. To be an eligible ABCP liquidity
with respect to those programs for which it is the facility and qualify for the 10 or 50 percent
sponsor and that meet the rule’s definition of an credit-conversion factor, the facility must be
ABCP program. An ABCP program is defined subject to an asset quality test at the time of
as a program that primarily issues (that is, more inception that does not permit funding against
than 50 percent) externally rated commercial (1) assets that are 90 days or more past due,
paper backed by assets or other exposures held (2) assets that are in default, and (3) assets or
in a bankruptcy-remote, special-purpose entity. exposures that are externally rated below invest-
Thus, a bank sponsoring a program issuing ment grade at the time of funding if the assets or
ABCP that does not meet the rule’s definition of exposures were externally rated at the inception
an ABCP program must continue to include the of the facility. However, a liquidity facility may
program’s assets in the institution’s risk- also be an eligible liquidity facility if it funds
weighted asset base. against assets that are guaranteed—either con-
ditionally or unconditionally—by the U.S. gov-
Liquidity facilities supporting ABCP. Liquidity
ernment, U.S. government agencies, or by an
facilities supporting ABCP often take the form
OECD central government, regardless of whether
of commitments to lend to, or to purchase assets
the assets are 90 days past due, in default, or
from, the ABCP programs in the event that
externally rated investment grade.
funds are needed to repay maturing commercial
The 10 or 50 percent credit-conversion fac-
paper. Typically, this need for liquidity is due to
tors apply, regardless of whether the structure
17. The Board of Governors of the Federal Reserve Sys-
tem, the Federal Deposit Insurance Corporation, the Office of 18. See the Board staff’s October 12, 2007, legal interpre-
the Comptroller of the Currency, and the Office of Thrift tation regarding the risk-based capital treatment of ABCP
Supervision. liquidity facilities.

Page 20
issuing the ABCP meets the rule’s definition of absorb 10 percent of the losses in all of the
an ABCP program. For example, a capital charge underlying asset pools in an ABCP program and
would apply to an eligible short-term liquidity also provides pool-specific liquidity facilities
facility that provides liquidity support to ABCP that cover 100 percent of each of the underlying
where the ABCP constitutes less than 50 percent asset pools. The bank would be required to hold
of the securities issued by the program, thus capital against 10 percent of the underlying asset
causing the issuing structure not to meet the pools because it is providing the program-wide
rule’s definition of an ABCP program. However, credit enhancement. The bank would also be
if a bank (1) does not meet this definition and required to hold capital against 90 percent of the
must include the program’s assets in its risk- liquidity facilities it is providing to each of the
weighted asset base or (2) otherwise chooses to underlying asset pools. For risk-based capital
include the program’s assets in risk-weighted purposes, the bank would not be required to hold
assets, then no risk-based capital requirement capital against any credit enhancements or liquid-
will be assessed against any liquidity facilities ity facilities that comprise the same program
provided by the bank that support the program’s assets.
ABCP. Ineligible liquidity facilities will be If different banks have overlapping exposures
treated as recourse obligations or direct-credit to an ABCP program, however, each organiza-
substitutes for the purposes of the Board’s tion must hold capital against the entire maxi-
risk-based capital guidelines. mum amount of its exposure. As a result, while
The Board’s risk-based capital guidelines do duplication of capital charges will not occur for
not specifically mandate, authorize, or prohibit a individual banks, some systemic duplication
look-through approach to eligible ABCP liquid- may occur where multiple BOs have overlap-
ity facilities. The Federal Reserve and other ping exposures to the same ABCP program.
federal banking agencies have taken the position
that a risk weight may be applied to the credit Asset-quality test. For a liquidity facility, either
equivalent amount of an eligible ABCP liquidity short- or long-term, that supports ABCP not to
facility by looking through to the underlying be considered a recourse obligation or a direct-
assets of the ABCP conduit after considering credit substitute, it must meet the risk-based
any collateral or guarantees, or external credit capital rule’s definition of an eligible ABCP
ratings, if applicable. For example, if an eligible liquidity facility. An eligible ABCP liquidity
short-term liquidity facility providing liquidity facility must meet a reasonable asset-quality test
support to ABCP covered an asset-backed secu- that, among other things, precludes funding
rity (ABS) externally rated AAA, then the against assets that are 90 days or more past due
notional amount of the liquidity facility would or in default. When assets are 90 days or more
be converted at 10 percent to an on-balance- past due, they typically have deteriorated to the
sheet credit-equivalent amount and assigned to point where there is an extremely high probabil-
the 20 percent risk-weight category appropriate ity of default. Assets that are 90 days past due,
for AAA-rated ABS. for example, often must be placed on nonaccrual
status in accordance with the agencies’ Uniform
Overlapping exposures to an ABCP program. A Retail Credit Classification and Account Man-
bank may have multiple overlapping exposures agement Policy.19 Further, they generally must
to a single ABCP program (for example, both a also be classified substandard under that policy.
program-wide credit enhancement and multiple In addition to the above, if the assets covered
pool-specific liquidity facilities to an ABCP by the liquidity facility are initially externally
program that is not consolidated for risk-based rated (at the time the facility is provided), the
capital purposes). A bank must hold risk-based facility can be used to fund only those assets that
capital only once against the assets covered by are externally rated investment grade at the time
the overlapping exposures. Where the overlap- of funding. The practice of purchasing assets
ping exposures are subject to different risk- that are externally rated below investment grade
based capital requirements, the bank must apply out of an ABCP program is considered to be the
the risk-based capital treatment that results in equivalent of providing credit protection to the
the highest capital charge to the overlapping commercial paper investors. Thus, liquidity
portion of the exposures. facilities permitting purchases of below-
For example, assume a bank provides a
program-wide credit enhancement that would 19. See 65 Fed. Reg. 36904 (June 12, 2000).

Page 21
investment-grade securities will be considered alized basis) and (2) there is no material
either recourse obligations or direct-credit adverse change in the BO’s ABCP underwrit-
substitutes. ing standards. The amount of available excess
However, neither the ‘‘90-days-past-due’’ limi- spread may be calculated as the average of the
tation nor the ‘‘investment grade’’ limitation current month’s and the two previous months’
apply to the asset-quality test with respect to excess spread.
assets that are conditionally or unconditionally
guaranteed by the U.S. government or its agen- Recourse directly to the seller, other than the
cies or by another OECD central government. funded credit enhancements enumerated above,
An ABCP liquidity facility is considered to be regardless of the seller’s external credit rating, is
in compliance with the requirement for an asset not an acceptable form of credit enhancement
quality test if (1) the liquidity provider has for purposes of satisfying the asset quality test.
access to certain types of acceptable credit Seller recourse—for example, a seller’s agree-
enhancements and (2) the notional amount of ment to buy back nonperforming or defaulted
such credit enhancements available to the liquid- loans or downgraded securities—may expose
ity facility provider exceeds the amount of the liquidity provider to an increased level of
underlying assets that are 90 days or more past credit risk. A decline in the performance of
due, defaulted, or below investment grade for assets sold to an ABCP conduit may signal
which the liquidity provider may be obligated to impending difficulties for the seller.
fund under the facility. In this circumstance, the If the amount of acceptable credit enhance-
liquidity facility may be considered ‘‘eligible’’ ment associated with the pool of assets is less
for purposes of the risk-based capital rule than the current amount of assets that are 90
because the provider of the credit enhancement days or more past due, in default, or below
generally bears the credit risk of the assets that investment grade that the liquidity facility pro-
are 90 days or more past due, in default, or vider may be obligated to fund against, the
below investment grade rather than the banking liquidity facility should be treated as recourse or
organization providing liquidity. 19a a direct credit substitute. The full amount of
The following forms of credit enhancements assets supported by the liquidity facility would
are generally acceptable for purposes of satisfy- be subject to a 100 percent credit conversion
ing the asset quality test: factor. 19b The Federal Reserve Board reserves
the right to deem an otherwise eligible liquidity
• ‘‘funded’’ credit enhancements that the BO facility to be, in substance, a direct credit
may access to cover delinquent, defaulted, or substitute if a member bank uses the liquidity
below-investment-grade assets, such as over- facility to provide credit support.
collateralization, cash reserves, subordinated The bank is responsible for demonstrating to
securities, and funded spread accounts; the Federal Reserve Board whether acceptable
• surety bonds and letters of credit issued by a credit enhancements cover the 90 days or more
third party with a nationally recognized statis- past due, defaulted, or below-investment-grade
tical rating organization with a rating of single assets that the organization may be obligated to
A or higher that the BO may access to cover fund against in each seller’s asset pool. If the
delinquent, defaulted, or below-investment- bank cannot adequately demonstrate satisfaction
grade assets, provided that the surety bond or of the conditions in the above-referenced inter-
letter of credit is irrevocable and legally agency guidance, the Federal Reserve Board
enforceable; and further reserves the right to determine that a
• one month’s worth of excess spread that the credit enhancement is unacceptable for purposes
BO may access to cover delinquent, defaulted, of the requirement for an asset quality test and,
or below-investment-grade assets if the fol- therefore, it may deem the liquidity facility to be
lowing conditions are met: (1) excess spread ineligible.
is contractually required to be trapped when it
falls below 4.5 percent (measured on an annu- Market risk capital requirements for ABCP
programs. Any facility held in the trading book
whose primary function, in form or in substance,
19a. See SR-05-13 and its attachment, ‘‘Interagency Guid-
ance on the Eligibility of Asset-Backed Commercial Paper
is to provide liquidity to ABCP—even if the
Liquidity Facilities and the Resulting Risk-Based Capital
Treatment.’’ 19b. See 12 CFR 208, appendix A, section III.B.3.b.i.

Page 22
facility does not qualify as an eligible ABCP incorporated in board reports and risk-
liquidity facility under the rule—will be subject management reviews.
to the banking-book risk-based capital require-
ments. Specifically, banks are required to con-
vert the notional amount of all trading-book
positions that provide liquidity to ABCP to Policies and Procedures
credit-equivalent amounts by applying the appro-
priate banking-book credit-conversion factors. Senior management is responsible for ensuring
For example, the full amount of all eligible that the risks arising from securitization activi-
ABCP liquidity facilities with an original matu- ties are adequately managed on both a short-
rity of one year or less will be subject to a term and long-run basis. Management should
10 percent conversion factor, regardless of ensure that adequate policies and procedures are
whether the facility is carried in the trading in place for incorporating the risk of these
account or the banking book. activities into the overall risk-management pro-
cess of the institution. Such policies should
ensure that the economic substance of the risk
exposures generated by these activities is fully
SOUND RISK-MANAGEMENT recognized and appropriately managed. In addi-
PRACTICES tion, BOs involved in securitization activities
should have appropriate policies, procedures,
An institution must incorporate the risks and controls for underwriting ABS; funding the
involved in its securitization activities into its possible return of revolving receivables (for
overall risk-management system. The system example, credit card receivables and home-
should entail (1) inclusion of risk exposures in equity lines); and establishing limits on expo-
reports to the institution’s senior management sures to individual institutions, types of collat-
and board to ensure proper management eral, and geographic and industrial concentrations.
oversight; (2) adoption of appropriate policies, The institution’s directors and managers need to
procedures, and guidelines to manage the risks ensure that—
involved; (3) appropriate measurement and
monitoring of risks; and (4) assurance of • independent risk-management processes are
appropriate internal controls to verify the in place to monitor securitization-pool
integrity of the management process with performance on an individual and aggregate
respect to these activities. transaction level (an effective risk-
management function includes appropriate
information systems to monitor securitiza-
Board and Senior Management tion activities);
Oversight • conservative valuation assumptions and mod-
eling methodologies are used to establish,
Both the board of directors and senior manage- evaluate, and adjust the carrying value of
ment are responsible for ensuring that they fully retained interests on a regular and timely
understand the degree to which the organization basis;
is exposed to the credit, market, liquidity, • audit or internal-review staffs periodically
operational, legal, and reputational risks involved review data integrity, model algorithms, key
in the institution’s securitization activities. They underlying assumptions, and the appropriate-
are also responsible for ensuring that the formal- ness of the valuation and modeling process for
ity and sophistication of the techniques used the securitized assets the institution retains
to manage these risks are commensurate with (the findings of such reviews should be
the nature and volume of the organization’s reported directly to the board or an appropri-
activities. Institutions with significant securiti- ate board committee);
zation activities are expected to have more • accurate and timely risk-based capital calcu-
elaborate and formal approaches to manage the lations are maintained, including recognition
risk of these activities. The board should approve and reporting of any recourse obligation result-
all significant policies relating to the manage- ing from securitization activity;
ment of risk arising from securitization activities • internal limits are in place to govern the
and should ensure that risk exposures are fully maximum amount of retained interests as a

Page 22.1
percentage of total equity capital; and

• the institution has a realistic liquidity plan in
place in case of market disruptions.
Independent Risk-Management
Function
Institutions engaged in securitizations need to
have an independent risk-management function
commensurate with the complexity and volume
of their securitizations and their overall risk
exposures. The risk-management function should
ensure that securitization policies and operating
procedures, including clearly articulated risk
limits, are in place and appropriate for the
institution’s circumstances. A sound asset-

Page 22.2
securitization policy should include or address, activities should also be included in any aggre-
at a minimum— gations of credit risk by borrower, industry, or
economic sector.
• a written and consistently applied accounting An institution’s information systems should
methodology; identify and segregate those credit exposures
• regulatory reporting requirements; arising from the institution’s loan-sale and
• valuation methods, including FAS 140 residual- securitization activities. Such exposures include
value assumptions, and procedures to for- the sold portions of participations and syndica-
mally approve changes to those assumptions; tions, exposures arising from the extension of
• a management reporting process; and credit-enhancement and liquidity facilities, the
• exposure limits and requirements for both effects of an early-amortization event, and the
individual- and aggregate-transaction investment in ABS. The management reports
monitoring. should provide the board and senior manage-
ment with timely and sufficient information to
It is essential that the risk-management func- monitor the institution’s exposure limits and
tion monitor origination, collection, and default- overall risk profile.
management practices. This includes regular
evaluations of the quality of underwriting, sound-
ness of the appraisal process, effectiveness Stress Testing
of collections activities, ability of the default-
management staff to resolve severely delinquent The use of stress testing, including combina-
loans in a timely and efficient manner, and tions of market events that could affect a BO’s
appropriateness of loss-recognition practices. credit exposures and securitization activities, is
Because the securitization of assets can result another important element of risk management.
in the current recognition of anticipated income, Stress testing involves identifying possible events
the risk-management function should pay par- or changes in market behavior that could have
ticular attention to the types, volumes, and risks unfavorable effects on the institution, and assess-
of assets being originated, transferred, and ser- ing the organization’s ability to withstand them.
viced. Senior management and the risk- Stress testing should consider not only the
management staff must be alert to any pres- probability of adverse events but also likely
sures on line managers to originate abnormally worst-case scenarios. Stress testing should be
large volumes or higher-risk assets to sustain done on a consolidated basis and should con-
ongoing income needs. Such pressures can lead sider, for instance, the effect of higher-than-
to a compromise of credit-underwriting stan- expected levels of delinquencies and defaults, as
dards. This may accelerate credit losses in future well as the consequences of early-amortization
periods, impair the value of retained inter- events with respect to credit card securities, that
ests, and potentially lead to funding problems. could raise concerns regarding the institution’s
capital adequacy and its liquidity and funding
capabilities. Stress-test analyses should also
Risk Measurement and Monitoring include contingency plans for possible manage-
ment actions in certain situations.
An institution’s risk-management function should
include information and risk-measurement and
-monitoring systems that fully incorporate the
risks involved in its securitization activities. Internal Controls
BOs must be able to identify credit exposures
from all securitization activities, as well as One of management’s most important responsi-
measure, quantify, and control those exposures bilities is establishing and maintaining an effec-
on a fully consolidated basis. The economic tive system of internal controls. Among other
substance of the credit exposures of securitiza- things, internal controls should enforce the offi-
tion activities should be fully incorporated into cial lines of authority and the appropriate sepa-
the institution’s efforts to quantify its credit risk, ration of duties in managing the risks of the
including efforts to establish more formal grad- institution. These internal controls must be suit-
ing of credits to allow for statistical estimation able for the type and level of risks at the
of loss-probability distributions. Securitization institution, given the nature and scope of its

Page 23
activities. Moreover, these internal controls procedures (FAS 140), deal covenants, and the
should ensure that financial reporting is reliable accuracy of MIS and regulatory reports. The
(in published financial reports and regulatory audit function also should confirm that the
reports), including adequate allowances or institution’s regulatory reporting process is
liabilities for expected losses. designed and managed to facilitate timely and
Effective internal controls are essential to an accurate report filing. Furthermore, when a third
institution’s management of the risks associated party services loans, the auditors should perform
with securitization. When properly designed and an independent verification of the existence of
consistently enforced, a sound system of inter- the loans to ensure that balances reconcile to
nal controls will help management safeguard internal records.
the institution’s resources; ensure that financial
information and reports are reliable; and comply
with contractual obligations, including securiti- Management Information Systems
zation covenants. Internal controls will also
reduce the possibility of significant errors and An institution’s reporting and documentation
irregularities, and assist in their timely detec- methods must support the initial valuation of
tion. Internal controls typically (1) limit authori- any retained interests and provide ongoing
ties; (2) safeguard access to and use of records; impairment analyses of these assets. Pool-
(3) separate and rotate duties; and (4) ensure performance information will help well-managed
both regular and unscheduled reviews, including institutions ensure, on a qualitative basis, that a
testing. sufficient amount of economic capital is being
Operational and managerial standards have held to cover the various risks inherent in
been established for internal control and infor- securitization transactions. The absence of an
mation systems.20 A system of internal controls adequate management information system (MIS)
should be maintained that is appropriate to the will hinder management’s ability to monitor
institution’s size and nature, its scope, and the specific pool performance and securitization
risk of its activities.21 activities. MIS reports, at a minimum, should
address the following:
Audit Function or Internal Review • Securitization summaries for each transac-

tion. The summary should include relevant
The institution’s board of directors is respon- transaction terms such as collateral type,
sible for ensuring that its audit staff or facility amount, maturity, credit-enhancement
independent-review function is competent to and subordination features, financial cov-
review its securitization activities. The audit enants (termination events and spread-account
function should perform periodic reviews of capture ‘‘triggers’’), right of repurchase, and
securitization activities, including transaction counterparty exposures. Management should
testing and verification, and report all findings to ensure that the summaries for each transaction
the board or appropriate board committee. The are distributed to all personnel associated with
audit function also may be useful to senior securitization activities.
management in identifying and measuring risk • Performance reports by portfolio and specific
related to securitization activities. Principal audit product type. Performance factors include
targets should include compliance with gross portfolio yield, default rates and loss
securitization policies, operating and accounting severity, delinquencies, prepayments or pay-
ments, and excess spread amounts. The reports
should reflect the performance of assets, both
20. See the safety-and-soundness standards for national on an individual-pool basis and total managed
banks at 12 CFR 30 (OCC) and for savings associations at 12 assets. These reports should segregate specific
CFR 570 (OTS). products and different marketing campaigns.
21. Institutions that are subject to the requirements of
FDIC regulation 12 CFR 363 should include an assessment of • Vintage analysis for each pool using monthly
the effectiveness of internal controls over their asset- data. Vintage analysis will help management
securitization activities as part of management’s report on the understand historical performance trends and
overall effectiveness of the system of internal controls over
financial reporting. This assessment implicitly includes the
their implications for future default rates,
internal controls over financial information that is included in prepayments, and delinquencies, and therefore
regulatory reports. retained interest values. Management can use

Page 24
these reports to compare historical perfor- analysis into their overall interest-rate risk
mance trends with underwriting standards, measurement system.22 Examiners will review
including the use of a validated credit-scoring the institution’s analysis and the volatility
model, to ensure loan pricing is consistent associated with retained interests when assess-
with risk levels. Vintage analysis also helps in ing the Sensitivity to Market Risk component
the comparison of deal performance at peri- rating (the ‘‘S’’ in the CAMELS rating system
odic intervals and validates retained-interest for banks or the ‘‘R’’ for the BHC RFI/C(D)
valuation assumptions. rating system).23
• Static-pool cash-collection analysis. A static- • Statement of covenant compliance. Ongoing
pool cash-collection analysis involves review- compliance with deal-performance triggers as
ing monthly cash receipts relative to the defined by the pooling and servicing agree-
principal balance of the pool to determine the ments should be affirmed at least monthly.
cash yield on the portfolio, comparing the Performance triggers include early amortiza-
cash yield to the accrual yield, and tracking tion, spread capture, changes to overcollater-
monthly changes. Management should com- alization requirements, and events that would
pare monthly the timing and amount of cash result in servicer removal.
flows received from the trust with those pro-
jected as part of the FAS 140 retained-interest
valuation analysis. Some master-trust struc- Securitization Convenants Linked to
tures allow excess cash flow to be shared
between series or pools. For revolving-asset
Supervisory Actions or Thresholds
trusts with this master-trust structure, manage- A bank’s board of directors and senior manage-
ment should perform a cash-collection analy- ment are responsible for initiating policies and
sis for each master-trust structure. These analy- procedures and for monitoring processes and
ses are essential in assessing the actual internal controls that will provide reasonable
performance of the portfolio in terms of default assurance that the bank’s contracts and commit-
and prepayment rates. If cash receipts are less ments do not include detrimental covenants that
than those assumed in the original valuation affect the safety and soundness of the bank.
of the retained interest, this analysis will When examiners review a bank’s securitization
provide management and the board with an contracts and related documentation, they should
early warning of possible problems with col- be alert to any covenants that use adverse
lections or extension practices and impairment supervisory actions or the breach of supervisory
of the retained interest. thresholds as triggers for early-amortization
• Sensitivity analysis. A sensitivity analysis mea- events or the transfer of servicing. Examples of
sures the effect of changes in default rates, such supervisory actions include a downgrade in
prepayment or payment rates, and discount the organization’s CAMELS rating, an enforce-
rates to assist management in establishing and ment action, or a downgrade in a bank’s prompt-
validating the carrying value of the retained corrective-action capital category. The inclusion
interest. Stress tests should be performed at of supervisory-linked covenants in securitiza-
least quarterly. Analyses should consider tion documents is considered to be an ‘‘unsafe
potential adverse trends and determine ‘‘best,’’ and unsound banking practice’’ that undermines
‘‘probable,’’ and ‘‘worst-case’’ scenarios for the objective of supervisory actions and thresh-
each event. Other factors that need to be olds. An early amortization or transfer of ser-
considered are the impact of increased defaults vicing triggered by such events can create or
on collections staffing, the timing of cash exacerbate liquidity and earnings problems for a
flows, spread-account capture triggers, over- bank that may lead to further deterioration in its
collateralization triggers, and early- financial condition.
amortization triggers. An increase in defaults
can result in higher-than-expected costs and a
delay in cash flows, thus decreasing the value 22. The Joint Agency Policy Statement on Interest-Rate
of the retained interests. Management should Risk (see SR-96-13 and section 4090.1) advises institutions
periodically quantify and document the poten- with a high level of exposure to interest-rate risk relative to
capital that they will be directed to take corrective action.
tial impact to both earnings and capital and 23. See the appendix to section 5020.1 (section A.5020.1)
should report the results to the board of for a description of the CAMELS rating system. See SR-04-18
directors. Management should incorporate this for a description of the RFI/C(D) rating system.

Page 25
Convenants that contain triggers tied, directly amortization triggers will specifically be consid-
or indirectly, to supervisory actions or thresh- ered in the context of the bank’s overall liquidity
olds can also result in the early amortization of position and contingency funding plan. For
a securitization at a time when the sponsoring organizations with limited access to other fund-
organization’s ability to access other funding ing sources or a significant reliance on securiti-
sources is limited. If an early-amortization event zation, the existence of these triggers presents a
occurs, investors may lose confidence in the greater degree of supervisory concern. Any
stability of the sponsoring organization’s asset- bank that uses securitization as a funding source
backed securities, thus limiting its ability to should have a viable contingency funding plan
raise new funds through securitization. At the in the event it can no longer access the securi-
same time, the organization must fund new tization market. Examiners should encourage
receivables on the balance sheet, potentially bank management to amend, modify, or remove
resulting in liquidity problems. Moreover, the covenants linked to supervisory actions from
existence of a supervisory-linked trigger poten- existing transactions. Any impediments a bank
tially could inhibit supervisors from taking action may have to taking such actions should be
intended to address problems at a troubled documented and discussed with the appropriate
institution because the action could trigger an supervisory staff of its responsible Reserve Bank.
event that worsens the institution’s condition or
causes its failure.
The Federal Reserve and the other federal
banking agencies (the OCC, the FDIC, and the APPRAISALS AND
OTS) also are concerned that covenants related MORTGAGE-BACKED
to supervisory actions may obligate a bank’s SECURITIES
management to disclose confidential examina-
tion information, such as the CAMELS rating. Under 12 CFR 225.63(a)(8), an appraisal per-
Disclosure of such information by a bank’s formed by a state-certified or -licensed appraiser
directors, officers, employees, attorneys, audi- is not required for any real estate–related finan-
tors, or independent auditors, without explicit cial transaction in which a regulated institution
authorization by the institution’s primary regu- purchases a loan or interest in a loan; pooled
lator, violates the agencies’ information- loans; or an interest in real property, including
disclosure rules and may result in follow-up mortgage-backed securities, provided that the
supervisory actions. (See SR-02-14.) appraisal prepared for each pooled loan or real
Because of the supervisory concerns about property interest met the requirements of the
convenants linked to supervisory actions, a fed- regulation. Banks must establish procedures for
eral bank interagency advisory was issued on determining and ensuring that applicable apprais-
May 23, 2002. The advisory emphasizes that a als meet the requirements.
bank’s management and board of directors
should ensure that covenants related to supervi-
sory actions or thresholds are not included in
securitization documents. Covenants that pro- EXAMINATION GUIDELINES
vide for the early termination of the transaction FOR ASSET SECURITIZATION
or compel the transfer of servicing due, directly
or indirectly, to the occurrence of a supervisory A banking organization may be involved in
action or event will be criticized, under appro- originating the assets to be pooled, packaging
priate circumstances, as an unsafe and unsound the assets for securitization, servicing the pooled
banking practice. The agencies also may take assets, acting as trustee for the pool, providing
other supervisory actions, such as requiring credit enhancements, underwriting or placing
additional capital or denying capital relief for the ABS, or investing in the securities. Indi-
risk-based capital calculations, regardless of the vidual securitization arrangements often possess
GAAP treatment. unique features, and the risks addressed in this
Examiners should consider the potential abbreviated version of the examiner guidelines24
impact of such covenants in existing transac-
tions when evaluating both the overall condition
of the bank and the specific component ratings 24. A complete version of the ‘‘Examination Guidelines
of capital, liquidity, and management. Early- for Asset Securitization’’ is attached to SR-90-16.

Page 26
do not apply to all securitization arrangements. risk, liquidity risk, and concentration risk; the
Conversely, arrangements may entail risks not underlying assets and structure of the securiti-
summarized here. Examiners should judge a zation arrangement would be evaluated only
banking organization’s exposure to securitiza- within this context.
tion with reference to the specific structures in Appropriate policies, procedures, and con-
which the organization is involved and the trols should be established by a BO before
degree to which the organization has identified participating in asset securitization. Controls
exposures and implemented policies and con- should include well-developed management
trols to manage them. Examiners may tailor the information systems. In addition, significant
scope of their examinations if the banking orga- policies and procedures should be approved and
nization’s involvement in securitization is reviewed periodically by the organization’s board
immaterial relative to its size and financial of directors.
strength. In addition to evaluating and monitoring
A banking organization participating in secu- exposure to particular securitization deals, a BO
ritization, in any capacity, should ensure that the should manage its overall exposure on a con-
activities are clearly and logically integrated solidated holding company basis. Management
into the overall strategic objectives of the orga- of these exposures should include—
nization. The management of the organization
should understand the risks and should not rely • reasonable limits on geographic and industrial
excessively on outside expertise to make crucial concentrations, as well as on exposures to
decisions regarding securitization activities. individual institutions;
As mentioned earlier, the degree of securiti- • internal systems and controls to monitor these
zation exposure faced by an individual banking exposures and provide periodic and timely
organization depends on the role of the organi- reports to senior management and the board of
zation in the securitization process. An organi- directors on performance and risks; and
zation involved in the issuance of ABS as • procedures for identifying potential or actual
originator, packager, servicer, credit enhancer, conflicts of interest and policies for resolving
underwriter, or trustee may face combinations those conflicts.
and degrees of risk different than those faced by
an organization that only invests in ABS. Exam- The following general guidelines are intended
iners should assess a BO’s level, identification, to help examiners assess the exposures of
and management of risks within the context of banks and bank holding companies to asset
its roles. securitization.
A BO should conduct an independent analysis
of its exposures before participating in any
aspect of securitization and should continue to
monitor its exposures throughout its involve- Banking Organizations Involved in
ment. The analysis and subsequent monitoring Issuing or Managing ABS
should take into account the entire securitization
arrangement, emphasizing different risks accord- A BO involved in the issuance of ABS as
ing to the role that the organization plays. originator, packager, servicer, credit enhancer,
Excessive reliance on opinions of third parties underwriter, or trustee should analyze the assets
and reported collateral values should be avoided. underlying the asset-backed security and the
An organization involved in the issuance of structure of the arrangement, including—
ABS should scrutinize the underlying assets,
giving consideration to their yield, their matu- • the characteristics and expected performance
rity, their credit risk, their prepayment risk, and of the underlying assets,
the accessibility of collateral in cases of default, • the BO’s ability to meet its obligations under
as well as the structure of the securitization the securitization arrangement, and
arrangement and the ability of the other partici- • the ability of the other participants in the
pants in the transaction to meet their obligations. arrangement to meet their obligations.
On the other hand, a BO investing in ABS can
be expected to place greater emphasis on the Analysis of the underlying assets should be
characteristics of the ABS as securities, paying conducted independently by each participant in
attention primarily to credit risk, prepayment the process, giving consideration to yield,

Page 27
maturity, credit risk, prepayment risk, and the Policy and Portfolio Analysis
accessibility of collateral in cases of default. An
originator should further consider the impact of Credit risk. Institutions should be aware that the
securitization on the remaining asset portfolio credit risk involved in many securitization
and on the adequacy of loan-loss reserves and activities may not always be obvious. For cer-
overall capital. tain types of loan-sales and securitization trans-
Financial position and operational capacity actions, a BO may actually be exposed to
should be adequate to meet obligations to other essentially the same credit risk as in traditional
parties in a securitization arrangement, even lending activities, even though a particular trans-
under adverse scenarios. Accordingly, a BO action may, superficially, appear to have isolated
should ensure that the pricing of services is the institution from any risk exposure. In such
adequate to cover costs over the term of the cases, removal of an asset from the balance
obligation, as well as to compensate for associ- sheet may not result in a commensurate reduc-
ated risks. Further, the organization should have tion in credit risk. Transactions that can give rise
contingency plans to transfer responsibilities to to such instances include loan sales with
another institution in the event that those respon- recourse; credit derivatives; direct-credit substi-
sibilities can no longer be fulfilled. Examiners tutes, such as letters of credit; and liquidity
should determine that the BO has policies and facilities extended to securitization programs, as
controls for managing contractual obligations, well as certain asset-securitization structures,
including management of collateral, if applica- such as the structure typically used to securitize
ble. Staffing levels should be adequate to fulfill credit card receivables.
responsibilities. The partial, first-loss recourse obligations an
If a BO’s obligations, under a securitization institution retains when selling assets, and the
agreement, are subcontracted to other parties, an extension of partial credit enhancements (for
assessment of the subcontractor’s financial posi- example, 10 percent letters of credit) in connec-
tion and operational capacity should be con- tion with asset securitization, can be sources of
ducted before delegating responsibility. Further, concentrated credit risk by exposing institutions
the subcontractor’s financial position and com- to the full amount of expected losses on the
pliance with contractual obligations should be protected assets. For instance, the credit risk
monitored periodically. associated with whole loans or pools of assets
that are sold to secondary-market investors can
A BO involved in issuing ABS should make often be concentrated within the partial, first-
certain that the agreement permits it to assess loss recourse obligations retained by the BOs
the ability of other participants in the securiti- that are selling and securitizing the assets. In
zation arrangement to meet their obligations these situations, even though institutions may
(considering obligations that they may have have reduced their exposure to catastrophic loss
under other securitization arrangements). The on the assets sold, they generally retain the same
rights and obligations of each of the participants credit-risk exposure that they would have had if
under possibly novel legal and institutional they continued to hold the assets on their bal-
arrangements should be clearly documented. ance sheets.
Funding and liquidity management for origi- In addition to recourse obligations, institu-
nators and packagers of securitized assets should tions assume concentrated credit risk through
avoid excessive reliance on the device of secu- the extension of partial direct-credit substitutes,
ritization. Originators and packagers should such as through the purchase (or retention) of
monitor the securitization market closely, develop subordinated interests in their own asset securi-
a broad customer base for their securitization tizations or through the extension of letters of
activities, and maintain diversified funding credit. For example, BOs that sponsor certain
sources. asset-backed commercial paper programs, or
BOs should not rely excessively on the so-called remote-origination conduits, can be
expertise of a single individual or a small group exposed to high degrees of credit risk even
of individuals, either inside or outside the orga- though it may seem that their notional exposure
nization, for the management of participation in is minimal. A remote-origination conduit lends
securitization activities. Examiners should ensure directly to corporate customers referred to it by
that an organization acting as trustee for ABS the sponsoring BO that used to lend directly to
follows the usual standards for trust services. these same borrowers. The conduit funds this

Page 28
lending activity by issuing commercial paper investors by the excess yield, spread accounts,
that, in turn, is guaranteed by the sponsoring and structural provisions of the securitization.
BO. The net result is that the sponsoring insti- Excess yield provides the first level of credit
tution has much the same credit-risk exposure protection that can be drawn upon to cover cash
through this guarantee that it would have had if shortfalls between the principal and coupon
it had made the loans directly and held them on owed to investors and the investors’ pro rata
its books. This is an off-balance-sheet transac- share of the master trust’s net cash flows. The
tion, however, and its associated risks may not excess yield is equal to the difference between
be fully reflected in the institution’s risk- the overall yield on the underlying credit card
management system. portfolio and the master trust’s operating
Furthermore, BOs that extend liquidity facili- expenses.26 The second level of credit protection
ties to securitized transactions, particularly to is provided by the spread account, which is
asset-backed commercial paper programs, may essentially a reserve funded initially from the
be exposed to high degrees of credit risk which excess yield.
may be subtly embedded within a facility’s In addition, the structural provisions of credit
provisions. Liquidity facilities are commitments card securitizations generally provide credit pro-
to extend short-term credit to cover temporary tection to investors through the triggering of
shortfalls in cash flow. While all commitments early-amortization events. Such an event usually
embody some degree of credit risk, certain is triggered when the underlying pool of credit
commitments extended to asset-backed commer- card receivables deteriorates beyond a certain
cial paper programs to provide liquidity may point and requires that the outstanding credit
subject the extending institution to the credit card securities begin amortizing early to pay off
risk of the underlying asset pool, often trade investors before the prior credit enhancements
receivables, or of a specific company using the are exhausted. As the early amortization accel-
program for funding. Often, the stated purpose erates the redemption of principal (paydown) on
of these liquidity facilities is to provide funds to the security, the credit card accounts that were
the program to retire maturing commercial paper assigned to the master credit-card trust return to
when a mismatch occurs in the maturities of the the securitizing institution more quickly than
underlying receivables and the commercial paper, had originally been anticipated. Thus, the insti-
or when a disruption occurs in the commercial tution is exposed to liquidity pressures and any
paper market. However, depending on the pro- further credit losses on the returned accounts.
visions of the facility—such as whether the Examiner procedures for reviewing credit risk
facility covers dilution of the underlying receiv- are outlined below:
able pool—credit risk can be shifted from the
program’s explicit credit enhancements to the • Examiners should review a BO’s policies and
liquidity facility.25 Such provisions may enable procedures to ensure that the organization
certain programs to fund riskier assets and yet follows prudent standards of credit assessment
maintain the credit rating on the program’s and approval for all securitization exposure.
commercial paper without increasing the pro- Procedures should include an initial thorough
gram’s credit-enhancement levels. and independent credit assessment of each
The structure of various securitization trans- loan or pool for which it has assumed credit
actions can also result in an institution’s retain- risk, followed by periodic credit reviews to
ing the underlying credit risk in a sold pool of monitor performance throughout the life of
assets. Examples of this contingent credit-risk the exposure.
retention include credit card securitizations in • Examiners should determine that rigorous
which the securitizing organization explicitly credit standards are applied, regardless of the
sells the credit card receivables to a master trust, role an organization plays in the issuance of
but, in substance, retains the majority of the ABS. The servicer, credit enhancer, and under-
economic risk of loss associated with the assets
because of the credit protection provided to 26. The monthly excess yield is the difference between the
overall yield on the underlying credit card portfolio and the
25. Dilution essentially occurs when the receivables in the master trust’s operating expenses. It is calculated by subtract-
underlying asset pool—before collection—are no longer viable ing from the gross portfolio yield (1) the coupon paid to
financial obligations of the customer. For example, dilution investors; (2) charge-offs for that month; and (3) a servicing
can arise from returns of consumer goods or unsold merchan- fee, usually 200 basis points, paid to the banking organization
dise by retailers to manufacturers or distributors. sponsoring the securitization.

Page 29
writer must perform assessments and approv- • Pricing policies and practices should be
als independent of and distinct from reviews reviewed to determine that they incorporate an
provided by the originator or packager. analysis of the tradeoff between risk and
• Major policies and procedures, including return.
internal credit-review and -approval proce- • Examiners should consider securitization risks
dures and in-house exposure limits, should be when analyzing the adequacy of an organiza-
reviewed periodically and approved by the tion’s capital or reserve levels. Adverse credit
institution’s board of directors. risk should be classified accordingly.
• Failure, fraud, or mismanagement on the part
of one participant in an ABS issue could result Concentration risk. A banking organization
in loss to any of the other institutions involved involved in originating, packaging, servicing,
in the issue. A BO involved in securitization underwriting, or enhancing the creditworthiness
should have adequate procedures for evaluat- of ABS must take special care to follow in-house
ing the internal control procedures and finan- diversification requirements for aggregate out-
cial strength of other institutions with which it standings to a particular institution, industry, or
is involved. geographic area. Examiner procedures for review-
• Securitization arrangements may remove ing concentration risk are outlined below:
a credit enhancer from direct access to the
collateral. The remedies available to a BO • When determining compliance with internal
involved in the provision of credit enhance- credit-exposure limits, securitization exposure
ment in the event of a default should be should be aggregated with all loans, exten-
clearly documented. sions of credit, debt and equity securities,
• Examiners should ensure that, regardless of legally binding financial guarantees, commit-
the role an institution plays in securitization, ments, and any other investments involving
ABS documentation clearly specifies the limi- the same obligor.
tations of the institution’s legal responsibility • Examiners should review all pools of sold
to assume losses. assets for industrial or geographic concentra-
• Examiners should verify that a banking orga- tions. Excessive exposures to an industry or
nization acting as originator, packager, or region among these assets should be noted in
underwriter has written policies addressing the review of the BO’s loan portfolio.
the repurchase of assets and other reimburse- • Inherent in securitization is the risk that, if
ment to investors in the event that a defaulted another party involved in the securitization
package results in losses exceeding any con- arrangement becomes unable to perform
tractual credit enhancement. A BO that repur- according to contract terms, the issue might
chases defaulted assets or pools in con- default even while the underlying credits are
tradiction of the underlying agreement in performing. This credit exposure to the other
effect sets a standard by which it could poten- managing parties in a securitization transac-
tially be found legally liable for all ‘‘sold’’ tion should be included under a BO’s general
assets. A BO that responds in this manner to line to those institutions. Examiners should,
the ‘‘moral hazard’’ or reputational risk aris- therefore, ensure that, in addition to policies
ing from its securitization activities may face limiting direct credit exposure, an institution
additional risk from other areas of its securi- has developed exposure limits with respect
tization activities. Examiners should review to particular originators, credit enhancers, and
any situations in which the organization has servicers.
repurchased or otherwise reimbursed inves-
tors for poor-quality assets. Reputational risk. The securitization activities
• A BO’s records should be reviewed to ensure of many institutions may also expose them to
that credit, pricing, and servicing standards for significant reputational risks. Often, BOs that
securitized assets are equivalent to standards sponsor the issuance of asset-backed securities
for assets that remain on the books. The act as servicers, administrators, or liquidity pro-
quality of securitized assets should be accu- viders in the securitization transactions. These
rately characterized to investors and other institutions must be aware of the potential losses
parties to the securitization arrangement to and risk exposure associated with reputational
avoid unforeseen pressures to repurchase risk that arise from these securitization activi-
defaulted issues. ties. The securitization of assets whose perfor-

Page 30
mance has deteriorated may result in a negative purchase and hold unsold securities. In the
market reaction that could increase the spreads absence of this analysis, the institution should
on an institution’s subsequent issuances. To only handle ABS on a best-efforts basis. All
avoid a possible increase in their funding costs, potential credit exposure should be within
institutions have supported their securitization legal lending limits.
transactions by improving the performance of • Examiners should ensure that a BO engaged
the securitized asset pool (for example, by in underwriting or market making has imple-
selling discounted receivables or adding higher- mented adequate hedging or other risk-
quality assets to the securitized asset pool). management policies to limit its exposure to
Thus, an institution’s voluntary support of its adverse price movements.
securitization in order to protect its reputation • Examiners should determine whether an orga-
can adversely affect the sponsoring or issuing nization targets certain loans at origination to
organization’s earnings and capital. be packaged and securitized. If so, examiners
should review the length of time these assets
Liquidity and market risk. The existence of are held while being processed. Examiners
recourse provisions in asset sales, the extension should review management information sys-
of liquidity facilities to securitization programs, tems reports to age targeted loans and to
and early-amortization triggers of certain asset- determine if there is any decline in value
securitization transactions can involve signifi- while the loans are in the pipeline. Loans held
cant liquidity risk to institutions engaged in for resale in this pipeline should be segregated
these securitization activities. Institutions should and carried at the lower of cost or market
ensure that their liquidity contingency plans value.
fully incorporate the potential risk posed by
their securitization activities. When new ABS Transfer risk and operational risk. Transfer risk
are issued, the issuing banking organization is analogous to liquidity risk. It is the risk that an
should determine their potential effect on its organization with obligations under securitiza-
liquidity at the inception of each transaction and tion arrangements may wish to relinquish those
throughout the life of the securities to better obligations but may not be able to do so.
ascertain its future funding needs. Operational risk arises from uncertainty about
An institution’s contingency plans should con- an organization’s ability to meet its obligations
sider the need to obtain replacement funding and under securitization arrangements and may arise
specify the possible alternative funding sources, from insufficient computer resources or from a
in the event of the amortization of outstanding failure of fees to cover associated costs. An
ABS. Replacement funding is particularly organization filling a role that potentially requires
important for securitizations of revolving receiv- long-term resource commitments, such as ser-
ables, such as credit cards, in which an early vicer or credit enhancer, is most susceptible to
amortization of the ABS could unexpectedly transfer risk and operational risk. Examiner
return the outstanding balances of the securi- procedures for reviewing transfer and opera-
tized accounts to the issuing institution’s bal- tional risk are outlined below:
ance sheet. Early amortization of a banking
organization’s ABS could impede an institu- • Examiners should determine that a BO has
tion’s ability to fund itself—either through reis- reviewed the relevant contracts to verify that
suance or other borrowings—since the institu- they are free of any unusual features that
tion’s reputation with investors and lenders may increase the potential cost of transfer of
be adversely affected. Moreover, the liquidity obligations.
risk and market risk to which ABS are subject • Examiners should ascertain that a BO has
may be exacerbated by thin secondary markets evaluated the fee structure of the securitiza-
for them. Examiner procedures for reviewing tion to determine that fees are sufficient to
liquidity and market risk are outlined below: cover the costs of associated services. Further,
examiners should determine that a BO has
• Examiners should review the policies of a BO reviewed the projected cash flow from the
engaged in underwriting, looking for situa- underlying assets to ensure that principal and
tions in which it cannot sell underwritten interest payments will be timely and will be
ABS. Credit review, funding capabilities, and sufficient to cover costs, even under adverse
approval limits should allow the institution to scenarios.

Page 31
• A servicer or credit enhancer subcontracting tions requires a BO that participates in them in

or participating responsibilities should ini- any capacity to fully investigate all applicable
tially assess the financial condition and repu- laws and regulations, to establish policies and
tation of any organization to which responsi- procedures to ensure legal review of all securi-
bility may be delegated. Subsequent periodic tization activities, and to take steps to protect the
monitoring by the servicer or credit enhancer organization from liability in the case of prob-
should assess the financial condition of orga- lems with particular asset-backed issues. Orga-
nizations to which responsibility has been nizations and examiners should be aware of
delegated, as well as their compliance with the continual evolution of criteria on the types
contractual obligations. Trustees should, like- of assets that may be securitized and the types of
wise, monitor the financial condition and com- BOs that may engage in the various aspects of
pliance of all participants in the securitization securitization. Examiner procedures for check-
arrangement. ing an institution’s legal-review and liability-
protection measures are outlined below:
Conflicts of interest. With respect to the various
functions performed by a BO, the potential for • Different responsibilities in connection with
conflicts of interest exists when an organization securitizations may be split among various
plays multiple roles in securitization. Policies subsidiaries of an organization. Examiners
and procedures must address this potential con- should, therefore, review the overall risk
flict, especially the risk of legal ramifications or exposure to an organization. Specifically,
negative market perceptions if the organization examiners should be alert to situations in
appears to compromise its fiduciary responsibil- which the structure of a securitization obscures
ity to obligors or investors. Examiner proce- the concentration risk in individual ABS or in
dures for reviewing conflicts of interest are a portfolio of ABS. Examiners should also be
outlined below: mindful of structures that may effectively
conceal low-quality assets or contingent
• Examiners should review a BO’s policies for liabilities from examination scrutiny and pos-
disclosure of confidential but pertinent infor- sible classification.
mation about the underlying assets and obli- • Examiners should review a BO’s insurance
gors. An organization involved in the origina- coverage to determine if it is sufficient to
tion or processing of a securitization transaction cover its fiduciary responsibilities under secu-
should have written statements from obligors ritization arrangements. At least one rating
allowing the disclosure of pertinent confiden- agency requests that servicers carry errors and
tial information to potential investors. In addi- omissions insurance that will cover a mini-
tion, the underwriting bank must follow proper mum of 5 percent of the outstanding obligation.
procedures of due diligence. • Private placements of ABS are not subject to
• If the securitization business of an originator, the same legal-disclosure requirements as pub-
underwriter, or credit enhancer is volume- lic placements. An organization involved in
driven, legal obligations or prudent banking private placements of ABS should, therefore,
practices may be breached. Examiners should exercise special caution with regard to disclo-
review credit standards used in analyzing sure of the risks and attributes of the securi-
assets earmarked for securitization to deter- tized assets.
mine that sound banking practices are not
being compromised to increase volume or to
realize substantial fees.
• Examiners should determine that the Banking Organizations Investing
organization’s policies addressing activities at in ABS
various subsidiaries or affiliates are managed
consistently and prudently in compliance with ABS may appear similar to corporate notes;
regulatory policies. however, ABS possess many unique character-
istics that affect their riskiness as investments. A
BO should independently analyze all potential
Legal Review and Liability risk exposures before investing in ABS and
should continue to monitor exposures through-
The complexity of asset-securitization transac- out the life of the ABS. Analyses should focus

Page 32
primarily on characteristics of ABS, such as and has approval criteria for all ABS expo-
credit risk, concentrations of exposures, interest- sure. Procedures should include an initial
rate risk, liquidity risk, market risk, and prepay- thorough and independent credit assessment
ment risk. As an integral part of these analyses, of ABS issues for which the organization has
a BO investing in ABS should evaluate the assumed any degree of credit risk, followed
underlying assets, the participants in the securi- by periodic reviews to monitor performance
tization arrangement, and the structure of the of the ABS throughout the life of the exposure.
securitization arrangement, although it should • Examiners should determine that a banking
not be expected to analyze these factors in the organization does not rely solely on conclu-
same detail as BOs involved in the issuance of sions of external rating services in evaluating
ABS. ABS.
Any purchase of ABS should be consistent • Examiners should determine that a banking
with the overall objectives of the organization. organization investing in ABS has inde-
The securities should constitute an integrated pendently made use of available documents in
component of the investment or hedging plans evaluating the credit risk of ABS. These
of the organization and should not be purchased documents include indentures, trustee reports,
for speculative purposes. A banking organiza- rating-agency bulletins, and prospectuses.
tion should not rely on investment or trading • Examiners should determine that a banking
strategies, which depend on the existence of organization investing in privately placed ABS
liquid secondary ABS markets. is aware of the differences in disclosure
requirements between publicly placed and
privately placed securities, and has taken extra
Policy and Portfolio Analysis steps to obtain and analyze information rel-
evant to the evaluation of holdings of any
Credit risk. While ABS are often insulated, to privately placed ABS.
some extent, from the credit risk of the under- • Major policies and procedures, including
lying assets, credit risk is still affected by a internal credit-review and -approval proce-
number of factors, in addition to the perfor- dures and in-house exposure limits, should be
mance of the underlying asset pool. These reviewed periodically and approved by the
factors include the ability of the parties involved institution’s board of directors.
in the securitization arrangement to fulfill their • Failure, fraud, or mismanagement on the part
obligations and the structure of the securitiza- of another party could result in loss to inves-
tion itself. tors. A banking organization should have
In the event of default by obligors or other adequate procedures for assessing the finan-
failure of the securitization structure, access to cial strength and operational capacity of insti-
collateral may be difficult and recourse to the tutions involved in enhancing the credit qual-
various providers of credit enhancement may be ity of or managing an ABS issue.
time-consuming and costly. Some forms of credit • A banking organization should have proce-
enhancement may be revocable. Banking orga- dures for evaluating the structural soundness
nizations should not place undue reliance on of securitization arrangements for ABS in
collateral values and credit enhancement in which it invests. The degree of investor con-
evaluating ABS. trol over transfer of servicing rights should be
In many cases, ratings of the creditworthiness clearly delineated.
of ABS issues are available from external credit • Securitization arrangements may remove the
agencies. A banking organization may use credit ultimate investor from direct access to the
ratings as a source of information, but should collateral; the remedies available to an inves-
not depend solely on external agencies’ evaluator, in the event of default, should be clearly
tions of creditworthiness. Unrated ABS should documented.
be subject to particular scrutiny. Examiner pro-
cedures for reviewing credit risk are outlined Concentration risk. Banking organizations may
below: face concentrations of risk within the pool of
assets, underlying an individual ABS issue,
• Examiners should review a BO’s policies and across different ABS issues, or through combi-
procedures to ensure that the organization nations of ABS and other credit exposures.
follows prudent standards of credit assessment Banking organizations that invest in ABS must

Page 33
take special care to follow in-house diversifica- information on the historical costs, market
tion requirements for aggregate outstandings to values, and unrealized gains and losses on
a particular institution, industry, or geographic ABS held in investment, trading, or resale
area. Examiner procedures for reviewing con- portfolios.
centration risk are outlined below:
Prepayment risk. The prepayment of assets
• When determining compliance with internal underlying ABS may create prepayment risk for
credit-exposure limits, securitization exposure an investor in ABS. Prepayment risk may not be
should be aggregated with all loans, exten- adequately reflected in agency ratings of ABS.
sions of credit, debt and equity securities, Examiner procedures for reviewing prepayment
legally binding financial guarantees and com- risk are outlined below:
mitments, and any other investments involv-
ing the same obligor. • Examiners should determine that a BO invest-
• Inherent in securitization is the risk that, if ing in ABS has analyzed the prepayment risk
another party involved in the transaction of ABS issues in its portfolio. Special care
becomes unable to perform, according to con- should be taken in the analysis of issues
tract terms, the issue might default, even while involving multiple tranches.
the underlying credits are performing. Exam- • Prepayment risk for ABS should be incorpo-
iners should, therefore, ensure that, in addition rated into an organization’s net income-at-risk
to policies limiting direct credit exposure, an model, if such a model is used.
institution has developed exposure limits for
particular credit enhancers, servicers, or trust-
ees. Credit exposure to the other managing Legal Review
parties in a securitization should be included
under a BO’s general line to those institutions. Examiners should review policies and proce-
• Examiners should review the ABS portfolio dures for compliance with applicable state lend-
for any industrial or geographic concentra- ing limits and federal law, such as section 5136
tions. Excessive exposures to a particular of the Revised Codes. These requirements must
industry or region within the portfolio should be analyzed to determine whether a particular
be noted in the examiner’s review. ABS issue is considered a single investment or a
loan to each of the creditors underlying the pool.
Liquidity risk and market risk. Limited second- Collateralized mortgage obligations may be
ary markets may make ABS, especially unrated exempt from this limitation, if they are issued or
or innovative ABS, less liquid than many other guaranteed by an agency or instrumentality of
debt instruments. Examiner procedures for the U.S. government.
reviewing liquidity and market risk are outlined
below:
• If an investing bank is purchasing securitized

assets for trading purposes, the examiner Internal Audit and Management
should ensure that the trading assets are car- Information Systems
ried at market value or at the lower of market
or book value, and that market values are A BO’s management of securitization risk
determined regularly. The risks involved are depends on the providing of timely and accurate
similar in character to the risks involved in information about the organization’s exposure
trading other marketable securities. As with to those responsible for monitoring risks. Exam-
any trading activity, the BO must take proper iners must be aware that a BO’s involvement in
steps to analyze market character and depth. asset securitization can be very extensive and
• A banking organization investing in ABS place significant demands on systems without
should not depend on secondary-market liquid- being readily evident, either as an on-balance-
ity for the securities, especially in the case of sheet exposure or a contingent liability. System
ABS involving novel structures or innovative overload or other technical default in the orga-
types of assets. nization’s systems could render the organization
• Management information systems should pro- unable to provide proper monitoring or servic-
vide management with timely and periodic ing. While the risk is not clearly associated with

Page 34
the servicer (whose responsibility is long term • Management information systems and report-
and requires ongoing resource commitments), ing procedures should be reviewed to deter-
systems breakdowns may have risk implications mine that they—
for the credit enhancer and trustee. Examiners — provide a listing of all securitizations for
should ensure that internal auditors examine all which the banking organization is either
facets of securitization regularly, as outlined originator, servicer, credit enhancer, under-
below: writer, trustee, or investor;
— provide concentration listings by industry
• Examiners should ensure that internal systems and geographic area;
and controls adequately track the performance — generate information on total exposure to
and condition of internal exposures and should specific originators, servicers, credit
monitor the organization’s compliance with enhancers, trustees, or underwriters;
internal procedures and limits. In addition, — generate information on portfolio aging
adequate audit trails and internal-audit cover- and performance relative to expectations;
age should be provided. and
• Cost-accounting systems should be adequate — provide periodic and timely information
to permit a reliable determination of the prof- to senior management and directors on the
itability and volatility of asset-securitization organization’s involvement in, and credit
activities. exposure arising from, securitization.
ADDITIONAL REFERENCES
The following is a list of accounting literature issued by FASB and the AICPA that relates to asset
securitization or asset transfers.
FASB Statements
FASB Statement No. 5 Accounting for Contingencies
FASB Statement No. 6 Classification of Short-Term Obligations Expected to Be
Refinanced
FASB Statement No. 48 Revenue Recognition When Right of Return Exists
FASB Statement No. 65 Accounting for Certain Mortgage Banking Enterprises, as amended
FASB Statement No. 66 Accounting for Sales of Real Estate
FASB Statement No. 77 Reporting by Transferors for Transfers of Receivables with Recourse
FASB Statement No. 91 Accounting for Nonrefundable Fees and Costs Associated with
Originating or Acquiring Loans and Initial Direct Costs of Leases
FASB Statement No. 105 Disclosure of Information About Financial Instruments with
Off-Balance-Sheet Risk and Financial Instruments with
Concentrations of Credit Risk
FASB Statement No. 115 Accounting for Certain Investments in Debt and Equity Securities
FASB Statement No. 122 Accounting for Mortgage-Servicing Rights
FASB Statement No. 133 Accounting for Derivative Instruments and
Hedging Activities
FASB Statement No. 134 Accounting for Mortgage-Backed Securities Retained After the
Securitization of Mortgage Loans Held for Sale by a Mortgage
Banking Enterprise
FASB Statement No. 137 Accounting for Derivative Instruments and
Hedging Activities—Deferral of the Effective Date of FASB
Statement No. 133 (an amendment of FASB Statement No. 133)
FASB Statement No. 138 Accounting for Certain Derivative Instruments and
Hedging Activities (an amendment of FASB Statement No. 133)

Page 35
FASB Statement No. 140 Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities (a replacement of
FASB Statement No. 125)
FASB Statement No. 149 Amendment of Statement 133 on Derivative Instruments and Hedging
Activities
FASB Statement No. 150 Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity
FASB Interpretations
FIN 8 Classification of a Short-Term Obligation Repaid Prior to Being Replaced by a
Long-Term Security
FIN 45 Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others
FIN 46-R Consolidation of Variable Interest Entities
Technical Bulletins
TB 85-2 Accounting for Collateralized Mortgage Obligations
TB 87-3 Accounting for Mortgage Servicing Fees and Rights
TB 01-1 Effective Date for Certain Financial Institutions of Certain Provisions of Statement 140
Related to the Isolation of Transferred Financial Assets
EITF (Emerging Issues Task Force) Abstracts

84-15 Grantor Trusts Consolidation
84-21 Sale of a Loan with a Partial Participation Retained
84-30 Sales of Loans to Special-Purpose Entities
85-13 Sale of Mortgage-Service Rights on Mortgages Owned by Others
85-20 Recognition of Fees for Guaranteeing a Loan
85-26 Measurement of Servicing Fees Under FASB Statement No. 65 When a Loan Is Sold
with Servicing Retained
85-28 Consolidation Issues Relating to Collateralized Mortgage Obligations
86-24 Third-Party Establishment of CMO
86-38 Implications of Mortgage Prepayments on Amortization of Servicing Rights
86-39 Gains from the Sale of Mortgage Loans with Servicing Rights Retained
87-25 Sales of Convertible, Adjustable-Rate Mortgages with Contingent Repayment Agreement
87-34 Sales of Mortgage-Servicing Rights with a Subservicing Agreement
88-11 Sale of Interest-Only or Principal-Only Cash Flows from Loans Receivable
88-17 Accounting for Fees and Costs Associated with Loan Syndications and Loan Participations
88-20 Difference Between Initial Investment and Principal Amount of Loans in a Purchased
Credit-Card Portfolio
88-22 Securitization of Credit Card Portfolios
89-4 Collateralized Mortgage Obligation Residuals
89-5 Sale of Mortgage-Loan-Servicing Rights
89-18 Divestitures of Certain Investment Securities to an Unregulated Common Controlled Entity
Under FIRREA
90-2 Exchange of Interest-Only or Principal-Only Securities for a Mortgage-Backed Security
90-18 Effect of a ‘‘Removal of Accounts’’ Provision on the Accounting for a Credit Card
Securitization
93-18 Recognition for Impairment of an Investment in a Collateralized Mortgage Obligation
Instrument or in a Mortgage-Backed Interest-Only Certificate

Page 36
94-4 Classification of an Investment in a Mortgage-Backed Interest-Only Certificate as

Held-to-Maturity
94-8 Accounting for Conversion of a Loan into a Debt Security in a Debt Restructuring
94-5 Determination of What Constitutes All Risks and Rewards and No Significant Unresolved
Contingencies in a Sale of Mortgage-Loan-Servicing Rights
95-5 Determination of What Risks and Rewards, If Any, Can Be Retained and Whether Any
Unresolved Contingencies May Exist in a Sale of Mortgage-Loan-Servicing Rights
D-39 Questions Related to the Implementation of FASB Statement No. 115
D-75 When to Recognize Gains and Losses on Assets Transferred to a Qualifying
Special-Purpose Entity
D-94 Questions and Answers Related to the Implementation of FASB Statement No. 140
D-99 Questions and Answers Related to Servicing Activities in a Qualifying Special-Purpose
Entity Under FASB Statement No. 140
AICPA Statements of Position

90-3 Definition of the Term ‘‘Substantially the Same’’ for Holders of Debt Instruments,
as Used in Certain Audit Guides and a Statement of Position
94-6 Disclosure of Certain Significant Risks and Uncertainties

Page 37
1. To determine if the bank is in compliance adopted measures to minimize the impact of

with laws, regulations, and policy statements. these failures if they occur.
2. To determine if the bank has originated, 13. To determine that the organization is aware
serviced, credit-enhanced, served as a trustee of the legal risks and uncertainty of various
for, or invested in securitized assets. aspects of securitization.
3. To determine that securitization activities 14. To determine that concentrations of expo-
are integrated into the overall strategic sure in the underlying asset pools, asset-
objectives of the organization. backed securities portfolio, or structural
4. To determine that management has an elements of securitization transactions are
appropriate level of experience in securiti- avoided.
zation activities. 15. To determine that all sources of risk are
5. To ensure that the bank does not hold any evaluated at the inception of each securiti-
asset-backed securities that are inappropri- zation activity and are monitored on an
ate, for example, interest-only strips (IOs) ongoing basis.
and principal-only strips (POs), given the 16. To determine whether the institution’s
size of the bank and the sophistication of its retained interests from asset securitization
operations. are properly documented, valued, and
6. To ensure that all asset-backed securities accounted for.
owned, any assets sold with recourse, 17. To verify that the amount of retained inter-
retained interests, and variable interest enti- ests not supported by adequate documenta-
ties (VIEs) (for example, asset-backed com- tion has been charged off and that the assets
mercial paper (ABCP) programs that are involved in those retained interests are not
defined as VIEs under GAAP) are properly used for risk-based calculation purposes.
accounted for on the bank’s books and are 18. To ascertain the existence of sound risk
correctly reported on the bank’s regulatory modeling, management information sys-
reports. tems (MIS), and disclosure practices for
7. To determine that sources of credit risk are asset securitization.
understood, properly analyzed, and man- 19. To obtain assurances that the board of
aged, without excessive reliance on credit directors and management oversee sound
ratings by outside agencies. policies and internal controls concerning
8. To determine that credit, operational, and the recording of asset-securitization trans-
other risks are recognized and addressed actions and any valuation of retained inter-
through appropriate policies, procedures, ests derived therefrom.
management reports, and other controls. 20. To determine that capital is commensurate
9. To determine if officers are operating in with, and that there are accurate determina-
conformance with established bank policies tions of, the risk weights for the risk expo-
and procedures. sures arising from recourse obligations,
10. To determine whether liquidity and market direct-credit substitutes, asset- and mortgage-
risks are recognized and whether the orga- backed securities, ABCP programs and
nization is excessively dependent on secu- ABCP liquidity facilities, and other asset-
ritization as a substitute for day-to-day core securitization transactions.
funding or as a source of income. 21. To determine whether there is an indepen-
11. To determine that steps have been taken to dent audit function that is capable of evalu-
minimize the potential for conflicts of inter- ating asset-securitization activities and any
est arising from the institution’s securitiza- associated retained interests.
tion activities. 22. To initiate corrective action if policies,
12. To determine that possible sources of struc- practices, procedures, or internal controls
tural failure in securitization transactions are deficient or when violations of law, regu-
are recognized and that the organization has lations, or policy statements are disclosed.

Page 1
1. a. Request a schedule of all asset-backed nators and purchasers of securitized assets

securities owned by the bank. Reconcile should have prospectuses on the issue.
the balance of these assets to the subsid- Obtaining a copy of the prospectus can
iary ledgers of the balance sheet, and be an invaluable source of information.
review credit ratings assigned to these Prospectuses generally contain informa-
securities by independent rating agen- tion on credit enhancement, default provi-
cies. Determine that the accounting meth- sions, subordination agreements, etc. In
ods and procedures used for these assets, addition to the prospectus, obtain the docu-
at inception and throughout the carrying mentation confirming the purchase or sale
life, are appropriate. of a security.
b. Request and review information on the 7. Ensure that, regardless of the role an insti-
types and amount of assets that have tution plays in securitization, the documen-
been securitized by the bank. In addition, tation for an asset-backed security clearly
request information concerning potential specifies the limitations of the institution’s
contractual or contingent liability arising legal responsibility to assume losses.
from any guarantees, underwriting, and 8. Determine the existence of independent risk-
servicing of the securitized assets. management processes and management
2. Review the parent company’s policies and information systems (MIS). Determine
procedures to ensure that its banking and whether these processes and systems are
nonbanking subsidiaries follow prudent stan- being used to monitor securitization-pool
dards of credit assessment and approval for performance on an aggregate and individual
all securitization exposure. Procedures transaction level.
should include a thorough and independent 9. Verify whether the BO, acting as originator,
credit assessment of each loan or pool for packager, or underwriter, has written poli-
which it has assumed credit risk, followed cies addressing the repurchase of assets and
by periodic credit reviews to monitor per- other measures to reimburse investors in the
formance throughout the life of the expo- event that a defaulted package results in
sure. If a banking organization (BO) invests losses exceeding any contractual credit
in asset-backed securities (ABS), determine enhancement. The repurchase of defaulted
whether it relies soley on conclusions of assets or pools in contradiction of or outside
external rating services when evaluating the the terms of the underlying agreement in
securities. effect sets a standard by which a banking
3. Determine that rigorous credit standards are organization could potentially be found
applied regardless of the role the organiza- legally liable for all ‘‘sold’’ assets. Review
tion plays in the securitization process, and report any situations in which the orga-
for example, servicer, credit enhancer, or nization has repurchased or otherwise
investor. reimbursed investors for poor-quality
4. Determine that major policies and proce- assets.
dures, including internal credit-review and 10. Classify adverse credit risk associated with
credit-approval procedures and ‘‘in-house’’ the securitization of assets when analyzing
exposure limits, are reviewed periodically the adequacy of an organization’s capital or
and approved by the bank’s board of reserve levels. Evaluate credit risk of ABS,
directors. and classify any adverse credit risk. List
5. Determine whether adequate procedures for classified assets. Evaluate the impact of the
evaluating the organization’s internal con- classification on capital adequacy and the
trol procedures and the financial strength of overall soundness of the institution.
the other institutions involved in the secu- 11. Aggregate securitization exposures with all
ritization process are in place. loans, extensions of credit, debt and equity
6. Obtain the documentation outlining the rem- securities, legally binding financial guaran-
edies available to provide credit enhance- tees and commitments, and any other invest-
ment in the event of a default. Both origi- ments involving the same obligor when

Page 1
4030.3 Asset Securitization: Examination Procedures
determining compliance with internal credit- tions, as required by the risk-based capital
exposure limits. guidelines.
12. Review the bank’s valuation assumptions f. If the bank had multiple positions with
and modeling methodology used for ABS to overlapping exposures, determine if the
determine if they are conservative and bank applied the risk-based capital treat-
appropriate and are being used to establish, ment that resulted in the highest capital
evaluate, and adjust the carrying value of charge. (See 12 CFR, appendix A, sec-
retained interests on a regular and timely tion III.B.6.c.)
basis. 16. Ascertain that internal limits govern the
13. Determine if audit or internal-review staffs amount of retained interests held as a per-
periodically review data integrity, model centage of total equity capital.
algorithms, key underlying assumptions, and 17. Establish that an adequate liquidity contin-
the appropriateness of the valuation and gency plan is in place and will be used in
modeling process for the securitized assets the event of market disruptions. Determine
that the institution retains. whether liquidity problems may arise as the
14. Review the risk-based capital calculations, result of an overdependence on asset-
and determine if they include recognition securitization activities for day-to-day core
and the correct reporting of any recourse funding.
obligations, direct-credit substitutes, residual 18. Determine whether consistent, conservative
interests, asset- and mortgage-backed secu- accounting practices are in place that satisfy
rities, asset-backed commercial paper the reporting requirements of regulatory
(ABCP) programs, liquidity facilities, and supervisors, GAAP reporting requirements,
other transactions involving such securitiza- and valuation assumptions and methods.
tion activities. Ascertain that adequate disclosures of asset-
15. Determine if the bank consolidates, in accor- securitization activities are made commen-
dance with GAAP (FASB’s FIN 46-R, surate with the volume of securitizations
‘‘Consolidation of Variable Interest Enti- and the complexities of the institution.
ties’’), the assets of any ABCP program or 19. Establish that risk-exposure limits and
other such program that it sponsors. requirements exist and are adhered to on an
a. Determine if the bank’s ABCP program aggregate and individual transaction basis.
met the definition of a sponsored ABCP 20. Review securitized assets for industrial or
program under the risk-based capital geographic concentrations. Excessive expo-
guidelines. sures to an industry or region among the
b. Verify that the assets of the bank’s eli- underlying assets should be noted in the
gible ABCP program and any associated review of the loan portfolio.
minority interest were excluded from the 21. Ensure that, in addition to policies limiting
bank’s calculation of its risk-based capi- direct credit exposure, an institution has
tal ratios. developed exposure limits for particular
c. Ascertain whether the liquidity facilities originators, credit enhancers, trustees, and
the bank extends to the ABCP program servicers.
satisfy the risk-based capital definition 22. Review the policies of the banking organi-
and requirements, including the appro- zation engaged in underwriting, watching
priate asset-quality test, of an eligible for situations in which it cannot sell under-
ABCP program liquidity facility. (See 12 written asset-backed securities. Credit
CFR 208, appendix A, III.B.3.a.iv.) review, funding capabilities, and approval
d. Determine whether the bank applied the limits should allow the institution to pur-
correct credit-conversion factor to eli- chase and hold unsold securities. All poten-
gible ABCP liquidity facilities when it tial credit exposure should be within legal
determined the amount of risk-weighted lending limits.
assets for its risk-based capital ratios. 23. Ensure that internal systems and controls
(See 12 CFR 208, appendix A, section adequately track the performance and con-
III.D.) dition of internal exposures and monitor the
e. Determine if all ineligible ABCP liquid- organization’s compliance with internal pro-
ity facilities were treated as either direct- cedures and limits. In addition, adequate
credit substitutes or as recourse obliga- audit trails and internal audit coverage

Page 2
Asset Securitization: Examination Procedures 4030.3
should be provided. Ensure that the reports this limitation, if they are issued or guaran-
have adequate scope and frequency of detail. teed by an agency or instrumentality of the
24. Determine that management information U.S. government.
systems provide— 27. Determine whether the underwriting of ABS
a. a listing of each securitization transac- of affiliates is—
tion in which the organization is involved; a. rated by an unaffiliated, nationally rec-
b. a listing of industry and geographic ognized statistical rating organization; or
concentrations; b. issued or guaranteed by Fannie Mae,
c. information on total exposure to specific FHLMC, or GNMA, or represents inter-
originators, servicers, credit enhancers, ests in such obligations.
trustees, or underwriters; 28. Determine if purchases of high-risk
d. information regarding portfolio monthly mortgage-backed securities were made to
vintage or aging and information on a reduce the overall interest-rate risk of the
portfolio’s performance by specific prod- bank. Determine if the bank evaluates and
uct type relative to expectations; documents at least quarterly whether these
e. periodic and timely information to senior securities have reduced the interest-rate risk.
management and directors on the orga- 29. Review and discuss any documentation
nization’s involvement in, and credit exceptions, violations, internal control
exposure arising from, securitization; exceptions, and classifications with
f. static-pool cash-collection analysis; management, and obtain management’s
g. sensitivity analysis; and response.
h. a statement of covenant compliance. 30. Review the bank’s liquidity agreements with
25. Ensure that internal auditors examine all any asset-backed commercial paper pro-
facets of securitization regularly. grams and determine whether the agree-
26. Review policies and procedures for compli- ments have any credit-related components.
ance with applicable state lending limits Is the bank required to purchase the assets?
and federal law, such as section 5136 of the Are these assets repurchased from the bank?
Revised Codes. These requirements must be If the facility is determined to be a commit-
analyzed to determine whether a particular ment, determine whether its maturity is
asset-backed-security issue is considered a short term or long term. Do any of the
single investment or a loan to each of the liquidity agreements contain a material
creditors underlying the pool. Collateralized adverse clause or any other credit-
mortgage obligations may be exempt from contingency provision?

Page 3
Review the bank’s internal controls, policies, price movements when it is engaged in
practices, and procedures for all aspects of asset underwriting or market-making activities?
securitization. The bank’s system should be 3. Are the bank’s securitization policies reviewed
documented completely and concisely and and reaffirmed at least annually to determine
should include, where appropriate, narrative if they are compatible with changing market
descriptions, flow charts, copies of forms used, conditions?
and other pertinent information.
INTERNAL CONTROL AND

POLICIES MANAGEMENT INFORMATION
SYSTEMS
1. Does the bank employ the services of a
securities dealer? If so, does the bank rely 1. Do the internal systems and controls
solely on the advice of such dealer when adequately track the performance and condi-
purchasing asset-backed securities for the tion of internal exposures, and do the systems
bank’s investment portfolio? Does the bank monitor the bank’s compliance with internal
have persons who are responsible for review- procedures and limits? Are adequate audit
ing or approving the investment manager’s trails and internal audit coverage provided?
acquisitions? Are minimum criteria estab- 2. Do the cost accounting systems provide a
lished for selecting a securities dealer? reliable determination of the profitability and
2. Has the board of directors, consistent with its volatility of asset-securitization activities?
duties and responsibilities, reviewed and rati- 3. Are management information systems and
fied asset-securitization policies, practices, reporting procedures adequate in that they
and procedures? Do these policies, practices, provide—
and procedures— a. a listing of all securitizations for which
a. require an initial thorough and indepen- the bank is either originator, servicer,
dent credit assessment of each pool for credit enhancer, underwriter, or trustee?
which the bank has assumed credit risk, as b. a listing of industry and geographic con-
either a participant in the securitization centrations?
process or as an investor? c. information on total exposure to specific
b. address the bank’s repurchase of assets originators, servicers, credit enhancers,
and other forms of reimbursement to inves- trustees, or underwriters?
tors, when the bank is acting as the d. information regarding portfolio aging and
originator, packager, or underwriter, in the performance relative to expectations?
event that a default results in losses e. periodic and timely information to senior
exceeding any contractual credit management and directors on the organi-
enhancement? zation’s involvement in, and credit expo-
c. ensure that the credit, pricing, and servic- sure arising from, securitization?
ing standards for securitized assets are f. credit ratings assigned by independent
equivalent to standards for assets that rating agencies to all asset-backed securities
remain on the bank’s books? held by the bank?
d. ensure that the credit, pricing, and servic- 4. Do management information systems and
ing standards and that compliance with reporting procedures adequately document
any provisions relating to government the bank’s calculation and determination of
guarantees are reviewed periodically by risk-based capital ratios (including the assign-
the board of directors? ment of the appropriate risk-based capital
e. establish in-house diversification charges (risk weights and credit-conversion
requirements for aggregate outstanding factors)) against the exposures arising from
exposures to a particular institution, indus- asset-backed and mortgage-backed securiti-
try, or geographic area? zation transactions or activities, including
f. hedge the bank’s exposure to adverse asset-backed commercial paper programs

Page 1
4030.4 Asset Securitization: Internal Control Questionnaire
(including exposures arising from direct- mortgage-backed and other types of asset-
credit substitutes, recourse obligations, backed loans)?
residual interests, liquidity facilities, and

Page 2
Elevated-Risk Complex Structured Finance Activities
This section sets forth the Interagency Statement CSFT, it bears the usual market, credit, and
on Sound Practices Concerning Elevated-Risk operational risks associated with the transaction.
Complex Structured Finance Activities, issued In some circumstances, a financial institution
January 11, 2007.1 The supervisory guidance also may face heightened legal or reputational
addresses risk-management principles that should risks due to its involvement in a CSFT. For
assist institutions to identify, evaluate, and man- example, in some circumstances, a financial
age the heightened legal and reputational risks institution may face heightened legal or reputa-
that may arise from their involvement in com- tional risk if a customer’s regulatory, tax, or
plex structured finance transactions (CSFTs). accounting treatment for a CSFT, or disclosures
The guidance is focused on sound practices to investors concerning the CSFT in the custom-
related to CSFTs that may create heightened er’s public filings or financial statements, do not
legal or reputational risks to the institution and comply with applicable laws, regulations, or
are defined as ‘‘elevated-risk CSFTs.’’ Such accounting principles. Indeed, in some instances,
transactions are typically conducted by a limited CSFTs have been used to misrepresent a cus-
number of large financial institutions.2 (See tomer’s financial condition to investors, regula-
SR-07-05.) tory authorities, and others. In these situations,
investors have been harmed and financial insti-
tutions have incurred significant legal and repu-
INTERAGENCY STATEMENT tational exposure. In addition to legal risk,
reputational risk poses a significant threat to
ON SOUND PRACTICES financial institutions because the nature of their
CONCERNING ELEVATED-RISK business requires them to maintain the confi-
COMPLEX STRUCTURED dence of customers, creditors, and the general
FINANCE ACTIVITIES marketplace.
The agencies4 have long expected financial
Financial markets have grown rapidly over the institutions to develop and maintain robust con-
past decade, and innovations in financial instru- trol infrastructures that enable them to identify,
ments have facilitated the structuring of cash evaluate, and address the risks associated with
flows and allocation of risk among creditors, their business activities. Financial institutions
borrowers, and investors in more efficient ways. also must conduct their activities in accordance
Financial derivatives for market and credit risk, with applicable statutes and regulations.
asset-backed securities with customized cash-
flow features, specialized financial conduits that
manage pools of assets, and other types of
structured finance transactions serve important Scope and Purpose of Statement
business purposes, such as diversifying risks,
allocating cash flows, and reducing cost of The agencies issued this statement to describe
capital. As a result, structured finance transac- the types of risk-management principles they
tions have become an essential part of U.S. and believe may help a financial institution to iden-
international capital markets. Financial institu- tify CSFTs that may pose heightened legal or
tions have played and continue to play an active reputational risks to the institution and to evalu-
and important role in the development of struc-
tured finance products and markets, including case of the Board of Governors of the Federal Reserve System
the market for the more complex variations of (FRB); to national banks in the case of the Office of the
Comptroller of the Currency (OCC); to federal and state
structured finance products. savings associations and savings and loan holding companies
When a financial institution3 participates in a in the case of the Office of Thrift Supervision (OTS); to state
nonmember banks in the case of the Federal Deposit Insurance
Corporation (FDIC); and to registered broker-dealers and
1. See 72 Fed. Reg. 1372, January 11, 2007. investment advisers in the case of the Securities and Exchange
2. The statement will not affect or apply to the vast Commission (SEC). The U.S. branches and agencies of
majority of financial institutions, including most small foreign banks supervised by the FRB, the OCC, and the FDIC
institutions. also are considered to be financial institutions for purposes of
3. As used in this statement, the term financial institution this statement.
or institution refers to state member banks and bank holding 4. The federal banking agencies (the FRB, the OCC, the
companies (other than foreign banking organizations) in the FDIC, and the OTS) and the SEC.

Page 1
4033.1 Elevated-Risk Complex Structured Finance Activities
ate, manage, and address these risks within the concerning market, credit, operational, legal,
institution’s internal control framework. and reputational risks as well as internal audit
Structured finance transactions encompass a and other appropriate internal controls.
broad array of products with varying levels of This statement does not create any private
complexity. Most structured finance transac- rights of action and does not alter or expand the
tions, such as standard public mortgage-backed legal duties and obligations that a financial
securities transactions, public securitizations of institution may have to a customer, its share-
retail credit cards, asset-backed commercial holders, or other third parties under applicable
paper conduit transactions, and hedging-type law. At the same time, adherence to the prin-
transactions involving ‘‘plain vanilla’’ deriva- ciples discussed in this statement would not
tives and collateralized loan obligations, are necessarily insulate a financial institution from
familiar to participants in the financial markets, regulatory action or any liability the institution
and these vehicles have a well-established track may have to third parties under applicable law.
record. These transactions typically would not
be considered CSFTs for the purpose of this
statement. Identification and Review of
Because this statement focuses on sound prac-
tices related to CSFTs that may create height-
Elevated-Risk CSFTs
ened legal or reputational risks—transactions A financial institution that engages in CSFTs
that typically are conducted by a limited number should maintain a set of formal, written, firm-
of large financial institutions—it will not affect wide policies and procedures that are designed
or apply to the vast majority of financial insti- to allow the institution to identify, evaluate,
tutions, including most small institutions. As in assess, document, and control the full range of
all cases, a financial institution should tailor its credit, market, operational, legal, and
internal controls so that they are appropriate in reputational risks associated with these transac-
light of the nature, scope, complexity, and risks tions. These policies may be developed specifi-
of its activities. Thus, for example, an institution cally for CSFTs, or included in the set of
that is actively involved in structuring and broader policies governing the institution gener-
offering CSFTs that may create heightened legal ally. A financial institution operating in foreign
or reputational risk for the institution should jurisdictions may tailor its policies and
have a more formalized and detailed control procedures as appropriate to account for, and
framework than an institution that participates in comply with, the applicable laws, regulations,
these types of transactions less frequently. The and standards of those jurisdictions.5
internal controls and procedures discussed in A financial institution’s policies and proce-
this statement are not all-inclusive, and, in dures should establish a clear framework for the
appropriate circumstances, an institution may review and approval of individual CSFTs. These
find that other controls, policies, or procedures policies and procedures should set forth the
are appropriate in light of its particular CSFT responsibilities of the personnel involved in the
activities. origination, structuring, trading, review, approval,
Because many of the core elements of an documentation, verification, and execution of
effective control infrastructure are the same CSFTs. Financial institutions may find it helpful
regardless of the business line involved, this to incorporate the review of new CSFTs into
statement draws heavily on controls and proce- their existing new-product policies. In this
dures that the agencies previously have found to regard, a financial institution should define what
be effective in assisting a financial institution to constitutes a ‘‘new’’ complex structured finance
manage and control risks and identifies ways in product and establish a control process for the
which these controls and procedures can be approval of such new products. In determining
effectively applied to elevated-risk CSFTs.
Although this statement highlights some of the 5. In the case of U.S. branches and agencies of foreign
most significant risks associated with elevated- banks, these policies, including management, review, and
risk CSFTs, it is not intended to present a full approval requirements, should be coordinated with the foreign
exposition of all risks associated with these bank’s group-wide policies developed in accordance with the
rules of the foreign bank’s home-country supervisor and
transactions. Financial institutions are encour- should be consistent with the foreign bank’s overall corporate
aged to refer to other supervisory guidance and management structure as well as its framework for risk
prepared by the agencies for further information management and internal controls.

Page 2
Elevated-Risk Complex Structured Finance Activities 4033.1
whether a CSFT is new, a financial institution material impact on the regulatory, tax, or
may consider a variety of factors, including accounting treatment of the related transac-
whether it contains structural or pricing variation, or the client’s disclosure obligations;6
tions from existing products; whether the prod- • have material economic terms that are incon-
uct is targeted at a new class of customers; sistent with market norms (for example, deep
whether it is designed to address a new need of ‘‘in the money’’ options or historic rate roll-
customers; whether it raises significant new overs); or
legal, compliance, or regulatory issues; and • provide the financial institution with compen-
whether it or the manner in which it would be sation that appears substantially disproportion-
offered would materially deviate from standard ate to the services provided or investment
market practices. An institution’s policies should made by the financial institution or to the
require new complex structured finance prod- credit, market, or operational risk assumed by
ucts to receive the approval of all relevant the institution.
control areas that are independent of the profit
center before the product is offered to customers. The examples listed previously are provided
for illustrative purposes only, and the policies
and procedures established by financial institu-
tions may differ in how they seek to identify
Identifying Elevated-Risk CSFTs elevated-risk CSFTs. The goal of each institu-
tion’s policies and procedures, however, should
As part of its transaction and new-product remain the same: to identify those CSFTs that
approval controls, a financial institution should warrant additional scrutiny in the transaction or
establish and maintain policies, procedures, and new-product approval process due to concerns
systems to identify elevated-risk CSFTs. Because regarding legal or reputational risks.
of the potential risks they present to the institu- Financial institutions that structure or market,
tion, transactions or new products identified as act as an advisor to a customer regarding, or
elevated-risk CSFTs should be subject to height- otherwise play a substantial role in a transaction
ened reviews during the institution’s transaction may have more information concerning the
or new-product approval processes. Examples customer’s business purpose for the transaction
of transactions that an institution may determine and any special accounting, tax, or financial
warrant this additional scrutiny are those that disclosure issues raised by the transaction than
(either individually or collectively) appear to the institutions that play a more limited role. Thus,
institution during the ordinary course of its the ability of a financial institution to identify
transaction approval or new-product approval the risks associated with an elevated-risk CSFT
process to— may differ depending on its role.
• lack economic substance or business purpose;
• be designed or used primarily for questionable Due Diligence, Approval, and
accounting, regulatory, or tax objectives, par- Documentation Process for
ticularly when the transactions are executed at Elevated-Risk CSFTs
year-end or at the end of a reporting period for
the customer; Having developed a process to identify elevated-
• raise concerns that the client will report or risk CSFTs, a financial institution should imple-
disclose the transaction in its public filings or ment policies and procedures to conduct a height-
financial statements in a manner that is mate- ened level of due diligence for these transactions.
rially misleading or inconsistent with the sub- The financial institution should design these
stance of the transaction or applicable regula- policies and procedures to allow personnel at an
tory or accounting requirements; appropriate level to understand and evaluate the
• involve circular transfers of risk (either potential legal or reputational risks presented by
between the financial institution and the cus-
tomer or between the customer and other 6. This item is not intended to include traditional, nonbind-
related parties) that lack economic substance ing ‘‘comfort’’ letters or assurances provided to financial
or business purpose; institutions in the loan process where, for example, the parent
of a loan customer states that the customer (i.e., the parent’s
• involve oral or undocumented agreements subsidiary) is an integral and important part of the parent’s
that, when taken into account, would have a operations.

Page 3
the transaction to the institution and to manage CSFT involves minimal or manageable risks
and address any heightened legal or reputational solely because another financial institution will
risks ultimately found to exist with the transaction. participate in the transaction or because of the
size or sophistication of the customer or coun-
Due diligence. If a CSFT is identified as an terparty. Moreover, a financial institution should
elevated-risk CSFT, the institution should care- carefully consider whether it would be appropri-
fully evaluate and take appropriate steps to ate to rely on opinions or analyses prepared by
address the risks presented by the transaction, or for the customer concerning any significant
with a particular focus on those issues identified accounting, tax, or legal issues associated with
as potentially creating heightened levels of legal an elevated-risk CSFT.
or reputational risk for the institution. In gen-
eral, a financial institution should conduct the Approval process. A financial institution’s poli-
level and amount of due diligence for an cies and procedures should provide that CSFTs
elevated-risk CSFT that is commensurate with identified as having elevated legal or reputa-
the level of risks identified. A financial institutional risk are reviewed and approved by appro-
tion that structures or markets an elevated-risk priate levels of control and management person-
CSFT to a customer, or that acts as an advisor to nel. The designated approval process for such
a customer or investors concerning an elevated- CSFTs should include representatives from the
risk CSFT, may have additional responsibilities relevant business line(s) and/or client manage-
under the federal securities laws, the Internal ment, as well as from appropriate control areas
Revenue Code, state fiduciary laws, or other that are independent of the business line(s)
laws or regulations and, thus, may have greater involved in the transaction. The personnel
legal- and reputational-risk exposure with respect responsible for approving an elevated-risk CSFT
to an elevated-risk CSFT than a financial insti- on behalf of a financial institution should have
tution that acts only as a counterparty for the sufficient experience, training, and stature within
transaction. Accordingly, a financial institution the organization to evaluate the legal and repu-
may need to exercise a higher degree of care in tational risks, as well as the credit, market, and
conducting its due diligence when the institution operational risks to the institution.
structures or markets an elevated-risk CSFT or The institution’s control framework should
acts as an advisor concerning such a transaction have procedures to deliver the necessary or
than when the institution plays a more limited appropriate information to the personnel respon-
role in the transaction. sible for reviewing or approving an elevated-
To appropriately understand and evaluate the risk CSFT to allow them to properly perform
potential legal and reputational risks associated their duties. Such information may include, for
with an elevated-risk CSFT that a financial example, the material terms of the transaction, a
institution has identified, the institution may find summary of the institution’s relationship with
it useful or necessary to obtain additional infor- the customer, and a discussion of the significant
mation from the customer or to obtain special- legal, reputational, credit, market, and opera-
ized advice from qualified in-house or outside tional risks presented by the transaction.
accounting, tax, legal, or other professionals. As Some institutions have established a senior
with any transaction, an institution should obtain management committee that is designed to
satisfactory responses to its material questions involve experienced business executives and
and concerns prior to consummation of a senior representatives from all of the relevant
transaction.7 control functions within the financial institution
In conducting its due diligence for an elevated- (including such groups as independent risk man-
risk CSFT, a financial institution should inde- agement, tax, accounting, policy, legal, compli-
pendently analyze the potential risks to the ance, and financial control) in the oversight and
institution from both the transaction and the approval of those elevated-risk CSFTs that are
institution’s overall relationship with the cus- identified by the institution’s personnel as requir-
tomer. Institutions should not conclude that a ing senior management review and approval due
transaction identified as being an elevated-risk to the potential risks associated with the trans-
actions. While this type of management com-
7. Of course, financial institutions also should ensure that
mittee may not be appropriate for all financial
their own accounting for transactions complies with appli- institutions, a financial institution should estab-
cable accounting standards, consistently applied. lish processes that assist the institution in con-

Page 4
Elevated-Risk Complex Structured Finance Activities 4033.1
sistently managing the review and approval of action that the institution is otherwise required
elevated-risk CSFTs on a firm-wide basis.8 to provide; and
If, after evaluating an elevated-risk CSFT, the
• verify that the institution’s policies and pro-
financial institution determines that its partici-
cedures are being followed and allow the
pation in the CSFT would create significant
internal audit function to monitor compliance
legal or reputational risks for the institution, the
with those policies and procedures.
institution should take appropriate steps to
address those risks. Such actions may include
When an institution’s policies and procedures
declining to participate in the transaction, or
require an elevated-risk CSFT to be submitted
conditioning its participation upon the receipt of
for approval to senior management, the institu-
representations or assurances from the customer
tion should maintain the transaction-related docu-
that reasonably address the heightened legal or
mentation provided to senior management as
reputational risks presented by the transaction.
well as other documentation, such as minutes of
Any representations or assurances provided by a
the relevant senior management committee, that
customer should be obtained before a transac-
reflect senior management’s approval (or disap-
tion is executed and be received from, or
proval) of the transaction, any conditions
approved by, an appropriate level of the custom-
imposed by senior management, and the factors
er’s management. A financial institution should
considered in taking such action. The institution
decline to participate in an elevated-risk CSFT
should retain documents created for elevated-
if, after conducting appropriate due diligence
risk CSFTs in accordance with its record reten-
and taking appropriate steps to address the risks
tion policies and procedures as well as appli-
from the transaction, the institution determines
cable statutes and regulations.
that the transaction presents unacceptable risk to
the institution or would result in a violation of
applicable laws, regulations, or accounting
principles. Other Risk-Management Principles for
Elevated-Risk CSFTs
Documentation. The documentation that finan-
cial institutions use to support CSFTs is often General business ethics. The board and senior
highly customized for individual transactions management of a financial institution also should
and negotiated with the customer. Careful gen- establish a ‘‘tone at the top’’ through both
eration, collection, and retention of documents actions and formalized policies that sends a
associated with elevated-risk CSFTs are impor- strong message throughout the financial institu-
tant control mechanisms that may help an insti- tion about the importance of compliance with
tution monitor and manage the legal, reputa- the law and overall good business ethics. The
tional, operational, market, and credit risks board and senior management should strive to
associated with the transactions. In addition, create a firm-wide corporate culture that is
sound documentation practices may help reduce sensitive to ethical or legal issues as well as the
unwarranted exposure to the financial institu- potential risks to the financial institution that
tion’s reputation. may arise from unethical or illegal behavior.
A financial institution should create and col- This kind of culture coupled with appropriate
lect sufficient documentation to allow the insti- procedures should reinforce business-line own-
tution to— ership of risk identification and encourage per-
sonnel to move ethical or legal concerns regard-
• document the material terms of the transaction; ing elevated-risk CSFTs to appropriate levels of
• enforce the material obligations of the management. In appropriate circumstances,
counterparties; financial institutions may also need to consider
• confirm that the institution has provided the implementing mechanisms to protect personnel
customer any disclosures concerning the trans- by permitting the confidential disclosure of con-
cerns.9 As in other areas of financial institution
8. The control processes that a financial institution estab-

lishes for CSFTs should take account of, and be consistent 9. The agencies note that the Sarbanes-Oxley Act of 2002
with, any informational barriers established by the institution requires companies listed on a national securities exchange or
to manage potential conflicts of interest, insider trading, or inter-dealer quotation system of a national securities associa-
other concerns. tion to establish procedures that enable employees to submit

Page 5
management, compensation and incentive plans procedures related to elevated-risk CSFTs. Inter-
should be structured, in the context of elevated- nal audit should periodically validate that busi-
risk CSFTs, so that they provide personnel with ness lines and individual employees are comply-
appropriate incentives to have due regard for the ing with the financial institution’s standards for
legal-, ethical-, and reputational-risk interests of elevated-risk CSFTs and appropriately identify-
the institution. ing any exceptions. This validation should
include transaction testing for elevated-risk
Reporting. A financial institution’s policies and CSFTs.
procedures should provide for the appropriate
levels of management and the board of directors Training. An institution should identify relevant
to receive sufficient information and reports personnel who may need specialized training
concerning the institution’s elevated-risk CSFTs regarding CSFTs to be able to effectively per-
to perform their oversight functions. form their oversight and review responsibilities.
Appropriate training on the financial institu-
Monitoring compliance with internal policies tion’s policies and procedures for handling
and procedures. The events of recent years elevated-risk CSFTs is critical. Financial insti-
evidence the need for an effective oversight and tution personnel involved in CSFTs should be
review program for elevated-risk CSFTs. A familiar with the institution’s policies and pro-
financial institution’s program should provide cedures concerning elevated-risk CSFTs, includ-
for periodic independent reviews of its CSFT ing the processes established by the institution
activities to verify and monitor that its policies for identification and approval of elevated-risk
and controls relating to elevated-risk CSFTs are CSFTs and new complex structured finance
being implemented effectively and that elevated- products and for the elevation of concerns
risk CSFTs are accurately identified and have regarding transactions or products to appropriate
received proper approvals. These independent levels of management. Financial institution per-
reviews should be performed by appropriately sonnel involved in CSFTs should be trained to
qualified audit, compliance, or other personnel identify and properly handle elevated-risk CSFTs
in a manner consistent with the institution’s that may result in a violation of law.
overall framework for compliance monitoring,
which should include consideration of issues
such as the independence of reviewing person-
nel from the business line. Such monitoring may
CONCLUSION
include more-frequent assessments of the risk Structured finance products have become an
arising from elevated-risk CSFTs, both individu- essential and important part of the U.S. and
ally and within the context of the overall cus- international capital markets, and financial insti-
tomer relationship, and the results of this moni- tutions have played an important role in the
toring should be provided to an appropriate level development of structured finance markets. In
of management in the financial institution. some instances, however, CSFTs have been
used to misrepresent a customer’s financial con-
Audit. The internal audit department of any dition to investors and others, and financial
financial institution is integral to its defense institutions involved in these transactions have
against fraud, unauthorized risk taking, and sustained significant legal and reputational harm.
damage to the financial institution’s reputation. In light of the potential legal and reputational
The internal audit department of a financial risks associated with CSFTs, a financial institu-
institution should regularly audit the financial tion should have effective risk-management and
institution’s adherence to its own control proce- internal control systems that are designed to
dures relating to elevated-risk CSFTs, and fur- allow the institution to identify elevated-risk
ther assess the adequacy of its policies and CSFTs; to evaluate, manage, and address the
concerns regarding questionable accounting or auditing mat-
risks arising from such transactions; and to
ters on a confidential, anonymous basis. (See 15 USC 78j- conduct those activities in compliance with
1(m).) applicable law.

Page 6
Management of Insurable Risks
Bank management is responsible for controlling the probability of losses and the net costs
risk at a level deemed acceptable for the orga- associated with them. In that context, cost is
nization. An effective risk-management pro- broadly defined to include—
gram begins with the identification of exposures
that could disrupt the timely and accurate deliv- • the direct and consequential cost of loss-
ery of business services or result in unexpected prevention measures (controls), plus
financial claims on bank resources. Risk man- • insurance premiums, plus
agement also involves the implementation of • losses sustained, including the consequential
cost-effective controls and the shifting, transfer, effects and expenses to reduce such losses,
or assignment of risk to third parties through minus
insurance coverage or other risk-transfer tech- • recoveries from third parties and indemnities
niques. Although the design and sophistication from insurers on account of such losses, plus
of risk-management procedures varies from bank • pertinent administrative costs.
to bank, each institution’s decision-making pro-
cess should effectively identify; control; and, Bank risks with potentially high or even
when or where appropriate, result in some catastrophic financial consequences should be
transfer of risk. The risk-assessment program eliminated or substantially mitigated whenever
should be conducted annually to establish possible, even when the risk’s frequency of
whether potential service disruptions and esti- occurrence is low. These risks can be eliminated
mated risk-related financial costs and losses can by discontinuing operations where appropriate
be contained at levels deemed acceptable to or by assigning the risk exposure to other parties
bank management and the board of directors. using third-party service providers. When the
Note that insurance can provide a bank with the exposure cannot be shifted to other parties or
resources to restore business operations and otherwise mitigated, the bank must protect itself
financial stability only after an unanticipated with appropriate levels of insurance. Certain
event has occurred, but a bank’s own risk- loss exposures may be deemed reasonable
management controls can prevent and minimize because their probability of frequency and
losses before they occur. severity of loss are low, the level of expected
financial loss or service disruption is minimal,
or the costs associated with the recovery of
assets and restoration of services are low.
RISK-MANAGEMENT PROGRAM Bank management may decide to reduce
insurance premiums and claims-processing
A sound operational risk-management program costs by self-insuring for various types of
requires the annual review of all existing busi- losses, setting higher deductible levels, lower-
ness operations and a risk assessment of all ing the coverage limits for insurance pur-
proposed services. Identified risks should be chased, and narrowing coverage terms and con-
analyzed to estimate their potential and prob- ditions. A financial organization’s primary
able levels of loss exposure. While the histori- defenses against loss are adequate internal con-
cal loss experience of the bank and other service trols and procedures, which insurance is
providers may be helpful in quantifying loss intended to complement, not replace. Thus, an
exposure, technological and societal changes overall appraisal of the organization’s control
may result in exposure levels that differ from environment is a significant consideration in
historical experience. Nevertheless, current determining the adequacy of the insurance pro-
exposure estimates should be derived from the gram. To the extent that controls are lacking,
bank’s historical loss experience and augmented the need for additional insurance coverage
with industry experience. In addition, the bank’s increases. These determinations should be
insurance broker or agent should be a source of based on the results of the risk assessment and
advice. be consistent with the limits established by the
Management must decide the most appropri- board of directors. Insurance decisions may
ate method for addressing a particular risk. also be influenced by the insurance broker’s
Although many factors influence this decision, advice regarding current insurance market and
the purpose of risk management is to minimize premium trends.

Page 1
4040.1 Management of Insurable Risks
Following September 2001, insurance com- costs, often exceed expectations. In addition, it
panies reevaluated their position on providing can be difficult to identify potential sources of
coverage for acts of terrorism. As a result, liability exposure.
terrorism coverage has become expensive or The third category, personnel risk, concerns
unavailable. The bank’s ‘‘schedule of insur- those exposures associated with the loss of key
ance’’ should note which policies contain exclu- personnel through death, disability, retirement,
sions, sublimits, or large deductibles for losses or resignation, as well as threats to all employ-
incurred as a result of terrorism. ees and third parties arising out of crimes such
When selecting insurance carriers, banks as armed robbery and extortion. The conse-
should consider the financial strength and claims- quences of personnel loss are often more pro-
paying capacity of the insurance underwriter, as nounced in small and medium-sized banks that
well as the robustness or strength of the super- do not have the financial resources to support a
visory regime to which the insurer is subject. broad level of management.
This procedure is important for all significant
policy-coverage lines. Rating agencies typically
consider a number of insurers vulnerable, and
some underwriters may have large environmen-
tal exposures but capped equity resources. Many INSURANCE PROGRAM
large commercial enterprises acquire insurance
coverage from foreign companies or from sub- Program Objectives
sidiaries of U.S. insurers domiciled in the Car-
ibbean or other countries. The quality of insur-
ance supervision in many foreign countries may A bank’s insurance program should match the
not meet the standards expected in the United objectives of its management, the director-
States. approved risk guidelines, and its individual risk
profile. Insurance is primarily the transfer of
the financial effect of losses and should be con-
sidered as only a part of the broader risk-
TYPES OF RISKS management process. In that sense, it is
imperative that management understands the
Business risks generally fall into three catego- costs and benefits of the bank’s insurance
ries: (1) physical property damage, (2) liability program.
resulting from product failure or unintended Due to the fluid nature of the insurance
employee performance, and (3) loss of key market and insurance products, there is no
personnel. Common property risks are fires or standard program or contract structure. Rather,
natural disasters such as storms and earth- many different insurance policies, coverages,
quakes, but acts of violence or terrorism can also endorsements, limits, deductibles, and payment
be included in this category. Risk-management plans fit together to form an insurance program.
programs for property damage should consider Based on the size and scope of a bank’s opera-
not only the protection and replacement of the tions, broader or narrower coverage, higher or
physical plant, but also the effects of business lower limits, and separate policies may be pur-
interruptions, loss of business assets, and recon- chased. Insurance programs should be custom-
struction of records. ized to the risks that each bank faces. If a bank
Insurance programs increasingly cover the is particularly susceptible to a specific risk,
consequences of the second category, product purchasing additional insurance for that risk
failure or unintended employee performance. may be prudent.
These risks include the injury or death of A policy’s deductible size and coverages, and
employees, customers, and others; official mis- the limits purchased, determine how much risk
conduct; and individual and class-action law- the bank has retained. Likewise, the payment
suits alleging mistreatment or the violation of plan of an insurance policy greatly influences
laws or regulations. All aspects of a bank’s the amount of risk transferred. An insurance
operation are susceptible to liability risks. While policy alone does not represent significant risk
property-loss levels can be estimated with rela- transfer if the payment plan includes reimburse-
tive confidence, jury awards for personal injury ment to the insurance company for all losses,
or product liability, and the related litigation usually subject to a maximum. These reimburse-

Page 2
Management of Insurable Risks 4040.1
ment, loss-sensitive, or retrospectively rated protection and the $1 million deductible. A

plans can be viewed more as a risk-financing $5 million policy limit with a $1 million SIR
tool than as risk transfer. Management should provides $5 million in protection after the $1 mil-
understand and quantify the total ‘‘all-in’’ cost lion dollar SIR is paid by the bank. As in any
of these plans, as well as how these costs clause of an insurance contract, the terms can be
correspond with the risk guidelines approved by negotiated so a deductible does not reduce the
the directors. limits.
‘‘Occurrence’’ and ‘‘claims made’’ are two
separate types of coverage bases of policies that
Common Insurance-Policy differ as to the period protected, when claims are
Components and Concepts recognized, and when the policies are ‘‘trig-
gered’’ or respond. Under an occurrence, or
There is a difference between ‘‘policy’’ and ‘‘loss-sustained,’’ form the amount and type of
‘‘coverage,’’ but the two terms are often used coverage (if any) for the loss event is based on
interchangeably. The term ‘‘policy’’ usually the policy that was in force when the event took
refers to the actual insurance contract, while the place or occurred, regardless of when a claim is
term ‘‘coverage’’ refers to the types of risks to submitted. Under a claims-made, or ‘‘discov-
which the policy is designed to respond. For ery,’’ policy, the insurance policy in force when
example, a directors’ and officers’ policy may the loss event was discovered and reported to
include employment-practices liability (EPL) the insurance company would apply, regardless
coverage. However, the bank may also purchase of when the event causing the claim occurred.
a separate EPL policy Both types of policies have provisions regarding
An ‘‘endorsement’’ is a modification to a prompt claims-reporting to insurers. However,
policy. Endorsements can be either a simple claims-made policies are usually stricter and
change in wording from the original contract or their coverage may be compromised by failing
a more complex addition or deletion of a cov- to report claims in a timely manner.
erage section. To expand on the example above,
EPL coverage is often endorsed onto a directors’
and officers’ policy. When an endorsement adds Self-Insurance or Alternative Risk
a coverage to a policy, it is often called a Transfer
‘‘rider.’’
The ‘‘limit of insurance’’ is the dollar amount There are numerous nontraditional insurance
of insurance protection purchased. Each policy programs that larger, more complex banking
has a different limit, and some may have sepa- organizations employ. These programs include,
rate limits for separate coverages provided under but are not limited to, captive insurance compa-
the same policy. Policies usually include a nies, individual or group self-insurance, risk-
‘‘per-occurrence’’ and an ‘‘aggregate’’ limit. retention groups, and purchasing groups. These
The per-occurrence limit is the most the insurer alternative risk-transfer (ART) programs are
will pay under the policy for any one insured complex, and they should include common bank
event, while the policy aggregate is the most the policies and procedures. For example, the bank
insurer will pay in total, regardless of the should have access to individuals with insurance
number and size of insurable events. expertise. Outside consultants, qualified insur-
‘‘Deductibles’’ and ‘‘self-insured retentions ance brokers, and bank directors or management
(SIRs)’’ are the dollar amounts the bank must with insurance expertise are an integral part of a
contribute to the loss before insurance applies.1 successful ART program. The ART program
They are effectively the same concept, with the should also incorporate stop-loss provisions and
difference being a deductible reduces the limits reinsurance coverage to cap the organization’s
of insurance while a SIR does not. A deductible exposure to severe claims or unexpected loss
is included within or as part of the limits. A SIR experience.
is outside or in addition to the provided limits.
For example, a $5 million policy limit with a
$1 million deductible consists of $4 million of COMMON POLICIES AND
COVERAGES
1. An organization can maintain an unfunded reserve for
loss-retention purposes. The following is not intended to be a compre-

Page 3
hensive list of policies and coverages available, In addition to the basic four FIB insuring
but rather a listing and description of those that agreements, Forgery or Alteration (Clause D)
banks most frequently purchase. The list is and Securities (Clause E) may also appear on
divided into three general types of insurance: the standard form. (These coverages may not be
liability, property, and life insurance. A fourth a component of the most basic insurance pro-
category is included for aircraft and aviation gram for a small bank.) Significant enhance-
insurance, which consists of various types of ments and additional coverages are often endorsed
property and liability coverage. While this last onto the FIB. Any misrepresentation, omission,
coverage category may be unnecessary for most concealment, or incorrect statement of material
banking organizations, for those institutions that fact in the insurance application is grounds for
do have exposure to risks associated with air- recission of the fidelity bond by the underwrit-
craft ownership, the risks may be exceptionally ing insurance company.
large. When the bank under examination is a sub-
sidiary of a bank holding company, and the
holding company has purchased one fidelity
Fidelity Insurance Bond bond to cover all affiliated banks, the examiner
should determine that the policy is sufficient to
Liability insurance is sometimes called ‘‘third- cover the exposures of the subsidiary bank being
party insurance’’ because three parties are examined. Examiners also should determine that
involved in a liability loss: the insured, the any policy premiums the subsidiary bank pays
insurance company, and the party (the claimant) to the parent holding company are not dispro-
who is injured or whose property is damaged by portionate to the bank’s benefits from the group
the insured. The insurance company pays the policy and that such premiums are consistent
claimant on behalf of the insured if the insured with the fair-market requirements of section
is legally liable for the injury or damage. An 23B of the Federal Reserve Act. Split-limit
insured’s legal liability for injury is often the coverage may reduce protection if a loss involves
result of a negligent act, but there are other the collusion of subsidiary bank employees or
sources of liability. Several examples of liability other affiliates of a bank holding company.
insurance are discussed below.
Fidelity bond coverage provides reimburse-
ment for loss from employee dishonesty; rob- Clause A: Fidelity (Employee Dishonesty)
bery; burglary; theft; forgery; mysterious disap-
pearance; and, in specified instances, damage to Clause A covers losses resulting directly from
offices or fixtures of the insured. Coverage dishonest or fraudulent acts an officer or
applies to all banking locations except auto- employee commits, either acting alone or in
mated teller machines, for which coverage must collusion with others. The employee must have
be specifically added. All banks should obtain had a manifest intent to cause a loss to the
fidelity bond coverage that is appropriate for financial institution, and the employee or another
their business needs. person or entity must obtain financial benefit
The most widely used form of fidelity bond is from the dishonest or fraudulent act. Officers,
the Financial Institution Bond (FIB), Standard attorneys retained by the bank, persons provided
Form No. 24 (formerly named the bankers’ by an employment contractor, and nonemployee
blanket bond). Standard Form No. 24 is a data processors who are performing services for
claims-made, or discovery, form. The ‘‘basic’’ the insured are typically all considered ‘‘employ-
FIB has four insuring agreements or parts. ees.’’ If any of the loss results from loans, that
Employee Dishonesty/Fidelity (Clause A) cov- part of the loss is covered only if the employee
ers dishonest or fraudulent acts committed by was in collusion with other parties to the trans-
employees. On-Premises (Clause B) covers action and the employee received a minimum
losses from burglary, misplacement, or an unex- financial-benefit amount, as specified in the
plained disappearance that occurs on premises. policy. (‘‘Financial benefit’’ does not include
In-Transit (Clause C) covers losses from bur- any employee benefits earned in the normal
glary, misplacement, or an unexplained disap- course of employment, including salaries, com-
pearance that occurs while the property is in missions, fees, bonuses, promotions, awards,
transit. Counterfeit Currency (Clause F) covers profit-sharing plans, or pensions.) Clause A
losses from accepting counterfeit currency. should not prevent the recovery of losses from

Page 4
employee dishonesty that are concealed by fic- certificated security, a title, a deed or mortgage,
titious loans. a certificate of origin or title, an evidence of
debt, a security agreement, an instruction to a
Federal Reserve Bank, and a statement of
Clause B: On-Premises uncertificated security of a Federal Reserve
Bank. Coverage is included for certain counter-
Clause B covers losses of property (as defined in feit securities and instruments. The bank must
the bond) that occur on premises as a result of have acted in good faith and had actual physical
robbery, burglary, larceny, misplacement, theft, possession of the original instrument.
or a mysterious and unexplained disappearance.
Under specified conditions, damage to offices
and equipment may be covered under this clause, Clause F: Counterfeit Currency
However, premises coverage should not be con-
fused with standard fire or other types of prop- Clause F provides coverage for losses resulting
erty insurance. from the receipt of counterfeit money. The
coverage is counterfeit money of the United
States, Canada, or any other country where the
Clause C: In-Transit insured maintains a branch office.
Clause C covers loss of property that is in

transit. The property typically must be in the Common FIB Extensions, Riders, or
custody of (1) a natural person acting as a Endorsements
messenger for the insured, (2) a transportation
company transporting the property in an armored Fidelity bond protection can be extended by
motor vehicle, or (3) a transportation company purchasing additional coverage through exten-
transporting the property by means other than an sions, riders, and endorsements. If a bank has
armored motor vehicle. When an armored vehi- significant risk exposures in certain areas, these
cle is not used by a transportation company, additional protections should be considered. The
‘‘property’’ is generally limited to records, cer- most common of these protections are listed
tified securities, and negotiable instruments that below.
are not payable to the bearer, are not endorsed,
and have no restrictive endorsements. Some
insuring agreements insure certain financial Extortion/Threats to Persons or Property
institution employees that carry cash.
The extortion/threats to persons or property
rider insures against loss of property that is
Clause D: Forgery or Alteration surrendered away from a banking office as the
result of a threat to do bodily harm to a director,
Clause D covers forgery, which is the signing of trustee, employee, or relative, or of threats to
the name of another person or organization with damage banking premises or property. While a
the intent to deceive. Clause D also covers bank may add this coverage with a rider to its
losses resulting from the alteration of any nego- FIB, many banks purchase a separate, more
tiable instrument. Evidences of debt, which the comprehensive policy or endorse this coverage
bank receives either over-the-counter or through onto the directors’ and officers’ policy.
clearings, are not usually covered. Fraudulent
items received through an electronic funds trans-
fer system are generally excluded. Trading Losses
The trading-loss rider amends the FIB exclusion
Clause E: Securities by providing coverage for trading losses result-
ing directly from employee dishonesty.
Clause E covers losses that result from a bank’s
extending credit or assuming liability on the
faith of original securities, documents, or writ- Automated Teller Machines
ten instruments that are forged, altered, lost, or
stolen. These include but are not limited to a The automated teller machine (ATM) rider cov-

Page 5
ers losses of money from, or damage to, an Money-Order Issuer’s

unattended ATM that results from robbery, bur-
glary, or theft. With a money-order-issuer’s rider, coverage is
expanded to authorized third parties that issue
registered checks or personal money orders on
Electronic or Computer Systems behalf of the insured.
The electronic or computer-systems rider covers

direct losses caused by fraudulent funds trans-
fers originated through the bank’s computer Liability Insurance
systems. The fraud may be caused by a dishon-
est employee, customer, or third party. Electronic and Computer Crimes
To broaden the electronic and computer-systems
Unauthorized Signatures rider that is normally attached to the FIB, an
additional electronic and computer-crime rider
The unauthorized-signature rider covers losses may be purchased. This rider is a ‘‘companion
resulting from a bank’s acceptance, cashing, or policy’’ that covers losses the bank may incur
payment of any negotiable instrument or with- from having (1) transferred, paid, or delivered
drawal order that bears an unauthorized signa- any funds or property; (2) established any credit;
ture. An ‘‘unauthorized signature’’ is not forged, or (3) debited any account or given value as a
but is the signature of an individual who is not direct result of fraudulent input of electronic
an authorized signatory on the account. data or computer instructions into the insured’s
computer. These losses may result from some-
one’s unauthorized access to a terminal or the
Fraudulent Mortgages bank’s communications lines, or from the fraudu-
lent preparation of tapes or computer programs.
The fraudulent-mortgages rider insures against Under this rider, coverage may include elec-
loan losses that result from a bank’s accepting or tronic funds transfer systems, the bank’s propri-
acting on mortgages or deeds of trust that have etary systems, and voice instructions given over
defective signatures. ‘‘Defective signatures’’ are the telephone. Losses caused by software pro-
those obtained through fraud or trickery or grammers and consultants, ATM systems, com-
under false pretenses. puter viruses, software piracy, computer extor-
tion, and facsimiles may also be covered.
Counterfeit Checks
Excess Bank Employee Dishonesty Bond
The counterfeit-check rider insures against loss
from counterfeit checks and other negotiable The excess bank employee dishonesty bond
instruments. The coverage applies whether or adds limits over and above the FIB. Often an
not the counterfeit instruments are forged. FIB cannot be purchased with limits that are
large enough to satisfy the risk-transfer needs of
larger banks. When this occurs, the bank may
Service Contractors purchase an excess bond that would respond if a
claim is larger than the per-occurrence limits on
The service-contractor rider covers loss result- the FIB or if the aggregate limit of the FIB has
ing from fraudulent or dishonest acts committed been exhausted. The most common form of this
by a servicing contractor. A ‘‘servicing contrac- coverage is the excess bank employee dishon-
tor’’ services real estate and home-improvement esty blanket bond, Standard Form No. 28.
mortgages, as well as tax and insurance escrow
accounts; manages real property; or provides
other related services. The coverage extends to Combination Safe Depository
losses resulting from the contractor’s failure to
forward collected funds to the bank when the Combination safe depository insurance consists
servicing contractor has committed to do so. of two coverage sections that can be purchased

Page 6
together or separately. Coverage (A) applies to rity Act of 1974 (ERISA). For protection against
losses when the bank is legally obligated to pay exposure arising from a breach of fiduciary duty
for loss of a customer’s property held in safe under ERISA, a special ERISA errors and omis-
deposit boxes (including loss from damage or sions endorsement is required (also called fidu-
destruction). Coverage (B) generally covers loss, ciary or employee benefit plan liability). In
damage, or destruction of property in custom- addition to bank trust departments, banks whose
ers’ safe deposit boxes, whether or not the bank only fiduciary responsibilities relate to their
is legally liable, when the loss results from an employee benefit plan should consider this cov-
activity other than employee dishonesty, such as erage. A related specialized coverage called
robbery or burglary. IRA/Keogh errors and omissions is also available.
For properties held or managed by a bank’s
trust department, a master or comprehensive
policy is often obtained instead of individual
Directors’ and Officers’ Liability policies. A master policy protects the trust-
account properties from fire or other loss and
Directors’ and officers’ (D&O) liability insur- insures the accounts and the bank against third-
ance usually has three coverage parts: Side A, party liability in connection with the properties.
Side B, and Entity Securities Coverage (C). Side The master policy does not usually cover claims
A covers the directors and officers individually by trust customers against the bank for negli-
for alleged wrongful acts. Side B reimburses the gence, errors, or violations resulting in loss to
bank for money it has paid to or on behalf of its fiduciary accounts. However, separate fiduciary
directors and officers to indemnify them for (or trust department) errors and omissions poli-
damages they may be liable for as a result of cies incorporate these areas.
alleged wrongful acts. Entity Securities Cover-
age protects the corporation against securities
claims. Subject to many exclusions and defini-
tions, a ‘‘wrongful act’’ means any actual or Trust Errors and Omissions
alleged act, error, omission, misstatement, mis-
Trust errors and omissions insurance provides
leading statement, neglect, or breach of duty.
coverage for wrongful acts while the bank is
D&O policies are primarily written on a claims-
acting as trustee, guardian, conservator, or ad-
made basis. Larger banks will purchase excess
ministrator. This is a claims-made policy that
D&O coverage. Like the FIB, there are numer-
can be endorsed onto the D&O policy.
ous coverages or enhancements that can be
endorsed onto a D&O policy.
Entity errors and omissions. The entity errors Employment-Practices Liability

and omissions (E&O) insurance rider extends
coverage to the financial institution as an entity Employment-practices liability (EPL) insurance
for wrongful acts. A separate, more robust E&O provides coverage for an entity against em-
policy may also be purchased. The separate ployee claims of wrongful termination, discrimi-
policy is commonly referred to as bankers’ nation, sexual harassment or ‘‘wrongful employ-
professional liability. ment acts.’’ This is usually a claims-made policy
that can be endorsed onto the D&O policy.
Fiduciary liability and ERISA errors and omis-
sions. Fiduciary liability (or fiduciary errors and
omissions) extends insurance coverage for man- Bankers’ Professional Liability
agement of the bank’s own employee pension or
profit-sharing plans. A separate, more robust Bankers’ professional liability (BPL-E&O) pro-
fiduciary policy may be purchased to expand vides coverage for claims resulting from any
further the coverage of the bank’s management actual or alleged wrongful acts, errors, or omis-
of its own plans. Without this additional special sions bank employees commit in the perfor-
endorsement, neither the fiduciary errors and mance of professional duties. Coverage can be
omissions nor the bank’s directors’ and officers’ broadened to include securities E&O, insurance
liability insurance will cover liability arising agent E&O, brokerage service E&O, and notary
under the Employee Retirement Income Secu- E&O.

Page 7
Mortgage Impairment statutory coverage of workers’ compensation is

a no-fault system intended to benefit both the
Mortgage-impairment insurance coverage pro- injured employee and the employer.
tects the bank’s interest, as mortgagee, from loss
when contractually required insurance on real
property held as collateral has inadvertently not Automobile Liability and Physical
been obtained. Upon discovery of the lack of Damage
required coverage, the bank has a limited time to
either induce the borrower to obtain the required Automobile liability insurance provides third-
insurance or to place the insurance on its own. party liability protection for bodily injury or
property damage resulting from accidents that
involve the bank’s vehicles. First-party cover-
Mortgage Errors and Omissions age for damage to the vehicles is also provided.
This coverage should be extended to include—
Mortgage errors and omissions insurance, a
broader version of mortgage-impairment cover- • nonowned and hired coverage, if employees
age, provides coverage for direct damage and use personal autos or rent autos while on bank
E&O losses to either the bank or the borrower. business;
Mortgage E&O coverage also applies to the • coverage for autos that have been repossessed;
bank’s mishandling of real estate taxes, life and and
disability insurance, and escrowed insurance • garage-keeper’s liability, if the bank rents its
premiums. Claims must result in a loss to the parking facilities to customers or the public.
mortgaged property.
Commercial General Liability Umbrella and Excess Liability
Commercial general liability (CGL) insurance Umbrella and excess liability insurance offers
protects against claims of bodily injury or prop- additional liability limits in excess of the cov-
erty damage for which the business may be erage limits of any policy over which it
liable and which may arise from the bank’s ‘‘attaches’’ or becomes effective. Basic umbrella
premises, operations, and products. In addition coverage attaches to CGL and automobile insur-
to bodily injury and property damage, CGL can ance and to the employers’ liability section of
include liability coverage for various other workers’ compensation policies. An excess lia-
offenses that might give rise to claims, such as bility policy attaches over an umbrella policy.
libel, slander, false arrest, and advertising injury. More complex insurance programs may include
A CGL policy can be underwritten on either an both umbrella and excess liability policies that
occurrence or a claims-made basis. attach over the D&O, E&O, EPL, or other
insurance.
Workers’ Compensation and Employers’

Liability
Property Insurance
Workers’ compensation insurance covers inju-
ries or deaths of employees caused by accidents Several types of insurance coverage are avail-
in the course of employment. Workers’ compen- able to help banks recover from property dam-
sation insurance consists of two basic coverage age. Some of the more common types of prop-
parts: statutory benefits and employers’ liability erty coverages are briefly described below.
(EL). The two are mutually exclusive remedies
to an employee injured on the job. EL protects a
company from a lawsuit filed by an employee, Broad Form Property Insurance
while statutory benefits coverage provides medi-
cal care and long-term disability, death, or other Property insurance insures against the loss of or
benefits. State laws govern these provisions, so damage to real and personal property. The loss
the provisions differ from state to state. The or damage may be caused by perils such as fire,

Page 8
theft, windstorm, hail, explosion, riot, aircraft, Business Interruption

motor vehicles, vandalism, malicious mischief,
riot and civil commotion, and smoke. Business-interruption insurance indemnifies the
insured against losses arising from its inability
to continue normal operations and functions of
Fire the business. Coverage is triggered by the total
or partial suspension of business operations due
Fire insurance covers all losses directly attrib- to the loss of, loss of use of, or damage to all or
uted to fire, including damage from smoke or part of the bank’s buildings, plant machinery,
water and chemicals used to extinguish the fire. equipment, or other personal property, when the
Additional fire damage for the building contents loss is the result of a covered cause.
may be included, but often is written in combi- Contingent business-interruption insurance is
nation with the policy on the building and also available to cover the bank’s loss of earn-
permanent fixtures. Most fire insurance policies ings caused by a loss to another business that is
contain ‘‘co-insurance’’ clauses, meaning that one of its major suppliers or customers. This
insurance coverage must be maintained at a insurance is also known as ‘‘business income
fixed proportion of the replacement value of the from dependent properties.’’
building. If a bank fails to maintain the required
relationship of protection, all losses will be
reimbursed at the ratio of the amount of the Crimes
insurance carried to the amount required, applied
to the value of the building at the time of the Crime insurance covers money, securities, mer-
loss. When determining insurable value for fire chandise, and other property from various crimi-
insurance purposes, the basis typically is the nal causes of loss, such as burglary, robbery,
cost of replacing the property with a similar kind theft, and employee dishonesty.
or quality at the time of loss. Different types of
values, however, may be included in policies,
and care should be taken to ensure that the bank Data Processing
is calculating the correct value for its needs.
Data processing insurance coverage provides
loss protection if data processing systems break
down. This insurance also covers the additional
Business Personal Property expense incurred in making the system opera-
tional again.
Traditionally known as ‘‘contents’’ insurance,
business personal property insurance affords
insurance protection coverage for the furniture,
fixtures, equipment, machinery, merchandise, Difference in Conditions
materials, and all other personal property owned
A difference-in-conditions (DIC) insurance con-
by the bank and used in its business.
tract is a separate coverage that expands or
supplements property insurance that was written
on a named-perils basis. A DIC policy will
Blanket Coverage cover the property on an all-risk basis, subject to
certain exclusions.
Blanket insurance covers, in a single contract,
either multiple types of property at a single
location or one or more types of property at Ocean and Inland Marine
multiple locations.
Ocean marine insurance covers ships and their
cargo against such causes as fire, lightning, and
Builder’s Risk ‘‘perils of the seas.’’ These include high winds,
rough waters, running aground, and collision
Builder’s-risk insurance is commercial property with other ships or objects.
coverage specifically for buildings that are in the Inland marine insurance was originally
course of construction. developed to provide coverage for losses to

Page 9
cargo transported over land. It now covers Life Insurance

limited types of property in addition to goods in
transit. Common types of life insurance policies pur-
chased by banks are described below.
Valuable Papers and Destruction of

Records Key Person
Valuable-papers and destruction-of-records When the death of a bank officer, or key person,
insurance coverage is for the physical loss or would be of such consequence to the bank as to
damage to valuable papers and records of the give it an insurable interest, key-person life
insured. The coverage includes practically all insurance would insure the bank on the life of
types of printed documents or records except this individual.
money.
Split-Dollar
Accounts Receivable
In split-dollar life insurance, the purchaser of the
Accounts-receivable insurance covers losses that policy pays at least part of the insurance premi-
occur when an insured is unable to collect ums and is entitled to only a portion of the cash
outstanding accounts because of damage to or surrender value, death benefit, or both. See
destruction of the accounts-receivable records SR-93-37 (‘‘Split-Dollar Life Insurance,’’ June
that was caused from a peril covered in the 18, 1993) and its attachments for further discus-
policy. sion of the Federal Reserve’s position on these
arrangements between bank holding companies
and their subsidiary banks.
Cash Letters
Bank-Owned
Cash-letter insurance covers the costs for repro-
ducing cash-letter items and items that remain Bank-owned life insurance consists of tax-
uncollectible after a specified period of time. advantaged insurance policies that are pur-
Generally, these policies do not cover losses due chased to cover the lives of bank officers and
to dishonest acts of employees. other highly compensated employees. The poli-
cies may be used as a funding mechanism for
employee pension and benefit plans. The bank is
First-Class, Certified, and Registered the owner and beneficiary of the policy, and the
Mail cash value of the policy is considered an asset of
the bank.
The insurance coverage for first-class, certified,
and registered mail provides protection on the
shipment of property sent through the mail, as
well as during transit by messenger or carrier to Aircraft or Aviation Insurance
and from the post office. The insurance is
principally used to cover registered mail in Although aviation-liability exposures are fre-
excess of the maximum $25,000 insurance pro- quently overlooked in the myriad of other finan-
vided by the U.S. Postal Service. cial institution exposures, they have tremendous
potential for large catastrophic losses and must
be addressed by senior risk-management execu-
Commercial Multiple Peril tives at all financial institutions. Often hidden or
obscure, aviation liability ranges from the more
Commercial multiple peril insurance encom- typical owned and nonowned liability and
passes a range of insurance coverages, including physical-damage exposures to the more exotic
property and liability. Small institutions may exposures from hangar-keepers, aviation prod-
purchase this package policy when stand-alone ucts, and airport or heliport premises. In view of
polices are excessive or inefficient. the specialized nature of aviation exposures, it is

Page 10
important that the bank deal with knowledge- aircraft hull, borrowers should be required to
able and experienced agents or brokers and maintain full-value, all-risk physical-damage in-
underwriters in developing its aviation insur- surance (both ground-risk and in-flight cover-
ance program. While exposure categories over- age) in favor of the bank. However, a number of
lap significantly, the following summary high- warranties in aircraft insurance policies could
lights the key areas of concern to most financial void the contract, so bankers are further advised
institutions. to require that a borrower’s hull insurance pol-
icy contain a breach-of-warranty endorsement to
protect the bank if the borrower or owner
Aviation Liability violates provisions of the policy. The under-
writer should agree to give the bank at least 30
Aviation liability insurance can be written to days’ advance notice of any change in the
include aviation-products liability, all owned or policy. Depending on the use of the aircraft,
nonowned exposures, and passenger liability. A special consideration should be given to the
bank’s umbrella liability insurance program territorial limits of coverage, as well as to
should also apply over the aviation policy’s confiscation protection. Since breach-of-warranty
limit. endorsements, like aircraft insurance policies,
are far from standard, it is important that the
Nonowned Exposures bank understand and agree with the underwrit-
er’s language. It is particularly appropriate to
While many banks do not feel the need for review the consequences of potential recovery
aviation insurance because they do not own an to the lien holder if the aircraft is damaged while
aircraft, they may overlook liability exposures a delinquency exists on the note.
from nonowned aircraft and may, in fact, need
this coverage. For example, an employee may
use a personal aircraft on bank business, or lease Bank as Lessor
or rent an aircraft to ferry customers or employ-
ees to a distant meeting. Financing or leasing an If the bank’s security interest is that of the
aircraft could create a nonowned exposure, even lessor, aviation liability insurance should be
though the aircraft is not under bank control. carried by the bank as lessor and also by the
Most aviation-underwriting markets have pro- customer as lessee. In certain cases, it may be
grams available to meet the above exposures. appropriate to require the lessee, through his or
However, additional exposures may require spe- her underwriter, to provide the equivalent of the
cial coverage. Banks should consider the follow- breach-of-warranty endorsement to the liability
ing situations: program and physical-damage coverage. The
bank may also consider obtaining contingent
• If the bank repairs and maintains the aircraft, lessor’s liability.
it may incur a products-liability exposure after
control is relinquished to others, such as when
the aircraft is sold. Airport Premises and Hangar-Keepers
• If the bank finances aircraft, maintaining only
a security interest, it becomes an owner when Airport-premises and hangar-keeper’s insurance
it repossesses the aircraft. In this case, there apply if the bank repossesses real estate on
could be a definite need for both liability and which an airport facility exists and continues to
physical-damage coverage. The coverage may operate, or if the bank permits use of the facility
be written at the time of repossession pending further sale. In either case, the bank
or negotiated in advance of the need for it. may assume liability exposures associated with
The bank should not attempt to continue the control tower, as well as airport-premises
coverage for its exposure under the borrow- liability. Both the bank’s comprehensive general
er’s policy. liability and aviation liability programs should
be reviewed for proper coverage.
If the bank owns or operates a hangar for its
All-Risk Physical Damage aircraft and attempts to share the burden of costs
with others by renting aircraft space, it can pick
To protect the bank’s security interest in an up exposure to hangar-keeper’s liability, unless

Page 11
the contract is properly worded. Appropriate • dates that premiums are due
consideration should be given to hold-harmless • premium amounts
indemnification clauses, any regular or special • claim-reporting procedures
insurance requirements, and waivers of
subrogation. In preparation for policy renewal, the bank’s
risk manager and insurance broker organize
much of the bank’s relevant insurance data into
Accidental Death and Dismemberment a ‘‘submission.’’ The submission may include—
and Travel
• historical, current, and forecasted exposure
Accidental death and dismemberment and travel information, such as sales, number and type of
insurance is another aspect of aviation insurance employees, property characteristics and val-
that banking institutions should consider. Many ues, and number and type of autos;
insurance programs for accidental death and • loss and claim history by line of insurance,
dismemberment and corporate business travel including detailed information on large claims,
accidents exclude coverage in corporate-owned, loss development, and litigation;
-leased, or -hired aircraft. Banks need to review • information on company risk-management
the language of these policies carefully to be policies and financials; and
certain that they provide necessary and adequate • specifications on desired coverages, terms and
coverages for the use of such aircraft. conditions, limits, deductibles, and payment
plans.
RECORDKEEPING The submission is delivered to the insurance

company underwriter and forms the basis for
The diversity of available insurance policies and determining premiums, rates, limits, and the
their coverages emphasize the need for banks to program structure. The information may give
maintain a concise, easily referenced schedule the examiner a sense of why premiums and
of their insurance coverage, referred to as the coverages change from year to year and whether
‘‘schedule of insurance.’’ These records should purchased limits are sufficient.
include the following information: Banks should retain the original policies and
supporting documents for appropriate time
• insurance coverages provided, with major periods. Records of losses should also be main-
exclusions detailed tained, regardless of whether the bank was
• the underwriter reimbursed. This information indicates areas
• deductible amounts where internal controls may need to be improved
• upper limits on policies and is useful in measuring the level of risk
• terms of the policies exposure in a particular area.

Page 12
1. To determine whether insurance is effec- sufficient to enable effective risk and insur-
tively integrated into the operational-risk- ance management.
management program, and whether the insur- 4. To ascertain if, and ensure that, the risk
ance is appropriate, in light of the institution’s manager has initiated corrective action when
internal-control environment. policies, practices, procedures, or internal
2. To determine if insurance coverage adequately controls are deficient or when violations of
protects against significant or catastrophic banking laws and regulations have been
loss. noted.
3. To determine if recordkeeping practices are

Page 1
1. If selected for implementation, complete or the value of self-insurance is quantified;

update the ‘‘Bank Risk and Insurance Man- and how ‘‘premiums’’ are accounted for,
agement’’ section of the internal control funded, allocated, and tracked.
questionnaire. 6. Determine whether insurance coverage pro-
2. Test for compliance with policies, practices, vides adequate protection for the bank. The
procedures, and internal controls in conjunc- quality of internal controls and the audit
tion with performing the remaining exami- function must be considered when making
nation procedures. From the examiner this assessment.
who is assigned to ‘‘internal control,’’ obtain a. Determine whether the bank manages its
a listing of any deficiencies noted in the insurance coverage as an element of the
latest review conducted by internal or operational-risk-management program.
external auditors and risk managers. Deter- b. Determine whether the insurance pro-
mine if appropriate corrections have been gram is managed on a corporate-wide
made. basis or within each business unit.
3. Determine if the bank has designated a c. Identify any products, processes, or sys-
qualified risk manager, with expertise in tems that the bank is not able to obtain
insurance programs, to be responsible for insurance coverage for and determine
loss control. If not, determine which officer how the associated risk is being managed.
handles the risk- and insurance-management
d. Determine whether the bank maintains a
function and whether external consultants
database of operational-loss events, the
are employed in designing the insurance
comprehensiveness of the database, and
program.
the claims history of operational losses.
4. Obtain the bank’s schedule of insurance
policies in force and the renewal submis- e. Review the due-diligence process used
sions. If the bank does not maintain a to assess the qualifications of providers
schedule, request that the bank complete a of insurance coverage, including primary
schedule of existing insurance coverage. reinsurers.
a. Determine whether there have been any 7. If the bank’s fidelity insurance has lapsed,
material changes in insurance coverage, determine that the appropriate Federal
limits, or deductibles since the last Reserve Bank has been notified.
examination and the reasons for such 8. Determine that the bank has adequate pro-
changes. Do the changes reflect— cedures to ensure that—
• revised business strategies, the bank a. reports of losses are filed with the bond-
structure, operating processes, or tech- ing company pursuant to policy
nology systems that affect insurable provisions,
risks, and b. premiums are paid before policy expira-
• shifts to self-insurance or co-insurance tion dates,
or a change in insurance carriers? c. policies are renewed without a lapse of
b. If there have been material changes, coverage at expiration dates, and
determine how they are being managed. d. material changes in exposures are reported
5. Using the bank-prepared summary of insur- to the bank’s insurance agent or broker
ance coverage, determine that coverage con- and result in appropriate insurance-
forms to the guidelines for maximum loss policy endorsements.
exposure, as established by the board of
directors. If the procedures are deficient, verify that reports
a. Determine whether the use of insurance have been filed as required and premiums have
is in accordance with board-approved been paid.
risk-management policies and guide-
lines. 9. Review any significant financial institution
b. If the bank self-insures, determine what bond claims that were filed since the last
methods are used for this purpose; how examination to determine—

Page 1
4040.3 Management of Insurable Risks: Examination Procedures
a. any adverse effect on the bank’s condition, policies, practices, procedures, or inter-
b. whether the incident (or incidents) reflects nal controls are deficient;
any deficiencies with respect to internal b. recommended improvements in the risk-
controls and procedures, and management program that relate to
c. whether management has taken appropri- insurance;
ate steps to correct any deficiencies and c. important areas in which insurance cov-
made appropriate reports to the board of erage is either nonexistent or inadequate
directors. in view of current circumstances; and
10. Prepare, in appropriate report form, and d. any other deficiencies noted.
discuss with appropriate officers— 11. Update the workpapers with any informa-
a. recommended corrective action when tion that will facilitate future examinations.

Page 2
Review the bank’s internal controls, policies, broker, direct writer, or consultant to assist
practices, and procedures for its own insurance in selecting and providing advice on alter-
coverage. The bank’s risk-management system native means of providing insurance
should be documented completely and concisely coverage?
and should include, where appropriate, the risk- 5. Does the bank’s security officer coordinate
assessment matrix, a narrative description, flow- his or her activities with the person respon-
charts, the schedule of insurance coverage, pol- sible for handling the operational-risk-
icy forms, renewal submissions, and other management function?
pertinent information. 6. Does the bank maintain a concise, easily
referenced schedule of existing insurance
coverage?
BANK RISK AND INSURANCE 7. Does the bank maintain records, by type of
MANAGEMENT risk, to facilitate an analysis of the bank’s
experience in costs, claims, losses, and
1. Does the bank have established insurance settlements under the various insurance poli-
guidelines that provide for— cies in force?
a. a reasonably frequent, and at least annual, 8. Is a complete schedule of insurance cover-
determination of risks the bank assumes age presented to the board of directors at
or transfers, including high-dollar and least annually for review and approval?
low-probability events? Does the schedule include the respective
b. limits as to the amount of risk that may insurance premiums (net costs), claims, and
be retained or self-insured? loss experience, and is this information
c. periodic appraisals of major fixed assets reviewed as part of this process?
to be insured?
d. a credit or financial analysis of the insur-
ance companies who have issued poli-
cies to the bank? CONCLUSION
2. Does the bank have a risk manager who is
responsible for assessing and developing 1. Is the foregoing information an adequate
controls to deal with the consolidated risks basis for evaluating internal control; that is,
of the institution? there are no significant deficiencies in areas
3. Is the bank’s insurance program managed not covered in this questionnaire that impair
as an element of its overall operational-risk- any controls? Explain negative answers
management program; that is, are insurance briefly, and indicate any additional exami-
coverages reviewed and coordinated by the nation procedures deemed necessary.
person handling the operational-risk- 2. Based on a composite evaluation, as evi-
management function? denced by answers to the foregoing ques-
4. Does the bank use the services of a profes- tions, internal control is considered
sionally knowledgeable insurance agent, (adequate/inadequate).

Page 1
Purchase and Risk Management of Life Insurance
State member banks may purchase bank-owned this guidance to help ensure that institutions’
life insurance (BOLI) as principal if such pur- risk-management processes for BOLI are con-
chases are permitted for national banks and sistent with safe and sound banking practices.
permitted under state law. The legal authority Among the safe and sound banking practices
and guidance for acquiring permissible BOLI discussed in this statement are (1) the need for
and for engaging in insurance activities is dis- senior management and board oversight of BOLI,
cussed within the following interagency state- including both a thorough pre-purchase analysis
ment. When such insurance purchases or insur- of risks and rewards and post-purchase risk
ance activities are not permissible for national assessment and (2) the permissibility of BOLI
banks, a determination of permissibility depends purchases and holdings, as well as their risks
on a decision of the FDIC (1) that the invest- and associated safety-and-soundness consider-
ment or activity would not pose any significant ations. The statement’s appendix [titled appen-
risk to the insurance fund and (2) that the bank dix A for this section of the manual] contains a
continues to comply with the required capital discussion of insurance types and the purposes
standards. for which institutions commonly purchase life
The bank supervisory agencies have concerns insurance, as well as a glossary of BOLI-related
that some banks have committed a significant terminology [titled appendix B for this section].
amount of capital to BOLI without having an The statement’s guidance for the pre-purchase
adequate understanding or a proper assessment analysis of life insurance applies to all BOLI
of the full array of risks it poses—especially contracts entered into after December 7, 2004.
risks that are difficult to measure, such as The guidance concerning the ongoing risk man-
liquidity, transaction/operational, reputation, and agement of BOLI subsequent to its purchase
compliance/legal risks. Banks are therefore applies to all holdings of life insurance regard-
expected to implement appropriate riskless of when purchased. Institutions that pur-
management processes, including meaningful chase life insurance after December 7, 2004,
risk limits, before implementing or adding to a that are not in compliance with this guidance
BOLI program. The following interagency guid- may be subject to supervisory action. Institu-
ance was developed for banks and savings tions that entered into BOLI contracts before
associations (institutions) and examination staff this date will be evaluated according to each
to help ensure that risk-management practices agency’s pre-purchase guidance in effect at that
for BOLI are consistent with safe and sound time.
business practices. The interagency statement Compliance with the supervisory guidance in
was issued on December 7, 2004. this statement regarding permissible uses for
insurance (e.g., recovery of the costs of provid-
ing benefits) does not determine whether the
INTERAGENCY STATEMENT ON policy satisfies state insurable interest
THE PURCHASE AND RISK requirements.
MANAGEMENT OF LIFE
INSURANCE
Legal Authority
This interagency statement1 provides general
guidance for banks and savings associations
National banks may purchase and hold certain
(institutions) regarding supervisory expectations
types of life insurance under 12 USC 24 (Sev-
for the purchase of and risk management for
enth), which provides that national banks may
BOLI. Guidance is also provided for split-dollar
exercise ‘‘all such incidental powers as shall be
arrangements and the use of life insurance as
necessary to carry on the business of banking.’’
security for loans. The agencies are providing
Federal savings associations also may purchase
and hold certain types of life insurance inciden-
1. Adopted by the Board of Governors of the Federal tal to the express powers granted under the
Reserve System (FRB), the Office of the Comptroller of the
Currency (OCC), the Federal Deposit Insurance Corporation
Home Owners’ Loan Act. The OCC and OTS
(FDIC), and the Office of Thrift Supervision (OTS) (the have delineated the scope of these authorities
agencies). through various interpretations addressing the

Page 1
4042.1 Purchase and Risk Management of Life Insurance
permissible use of life insurance by national economically hedging their equity-linked obli-
banks and federal savings associations. gations under employee benefit plans. As dis-
Under these authorities, national banks and cussed more fully in the section on ‘‘Price
federal savings associations may purchase life Risk,’’ for equity-linked variable life insurance
insurance in connection with employee compen- holdings to be permissible, the national bank or
sation and benefit plans, key-person insurance, federal savings association must demonstrate
insurance to recover the cost of providing pre- that—
and post-retirement employee benefits, insur-
ance on borrowers, and insurance taken as • it has a specific, equity-linked obligation; and
security for loans. The OCC and OTS may • both at the inception of the hedge and on an
approve other uses on a case-by-case basis. ongoing basis, changes in the value of the
National banks and federal savings associa- equity-linked variable life insurance policy
tions may not purchase life insurance— are highly correlated with changes in the value
of the equity-linked obligation.
• for speculation;
• to provide funds to acquire shares of stock If a national bank or federal savings association
from the estate of a major shareholder upon does not meet these requirements, the equity-
the shareholder’s death, for the further pur- linked variable life insurance holdings are not
pose of controlling the distribution of owner- permissible. The use of equity-linked variable
ship in the institution; life insurance holdings as a long-term hedge
• as a means of providing estate-planning bene- against general benefit costs is not permissible
fits for insiders, unless the benefit is a part of because the life insurance is not hedging a
a reasonable compensation package; or specific equity-linked liability and does not meet
• to generate funds for normal operating expenses the ‘‘highly correlated’’ requirement.
other than employee compensation and benefits. As a general matter, the ability of state-
chartered banks to purchase insurance (includ-
National banks and federal savings associa- ing equity-linked variable life insurance) is gov-
tions may not hold life insurance in excess of erned by state law. In some instances, state laws
their risk of loss or cost to be recovered. For permit state-chartered banks to engage in activi-
example, once an individual no longer qualifies ties (including making investments) that
as a key person because of retirement, resigna-
tion, discharge, change of responsibilities, or for
any other reason, the risk of loss has been
eliminated. Therefore, national banks and fed-
eral savings associations may be required to
surrender or otherwise dispose of key-person
life insurance held on an individual who is no
longer a key person. Typically, term or declining
term insurance is the most appropriate form of
life insurance for key-person protection.
National banks and federal savings associa-
tions may hold equity-linked variable life insur-
ance policies (that is, insurance policies with a
return tied to the performance of a portfolio of
equity securities held in a separate account2 of
the insurance company) only for the purpose of
2. A separate account is a design feature that is generally

available to purchasers of whole life or universal life whereby
the policyholder’s cash surrender value is supported by assets
segregated from the general assets of the carrier. Under such
an arrangement, the policyholder neither owns the underlying
separate account nor controls investment decisions (e.g.,
timing of investments or credit selection) in the underlying
separate account that is created by the insurance carrier on its
behalf. Nevertheless, the policyholder assumes all investment
and price risk.

Page 2
Purchase and Risk Management of Life Insurance 4042.1
go beyond the authority of a national bank. The will be surrendered before the deaths of those
Federal Deposit Insurance Act (section 24) gen- insured, the possibility that the institution will
erally requires insured state-chartered banks to surrender all of these policies simultaneously
obtain the FDIC’s consent before engaging as and avoid the surrender charges is a gain con-
principal in activities (including making invest- tingency. Under FASB Statement No. 5,
ments) that are not permissible for a national ‘‘Accounting for Contingencies,’’ ‘‘[c]ontingen-
bank. Similarly, the Federal Deposit Insurance cies that might result in gains usually are not
Act (section 28) generally requires a state- reflected in the accounts since to do so might be
chartered savings association to obtain the to recognize revenue prior to its realization.’’
FDIC’s consent prior to engaging as principal in Accordingly, an institution should report each of
activities (including making investments) that the insurance policies on its balance sheet at the
are not permissible for a federal savings asso- policy’s CSV reported by the insurance carrier,
ciation. While insured state-chartered banks and less any applicable surrender charges not reflected
state savings associations may seek the FDIC’s in the reported CSV, without regard to the
consent to make purchases of life insurance that existence of the rider.
would not be within the authority of a national In accordance with the instructions for Con-
bank or federal savings association, such banks solidated Reports of Condition and Income and
and savings associations should be aware that Thrift Financial Reports, an institution should
the FDIC will not grant permission to make life report the carrying value of its BOLI holdings as
insurance purchases if the FDIC determines that an ‘‘other asset’’ and the earnings on these
doing so would present a significant risk to the holdings should be reported as ‘‘other noninter-
deposit insurance fund or that engaging in such est income.’’
purchases is inconsistent with the purposes of The agencies have seen a number of cases in
federal deposit insurance. which institutions have failed to account prop-
erly for a type of deferred compensation agree-
ment, commonly referred to as a revenue-neutral
Accounting Considerations plan or an indexed retirement plan. The account-
ing for such plans is separate and distinct from
the accounting for BOLI. However, because
Institutions should follow generally accepted many institutions buy BOLI to help offset the
accounting principles (GAAP) applicable to life cost of providing such deferred compensation,
insurance for financial and regulatory reporting the agencies have issued guidance addressing
purposes. Financial Accounting Standards Board the accounting requirements for both deferred
(FASB) Technical Bulletin No. 85-4, ‘‘Account- compensation agreements and BOLI. See the
ing for Purchases of Life Insurance’’ (TB 85-4), Interagency Advisory on Accounting for Deferred
discusses how to account for holdings of life Compensation Agreements and Bank-Owned
insurance. Under TB 85-4, only the amount that Life Insurance, dated February 11, 2004, for a
could be realized under an insurance contract as complete description, including examples, of the
of the balance-sheet date (that is, the CSV appropriate accounting treatment.
reported to the institution by the carrier, less any
applicable surrender charges not reflected by the
insurance carrier in the reported CSV) is reported
as an asset. The guidance set forth in TB 85-4
concerning the carrying value of insurance on Supervisory Guidance on BOLI
the balance sheet is generally appropriate for all
forms of BOLI. Before entering into a BOLI contract, institu-
An institution may purchase multiple perma- tions should have a comprehensive risk-
nent insurance policies from the same insurance management process for purchasing and holding
carrier with each policy having its own surren- BOLI. A prudent risk-management process
der charges. In some cases, the insurance carrier includes—
will issue a rider or other contractual provision
stating that it will waive the surrender charges if • effective senior management and board over-
all of the policies are surrendered at the same sight;
time. Because it is not known at any balance- • comprehensive policies and procedures, includ-
sheet date whether one or more of the policies ing appropriate limits;

Page 3
• a thorough pre-purchase analysis of BOLI capital concentration threshold, and any appli-
products; and cable state restrictions on BOLI holdings.3 In
• an effective ongoing system of risk assess- this regard, given the liquidity, transaction/
ment, management, monitoring, and internal operational, reputation, and compliance/legal
control processes, including appropriate inter- risks associated with BOLI, it is generally not
nal audit and compliance frameworks. prudent for an institution to hold BOLI with an
aggregate CSV that exceeds 25 percent of the
The risks associated with temporary (term) insur- institution’s capital as measured in accordance
ance are significantly less than those arising with the relevant agency’s concentration guide-
from holdings of permanent insurance. Accord- lines.4 Therefore, the agencies expect an insti-
ingly, the risk-management process for tempo- tution that plans to acquire BOLI in an amount
rary insurance may take this difference into that results in an aggregate CSV in excess of
account and need not be as extensive as the 25 percent of capital, or any lower internal limit,
risk-management process for permanent to gain prior approval from its board of directors
insurance. or the appropriate board committee. The agen-
cies particularly expect management to justify
that any increase in BOLI resulting in an aggre-
Senior Management and Board Oversight gate CSV above 25 percent of capital does not
constitute an imprudent capital concentration.
The safe and sound use of BOLI depends on An institution holding BOLI in an amount that
effective senior management and board over- approaches or exceeds the 25 percent of capital
sight. Regardless of an institution’s financial concentration threshold can expect examiners to
capacity and risk profile, the board must under- more closely scrutinize the risk-management
stand the complex risk characteristics of the policies and controls associated with the BOLI
institution’s insurance holdings and the role this assets and, where deficient, to require corrective
asset is intended to play in the institution’s action.
overall business strategy. Although the board When seeking the board’s approval to pur-
may delegate decision-making authority related chase or increase BOLI, management should
to purchases of BOLI to senior management, the inform the board members of the existence of
board remains ultimately responsible for ensur- this interagency statement, remind them of the
ing that the purchase and holding of BOLI is illiquid nature of the insurance asset, advise
consistent with safe and sound banking practices. them of the potential adverse financial impact of
An institution holding life insurance in a early surrender, and identify any other signifi-
manner inconsistent with safe and sound bank- cant risks associated with BOLI. Such risks
ing practices is subject to supervisory action. might include, but are not limited to, the costs
Where ineffective controls over BOLI risks associated with changing carriers in the event of
exist, or the exposure poses a safety-and- a decline in the carrier’s creditworthiness and
soundness concern, the appropriate agency may the potential for noncompliance with state insur-
take supervisory action against the institution, able interest requirements and federal tax law.
including requiring the institution to divest
affected policies, irrespective of potential tax
consequences.
3. In July 1999, the OTS adopted a policy that savings
associations may not invest more than 25 percent of their total
capital in BOLI without first notifying and obtaining authori-
Policies and Procedures zation from their OTS Regional Office. In order to maintain
strong and effective communications with institutions under
Consistent with prudent risk-management prac- its supervision, the OTS retains this policy. The other agencies
tices, each institution should establish internal may also institute approval or notification requirements.
4. Each agency’s definition of a concentration differs
policies and procedures governing its BOLI slightly. Institutions should refer to the definition provided by
holdings, including guidelines that limit the their supervisory agency when measuring the CSV of BOLI as
aggregate CSV of policies from any one insur- a percentage of capital: OCC Bulletin 95-7 for national banks;
ance company as well as the aggregate CSV of FRB Commercial Bank Examination Manual, section 2050.1,
for state member banks; FDIC Manual of Examination Poli-
policies from all insurance companies. When cies, section 11.1, for insured state nonmember banks; and
establishing these internal CSV limits, an insti- OTS Thrift Activities Handbook, section 211, for savings
tution should consider its legal lending limit, the associations.

Page 4
Pre-purchase Analysis underscores the importance of carefully evalu-

ating BOLI costs and benefits across multiple
The objective of the pre-purchase analysis is to scenarios, both currently and into the future.
help ensure that the institution understands the
risks, rewards, and unique characteristics of Step 2—Quantify the amount of insurance appro-
BOLI. The nature and extent of this analysis priate for the institution’s objectives. An insti-
should be commensurate with the size and tution should estimate the size of the employee
complexity of the potential BOLI purchases and benefit obligation or the risk of loss to be
should also take into account existing BOLI covered and ensure that the amount of BOLI
holdings. A mark of a well-managed institution purchased is not excessive in relation to this
is the maintenance of adequate records concern- estimate and the associated product risks. When
ing its pre-purchase analyses, usually including using BOLI to recover the cost of providing
documentation of the purpose and amount of employee benefits, the estimated present value
insurance needed. of the expected future cash flows from BOLI,
An effective pre-purchase analysis involves less the costs of insurance, should not exceed the
the following management actions: estimated present value of the expected after-tax
employee benefit costs. In situations where an
Step 1—Identify the need for insurance and institution purchases BOLI on a group of eli-
determine the economic benefits and appropri- gible employees, it may estimate the size of the
ate insurance type. An institution should deter- obligation or the risk of loss for the group on an
mine the need for insurance by identifying the aggregate basis and compare that to the aggre-
specific risk of loss to which it is exposed or the gate amount of insurance to be purchased. This
specific costs to be recovered. It is not appro- estimate should be based on reasonable financial
priate to purchase life insurance to recover a loss and actuarial assumptions. State insurable inter-
that the institution has already incurred. An est laws may further restrict or limit the amount
institution’s purchase of insurance to indemnify of insurance that may be purchased on a group
it against a specific risk of loss does not relieve of employees. Management must be able to
it from other responsibilities related to manag- support, with objective evidence, the reasonable-
ing that risk. The type of BOLI product, e.g., ness of all of the assumptions used in determin-
general5 or separate account, and its features ing the appropriate amount of insurance cover-
should be appropriate to meet the identified age needed by the institution, including the
needs of the institution. The appendix [appendix rationale for its discount rates and cost
A] contains a description of insurance types and projections.
design features.
An institution should analyze the cost and Step 3—Assess the vendor’s qualifications. When
benefits of planned BOLI purchases. The analy- making a decision about vendors, an institution
sis should include the anticipated performance should consider its own knowledge of insurance
of the BOLI policy and an assessment of how risks, the vendor’s qualifications, and the amount
the purchase will accomplish the institution’s of resources the institution is willing to spend to
objectives. Before purchasing BOLI, an institu- administer and service the BOLI. Depending on
tion should analyze projected policy values the role of the vendor, the vendor’s services can
(CSV and death benefits) using multiple illus- be extensive and may be critical to successful
trations of these projections provided by the implementation and operation of a BOLI plan,
carrier, some of which incorporate the institu- particularly for the more complex separate-
tion’s own assumptions. An institution should account products.
consider using a range of interest-crediting rates While it is possible to purchase insurance
and mortality-cost assumptions. In some cases, directly from insurance carriers, the vast major-
the net yield (after mortality costs) could be ity of insurance purchases are made through
negative, particularly for separate-account prod- vendors—either brokers, consultants, or agents.
ucts. The potential for unfavorable net yields A vendor may design, negotiate, and administer
the BOLI policy. An institution should ensure
that it understands the product it is purchasing
5. A general account is a design feature that is generally
available to purchasers of whole or universal life insurance
and that it selects a product that best meets its
whereby the general assets of the insurance company support needs. Management, not just the vendor, must
the policyholder’s CSV. demonstrate a familiarity with the technical

Page 5
details of the institution’s insurance assets, and stand the products it is considering purchasing,
be able to explain the reasons for and the risks and select those with the characteristics that best
associated with the product design features they match the institution’s objectives, needs, and
have selected. risk tolerance.
An institution that uses a vendor should make Design features of permanent insurance poli-
appropriate inquiries to satisfy itself about the cies determine (1) whether the policy is a
vendor’s ability to honor its long-term commit- general account, separate account, or hybrid
ments, particularly when the vendor is expected product;6 (2) whether the insurance contract is a
to be associated with the institution’s insurance modified endowment contract (MEC) that car-
program over an extended period of time. The ries certain tax penalties if surrendered; and
institution should evaluate the adequacy of the (3) the method used to credit earnings to the
vendor’s services and its reputation, experience, policy. Some implications of these design fea-
financial soundness, and commitment to the tures are discussed in more detail in the ‘‘Risk
BOLI product. Vendors typically earn a large Management of BOLI’’ section of this inter-
portion of their commissions upon the sale of agency statement.
the product, yet they often retain long-term When purchasing insurance on a key person
servicing responsibilities for their clients. The or a borrower, management should consider
vendor’s commitment to investing in the opera- whether the institution’s need for the insurance
tional infrastructure necessary to support BOLI might end before the insured person dies. An
is a key consideration in vendor selection. institution generally may not hold BOLI on a
An institution should be aware that the ven- key person or a borrower once the key person
dor’s financial benefit from the sale of insurance leaves the institution or the borrower has either
may provide the vendor with an incentive to repaid the loan, or the loan has been charged off.
emphasize the benefits of a BOLI purchase to Therefore, the maturity of the term or declining
the institution without a commensurate explana- term insurance should be structured to match the
tion of the associated risks. Therefore, reliance expected tenure of the key person or the matu-
solely upon pre-packaged, vendor-supplied com- rity of the loan, respectively. Permanent insur-
pliance information does not demonstrate pru- ance generally is not an appropriate form of life
dence with respect to the purchase of insurance. insurance under these circumstances.
An institution should not delegate its selection
of product design features to its vendors. An Step 5—Select the carrier. To achieve the tax
institution that is unable to demonstrate a thor- benefits of insurance, institutions must hold
ough understanding of BOLI products it has BOLI policies until the death of the insured.
purchased and the associated risks may be Therefore, carrier selection is one of the most
subject to supervisory action. critical decisions in a BOLI purchase and one
that can have long-term consequences. While a
Step 4—Review the characteristics of the avail- broker or consultant may assist the institution in
able insurance products. There are a few basic evaluating carrier options, the institution alone
types of life insurance products in the market- retains the responsibility for carrier selection.
place. These products, however, can be com- Before purchasing life insurance, an institution
bined and modified in many different ways. The should perform a credit analysis on the selected
resulting final product can be quite complex. carrier(s) in a manner consistent with safe and
Furthermore, certain permanent insurance prod- sound banking practices for commercial lend-
ucts have been designed specifically for banks. ing. A more complete discussion of the credit-
These products differ from other forms of analysis standards is included in the ‘‘Credit
corporate-owned life insurance (COLI) policies Risk’’ section of this interagency statement.
in that the policies designed for banks are Management should review the product design,
generally structured without surrender or front- pricing, and administrative services of proposed
end sales charges in order to avoid having to carriers and compare them with the institution’s
report these charges as expenses when initially needs. Management should also review the car-
recording the carrying value. However, BOLI rier’s commitment to the BOLI product, as well
products may have lower net yields than COLI as its credit ratings, general reputation, experi-
products due to the absence of these charges. An
institution should review the characteristics of 6. A hybrid product combines features of both general- and
the various insurance products available, under- separate-account products.

Page 6
ence in the marketplace, and past performance. pensation provided to the insured to ensure that
Carriers not committed to general-account BOLI the insured’s total compensation is not exces-
products may have an incentive to lower the sive. Excessive compensation is considered an
interest-crediting rate on BOLI over time, reduc- unsafe and unsound banking practice. Guide-
ing the favorable economics of the product. The lines for determining excessive compensation
interest-crediting rate refers to the gross yield on can be found in the Interagency Guidelines
the investment in the insurance policy, that is, Establishing Standards for Safety and Soundness.8
the rate at which the cash value increases before Because shareholders and their family mem-
considering any deductions for mortality cost, bers who are not officers, directors, or employ-
load charges, or other costs that are periodically ees of an institution do not provide goods or
charged against the policy’s cash value. Insur- services to the institution, they should not receive
ance companies frequently disclose both a cur- compensation from the institution. This includes
rent interest-crediting rate and a guaranteed compensation in the form of split-dollar life
minimum interest-crediting rate. Institutions insurance arrangements.
should be aware that the guaranteed minimum Prior to an institution’s purchase of a life
interest-crediting rate may be periodically reset insurance policy to be used in a split-dollar life
in accordance with the terms of the insurance insurance arrangement, the institution and the
contract. As a result, the potential exists for a insured should enter into a written agreement.
decline in the interest-crediting rate. Written agreements usually describe the rights
While institutions can exercise what is known of the institution, the insured individual, and any
as a 1035 exchange7 option to change carriers, other parties (such as trusts or beneficiaries) to
there are some practical constraints to using this the policy’s CSV and death benefits. It is impor-
option. First, the institution must have an insur- tant for an institution to be aware that ownership
able interest in each individual to be insured of the policy by the employee, a third party, or a
under the new carrier’s policy. In a 1035 trust (non-institution owner) may not adequately
exchange, former employees of the institution protect the institution’s interest in the policy
may not be eligible for coverage under the new because the institution ordinarily will not have
policy because state insurable interest laws may the sole right to borrow against the CSV or to
prohibit their eligibility. Second, the original liquidate the policy in the event that funds are
carrier may impose an exchange fee specifically needed to provide liquidity to the institution.
applicable to such 1035 exchanges. Moreover, if a non-institution owner borrows
heavily against the CSV, an institution’s ability
Step 6—Determine the reasonableness of com- to recover its premium payments upon the death
pensation provided to the insured employee if of the insured may be impaired.
the insurance results in additional compensa- At a minimum, an institution’s economic
tion. Insurance arrangements that are funded by interest in the policy should be equal to the
the institution and that permit the insured officer, premiums paid plus a reasonable rate of return,
director, or employee to designate a beneficiary defined as a rate of return that is comparable to
are a common way to provide additional com- returns on investments of similar maturity and
pensation or other benefits to the insured. Split- credit risk.
dollar life insurance arrangements are often used Split-dollar life insurance has complex tax
for this purpose. Before an institution enters into and legal consequences. An institution consid-
a split-dollar arrangement or otherwise pur- ering entering into a split-dollar life insurance
chases insurance for the benefit of an officer, arrangement should consult qualified tax, legal,
director, or employee, the institution should and insurance advisers.
identify and quantify its compensation objective
and ensure that the arrangement is consistent Step 7—Analyze the associated risks and the
with that objective. The compensation provided ability to monitor and respond to those risks. An
by the split-dollar or other insurance arrange- institution’s pre-purchase analysis should include
ment should be combined with all other com- a thorough evaluation of all significant risks, as
7. A 1035 exchange is a tax-free replacement of an 8. For national banks, appendix A to 12 CFR 30; for state
insurance policy for another insurance contract covering the member banks, appendix D-1 to 12 CFR 208; for insured state
same person in accordance with section 1035 of the Internal nonmember banks, appendix A to 12 CFR 364; for savings
Revenue Code. associations, appendix A to 12 CFR 570.

Page 7
well as management’s ability to identify, mea- • Identification of which employees are, or will
sure, monitor, and control those risks. An expla- be, insured (e.g., vice presidents and above,
nation of key risks (liquidity, transaction/ employees of a certain grade level). For exam-
operational, reputation, credit, interest rate, ple, an institution that acquires another insti-
compliance/legal, and price) is included in the tution that owns BOLI may acquire insurance
‘‘Risk Management of BOLI’’ section of this on individuals that it would not insure under
interagency statement. its own standards. While the acquiring insti-
tution need not correct such exceptions, it is
Step 8—Evaluate the alternatives. Regardless of important to know that such exceptions exist.
the purpose of BOLI, a comprehensive pre- • Assessment of death benefit amounts relative
purchase analysis will include an analysis of to employee salaries. Such information helps
available alternatives. Prior to acquiring BOLI, management to assess the reputation and insur-
an institution should thoroughly analyze the able interest risks associated with dispropor-
risks and benefits, compared to alternative meth- tionately large death benefits.
ods for recovering costs associated with the loss • Calculation of the percentage of insured per-
of key persons, providing pre- and post- sons still employed by the institution. Larger
retirement employee benefits, or providing addi- institutions often find that their policies insure
tional employee compensation, as appropriate. more former employees than current employ-
ees. This information can help the institution
Step 9—Document the decision. A well-managed assess reputation risk.
institution maintains adequate documentation • Evaluation of the material changes to BOLI
supporting its comprehensive pre-purchase analy- risk-management policies.
sis, including an analysis of both the types and • Assessment of the effects of policy exchanges.
design of products purchased and the overall Exchanges typically are costly and it is a
level of BOLI holdings. sound practice to review the costs and benefits
of such actions.
• Analysis of mortality performance and impact
Risk Management of BOLI on income. Material gains from death benefits
can create reputation risks.
Risk assessment and risk management are vital • Evaluation of material findings from internal
components of an effective BOLI program. In and external audits and independent risk-
addition to conducting a risk assessment as part management reviews.
of a thorough pre-purchase analysis, monitoring • Identification of the reason for, and tax impli-
BOLI risks on an ongoing basis is important, cations of, any policy surrenders. In some
especially for an institution whose aggregate cases, institutions have surrendered BOLI poli-
BOLI holdings represent a capital concentra- cies and incurred tax liabilities and penalties.
tion. Management of an institution should review Formal assessment of the costs and benefits of
the performance of the institution’s insurance a surrender is a useful component of sound
assets with its board of directors at least annu- corporate governance.
ally. More-frequent reviews are appropriate if • Peer analysis of BOLI holdings. To address
there are significant anticipated changes to the reputation risk, an institution should compare
BOLI program such as additional purchases, a its BOLI holdings relative to capital to the
decline in the financial condition of the insur- holdings of its peers to assess whether it is an
ance carrier(s), anticipated policy surrenders, or outlier.
changes in tax laws or interpretations that could
have an impact on the performance of BOLI.
This risk-management review should include, Liquidity Risk
but not necessarily be limited to:
Liquidity risk is the risk to earnings and capital
• Comprehensive assessment of the specific risks arising from an institution’s inability to meet its
discussed in this section.9 obligations when they come due without incur-
9. All of the risks discussed in this section are applicable to expose an institution to liquidity, interest-rate, or price risk.
permanent insurance. In contrast, because temporary insur- These risks need not be evaluated in the comprehensive
ance does not have a savings component or a CSV, it does not assessment of the risks of temporary insurance.

Page 8
ring unacceptable losses. Before purchasing per- up to the basis (that is, the original amount
manent insurance, management should recog- invested) without creating a taxable event. How-
nize the illiquid nature of the product and ensure ever, a non-MEC policy increases in complexity
that the institution has the long-term financial if it is in the form of a separate account covered
flexibility to hold the asset in accordance with by a stable value protection (SVP) contract. An
its expected use. The inability to hold the life SVP contract protects the policy owner from
insurance until the death(s) of the insured(s) declines in the value of the assets in the separate
when the death benefits will be collected may account arising from changes in interest rates,
compromise the success of the BOLI plan. An thereby mitigating price risk and earnings vola-
institution generally does not receive any cash tility. An SVP contract is most often used in
flow from the insurance until the death benefit is connection with fixed-income investments. Insti-
paid. Depending upon the age of the insured tutions should recognize that SVP providers
population, it is possible that an institution that often place restrictions on the amount that may
insures a small number of employees may not be withdrawn from the separate account, thereby
recognize any cash flow from the insurance for reducing the liquidity of the BOLI asset. An
many years. The illiquid nature of insurance institution considering the purchase of a non-
assets, combined with the difficulty of project- MEC for its potential liquidity advantages com-
ing liquidity needs far into the future, is a major pared to a MEC also should be aware of
reason an institution should keep its BOLI contractual provisions, such as 1035 exchange
holdings below the agencies’ concentration fees and ‘‘crawl-out’’ restrictions,10 which may
guidelines. Examiners will consider an institu- limit such advantages.
tion’s BOLI holdings when assessing liquidity
and assigning the liquidity component rating.
The purchase of BOLI may negatively affect Transaction/Operational Risk
an institution’s liquidity position, both because
BOLI is one of the least liquid assets on an As it applies to BOLI, transaction/operational
institution’s balance sheet, and because institu- risk is the risk to earnings and capital arising
tions normally fund BOLI purchases through the from problems caused by the institution’s failure
sale of liquid assets (e.g., marketable securities). to fully understand or to properly implement a
To access the CSV of BOLI, the institution must transaction. Transaction/operational risk arises
either surrender or borrow against the policy. In due to the variety and complexity of life insur-
accordance with the policy contract and federal ance products, as well as tax and accounting
tax laws, the surrender of a policy may subject treatments. To help mitigate this risk, manage-
an institution to surrender charges, tax liabilities ment should have a thorough understanding of
for previously untaxed increases in the CSV, and how the insurance product works and the vari-
tax penalties. Borrowing against the CSV is ables that dictate the product’s performance.
disadvantageous in most cases due to limitations The variables most likely to affect product
on the ability to deduct interest on the borrowing performance are the policy’s interest-crediting
and other possible adverse tax consequences. rate, mortality cost, and other expense charges.
A BOLI product qualifying as a modified Transaction/operational risk is also a function
endowment contract (MEC) for tax purposes has of the type and design features of a life insur-
particular liquidity disadvantages. If an institu- ance contract. With a general-account product,
tion surrenders a MEC, it will incur a tax there are only two parties to the contract: the
liability on the increase in the policy’s CSV policy owner and the insurance carrier. With a
from earnings on the policy since its inception separate-account product, the insurance carrier
and may incur an additional tax penalty for early has a separate contract with an investment
surrender. manager. There could also be an SVP provider
In order to avoid such additional tax penal- with whom the carrier has a separate contract.
ties, an institution may opt to purchase a non- Transaction/operational risk may also arise as
MEC contract. A non-MEC contract permits the a result of the variety of negotiable features
policy owner to surrender the policy without associated with a separate-account product.
incurring the additional tax penalty that, under
certain circumstances, applies to MECs. More- 10. A crawl-out restriction limits the amount of CSV
over, depending on the terms of the insurance eligible for a 1035 exchange or surrender over a period of
contract, an institution generally may withdraw time.

Page 9
These include the investment options; the terms, Institutions should also recognize that their
conditions, and cost of SVP; and mortality actions, subsequent to purchase, could jeopar-
options. Deferred acquisition costs (DAC) rep- dize the tax-advantaged status of their insurance
resent the insurance carrier’s up-front costs holdings. The risk that a life insurance policy
associated with issuing an insurance policy, could be characterized by the Internal Revenue
including taxes and commissions and fees paid Service (IRS) as an actively managed invest-
to agents for selling the policy. The carrier ment is particularly relevant to separate-account
charges the policyholder for these costs and policies. Many larger institutions prefer separate-
capitalizes the DAC, including the prepayment account products because of perceived lower
of taxes in accordance with federal tax law. As credit risk and greater transparency (that is,
the carrier recovers the DAC in accordance with explicit disclosure of costs). Assets held by the
applicable tax law, it credits the amount to the insurance company on behalf of the policy
separate-account policyholder. Once it has been owners in the separate account are intended to
credited to the institution, the DAC is essentially be beyond the reach of the insurance company’s
a receivable from the carrier and, therefore, general creditors in the event of insolvency;
represents a general-account credit exposure. however, the protected status of separate-
Separate-account policies have additional account assets is generally untested in the courts.
transaction risks that can result from accounting While the separate-account structure helps to
requirements. Several institutions have had to mitigate an institution’s credit exposure to the
restate their earnings because of contractual insurance carrier, the institution can have no
provisions in their policies that were ambiguous ‘‘control’’ over investment decisions (e.g., tim-
with respect to the amount of the CSV available ing of investments or credit selection) in the
upon surrender of the policy. Because BOLI underlying account. Generally, allocating
must be carried at the amount that could be separate-account holdings across various divi-
realized under the insurance contract as of the sions of an insurance company’s portfolio does
balance-sheet date, if any contractual provision not raise concerns about ‘‘control,’’ but other
related to costs, charges, or reserves creates actions that a policy owner takes may be con-
uncertainty regarding the realization of a poli- strued as investment control and could jeopar-
cy’s full CSV, the agencies will require an dize the tax-advantaged status.
institution to record the BOLI net of those To benefit from the favorable tax treatment of
amounts. As part of an effective pre-purchase insurance, a BOLI policy must be a valid
analysis, an institution should thoroughly review insurance contract under applicable state law
and understand how the accounting rules will and must qualify under applicable federal law.
apply to the BOLI policy it is considering Institutions must have an insurable interest in
purchasing. the covered employee, as set forth in applicable
state laws. Furthermore, the favorable tax-
equivalent yields of BOLI result only when an
Tax and Insurable Interest Implications institution generates taxable income. Institutions
that have no federal income tax liability receive
Before the purchase of BOLI and periodically only the nominal interest-crediting rate as a
thereafter, management should also explicitly yield. In such an environment, BOLI loses much
consider the financial impact (e.g., tax provi- of its yield advantage relative to other invest-
sions and penalties) of surrendering a policy. ment alternatives.
Recent adverse press coverage of corporate- Some institutions seem to have drawn com-
owned life insurance (COLI) should serve as a fort from assurances from insurance carriers that
reminder to institutions that the current tax law the carrier would waive lack of insurable inter-
framework, as it applies to BOLI, is always est as a defense against paying a claim. While
subject to legislative changes. A tax change that the carrier may indeed make a payment, such
makes future BOLI cash flows subject to income payment may not necessarily go to the institu-
tax, while perhaps deemed unlikely by many tion. Such assurances may not be sufficient to
institutions, would have a negative impact on satisfy the IRS requirements for a valid insur-
the economics of the BOLI holdings. An insti- ance contract, nor do they eliminate potential
tution should recognize that earnings from BOLI claims from the estate of the insured that might
could make it subject to the alternative mini- seek to claim insurance proceeds on the basis
mum tax. that the institution lacked an insurable interest.

Page 10
For example, some institutions have estab- A well-managed institution will take steps to
lished out-of-state trusts to hold their BOLI reduce the reputation risk that may arise as a
assets. While such trusts may have legitimate result of its BOLI purchases, including main-
uses, such as to gain access to an insurance taining appropriate documentation evidencing
carrier’s product, in some cases the purpose is to informed consent by the employee, prior to
avoid unfavorable insurable interest laws in the purchasing insurance. Some institutions assert
institution’s home state and to domicile the that they make employees aware via employee
policy in a state with more lenient requirements. handbooks, manuals, or newsletters of the pos-
In some cases, institutions have not made sibility that the institution may acquire life
employees aware that they have taken out insur- insurance on them. Although such disclosure
ance on their lives. may satisfy state insurance requirements, any
A recent Fifth Circuit Court of Appeals ruling approach that does not require formal employee
demonstrates the potential danger of this consent may significantly increase an institu-
approach. A Texas employer used a Georgia tion’s reputation risk.
trust to hold life insurance policies on its employ- Some institutions have begun to purchase
ees in Texas, and the trust agreement provided separate-account, non-MEC product designs in
that the insurable interest law of Georgia should order to address the liquidity concerns with
apply. In a lawsuit brought by the estate of a MEC policies. One consequence of this product
deceased employee, the court ignored this pro- design choice, however, is that it has become
vision because the insured employee was not a increasingly common for institutions to insure a
party to the trust agreement. It then found that very large segment of their employee base,
the insurable interest law of Texas applied and including non-officers. Because non-MEC
under that state’s law, the employer did not have designs have a higher ratio of death benefit to
an insurable interest in the employee. The result premium dollar invested, some institutions have,
was that the employer was not entitled to the therefore, taken out very high death benefit
insurance death benefits.11 The outcome in this policies on employees, including lower-level
case suggests that institutions that have used, or employees, further adding to reputation risk and
are considering using, an out-of-state trust to highlighting the importance of obtaining explicit
take advantage of more-favorable insurable inter- consent.
est laws in another state should assess whether
they could be vulnerable to a similar legal
challenge.
Institutions should have appropriate legal Credit Risk
review to help ensure compliance with applica-
ble tax laws and state insurable interest require- Credit risk is the potential impact on earnings
ments. Institutions that insure employees for and capital arising from an obligor’s failure to
excessive amounts may be engaging in imper- meet the terms of any contract with the institu-
missible speculation or unsafe and unsound tion or otherwise perform as agreed. All life
banking practices. The agencies may require insurance policyholders are exposed to credit
institutions to surrender such policies. risk. The credit quality of the insurance com-
pany and duration of the contract are key vari-
ables. With insurance, credit risk arises from the
Reputation Risk insurance carrier’s contractual obligation to pay
death benefits upon the death of the insured, and
Reputation risk is the risk to earnings and capital if applicable, from the carrier’s obligation to pay
arising from negative publicity regarding an the CSV (less any applicable surrender charges)
institution’s business practices. While this risk upon the surrender of the policy.
arises from virtually all bank products and Most BOLI products have very long-term
services, reputation risk is particularly prevalent (30- to 40-year) expected time frames for full
in BOLI because of the potential perception collection of cash proceeds, i.e., the death bene-
issues associated with an institution’s owning or fit. For general-account policies, the CSV is an
benefiting from life insurance on employees. unsecured, long-term, and nonamortizing obli-
gation of the insurance carrier. Institutions record
11. Mayo v. Hartford Life Insurance Company, 354 F.3d and carry this claim against the insurance com-
400 (5th Cir. 2004). pany as an asset.

Page 11
Before purchasing BOLI, an institution should policy owner surrenders the policy and the cost
conduct an independent financial analysis of the basis of the separate account to the policy
insurance company and continue to monitor its owner. Under most arrangements, the insurance
condition on an ongoing basis. The institution’s carrier is not responsible for making a payment
credit-risk-management function should partici- under the SVP contract if a third-party protec-
pate in the review and approval of insurance tion provider fails to make a required payment
carriers. As with lending, the depth and fre- to it. The SVP contract thus represents an
quency of credit analysis (both initially and on additional source of credit risk for a separate-
an ongoing basis) should be a function of the account product. The policyholder’s exposure
relative size and complexity of the transaction under an SVP contract is to both the protection
and the size of outstanding exposures. Among provider, which must make any required pay-
other things, an institution should consider its ment to the insurance carrier, and the carrier,
legal lending limit, concentration guidelines which must remit the payment received from the
(generally defined as the aggregate of direct, protection provider to the institution. Because of
indirect, and contingent obligations and expo- this exposure, an institution should also evaluate
sures that exceed 25 percent of the institution’s the repayment capacity of the SVP provider.
capital), and any applicable state restrictions on State insurance regulation governing reserve
BOLI holdings when assessing its broader credit- requirements for insurance carriers, state
risk exposure to insurance carriers. To measure guaranty funds, and reinsurance arrangements
credit exposures comprehensively, an institution help to reduce direct credit risks from general-
should aggregate its exposures to individual account exposures. Further, an institution can
insurance carriers, and the insurance industry as use a 1035 exchange to exit a deterio-
a whole, attributable to both BOLI policies and rating credit exposure, although most policies
other credit relationships (e.g., loans and deriva- impose fees for the exchange. While credit risk
tives exposures). for existing general- and separate-account poli-
There are product design features of a BOLI cies may be low currently, the extremely long-
policy that can reduce credit risk. As noted term nature of a BOLI policy underscores the
earlier, an institution can purchase separate- fact that credit risk remains an important risk
account products, where the institution assumes associated with life insurance products. Strong
the credit risk of the assets held in the separate current credit ratings offer no guarantee of
account, rather than the direct credit risk of the strong credit ratings 20, 30, or 40 years into the
carrier as would be the case in a general-account future.
policy. With separate-account policies, the insur-
ance carrier owns the assets, but maintains the
assets beyond the reach of general creditors in Interest-Rate Risk
the event of the insurer’s insolvency. However,
even with a separate-account policy, the policy Interest-rate risk is the risk to earnings and
owner incurs some general-account credit-risk capital arising from movements in interest rates.
exposure to the insurance carrier associated with Due to the interest-rate risk inherent in general-
the carrier’s mortality and DAC reserves. account products, it is particularly important
Amounts equal to the mortality and DAC that management fully understand how these
reserves are owed to the policyholder and rep- products expose the policyholder to interest-rate
resent general-account obligations of the insur- risk before purchasing the policy. The interest-
ance carrier. In addition, the difference, if any, rate risk associated with these products is pri-
between the CSV and the minimum guaranteed marily a function of the maturities of the assets
death benefit would be paid out of the insurance in the carrier’s investment portfolio, which often
carrier’s general account. range from four to eight years. When purchasing
A separate-account policy may have a stable a general-account policy, an institution chooses
value protection (SVP) contract issued by the one of a number of interest-crediting options
insurance carrier or by a third party that is (that is, the method by which the carrier will
intended to protect the policyholder from most increase the policy’s CSV). Using the ‘‘port-
declines in fair value of separate-account assets. folio’’ crediting rate, the institution will earn a
In general, the provider of an SVP contract return based upon the existing yield of the
agrees to pay any shortfall between the fair carrier’s portfolio each year. Using the ‘‘new
value of the separate-account assets when the money’’ crediting rate, the institution earns a

Page 12
return based upon yields available in the market placed policies in which the institution is the
at the time it purchases the policy. only policyholder associated with the separate-
Separate-account products may also expose account assets.
the institution to interest-rate risk, depending on When purchasing BOLI, institutions should
the types of assets held in the separate account. be aware that the splitting of commissions
For example, if the separate-account assets con- between a vendor and the institution’s own
sist solely of U.S. Treasury securities, the insti- subsidiary or affiliate insurance agency presents
tution is exposed to interest-rate risk in the same compliance risk. The laws of most states pro-
way as holding U.S. Treasury securities directly hibit the payment of inducements or rebates to a
in its investment portfolio. However, because person as an incentive for that person to pur-
the institution cannot control the separate- chase insurance. These laws may also apply to
account assets, it is more difficult for the insti- the person receiving the payment. When an
tution to control this risk. Accordingly, before insurance vendor splits its commission with an
purchasing a separate-account product, an insti- institution’s insurance agency that was not oth-
tution’s management should thoroughly review erwise involved in the transaction, such a pay-
and understand the instruments governing the ment may constitute a prohibited inducement or
investment policy and management of the sepa- rebate. Accordingly, an institution should assure
rate account. Management should understand itself that this practice is permissible under
the risk inherent within the separate account and applicable state law and in compliance with
ensure that the risk is appropriate for the insti- Federal Reserve Regulation W before participat-
tution. The institution also should establish moni- ing in any such arrangement. Moreover, pay-
toring and reporting systems that will enable ments to an affiliate that did not perform ser-
management to monitor and respond to interest- vices for the institution could also raise other
rate fluctuations and their effect on separate- regulatory and supervisory issues.
account assets. Due to the significance of the compliance
risk, institutions should seek the advice of coun-
sel on these legal and regulatory issues.
Compliance/Legal Risk
Compliance/legal risk is the risk to earnings and Price Risk
capital arising from violations of, or nonconfor-
mance with, laws, rulings, regulations, pre- Price risk is the risk to earnings and capital
scribed practices, or ethical standards. Failure to arising from changes in the value of portfolios
comply with applicable laws, rulings, regula- of financial instruments. Accounting rules per-
tions, and prescribed practices could compro- mit owners of insurance contracts to account for
mise the success of a BOLI program and result general-account products using an approach that
in fines or penalties imposed by regulatory is essentially based on cost plus accrued earn-
authorities or loss of tax benefits. Among the ings. However, for separate-account products
legal and regulatory considerations that an insti- without SVP, the accounting would largely be
tution should evaluate are compliance with state based on the fair value of the assets held in the
insurable interest laws, the Employee Retire- account because this value is the amount that
ment Income Security Act of 1974 (ERISA), could be realized from the separate account if
Federal Reserve Regulations O and W (12 CFR the policy is surrendered. (See ‘‘Accounting
215 and 223, respectively), the Interagency Considerations’’ above.) Typically, the policy-
Guidelines Establishing Standards for Safety holder of separate-account products assumes all
and Soundness, the requirements set forth under price risk associated with the investments within
the ‘‘Legal Authority’’ section of this document, the separate account. Usually, the insurance
and federal tax regulations applicable to BOLI. carrier will provide neither a minimum CSV nor
Tax benefits are critical to the success of most a guaranteed interest-crediting rate for separate-
BOLI plans. Accordingly, an institution owning account products. Absent an SVP contract, the
separate-account BOLI must implement internal amount of price risk generally depends upon the
policies and procedures to ensure that it does not type of assets held in the separate account.
take any action that might be interpreted as Because the institution does not control the
exercising ‘‘control’’ over separate-account separate-account assets, it is more difficult for it
assets. This is especially important for privately to control the price risk of these assets than if

Page 13
they were directly owned. To address income- not have a neutral effect on an institution’s
statement volatility, an institution may purchase reported earnings.
an SVP contract for its separate-account policy. Unlike separate-account holdings of debt secu-
The SVP contract is designed to ensure that the rities, SVP contracts on separate-account equity
amount that an institution could realize from its holdings are not common. The economic hedg-
separate-account policy, in most circumstances, ing criteria for equity-linked insurance products
remains at or above the cost basis of the separate lessen the effect of price risk because changes in
account to the policyholder. Institutions should the amount of the institution’s equity-linked
understand, however, that SVP contracts protect liability are required to offset changes in the
against declines in value attributable to changes value of the separate-account assets. If the
in interest rates; they do not cover default risk. insurance cannot be characterized as an effective
Moreover, one purpose of the SVP contract is to economic hedge, the presence of equity securi-
reduce volatility in an institution’s reported ties in a separate account is impermissible, and
earnings. To realize any economic benefit of the the agencies will require institutions to reallo-
SVP contract, an institution would have to cate the assets unless retention of the policy is
surrender the policy. Since policy surrender is permitted under federal law.13
nearly always an uneconomic decision, the SVP In addition to the general considerations dis-
contract provides, in a practical sense, account- cussed previously, which are applicable to any
ing benefits only. separate-account product, an institution should
Before purchasing a separate-account life perform further analysis when purchasing a
insurance product, management should thor- separate-account product involving equity secu-
oughly review and understand the instruments rities. At a minimum, the institution should:
governing the investment policy and manage-
ment of the separate account. Management 1. Compare the equity-linked liability being
should understand the risk inherent in the sepa- hedged (e.g., deferred compensation) and the
rate account and ensure that the risk is appro- equity securities in the separate account.
priate. If the institution does not purchase SVP, Such an analysis considers the correlation
management should establish monitoring and between the liability and the equity securi-
reporting systems that will enable it to recognize ties, expected returns for the securities
and respond to price fluctuations in the fair (including standard deviation of returns), and
value of separate-account assets. current and projected asset and liability
Under limited circumstances it is legally per- balances.
missible for an institution to purchase an equity-
linked variable life insurance policy if the policy 2. Determine a target range for the hedge effec-
is an effective economic hedge against the tiveness ratio (e.g., 95 to 105 percent) and
institution’s equity-linked obligations under establish a method for measuring hedge effec-
employee benefit plans.12 An effective economic tiveness on an ongoing basis. The institution
hedge exists when changes in the economic should establish a process for altering the
value of the liability or other risk exposure being program if hedge effectiveness drops below
hedged are matched by counterbalancing changes acceptable levels. Consideration should be
in the value of the hedging instrument. Such a given to the potential costs of program
relationship would exist where the obligation changes.
under an institution’s deferred compensation 3. Establish a process for analyzing and report-
plan is based upon the value of a stock market ing to management and the board the effect
index and the separate account contains a stock of the hedge on the institution’s earnings and
mutual fund that mirrors the performance of that capital ratios. The analysis usually considers
index. Institutions need to be aware that this results both with and without the hedging
economic hedge may not qualify as a hedge for transaction.
accounting purposes. Thus, the use of equity-
linked variable life insurance policies to eco-
nomically hedge equity-linked obligations may
13. Insured state banks and state savings associations may
request the FDIC’s consent to retain the policies, but consent
12. Insured state banks and state savings associations may will not be granted if it is determined that retaining the
make such purchases only if permitted to do so under policies presents a significant risk to the appropriate insurance
applicable state law. fund.

Page 14
Risk-Based Capital Treatment separate account, as stated in the investment

agreement, to the entire carrying value of the
If an institution owns a general-account insur- separate-account policy, except for any portions
ance product, it should apply a 100 percent risk of the carrying value that are general-account
weight to its claim on the insurance company for claims or are attributable to SVP. In no case,
risk-based capital purposes. A BOLI investment however, may the risk weight for the carrying
in a separate-account insurance product, how- value of the policy (excluding any general-
ever, may expose the institution to the market account and SVP portions) be less than 20 percent.
and credit risks associated with the pools of Alternatively, an institution may use a pro
assets in the separate account. The assets in a rata approach to risk-weighting the carrying
pool may have different risk weights, similar to value of a qualifying separate-account policy
the assets held in a mutual fund in which an (excluding any general-account and SVP por-
institution has invested. For risk-based capital tions). The pro rata approach is based on the
purposes, if an institution can demonstrate that investment limits stated in the investment agree-
the BOLI separate-account policy meets the ment for each class of assets that can be held in
requirements below, it may choose to ‘‘look the separate account, with the constraint that the
through’’ to the underlying assets to determine weighted average risk weight may not be less
the risk weight. than 20 percent. If the sum of the permitted
investments across market sectors in the invest-
ment agreement is greater than 100 percent, the
institution must use the highest risk weight for
Criteria for a Look-Through Approach the maximum amount permitted in that asset
class, and then proceed to the next-highest risk
To qualify for the ‘‘look-through’’ approach, weight until the permitted amounts equal
separate-account BOLI assets must be protected 100 percent.
from the insurance company’s general creditors For example, if a separate-account investment
in the event of the insurer’s insolvency. An agreement permits a maximum allocation of
institution should document its assessment, based 60 percent for corporate bonds, 40 percent for
upon applicable state insurance laws and other U.S. government–sponsored enterprise debt secu-
relevant factors, that the separate-account assets rities, and 60 percent for U.S. Treasury securi-
would be protected from the carrier’s general ties, then the institution must risk-weight 60 per-
creditors. If the institution does not have suffi- cent of the carrying value of the separate-
cient information to determine that a BOLI account investment (excluding any portion
separate-account policy qualifies for the look- attributable to SVP) at the 100 percent risk
through approach, the institution must apply the weight applicable to corporate bonds and the
standard risk weight of 100 percent to this asset. remaining 40 percent at the 20 percent risk
In addition, when an institution has a separate- weight for U.S. government–sponsored enter-
account policy, the portion of the carrying value prise debt securities. Because the sum of the
of the institution’s insurance asset that repre- permitted allocation for corporate bonds and
sents general-account claims on the insurer, government-sponsored enterprise debt securities
such as deferred acquisition costs (DAC) and totals 100 percent, the institution cannot use the
mortality reserves that are realizable as of the zero percent risk weight for U.S. Treasury secu-
balance-sheet date, and any portion of the car- rities. However, if the permitted allocation for
rying value attributable to an SVP contract, are U.S. government–sponsored enterprise debt secu-
not eligible for the look-through approach. These rities was 30 percent rather than 40 percent, the
amounts should be risk-weighted at the 100 per- institution could risk-weight the remaining
cent risk weight applicable to claims on the 10 percent of the carrying value of its invest-
insurer or the SVP provider, as appropriate. ment at the zero percent risk weight for U.S.
Treasuries.
Regardless of the look-through approach an
Look-Through Approaches institution employs, the weighted average risk
weight for the separate-account policy (exclud-
When risk-weighting a qualifying separate- ing any general-account and SVP portions) may
account policy, an institution may apply the not be less than 20 percent, even if all the assets
highest risk weight for an asset permitted in the in the separate account would otherwise qualify

Page 15
for a zero percent risk weight. Furthermore, the ent asset classes in the separate-account invest-
portion of the carrying value of the separate- ment agreement.
account policy that represents general-account
claims on the insurer, such as realizable DAC Example. The separate-account investment agree-
and mortality reserves, and any portion of the ment requires the account to hold a minimum of
carrying value attributable to an SVP contract, 10 percent in U.S. Treasury obligations. It also
should be risk-weighted at the risk weight appli- imposes a maximum allocation of 50 percent in
cable to the insurer or the SVP provider, as mortgage-backed securities issued by U.S.
appropriate. government–sponsored enterprises, and a maxi-
The following example demonstrates the mum allocation of 50 percent in corporate bonds.
appropriate risk-weight calculations for the pro Assume that the portion of the carrying value of
rata approach, incorporating the components of the separate-account policy attributable to real-
a BOLI separate-account policy that includes izable DAC and mortality reserves equals $10
general-account claims on the insurer as well as and that the portion attributable to the SVP
the investment allocations permitted for differ- totals $10.
Carrying value of separate-account policy $100.00

Less: Portion attributable to DAC and mortality reserves 10.00
Portion attributable to SVP 10.00
Net carrying value of separate-account policy available for pro rata $ 80.00
Risk-weight calculation:
U.S. Treasury @ 10% x $80 = $8 x 0% RW 0.00
Corporate bonds @ 50% x $80 = $40 x 100% RW $ 40.00
GSE MBS @ 40% x $80 = $32 x 20% RW 6.40
Separate-account risk-weighted assets subject to pro rata $ 46.40
Add back: DAC and mortality reserves = $10 x 100% RW $ 10.00

Add back: SVP = $10 x 100% RW 10.00
General-account and SVP risk-weighted assets $ 20.00
Total BOLI-related risk-weighted assets $ 66.40
Summary management process the agencies expect insti-

tutions to employ.
The purchase of BOLI can be an effective way Where an institution has acquired BOLI in
for institutions to manage exposures arising an amount that approaches or exceeds agency
from commitments to provide employee com- concentration levels, examiners will more
pensation and pre- and post-retirement benefits. closely scrutinize the components of the risk-
Consistent with safe and sound banking prac- management process and the institution’s asso-
tices, institutions must understand the risks associated documentation. Where BOLI has been
ciated with this product and implement a risk- purchased in an impermissible manner, ineffec-
management process that provides for the tive controls over BOLI risks exist, or a BOLI
identification and control of such risks. A sound exposure poses a safety-and-soundness concern,
pre-purchase analysis, meaningful ongoing moni- the appropriate agency may take supervisory
toring program, reliable accounting process, and action, including requiring the institution to
accurate assessment of risk-based capital require- divest affected policies, irrespective of tax
ments are all components of the type of risk- consequences.

Page 16
Appendix A—Common Types of Life paid for the entire life of the insured. Death
Insurance benefit protection is provided for the entire
life of the insured, assuming all premiums are
paid.
Life insurance can be categorized into two broad
types: temporary (also called ‘‘term’’) insurance • Universal life. A form of permanent insurance
and permanent insurance. There are numerous designed to provide flexibility in premium
variations of these products. However, most life payments and death benefit protection. The
insurance policies fall within one (or a combi- policyholder can pay maximum premiums and
nation) of the following categories. maintain a very high CSV. Alternatively, the
policyholder can make minimal payments in
an amount just large enough to cover mortal-
Temporary (Term) Insurance ity and other insurance charges.
Temporary (term) insurance provides life insur-

ance protection for a specified time period. Purposes for Which Institutions
Death benefits are payable only if the insured Commonly Purchase Life Insurance
dies during the specified period. If a loss does
not occur during the specified term, the policy Key person. Institutions often purchase life insur-
lapses and provides no further protection. Term ance to protect against the loss of ‘‘key persons’’
insurance premiums do not have a savings whose services are essential to the continuing
component; thus, term insurance does not create success of the institution and whose untimely
cash surrender value (CSV). death would be disruptive. For example, an
institution may purchase insurance on the life of
an employee or director whose death would be
Permanent Insurance of such consequence to the institution as to give
it an insurable interest in his or her life. The
In contrast to term insurance, permanent insur- determination of whether an individual is a key
ance is intended to provide life insurance pro- person does not turn on that individual’s status
tection for the entire life of the insured, and its as an officer or director, but on the nature of the
premium structure includes a savings compo- individual’s economic contribution to the
nent. Permanent insurance policy premiums typi- institution.
cally have two components: the insurance com- The first step in indemnifying an institution
ponent (e.g., mortality cost, administrative fees, against the loss of a key person is to identify the
and sales loads) and the savings component. key person. The next and possibly most difficult
Mortality cost represents the cost imposed on step is estimating the insurable value of the key
the policyholder by the insurance company to person or the potential loss of income or other
cover the amount of pure insurance protection value that the institution may incur from the
for which the insurance company is at risk. untimely death of that person.
The savings component typically is referred Because the most appropriate method for
to as CSV. The policyholder may use the CSV to determining the value of a key person is depen-
make the minimum premium payments neces- dent upon individual circumstances, the agen-
sary to maintain the death benefit protection and cies have not established a formula or a specific
may access the CSV by taking out loans or process for estimating the value of a key person.
making partial surrenders. If permanent insur- Instead, the agencies expect institutions to con-
ance is surrendered before death, surrender sider and analyze all relevant factors and use
charges may be assessed against the CSV. Gen- their judgment to make a decision about the
erally, surrender charges are assessed if the value of key persons.
policy is surrendered within the first 10 to 15 Key-person life insurance should not be used
years. in place of, and does not diminish the need for,
Two broad categories of permanent insurance adequate management-succession planning.
are: Indeed, if an institution has an adequate
management-succession plan, its reliance on a
• Whole life. A traditional form of permanent key person should decline as the person gets
insurance designed so that fixed premiums are closer to retirement.

Page 17
Financing or cost recovery for benefit plans. Split-dollar life insurance arrangements. Insti-
Like other businesses, institutions often use life tutions sometimes use split-dollar life insurance
insurance as a financing or cost-recovery vehicle arrangements to provide retirement benefits and
for pre- and post-retirement employee benefits, death benefits to certain employees as part of
such as individual or group life insurance, health their compensation. Under split-dollar arrange-
insurance, dental insurance, vision insurance, ments, the employer and the employee share the
tuition reimbursement, deferred compensation, rights to the policy’s CSV and death benefits.
and pension benefits. The employer and the employee may also share
Permanent insurance is used for this purpose. premium payments. If the employer pays the
In these arrangements, an institution insures the entire premium, the employee may need to
lives of directors or employees in whom it has recognize taxable income each year in accor-
an insurable interest to reimburse the institution dance with federal income tax regulations.
for the cost of employee benefits. The group of Split-dollar arrangements may be structured
insured individuals may be different from the in a number of ways. The two most common
group that receives benefits. The institution’s types of split-dollar arrangements are:
obligation to provide employee benefits is sepa-
rate and distinct from the purchase of the life • Endorsement split-dollar. The employer owns
insurance. The life insurance purchased by the the policy and controls all rights of ownership.
institution remains an asset even after the The employer provides the employee an
employer’s relationship with an insured employee endorsement of the portion of the death bene-
is terminated. The employees who receive benefit specified in the plan agreement with the
fits, whether insured or not, have no ownership employee. The employee may designate a
interest in the insurance (other than their general beneficiary for the designated portion of the
claim against the institution’s assets arising death benefit. Under this arrangement, the
from the institution’s obligation to provide the employer typically holds the policy until the
stated employee benefits). employee’s death. At that time, the employ-
ee’s beneficiary receives the designated por-
There are two common methods of financing tion of the death benefits, and the employer
employee benefits through the purchase of life receives the remainder of the death benefits.
insurance. The first is the cost-recovery method, • Collateral-assignment split-dollar. The
which usually involves present-value analysis. employee owns the policy and controls all
Typically, the institution projects the amount of rights of ownership. Under these arrange-
the expected benefits owed to employees and ments, the employer usually pays the entire
then discounts this amount to determine the premium or a substantial part of the premium.
present value of the benefits. Then, the institu- The employee assigns a collateral interest in
tion purchases a sufficient amount of life insur- the policy to the employer that is equal to the
ance on the lives of certain employees so that employer’s interest in the policy. The employ-
the gain (present value of the life insurance er’s interest in the policy is set forth in the
proceeds less the premium payments) from the split-dollar agreement between the employer
insurance proceeds reimburses the institution for and the employee. Upon retirement, the
the benefit payments. Under this method, the employee may have an option to buy the
institution absorbs the cost of providing the employer’s interest in the insurance policy.
employee benefits and the cost of purchasing the This transfer of the employer’s interest to the
life insurance. The institution holds the life employee is typically referred to as a ‘‘roll-
insurance and collects the death benefit to reim- out.’’ If a ‘‘roll-out’’ is not provided or exer-
burse the institution for the cost of the employee cised, the employer does not receive its inter-
benefits and the insurance. est in the policy until the employee’s death.
The second method of financing employee
benefits is known as cost offset. With this Split-dollar life insurance is a very complex
method, the institution projects the annual subject that can have unforeseen tax and legal
employee benefit expense associated with the consequences. Internal Revenue Service regula-
benefit plan. Then, the institution purchases life tions issued in 200314 govern the taxation of
insurance on the lives of certain employees. The
amount earned on the CSV each year should not 14. 68 Fed. Reg. 54336 (Sept. 17, 2003), chiefly codified at
exceed the annual benefit expense. 26 CFR 1.61-22 and 1.7872-15.

Page 18
split-dollar life insurance arrangements entered standing principal of the debt. The insurance
into or materially modified after September 17, policy should be structured so that the expected
2003.15 These rules provide less favorable tax insurance proceeds never substantially exceed
treatment to split-dollar arrangements than the risk of loss.
existed previously. Institutions considering enter- When purchasing life insurance on borrowers
ing into a split-dollar life insurance arrangement in a homogeneous pool of loans, an institution’s
should consult qualified tax, insurance, and legal management should, given the facts and circum-
advisers. stances known at the time of the insurance
purchase, make a reasonable effort to match the
Life insurance on borrowers. State law gener- insurance proceeds on an aggregate basis to the
ally recognizes that a lender has an insurable total outstanding loan balances. If allowed by
interest in the life of a borrower to the extent of state law, institutions may match the insurance
the borrower’s obligation to the lender. In some proceeds to the outstanding loan balances plus
states, the lender’s insurable interest may equal the cost of insurance on either a present-value or
the borrower’s obligation plus the cost of insur- future-value basis. This relationship should be
ance and the time value of money. Institutions maintained throughout the duration of the
are permitted to protect themselves against the program.
risk of loss from the death of a borrower. This The purchase of life insurance on a borrower
protection may be provided through self- is not an appropriate mechanism for effecting a
insurance, the purchase of debt-cancellation con- recovery on an obligation that has been charged
tracts, or by the purchase of life insurance off, or is expected to be charged off, for reasons
policies on borrowers. other than the borrower’s death. In the case of a
Institutions can take two approaches in pur- charged-off loan, the purchase of life insurance
chasing life insurance on borrowers. First, an on the borrower does not protect the institution
institution can purchase life insurance on an from a risk of loss since the loss has already
individual borrower for the purpose of protect- occurred. Therefore, the institution does not
ing the institution specifically against loss aris- need to purchase insurance. Acquiring insurance
ing from that borrower’s death. Second, an that an institution does not need may subject the
institution may purchase life insurance on bor- institution to unwarranted risks, which would be
rowers in a homogeneous group of loans employ- an unsafe and unsound banking practice. In the
ing a cost-recovery technique similar to that case of a loan that the institution expects to
used in conjunction with employee benefit plans. charge off for reasons other than the borrower’s
Under this method, the institution insures the death, the risk of loss is so pronounced that the
group of borrowers for the purpose of protecting purchase of life insurance by the institution at
the institution from loss arising from the death that time would be purely speculative and an
of any borrower in the homogeneous pool. unsafe and unsound banking practice.
Examples of homogeneous pools of loans include Internal Revenue Code section 264(f) disal-
consumer loans that have distinctly similar char- lows a portion of an institution’s interest deduc-
acteristics, such as automobile loans, credit card tion for debt incurred to purchase life insurance
loans, and residential real estate mortgages. on borrowers. Institutions considering the pur-
When purchasing insurance on an individual chase of insurance on borrowers should consult
borrower, an institution should, given the facts their tax advisers to determine the economic
and circumstances known at the time of the viability of this strategy.
insurance purchase, make a reasonable effort to
structure the insurance policy in a manner con- Life insurance as security for loans. Institutions
sistent with the expected repayment of the sometimes take an interest in an existing life
borrower’s loan. To accomplish this, manage- insurance policy as security for a loan. Institu-
ment should estimate the risk of loss over the tions also make loans to individuals to purchase
life of the loan and match the anticipated insur- life insurance, taking a security interest in the
ance proceeds to the risk of loss. Generally, the policy, a practice known as ‘‘insurance-premium
risk of loss will be closely related to the out- financing.’’ As with any other type of lending,
extensions of credit secured by life insurance
15. Split-dollar arrangements entered into prior to Septem-
should be made on terms that are consistent with
ber 17, 2003, and not materially modified thereafter may be safe and sound banking practices. For instance,
treated differently. the borrower should be obligated to repay the

Page 19
loan according to an appropriate amortization erally available to purchasers of whole or uni-

schedule. versal life insurance whereby the general assets
Generally, an institution may not rely on its of the insurance company support the policy’s
security interest in a life insurance policy to CSV.
extend credit on terms that excuse the borrower
from making interest and principal payments Interest-crediting rate. The gross yield on the
during the life of the borrower with the result investment in the insurance policy, that is, the
that the institution is repaid only when the rate at which the cash value increases before
policy matures upon the death of the insured. considering any deductions for mortality cost,
Lending on such terms is generally speculative load charges, or other costs that are periodically
and an unsafe and unsound banking practice. charged against the policy’s cash value.
Institutions may acquire ownership of life There are a number of crediting rates, includ-
insurance policies for debts previously con- ing ‘‘new money’’ and ‘‘portfolio.’’ Using the
tracted (DPC) by invoking their security interest ‘‘portfolio’’ crediting rate, the institution will
in a policy after a borrower defaults. Consistent earn a return based upon the existing yield of the
with safety and soundness, institutions should insurance carrier’s portfolio each year. Using
use their best efforts to surrender or otherwise the ‘‘new money’’ crediting rate, the institution
dispose of permanent life insurance acquired for will earn a return based upon yields available in
DPC at the earliest reasonable opportunity.16 In the market at the time it purchases the policy.
the case of temporary insurance acquired for
DPC, retention until the next renewal date or the Modified endowment contract (MEC). Type of
next premium date, whichever comes first, will policy that is defined in Internal Revenue Code
be considered reasonable. section 7702A. A MEC generally involves the
payment of a single premium at the inception of
the contract; thus, it fails the so-called seven-pay
Appendix B—Glossary test set forth in the statute. MECs are denied
some of the favorable tax treatment usually
Cash surrender value (CSV). The value avail- accorded to life insurance. For example, most
able to the policyholder if the policy is surren- distributions, including loans, are treated as
dered. If no loans are outstanding, this amount is taxable income. An additional 10 percent pen-
generally available in cash. If loans have been alty tax also is imposed on distributions in some
made, the amount available upon surrender is circumstances. However, death benefits remain
equal to the cash surrender value less the out- tax-free.
standing loan (including accrued interest).
Mortality charge. The pure cost of the life
Deferred acquisition costs (DAC). DAC repre- insurance death benefit within a policy. It rep-
sents the insurance carrier’s up-front costs asso- resents a cost to the purchaser and an income
ciated with issuing an insurance policy, includ- item to the carrier. Mortality charges retained by
ing taxes and commissions and fees paid to the insurance carrier are used to pay claims.
agents for selling the policy. The carrier charges
the policyholder for these costs. Carriers capi- Mortality reserve. In separate-account products,
talize DAC and recover them in accordance with the mortality reserve represents funds held by an
applicable tax law. As the carrier recovers DAC, insurance carrier outside of the separate account
it credits the amount to the policyholder. to provide for the payment of death benefits.
Experience-rated pricing. A pricing method that Non-MEC. An insurance contract that is not
bases prices for insurance products on the actual categorized as a MEC under Internal Revenue
expenses and claims experience for the pool of Code section 7702A.
individuals being insured.
Separate account. A separate account is a design
General account. A design feature that is gen- feature that is generally available to purchasers
of whole life or universal life whereby the
16. The OCC has generally directed national banks to
policyholder’s CSV is supported by assets seg-
surrender or divest permanent life insurance acquired for DPC regated from the general assets of the carrier.
within 90 days of obtaining control of the policy. Under such an arrangement, the policyholder

Page 20
neither owns the underlying separate account Appendix C—Interagency

nor controls investment decisions (e.g., timing Interpretations of the Interagency
of investments or credit selection) in the under- Statement on the Purchase and Risk
lying separate account that is created by the
insurance carrier on its behalf. Nevertheless, the
Management of Life Insurance
policyholder assumes all investment and price
risk. The federal banking and thrift agencies devel-
oped responses to questions regarding the
Seven-pay test. The seven-pay test is a test set December 7, 2004, Interagency Statement on
forth in Internal Revenue Code section 7702A the Purchase and Risk Management of Life
that determines whether or not a life insurance Insurance. A summary of these interpretations is
product is a MEC for federal tax purposes. included below to provide clarification on a
wide variety of matters pertaining to financial
Split-dollar life insurance. A split-dollar life reporting, credit-exposure limits, concentration
insurance arrangement splits the policy’s pre- limits, and the appropriate methodologies to use
mium and policy benefits between two parties, for calculating the amount of insurance an
usually an employer and employee. The two institution may purchase.
parties may share the premium costs while the
policy is in effect, pursuant to a prearranged
contractual agreement. At the death of the Legal Authority—State and Federal Law
insured or the termination of the agreement, the
parties split the policy benefits or proceeds in As a general matter, the ability of state-chartered
accordance with their agreement. banks to purchase insurance (including equity-
linked variable life insurance) is governed by
Stable value protection (SVP) contracts. In gen- state law. Section 24 of the Federal Deposit
eral, an SVP contract pays the policy owner of a Insurance Act (the FDI Act) generally requires
separate account any shortfall between the fair insured state-chartered banks to obtain the con-
value of the separate-account assets when the sent of the Federal Deposit Insurance Corpora-
policy owner surrenders the policy and the cost tion (FDIC) before engaging as principal in
basis of the separate account to the policy activities (including making investments) that
owner. The cost basis of the separate account are not permissible for a national bank. Some
typically would take into account the fair value state bank regulatory agencies have issued their
of the assets in the account when the policy was own BOLI guidance or directives for their
initially purchased, the initial fair value of assets respective state-chartered institutions. A state-
added to the account thereafter, interest credited chartered institution should follow any BOLI
to the account, the amount of certain redemp- guidance or directive issued by its state super-
tions and withdrawals from the account, and visory authority that is more restrictive than the
credit losses incurred on separate-account assets. interagency statement. Generally, if state law or
Thus, SVP contracts mitigate price risk. SVP policy is less restrictive than the interagency
contracts are most often used in connection with statement, a state-chartered institution should
fixed-income investments. follow the interagency statement. If federal law
is less restrictive than state law, a state-chartered
1035 exchange. A tax-free replacement of an institution should follow the state law.
insurance policy for another contract covering
the same person(s) in accordance with section
1035 of the Internal Revenue Code. Permissibility of Equity-Linked Securities
in Separate-Account BOLI
Variable life insurance. Variable life insurance
policies are investment-oriented life insurance The interagency statement states that national
policies that provide a return linked to an banks and federal savings associations may hold
underlying portfolio of securities. The portfolio equity-linked variable life insurance policies
typically is a group of mutual funds chosen by (that is, insurance policies with a return tied to
the insurer and housed in a separate account, the performance of a portfolio of equity securi-
with the policyholder given some discretion in ties held in a separate account of the insurance
choosing among the available investment options. company) only in very limited circumstances.

Page 21
Similarly, state member banks may also hold considerations, it is also important to diversify
equity-linked variable life insurance policies BOLI exposures in order to control transaction
only in very limited circumstances. Because the risks that may be associated with an individual
range of instruments with equity-like character- carrier’s policies.
istics varies significantly, the permissibility of
each such instrument must be analyzed on a
case-by-case basis. Furthermore, the agencies Per-Carrier Limits
have significant concerns regarding whether an
institution properly understands the complex Institutions should establish a per-carrier limit
risk profile that securities with ‘‘equity-like’’ for separate-account policies. Diversification
characteristics often present. Some securities, among carriers reduces transaction risks. Insti-
even if legally permissible, may be inappropri- tutions should also explicitly consider whether it
ate for the vast majority of financial institutions, is appropriate to combine general- and separate-
whether held in an investment portfolio or a account exposures from the same carrier for
separate-account BOLI product. The agencies’ purposes of measuring exposure against internal
April 1998 Supervisory Policy Statement on limits. The agencies believe that institutions,
Investment Securities and End-User Derivatives based upon their risk tolerance and understand-
Activities provides guidance on the appropriate- ing of insurance risks, should determine for
ness of investments and risk-management themselves whether to combine such policies. In
expectations. this regard, the agencies note that separate-
account policies also present general-account
credit exposures. For example, deferred acqui-
Senior Management and Board sition costs (DAC) and mortality reserves asso-
Oversight—Establishing BOLI ciated with separate-account policies are general
Concentration Limits obligations of the insurance carrier. Moreover,
when the death of an insured occurs, the differ-
Each institution should establish internal poli- ence between the death benefit amount and the
cies and procedures governing its BOLI hold- cash surrender value comes from the carrier’s
ings that limit the aggregate cash surrender general account. Finally, the actual credit expo-
value (CSV) of policies from any one insurance sure under a BOLI policy may be many times
company as well as the aggregate CSV of greater than the carrying value of the policy
policies from all insurance companies. The inter- currently recorded on the institution’s balance
agency statement is not intended to loosen the sheet, given the typical relationship between
standards with respect to prior BOLI guidance. CSV and policy death benefits. Institutions
The agencies have rigorous expectations regard- should keep these factors in mind when evalu-
ing the establishment of prudent limits and ating whether and, if so, how to aggregate
appropriate board and management oversight of general- and separate-account exposures for pur-
the limit-setting process. Accordingly, excep- poses of monitoring compliance with internal
tions will be subject to increased supervisory limits.
attention. The agencies continue to expect insti-
tutions to adopt per-carrier limits for BOLI,
keeping in mind legal lending limits. Although Legal Limits and Concentrations
the federal statutory and regulatory lending
limits do not, as a general rule, impose a When establishing internal CSV limits, an insti-
per-carrier legal constraint on BOLI because tution should consider its legal lending limit, the
BOLI is not a loan, BOLI nevertheless does capital concentration thresholds, and any appli-
represent a long-term credit exposure. The agen- cable state restrictions on BOLI holdings. The
cies expect institutions to manage credit expo- following are the agencies’ capital concentration
sures in a prudent manner, irrespective of definitions:
whether the exposure is subject to a statutory or
regulatory limit. If an institution establishes an • The FDIC uses 25 percent of tier 1 capital to
aggregate limit for BOLI based upon its appli- measure a capital concentration.
cable capital concentration threshold, it would
seldom be prudent to have its per-carrier limit • The other agencies use tier 1 capital plus the
equal to the aggregate limit. Apart from credit allowance for loan and lease losses (ALLL).

Page 22
A state-chartered institution should be guided by person’s death. The interagency statement pro-
the more restrictive of the applicable state and vides that a national bank or federal savings
federal limitations and thresholds. For example, association may be required to surrender or
if a state defines BOLI as an extension of credit otherwise dispose of key-person life insurance
subject to a statutory or regulatory lending limit, held on an individual who is no longer a key
or otherwise imposes a per-carrier limit on person because the institution will no longer
BOLI, then institutions subject to that state’s suffer a financial loss from the death of that
jurisdiction should ensure that their BOLI expo- person. However, when an individual upon
sure to an individual carrier does not exceed the whom key-person life insurance has been held is
applicable state limit. no longer a key person, an institution may be
able to recharacterize its objective for the insur-
ance policy as recovery of the cost of providing
Permissibility of Holding Life Insurance employee benefits. In such cases, the institution
on Former Employees and Former Key must demonstrate, through appropriate analysis
Persons and quantification, that the insurance coverage
satisfies the retention conditions, as set forth in
A well-managed institution adequately docu- the preceding paragraph. For a state-chartered
ments the purpose for which it is acquiring institution, the recharacterization and retention
BOLI, as part of its pre-purchase analysis. When of such key-person life insurance must be per-
an institution purchases life insurance on a missible under applicable state law. In circum-
group of employees (whether it is a group policy stances where a national bank or federal savings
or a series of individual policies) as a means to association would be required to surrender or
finance or recover the cost of employee benefits, otherwise dispose of key-person life insurance,
and one or more of the insured employees is no a state-chartered institution must also surrender
longer employed by the bank, the insurance or otherwise dispose of a key-person policy
coverage may be retained by the institution unless the retention of the policy is permitted
provided— under applicable state law and the institution
obtains the FDIC’s consent to continue to hold
• the application of the cost-recovery or cost- the policy under section 24 or section 28 of the
offset method (see ‘‘Quantifying the Amount FDI Act, as appropriate.
of Insurance Appropriate for the Institution’s
Objectives’’ below) indicates that the amount
of insurance held is not in excess of the Quantifying the Amount of Insurance
amount required to recover or offset the cost Appropriate for the Institution’s
of the institution’s employee benefits, Objectives
• the policy is not specifically designated to
cover only loss of income to the banking Institutions are responsible for ensuring that
organization that may arise from the death of they do not purchase excessive amounts of
the employee, insurance coverage on their employees relative
• the coverage continues to qualify as an insur- to salaries paid and the costs of benefits to
able interest under applicable state law, and recover. Examiners will evaluate an institution’s
• the insurance asset continues to be a permis- BOLI holdings and make a supervisory judg-
sible holding under applicable state law for ment as to whether insurance amounts on
state-chartered institutions. employees are so excessive as to constitute
speculation or an unsafe or unsound practice on
Additionally, if the policy no longer qualifies as a case-by-case basis, as they do for other aspects
insurance under the applicable state insurable- of an institution’s operations. Such an evalua-
interest law, the policy may no longer be eligible tion would be based on the totality of the
for favorable tax treatment. These conditions circumstances.
apply to ‘‘benefits BOLI’’ despite the fact that Institutions may use either the cost-recovery
the former employee was a ‘‘key person.’’ or cost-offset method to quantify the amount of
This is in contrast to true key-person insur- insurance permissible for purchase to finance or
ance, in which the institution purchases life recover employee benefit costs. When using the
insurance on a key person in order to protect cost-offset approach, an institution must ensure
itself from financial loss in the event of that that the projected increase in CSV each year

Page 23
over the expected duration of the BOLI is less surrender all of these policies simultaneously
than or equal to the expected employee benefit and avoid the surrender charges is a gain con-
expense for that year. When using the cost- tingency. This guidance should be applied to all
recovery method, regardless of an institution’s insurance policies held by an institution regard-
quantification method, management must be less of when they were acquired. Therefore, an
able to support, with objective evidence, the institution that has purchased BOLI is required
reasonableness of all assumptions used in deter- to report the CSV on the bank’s balance sheet
mining the appropriate amount of insurance net of the surrender charges (even if the policies
coverage needed, including the rationale for its have been in force for some time and the
discount rates (when the cost-recovery method institution’s auditors have not previously required
is used) and cost projections. reporting the CSV net of the surrender charges).
Based on the agencies’ review of FASB
Technical Bulletin No. 85-4, ‘‘Accounting for
Applicability of Prior Guidance for Purchases of Life Insurance’’ (TB 85-4), includ-
Split-Dollar Arrangements ing its appendix, the agencies believe that TB
85-4 is intended to be applied on a policy-by-
The pre-purchase analysis guidance in the inter- policy basis. It, therefore, does not permit the
agency statement applies to life insurance poli- aggregation of multiple separate policies for
cies used in split-dollar arrangements that are balance-sheet-measurement purposes. Accord-
acquired after December 7, 2004. The guidance ingly, the agencies do not intend to defer to
concerning the ongoing risk management of life institutions or their auditors on this issue. As of
insurance after its purchase applies to life insur- the balance-sheet date, an institution should
ance policies, including those used in split- determine the amount that could be realized
dollar arrangements, regardless of when acquired. under each separate insurance policy on a stand-
The FDIC’s prior guidance on split-dollar alone basis without regard to the existence of
arrangements, which was included in supervi- other insurance policies or riders covering mul-
sory guidance on BOLI that was issued in 1993, tiple policies. If a single insurance policy covers
has been superseded; until the issuance of the more than one individual, the realizable amount
interagency statement, the FDIC had generally of the entire policy should be determined. A
followed the Office of the Comptroller of the single insurance policy covering multiple indi-
Currency’s prior guidelines from 2000. Other- viduals should not be subdivided into hypotheti-
wise, the prior guidance issued by the agencies cal separate policies for each covered individual,
on split-dollar life insurance remains in effect. even if the carrier reports CSVs for each cov-
Each agency issued the interagency statement ered individual.
under its own bulletin, letter, or notice. For If a change in an institution’s accounting for
example, the Federal Reserve Board’s issuance its holdings of life insurance is necessary for
of the interagency statement is cross-referenced regulatory reporting purposes, the institution
in SR-04-19, and the prior guidance on split- should follow Accounting Principles Board
dollar life insurance arrangements is not super- Opinion No. 20, ‘‘Accounting Changes’’(APB
seded. 20).17 APB 20 defines various types of account-
ing changes and addresses the reporting of
corrections of errors in previously issued finan-
Accounting Considerations cial statements. APB 20 states that ‘‘[e]rrors in
financial statements result from mathematical
An institution may purchase multiple permanent mistakes, mistakes in the application of account-
insurance policies from the same insurance car- ing principles, or oversight or misuse of facts
rier, with each policy having its own surrender that existed at the time the financial statements
charges. In some cases, the insurance carrier were prepared.’’
will issue a rider or other contractual provision
stating that it will waive the surrender charges if
all of the policies are surrendered at the same
time. Because it is not known at any balance-
17. Effective December 15, 2005, APB 20 will be replaced
sheet date whether one or more of the policies by FASB Statement No. 154, ‘‘Accounting Changes and Error
will be surrendered before the deaths of the Corrections—A replacement of APB Opinion No. 20 and
insureds, the possibility that the institution will FASB Statement No. 3.’’

Page 24
For regulatory reporting purposes, an institu- Rate of Return to the Bank in Split-Dollar
tion must determine whether the reason for a Insurance Arrangements
change in its accounting for its holdings of life
insurance meets the APB 20 definition of an The agencies would consider the institution’s
accounting error. If the reason for the change economic interest in a split-dollar life insurance
meets this definition and the amount is material, arrangement policy, at a minimum, to be a return
the error should be reported as a prior-period of the premiums paid plus a reasonable rate of
adjustment in the institution’s regulatory reports. return. The agencies would generally consider a
Otherwise, the effect of the correction of the reasonable rate of return to be one that provides
error should be reported in current earnings. If the bank a return that is commensurate with
the effect of the correction of the error is alternative investments having similar risk char-
material, the institution should also consult with acteristics (including credit quality and term) at
its primary federal regulatory agency to deter- the time in which the bank enters into the
mine whether any previously filed regulatory split-dollar arrangement. The rate of return is to
reports should be amended. For the Call Report, be calculated net of any payments made (or to
the institution should report the amount of the be made) from insurance proceeds to the employ-
adjustment in Schedule RI-A, item 2, ‘‘Restate- ee’s beneficiaries.
ments due to corrections of material accounting The agencies look at the economic value of
errors and changes in accounting principles,’’ compensation arrangements when determining
with an explanation in Schedule RI-E, item 4. the reasonableness of split-dollar compensation,
The effect of the correction of the error on but the agencies do not rely solely on income tax
income and expenses since the beginning of the rules for determining this economic value. Other
period in which the correction of prior-period factors that the agencies might consider include,
earnings is reported should be reflected in each but are not limited to, the benefit of a split-dollar
affected income and expense account on a year- arrangement to the employee as a percentage of
to-date basis in the Call Report Income State- salary and the expected length of time until the
ment (Schedule RI), not as a direct adjustment to institution recovers its invested funds.
retained earnings.

Page 25
1. To determine the level and direction of risk 5. To apply a forward-looking approach to the
that purchases and holdings of life insurance review of a bank’s purchase and risk man-
pose to the state member bank, and to rec- agement of life insurance, recognizing that
ommend corrective action, as appropriate. the bank may be exposed to increasing opera-
2. To perform— tional risks as a result of its large purchases
a. a risk assessment that summarizes the or holdings of this product. These risks may
level of inherent risk by risk category, and arise from—
b. an assessment of the adequacy of the a. separate-account assets that contain hold-
board of directors’ and management’s ings of complex equity-linked notes and
oversight of the activity, including an derivative products;
assessment of the bank’s internal control b. the growing use of guaranteed minimum
framework. death benefits and other complex guaran-
3. To ensure that the risk assessment considers tee structures, which may increase the
a state member bank’s purchase and risk operational risk to banks purchasing sig-
management of its— nificant amounts of life insurance; and
a. broad bank-owned life insurance (BOLI) c. the potential losses that could result from—
programs, in which life insurance is pur- • inadequate recordkeeping, which may
chased on a group of employees to offset be related to tracking the potentially
employee benefit programs and the bank large variety of contracts and agree-
is the beneficiary; ments and the potentially large number
b. split-dollar insurance arrangements for of insured current and former employ-
individual (usually senior-level) bank ees covered by the contracts, and
employees; and • a failure to ensure that contract agree-
c. holdings of key-person insurance. ments between the insurance company,
4. Recognizing that management may not be as the vendor(s), and the employees are
familiar with insurance products as it is with properly executed and honored.
more-traditional bank products, to adequately
identify and assess the risks of BOLI, as well
as the risk exposures that may arise from
purchases and holdings of life insurance.1 tional, liquidity, credit, legal, and reputational risk. Opera-
tional risk arises in part from the vast array of new life
1. As noted in more depth in section 4042.1, the December insurance products and structures being offered and from the
7, 2004, Interagency Statement on the Purchase and Risk complexity of tax considerations related to the products, under
Management of Life Insurance, these risks include opera- various state insurable-interest and federal tax laws.

Page 1
PRELIMINARY RISK underlying separate-account assets

ASSESSMENT and (2) if these assets constitute
higher-risk investments, including
1. Consider the following, among other rel- equity-linked notes, mortgage-backed
evant criteria as appropriate, when determin- securities with significant interest-
ing whether to include the review of bank- rate risk, or other investments entail-
owned life insurance (BOLI) in the ing significant market risk.
examination scope: • Determine whether any of the life
a. the volume, growth, and complexity of insurance policies are held in out-of-
BOLI purchases and holdings state trusts. If so, ascertain—
• Consider the amount of the bank’s — whether management and the
BOLI holdings, measured by the total board of directors can demon-
of their cash surrender values (CSVs) strate that they have performed an
as a percentage of capital, and deter- independent legal analysis to
mine whether the resulting percent- ensure that the legal structure
age is an asset concentration of capi- employed does not jeopardize the
tal. (For state member banks, the bank’s insurable interest in the
Federal Reserve has defined the capi- insurance policies or its access to
tal base for determining this concen- the policy proceeds, as applica-
tration threshold to be a percentage of ble; and
tier 1 capital plus the allowance for — whether the trust arrangement
loan and lease losses.) Determine inappropriately disadvantages the
whether the BOLI holdings have bank (for example, by permitting
grown or declined significantly in inappropriate investments or per-
recent years, when compared with the mitting the insured or the benefi-
BOLI holdings of peer banks (consult ciary to borrow against the policy
the Federal Reserve System’s intranet holding in such a way that could
for applicable surveillance and moni- jeopardize the bank’s ability to
toring data). recover amounts owed to it under
• Obtain a breakout of the CSV of the trust agreement).
BOLI assets, as reported on the bank’s b. BOLI concentrations
balance sheet, including the amounts • Determine if there is a CSV concen-
attributable to split-dollar insurance tration of life insurance to one carrier
arrangements, general BOLI plans in excess of 25 percent that includes
covering a group of employees to both separate-account and general-
recover the cost of employee compen- account BOLI holdings.
sation and benefit programs, and the • Determine if there are any market-
amount, if any, attributable to key- risk concentrations within the under-
person insurance. lying separate-account assets, includ-
• Obtain a listing of the amount of the ing, for example, interest-sensitive
bank’s reimbursable premium pay- fixed-income holdings.
ments under split-dollar life insurance • Determine if there are any equity-
arrangements and the amount receiv- linked notes or direct equity holdings
able for these policies, which is to be in the separate accounts.
booked as ‘‘other assets’’ on the • Determine if the bank holds any large-
bank’s balance sheet. exposure life insurance policies on
• Determine whether a portion of the particular individuals. If so, deter-
CSV is in separate-account holdings mine if the policies are split-dollar
of a life insurance company. If the arrangements and, if so—
bank has separate-account holdings, — whether the board or a board
determine (1) the composition of the committee has evaluated the rea-

Page 1
4042.3 Purchase and Risk Management of Life Insurance: Examination Procedures
sonableness of the compensation ‘‘Accounting for Purchases of Life Insur-

as part of the employee’s overall ance’’ (TB 85-4). Only the amount that
compensation package, and can be realized under an insurance con-
— whether the board or a board tract as of the balance-sheet date (that is,
committee has determined that the CSV reported to the bank by the
the overall compensation is insurance carrier, less any applicable sur-
appropriate. render charges not reflected by the insur-
c. the appropriateness and recency of mate- ance carrier in the reported CSV) is
rials presented to the bank’s board of reported as an asset. Since there is no
directors concerning the bank’s purchase right of offset, a BOLI investment is
and risk management of life insurance reported as an asset separately from any
relative to its insurance purchases and deferred compensation liability, pro-
holdings vided that it was not purchased in con-
d. the appropriateness and recency of audits nection with a tax-qualified plan.
and compliance reviews of the bank’s b. Call Report instructions. The bank is
purchases and risk management of life required to report the carrying value of
insurance its BOLI holdings (CSV net of applica-
e. the overall financial condition of the ble surrender charges) as a component of
bank, its supervisory rating, and any ‘‘other assets’’ and to report the earnings
concerns or potential concerns about its on these holdings as ‘‘other noninterest
liquidity income.’’
2. Depending upon the outcome of the prelimi- 4. Verify that the bank’s deferred compensa-
nary risk assessment and other relevant tion agreements were accounted for using
factors, consider performing the following the guidance in the February 11, 2004,
examination procedures. Interagency Advisory on Accounting for
Deferred Compensation Agreements and
Bank-Owned Life Insurance.
5. Verify that any accounts receivable that
OPERATIONAL-RISK represent the bank’s reimbursable life insur-
ASSESSMENT ance premiums paid are recorded as unim-
Senior Management and Board paired account receivables (for example,
life insurance policies that are not impaired
Oversight as a result of declining CSVs backing the
obligations or employees borrowing against
1. Evaluate whether board and senior manage-
CSVs). (Impaired amounts should be
ment oversight is effective and ensures that
expensed.)
the bank’s purchases and holdings of BOLI
are consistent with safe and sound banking
practices.
2. Determine whether the board of directors Policies and Procedures
understands the complex risk characteristics
of the bank’s insurance holdings and the 6. Assess the adequacy of the bank’s policies
role of BOLI in the bank’s overall business and procedures governing its BOLI pur-
strategy. chases and holdings, including its guide-
lines to limit the aggregate CSV of policies
from one insurance company as well as
limit the aggregate CSV of policies from all
Accounting Considerations insurance companies.
7. Verify if the bank’s board of directors or the
3. Determine if the bank’s financial and regu- board’s designated committee approved
latory reporting of its life insurance activi- BOLI purchases in excess of 25 percent of
ties follows applicable generally accepted capital or in excess of any lower internal
accounting principles (GAAP), including limit. (For state member banks, the Federal
the following guidance: Reserve has defined the capital base for
a. Financial Accounting Standards Board determining this concentration threshold to
(FASB) Technical Bulletin No. 85-4, be a percentage of tier 1 capital plus the
Page 2
Purchase and Risk Management of Life Insurance: Examination Procedures 4042.3
allowance for loan and lease losses.) loss to be covered in order to ensure that the
8. Determine the reasonableness of the bank’s amount of BOLI purchased was not exces-
internal limits and whether management sive in relation to this estimate and the
and the board of directors have considered, associated product risks.
before purchasing BOLI, the bank’s legal 17. Determine whether management can sup-
lending limit, its applicable state and federal port, with objective evidence, the reason-
capital concentration threshold, and any ableness of all of the assumptions used in
other applicable state restrictions on BOLI. determining the appropriate amount of insur-
9. For banks that may have other credit expo- ance coverage needed by the bank, includ-
sures to insurance companies, determine if ing the rationale for its discount rates and
the bank has considered the credit expo- cost projections.
sures arising from its BOLI purchases when
assessing its overall credit exposure to a
carrier and to the insurance industry. Vendor Qualifications
10. Determine whether the bank’s management
has justified and analyzed the risks associ- 18. Evaluate whether the bank’s management
ated with a significant increase in the bank’s assessed its own knowledge of insurance
BOLI holdings. risks, the vendor’s qualifications, the amount
11. Determine if the bank has advised its board of resources the bank is willing to spend to
of directors of the existence of the Decem- administer and service the BOLI, and the
ber 7, 2004, Interagency Statement on the vendor’s ability to honor the long-term
Purchase and Risk Management of Life financial commitments associated with
Insurance and of the risks associated with BOLI.
BOLI.
Characteristics of Available Insurance

Products
Pre-Purchase Analysis
19. Evaluate whether the bank’s management
12. Ascertain whether the bank maintains has reviewed and understands the character-
adequate records of its pre-purchase analy- istics of the various life insurance products
sis of BOLI. available and of the products it has acquired.
13. Evaluate whether the bank’s board of direc- 20. Ascertain if and how the bank’s manage-
tors, or a designated board committee, and ment reviewed and selected the life insur-
senior management understand the risks, ance product characteristics that best matched
rewards, and unique characteristics of BOLI. its objectives, needs, and risk tolerance.
Ascertain whether management evaluated
and documented, before the bank acquired
Need for Insurance, Economic Benefits, BOLI, the risks of the variety and complex-
and Appropriate Insurance Type ity of life insurance products considered,
how the selected insurance product works,
14. Determine whether the bank identified the the variables that affect the product’s per-
specific risk of loss to which it is exposed or formance, and the applicable tax and
the specific costs to be recovered by the accounting treatments.
purchase of life insurance. 21. Determine whether the bank’s management
15. Determine whether the bank analyzed the reviewed and documented its consideration
costs and benefits of planned BOLI of the types and design features of BOLI.
purchases. Determine whether management reviewed
and documented the negotiable features
associated with a separate-account insur-
Amount of Insurance Appropriate for the ance product (for example, its investment
Institution’s Objectives options, terms, and conditions; the cost of
stable value protection (SVP); deferred
16. Find out if the bank estimated the size of its acquisition costs (DAC); and mortality
employee benefit obligation or the risk of options) and with any SVP provider that

Page 3
may have been separately contracted by the Split-Dollar or Other Insurance

insurance carrier. Arrangements That Result in Additional
22. Verify that the bank’s management con- Insured Employee Compensation
ducted a thorough review of life insurance
policies before acquiring the policies. Ascer- 28. When a bank acquires insurance that per-
tain if management determined how the mits a bank officer or employee to designate
accounting rules would apply to those poli- a beneficiary or provides the officer or
cies and if it understood any ambiguous employee with additional compensation,
contract provisions, such as costs, charges, determine if the bank identified and quanti-
or reserves, that may affect the amount of a fied its total compensation objective. Deter-
policy’s CSV. mine if the bank ensured (1) that the
acquired split-dollar life or other insurance
arrangement was consistent with that objec-
Tax and Insurable-Interest Implications tive, including when insurance compensa-
tion is combined with all other compensa-
23. For the bank’s pre-acquisition review of tion being provided, and (2) that the total
BOLI and its subsequent BOLI purchases, compensation was not excessive.
verify that the bank’s management consid- 29. Verify that the bank and the insured have
ered and documented its analysis of the entered into a written agreement that spe-
financial impact of surrendering a policy cifically states the bank’s rights, the insured
(for example, any tax implications). individual’s rights, and the rights of any
24. Verify that the bank’s management obtained other parties (trusts or beneficiaries) to the
appropriate legal reviews. An appropriate policy’s CSV and death benefits.
legal review ensures that— 30. Verify that the bank’s shareholders and
a. the bank complies with applicable tax their family members (who are not bank
and state insurable-interest requirements, officers, directors, or employees and who do
and not provide goods and services to the bank)
b. the bank’s insured amounts are not exces- do not receive compensation in the form of
sive (therefore, the bank is not involved split-dollar life or other insurance coverage
in impermissible speculation or unsafe benefits.
and unsound banking practices). 31. Determine whether the bank’s management
has assessed the bank’s ability to borrow
against the CSV of its split-dollar life insur-
Carrier Selection ance policies, as well as the ability of other
parties (whether an insured officer, employee,
25. Find out if the bank (1) reviewed the BOLI or noninstitution owner) to borrow against
product’s design and pricing and the admin- the policy CSV, without impairing the bank’s
istrative services of the proposed carrier and financial interest in the policy proceeds.
(2) compared these services with those of Determine also—
other insurance carriers. a. if the bank can liquidate the policy in
26. Ascertain whether the bank’s management order to meet liquidity needs; or
reviewed the selected carrier’s ongoing long- b. if the bank effects an early policy surren-
term ability to commit to the BOLI product, der (such as might occur if an employee
as well as its credit ratings, general reputa- terminates his or her employment), if the
tion, experience in the marketplace, and surrender would preclude the bank from
past performance. recovering its premium payments and a
27. Determine if the bank performed a credit market rate of return on the premiums
analysis on the selected BOLI carriers and if invested.
the analysis was consistent with safe and 32. Determine if and how management verified
sound banking practices for commercial that the bank would be able to recover its
lending. premium payments plus a market rate of
return on the premiums invested, after the
payment of policy proceeds to the employ-
ee’s beneficiary under the split-dollar
arrangement.

Page 4
Other Elements of Pre-Purchase Analysis j. a peer analysis of BOLI holdings.
33. Ascertain whether the bank’s management

thoroughly evaluated all significant risks. LIQUIDITY-RISK ASSESSMENT
Determine whether management has estab-
lished procedures to identify, measure, moni- 1. Find out if management, before the bank’s
tor, and control those risks. purchase of permanent insurance, recog-
34. Find out if the bank, before acquiring BOLI, nized the illiquid nature of the bank’s acqui-
thoroughly analyzed its associated risks and sition of its permanent insurance products.
benefits. As appropriate, determine whether Determine whether management ensured
the bank compared the risks of BOLI with that the bank had the long-term financial
those of alternative methods for recovering flexibility to continue holding the insurance
costs associated with the loss of key per- assets for their full term of expected use.
sons, providing pre- and post-retirement 2. Determine if management, before the bank’s
employee benefits, or providing additional purchase of permanent insurance, adequately
employee compensation. considered the contractual arrangements and
product types that limit product liquidity in
order to best optimize the value of the
Post-Purchase Analysis bank’s insurance assets and their possible
future use as liquidity and funding sources.
35. Find out if management reviewed at least Contract provisions that should be consid-
annually the bank’s life insurance purchases ered include—
and holdings with the bank’s board of a. 1035 exchange fees and ‘‘crawl-out
directors.1 Ascertain if the review included, restrictions,’’
at a minimum— b. provisions that would result in the prod-
a. a comprehensive assessment of the spe- uct’s categorization for federal tax pur-
cific risks associated with the bank’s poses as a modified endowment contract
permanent insurance acquisitions; (MEC) or a non-MEC contract, and
b. an identification of the bank’s employees c. SVP contract provisions that may limit
who are or will be insured (for example, the bank’s ability to surrender a policy
vice presidents and above, employees of early or that would increase the cost of
a certain grade level, etc.); an early surrender.
c. an assessment of death benefit amounts
relative to employee salaries;
d. a calculation of the percentage of insured REPUTATION-RISK ASSESSMENT
persons still employed by the bank;
e. an evaluation of the material changes to 1. Ascertain whether the bank has taken steps,
BOLI risk-management policies; including obtaining written consent from its
f. an assessment of the effects of policy insured officers and employees, to reduce its
exchanges; reputation risk that may result from BOLI
g. an analysis of mortality performance and purchases.
the impact on income; 2. Determine if the bank maintains appropriate
h. an evaluation of material findings from documentation evidencing that it obtained a
internal and external audits and indepen- formal written consent from its insured
dent risk-management reviews; officers and employees.
i. an identification of the reason for, and 3. Find out what segment of the employee
the tax implications of, any policy sur- base the bank has insured (i.e., officers or
renders; and non-officers) and if the bank has taken out
very high death benefit policies on employ-
ees, including lower-level employees.
1. More-frequent reviews should be conducted if signifi-
cant changes to the BOLI program are anticipated, such as
additional purchases, a decline in the financial condition of the
insurance carrier(s), anticipated policy surrenders, or changes
CREDIT-RISK ASSESSMENT
in tax laws or interpretations that could have an impact on the
performance of BOLI. 1. Determine if the bank’s management con-

Page 5
ducted an independent financial analysis of 4. Find out if the bank has acquired an SVP
the insurance carrier before the bank’s pur- contract for its separate-account policy in
chase of a life insurance policy. order to reduce income-statement volatility.
a. Ascertain if management continues to (SVP contracts protect against declines in
monitor the life insurance company’s value attributable to changes in interest
condition on an ongoing basis. rates; they do not cover default risk.)
b. Verify that the bank’s credit-risk man- 5. If the bank has not purchased an SVP
agement function participated in the contract, determine if management has
review and approval of insurance carriers. established and maintained monitoring and
2. Determine whether the bank considered its reporting systems that will recognize and
legal lending limit, its credit concentration respond to price fluctuations in the fair
guidelines (the aggregate exposures to indi- value of separate-account assets.
vidual insurance carriers and the life insur-
ance industry, including other bank credit 6. If the bank has purchased an equity-linked
relationships, such as credit exposures variable life insurance policy, determine
involving loans and derivatives), and any whether it is characterized as an effective
state restrictions on BOLI holdings. economic hedge against the bank’s equity-
3. Determine whether the bank’s credit analy- linked obligations under its employee bene-
sis of its BOLI holdings evaluated whether fit plans. (An effective hedge exists when
the policies to be acquired were either changes in the economic value of the liabil-
separate-account or general-account policies. ity or other risk exposure being hedged are
a. Find out whether the separate-account matched by counterbalancing changes in
policies included an SVP contract to the value of the hedging instruments. The
protect the bank (as a policyholder) from economic hedging criteria for equity-linked
declines in the fair value of separate- insurance products lessen the effect of price
account assets. risk because changes in the amount of the
b. Ascertain if the bank evaluated the insur- equity-linked liability are required to offset
ance carrier’s separately contracted SVP changes in the value of the separate-account
provider’s repayment capacity. assets.)
7. If the bank is purchasing or has purchased a
separate-account insurance product involv-
ing equity securities, determine if the bank’s
MARKET-RISK ASSESSMENT management has performed further analysis
that—
1. Determine whether management fully under-
stood (before the bank purchased its separate- a. compares the equity-linked liability being
account products)— hedged and the equity securities in the
a. how the life insurance products expose separate account,
the bank to interest-rate risk; b. determines a target range for the hedge-
b. the instruments governing the invest- effectiveness ratio and establishes a
ment policy, as well as how the separate method for measuring ongoing hedge
account is managed; effectiveness, and
c. the inherent risk of a separate account;
c. establishes a process for analyzing and
and
reporting to management and the board
d. whether the bank’s risk from the pur-
of directors the effect of the hedge on the
chase of separate-account products was
bank’s earnings and capital ratios (both
appropriate.
with and without the hedging transaction).
2. For general-account products, ascertain if
management understands the interest-
crediting option the bank chose when pur-
chasing the insurance policy.
3. Find out if the bank has established and if it COMPLIANCE/LEGAL-RISK
maintains appropriate monitoring and report- ASSESSMENT
ing systems for interest-rate fluctuations
and their effect on separate-account assets. 1. Determine whether the bank’s compliance

Page 6
and audit functions have evaluated its com- b. determine if the standard risk weight of
pliance with applicable state insurable- 100 percent was assigned to the bank’s
interest and federal tax laws in order to BOLI assets when the bank’s documen-
protect the bank’s earnings and capital from tation is inadequate or does not exist;
the loss of tax benefits or from the imposi- c. verify that a 100 percent risk weight has
tion of fines or penalties by regulatory been assigned to (1) the portion of the
authorities for violations of, or noncompli- bank’s insurance asset that represents
ance with, laws, rulings, regulations, pre- general-account claims on the insurer
scribed practices, and ethical standards. (such as DAC and mortality reserves that
2. When the bank owns separate-account are realizable on the balance-sheet date)
BOLI, determine whether the bank has and (2) any portion of the carrying value
implemented and maintains internal control attributable to an SVP contract (or if the
policies and procedures that adequately SVP provider is not an insurance com-
ensure that it does not take any action that pany, verify that the correct risk weight
might be interpreted as exercising ‘‘con- has been assigned for that obligor); and
trol’’ over separate-account assets. d. if the bank used a pro rata approach to
3. Determine whether the bank split commis- risk-weighting the carrying value of a
sions between a vendor and the bank’s own qualifying separate-account policy—
subsidiary or affiliate insurance agency when
purchasing life insurance. If so, determine • verify that the risk weight is applied
whether the bank’s compliance function has to the separate account based on the
assessed the bank’s compliance with state most risky portfolio that could be
and federal securities and insurance laws held by the separate account (as stated
regarding fee and commission arrangements. in the investment agreement), except
4. Ascertain whether the bank seeks and docu- for any portions of the carrying value
ments the advice of legal counsel when that are general-account claims attrib-
determining legal and regulatory issues, utable to either DAC or an SVP
requirements, and concerns related to its (which are generally risk-weighted at
potential purchase or ownership of BOLI. 100 percent);
5. For a general-account insurance product, • verify that in no case may the assigned
determine if the bank has assigned a stan- risk weight for the bank’s entire
dard risk weight of 100 percent to the separate-account holding be less than
general-account asset. 20 percent; and
6. For a BOLI separate-account product (when • when the sum of the permitted invest-
the bank uses the look-through approach to ments across market sectors in the
assign risk weights according to the risk- investment agreement is greater than
based capital rules)— 100 percent, determine if the bank
a. review the bank’s documentation, and assigned the highest risk weight for
determine if the bank adequately verified the maximum amount permitted in
that the separate-account BOLI assets that asset class, and then applied the
are protected from the insurance compa- next-highest risk weights to the other
ny’s general creditors in the event of the asset classes until the aggregate of the
insurance company’s insolvency; permitted amounts equals 100 percent.

Page 7
Examiners should use only those internal con- Accounting Considerations

trol questions that are appropriate, given the
size, complexity, and growth of a bank’s bank- 3. When accounting for its holdings of life
owned life insurance (BOLI) holdings. insurance, did the bank follow the guidance
in FASB’s Technical Bulletin No. 85-4,
‘‘Accounting for Purchases of Life Insur-
ance’’? Are the bank’s insurance policies
PRELIMINARY RISK reported on its balance sheet on the basis of
ASSESSMENT each policy’s cash surrender value (CSV),
less any applicable surrender charges that
1. Have the steps for conducting a preliminary are not reflected in the reported CSV?
risk assessment been followed, as they are 4. On the bank’s Call Report, did the bank’s
set forth in section 4042.3? Have other management —
relevant factors been considered to deter- a. report the carrying value of its BOLI
mine if further examination review may be holdings as an ‘‘other asset’’?
warranted, in accordance with risk-focused b. report the earnings on the bank’s hold-
supervision guidelines? ings as ‘‘other noninterest income’’?
2. What particular factors have been identified c. report the CSV separately, as required if
to warrant a review of the bank’s purchases the CSV amount exceeded the reporting
and risk management of life insurance? threshold?
d. expense only the noninvestment portion
of the premium, in the case of bank-
OPERATIONAL-RISK owned policies?
ASSESSMENT e. expense the premium for employee-
owned insurance purchased by the bank
Senior Management and Board of and record a receivable in ‘‘other assets’’
Directors Oversight for any portion of the premium to be
reimbursed to the bank under a contrac-
1. Has senior management and the board of tual agreement?
directors initiated and maintained effective 5. Were the bank’s deferred compensation
oversight of the bank’s BOLI by— agreements accounted for using the guid-
a. performing a thorough pre-purchase ance in the February 11, 2004, Interagency
analysis of its risks and rewards and a Advisory on Accounting for Deferred Com-
post-purchase risk assessment? pensation Agreements and Bank-Owned
b. determining the permissibility of the Life Insurance?
bank’s BOLI purchases and holdings
under both the applicable state and fed-
eral requirements (whichever require- Policies and Procedures
ments are more restrictive)?
c. determining the types and kinds of risks 6. Does the bank have comprehensive policies
that are associated with BOLI? and procedures, including guidelines, that
d. ascertaining and reviewing the safety- limit the aggregate CSV of policies from
and-soundness considerations associated any one insurance company, as well as the
with the bank’s BOLI? aggregate CSV of policies from all insur-
e. understanding the complex risk charac- ance companies?
teristics of the bank’s insurance holdings a. Does the board of directors or a desig-
and what role BOLI is to play in the nated board committee require senior
bank’s overall business? management to provide adequate and
2. Does the bank have a comprehensive risk- appropriate justification for establishing
management process for purchasing and or revising internal CSV limits on the
holding BOLI? amount of BOLI the bank holds? Does

Page 1
4042.4 Purchase and Risk Management of Life Insurance: Internal Control Questionnaire
this justification take into account the the estimated present value of the expected
bank’s legal lending limits, its capital after-tax employee benefit costs, when
and credit concentration threshold, and the bank uses BOLI to recover the costs
any applicable laws and regulations? of providing employee benefits?
b. Is written justification required when the 9. Did the bank’s management —
amount of the bank’s BOLI holdings a. review and assess its own knowledge of
approaches or exceeds 25 percent of the insurance risks, the vendor’s qualifica-
bank’s capital (tier 1 capital plus the tions, and the amount of the bank’s
allowance for loan and lease losses)? resources that will be needed to admin-
Does the board of directors or a board ister and service the BOLI?
committee approve this justification? b. demonstrate its familiarity with the tech-
nical details of the bank’s insurance
assets, and is management able to explain
the reasons for and the risks associated
Pre-Purchase Analysis with the product design features that
have been selected?
7. Did the bank’s management perform a c. make appropriate inquiries to determine
written pre-purchase analysis of its BOLI whether the vendor has the financial
products? ability to honor its long-term commit-
8. Did management identify the bank’s need ments over an extended period of time?
for BOLI, the appropriate type of insurance d. assure itself of the vendor’s commitment
to be acquired, and the economic benefits to to investing in the operational infrastruc-
be derived from the purchase of BOLI? Did ture that is necessary to support the
this analysis accomplish the following: BOLI?
a. identify the specific risk of loss to be e. undertake its own independent review
covered by the insurance, or the costs the and not rely solely on prepackaged,
insurance is supposed to cover? vendor-supplied compliance information
b. determine what type BOLI (for example, (such reliance is a potential cause for
general- or separate-account) and what supervisory action)?
BOLI features are needed, before acquir- f. properly evaluate the characteristics of
ing the product? the available insurance products against
c. evaluate the permissibility and market the bank’s objectives, needs, and risk
risk of any underlying separate-account tolerance?
asset holdings, if separate-account BOLI g. determine if the bank’s need for insur-
is held? ance on key persons or on a borrower’s
d. analyze projected policy values (CSV loan resulted in a matching of the matu-
and death benefits) using various interest- rity of the term or declining term insur-
crediting rates and mortality cost ance to the key person’s expected tenure
assumptions? or the maturity of the borrower’s loan?
e. estimate the size of the employee benefit h. conduct a review of the insurance carrier
obligation or the risk of loss to be cov- that included—
ered? Did management ensure that the • a credit analysis of the potential insur-
amount of BOLI coverage was appropri- ance carrier (the analysis should have
ate for the bank’s objectives and that been performed in a manner consis-
BOLI was not excessive in relation to tent with safe and sound banking
this estimate and the associated product practices for commercial lending)?
risks? • a review of the bank’s needs and a
f. review the range of assumptions? Was comparison of those needs with the
management able to justify the assump- proposed carrier’s product design,
tions with objective evidence, and deem pricing, and administrative services?
them reasonable in view of previous and • a review of the insurance carrier’s
expected market conditions? commitment to the BOLI product, as
g. assess whether the present value of the well as the carrier’s general reputa-
BOLI’s expected future cash flows (net tion, experience in the marketplace,
of the costs of the insurance) is less than and past performance?

Page 2
Purchase and Risk Management of Life Insurance: Internal Control Questionnaire 4042.4
i. determine whether the total amount of Tax and Insurable-Interest

compensation and insurance to be pro- Implications
vided to an employee is excessive, if the
purchased BOLI will result in the pay- 11. Has the bank’s management explicitly con-
ment of additional compensation? sidered the financial impact (for example,
j. analyze the associated significant credit the tax provisions and penalties) of surren-
risks and the bank’s ability to monitor dering a BOLI policy?
and respond to those risks? 12. Does the bank’s management have or has it
k. as appropriate, analyze the risks and obtained appropriate legal review to ensure
benefits of BOLI, compared with other that it will be in compliance with applicable
available methods for recovering costs tax and state insurable-interest require-
associated with the loss of key persons, ments? Is management aware of the rel-
providing pre- and post-retirement evant tax features of the insurance assets,
employee benefits, or providing addi- including whether the bank’s purchase
tional employee compensation? would—
l. sufficiently document its comprehensive a. make the bank subject to the alternative
pre-purchase analysis (including its analy- minimum tax?
sis of both the types and product designs b. jeopardize the tax-advantaged status of
of purchased BOLI and the bank’s over- the bank’s insurance holdings?
all level of BOLI holdings)? c. qualify (under applicable state law) an
insurable ownership interest in the BOLI
policy covering the bank’s officers or its
employees (including any applicable state
Post-Purchase Analysis law pertaining to the insured’s consent
and the amounts of allowable insurance
10. Do management and the board of directors coverage for an employee)?
annually review the performance of the 13. Did the bank establish an out-of-state trust
bank’s insurance assets? Does the annual to hold its BOLI assets, and, if so, has the
review include— bank adequately assessed its insurable inter-
a. a comprehensive assessment of the spe- est, given the arrangement?
cific risks associated with permanent
insurance acquisitions?
b. an identification of employees who are LIQUIDITY-RISK ASSESSMENT
or will be insured (e.g., vice presidents
and above, employees of a certain grade 1. Has the bank’s management fully recog-
level)? nized and considered the illiquid nature of
c. an assessment of death benefit amounts the BOLI to be acquired? (An institution’s
relative to employee salaries? BOLI holdings should be considered when
d. a calculation of the percentage of insured assessing liquidity and assigning the com-
persons still employed by the institution? ponent rating for liquidity.)
2. Did management determine if the bank has
e. an evaluation of the material changes to the long-term financial flexibility to hold
BOLI risk-management policies? the insurance asset for the full term of its
f. an assessment of the effects of policy expected use?
exchanges?
g. an analysis of mortality performance and
the impact on income?
REPUTATION-RISK ASSESSMENT
h. an evaluation of material findings from
internal and external audits and indepen- 1. Has the bank’s management implemented
dent risk-management reviews? procedures to ensure that the bank main-
i. an identification of the reason for and tains appropriate documentation that evi-
the tax implications of any policy dences employees’ informed consent for the
surrenders? bank’s purchase of insurance on their lives?
j. a peer analysis of BOLI holdings? Do these procedures ensure that the bank

Page 3
4042.4 Purchase and Risk Management of Life Insurance: Internal Control Questionnaire
obtains employees’ explicit consent before MARKET-RISK ASSESSMENT

purchasing the insurance?
2. Has the bank obtained insurance products 1. Did management adequately assess the
that insure large segments of its employee interest-rate risk exposure of BOLI before
base (including the bank’s non-officers)? purchasing the products for separate-account
Do these policies provide very high death and general-account assets?
benefits on employees, possibly causing the 2. Has the bank’s management reviewed, and
bank to be exposed to increased reputation does it understand the instruments govern-
risk if explicit consent was not obtained ing the separate-account investment policy
from the employees? and its management?
a. Does the bank’s management understand
the risk inherent within the separate
account?
b. Has the bank’s management determined
CREDIT-RISK ASSESSMENT if the risk is appropriate?
3. Have monitoring and reporting systems been
1. Did the bank’s management conduct an
established that will enable the bank’s man-
independent financial analysis of the insur-
agement to monitor, measure, and appropri-
ance carrier before purchasing the life insur-
ately manage interest-rate risk exposure
ance policy?
from BOLI holdings when assessing the
a. Does management continue to monitor bank’s overall sensitivity to interest-rate
the life insurance company’s financial risk?
condition on an ongoing basis?
b. Did the bank’s credit-risk management
function participate in the review and
approval of insurance carriers? COMPLIANCE/LEGAL-RISK
ASSESSMENT
2. When establishing exposure limits for aggre-
gate BOLI holdings and exposures to indi- 1. Has the bank’s audit and/or compliance
vidual carriers, did the bank’s management function reviewed the bank’s legal and
consider— regulatory requirements as they pertain to
a. the bank’s legal lending limit? life insurance holdings? Did the review
b. the applicable state and federal credit consider—
concentration exposure guidelines? a. state insurable-interest laws?
c. the aggregate CSV exposures as a per- b. the Employee Retirement Income Secu-
centage of the bank’s capital? rity Act of 1974 (ERISA)?
3. Has the bank’s credit-risk management pro- c. the Federal Reserve Board’s Regulation
cess taken into account credit exposures W (12 CFR 223)?
arising from both BOLI holdings and other d. applicable federal prohibitions on insider
credit exposures (loans, derivatives, and loans, including the Federal Reserve
other insurance products) when measuring Board’s Regulation O, that may apply to
exposures to individual carriers? split-dollar life insurance arrangements?
e. the interagency guidelines for establish-
4. Did the bank’s credit analysis of its BOLI ing standards for safety and soundness?1
holdings consider whether the policies to be f. other state and federal regulations appli-
acquired were separate-account or general- cable to BOLI?
account policies?
2. To ensure that the life insurance qualifies
a. For the separate-account policies, did the for its tax-advantaged status, has the bank’s
credit review include a risk analysis of management implemented and maintained
the underlying separate-account assets? internal policies and procedures to ensure
b. For separate-account policies that include that ‘‘control’’ will not be exercised over
a stable value protection (SVP) contract, any of the separate-account assets, espe-
has the repayment capacity of the insur-
ance carrier’s separately contracted SVP
providers been evaluated? 1. For state member banks, see 12 CFR 208, appendix D-1.

Page 4
Purchase and Risk Management of Life Insurance: Internal Control Questionnaire 4042.4
cially those involving privately placed poli- a. For a general-account insurance product,
cies? has the bank applied a standard risk
3. Does the bank’s board of directors, its weight of 100 percent to the general-
designated board committee, and its man- account asset?
agement seek the assistance of legal counsel b. When the bank has applied a look-
when determining the legal and regulatory through approach for separate-account
issues related to the acquisition and holding holdings—
of life insurance policies? • has management determined if BOLI
4. Has management thoroughly reviewed, and assets would be protected from the
does it understand, the instruments govern- insurance company’s general credi-
ing the investment policy and the manage- tors in the event of its insolvency?
ment of a separate account, before purchas- Has the bank documented its assess-
ing a separate-account policy? ment that BOLI assets are protected?
5. If the bank has not purchased SVP for a • has the portion of the carrying value
separate-account BOLI policy, has manage- of the separate-account policy (that
ment established the appropriate monitoring reflects the amounts attributable to
and reporting systems that will enable it to the insurer’s DAC and mortality
recognize and respond to price fluctuations reserves, and any other portion that is
in the fair value of the separate-account attributable to the carrying value of
assets? an SVP contract) been risk-weighted
6. When the bank considers or purchases a using the 100 percent risk weight
separate-account BOLI product involving applicable to the insurer’s general-
equity securities, does it analyze the equity account obligations? Or, if the SVP
securities? Does this analysis— provider is not an insurance company,
a. compare the specific equity-linked liabil- has the portion of the carrying value
ity being hedged against the securities been risk-weighted as appropriate for
held in a separate account? that obligor?
b. establish a target ratio for hedge effec- 8. When the bank has used a pro rata approach
tiveness, as well as a method for mea- to risk-weighting the carrying value of a
suring hedge effectiveness on an ongoing qualifying separate-account policy, did it
basis? use the appropriate procedures, as outlined
c. establish a process for analyzing and in the December 7, 2004, Interagency State-
reporting to the board of directors, its ment on the Purchase and Risk Manage-
designated committee, and senior man- ment of Life Insurance (see section 4042.1
agement the effect of the hedge on the and SR-04-19 and its attachment)?
bank’s earnings and capital ratios (this a. Has the bank ensured that its assigned
analysis should include a consideration aggregate risk weight for all separate-
of the results both with and without the account BOLI holdings will be 20 per-
hedging transaction)? cent or more?
7. When reporting its risk-based capital, has b. When the sum of the permitted invest-
the bank ensured that it accurately calcu- ments across market sectors in the invest-
lates and reports its risk-weighted assets for ment agreement is greater than
BOLI holdings according to the risk-based 100 percent, was the highest risk weight
capital guidelines and the December 7, applied for the maximum amount permit-
2004, Interagency Statement on the Pur- ted in that asset class, and was the
chase and Risk Management of Life Insur- next-highest risk weight then applied
ance (see section 4042.1 and SR-04-19 and until the cumulative permitted amounts
its attachment)? equal 100 percent?

Page 5
Insurance Sales Activities and Consumer Protection in Sales
of Insurance
Banking organizations have long been engaged functions for the carrier, which may include
in the sale of insurance products and annuities, marketing, accounting, data processing, policy
although these activities historically have been recordkeeping, and monitoring or processing
subject to several restrictions. For example, until claims. The MGA may rely on various local
recently, national banks could sell most types of agents or agencies to sell the carrier’s products.
insurance, but only through an agency located in Most states require an MGA to be licensed.
a small town. Bank holding companies also
were permitted to engage in only limited insur-
ance agency activities under the Bank Holding OVERVIEW AND SCOPE
Company Act. State-chartered banks, on the
other hand, generally have been permitted to The following guidance pertains to state mem-
engage in insurance sales activities as agent to ber banks that are either directly or indirectly
the extent permitted by state law. engaged in the sale of insurance or annuity
The Gramm-Leach-Bliley Act of 1999 (the products. Examiner guidance on performing
GLB Act), however, authorized national banks appropriate risk assessments of a state member
and state-chartered member banks to sell all bank’s insurance and annuity sales activities is
types of insurance products through a financial included.2 Additionally, guidance is provided
subsidiary. The GLB Act generally did not for examining a state member bank’s compli-
change the powers of banks to sell insurance ance with the consumer protection rules relating
directly. As a result of the GLB Act and mar- to insurance and annuities sales activities that
ketplace developments, many banking organiza- are contained in the Board’s December 2000
tions are increasing the range and volume of revisions to Regulation H (subpart H) (12 CFR
their insurance and annuities sales activities. To 208.81–86), ‘‘Consumer Protection in Sales of
the extent permitted by applicable law, banking Insurance’’ (CPSI). Subpart H, which became
organizations may conduct insurance and annu- effective on October 1, 2001, implements the
ity sales activities through a variety of structures consumer protection requirements of the GLB
and delivery channels, including ownership of Act, which are codified at 12 USC 1831x. (See
an insurance underwriter or an insurance agency 65 Fed. Reg. 75841, December 4, 2000.) The
or broker, the employment by a bank of licensed regulation applies not only to the sale of insur-
agents, a joint marketing arrangement with a ance products or annuities by the bank, but also
producer,1 independent agents located at a bank’s to activities of any person engaged in insurance
office, direct mail, telemarketing, and Internet product or annuity sales on behalf of the bank,
marketing. as discussed in this guidance. The guidance is
A banking organization may also conduct generally not applicable to debt-cancellation
insurance or annuity sales activities through a contracts and debt-suspension agreements, unless
managing general agent (MGA). An MGA is a these products are considered to be insurance
wholesaler of insurance products and services to products by the state in which the sales activities
insurance agents. The MGA has a contractual are conducted.
agreement with an insurance carrier to assume The GLB Act permits state member banks
that are not authorized by applicable state law to
1. The term ‘‘producer’’ refers broadly to persons, partner- sell insurance directly to do so through a finan-
ships, associations, limited liability corporations, etc., that cial subsidiary.3 A financial subsidiary engaged
hold a license to sell or solicit contracts of insurance to the
public. Insurance agents and agencies are producers who,
in insurance sales may be located wherever state
through a written contractual arrangement known as a direct
appointment, represent one or more insurance underwriters. 2. The term ‘‘risk assessment’’ denotes the work product
Independent agents and agencies are those producers that sell described in SR-97-24, ‘‘Risk-Focused Framework for
products underwritten by one or more insurance underwriters. Supervision of Large Complex Institutions,’’ and entails an
Captive agents and agencies represent a specific underwriter analysis of (1) the level of inherent risk by type of risk
and sell only its products. Brokers are producers that represent (operational, legal, market, liquidity, credit, and reputation
the purchaser of insurance and obtain bids from competing risk) for a business line or business function, (2) the adequacy
underwriters on behalf of their clients. State insurance laws of management controls over that business line or business
and regulations often distinguish between an insurance agent function, and (3) the direction of the risk (increasing, decreas-
and a broker; in practice, the terms are often used ing, or stable).
interchangeably. 3. Rules pertaining to state member bank financial subsid-

Page 1
4043.1 Insurance Sales Activities and Consumer Protection in Sales of Insurance
law permits the establishment and operation of of risk such activities pose to the state member
an insurance agency. Such subsidiaries, how- bank. The review includes insurance and annu-
ever, would be subject to state licensing and ity sales activities the state member bank con-
other requirements. ducts directly (by or in conjunction with a
The Federal Reserve is responsible for evalu- subsidiary or affiliate) or through a third-party
ating the consolidated risk profile of a state arrangement. Primary risks that may arise from
member bank. This reponsibility includes deter- insurance sales activities include operational,
mining the risks posed to the state member bank legal, and reputational risk. If the state member
from the insurance and annuity sales activities it bank does not adequately manage these risks,
conducts directly or indirectly, as well as deter- they could have an adverse impact on its earn-
mining the effectiveness of the bank’s risk- ings and capital. The examiner should produce
management systems. However, the GLB Act (1) a risk assessment that summarizes the level
also established a regulatory framework that is of inherent risk to the state member bank by risk
designed to ensure that the Federal Reserve category and (2) an assessment of the adequacy
coordinates with, and relies to the extent pos- of board of directors’ and management over-
sible on information from, the state insurance sight of the insurance and annuity sales activi-
authorities when it is supervising the insurance ties, including their internal control framework.
activities a state member bank conducts through For those state member banks selling insurance
a functionally regulated subsidiary. or annuity products, or that enter into arrange-
Consistent with the Federal Reserve’s risk- ments under which another party sells insurance
focused framework for supervising banking or annuity products at the bank’s offices or on
organizations, resources allocated to the review behalf of the bank, a second objective of the
of insurance sales activities should be commen- review is to determine the bank’s compliance
surate with the significance of the activities and with the consumer protection provisions of the
the risk they pose to the bank. The scope of the GLB Act and the CPSI regulation.
review depends on the significance of the activ-
ity to the state member bank and the extent to
which the bank is directly involved in the
activity. Examiner judgment is required to tailor State Regulation of Insurance
the reviews, as appropriate, on the basis of the Activities
legal, organizational, and risk-management struc-
ture of the state member bank’s insurance and Historically, insurance activities have primarily
annuity sales activities and on other relevant been regulated by the states. In 1945, Congress
factors.4 passed the McCarran-Ferguson Act, which
granted states the power to regulate most aspects
of the insurance business. The McCarran-
Ferguson Act states that ‘‘no act of Congress
SUPERVISORY APPROACH FOR shall be construed to invalidate, impair, or super-
THE REVIEW OF INSURANCE sede any law enacted by any state for the
AND ANNUITY SALES purpose of regulating the business of insurance,
ACTIVITIES or which imposes a fee or tax upon such
business, unless such Act specifically relates to
the business of insurance’’ (15 USC 1012(b)).
Supervisory Objective State regulation of insurance producers is
centered on the protection of the consumer and
The primary objective for the review of a state
consists primarily of licensing and continuing
member bank’s insurance and annuity sales
education requirements for producers. A pro-
activities is to determine the level and direction
ducer generally must obtain a license from each
state in which it sells insurance and for each
iaries are found in the Board’s Regulation H (12 CFR
208.71–77). product sold. Each state in which a producer
4. See SR-02-01, ‘‘Revisions to Bank Holding Company sells insurance has regulatory authority over the
Supervision Procedures for Organizations with Total Consoli- producer’s activities in the state.
dated Assets of $5 Billion or Less,’’ and section 1000.1 for a
discussion of the Federal Reserve’s risk-focused examinations
The GLB Act does include several provisions
and the risk-focused supervision program for community that are designed to keep states from (1) unfairly
banking organizations. See also SR-97-24. regulating a bank to prevent it from engaging in

Page 2
Insurance Sales Activities and Consumer Protection in Sales of Insurance 4043.1
authorized insurance activities or (2) otherwise lines of business—guidance that corresponds to

discriminating against banks engaged in insur- regulations related to advertising, misrepresen-
ance activities. These provisions are complex tations, and disclosures for these different busi-
and beyond the scope of this guidance. How- ness lines. The reports of examination issued by
ever, the GLB Act generally does not prohibit a the state insurance departments are usually avail-
state from requiring a bank or bank employee able to the public.
engaged in insurance sales, solicitation, or cross- Because the underwriter, not the producer, is
marketing activities to be licensed within the liable to the insured, the failure of an insurance
state. producer generally would not result in financial
State insurance regulatory authorities do not loss to consumers or state guarantee funds.
conduct routine, periodic examinations of an Consequently, there are no regulatory capital
insurance producer. A state examination of an requirements for insurance producers, nor do
insurance producer is generally conducted only states require regulatory reporting of financial
on an ad hoc basis and is primarily based on the statement data on insurance producers. While
volume and severity of consumer complaints. the underwriter is ultimately liable to the insured,
The state examination may also be based in part in some instances, a producer and its owner may
on the producer’s market share and on previous be held liable for misrepresentations, as well as
examination findings. Additionally, a review of for violations of laws and regulations.
a producer would typically not assess its finan-
cial condition.
A state’s market conduct examination of
insurance sales practices is focused at the Functional Regulation
insurance-underwriter level.5 The insurance
underwriter is generally held accountable for Under the GLB Act, banking supervisors’
compliance with state insurance laws to protect reviews of insurance or securities activities con-
the consumer from the unfair sales practices of ducted in a bank’s functionally regulated sub-
any producer that markets the insurance under- sidiary are not to be extensions of more tradi-
writer’s products. Market conduct examinations tional bank-like supervision. Rather, to the extent
of an insurance underwriter may potentially possible, bank supervisors are to rely on the
uncover a concern about a particular producer, functional regulators to appropriately supervise
such as a bank-affiliated producer.6 However, in the insurance and securities activities of a func-
the past, a state insurance regulatory authority tionally regulated subsidiary. A functionally
has not typically examined a producer unless the regulated subsidiary includes any subsidiary of a
producer is owned by the insurance underwriter. bank that (1) is engaged in insurance activities
Generally, market conduct examinations and subject to supervision by a state insurance
include reviews of the insurance underwriters’ regulator or (2) is registered as a broker-dealer
complaint handling, producer licensing, policy- with the Securities and Exchange Commission.
holder service, and marketing and sales prac- The GLB Act does not limit the Federal Re-
tices. Typically, a state authority will direct a serve’s supervisory authority with respect to a
corrective action for insurance sales activity at bank or the insurance activities conducted by a
the underwriter. The states generally have spe- bank. The functional regulators for insurance
cific guidance for their market conduct exami- sales activities, including the activities of insur-
nations of life, health, and property/casualty7 ance producers, consist of the insurance depart-
ments in each of the 50 states, the District of
5. Generally, market conduct reviews of insurance under- Columbia, Puerto Rico, the U.S. Virgin Islands,
writers are conducted on an ad hoc basis, triggered primarily American Samoa, and Guam.
by the volume and severity of consumer complaints, and are
based on the underwriter’s market share or on previous
examination findings. In some states, however, market con-
duct reviews of insurance underwriters are conducted on a interest in a physical property for loss of the property or the
periodic, three- to five-year schedule. loss of its income-producing abilities. Casualty insurance is
6. The terms ‘‘insurance underwriter,’’ ‘‘insurer,’’ ‘‘insur- primarily concerned with the legal liability for losses caused
ance carrier,’’ and ‘‘insurance company’’ are industry terms by injury to persons or damage to the property of others. It
that apply similarly to the party to an insurance arrangement may also include such diverse forms of insurance as crime
who undertakes to indemnify for losses, that is, the party that insurance, boiler and machinery insurance, and aviation
assumes the principal risk under the contract. insurance. Many casualty insurers also underwrite surety
7. Property insurance indemnifies a person who has an bonds.

Page 3
The GLB Act places certain limits on the functionally regulated nonbank subsidiary of a
ability of the Federal Reserve to examine, obtain state member bank. These GLB Act limitations
reports from, or take enforcement action against do not apply to a state member bank even if the
a functionally regulated nondepository subsidi- state member bank is itself licensed by a state
ary of a state member bank. For purposes of insurance regulatory authority to conduct insur-
these limitations, a subsidiary licensed by a state ance sales activities.
insurance department to conduct insurance sales Staff who are conducting reviews of state
activities is considered functionally regulated member bank insurance or annuity sales activi-
only with respect to its insurance activities and ties should be thoroughly familiar with SR-00-
any activities incidental to these activities.8 13, which provides guidance on reviews of
The GLB Act indicates that the Federal functionally regulated state member bank sub-
Reserve must rely, to the fullest extent possible, sidiaries. Reserve Bank staff may conduct an
on information obtained by the appropriate state examination of a functionally regulated subsid-
insurance authority of a nondepository insur- iary, or request a specialized report from a
ance agency subsidiary of a state member bank. functionally regulated subsidiary, only after ob-
In addition, the Federal Reserve may examine a taining approvals from the appropriate staff of
functionally regulated subsidiary of a state mem- the Board’s Division of Banking Supervision
ber bank only in the following situations: and Regulation.
When preparing or updating the risk assess-
• The Federal Reserve has reasonable cause to ment of a state member bank’s insurance or
believe that the subsidiary is engaged in annuity sales activities, Federal Reserve staff,
activities that pose a material risk to an when appropriate, should coordinate their activi-
affiliated depository institution, as determined ties with the appropriate state insurance authori-
by the responsible Reserve Bank and Board ties. The Federal Reserve’s supervision of state
staff. member banks engaged in insurance sales ac-
• After reviewing relevant information (includ- tivities is not intended to replace or duplicate the
ing information obtained from the appropriate regulation of insurance activities by the appro-
functional regulator), it is determined that an priate state insurance authorities.
examination is necessary to adequately under-
stand and assess the banking organization’s
systems for monitoring and controlling the Information Sharing with the Functional
financial and operational risks that may pose a Regulator
threat to the safety and soundness of an
affiliated depository institution. The Federal Reserve and the National Associa-
• On the basis of reports and other available tion of Insurance Commissioners (NAIC)
information (including information obtained approved a model memorandum of understand-
from the appropriate functional regulator), ing (MOU) on the sharing of confidential infor-
there is reasonable cause to believe that the mation between the Federal Reserve and indi-
subsidiary is not in compliance with a federal vidual state insurance departments.9 The Board
law that the Federal Reserve has specific also approved the delegation of authority to the
jurisdiction to enforce with respect to the Board’s general counsel to execute agreements
subsidiary (including limits relating to trans- with individual states, based on this MOU.
actions with affiliated depository institutions), Examiners should follow required Board admin-
and the Federal Reserve cannot assess such istrative procedures before sharing any confiden-
compliance by examining the state member tial information with a state insurance regulator.
bank or other affiliated depository institution. (These procedures generally require Federal
Reserve staff to identify and forward to Board
Other similar restrictions limit the ability of staff for review any confidential information that
the Federal Reserve to obtain a report directly may be appropriate to share with the applicable
from, or take enforcement action against, a
9. The NAIC is the organization of insurance regulators

8. For example, if a state member bank subsidiary engages from the 50 states, the District of Columbia, and the four U. S.
in mortgage lending and is also licensed as an insurance territories. The NAIC provides a forum for the development of
agency, it would be considered a functionally regulated uniform policy among the states and territories. The NAIC is
subsidiary only to the extent of its insurance sales activities. not a governmental or regulatory body.

Page 4
state insurance regulator concerning insurance nonaffiliates may be subject to the Fair Credit
sales activities conducted by state member Reporting Act (FCRA) as well. For example,
banks.) The Board’s Division of Consumer and under the FCRA, if a bank wants to share with
Community Affairs CP Letter 2001-11 outlines its insurance subsidiary information from a credit
the procedures for sharing consumer complaint report or from a consumer application for credit
information with state insurance regulators. (such as the consumer’s assets, income, or
marital status), the bank must first notify the
consumer about the intended sharing and give
the consumer an opportunity to opt out. The
STATUTORY AND REGULATORY same rules would apply to an insurance com-
REQUIREMENTS AND POLICY pany that wants to share information from credit
GUIDANCE reports or from applications for insurance with
an affiliate or a third party.
Privacy Rule and the Fair Credit

Reporting Act
Anti-Tying Prohibitions
State member banks that sell insurance to con-
sumers must comply with the privacy provisions
under title V of the GLB Act (12 USC 6801– Federal law (section 106(b) of the BHC Act
6809), as implemented by the Board’s Regula- Amendments of 1970 (12 USC 1972(b))) gen-
tion P (12 CFR 216) (the privacy rule). Func- erally prohibits a bank from requiring that a
tionally regulated state member bank nonbank customer purchase a product or service from the
insurance agency subsidiaries are not covered bank or an affiliate as a prerequisite to obtaining
by the Federal Reserve’s privacy rule; however, another product or service (or a discount on the
they must comply with the privacy regulations other product or service) from the bank. This
(if any) issued by their relevant state insurance prohibition applies whether the customer is
regulator. retail or institutional, or whether the transaction
The privacy rule regulates a state member is on bank premises or off premises. For exam-
bank’s treatment of nonpublic personal informa- ple, a state member bank may not require that a
tion about a ‘‘consumer,’’ an individual who customer purchase insurance from the bank or a
obtains a financial product or service (such as subsidiary or affiliate of the bank in order to
insurance) from the institution for personal, obtain a loan from the bank (or a reduced
family, or household purposes. The privacy rule interest rate on the loan).10
generally requires a bank to provide a notice to
each of its customers that describes its privacy
policies and practices no later than when the
bank establishes a business relationship with the Policy Statement on Income from
customer. The privacy rule also generally pro- Sale of Credit Life Insurance
hibits a bank from disclosing any nonpublic
personal information about a consumer to any The Federal Reserve Board’s Policy Statement
nonaffiliated third party, unless the bank first on Income from Sale of Credit Life Insurance
provides to the consumer a privacy notice and a (see the Federal Reserve Regulatory Service at
reasonable opportunity to prevent (or ‘‘opt out’’ 3-1556) sets forth the principles and standards
of) the disclosure, and the consumer does not that apply to a bank’s sales of credit life insur-
opt out. The privacy rule permits a financial ance and the limitations that apply to the receipt
institution to provide a joint notice with one or of income from those sales by certain individu-
more of its affiliates or other financial institu- als and entities associated with the bank. See
tions, as identified in the privacy notice itself, also the examination procedures related to this
provided that the notice is accurate with respect policy statement in section 2130.3.
to the institution and the other institutions.
While the privacy rule applies to the sharing
of nonpublic personal information by a bank 10. See section 2040.1 and ‘‘Tie-In Considerations of the
with nonaffiliated third parties, the sharing of BHC Act,’’ section 3500.0, of the Bank Holding Company
certain consumer information with affiliates or Supervision Manual.

Page 5
RISK-MANAGEMENT PROGRAM Sales Practices and Handling of

Customer Complaints
Every state member bank engaged in insurance
Elements of a Sound Insurance or or annuity sales activities should have board-
Annuity Sales Program approved policies and procedures for handling
customer complaints related to these sales. The
A state member bank engaged in insurance or customer complaint process should provide for
annuity sales activities should— the recording and tracking of all complaints and
require periodic reviews of complaints by com-
• conduct insurance sales programs in a safe pliance personnel. A state member bank’s board
and sound manner; of directors and senior management should also
• have appropriate written policies and proce- review complaints if the complaints involve
dures in place that are commensurate with the significant compliance issues that may pose a
volume and complexity of its insurance sales risk to the state member bank.
activities;
• obtain its board of directors’ approval of the Third-Party Arrangements
scope of the insurance and annuity sales
program and of written policies and proce- State member banks, to the extent permitted by
dures for the program; applicable law, may enter into agreements with
• effectively oversee the sales program activi- third parties, including unaffiliated agents or
ties, including third-party arrangements; agencies, to sell insurance or annuities or pro-
• have an effective, independent internal audit vide expertise and services that otherwise would
and compliance program; have to be developed in-house. Many banks hire
third parties to assist in establishing an insur-
• appropriately train and supervise the employ- ance program or to train their own insurance
ees conducting insurance and annuity sales staff. A bank may also find it advantageous to
activities; offer more specialized insurance products through
• take reasonable precautions to ensure that a third-party arrangement.
disclosures to customers for insurance and A state member bank’s management should
annuity sales and solicitations are complete conduct a comprehensive review of an unaffili-
and accurate and are in compliance with ated third party before entering into any arrange-
applicable laws and regulations; ment to conduct insurance or annuity sales with
the third party. The review should include an
• ensure compliance with all applicable federal, assessment of the third party’s financial condi-
state, or other jurisdiction regulations, includ- tion, management experience, reputation, and
ing compliance with sections 23A and 23B of ability to fulfill its contractual obligations to the
the Federal Reserve Act as that act applies to state member bank, which includes compliance
affiliate transactions; and with applicable consumer protection laws and
• have controls in place to ensure accurate and regulations.
timely financial reporting. The state member bank’s board of directors or
its designated committee should approve any
Every state member bank conducting insurance agreements with third parties. Agreements should
or annuity sales activities should have appropri- outline the duties and responsibilities of each
ate, board-approved policies, procedures, and party; describe the third-party activities permit-
controls in place to monitor and ensure that it ted on the institution’s premises; address the
complies with both federal and state regulatory sharing or use of confidential customer informa-
requirements. Consistent with the principle of tion; and define the terms for use of the state
functional regulation, the Federal Reserve will member bank’s office space, equipment, and
rely primarily on the appropriate state insurance personnel. If an arrangement includes dual
authorities to monitor and enforce compliance employees (for example, bank employees who
with applicable state insurance laws and regula- are also employed by an independent third
tions, including state consumer protection laws party), the agreement must provide for written
and regulations governing insurance sales. employment contracts that specify the duties of

Page 6
these employees and their compensation The state member bank should require its own
arrangements. insurance or annuity sales personnel or third-
In addition, a third-party agreement should party sales personnel selling at or on behalf of
specify that the third party will comply with all the bank to receive appropriate training and
applicable laws and regulations and will conduct licensing. Training should cover appropriate
its activities in a manner consistent with the policies and procedures for the bank’s sales of
CPSI regulation, if applicable. The agreement insurance and annuity products. Personnel who
should authorize the banking organization to are referring potential or established customers
monitor the third party’s compliance with its to a licensed insurance producer should also be
agreement, as well as authorize the bank to have trained to ensure that referrals are made in
access to third-party records considered neces- conformance with the CPSI regulation, if appli-
sary to evaluate compliance. A state member cable. The training should also include proce-
bank that contracts with a functionally regulated dures and guidance to ensure that an unlicensed
third party should obtain from and review, as or referring individual cannot be deemed to be
appropriate, any relevant, publicly available acting as an insurance agent that is subject to
regulatory reports of examination of the third licensing requirements.
party.11 Finally, the agreement should provide When insurance or annuities are sold by a
for indemnification of the institution by the state member bank or third parties at an office
unaffiliated third party for any losses caused by of, or on behalf of, the organization, the institu-
the conduct of the third party’s employees in tion should have policies and procedures to
connection with its sales activities. designate, by title or name, the individuals
The state member bank is responsible for responsible for supervising insurance sales
ensuring that any third party or dual employee activities, as well as for supervising the referral
selling insurance at or on behalf of the bank is activities of bank employees not authorized to
appropriately trained either by the bank or the sell these products. A state member bank also
third party with respect to compliance with the should designate supervisory personnel respon-
minimum disclosures and other requirements of sible for monitoring compliance with any third-
the CPSI regulation and applicable state regula- party agreement, as well as with the CPSI
tions. The banking organization should obtain regulation, if applicable.
and review copies of third-party training and
compliance materials to monitor the third par-
ty’s performance of its disclosure and training Compliance
obligations.
State member banks should have policies and
procedures to ensure that insurance or annuity
Designation, Training, and Supervision of sales activities are conducted in compliance
Personnel with applicable laws and regulations (including
the CPSI regulation for sales conducted by or on
A state member bank hiring personnel to sell behalf of the state member bank) and the insti-
insurance or annuities should investigate the tution’s internal policies and procedures. Com-
backgrounds of the prospective employees. pliance procedures should identify any potential
When a candidate for employment has previous conflicts of interest and how such conflicts
insurance industry experience, the state member should be addressed. For example, sales-
bank should have procedures to determine compensation programs should be conducted in
whether the individual has been the subject of a manner that would not expose the bank to
any disciplinary actions by state insurance undue legal or reputation risks. The compliance
regulators.12 procedures should also provide for a system to
monitor customer complaints and their resolu-
11. The reports of examination issued by state insurance
tion. Where applicable, compliance procedures
regulators are generally public documents. Many states do not also should call for verification that third-party
conduct periodic examinations of insurance sales activities. sales are being conducted in a manner consistent
12. Information from the states on the issuance and with the governing agreement with the banking
termination of producer licenses and on producers’ compli-
ance with continuing education requirements is available from
organization.
the NAIC database known as the National Insurance Producer The compliance function should be conducted
Registry (NIPR). independently of the insurance and annuity prod-

Page 7
uct sales and management activities. Compli- by law to suspend or revoke a producer’s license
ance personnel should determine the scope and and assess monetary penalties against a pro-
frequency of their reviews, and findings of ducer if warranted.
compliance reviews should be reported directly Operational risk may arise from errors in
to the state member bank’s board of directors or processing sales-related information or from a
to its designated board committee. lack of appropriate controls over systems or staff
responsible for carrying out the insurance or
annuity sales activities. Additionally, state mem-
RISK ASSESSMENT OF ber banks that have recently commenced insur-
ance or annuity sales activities, or that are
INSURANCE AND ANNUITY expanding their insurance or annuity sales busi-
SALES ACTIVITIES ness, also are exposed to risk arising from
inadequate strategic and financial planning
A risk assessment of insurance activities may be
associated with the activities, which could result
accomplished in the course of conducting a
in financial loss. Examiners should be attuned to
regularly scheduled state member bank exami-
risks that may arise from inadequate controls
nation or as a targeted review. The purpose of
over insurance activities, a rapid expansion of
preparing the risk assessment is to determine the
the insurance or annuity sales programs offered
level and direction of risk to the bank arising
by the state member bank, the introduction of
from its insurance and annuity sales activities.
new products or delivery channels, and legal and
Risks to state member banks engaged in insur-
regulatory developments.
ance and annuity sales programs consist prima-
Operational risk may arise from inadequate
rily of legal, reputational, and operational risk,
premium-payment procedures and trust-account-
all of which may lead to financial loss. After
balance administration by an agency. When the
completing the risk assessment, if material con-
insurance agency bills the insured, the agent
cerns remain, the Board’s Division of Banking
must comply with requirements for forwarding
Supervision and Regulation staff should be con-
the payments to the insurer and for safekeeping
sulted for further guidance.
the funds. Inadequate internal controls over this
Legal and reputational risk may arise from a
activity may result in the inappropriate use of
variety of sources, such as fraud; noncompli-
these funds by the agent or agency. The state
ance with statutory or regulatory requirements,
member bank should ensure that appropriate
including those pertaining to the handling of
controls are in place to verify that all funds that
premiums collected on behalf of the under-
are owed to the insurer or the insured are
writer; claims processing; insurance and annuity
identified in the trust account and that the
sales practices; and the handling of ‘‘errors and
account is in balance.
omissions’’ claims.13 Other sources of legal and
When conducting a risk assessment, the
reputational risk may arise from failing to safe-
examiner should first obtain relevant informa-
guard nonpublic customer information, a high
tion to determine the existence and scale of
volume of customer complaints, or public regu-
insurance or annuity sales activity. Such infor-
latory sanctions against a producer.
mation is available in the state member bank’s
Legal and reputational risks may also arise
Uniform Bank Performance Report (UBPR) and
from an agent’s obligation to provide a customer
in other System reports on insurance activities.
with products that are suited to the customer’s
Relevant reports, including applicable balance
particular needs and are priced and sold in
sheets and income statements for the insurance
accordance with state regulations. Additionally,
and annuity sales activities, may also be obtained
an agent or agency may be liable for failing to
from the state member bank. When preparing a
carry out the appropriate paperwork to bind a
risk assessment for an insurance or annuity sales
policy that it has sold to a customer, or for
activity that is conducted by a functionally
making an error in binding the policy. State
regulated nonbank subsidiary of a state member
insurance departments generally are permitted
bank, examiners should rely, to the fullest extent
possible, on information available from the state
13. Errors and omissions insurance indemnifies the insured member bank and the appropriate state insur-
against loss sustained because of an error or oversight by the
insured. For instance, an insurance agency generally pur-
ance regulator for the subsidiary. If information
chases this type of coverage to protect itself against such that is needed to assess the risk cannot be
things as failing to issue a policy. obtained from the state member bank or the

Page 8
applicable functional regulator, the examiner • that the insurance product or annuity is backed
should consult with the appropriate designated by the federal government or the bank or is
Board staff. Requests should not be made directly insured by the Federal Deposit Insurance
to a functionally regulated nonbank insurance Corporation (FDIC);
and annuity sales subsidiary of a state member • that an insurance product or annuity does not
bank without first obtaining approval from the have investment risk, including the potential
appropriate Board staff. that principal may be lost and the product may
decline in value, when in fact the product or
annuity does have such risks; or
CONSUMER PROTECTION IN • in the case of a bank or subsidiary of the bank
SALES OF INSURANCE RULES at which insurance products or annuities are
sold or offered for sale, that (1) the bank may
condition approval of an extension of credit to
Overview of the CPSI Regulation a consumer by the bank or subsidiary on the
purchase of an insurance product or annuity
The CPSI regulation is applicable to all insured from the bank or a subsidiary of the bank, and
depository institutions.14 The regulation, how- (2) the consumer is not free to purchase the
ever, generally does not apply to nonbank affili- insurance product or annuity from another
ates or subsidiaries of a state member bank source.
unless the company engages in the retail sale of
insurance products or annuities at an office of, or The regulation also incorporates the anti-tying
on behalf of, an insured depository institution. provisions of section 106(b) of the Bank Hold-
Interpretations of the regulation issued by the ing Company Act Amendments of 1970 (12
federal banking agencies are found in appendix USC 1972). Additionally, banks are prohibited
A of this section. Federal Reserve examiners are from selling life or health insurance products if
responsible for reviewing state member banks’ the status of the applicant or insured as a victim
compliance with the regulation. of domestic violence or as a provider of services
The regulation applies to the retail sale of to domestic violence victims is considered as a
insurance products and annuities by banks or by factor in decision making on the product, except
any other person at an office of a bank, or acting as expressly authorized by state law.
on behalf of a bank. For purposes of the CPSI
regulation, ‘‘office’’ means the premises of the
bank where retail deposits are accepted. The Insurance Disclosures
regulation applies only to the retail sale of
insurance or annuity products—that is, when the The CPSI regulation also requires that a bank or
insurance is sold or marketed to an individual a person selling insurance at an office of, or on
primarily for personal, family, or household behalf of, a bank make the following affirmative
purposes. disclosures (to the extent accurate), both orally
and in writing, before the completion of the
initial sale of an insurance product or an annuity
Misrepresentations Prohibited to a consumer. However, sales by mail or, if the
consumer consents, via electronic media (such
The regulation prohibits a bank or other covered as the Internet) do not require oral disclosure.
person from engaging in any practice or using
any advertisement at any office of, or on behalf • The insurance product or annuity is not a
of, the bank or a subsidiary of the bank if the deposit or other obligation of, or guaranteed
practice or advertisement could mislead any by, the bank or an affiliate of the bank.
person or otherwise cause a reasonable person to • The insurance product or annuity is not insured
erroneously believe— by the FDIC or any other U.S. government
agency, the bank, or (if applicable) an affiliate
of the bank.
14. The CPSI regulation applies to all federally insured
depository institutions, including all federally chartered U.S.
• The insurance product or annuity, if applica-
branches and state-chartered insured U.S. branches of foreign ble, has investment risk, including the pos-
banking organizations. sible loss of value.

Page 9
For telephone sales, written disclosures must Referrals

be mailed within three business days. The above
disclosures must be included in advertisements Any person who accepts deposits from the
and promotional materials for insurance prod- public in an area where deposits are routinely
ucts and annuities, unless the advertisements or accepted may refer a consumer to a qualified
promotional materials are of a general nature person who sells insurance products or annuities
and describe or list the nature of services or only if the person making the referral receives
products offered by the bank. Disclosures must no more than a one-time, nominal fee of a fixed
be conspicuous and readily understandable. dollar amount for the referral. The amount of the
referral fee may not depend on whether a sale
results from the referral.
Credit Disclosures
When an application for credit is made in Qualifications
connection with the solicitation, offer, or sale of
an insurance product or annuity, the consumer A bank may not permit any person to sell or
must be notified that the bank may not condition offer insurance products or annuities at its office
the extension of credit on either (1) the consum- or on its behalf, unless that person is at all times
er’s purchase of an insurance product or annuity properly qualified and licensed under applicable
from the bank or any of its affiliates or (2) the state law for the specific products being sold or
consumer’s agreement not to obtain, or a prohi- recommended.
bition on the consumer from obtaining, an
insurance product or annuity from an unaffili-
ated entity. These disclosures must be made Relationship of the CPSI Regulation
both orally and in writing; however, applications to State Regulation
taken by mail or, if the consumer consents, via
electronic media, do not require oral disclosure. The GLB Act contains a legal framework for
For telephone applications, the written disclo- determining the effect of the CPSI regulation on
sure must be mailed within three business days. state laws governing the sale of insurance,
The disclosures must be conspicuous and readily including state consumer protection standards.
understandable. In general, if a state has legal requirements that
are inconsistent with, or contrary to, the CPSI
regulation, initially the federal regulation does
Consumer Acknowledgment not apply in the state. However, the federal
banking agencies may, after consulting with the
The bank must obtain written or electronic state involved, decide to preempt any inconsis-
acknowledgments of the consumer’s receipt of tent or contrary state laws if the agencies find
the disclosures described above at the time they that the CPSI regulation provides greater pro-
are made or at the completion of the initial tections than the state laws. It is not expected
purchase. For telephone sales, the bank must that there will be significant conflict between
receive an oral acknowledgment and make a state and federal laws in this area. If the con-
reasonable effort to obtain a subsequent written sumer protection laws of a particular state appear
or electronic acknowledgment. to be inconsistent with and less stringent (that is,
provide less consumer protection) than the CPSI
regulation, examiners should inform the staff of
the Board’s Division of Banking Supervision
Location and Regulation.
Insurance and annuity sales activities must take
place, to the extent practicable, in an area
physically segregated from one where retail Relationship to Federal Reserve
deposits are routinely accepted from the general Guidance on the Sale of Nondeposit
public (such as teller windows). The bank must Investment Products
clearly identify and delineate areas where insur-
ance and annuity sales activities occur. When a bank sells insurance products or annu-

Page 10
ities that also are securities (such as variable life other person that is engaged in such activities at
insurance annuities), it must conform with the an office of the bank or on behalf of the state
applicable Federal Reserve and interagency guid- member bank. For purposes of the CPSI regu-
ance pertaining to a bank’s retail sales of non- lation, activities ‘‘on behalf of a state member
deposit investment products (NDIPs).15 If the bank’’ include activities in which a person,
CPSI regulation and the guidance pertaining to whether at an office of the bank or at another
NDIPs conflict, the CPSI regulation prevails. location, sells, solicits, advertises, or offers an
insurance product or annuity and in which at
least one of the following applies:
Examining a State Member Bank for
• The person represents to a consumer that the
Compliance with the CPSI Regulation sale, solicitation, advertisement, or offer of
Examinations for compliance with the CPSI any insurance product or annuity is by or on
regulation should be conducted consistent with behalf of the bank.
the risk-focused supervisory approach when a • The bank refers a consumer to a seller of
state member bank sells insurance products or insurance products or annuities, and the bank
annuities directly, or when a third party sells has a contractual arrangement to receive com-
insurance or annuities at or on behalf of, a state missions or fees derived from the sale of an
member bank. To the extent practicable, the insurance product or annuity resulting from
examiner should conduct the review at the state the bank’s referral.
member bank. In certain instances, however, the
• Documents evidencing the sale, solicitation,
examiner’s review at the state member bank
advertising, or offer of an insurance product or
may identify potential supervisory concerns
annuity identify or refer to the bank.
about the state member bank’s compliance with
the CPSI regulation as it pertains to insurance or
annuities sales conducted by a functionally regu-
lated nonbank affiliate or subsidiary of the state
member bank that is selling insurance products APPENDIX A—JOINT
or annuities at or on behalf of the state member INTERPRETATIONS OF THE
bank. CONSUMER PROTECTION IN
If the examiner determines that an on-site SALES OF INSURANCE
review of a functionally regulated nonbank
affiliate or subsidiary of the state member bank
REGULATION
is appropriate to adequately assess the state In response to a banking association’s inquiries,
member bank’s compliance with the CPSI regu- the federal banking agencies jointly issued
lation, the examiner should discuss the situation interpretations regarding the Consumer Protec-
with staff of the Board’s Division of Banking tion in Sales of Insurance (CPSI) regulation.1 A
Supervision and Regulation. The approval of the joint statement, issued on August 17, 2001,
Division of Banking Supervision and Regula- contains responses to a set of questions relating
tion’s officer that is responsible for the supervi- to disclosure and acknowledgment, the scope of
sory policy and examination guidance pertain- applicability of the regulation, and compliance.
ing to insurance and annuity sales activities Additionally, a February 28, 2003, joint state-
should be obtained before examining or request- ment responded to a request to clarify whether
ing any information directly from a functionally the disclosure requirements apply to renewals of
regulated nonbank affiliate or subsidiary of the pre-existing insurance policies sold before Octo-
state member bank that is selling insurance or ber 1, 2001, the effective date of the regulation.
annuity products at or on behalf of the state The issues raised and the banking agencies’
member bank. responses are summarized below.
The examination guidelines described in sec-
tion 4043.3 apply to retail sales, solicitations,
advertisements, or offers of insurance products 1. These letters, issued jointly by the Board of Governors
and annuities by any state member bank or any of the Federal Reserve System, the Office of the Comptroller
of the Currency, the Federal Deposit Insurance Corporation,
15. Interagency Statement on Retail Sales of Nondeposit and the Office of Thrift Supervision, may be accessed on these
Investment Products, February 17, 1994. See SR-94-11. agencies’ web sites.
Commercial Bank Examination Manual December 2003

Page 11
Disclosures scribed any steps that must be taken for a

depository institution’s efforts to obtain a writ-
ten acknowledgment to be deemed ‘‘reason-
Credit Disclosures able’’ in a transaction conducted by telephone.
Examples of reasonable efforts, however,
A bank or other person who engages in insur- include—
ance sales activities at an office of, or on behalf
of, a bank (‘‘a covered person’’) must make the • providing the consumer with a return-
credit disclosures set forth in the regulation if a addressed envelope or similar means to facili-
consumer is solicited to purchase insurance tate the consumer’s return of the written
while the consumer’s loan application is pend- acknowledgment,
ing. A consumer’s application for credit is still
‘‘pending’’ for purposes of the regulation if the • making a follow-up phone call or contact,
depository institution has approved the consum- • sending a second mailing, or
er’s loan application but not yet notified the • similar actions.
consumer. Until the consumer is notified of the
loan approval, the covered person must provide The covered person should (1) maintain docu-
the credit disclosures if the consumer is solic- mentation that the written disclosures and the
ited, offered, or sold insurance. request for written acknowledgment of those
disclosures were mailed to the consumer and
(2) should record his or her efforts to obtain the
Disclosures for Sales by Mail and signed acknowledgment. The ‘‘reasonable
Telephone efforts’’ policy exception for telephone sales
does not apply to other types of transactions,
The regulation requires a covered person to such as mail solicitations, in which a covered
provide oral disclosures and to obtain an oral person must obtain from the consumer a written
acknowledgment of these disclosures when sales (in electronic or paper form) acknowledgment.
activities are conducted by telephone. This
requirement applies regardless of whether the
Appropriate form or format for acknowledgment
consumer will also receive and acknowledge
provided electronically. Electronic acknowledg-
written disclosures in person, through the mail,
ments are not required to be in a specific format
or electronically.
but must be consistent with the provisions of the
CPSI regulation applicable to consumer
Use of Short-Form Insurance Disclosures acknowledgments. That is, the electronic
acknowledgment must establish that the con-
There is no short form for the credit disclosures. sumer has acknowledged receipt of the credit
A depository institution, however, may use the and insurance disclosures, as applicable.
short-form insurance disclosures set forth below
in visual media (such as television broadcasting, Retention of acknowledgments by an insurance
ATM screens, billboards, signs, posters, and company. If an insurance company provides the
written advertisements and promotional disclosures and obtains the acknowledgment on
materials): behalf of a depository institution, the insurance
company may retain the acknowledgment. The
• NOT A DEPOSIT depository institution is responsible for ensuring
• NOT FDIC-INSURED that sales made ‘‘on behalf of’’ the depository
• NOT INSURED BY ANY FEDERAL institution are in compliance with the CPSI
GOVERNMENT AGENCY regulation. An insurance company may main-
• NOT GUARANTEED BY THE BANK tain documentation showing compliance with
• MAY GO DOWN IN VALUE the CPSI regulation, but the depository institu-
tion should have access to such records and the
records should be readily available for review
Acknowledgment of Disclosures by examiners.
Reasonable efforts to obtain written acknowl- Form of written acknowledgment. There is no

edgment. The banking agencies have not pre- prescribed form for the written acknowledg-
December 2003 Commercial Bank Examination Manual

Page 12
ment. The regulation requires, however, that a Solicitations and Applications Distributed
covered person obtain the consumer’s acknowl- Before, but Returned After, the Effective
edgment of receipt of the complete insurance Date of the CPSI Regulation
and credit disclosures.
Direct-mail solicitations and ‘‘take-one’’ appli-
Timing of acknowledgment receipt. A covered cations that are distributed on or after October 1,
person must obtain the consumer’s acknowledg- 2001, must comply with the CPSI regulation. If
ment either at the time a consumer receives a consumer seeks to purchase insurance after the
disclosures or at the time of the initial purchase effective date of the regulation in response to a
of an insurance product. solicitation or advertisement that was distributed
before that date, the depository institution would
Oral acknowledgment of oral disclosure. The be in compliance with the regulation if the
CPSI regulation does not prescribe any specific institution provides the consumer, before the
wording for an oral acknowledgment. However, initial sale, with the disclosures required by the
if a covered person has made the insurance and regulation. These disclosures must be both writ-
credit disclosures orally, an affirmative response ten and oral, except that oral disclosures are not
to the question ‘‘Do you acknowledge that you required if the consumer mails in the application.
received this disclosure?’’ is acceptable.
Renewals of Insurance
Renewals of insurance are not subject to the
Scope of the CPSI Regulation disclosure requirements (see ‘‘Disclosures’’
above) but are subject to other requirements of
the CPSI regulation. A ‘‘renewal’’ of insurance
Applicability to Private Mortgage means continuation of coverage involving the
Insurance same type of insurance for a consumer as issued
by the same carrier. A renewal need not be on
Depending on the nature of a depository insti-
the same terms and conditions as the original
tution’s involvement in an insurance sales trans-
policy, provided that the renewal does not
action, the CPSI regulation may cover sales of
involve a different type of insurance and the
private mortgage insurance. If the depository
consumer has previously received the disclo-
institution itself purchases the insurance to pro-
sures required by the regulation at the time of
tect its interest in mortgage loans it has issued
the initial sale. An upgrade in coverage at a time
and merely passes the costs of the insurance on
when a policy is not up for renewal would be
to the mortgage borrowers, the transaction is not
treated as a renewal, provided that the solicita-
covered by the regulation. If, however, a con-
tion and sale of the upgrade does not involve a
sumer has the option of purchasing the private
different type of insurance and the consumer has
mortgage insurance and (1) the depository insti-
previously received the disclosures required by
tution offers the private mortgage insurance to a
the regulation at the initial sale.
consumer or (2) any other person offers the
private mortgage insurance to a consumer at an
office of a depository institution, or on behalf of
a depository institution, the transaction would Disclosures Required with Renewals of
be covered by the regulation. Insurance Coverage
The banking agencies’ interpretations clarified
that the CPSI regulation does not mandate
Applicability to Federal Crop Insurance disclosures for renewals of policies sold before
October 1, 2001. Accordingly, the regulation
The CPSI regulation does not apply to federal does not require the disclosures to be furnished
crop insurance that is sold for commercial or at the time of renewal of a policy, including a
business purposes. However, if the crop insur- pre-existing policy. However, renewals are sub-
ance is purchased by an individual primarily for ject to the other provisions of the regulation.
family, personal, or household purposes, it would Moreover, the banking agencies would expect
be covered. that, consistent with applicable safety-and-

Page 13
soundness requirements, depository institutions be a contemporaneous checklist completed by

would take reasonable steps to avoid customer the covered person to indicate that he or she
confusion in connection with renewals of pre- made the oral disclosures and received the oral
existing policies. acknowledgment. A contemporaneous note to
the consumer’s file would also be adequate. The
documentation should be maintained in the con-
‘‘On-Behalf-of’’ Test and Use of sumer’s file so that it is accessible to examiners.
Corporate Name or Logo
Under the CPSI regulation, an affiliate of a bank Setting for Insurance Sales
is not considered to be acting ‘‘on behalf of’’ a
bank simply because the affiliate’s marketing or A depository institution must identify the areas
other materials use a corporate name or logo that where insurance sales occur and must clearly
is common to the bank and the affiliate. In delineate and distinguish those areas from areas
general, this exclusion applies even if a bank where the depository institution’s retail deposit-
and its parent holding company have a similar, taking activities occur. Although the banking
but not identical, name. For example, if the agencies did not define how depository institu-
names of all of the affiliates of a bank holding tions could ‘‘clearly delineate and distinguish’’
company share the words ‘‘First National,’’ an insurance areas, signage or other means may be
affiliate would not be considered to be engaged used.
in an activity ‘‘on behalf of’’ an affiliated bank
simply by using the terms ‘‘First National’’ as
part of a corporate logo or identity. The affiliate
would, however, be considered to be acting ‘‘on APPENDIX B—GLOSSARY
behalf of’’ an affiliated bank if the name of the
bank (for example, ‘‘First National Bank’’) For additional definitions of insurance terms,
appears in a document as the seller, solicitor, see section 4040.1.
advertiser, or offeror of insurance. A transaction
also would be covered if it occurs on the Accident and health insurance. A type of cov-
premises of a depository institution or if one of erage that pays benefits in case of sickness,
the other prongs of the ‘‘on-behalf-of’’ test is accidental injury, or accidental death. This cov-
met. erage may provide for loss of income when the
insured is disabled and provides reimbursement
for medical expenses when the insured is ill. The
insurance can provide for debt payment if it is
Compliance taken out in conjunction with a loan. (See Credit
life insurance.)
Appropriate Documentation of an Oral
Disclosure or Oral Acknowledgment Actuary. A professional whose function is to
calculate statistically various estimates for the
There is no specific documentation requirement field of insurance, including the estimated risk
for oral disclosures or acknowledgments. How- of loss on an insurable interest and the appro-
ever, other applicable regulatory reporting stan- priate level for premiums and reserves.
dards would apply. Appropriate documentation
of an oral disclosure would clearly show that the Admitted insurer. An insurance company licensed
covered person made the credit and insurance by a state insurance department to underwrite
disclosures to a consumer. Similarly, appropriate insurance products in that state.
documentation of an oral acknowledgment would
clearly show that the consumer acknowledged Agency contract (or agreement). An agreement
receiving the credit and insurance disclosures. that establishes the contractual relationship
For example, a tape recording of the conversa- between an agent and an insurer.
tion (where permitted by applicable laws) in
which the covered person made the oral disclo- Agent. A licensed insurance company represen-
sures and received the oral acknowledgment tative under contract to one or more insurance
would be acceptable. Another example would companies. Depending on the line of insurance

Page 14
represented, an agent’s power may include to annuitants at fixed, guaranteed minimum

soliciting, advertising, and selling insurance; rates of interests.
collecting premiums; claims processing; and
effecting insurance coverage on behalf of an • Variable-annuity contracts provide for pay-
insurance underwriter. Agents are generally comments based on the performance of annuity
pensated by commissions on policies sold, investments. Variable-annuity contracts are
although some may receive salaries. usually sold based on a series of payments and
offer a range of investment or funding options,
• Captive or exclusive agent. An agent who such as stocks, bonds, and money market fund
represents a single insurer. investments. The annuity principal and the
investment return are not guaranteed as they
• General agent. An agent who is contractually depend on the performance of the underlying
awarded a specific geographic territory for an funding option.
individual insurance company. They are
responsible for building their own agency and Annuity payments may commence with the
usually represent only one insurer. Unlike execution of the annuity contract (immediate
exclusive agents, who usually receive a salary annuity) or may be deferred until some future
in addition to commissions, general agents are date (deferred annuity).
typically compensated on a commission basis
only. Assigned risk. A risk that is not usually accept-
able to insurers and is therefore assigned to a
• Independent agent. An agent who is under group of insurers who are required to share in
contractual agreements with at least two dif- the premium income and losses, in accordance
ferent insurers. Typically, all of the indepen- with state requirements, in order for the insurer
dent agent’s compensation originates from to sell insurance in the state.
commissions.
Assignment. The legal transfer of one person’s
Aggregate excess-of-loss reinsurance. A form of interest in an insurance policy to another person
‘‘excess-of-loss’’ reinsurance that indemnifies or business.
the ceding company against the amount by
which all of the ceding company’s losses Bank-owned life insurance (BOLI). Life insur-
incurred during a specific period (usually 12 ance purchased and owned by a bank to fund its
months) exceed either (1) a predetermined dol- exposure arising from employee compensation
lar amount or (2) a percentage of the company’s and benefit programs. In a typical BOLI pro-
subject premiums. This type of contract is also gram, a bank insures a group of employees; pays
commonly referred to as stop-loss reinsurance the life insurance policy premiums; owns the
or excess-of-loss ratio reinsurance. cash values of the policies, which are booked on
the bank’s balance sheet as ‘‘other assets’’; and
Allied lines. Various insurance coverages for is the beneficiary of the policies upon the death
additional types of losses and against losses by of any insured employee or former employee.
additional perils. The coverages are closely (See SR-04-19 and section 4042.1.)
associated with and usually sold with fire insur-
ance. Examples include coverage against loss by Beneficiary. The person or entity named in an
perils other than fire, coverage for sprinkler- insurance policy as the recipient of insurance
leakage damage, and business-interruption proceeds upon the policyholder’s death or when
coverage. an endorsement matures. A revocable benefi-
ciary can be changed by the policyholder at any
Annuity. A contract that provides for a series of time. An irrevocable beneficiary can be changed
payments payable over an individual’s life span by the policyholder only with the written per-
or other term, on the basis of an initial lump-sum mission of the beneficiary.
contribution or series of payments made by the
annuitant into the annuity during the accumula- Binder. A written or oral agreement, typically
tion phase of the contract. issued by an insurer, agent, or broker for prop-
erty and casualty insurance, to indicate accep-
• Fixed-annuity contracts provide for payments tance of a person’s application for insurance and

Page 15
to provide interim coverage pending the insur- insurance or reinsurance risk underwritten by an
ance company’s issuance of a binding policy. insurance company.
Blanket bond. Coverage for an employer for loss Ceding commission. The fee paid to a reinsur-
incurred as a result of employee dishonesty. ance company for assuming the risk of a pri-
mary insurance company.
Boiler and machinery insurance. Insurance
against the sudden and accidental breakdown of Ceding company (also cedant, reinsured, reas-
boilers, machinery, and electrical equipment, sured). The insurer that transfers all or part of
including coverage for damage to the equipment the insurance or reinsurance risk it has under-
and property damage, including the property of written to another insurer or reinsurer via a
others. Coverage can be extended to cover reinsurance agreement.
consequential losses, including loss from inter-
ruption of business. Cession. The amount of insurance risk trans-
ferred to the reinsurer by the ceding company.
Broker. A person who represents the insurance
buyer in the purchase of insurance. Brokers do
Churning. The illegal practice wherein a cus-
not have the power to bind an insurance com-
tomer is persuaded to unnecessarily cancel one
pany to an insurance contract. Once a contract is
insurance policy in favor of buying a purport-
accepted, the broker is compensated for the
edly superior policy, often using the cash sur-
transaction through a commission from the insur-
render value of the existing policy to pay the
ance company. An individual may be licensed as
early premiums of the new policy. In such a
both a broker and an agent.
transaction, the salesperson benefits from the
additional commission awarded for booking a
Bulk reinsurance. A transaction sometimes
new policy.
defined by statute as any quota-share, surplus
aid, or portfolio reinsurance agreement through
which an insurer assumes all or a substantial Claim. A request for payment of a loss under the
portion of the liability of the reinsured terms of a policy. Claims are payable in the
company. manner suited to the insured risk. Life, property,
casualty, health, and liability claims generally
Captive insurer. An insurance company estab- are paid in a lump sum after the loss is incurred.
lished by a parent firm to insure or reinsure its Disability and loss-of-time claims are paid peri-
own risks or the risks of affiliated companies. A odically during the period of disability or through
captive may also underwrite insurable risks of a discounted lump-sum payment.
unaffiliated companies, typically the risks of its
customers or employees. For example, a bank Coinsurance. A provision in property and casu-
may form a captive insurance company to under- alty insurance that requires the insured to main-
write its own directors’ and officers’ risks or to tain a specified amount of insurance based on
underwrite credit life or private mortgage insur- the value of the property insured. Coinsurance
ance (third-party risks) related to its lending clauses are also found in health insurance and
activities. require the insured to share a percentage of the
loss.
Cash surrender value of life insurance. The
amount of cash available to a life insurance Combination-plan reinsurance. A reinsurance
policyholder upon the voluntary termination of a agreement that combines the excess-of-loss and
life insurance policy before it becomes payable the quota-share forms of coverage within one
by death or maturity. contract, with the reinsurance premium estab-
lished as a fixed percentage of the ceding
Casualty insurance. Coverage for the liability company’s subject premium. After deducting
arising from third-party claims against the the excess recovery on any one loss for one risk,
insured for negligent acts or omissions causing the reinsurer indemnifies the ceding company on
bodily injury or property damage. the basis of a fixed quota-share percentage. If a
loss does not exceed the excess-of-loss retention
Cede. To transfer to a reinsurer all or part of the level, only the quota-share coverage applies.

Page 16
Commission. The remuneration paid by insur- Deductible. The amount a policyholder agrees
ance carriers to insurance agents and brokers for to pay toward the total amount of insurance loss.
the sale of insurance and annuity products. The deductible may apply to each claim for a
loss occurrence, such as each automobile acci-
Comprehensive personal liability insurance. A dent, or to all claims made during a specified
type of insurance that reimburses the policy- period, as with health insurance.
holder if he or she becomes liable to pay money
for damage or injury he or she has caused to Directors and officers liability insurance. Lia-
others. This coverage does not include automo- bility insurance covering a corporation’s obliga-
bile liability but does include almost every tion to reimburse its directors or officers for
activity of the policyholder, except business claims made against them for alleged wrongful
operations. acts. It also provides direct coverage for com-
pany directors and officers themselves in instances
Contractholder. The person, entity, or group to when corporate indemnification is not available.
whom an annuity is issued.
Credit for reinsurance. A statutory accounting Direct premiums written. Premiums received by
procedure, set forth under state insurance regu- an underwriter for all policies written during a
lations, that permits a ceding company to treat given time period by the insurer, excluding
amounts due from reinsurers as assets, or as those received through reinsurance assumed.
offsets to liabilities, on the basis of the reinsur-
er’s status. Direct writer. An insurance company that deals
directly with the insured through a salaried
Credit life insurance. A term insurance product representative, as opposed to those insurers that
issued on the life of a debtor that is tied to use agents. This term also refers to insurers that
repayment of a specific loan or indebtedness. operate through exclusive agents. In reinsur-
Proceeds of a credit life insurance policy are ance, a direct writer is the company that origi-
used to extinguish remaining indebtedness at the nally underwrites the insurance policies ceded.
time of the borrower’s death. The term is
applied broadly to other forms of credit-related Disability income insurance. An insurance prod-
insurance that provide for debt satisfaction in uct that provides income payment to the insured
the event of a borrower’s disability, accident or when his or her income is interrupted or termi-
illness, and unemployment. Credit life insurance nated because of illness or accident.
has historically been among the most common
bank insurance products. Endowment insurance. A type of life insurance
contract under which the insured receives the
Credit score. A number that is based on an face value of the policy if he or she survives the
analysis of an individual’s credit history and that endowment period. Otherwise, the beneficiary
insurers may consider as an indicator of risk for receives the face value of the policy upon the
purposes of underwriting insurance. Where not death of the insured.
prohibited by state law, insurers may consider a
person’s credit history when underwriting per- Errors and omissions (E&O) liability insurance.
sonal lines. Professional liability insurance that covers neg-
ligent acts or omissions resulting in loss. Insur-
Debt-cancellation contract/debt-suspension ance agents are continually exposed to the claim
agreement. A loan term or contract between a that inadequate or inappropriate coverage was
lender and borrower whereby, for a fee, the recommended, resulting in a lack of coverage
lender agrees to cancel or suspend payment on for losses incurred. The agent or the carrier may
the borrower’s loan in the event of the borrow- be responsible for coverage for legitimate claims.
ers’s death, serious injury, unemployment, or
other specified events. The Office of the Comp- Excess-of-loss reinsurance. A form of reinsur-
troller of the Currency considers these products ance whereby an insurer pays the amount of
to be banking products. State law determines each claim for each risk up to a limit determined
whether these products are bank or insurance in advance, and the reinsurer pays the amount of
products for state-chartered banks and insurance the claim above that limit up to a specific sum.
companies. It includes various types of reinsurance, such as

Page 17
catastrophe reinsurance, per-risk reinsurance, Flood insurance. A special insurance policy to

per-occurrence reinsurance, and aggregate protect against the risk of loss or damage to
excess-of-loss reinsurance. property caused by flooding. Regular homeown-
ers’ policies do not pay for damages caused by
Excess-per-risk reinsurance. A form of excess- flooding.
of-loss reinsurance that, subject to a specified
limit, indemnifies the ceding company against
General liability insurance. A broad commer-
the amount of loss in excess of a specified
cial policy that covers all business liability
retention for each risk involved in each
exposures, such as product liability, completed
occurrence.
operations, premises and operations, indepen-
Excess and surplus lines. Property/casualty cov- dent contractors, and other exposures that are
erage that is unavailable from insurers licensed not specifically excluded.
by the state (admitted insurers) and must be
purchased from a nonadmitted underwriter. Gross premiums written. Total premiums for
insurance written during a given period, before
Exposure. The aggregate of all policyholder deduction for reinsurance ceded.
limits of liability arising from policies written.
Group insurance. Insurance coverage typically
Face amount. The amount stated on the face of issued to an employer under a master policy for
the insurance policy to be paid, depending on the benefit of employees. The insurer usually
the type of coverage, upon death or maturity. It does not condition coverage of the people that
does not include dividend additions or addi- make up the group upon satisfactory medical
tional amounts payable under accidental death examinations or other requirements. The indi-
or other special provisions. vidual members of the group hold certificates as
Facultative reinsurance. Reinsurance of indi- evidence of their insurance.
vidual risks by offer and acceptance wherein the
reinsurer retains the faculty to accept or reject Health insurance. An insurance product that
each risk offered by the ceding company. provides benefits for medical expenses incurred
as a result of sickness or accident, as well as
Facultative treaty. A reinsurance contract under income payments to replace lost income when
which the ceding company has the option to the insured is unable to work because of illness,
cede and the reinsurer has the option to accept or accident, or disability. This product may be in
decline classified risks of a specific business the form of traditional indemnity insurance or
line. The contract merely reflects how individual managed-care plans and may be underwritten on
facultative reinsurance shall be handled. an individual or group basis.
Financial guarantee insurance. Financial guar- Incurred but not reported (IBNR). The loss-
antee insurance is provided for a wide array of reserve value established by insurance and rein-
financial risks. Typically, coverage is provided surance companies in recognition of their liabil-
for the fulfillment of a specific financial obliga- ity for future payments on losses that have
tion originated in a business transaction. The occurred but have not yet been reported to them.
insurer, in effect, is lending the debtor its own This definition is often erroneously expanded to
credit rating to enhance the debtor’s creditwor- include adverse loss development on reported
thiness. claims. The term incurred but not enough
Financial strength rating. Opinion as to an reported (IBNER) is being increasingly used to
insurance company’s ability to meet its senior reflect more accurately the adverse development
policyholder obligations and claims. For many on inadequately reserved reported claims.
years, the principal rating agency for property
and casualty insurers and life insurers has been Inland marine insurance. A broad field of insur-
A.M. Best. Other rating agencies, such as Fitch, ance that covers cargo being shipped by air,
Moody’s, Standard and Poor’s, and Weiss, also truck, or rail. It includes coverage for most
rate insurers. property involved in transporting cargo as well
as for bridges, tunnels, and communications
Fixed annuity. See Annuity. systems.

Page 18
Key person life insurance. Life insurance period. Lenders who finance more than 80 per-
designed to cover the key employees of an cent of the property’s fair value generally require
employer. It may be written on a group- or an such insurance.
individual-policy basis.
Mortgage insurance. Life insurance that pays
Lapse. The termination or discontinuance of a the balance of a mortgage even if the borrower
policy resulting from the insured’s failure to pay dies. Coverage typically is in the form of term
the premium due. life insurance, with the coverage declining as the
debt is paid off.
Liability insurance. Protects policyholders from
financial loss due to liability resulting from Multiperil insurance. An insurance contract pro-
injuries to other persons or damage to their viding coverage against many perils, usually
property. combining liability and physical damage
coverage.
Lines. A term used in insurance to denote
insurance business lines, as in ‘‘commercial Net premiums written. The amount of gross
lines’’ and ‘‘personal lines.’’ premiums written, after deduction for premiums
ceded to reinsurers.
Long-term care insurance. Health insurance
designed to supplement the cost of nursing Ninety-day loss rule. A state requirement for an
home care or other care facilities in the event of insurer to establish a loss provision for reinsur-
a long-term illness or permanent disability or ance recoverables over 90 days past due.
incapacity.
Obligatory treaty. A reinsurance contract under
Managing general agent. A managing general which business must be ceded in accordance
agent (MGA) is a wholesaler of insurance prod- with contract terms and must be accepted by the
ucts and services to insurance agents. An MGA reinsurer.
receives contractual authority from an insurer to
assume many of the insurance company’s func- Policyholder. The person or entity who owns an
tions. The MGA may provide insurance prod- insurance policy. This is usually the insured
ucts to the public through local insurance agents person, but it may also be a relative of the
as well as provide services to an insurance insured, a partnership, or a corporation.
company, including marketing, accounting, data
processing, policy maintenance, and claims- Premium. The payment, or one of the periodic
monitoring and -processing services. Many payments, a policyholder agrees to make for
insurance companies prefer the MGA distribu- insurance coverage.
tion and management system for their insurance
products because it avoids the high cost of Private mortgage insurance (PMI). Coverage
establishing branch offices. Most states require for a mortgage lender against losses due to a
that an MGA be licensed. collateral shortfall on a defaulted residential real
estate loan. Most banks require borrowers to
Manuscript policy. A policy written to include take out a PMI policy if a downpayment of less
specific coverage or conditions not provided in a than 20 percent of a home’s value is made at the
standard policy. time the loan is originated. PMI does not directly
benefit a borrower, although its existence pro-
Morbidity. The incidence and severity of illness vides the opportunity to purchase a home to
and disease in a defined class of insured persons. many people who otherwise would not qualify
for a loan.
Mortality. The rate at which members of a group
die in a specified period of time or die from a Producer. A person licensed to sell, solicit, or
specific illness. negotiate insurance.
Mortgage guarantee insurance. A product that Professional designations and organizations.

insures lenders against nonpayment by borrow- Three of the most common insurance profes-
ers. The policies are issued for a specified time sional designations are chartered life under-

Page 19
writer (CLU), chartered property casualty under- Reinsurance premium. The consideration paid
writer (CPCU), and chartered financial consultant by a ceding company to a reinsurer for the
(ChFC). Insurance agents also join professional coverage provided by the reinsurer.
organizations such as the American Society of
Chartered Life Underwriters, the International Residual market. Also known as the shared
Association of Financial Planning, the National market, it covers applications for insurance that
Association of Life Underwriters, the National were rejected by underwriters in the voluntary
Association of Health Underwriters, the Ameri- market that is covered by agency direct-
can Council of Life Insurance, the Life Insur- marketing systems, perhaps because of high loss
ance Marketing and Research Association, the experience by the insured party. The residual
Life Underwriter Training Council, and the market includes government insurance pro-
Million Dollar Round Table. grams, specialty pools, and shared market
mechanisms such as assigned-risk plans.
Pro rata reinsurance. A generic term describing
all forms of ‘‘quota-share’’ and ‘‘surplus rein- Retrocession. A reinsurance transaction whereby
surance,’’ in which the reinsurer shares a pro a reinsurer (the retrocedant) cedes all or part of
rata portion of the losses and premiums of the the reinsurance risks it has assumed to another
ceding company. reinsurer (the retrocessionaire).
Property insurance. Coverage for physical dam- Retrospective rating. An insurance plan in which
age or destruction of real property (buildings, the current year’s premium is based on the
fixtures, and permanently attached equipment) insured’s own loss experience for that same
and personal property (movable items that are period, subject to a maximum and minimum.
not attached to land) that occurs during the
policy period as a result of, for example, fire, Rider. A written attachment, also known as an
windstorm, explosion, or vandalism. endorsement, to an insurance policy that changes
the original policy to meet specific require-
ments, such as increasing or decreasing benefits
Protected cell. A structure available to captive
or providing coverage for specific property items
insurers underwriting risks of unaffiliated com-
beyond that provided for under the insurance
panies whereby the assets associated with the
company’s standard contract terms.
self-insurance program of one organization are
segregated to provide legal-recourse protection
Self-insured retention (SIR). The percentage of a
from creditors of protected cells providing
risk or potential loss assumed by an insured,
insurance coverage to other organizations.
whether in the form of a deductible, self-
insurance, or no insurance at all.
Quota-share reinsurance. A form of pro rata
reinsurance indemnifying the ceding company Separate accounts. Certain life insurance assets
for a fixed percent of loss on each risk covered and related liabilities that are segregated and
in the contract in consideration of the same maintained to meet specific investment objec-
percentage of the premium paid to the ceding tives of contract holders, particularly those assets
company. and liabilities associated with pension plans and
variable products offered by life insurers,
Rebating. Directly or indirectly giving or offer- wherein the customer and not the insurer retains
ing to give any portion of the premium or any most of the investment and interest-rate risk.
other consideration to an insurance buyer as an
inducement to purchase or renew the insurance. Split-dollar life insurance. An arrangement that
Rebates are forbidden under most state insur- typically involves an agreement between an
ance codes. employer and an employee whereby the pre-
mium payment, cash values, policy ownership,
Reinsurance. Insurance placed by an under- and death benefits may be split. There are many
writer (the ceding company or reinsured) in variations of split-dollar arrangements, includ-
another company to transfer or reduce the ing arrangements in which a trust is created to
amount of the risk assumed under the original facilitate estate planning. Split-dollar life insur-
insurance policy (or group of policies). ance is designed to serve as a supplemental

Page 20
benefit to a particular company executive. The over the ‘‘underlying’’ liability insurance cover-
arrangement typically involves the payment of age to supplement underlying policies that have
the insurance premium by the employer, with been reduced or exhausted by loss.
the death benefit accruing to the employee.
Underwriting. The process by which a company
Subrogation. An insurance carrier may reserve determines whether it can accept an application
the ‘‘right of subrogation’’ in the event of a loss. for insurance and by which it may charge an
This means that the company may choose to appropriate premium for those applications
take action to recover the amount of a claim paid selected. For example, the underwriting process
to a covered insured if a third party caused the for life insurance classifies applicants by identi-
loss. After expenses, the amount recovered must fying such characteristics as age, sex, health,
be divided proportionately with the insured to and occupation.
cover any deductible for which the insured was
responsible. Unearned reinsurance premium. The part of the
reinsurance premium that is applicable to the
Term life insurance. An insurance product that unexpired portion of the policies reinsured.
provides, for a specified period of time, death
coverage only. Typically, it has no savings Universal life insurance. A form of permanent
component and, therefore, no cash value. insurance designed to provide flexibility in pre-
Because term insurance provides only mortality mium payments and death benefit protection.
protection, it generally provides the most cov- The policyholder can pay maximum premiums
erage per premium dollar. Most term life insur- and maintain a high cash surrender value. Alter-
ance policies are renewable for one or more time natively, the policyholder can make minimal
periods up to a stipulated maximum age; how- payments in an amount only large enough to
ever, premiums generally increase with the age cover mortality and other expense charges.
of the policyholder.
Variable annuity. See Annuity.
Title insurance. Insurance that protects banks
and mortgagees against unknown encumbrances Variable life insurance. A form of whole life, or
against real estate by indemnifying the mort- universal life, insurance in which the policyhold-
gagor and property owner in the event that clear er’s cash value is invested in ‘‘separate accounts’’
ownership of the property is clouded by the of the insurer. These accounts are segregated
discovery of faults in the title. Title insurance from the insurance carrier’s other asset holdings.
policies may be issued to either the mortgagor or Such separate account investments are generally
the mortgagee or both. Title insurance is written not available to a carrier’s general creditors in
largely only by companies specializing in this the event of the carrier’s insolvency. The poli-
class of insurance. cyholder assumes the investment and price risk.
Because variable life policies have investment
Treaty reinsurance. A reinsurance contract under features, life insurance agents selling these poli-
which the reinsured company agrees to cede, cies must be registered representatives of a
and the reinsurer agrees to assume, risks of a broker-dealer licensed by the Financial Industry
particular class or classes of business. Regulatory Authority and registered with the
Securities and Exchange Commission.
Twisting. In insurance, twisting involves making
misrepresentations to a policyholder to induce Vendors’ single-interest insurance. A form of
the policyholder to terminate one policy and force-placed insurance that is typically pur-
take out another policy with another company, chased by the bank to protect against loss or
when it is not to the insured’s benefit. Twisting damage to loan collateral in which the bank has
is a violation of the Unfair Trade Practices Act. a security interest. The bank passes its expense
Twisting is similar to the ‘‘churning’’ concept in for this insurance on to the consumer who has
securities sales, and it results in increased com- either refused or is unable to obtain property
missions for the inducing agent. insurance.
Umbrella liability insurance. This type of liabil- Viatical settlement. The cashing in of a life
ity insurance provides excess liability protection insurance policy at a discount from face amount

Page 21
by policyholders who are often terminally ill a cash value (essentially a savings account) that
and need the money for medical care. The accrues to the policyholder tax deferred. A
purchaser becomes the policyholder as well as policyholder receives the cash value in lieu of
the beneficiary and assumes the premium pay- death benefits if the policy matures or lapses
ments of the policy. before the insured’s death. A policyholder also
may borrow against the policy’s accumulated
Whole life insurance. A fixed-rate insurance cash value or use it to pay future premiums. For
product, with premiums and death benefits guar- most whole life insurance policies, premiums
anteed over the duration of the policy. There is are constant for the life of the insured’s contract.

Page 22
of Insurance
1. To understand the volume and complexity of The following objectives apply if insurance prod-
the state member bank’s insurance or annuity ucts or annuities are sold by a bank or another
program and insurance sales strategy. person at an office of, or on behalf of, the bank.
2. To assess the financial results of the insur-
ance and annuity sales activity compared 6. To assess the adequacy of the state member
with planned results. bank’s oversight program for ensuring com-
3. To determine if the state member bank’s pliance with the Consumer Protection in
insurance and annuity sales activities are Sales of Insurance (CPSI) regulation. (See
effectively integrated into the risk- section 4043.1.)
management, audit, and compliance func- 7. To assess the effectiveness of the state mem-
tions and if the control environment is ber bank’s audit and compliance programs
adequate. for the CPSI regulation.
4. To assess the adequacy of the state member 8. To assess the state member bank’s current
bank’s controls to ensure compliance with compliance with the CPSI regulation.
the applicable state and federal laws and 9. To obtain commitments for corrective action
regulations. when the state member bank is in violation of
5. To assess the state member bank’s level and the CPSI regulation or when applicable poli-
direction of operational, legal, and reputa- cies, procedures, practices, or management
tional risks from the insurance or annuity oversight to protect against violations is
sales activity. deficient.

Page 1
of Insurance
RISK ASSESSMENT OF including annuities, and health

INSURANCE AND ANNUITY insurance;
SALES ACTIVITIES • by the proportion of sales to commer-
cial and retail customers; and
The examiner should consider the following • by the portion of sales that is credit
procedures, as appropriate, when conducting a related, such as credit life and credit
risk assessment to determine the level and health insurance.
direction of risk exposure to the state member b. Determine any sales concentrations to
bank that is attributable to insurance or annuity particular entities, industries, or bank
sales activity. If there are specific areas of customers.
concern, the examiner should focus primarily on c. Note any concentrations to large com-
those areas. mercial accounts.
1. Scope of activities and strategies. Assess d. Determine what insurance services are
the significance and complexity of the provided to the bank, its employees, and
insurance or annuity sales program. bank affiliates.
a. Obtain a general overview of the scope 3. Legal-entity and risk-management structure
of the state member bank’s insurance or for insurance or annuity sales.
annuity sales activities and any antici- a. Obtain an organizational chart for the
pated or recent change in or expansion of legal-entity and risk-management struc-
such activities. ture for the insurance or annuity sales
b. Determine the state member bank’s strat- activities.
egy for insurance or annuity sales, includ- b. Determine—
ing strategies for cross-selling and refer- • whether the insurance or annuity sales
rals of insurance and banking products. activity is conducted in an affiliated
Determine the institution’s experience producer, by the bank itself, through
with any cross-marketing programs for another distribution arrangement, or
both insurance business generated by the by a combination of these arrangements;
bank and bank business generated by • the names of any affiliated insurance
insurance producers. agencies and the states where the
c. Obtain two years’ worth of income state- affiliated insurance agencies are
ments, balance sheets, and budget docu- licensed;
ments for the agency’s activities. Com- • the locations outside of the United
pare the expected budget items with their States where insurance or annuities are
actual results. sold or solicited; and
d. Determine the volume and type of insur- • if any subsidiary agency operates as a
ance or annuity products and services financial subsidiary under the Gramm-
sold or solicited. Leach-Bliley Act.
c. Determine if the insurance or annuity
e. Determine what other related services
producer is acting as a managing general
the state member bank provides in con-
agent (MGA).1 If so, determine—
nection with its insurance or annuity
sales activities, such as providing risk- • the scope of the MGA activities;
management services to clients seeking • the state member bank management’s
advice on appropriate insurance cover-
ages, claims processing, and other
activities. 1. MGAs do not assume underwriting risk. Through con-
tractual arrangements with an insurer, MGAs have the author-
2. Insurance sales products and concentrations. ity to write policies on behalf of the insurer in certain
a. Determine the composition of sales— instances, thereby binding the insurer to the policy. Certain
minimum provisions governing MGA agreements are delin-
• by line of business, such as property/ eated in the applicable National Association of Insurance
casualty insurance, life insurance Commissioners (NAIC) model law.

Page 1
4043.3 Insurance Sales Activities and Consumer Protection in Sales of Insurance: Examination Procedures
assessment of the risk associated with regulations pertaining to consumer

the MGA activity; and protection;
• what risk controls are in place to • whether there are appropriate policies
protect the state member bank from and procedures for the handling of
potential loss that may arise from the customer funds collected on behalf of
MGA’s activities, such as loss arising the underwriter; accurate and timely
from legal liability. financial reporting; complaint monitor-
4. Strategic and financial plans. Assess man- ing and resolution; effective system
agement controls over the insurance and security and disaster-recovery plans;
annuity sales activities. and policy-exception tracking and
a. Ascertain the state member bank man- reporting; and
agement’s strategic and financial plans • if the board of directors or its desig-
and goals for the insurance or annuity nated committee has formally approved
sales activity. the policies.
b. Review the state member bank’s due- b. Obtain a detailed balance sheet for agency
diligence process for acquiring and pric- subsidiaries, and determine if the assets
ing agencies, if applicable. held by insurance or annuity agency
c. Review the state member bank’s finan- subsidiaries of the state member bank are
cial budgets and forecasts for the activ- all bank-eligible investments.
ity, particularly plans for new products, c. Determine the independence of the state
marketing strategies and marketing member bank’s audit program applicable
arrangements, and the rate of actual and to the insurance and annuity sales activ-
expected growth for the activity. ity. Determine if the audit program’s
d. Determine the cause for significant scope, frequency, and resources are com-
deviations from the plan. mensurate with the insurance or annuity
e. Determine if any agency acquired by the sales activities conducted.
state member bank is providing the
d. Determine how the state member bank
expected return on investment and if the
selects insurance underwriters with whom
agency’s revenues are covering the debt
to do business, as well as how the state
servicing associated with the purchase, if
member bank monitors the continuing
applicable.
performance of the underwriters.
5. Review of board and committee records and
reports. e. Determine the adequacy of the oversight
a. Review the reports of any significant of the bank’s board of directors over the
state member bank oversight commit- insurance management team’s qualifica-
tees, including relevant board of directions, the training and licensing of per-
tors and board committee minutes and sonnel, and general compliance with state
risk-management reports. insurance regulations.
b. Determine if the board of directors, a f. Review the internal controls of the state
board committee, or senior management member bank related to third-party
of the state member bank reviews reports arrangements, including arrangements for
pertaining to consumer complaints and sales, processing, and auditing of insur-
complaint resolution, information pertain- ance or annuity sales activities.
ing to litigation and associated losses, 7. Claims, litigation, and functional regula-
and performance compared with the tory supervision. Assess legal and reputa-
organization’s plan for the insurance and tional risk.
annuity sales activities. a. Identify any significant litigation against
6. Policies and procedures. the state member bank arising from its
a. Determine— insurance or annuity sales activity and
• the adequacy of the state member the likely impact of the litigation on the
bank’s policies and procedures for con- state member bank.
ducting and monitoring insurance or b. Obtain the insurance agency’s errors and
annuity sales activities, including those omissions claims records for the past
policies designed to ensure adherence several years, including a listing of claims
with federal and state laws and it has made and the amount of claims, the

Page 2
Insurance Sales Activities and Consumer Protection in Sales of Insurance: Examination Procedures 4043.3
claim status, and the amount of claim 11. State supervisory insurance authorities.
payments. a. During discussions with state member
c. Review the state member bank’s policies bank management, determine whether
and procedures for tracking and resolv- state insurance regulators have raised
ing claims. Determine if they appear any issues or concerns in correspondence
adequate and if they are adhered to. or reports.
d. Determine if the applicable functional b. Consult with the state insurance regula-
regulator has any outstanding supervi- tors, as appropriate, to determine any
sory issues with the insurance agency. significant supervisory issues, actions, or
8. Consumer complaints. investigations. (For multistate agencies,
a. Determine if bank managagement has contacts with states may be prioritized
policies and procedures in place to assess on the basis of the location of the agen-
whether consumer complaints received cy’s head office or by a determination of
are likely to expose the state member the significance of sales by state. Both
bank to regulatory action, litigation, repu- financial examinations and market con-
tational damage, or other significant risk. duct examinations conducted by the state
b. Obtain applicable consumer complaint insurance departments are targeted at
files, and evaluate internal control proce- insurance underwriters, not agencies.
dures to ensure the complaints are being Therefore, information available from
adequately addressed. the states pertaining to agencies may be
9. Audit and compliance functions. very limited.)
a. Determine the date of the most recent 12. Operational risk assessment. Ascertain from
review of the insurance or annuity sales the state member bank’s management
activities by the audit and compliance whether there are—
functions. a. any significant operational problems or
b. Determine the adequacy of the state concerns relating to insurance or annuity
member bank’s management policies and sales activities;
procedures for ensuring that any deficien- b. policies and procedures in place to ensure
cies noted in such reviews are corrected, accurate and timely reporting to the state
and ascertain whether any such deficien- member bank’s management of insur-
cies are being adequately addressed.2 ance or annuity sales activity plans, finan-
10. Insurance underwriter oversight of agent/ cial results, and significant consumer
agency activities. complaints or lawsuits or compliance
a. Determine if there are adequate policies issues, such as errors and omissions
and procedures to review and resolve claims;4
any issues or concerns raised by an c. appropriate policies and procedures at
insurance underwriter regarding the pro- the state member bank to ensure accurate
ducers used by, or affiliated with, the reporting of insurance or annuity sales
state member bank.3 activity on Federal Reserve regulatory
b. Determine whether any of the insurance reports (Determine from applicable Board
underwriters conducted a periodic review or Reserve Bank contacts if there are any
of the producers that they engaged to sell outstanding issues with respect to poten-
insurance. tial reporting errors on submitted Federal
Reserve reports, bank call reports, or
2. Enforcement of the privacy provisions of the Gramm-
other applicable reports. If so, seek reso-
Leach-Bliley Act as they relate to state member banks is the lution of the issues.); and
responsibility of the Board’s Division of Consumer and d. adequate disaster-recovery plans and pro-
Community Affairs. However, enforcement of the privacy cedures to protect the state member bank
provisions of the GLB Act with respect to the insurance
activities of nondepository subsidiaries of a state member
bank is the responsibility of the state insurance regulators. 4. Errors and omissions insurance should be in place to
3. Insurance underwriters generally have procedures to protect the state member bank against loss sustained because
determine whether individual producers affiliated with agen- of an error or oversight, such as failure to issue an insurance
cies are selling the underwriters’ products in conformance policy. A tracking system to monitor errors and omission
with applicable laws and regulations. The findings and con- claims should be in place and monitored by the state member
clusions of these reviews should be available to the state bank, as appropriate. See section 4040.1, ‘‘Management of
member bank’s management. Insurable Risks.’’
Commercial Bank Examination Manual December 2003

Page 3
4043.3 Insurance Sales Activities and Consumer Protection in Sales of Insurance: Examination Procedures
from loss of data related to insurance or a. disclosures, advertising, and promotional

annuity sales activities. materials
b. consumer acknowledgments
c. physical separation from areas of deposit-
CONSUMER PROTECTION IN taking activities
SALES OF INSURANCE d. qualifications and licensing for insurance
REGULATION personnel
The following procedures should be risk-focused e. compliance programs and internal audits
in accordance with the Federal Reserve’s risk- f. hiring, training, and supervision of insur-
focused framework for supervising banking ance or annuity sales personnel employed
organizations. The procedures should be carried directly by the bank, or of third parties
out as necessary to adequately assess the state selling insurance or annuity products at a
member bank’s compliance with the Consumer state member bank office or on behalf of
Protection in Sales of Insurance (CPSI) the state member bank
regulation. g. compensation practices and training for
personnel making referrals
1. Determine the role of the state member 4. If a third party sells insurance or annuities at
bank’s board of directors and management the state member bank’s offices, or on
in ensuring compliance with the CPSI behalf of the bank, review the state member
regulation and applicable state consumer bank’s policies and procedures for ensuring
regulations. that the third party complies with the CPSI
2. Evaluate the management information sys- regulation and other relevant policies and
tem (MIS) reports the state member bank’s procedures of the bank.
board or designated committee rely on to
monitor compliance with the consumer regu- 5. Review the bank’s process for identifying
lations and to track complaints and com- and resolving consumer complaints related
plaint resolution. to the sale of insurance products and
3. Review the state member bank’s policies annuities.
and procedures to ensure they are consistent 6. Obtain and review the record of consumer
with the CPSI regulation, and conduct trans- complaints related to the CPSI regulation.
action testing, as necessary, in the following (These records are available from the
areas.5 Board’s Division of Consumer and Commu-
nity Affairs database. See CP letter 2001-
5. If the examiner determines that transaction testing of a
11.)
functionally regulated nonbank affiliate of the state member 7. Include examination findings, as appropri-
bank is appropriate in order to determine the state member ate, in the commercial bank examination
bank’s compliance with the CPSI regulation, the examiner
should first consult with and obtain approval from appropriate
report or in other communications to the
staff of the Board’s Division of Banking Supervision and bank, as appropriate, that pertain to safety-
Regulation. and-soundness reviews of the bank.
December 2003 Commercial Bank Examination Manual

Page 4
of Insurance
RISK ASSESSMENT OF compliance with the Consumer Protection

INSURANCE AND ANNUITY in Sales of Insurance (CPSI) regulation?
SALES ACTIVITIES 10. Does MIS include sales volumes and trends,
profitability, policy exceptions and associ-
ated controls, customer complaints, and
Program Management other information providing evidence of
compliance with laws and established
1. Does the state member bank have a com- policies?
prehensive program to ensure that its insur-
ance and annuity sales activities are con-
ducted in a safe and sound manner?
2. Does the state member bank have appropri- Compliance Programs and Internal
ate written policies and procedures commen- Audits
surate with the volume and complexity of
the insurance or annuity sales activities? 11. Are there policies and procedures in place
3. Has bank management obtained the approval to ensure that insurance or annuity sales
of the bank’s board of directors for the activities are conducted in compliance with
program scope and the associated policies applicable laws and regulations?
and procedures? 12. Do compliance procedures identify poten-
4. Have reasonable precautions been taken to tial conflicts of interest and how such con-
ensure that disclosures to customers for flicts should be addressed?
insurance or annuity sales and solicitations 13. Do the compliance procedures provide a
are complete and accurate, and are in system to monitor customer complaints and
compliance with applicable laws and track their resolution?
regulations? 14. When applicable, do compliance proce-
5. Does the state member bank effectively dures call for verification that third-party
oversee the insurance or annuity sales sales are being conducted in a manner
activities, including those involving third consistent with the agreement governing the
parties? third party’s arrangement with the state
6. Does the state member bank have an effec- member bank?
tive independent internal audit and compli- 15. Is the compliance function conducted inde-
ance program in place to monitor retail sales pendently of the insurance or annuity sales
of insurance or annuity products? and management activities?
7. Does the bank appropriately train and 16. Do compliance personnel determine the
supervise employees conducting insurance scope and frequency of the insurance-
or annuity sales activities? product review?
17. Are findings of insurance or annuity sales
activity compliance reviews periodically
Management Information Systems reported directly to the state member bank’s
board of directors or a designated commit-
8. Does the state member bank’s insurance tee thereof?
program management plan establish the
appropriate management information sys-
tems (MIS) necessary for the board of
directors to properly oversee the bank’s CONSUMER PROTECTION IN
insurance or annuity sales activities? SALES OF INSURANCE
9. Does MIS provide sufficient information to REGULATION
allow for the evaluation and measurement
of the effect of actions taken to identify, If applicable, review the state member bank’s
track, and resolve any issues relative to internal controls, policies, practices, and proce-

Page 1
4043.4 Insurance Sales Activities and Consumer Protection in Sales of Insurance: Internal Control Questionnaire
dures for retail insurance or annuity sales activi- insured by the FDIC or any other agency
ties conducted by the bank on bank premises or of the United States, the state member
on behalf of the bank. The bank’s program bank, or (if applicable) an affiliate of the
management for such activities should be well bank?
documented and should include appropriate per- c. in the case of an insurance product or
sonnel training, as well as compliance and annuity that involves an investment risk,
audit-function coverage of all efforts to ensure there is risk associated with the product,
compliance with the provisions of the Board’s including the possible loss of value?
CPSI regulation. 4. In the case of an application for credit, in
connection with which an insurance product
or annuity is solicited, offered, or sold, is a
Advertising and Promotional disclosure made that the state member bank
may not condition an extension of credit on
Materials either—
a. the consumer’s purchase of an insurance
1. Do advertising materials associated with the
product or annuity from the bank or any
insurance or annuity sales program create
of its affiliates?
an erroneous belief that—
b. the consumer’s agreement not to obtain,
a. an insurance product or annuity sold or
or a prohibition on the consumer’s
offered for sale by the state member
obtaining, an insurance product or annu-
bank, or on behalf of the bank, is backed
ity from an unaffiliated entity?
by the federal government or the bank,
5. Are the disclosures under question 3 above
or that the product is insured by the
provided orally and in writing before the
FDIC?
completion of the initial face-to-face sale of
b. an insurance product or annuity that
an insurance product or annuity to a
involves investment risk does not, in
consumer?
fact, have investment risk, including the
6. Are the disclosures under question 4 above
potential that principal may be lost and
made orally and in writing at the time the
the product may decline in value?
consumer applies in a face-to-face interac-
2. Does a review of advertising for insurance
tion for an extension of credit in connection
products or annuities sold or offered for sale
with which insurance is solicited, offered,
create an erroneous impression that—
or sold?
a. the state member bank or an affiliate or
7. If a sale of an insurance product or annuity
subsidiary may condition the grant of an
is conducted by telephone, are the disclo-
extension of credit to a consumer on the
sures under question 3 above provided in
purchase of an insurance product or
writing, by mail, within three business days?
annuity by the consumer from the bank
8. If an application for credit is by telephone,
or an affiliate or subsidiary of the bank?
are the disclosures under question 4 above
b. the consumer is not free to purchase an provided by mail to the consumer within
insurance product or annuity from another three business days?
source? 9. Are the disclosures under questions 3 and 4
above provided through electronic media,
instead of on paper, only if the consumer
Disclosures affirmatively consents to receiving the dis-
closures electronically, and only if the dis-
3. In connection with the initial purchase of an closures are provided in a format that the
insurance product or annuity by a consumer, consumer may retain or obtain later?
does the initial disclosure to the consumer, 10. Are disclosures made through electronic
except to the extent the disclosure would media, for which paper or oral disclosures
not be accurate, state that— are not required, presented in a meaningful
a. the insurance product or annuity is not a form and format?
deposit or other obligation of, or is not 11. Are disclosures conspicuous, simple, direct,
guaranteed by, the state member bank or readily understandable, and designed to call
an affiliate of the bank? attention to the nature and significance of
b. the insurance product or annuity is not the information provided?

Page 2
Insurance Sales Activities and Consumer Protection in Sales of Insurance: Internal Control Questionnaire 4043.4
12. Are required disclosures presented in a Hiring, Training, and Supervision

meaningful form and format?
17. Have background investigations of prospec-
tive employees that will sell insurance prod-
Consumer Acknowledgment ucts or annuities been completed?
18. When a candidate for employment has pre-
13. At the time a consumer receives the required vious insurance experience, has a review to
disclosures, or at the time of the consumer’s determine whether the individual has been
initial purchase of an insurance product or the subject of any disciplinary actions by
annuity, is a written acknowledgment from state insurance regulators been completed?
the consumer that affirms receipt of the
19. Do all insurance or annuity sales personnel,
disclosures obtained?
or third-party sales personnel conducting
14. If the required disclosures are provided in
sales activities at or on behalf of the state
connection with a transaction that is con-
member bank, receive appropriate training
ducted by telephone—
and continue to meet licensing requirements?
a. has an oral acknowledgment of receipt of
the disclosures been obtained, and is 20. Does training address policies and proce-
sufficient documentation maintained to dures for sales of insurance and annuity
show that the acknowledgment was products, and does it cover personnel mak-
given? ing referrals to a licensed insurance
b. have reasonable efforts to obtain a writ- producer?
ten acknowledgment from the consumer 21. Does training ensure that personnel making
been made? referrals about insurance products or annu-
ities are properly handling all inquiries so as
not to be deemed to be acting as unlicensed
Physical Separation from Deposit insurance agents or registered (or equiva-
Activities lently trained) securities sales representa-
tives (for insurance products that are also
15. Does the state member bank, to the extent securities) if they are not qualified?
practicable— 22. When insurance products or annuities are
a. keep the area where the bank conducts sold by the state member bank or third
transactions involving the retail sale of parties at an office of, or on behalf of, the
insurance products or annuities physi- organization, does the institution have poli-
cally segregated from the areas where cies and procedures to designate, by title or
retail deposits are routinely accepted from name, the individuals responsible for super-
the general public? vising insurance sales activities, as well as
b. identify the areas where insurance prod- the referral activities of bank employees not
uct or annuity sales activities occur? authorized to sell these products?
c. clearly delineate and distinguish insur- 23. Does the bank designate supervisory per-
ance and annuity sales areas from the sonnel responsible for monitoring compli-
areas where the bank’s retail deposit- ance with any third-party agreement, as
taking activities occur? well as with the CPSI regulation?
Qualifications and Licensing

Referrals
16. Does the state member bank permit any
person to sell, or offer for sale, any insur- 24. Are fees paid to nonlicensed personnel who
ance product or annuity in any part of its are making referrals to qualified insurance
office, or on its behalf, only if the person is or annuity salespersons limited to a one-
at all times appropriately qualified and time, nominal fee of a fixed dollar amount
licensed under applicable state insurance for each referral, and is the fee unrelated to
licensing standards for the specific products whether the referral results in a sales
being sold or recommended? transaction?

Page 3
4043.4 Insurance Sales Activities and Consumer Protection in Sales of Insurance: Internal Control Questionnaire
Third-Party Agreements 33. If the state member bank contracts with a

functionally regulated third party, does the
25. Does the state member bank’s management bank obtain, as appropriate, any relevant
conduct a comprehensive review of a third regulatory reports of examination of the
party before entering into any arrangement third party?
to conduct insurance or annuity sales activi- 34. How does the state member bank ensure
ties through the third party? that a third party selling insurance or annu-
26. Does the review include an assessment ity products at or on behalf of the bank
of the third party’s financial condition, complies with all applicable regulations,
management experience, reputation, and including the CPSI regulation?
ability to fulfill its contractual obligations to 35. How does the state member bank ensure
the bank, including compliance with appli- that any third party or dual employee selling
cable consumer protection laws and insurance or annuity products at or on
regulation? behalf of the bank is appropriately trained
27. Does the board of directors or a designated to comply with the minimum disclosures
committee thereof approve any agreement and other requirements of the Board’s
with the third party? CPSI regulation and applicable state
28. Does the agreement outline the duties and regulations?
responsibilities of each party; describe the 36. Does the bank obtain and review copies of
third-party activities permitted on the insti- third-party training and compliance materi-
tution’s premises; address the sharing or use als to monitor the third party’s performance
of confidential customer information; and regarding its disclosure and training
define the terms for use of the bank’s office obligations?
space, equipment, and personnel?
29. Does the third-party agreement specify that
the third party will comply with all appli-
cable laws and regulations and will conduct Consumer Complaints
its activities in a manner consistent with the
CPSI regulation, if applicable?
30. Does the agreement authorize the bank to 37. Does the state member bank have policies
monitor a third party’s compliance with the and procedures for handling customer com-
agreement, as well as to have access to plaints related to insurance and annuity
third-party records considered necessary to sales?
evaluate compliance? 38. Does the customer complaint process pro-
31. Does the agreement provide for indemnifi- vide for the recording and tracking of all
cation of the institution by the third party complaints?
for any losses caused by the conduct of the 39. Does the state member bank require peri-
third party’s employees in connection with odic reviews of complaints by compliance
its insurance or annuity sales activities? personnel? Is a review by the state member
32. If an arrangement includes dual employees, bank’s board and senior management
does the agreement provide for written required for significant compliance issues
employment contracts that specify the duties that may pose risk to the state member
of these employees and their compensation bank?
arrangements?

Page 4
Bank-Related Organizations
The examination of bank-related organizations Regulation W, which became effective April 1,

must be of sufficient scope to determine a bank’s 2003, and implements comprehensively sections
compliance with laws and to evaluate its invest- 23A and 23B of the Federal Reserve Act. To
ments through an appraisal of related facilitate compliance with these statutes, the
organizations’ assets, earnings, and manage- rule1 provides several exemptions and combines
ment. In addition, the examination must fully the statutory restrictions on transactions between
disclose the nature of the relationships between a member bank and its affiliates with numerous
the bank and its related organizations, as well as Board interpretations and exemptions that were
the effects of these relationships on the opera- previously issued.
tions and safety and soundness of the bank.
Various laws, rulings, and regulations have
encouraged banks to expand their services by Quantitative Limits
forming or acquiring related organizations.
Examples include— Section 23A(a)(1)(A) states that a member
• permission for a member bank to purchase for bank 1a ‘‘may engage in a covered transaction
its own account shares of a corporation that with an affiliate only if . . . in the case of any
performs, at locations at which the bank is affiliate,’’ the aggregate amount of covered trans-
authorized to engage in business, functions actions of the bank would not exceed 10 percent
that the bank is empowered to perform directly; of the capital stock and surplus of the bank. The
• authorization by specific laws to invest in rule’s interpretation of the 10 percent limit is
various statutory subsidiaries; and consistent with the statutory language. Section
223.11 of the rule clarified that a bank that has
• permission by Federal Reserve regulations to
crossed the 10 percent threshold with one affili-
invest in Edge Act and agreement corporations.
ate may still conduct additional covered trans-
A bank also may be controlled by an indi- actions with other affiliates, if transactions with
vidual or company that controls other bank or all affiliates would not exceed 20 percent of the
nonbank entities. No matter what the legal bank’s capital stock and surplus. 1b Sections
organization is between a bank and a related 223.11 and 223.12 of the rule set forth these
organization, a sound financial and satisfactory quantitative limits. The rule’s quantitative limits
management relationship between both groups prohibit a member bank from engaging in a new
is essential to the bank’s operation. Related covered transaction with that affiliate if the bank
organizations may assume several forms, as would be in excess of the 10 percent threshold
described later in this section. with that affiliate or if the level of covered
transactions with all its affiliates exceeded the
20 percent threshold. The rule generally does
SECTION 23A OF THE FEDERAL
RESERVE ACT 1. In this section of the manual, Regulation W is referred to
as ‘‘the rule’’ or by a specific section number of the rule.
1a. Member bank is defined in section 223.3(w) to mean
Section 23A of the Federal Reserve Act (FRA) ‘‘any national bank, state bank, banking association, or trust
(12 USC 371c) is the primary statute governing company that is a member of the Federal Reserve System.’’
transactions between a bank and its affiliates. Other provisions of federal law apply section 23A to state
Section 23A (1) designates the types of compa- nonmember banks and savings associations. The rule also
states that most subsidiaries of a member bank are to be
nies that are affiliates of a bank; (2) specifies the treated as part of the member bank itself for purposes of
types of transactions covered by the statute; sections 23A and 23B. The only subsidiaries of a member
(3) sets the quantitative limitations on a bank’s bank that are excluded from this treatment are financial
covered transactions with any single affiliate, subsidiaries, insured depository institution subsidiaries, and
certain joint venture subsidiaries—companies that are gener-
and with all affiliates combined; and (4) sets ally deemed affiliates of the member bank under the regula-
forth collateral requirements for certain bank tion. This treatment of subsidiaries reflects the fact that the
transactions with affiliates. (See also sections statute typically does not distinguish between a member bank
2080.1 and 2080.3.) and its subsidiaries, and all the significant restrictions of the
statute apply to actions taken by a member bank ‘‘and its
In addition to the statutory provisions of subsidiaries.’’
section 23A, the Board approved the issuance of 1b. 12 USC 371c(a)(1).

Page 1
4050.1 Bank-Related Organizations
not require a member bank to unwind existing sons holding any such office with the
covered transactions if the bank exceeds the member bank or any company that con-
10 percent or 20 percent limit because its capital trols the member bank;
declined or a preexisting covered transaction • any company, including a real estate invest-
increased in value. ment trust, that is sponsored and advised on a
The Board strongly encourages member banks contractual basis by the member bank or any
with covered transactions in excess of the 10 per- subsidiary or affiliate of the member bank;
cent threshold with any affiliate to reduce those • any investment company with respect to which
transactions before expanding the scope or extent a member bank or any affiliate thereof is an
of the bank’s relationships with other affiliates. investment adviser as defined in sec-
Section 223.11 of the rule also clarifies that tion 2(a)(20) of the Investment Company Act
transactions between a bank and a financial of 1940;
subsidiary of the bank are not subject to the • any investment fund for which the member
10 percent limit of section 23A but instead are bank or any affiliate of the member bank
subject to the 20 percent limitation serves as an investment adviser, if the member
bank and its affiliates own or control in the
aggregate more than 5 percent of any class of
Capital Stock and Surplus voting securities or of the equity capital of the
fund;
Under section 23A, the quantitative limits on
• a depository institution that is a subsidiary of
covered transactions are based on the ‘‘capital
the member bank;
stock and surplus’’ of the member bank. Section
• a financial subsidiary of the member bank;
223.3(d) of the rule defines capital stock and
• any company in which a holding company of
surplus to be the sum of the member bank’s tier
the member bank owns or controls, directly or
1 capital and tier 2 capital and the balance of the
indirectly, or acting through one or more other
bank’s allowance for loan and lease losses not
persons, 15 percent or more of the equity
included in its tier 2 capital plus the amount of
capital pursuant to the merchant banking
any investment in a financial subsidiary that
authority in section 4(k)(4)(H) or (I) of the
counts as a covered transaction that is required
Bank Holding Company Act (12 USC
to be deducted from the bank’s regulatory capi-
1843(k)(4)(H) or (I));
tal. Examiners can determine the amount of the
• any partnership for which the member bank or
quantitative limits based on the bank’s most
any affiliate of the member bank serves as a
recent consolidated Report of Condition and
general partner or for which the member bank
Income (the Call Report).
or any affiliate of the member bank causes any
director, officer, or employee of the member
Affiliates bank or affiliate to serve as a general partner;
• any subsidiary of an affiliate described in
The definition of an affiliate is found in section paragraphs (a)(1) through (10) of section 223.2
23A of the FRA and is further defined in of Regulation W; and
Regulation W. Affiliates are defined to include— • any company that the Board, or the appropri-
ate federal banking agency for the bank,
• any company that controls the member bank determines by regulation or order to have a
and any other company that is controlled by relationship with the member bank or any
the company that controls the member bank; subsidiary or affiliate of the member bank,
• a bank subsidiary of the member bank; such that covered transactions by the member
• any company— bank or its subsidiary with that company may
— that is controlled directly or indirectly, by be affected by the relationship, to the detri-
a trust or otherwise, by or for the benefit ment of the member bank or its subsidiary.
of shareholders who beneficially or other-
wise control, directly or indirectly, by The following are not considered to be affiliates
trust or otherwise, the member bank or of a bank:
any company that controls the member
bank; or • a nonbank subsidiary of that bank, unless a
— in which a majority of its directors or determination is made not to exclude such a
trustees constitute a majority of the per- subsidiary

Page 2
Bank-Related Organizations 4050.1
• a company engaged solely in holding that

bank’s premises
• a company engaged solely in conducting a
safe deposit business
• a company engaged solely in holding obliga-
tions of the United States or its agencies or
obligations fully guaranteed by the United
States or its agencies as to principal and
interest
• a company in which control arises from the
exercise of rights arising out of a bona fide
debt previously contracted (for a limited period
of time)
Definition of Affiliates by Type of Entity

Investment funds advised by the member bank or
an affiliate of the member bank. As stated
previously, section 23A includes as an affiliate
any company that is sponsored and advised on a
contractual basis by the member bank or any of
its affiliates 1c as well as any investment com-
pany for which the member bank or its affiliate
serves as an investment adviser, as defined in the
Investment Company Act of 1940 (the 1940
act). 1d In Regulation W, the Board used its
1c. 12 USC 371c(b)(1)(D)(i).

1d. 12 USC 371c(b)(1)(D)(ii).

Page 2.1
statutory authority to define as an affiliate any the bank and thus subjected transactions between
investment fund—even if not an investment the bank and a financial subsidiary to the limi-
company for purposes of the 1940 act—for tations of sections 23A and 23B.
which the member bank or an affiliate of the Section 23A defines a financial subsidiary as
bank serves as an investment adviser, if the bank a subsidiary of any bank (state or national) that
or an affiliate of the bank owns or controls more is engaged in an activity that is not permissible
than 5 percent of any class of voting securities for national banks to engage in directly (other
or similar interests of the fund. than a subsidiary that federal law specifically
Most investment funds that are advised by a authorizes national banks to own or control).
member bank (or an affiliate of a member bank) Specifically, a ‘‘financial subsidiary’’ is defined
are affiliates of the bank under section 23A as ‘‘any company that is a subsidiary of a bank
because the funds either are investment compa- that would be a financial subsidiary of a national
nies under the 1940 act or are sponsored by the bank under section 5136A of the Revised Stat-
member bank (or an affiliate of the member utes of the United States.’’ (See 12 USC
bank). The member bank or its affiliate, in some 371c(e)(1).) Section 5136A, in turn, defines a
instances, however, may advise but not sponsor financial subsidiary as any company that is
an investment fund that is not an investment controlled by one or more insured depository
company under the 1940 act. 1e The advisory institutions, other than (1) a subsidiary that
relationship of a member bank or affiliate with engages solely in activities that national banks
an investment fund presents the same potential are permitted to engage in directly or (2) a
for conflicts of interest regardless of whether the subsidiary that national banks are specifically
fund is an investment company under the 1940 authorized to control by the express terms of a
act. 1f An investment fund typically escapes federal statute (other than section 5136A), such
from the definition of investment company under as an Edge Act corporation or a small business
the 1940 act because it (1) sells interests only to investment company (SBIC). (See 12 USC
a limited number of investors or only to sophis- 24a(g)(3).) Section 5136A also generally pro-
ticated investors or (2) invests primarily in hibits a financial subsidiary of a national bank
financial instruments that are not securities. 1g from engaging in insurance underwriting, real
Section 223.2(a)(6) treats any investment fund estate investment and development, or merchant
as an affiliate if the bank or an affiliate of the banking activities. (See 12 USC 24a(a)(2).) The
bank serves as an investment adviser to the fund rule defines a financial subsidiary of a bank,
and owns more than 5 percent of the shares of exempts certain companies from the definition,
the fund. and sets forth special valuation and other rules
for financial subsidiaries. (See sections
Financial subsidiaries. In 1999, the Gramm- 223.2(a)(8), 223.3(p), and 223.32 of the rule.)
Leach-Bliley Act (the GLB Act) authorized
banks to own ‘‘financial subsidiaries’’ that Partnerships. Banks fund legitimate commer-
engage in activities not permissible for the cial and community development transactions
parent bank to conduct directly, such as under- through partnerships. Partnerships for which a
writing and dealing in bank-ineligible securities. member bank serves as a general partner are
The GLB Act amended section 23A to define a defined in Regulation W’s section 223.2(a),
financial subsidiary of a bank as an affiliate of which also lists the entities that generally are
affiliates.
1e. 12 USC 371c(b)(1)(E). Regulation W also defines an affiliate of a
1f. A member bank may face greater risk from the conflicts
of interest arising from its relationships with an investment
member bank as any partnership if the member
fund that is not registered as an investment company under the bank or an affiliate of the bank causes any officer
1940 act because the 1940 act restricts transactions between a or employee of the bank or affiliate to serve as a
registered investment company and entities affiliated with the general partner of the partnership (unless the
company’s investment adviser. (See 15 USC 80a-17.)
1g. The term ‘‘investment company’’ in the 1940 act does
partnership is an operating subsidiary of the
not include a company that is owned by qualified persons or bank, as discussed above). The rule considers a
by no more than 100 persons, provided that the company does partnership an affiliate of the member bank if the
not engage in a public offering of its securities. (See 15 USC bank or an affiliate of the bank causes any
80a-3(c)(1) and (7).) The term also generally does not include
investment funds that are engaged primarily in investing in
director of the bank or affiliate to serve as a
financial instruments other than securities. (See 15 USC general partner of the partnership (unless the
80a-3(a)(1).) partnership is an operating subsidiary of the

Page 3
bank). Also, if a company, such as a bank tions to this general rule: ‘‘financial subsidi-
holding company, controls more than 25 percent aries’’ of a member bank and ‘‘bank’’ subsidi-
of the equity through a partnership, that com- aries of a member bank are treated as affiliates
pany is an affiliate under Regulation W. of the parent bank. The statute provides that the
Board may determine that other subsidiaries of a
Subsidiaries of affiliates. Regulation W’s defi- member bank should be treated as affiliates in
nition of an affiliate includes any company appropriate circumstances. 1j
controlled by an investment fund that is an Under section 223.2(b)(1)(iii) of the rule,
affiliate of the member bank. (See section certain joint venture subsidiary companies of a
223.2(a)(11).) It accords affiliate status to any member bank are treated as an affiliate. A
company controlled by an investment fund subsidiary of a member bank is treated as an
affiliate of a member bank. More broadly, the affiliate if one or more affiliates of the bank, or
rule deems a subsidiary of an affiliate as an one or more controlling shareholders of the
affiliate of the member bank. Subsidiaries of bank, directly control the joint venture. For
interlocking directorate affiliates (section example, if a bank controls 30 percent of a
223.2(a)(4)) and sponsored and advised affili- company and an affiliate controls 70 percent of
ates (section 223.2(a)(5)) also are treated as Company A, then Company A is an affiliate.
affiliates of the member bank. The control rela- This expansion also covers situations in which a
tionship between such statutory affiliates and controlling natural-person shareholder or group
their subsidiaries may affect covered transac- of controlling natural-person shareholders of the
tions between the member bank and such sub- member bank (who, as natural persons, are not
sidiaries to the detriment of the bank. themselves section 23A affiliates of the bank)
exercise direct control over the joint venture
Companies designated by the appropriate fed- company.
eral banking agency. Under section 223.2(a)(12), The rule’s treatment of certain bank-affiliate
the Board or the appropriate federal banking joint ventures as affiliates does not apply to joint
agency for the relevant depository institution ventures between a member bank and any affili-
(under authority delegated by the Board) can ated insured depository institutions. For exam-
determine that any company that has certain ple, if two affiliated member banks each own
relationships with a member bank or an affiliate 50 percent of the voting common stock of a
of the bank is itself an affiliate of the bank. The company, the company would continue to qualify
Board and the federal banking agencies can thus as a subsidiary and not an affiliate of each bank
protect depository institutions in their transac- (despite the fact that an affiliate of each bank
tions with associated companies. A depository owned more than 25 percent of a class of voting
institution may petition the Board for review of securities of the company). The Board has
any such affiliate determination made by the retained its authority to treat such joint ventures
institution’s appropriate federal banking agency as affiliates under section 23A on a case-by-case
under the general procedures established by the basis.
Board for review of actions taken under del-
egated authority. 1h Employee benefit plans. Many employee stock
option plans, trusts, or similar entities that exist
Joint venture companies. Under the terms of to benefit shareholders, members, officers, direc-
section 23A, subsidiaries of a member bank tors, or employees of a member bank or its
generally are not treated as affiliates of the affiliates (‘‘ESOPs’’) are treated as affiliates of
bank. 1i The statute contains two specific excep- the bank for purposes of sections 23A and 23B.
The ESOP’s share ownership or the interlocking
management between the ESOP and its associ-
1h. See 12 CFR 265.3. ated member bank (or BHC), in many cases,
1i. See 12 USC 371c(b)(1)(A) and (b)(2)(A). Section 23A
defines a subsidiary of a specified company as a company that
exceeds the statutory thresholds for determining
is controlled by the specified company. Under the statute, a that a company is an affiliate. For example, if an
company controls another company if the first company owns ESOP controls more than 25 percent of the
or controls 25 percent or more of a class of voting securities voting shares of the bank or bank holding
of the other company, controls the election of a majority of the
directors of the other company, or exercises a controlling
company, the ESOP is an affiliate. (Under sec-
influence over the policies of the other company (12 USC
371c(b)(3) and (4).) 1j. 12 USC 371c(b)(2)(A).

Page 4
tion 223.2(b)(1)(iv), an ESOP of a member bank tors or trustees’’ of the other company. 1k The
or an affiliate of the bank cannot itself avoid rule, under section 223.3(g), expands the control
classification as an affiliate of the bank by also definition of section 23A by providing, as in
qualifying as a subsidiary of the bank. The Regulation Y, that control also exists when a
relationship between a member bank and its or company or shareholder controls the election of
its affiliate’s ESOP generally warrants coverage a majority of the ‘‘general partners (or individu-
by sections 23A and 23B.) als exercising similar functions)’’ of another
company. A company or shareholder would be
deemed to control another company (including a
Determination of Control partnership, limited-liability company, or other
similar organization) under section 23A if the
The definition of ‘‘control’’ with respect to company or shareholder controls the election of
affiliates is the same as that used in the Bank a majority of the principal policymakers of such
Holding Company Act (the BHC Act), that is, a other company.
company or shareholder shall be deemed to have Under the rule, three additional presumptions
control over another company if— of control are provided, similar to the presump-
tions contained in Regulation Y. First, a com-
• such company or shareholder, directly or pany will be deemed to control securities, assets,
indirectly, or acting through one or more other or other ownership interests controlled by any
persons, owns, controls, or has power to vote subsidiary of the company. 1 l Second, a com-
25 percent or more of any class of voting pany that controls instruments (including options
securities of the other company; and warrants) that are convertible or exercisable,
• such company or shareholder controls in any at the option of the holder or owner, into
manner the election of a majority of the securities, will be deemed to control the
directors or trustees of the other company; or securities. 1m Third, a rebuttable presumption
• the Board determines, after notice and oppor- provides that a company or shareholder that
tunity for hearing, that such company or owns or controls 25 percent or more of the
shareholder, directly or indirectly, exercises a equity capital of another company controls the
controlling influence over the management or other company, unless the company or share-
policies of the other company. holder demonstrates otherwise to the Board
based on the facts and circumstances of the
However, no company shall be deemed to own particular case. (See section 223.3(g).)
or control another company by virtue of its
ownership or control of shares in a fiduciary
capacity except (1) a company that is controlled, Covered Transactions
directly or indirectly, by a trust for the benefit of
shareholders who beneficially or otherwise con- The restrictions of section 23A do not apply to
trol, directly or indirectly, a member bank, or every transaction between a member bank and
(2) if the company owning or controlling such its affiliates. The section only applies to ‘‘cov-
shares is a business trust. ered transactions’’ between a member bank and
Pursuant to the merchant banking provisions its affiliates. 1n The FRA defines five types of
in section 4(k)(4)(H) or (I) of the BHC Act and covered transactions:
in the Board’s Regulation Y, a financial holding
company (FHC) shall be presumed to control • a loan or extension of credit to an affiliate
another company if the FHC directly or indi- • a purchase of or an investment in securities
rectly owns or controls 15 percent of the equity issued by an affiliate
capital of the other company unless the FHC
provides information acceptable to the Board
1k. 12 USC 371c(b)(3)(A)(ii).
demonstrating that the FHC does not control the 1l. See 12 CFR 225.2(e)(2)(i).
other company. 1m. See 12 CFR 225.31(d)(1)(i). The rule refers more
Section 23A provides that a company or generically to convertible ‘‘instruments.’’ It clarifies that the
shareholder shall be deemed to have control convertibility presumption applies regardless of whether the
right to convert resides in a financial instrument that techni-
over another company if, among other things, cally qualifies as a ‘‘security’’ under section 23A or the federal
such company or shareholder controls in any securities laws.
manner the election of a majority of the ‘‘direc- 1n. 12 USC 371c(b)(7).

Page 5
• a purchase of assets from an affiliate, includ- a guarantee in support of securities issued by a

ing assets subject to an agreement to repur- third party and underwritten by a securities
chase from the affiliate, except for purchases affiliate of the bank.2 Such a credit enhancement
of real and personal property as may be would not be issued ‘‘on behalf of’’ the affiliate.
specifically exempted by the Board by order Although the guarantee does provide some bene-
or regulation fit to the affiliate (by facilitating the underwrit-
• the acceptance of securities issued by an ing), this benefit is indirect. The proceeds of the
affiliate as collateral for a loan to any person guarantee would not be transferred to the affili-
or company (such an acceptance is prohibited ate for purposes of the attribution rule of section
if a loan is to an affiliate) 23A. 2a Section 23B would apply to the transac-
• the issuance of a guarantee, acceptance, or tion and, where an affiliate was issuer as well as
letter of credit, including an endorsement or underwriter, the transaction would be covered
standby letter of credit, on behalf of an affiliate by section 23A because the credit enhancement
would be on behalf of the affiliate.
Covered transactions must be made on terms
and conditions that are consistent with safe and
sound banking practices. Cross-Guarantee Agreements and
Among the transactions that generally are not Cross-Affiliate Netting Arrangements
subject to section 23A are dividends paid by a
member bank to its holding company, sales of A cross-guarantee agreement among a member
assets by a member bank to an affiliate for cash, bank, an affiliate, and a nonaffiliate in which the
an affiliate’s purchase of securities issued by a nonaffiliate may use the bank’s assets to satisfy
member bank, and many service contracts the obligations of a defaulting affiliate is a
between a member bank and an affiliate. Certain guarantee for purposes of section 23A. The
classes of transactions between a member bank cross-guarantee arrangements among member
and an affiliate are discussed below as to whether banks and their affiliates are subject to the
they are covered transactions for purposes of quantitative limits and collateral requirements of
section 23A. (See section 223.3(h).) section 23A. (See section 223.3(h)(5).)
As for cross-affiliate netting arrangements
(CANAs), such arrangements involve a member
Confirmation of a Letter of Credit Issued bank, one or more affiliates of the bank, and one
by an Affiliate or more nonaffiliates of the bank, where a
nonaffiliate is permitted to deduct obligations of
Section 23A includes as a covered transaction an affiliate of the bank to the nonaffiliate when
the issuance by a member bank of a letter of settling the nonaffiliate’s obligations to the bank.
credit on behalf of an affiliate, including the These arrangements also would include agree-
confirmation of a letter of credit issued by an ments in which a member bank is required or
affiliate as a covered transaction. (See section permitted to add the obligations of an affiliate of
223.3(h)(5).) When a bank confirms a letter of the bank to a nonaffiliate when determining the
credit, it assumes the risk of the underlying bank’s obligations to the nonaffiliate.
transaction to the same extent as if it had issued These types of CANAs expose a member
the letter of credit. 1o Accordingly, a confirma- bank to the credit risk of its affiliates because the
tion of a letter of credit issued by an affiliate is bank may become liable for the obligations of
treated in the same fashion as an issuance of a its affiliates. Because the exposure of a member
letter of credit on behalf of an affiliate. bank to an affiliate in such an arrangement
resembles closely the exposure of a member
bank when it issues a guarantee on behalf of an
Credit Enhancements Supporting a affiliate, the rule explicitly includes such arrange-
Securities Underwriting ments in the definition of covered transaction.
Accordingly, the quantitative limits of section
The definition of guarantee in section 23A 23A would prohibit a member bank from enter-
would not include a member bank’s issuance of ing into such a CANA to the extent that the
2. See 62 Fed. Reg. 45295 (August 27, 1997).

1o. See UCC 5-107(2). 2a. See 12 USC 371c(a)(2).

Page 6
netting arrangement does not cap the potential • any other similar transaction as a result of
exposure of the bank to the participating affiliate which an affiliate becomes obligated to pay
(or affiliates). money (or its equivalent) to a member bank 2d
A member bank’s purchase of a debt security

Keepwell Agreements issued by an affiliate is an extension of credit by
the bank to the affiliate for purposes of section
In a keepwell agreement between a member 23A under the rule. A member bank that buys
bank and an affiliate, the bank typically commits debt securities issued by an affiliate has made an
to maintain the capital levels or solvency of the extension of credit to an affiliate under section
affiliate. The credit risk incurred by the member 23A and must collateralize the transaction in
bank in entering into such a keepwell agreement accordance with the collateral requirements of
is similar to the credit risk incurred by a member section 23A. An exemption from the collateral
bank in connection with issuing a guarantee on requirements is provided for situations in which
behalf of an affiliate. As a consequence, keep- a member bank purchases an affiliate’s debt
well agreements generally should be treated as securities from a third party in a bona fide
guarantees for purposes of section 23A and, if secondary-market transaction.
unlimited in amount, would be prohibited by the
quantitative limits of section 23A.
Prohibition on the Purchase of

Extension of Credit Low-Quality Assets
Section 23A includes a ‘‘loan or extension of Section 23A includes a general prohibition on
credit’’ to an affiliate as a covered transaction, the purchase by a member bank of a low-quality
but does not define these terms. Section 223.3(o) asset from an affiliate. 2e Section 23A defines a
of the rule defines ‘‘extension of credit’’ to an low-quality asset to include (1) an asset classi-
affiliate to mean the making or renewal of a loan fied as ‘‘substandard,’’ ‘‘doubtful,’’ or ‘‘loss,’’ or
to an affiliate, the granting of a line of credit to treated as ‘‘other loans specially mentioned,’’ in
an affiliate, or the extending of credit to an the most recent report of examination or inspec-
affiliate in any manner whatsoever, including on tion by a federal or state supervisory agency (a
an intraday basis. A nonexhaustive list of trans- ‘‘classified asset’’), (2) an asset in nonaccrual
actions is provided that the Board deems to be status, (3) an asset on which payments are more
extensions of credit to an affiliate: than 30 days past due, or (4) an asset whose
terms have been renegotiated or compromised
• an advance to an affiliate by means of an due to the deteriorating financial condition of
overdraft, cash item, or otherwise the obligor. 2f Any asset meeting one of the
• a sale of federal funds to an affiliate above four criteria, including securities and real
• a lease that is the functional equivalent of an property, is a low-quality asset. 2g Regulation W
extension of credit to an affiliate 2b
• an acquisition by purchase, discount, exchange, which the loan’s interest rate is calculated. If the member bank
or otherwise of a note or other obligation, and the borrower, however, amend the loan agreement to
including commercial paper or other debt change the interest-rate term from ‘‘LIBOR plus 100 basis
securities, of an affiliate points’’ to ‘‘LIBOR plus 150 basis points,’’ the parties have
engaged in a new covered transaction.
• any increase in the amount of, extension of the 2d. The definition of extension of credit would cover,
maturity of, or adjustment to the interest-rate among other things, situations in which an affiliate fails to pay
term or other material term of, an extension of on a timely basis for services rendered to the affiliate by the
credit to an affiliate 2c member bank.
2e. See 12 USC 371c(a)(3). Section 23A does not prohibit
an affiliate from donating a low-quality asset to a member
2b. The Board would consider a full-payout, net lease bank, so long as the bank provides no consideration for the
permissible for a national bank under 12 USC 24 (seventh) asset.
and 12 CFR 23 to be the functional equivalent of an extension 2f. 12 USC 371c(b)(10).
of credit. 2g. The federal banking agencies generally consider non-
2c. A floating-rate loan does not become a new covered investment-grade securities to be classified assets. See, for
transaction whenever there is a change in the relevant index example, the Uniform Agreement on the Classification of
(for example, LIBOR or the member bank’s prime rate) from Assets and Appraisal of Securities Held by Banks (May 7,

Page 7
expands the definition of low-quality assets in quality assets if the bank performs an indepen-
several respects. (See 12 CFR 223.3(v).) dent credit evaluation and commits to the pur-
First, an asset identified by examiners as an chase of the asset before the affiliate acquires the
‘‘other transfer risk problem’’ (OTRP) is a asset. 2i Section 223.15 of the rule also provides
low-quality asset. Such assets represent credits an exception from the prohibition on the pur-
to countries that are not complying with their chase by a member bank of a low-quality asset
external debt-service obligations but are taking from an affiliate for certain loan renewals. The
positive steps to restore debt service through rule allows a member bank that purchased a loan
economic adjustment measures, generally as participation from an affiliate to renew its par-
part of an International Monetary Fund pro- ticipation in the loan, or provide additional
gram. Although OTRP assets are not considered funding under the existing participation, even if
classified assets, examiners are to consider these the underlying loan had become a low-quality
assets in their assessment of a bank’s asset asset, so long as certain criteria were met. These
quality and capital adequacy. 2h renewals or additional credit extensions may
Second, the rule considers a financial institu- enable both the affiliate and the participating
tion’s use of its own internal asset-classification member bank to avoid or minimize potential
systems. The rule includes within the definition losses. The exception is available only if (1) the
of low-quality asset not only assets classified underlying loan was not a low-quality asset at
during the last examination but also assets the time the member bank purchased its partici-
classified or treated as special mention under the pation and (2) the proposed transaction would
institution’s internal classification system (or not increase the member bank’s proportional
assets that received an internal rating that is share of the credit facility. The member bank
substantially equivalent to classified or special must also obtain the prior approval of its entire
mention in such an internal system). board of directors (or its delegees) and it must
The purchase by a depository institution from give a 20 days’ post-consummation notice to its
an affiliate of assets that have been internally appropriate federal banking agency. A member
classified raises potentially significant safety- bank is permitted to increase its proportionate
and-soundness concerns. The Board expects share in a restructured loan by 5 percent (or by
companies with internal rating systems to use a higher percentage with the prior approval of
the systems consistently over time and over the bank’s appropriate federal banking agency).
similar classes of assets and will view as an The scope of the exemption includes renewals
evasion of section 23A any company’s deferral of participations in loans originated by any
or alteration of an asset’s rating to facilitate sale affiliate of the member bank (not just affiliated
of the asset to an affiliated institution. depository institutions).
Finally, the rule defines low-quality asset to
include foreclosed property designated ‘‘other
real estate owned’’ (OREO), until it is reviewed Attribution Rule
by an examiner and receives a favorable classi-
fication. It further defines as a low-quality asset The ‘‘attribution rule,’’ found in section 223.16,
any asset (not just real estate) that is acquired in prevents a member bank from evading its
satisfaction of a debt previously contracted (not restrictions by using intermediaries, and it limits
just through foreclosure) if the asset has not yet the exposure that a member bank has to custom-
been reviewed in an examination or inspection. ers of affiliates of the bank. Any covered trans-
Under the rule, if a particular asset is good action by a member bank or its subsidiary with
collateral taken from a bad borrower, the asset any person is deemed to be a transaction with an
should cease to be a low-quality asset upon affiliate of the bank if any of the proceeds of the
examination. transaction are used for the benefit of, or are
Section 23A provides a limited exception to transferred to, the affiliate. For example, a mem-
the general rule prohibiting purchase of low- ber bank’s loan to a customer for the purpose of
purchasing securities from the inventory of a
1979) and also table 3 in section 2020.1 of this manual. Assets broker-dealer affiliate of the bank would be a
identified by examiners through the Shared National Credit covered transaction under section 23A.
and International Country Exposure Review Committee pro-
cesses also should be considered classified assets for purposes
of section 23A.
2h. See sections 7040.1 and 7040.3. 2i. 12 USC 371c(a)(3).

Page 8
Credit Transactions with an Affiliate Member banks will be able to determine the
section 23A value for most credit transactions
under the third prong of the rule’s valuation
Valuation of Credit Transactions with an formula. Under this prong, for example, a $100
Affiliate term loan is a $100 covered transaction, a $300
revolving credit facility is a $300 covered trans-
A credit transaction between a member bank action (regardless of how much of the facility
and an affiliate initially must be valued at the the affiliate has drawn down), and a guarantee
amount of funds provided by the member bank backstopping a $500 debt issuance of the affili-
to, or on behalf of, the affiliate plus any addi- ate is a $500 covered transaction.
tional amount that the bank could be required Under section 23A and the rule, a member
to provide to, or on behalf of, the affiliate. The bank has made an extension of credit to an
section 23A value of a credit transaction between affiliate if the bank purchases from a third party
a member bank and an affiliate is the greater a loan previously made to an affiliate of the
of (1) the principal amount of the credit trans- bank. A different valuation formula is provided
action; (2) the amount owed by the affiliate to for these indirect credit transactions: The mem-
the member bank under the credit transaction; ber bank must value the transaction at the price
or (3) the sum of (a) the amount provided to, paid by the bank for the loan plus any additional
or on behalf of, the affiliate in the transaction amount that the bank could be required to
and (b) any additional amount that the member provide to, or on behalf of, the affiliate under the
bank could be required to provide to, or on terms of the credit agreement.
behalf of, the affiliate under the terms of the
transaction. For example, if a member bank pays a third
The first prong of the rule’s valuation formula party $90 for a $100 term loan that the third
for credit transactions (‘‘the principal amount of party previously made to an affiliate of the bank
the credit transaction’’) would likely determine (because, for example, the loan was at a fixed
the valuation of a transaction in which a member rate and has declined in value because of a rise
bank purchased a zero-coupon note issued by an in the general level of interest rates), the covered
affiliate. A member bank should value such an transaction amount is $90 rather than $100. The
extension of credit at the principal, or face, lower covered-transaction amount reflects the
amount of the note (that is, at the amount that fact that the member bank’s maximum loss on
the affiliate ultimately must pay to the bank) the transaction is $90 rather than the original
rather than at the amount of funds initially principal amount of the loan. For another exam-
advanced by the bank. For example, assume a ple, if a member bank pays a third party $70 for
member bank purchased from an affiliate for a $100 line of credit to an affiliate, of which $70
$50 a 10-year zero-coupon note issued by the had been drawn down by the affiliate, the
affiliate with a face amount of $100. The rule’s covered-transaction amount would be $100 (the
valuation formula requires the member bank to $70 purchase price paid by the bank for the
value this transaction at $100. credit plus the remaining $30 that the bank
could be required to lend under the credit
The second prong of the rule’s valuation line).
formula for credit transactions (‘‘the amount
owed by the affiliate’’) likely would determine In another example, a member bank makes a
the valuation of a transaction in which an term loan to an affiliate that has a principal
affiliate fails to pay a member bank when due a amount of $100. The affiliate pays $2 in up-front
fee for services rendered by the bank to the fees to the member bank, and the affiliate
affiliate. This prong of the valuation formula receives net loan proceeds of $98. The member
does not include within section 23A’s quantita- bank must initially value the covered transaction
tive limits items such as accrued interest not yet at $100.
due on a member bank’s loan to an affiliate or Although the rule considers a member bank’s
the credit exposure of a member bank to an purchase of, or investment in, a debt security
affiliate on a derivative transaction that is not the issued by an affiliate as an extension of credit to
functional equivalent of a credit transaction an affiliate, these transactions are not valued like
(unless and until the affiliate defaults in making other extensions of credit. See section 223.23
a required payment to the bank on a settlement for the valuation rules for purchases of, and
date). investments in, the debt securities of an affiliate.

Page 8.1
Timing of a Credit Transaction with an mula. First, if the member bank buys from one
Affiliate affiliate a loan to a second affiliate, the bank
must value the transaction as a credit transaction
A member bank has entered into a credit trans- with the second affiliate under section 223.21.
action with an affiliate at the time during the day Second, if the member bank buys from one
that the bank becomes legally obligated to make affiliate a security issued by a second affiliate,
the extension of credit to, or issue the guarantee, the bank must value the transaction as an invest-
acceptance, or letter of credit on behalf of, the ment in securities issued by the second affiliate
affiliate. A covered transaction occurs at the under section 223.23. Third, if the member bank
moment that the member bank executes a legally acquires an affiliate that becomes an operating
valid, binding, and enforceable credit agreement subsidiary of the bank after the acquisition, the
or guarantee and does not occur only when a bank must value the transaction under section
member bank funds a credit facility or makes 223.31.
payment on a guarantee. Consistent with section A special valuation rule applies to a member
23A, the rule only requires a member bank to bank’s purchase of a line of credit or loan
compute compliance with its quantitative limits commitment from an affiliate. A member bank
when the bank is about to engage in a new initially must value such asset purchases at the
covered transaction. The rule does not require a purchase price paid by the bank for the asset
member bank to compute compliance with the plus any additional amounts that the bank is
rule’s quantitative limits on a continuous basis. obligated to provide under the credit facility. 2j
See section 223.21(b)(1) of the rule. This special valuation rule ensures that there are
The burden of the timing rule is significantly limits on the amount of risk a company can shift
mitigated by the exemption for intraday exten- to an affiliated bank.
sions of credit found in section 223.42(l). The In contrast with credit transactions, an asset
intraday credit exemption generally applies only purchase from a nonaffiliate that later becomes
to extensions of credit that a member bank an affiliate generally does not become a covered
expects to be repaid, sold, or terminated by the transaction for the purchasing member bank. If a
end of its U.S. business day. The rule generally member bank purchases assets from a nonaffili-
requires a member bank to ensure its intraday ate in contemplation of the nonaffiliate’s becom-
compliance with section 23A when making a ing an affiliate of the bank, however, the asset
loan to an affiliate during the day, which the purchase becomes a covered transaction at the
bank expects to remain a loan outstanding and time the nonaffiliate becomes an affiliate. In
on its books overnight. addition, the member bank must ensure that the
aggregate amount of the bank’s covered trans-
actions (including any such asset purchase from
the nonaffiliate) would not exceed the quantita-
Asset Purchases from an Affiliate tive limits of section 23A at the time the
nonaffiliate becomes an affiliate.
Regulation W provides that a purchase of assets The following examples are provided to assist
by a member bank from an affiliate initially member banks in valuing purchases of assets
must be valued at the total amount of consider- from an affiliate. A member bank’s receipt of an
ation given by the bank in exchange for the encumbered asset from an affiliate ceases to be a
asset. (See section 223.22.) This consideration covered transaction when, for example, the bank
can take any form and includes an assumption sells the asset.
of liabilities by the member bank. Asset pur-
chases are a covered transaction for a member • Cash purchase of assets. A member bank
bank for as long as the bank holds the asset. The purchases a pool of loans from an affiliate for
value of the covered transaction after the pur- $10 million. The member bank initially must
chase may be reduced to reflect amortization or value the covered transaction at $10 million.
depreciation of the asset, to the extent that such
reductions are consistent with GAAP and are 2j. A member bank would not be required to include
reflected on the bank’s financial statements. unfunded, but committed, amounts in the value of the covered
transaction if (1) the credit facility being transferred from the
Certain asset purchases by a member bank affiliate to the bank is unconditionally cancelable (without
from an affiliate are not valued in accordance cause) at any time by the bank and (2) the bank makes a
with the general asset-purchase valuation for- separate credit decision before each drawing under the facility.

Page 8.2
Going forward, if the borrowers repay $6 mil- investment in securities issued by an affiliate at
lion of the principal amount of the loans, the carrying value throughout the life of the invest-
member bank may value the covered transac- ment, even if the bank paid no consideration for
tion at $4 million. the securities.
• Purchase of assets through an assumption of Second, the approach is supported by the
liabilities. An affiliate of a member bank terms of the statute, which defines both a ‘‘pur-
contributes real property with a fair market chase of and an ‘‘investment in’’ securities
value of $200,000 to the member bank. The issued by an affiliate as a covered transaction.
member bank pays the affiliate no cash for the The statute’s ‘‘investment in’’ language indi-
property, but assumes a $50,000 mortgage on cates that Congress was concerned with a mem-
the property. The member bank has engaged ber bank’s continuing exposure to an affiliate
in a covered transaction with the affiliate and through an ongoing investment in the affiliate’s
initially must value the transaction at $50,000. securities.
Going forward, if the member bank retains the Third, GLB Act amendments to section 23A
real property but pays off the mortgage, the support the approach. The GLB Act defines a
member bank must continue to value the financial subsidiary of a bank as an affiliate of
covered transaction at $50,000. If the member the bank, but specifically provides that the
bank, however, sells the real property, the section 23A value of a bank’s investment in
transaction ceases to be a covered transaction securities issued by a financial subsidiary does
at the time of the sale (regardless of the status not include retained earnings of the subsidiary.
of the mortgage). The negative implication from this provision is
that the section 23A value of a bank’s invest-
ment in other affiliates includes the affiliates’
Purchases of and Investments in retained earnings, which would be reflected in
Securities Issued by an Affiliate the bank’s carrying value of the investment
under the rule.
Section 23A includes as a covered transaction a Finally, the carrying-value approach is con-
member bank’s purchase of, or investment in, sistent with the purposes of section 23A—
securities issued by an affiliate. Section 223.23 limiting the financial exposure of banks to their
of the rule requires a member bank to value a affiliates and promoting safety and soundness.
purchase of, or investment in, securities issued The valuation rule requires a member bank to
by an affiliate (other than a financial subsidiary revalue upwards the amount of an investment in
of the bank) at the greater of the bank’s pur- affiliate securities only when the bank’s expo-
chase price or carrying value of the securities. A sure to the affiliate increases (as reflected on the
member bank that paid no consideration in bank’s financial statements) and the bank’s capi-
exchange for affiliate securities has to value the tal increases to reflect the higher value of the
covered transaction at no less than the bank’s investment. In these circumstances, the valua-
carrying value of the securities. 2k In addition, if tion rule merely reflects the member bank’s
the member bank’s carrying value of the affiliate greater financial exposure to the affiliate and
securities increased or decreased after the bank’s enhances safety and soundness by reducing the
initial investment (due to profits or losses at the bank’s ability to engage in additional transac-
affiliate), the amount of the bank’s covered tions with an affiliate as the bank’s exposure to
transaction would increase or decrease to reflect that affiliate increases.
the bank’s changing financial exposure to the The valuation rule also provides that the
affiliate. However, the amount of the bank cov- covered-transaction amount of a member bank’s
ered transaction cannot decline below the amount investment in affiliate securities can be no less
paid by the bank for the securities. than the purchase price paid by the bank for the
Several important considerations support the securities, even if the carrying value of the
general carrying-value approach of this valua- securities declines below the purchase price.
tion rule. First, the approach is consistent with Although this aspect of the valuation rule is not
GAAP, which would require a bank to reflect its consistent with GAAP, using the member bank’s
purchase price for the securities as a floor for
2k. Carrying value refers to the amount at which the
valuing the covered transaction is appropriate.
securities are carried on the GAAP financial statements of the First, it ensures that the amount of the covered
member bank. transaction never falls below the amount of

Page 8.3
funds actually transferred by the member bank Securities Issued by an Affiliate as

to the affiliate in connection with the invest- Collateral
ment. In addition, the purchase-price floor limits
the ability of a member bank to provide addi-
tional funding to an affiliate as the affiliate General Valuation Rule (Section
approaches insolvency. If investments in secu- 223.24(a) and (b))
rities issued by an affiliate were valued strictly at
carrying value, then the member bank could Section 23A defines as a covered transaction a
lend more funds to the affiliate as the affiliate’s member bank’s acceptance of securities issued
financial condition worsened. As the affiliate by an affiliate as collateral for a loan or exten-
declined, the member bank’s carrying value of sion of credit to any person or company. 2 l This
the affiliate’s securities would decline, the sec- type of covered transaction has two classes: one
tion 23A value of the bank’s investment likely in which the only collateral for the loan is
would decline, and, consequently, the bank affiliate securities and another in which the loan
would be able to provide additional funding to is secured by a combination of affiliate securities
the affiliate under section 23A. This type of and other collateral.
increasing support for an affiliate in distress is Under the rule, if the credit extension is
what section 23A was intended to restrict. secured exclusively by affiliate securities, then
The examples provided below are designed to the transaction is valued at the full amount of the
assist member banks in valuing purchases of, extension of credit. This approach reflects the
and investments in, securities issued by an difficulty of measuring the actual value of typi-
affiliate. cally untraded and illiquid affiliate securities and
conservatively assumes that the value of the
• Purchase of the debt securities of an affiliate. securities is equal to the full value of the loan
The parent holding company of a member that the securities collateralize. An exception is
bank owns 100 percent of the shares of a provided to the general rule when the affiliate
mortgage company. The member bank pur- securities held as collateral have a ready market
chases debt securities issued by the mortgage (as defined by section 223.42 of the rule). In that
company for $600. The initial carrying value case, the transaction may be valued at the fair
of the securities is $600. The member bank market value of the affiliate securities. The
initially must value the investment at $600. exception grants relief in those circumstances
• Purchase of the shares of an affiliate. The when the value of the affiliate securities is
parent holding company of a member bank independently verifiable by reference to transac-
owns 51 percent of the shares of a mortgage tions occurring in a liquid market. 2m
company. The member bank purchases an Covered transactions of the second class, in
additional 30 percent of the shares of the which the credit extension is secured by affiliate
mortgage company from a third party for securities and other collateral, are valued at the
$100. The initial carrying value of the shares lesser of (1) the total value of the extension of
is $100. The member bank initially must value credit minus the fair market value of the other
the investment at $100. Going forward, if the collateral or (2) the fair market value of the
member bank’s carrying value of the shares
declines to $40, the member bank must con- 2l. See 12 USC 371c(b)(7)(D). This covered transaction
tinue to value the investment at $100. only arises when the member bank’s loan is to a nonaffiliate.
• Contribution of the shares of an affiliate. The Under section 23A, the securities issued by an affiliate are not
acceptable collateral for a loan or extension of credit to any
parent holding company of a member bank affiliate. (See 12 USC 371c(c)(4).) If the proceeds of a loan
owns 100 percent of the shares of a mortgage that is secured by an affiliate’s securities are transferred to an
company and contributes 30 percent of the affiliate by the unaffiliated borrower (for example, to purchase
shares to the member bank. The member bank assets or securities from the inventory of an affiliate), the loan
should be treated as a loan to the affiliate. The loan must then
gives no consideration in exchange for the be secured with collateral in an amount and of a type that
shares. If the initial carrying value of the meets the requirements of section 23A for loans by a member
shares is $300, then the member bank initially bank to an affiliate.
must value the investment at $300. Going 2m. In either case, the transaction must comply with
section 23B; that is, the member bank must obtain the same
forward, if the member bank’s carrying value amount of affiliate securities as collateral on the credit
of the shares increases to $500, the member extension that the bank would obtain if the collateral were not
bank must value the investment at $500. affiliate securities.

Page 8.4
affiliate securities (if the securities have a ready because securities issued by an affiliate are
market). The rule’s ready-market requirement ineligible collateral under section 223.14, the
applies regardless of the amount of affiliate loan would not be in compliance with section
collateral. 2n 223.14.
Exemption for Shares Issued by an Merger and Acquisition Transactions

Affiliated Mutual Fund Between a Member Bank and an
Section 223.24(c) of the rule provides an exemp-
Affiliate
tion for extensions of credit by a member bank
Under section 223.31 (a)–(c) of the rule, there
that are secured by shares of an affiliated mutual
are several methods by which a member bank
fund. The rule effects the exemption by provid-
acquires an affiliate. The first method is when a
ing that an affiliated mutual fund’s shares that
member bank directly purchases or otherwise
meet the above-mentioned criteria do not count
acquires the affiliate’s assets and assumes the
as affiliate-issued securities for purposes of the
affiliate’s liabilities. In this case, the transaction
valuation rule for extensions of credit secured
is treated as a purchase of assets, and the
by affiliate-issued securities. To qualify for the
covered-transaction amount is equal to the
exemption, the transaction must meet several
amount of any separate consideration paid by
conditions. First, to ensure that the affiliate
the member bank for the affiliate’s assets (if
collateral is liquid and trades at a fair price, the
any) plus the amount of any liabilities assumed
affiliated mutual fund must be an open-end
by the bank in the transaction.
investment company that is registered with the
The second method is when a member bank
SEC under the 1940 act. Second, to ensure that
acquires an affiliate by merger. Because a merger
the member bank can easily establish and moni-
with an affiliate generally results in the member
tor the value of the affiliate collateral, the
bank’s acquiring all the assets of the affiliate and
affiliated mutual fund’s shares serving as collat-
assuming all the liabilities of the affiliate, this
eral for the extension of credit must have a
transaction is effectively equivalent to the pur-
publicly available market price. Third, to reduce
chase and assumption transaction described in
the member bank’s incentives to use these
the previous paragraph. Accordingly, the merger
extensions of credit as a mechanism to support
transaction also is treated as a purchase of
the affiliated mutual fund, the member bank and
assets, and the covered-transaction amount is
its affiliates must not own more than 5 percent of
equal to the amount of any separate consider-
the fund’s shares (excluding certain shares held
ation paid by the member bank for the affiliate’s
in a fiduciary capacity). Finally, the proceeds of
assets (if any) plus the amount of any liabilities
the extension of credit must not be used to
assumed by the bank in the transaction. 2o
purchase the affiliated mutual fund’s shares
Another illustrative structure, whereby the bank
serving as collateral or otherwise used to benefit
acquires an affiliate, involves the contribution or
an affiliate. In such circumstances, the member
sale of a controlling block of an affiliate’s shares
bank’s extension of credit would be covered by
to a member bank. For example, the parent
section 23A’s attribution rule. For example, a
holding company of a member bank contributes
member bank proposes to lend $100 to a non-
between 25 percent and 100 percent of the
affiliate secured exclusively by eligible affiliated
voting shares of a mortgage company to the
mutual fund securities. The member bank knows
member bank. The parent holding company
that the nonaffiliate intends to use all the loan
retains no shares of the mortgage company. The
proceeds to purchase the eligible affiliated mutual
member bank gives no consideration in exchange
fund securities that would serve as collateral for
for the transferred shares. The mortgage com-
the loan. Under the attribution rule in section
pany has total assets of $300,000 and total
223.16, the member bank must treat the loan to
liabilities of $100,000. The mortgage compa-
the nonaffiliate as a loan to an affiliate, and
ny’s assets do not include any loans to an
2n. Under the rule, a member bank may use the higher of 2o. As noted, section 223.3(dd) of the rule makes explicit
the two valuation options for these transactions if, for exam- the Board’s view that these merger transactions generally
ple, the bank does not have the procedures and systems in involve the purchase of assets by a member bank from an
place to verify the fair market value of affiliate securities. affiliate.

Page 8.5
affiliate of the member bank or any other asset asset-purchase treatment on affiliate share trans-
that would represent a separate covered transac- fers when the company whose shares are being
tion for the member bank upon consummation transferred to the member bank was an affiliate
of the share transfer. As a result of the transac- of the bank before the transfer. If the transferred
tion, the mortgage company becomes an oper- company was not an affiliate before the transfer,
ating subsidiary of the member bank. The transit would not be appropriate to treat the share
action is treated as a purchase of the assets of the transfer as a purchase of assets from an affiliate.
mortgage company by the member bank from an Similarly, the rule only requires asset-purchase
affiliate under paragraph (a) of section 223.31. treatment for affiliate share transfers when the
The member bank initially must value the trans- transferred company becomes a subsidiary and
action at $100,000, the total amount of the not an affiliate of the member bank through the
liabilities of the mortgage company. Going for- transfer.
ward, if the member bank pays off the liabilities, If a bank purchases, or receives a donation,
the member bank must continue to value the of a partial interest in an affiliate, that transac-
covered transaction at $100,000. However, if the tion is treated as a purchase of, or investment in
member bank sells $15,000 of the transferred securities issued by an affiliate. This type of
assets of the mortgage company or if $15,000 of transaction is valued according to the purchase
the transferred assets amortize, the member price or GAAP carrying value. (See 12 CFR
bank may value the covered transaction at 223.23.)
$85,000.
As for the third type of transaction, the rule
provides that the acquisition by a member bank
of a company that was an affiliate of the bank Step-Transaction Exemption (Section
before the acquisition is treated as a purchase of 223.31(d) and (e))
assets from an affiliate if (1) as a result of the
transaction, the company becomes an operating Under section 223.31(d) of the rule, an exemp-
subsidiary of the bank and (2) the company has tion is provided for certain step transactions that
liabilities, or the bank gives cash or any other are treated as asset purchases under section
consideration in exchange for the securities. The 223.31(a) when a BHC acquires the stock of an
rule also provides that these transactions must unaffiliated company and, immediately after
be valued initially at the sum of (1) the total consummation of the acquisition, transfers the
amount of consideration given by the member shares of the acquired company to the holding
bank in exchange for the securities and (2) the company’s subsidiary member bank. For exam-
total liabilities of the company whose securities ple, a bank holding company acquires 100 per-
have been acquired by the member bank. In cent of the shares of an unaffiliated leasing
effect, the rule requires member banks to treat company. At that time, the subsidiary member
such share donations and purchases in the same bank of the holding company notifies its appro-
manner as if the member bank had purchased priate federal banking agency and the Board of
the assets of the transferred company at a its intent to acquire the leasing company from its
purchase price equal to the liabilities of the holding company. On the day after consumma-
transferred company (plus any separate consid- tion of the acquisition, the holding company
eration paid by the bank for the shares). (See 12 transfers all of the shares of the leasing company
CFR 223.31.) to the member bank. No material change in the
The assets and liabilities of an operating business or financial condition of the leasing
subsidiary of a member bank are treated in the company occurs between the time of the holding
rule as assets and liabilities of the bank itself for company’s acquisition and the member bank’s
purposes of section 23A.3 The rule only imposes acquisition. The leasing company has liabilities.
The leasing company becomes an operating
subsidiary of the member bank at the time of the
3. Because a member bank usually can merge a subsidiary
into itself, transferring all the shares of an affiliate to a transfer. This transfer by the holding company
member bank often is functionally equivalent to a transaction to the member bank, although deemed an asset
in which the bank directly acquires the assets and assumes the purchase by the member bank from an affiliate
liabilities of the affiliate. In a direct acquisition of assets and under paragraph (a) of section 223.31, would
assumption of liabilities, the covered-transaction amount would
be equal to the total amount of liabilities assumed by the qualify for the exemption in paragraph (d) of
member bank. section 223.31.

Page 8.6
The rule exempts these ‘‘step’’ transactions Financial Subsidiaries

under certain conditions. First, the member bank
must acquire the target company immediately
after the company became an affiliate (by being Section 23A Statutory Provisions for
acquired by the bank’s holding company, for Financial Subsidiaries
example). The member bank must acquire the
entire ownership position in the target company Section 23A has several special provisions that
that its holding company acquired. Also, there apply to covered transactions between a bank
must be no material change in the business or and its financial subsidiary. Section 23A defines
financial condition of the target company during a ‘‘financial subsidiary’’ as any company that is
the time between when the company becomes a subsidiary of a bank that would be a financial
an affiliate of the member bank and when the subsidiary of a national bank under section
bank is in receipt of the company. Finally, the 5136A of the Revised Statutes of the United
entire transaction must comply with the market- States. 3a Section 5136A, in turn, defines a finan-
terms requirement of section 23B, and the bank cial subsidiary of a national bank as any com-
must notify its appropriate federal banking pany that is controlled by one or more insured
agency and the Board, at or before the time that depository institutions, other than (1) a subsid-
the target company becomes an affiliate of the iary that engages solely in activities that national
bank, of its intent ultimately to acquire the target banks are permitted to engage in directly (and
company. subject to the same terms and conditions that
apply to national banks) or (2) a national bank is
Regulation W requires that the bank consum-
specifically authorized by the express terms of a
mate the step transaction immediately to ensure
federal statute (other than section 5136A), such
the quality and fairness of the transaction. To
as an Edge Act corporation or an SBIC. 3b
the extent that the member bank acquires the
Section 5136A also prohibits a financial subsid-
target company some time after the company
iary of a national bank from engaging in insur-
becomes an affiliate, the transaction looks
ance underwriting, real estate investment and
less like a single transaction in which the bank
development, or merchant banking activities. 3c
acquires the target company and more like
Under section 23A, the section’s 10 percent
two separate transactions, the latter of which
quantitative limit does not apply to covered
involves the bank acquiring assets from an
transactions between a bank and any individual
affiliate. The Board recognized, however, that
financial subsidiary of the bank. Accordingly, a
banking organizations may need a reasonable
bank may engage in covered transactions with
amount of time to address legal, tax, and busi-
any individual financial subsidiary up to 20 per-
ness issues relating to an acquisition. Regulation
cent of the bank’s capital stock and surplus. A
W thus permits member banks to avail them-
bank’s covered transactions with its financial
selves of the step-transaction exemption if the
subsidiaries, however, are subject to a statutory
bank acquires the target company within three
20 percent quantitative limit. Thus, a bank may
months after the target company becomes an
not engage in a covered transaction with any
affiliate so long as the appropriate federal bank-
affiliate (including a financial subsidiary) if the
ing agency for the bank has approved the longer
bank’s aggregate amount of covered transac-
time period.
tions with all affiliates (including financial sub-
The 100 percent ownership requirement (that sidiaries) would exceed 20 percent of the bank’s
the member bank must acquire the entire own- capital stock and surplus.
ership position in the target company that its Because financial subsidiaries of a bank are
holding company acquired) prevents a holding considered affiliates of the bank for purposes of
company from keeping the good subsidiaries of section 23A, purchases of and investments in
the target company and transferring its bad the securities of a financial subsidiary are cov-
subsidiaries to the holding company’s subsidi- ered transactions under the statute and count
ary member bank. If a banking organization fails against the bank’s quantitative limit. A bank’s
to meet the terms of the step-transaction exemp- investment in its financial subsidiary, for pur-
tion, the organization may be able to satisfy the
conditions of the rule’s internal-corporate-
reorganization exemption or may be able to 3a. 12 USC 24a(g)(3).
obtain a case-by-case exemption from the 3b. 12 USC 24a(a)(2).
Board. 3c. 12 USC 371c(e)(1).

Page 8.7
poses of section 23A, shall not include the financial subsidiaries) would exceed 20 percent
retained earnings of the financial subsidiary. of the bank’s capital stock and surplus.
Section 23A generally applies only to trans- The Board notes that the exemption from the
actions between (1) a bank and an affiliate of the 10 percent limit for investments by a member
bank and (2) a bank and a third party in which bank in its own financial subsidiary does not
some benefit from either type of transaction apply to investments by a member bank in the
accrues to an affiliate of the bank. The statute financial subsidiary of an affiliated depository
generally does not apply to transactions between institution. Although the financial subsidiary of
two affiliates. Section 23A establishes two spe- an affiliated depository institution is an affiliate
cial anti-evasion rules, however, that govern of the member bank for purposes of sections
transactions between a financial subsidiary of a 23A and 23B, the GLB Act states that only
bank and another affiliate of the bank. First, the ‘‘covered transactions between a bank and any
FRA provides that any purchase of or invest- individual financial subsidiary of the bank’’ are
ment in the securities of a bank’s financial not subject to the 10 percent limit in section
subsidiary by an affiliate of the bank will be 23A. 3e A member bank may not engage in a
deemed to be a purchase of, or investment in, covered transaction with the financial subsidiary
such securities by the bank itself. Second, the of an affiliated depository institution if the
GLB Act authorizes the Board to deem a loan or aggregate amount of the member bank’s cov-
other extensions of credit made by a bank’s ered transactions with that financial subsidiary
affiliate to any financial subsidiary of a bank to would exceed 10 percent of the bank’s capital
be an extension of credit by the bank to the stock and surplus.
financial subsidiary, if the Board determines that
Valuation of investments in securities issued by
such action is necessary or appropriate to pre-
a financial subsidiary. Because financial subsid-
vent evasion.
iaries of a member bank are considered affiliates
of the bank for purposes of section 23A, a
member bank’s purchases of and investments in
Regulation W Provisions for Financial the securities of its financial subsidiary are
Subsidiaries covered transactions under the statute. The GLB
Act further provides that a member bank’s
Regulation W includes, in section 223.32, sev-
investment in its own financial subsidiary, for
eral special rules that apply to transactions with
purposes of section 23A, shall not include the
financial subsidiaries.
retained earnings of the financial subsidiary. 3f In
light of this statutory provision, the rule’s sec-
Applicability of the 10 percent quantitative limit
tion 223.32(b) contains a special valuation rule
to transactions with a financial subsidiary. First,
for investments by a member bank in the secu-
section 223.32(a) of the rule provides that the
rities of its own financial subsidiary. 3g Such
10 percent quantitative limit in section 23A does
investments must be valued at the greater of
not apply with respect to covered transactions
(1) the price paid by the member bank for the
between a member bank and any individual
securities or (2) the carrying value of the secu-
financial subsidiary of the bank. A member
rities on the financial statements of the member
bank’s aggregate amount of covered transac-
bank (determined in accordance with GAAP but
tions with any individual financial subsidiary of
without reflecting the bank’s pro rata share of
the bank may exceed 10 percent of the bank’s
any earnings retained or losses incurred by the
capital stock and surplus. 3d A member bank’s
financial subsidiary after the bank’s acquisition
covered transactions with its financial subsidi-
of the securities). 3h
aries, however, are subject to the 20 percent
quantitative limit in section 23A. Thus, a mem- 3e. See 12 USC 371c(e)(3)(A).
ber bank may not engage in a covered transac- 3f. GLB Act section 121(b)(1) (12 USC 371c(e)(3)(B)).
tion with any affiliate (including a financial 3g. The rule’s special valuation formula for investments by
subsidiary) if the bank’s aggregate amount of a member bank in its own financial subsidiary does not apply
to investments by a member bank in a financial subsidiary of
covered transactions with all affiliates (including an affiliated depository institution. Such investments must be
valued using the general valuation formula set forth in section
223.23 for investments in securities issued by an affiliate and,
3d. Section 223.11 also indicates that covered transactions further, may trigger the anti-evasion rule contained in section
between a member bank and its financial subsidiary are 223.32(c)(1) of the rule.
exempt from the 10 percent limit. 3h. The rule also makes clear that if a financial subsidiary

Page 8.8
This valuation rule differs from the general acquires 100 percent of the shares of a secu-
valuation rule for investments in securities issued rities underwriter in a transaction valued at
by an affiliate only in that the financial subsid- $500. The member bank initially values the
iary rule requires, consistent with the GLB Act, investment at $500. In the following year, the
that the carrying value of the investment be securities underwriter earns $25 in profit,
computed without consideration of the retained which is added to its retained earnings. The
earnings or losses of the financial subsidiary member bank’s carrying value of the shares of
since the time of the member bank’s investment. the underwriter is not adjusted for purposes of
As a result of this rule, the covered-transaction this part, and the member bank must continue
amount for a member bank’s investment in to value the investment at $500. If, however,
securities issued by its financial subsidiary gen- the member bank contributes $100 of addi-
erally would not increase after the investment tional capital to the securities underwriter, the
was made except if the member bank made an member bank must value the aggregate invest-
additional capital contribution to the subsidiary ment at $600.
or purchased additional securities of the
subsidiary. Anti-evasion rules as they pertain to financial
The following examples were designed to subsidiaries. Section 23A generally applies only
assist member banks in valuing investments in to transactions between a member bank and an
securities issued by a financial subsidiary of the affiliate of the bank and transactions between a
member bank. Each example involves a securi- member bank and a third party when some
ties underwriter that becomes a financial subsid- benefit of the transaction accrues to an affiliate
iary of the member bank after the transactions of the bank. The statute generally does not apply
described below. to transactions between two affiliates. The GLB
Act establishes two special anti-evasion rules,
• Initial valuation. however, that govern transactions between a
— Direct acquisition by a member bank. A financial subsidiary of a member bank and
member bank pays $500 to acquire 100 per- another affiliate of the bank. 3i First, the GLB
cent of the shares of a securities under- Act provides that any purchase of, or investment
writer. The initial carrying value of the in, securities issued by a member bank’s finan-
shares on the member bank’s parent-only cial subsidiary by an affiliate of the bank will be
GAAP financial statements is $500. The deemed to be a purchase of, or investment in,
member bank initially must value the such securities by the bank itself. Second, the
investment at $500. GLB Act authorizes the Board to deem an
— Contribution of a financial subsidiary to a extension of credit made by a member bank’s
member bank. The parent holding com- affiliate to any financial subsidiary of the bank to
pany of a member bank acquires 100 per- be an extension of credit by the bank to the
cent of the shares of a securities under- financial subsidiary, if the Board determines that
writer in a transaction valued at $500 and such action is necessary or appropriate to pre-
immediately contributes the shares to the vent evasions of the Federal Reserve Act or the
member bank. The member bank gives no GLB Act. Section 223.32(c) of the rule incor-
consideration in exchange for the shares. porates both of these provisions.
The member bank initially must value the The Board exercised its authority under the
investment at the carrying value of the second anti-evasion rule by stating that an
shares on the member bank’s parent-only extension of credit to a financial subsidiary of a
GAAP financial statements. Under GAAP, member bank by an affiliate of the bank would
the member bank’s initial carrying value be treated as an extension of credit by the bank
of the shares would be $500. itself to the financial subsidiary if the extension
• Carrying value not adjusted for earnings and of credit is treated as regulatory capital of the
losses of the financial subsidiary. A member financial subsidiary. An example of the kind of
bank and its parent holding company engage credit extension covered by this provision would
in a transaction whereby the member bank be a subordinated loan to a financial subsidiary
that is a securities broker-dealer where the loan
is consolidated with its parent member bank under GAAP, the is treated as capital of the subsidiary under the
carrying value of the bank’s investment in the financial
subsidiary shall be determined based on parent-only financial
statements of the bank. 3i. GLB Act section 121(b)(1) (12 USC 371c(e)(4)).

Page 8.9
SEC’s net capital rules. Treating such an exten- and maintain policies and procedures designed
sion of credit as a covered transaction is appro- to manage the credit exposure arising from the
priate because the extension of credit by the derivative. These policies and procedures require,
affiliate has a similar effect on the subsidiary’s at a minimum, that the bank monitor and control
regulatory capital as an equity investment by the its exposure to its affiliates by imposing appro-
affiliate, which is treated as a covered transac- priate credit controls and collateral requirements.
tion by the terms of the GLB Act (as described Regulation W requires member banks to com-
above). The rule generally does not prevent a ply strictly with section 23B in their derivative
BHC or other affiliate of a member bank from transactions with affiliates. In this regard, sec-
providing financial support to a financial subsid- tion 23B requires a member bank to treat an
iary of the bank in the form of a senior or affiliate no better than a similarly situated non-
secured loan. affiliate. Section 23B generally does not allow a
member bank to use with an affiliate the terms
and conditions it uses with its most creditworthy
Derivative Transactions unaffiliated customer unless the bank can dem-
onstrate that the affiliate is of comparable cred-
Derivative transactions between a bank and its itworthiness as the bank’s most creditworthy
affiliates generally arise either from the risk- unaffiliated customer. Instead, section 23B
management needs of the bank or the affiliate. requires that an affiliate be treated comparably
Transactions arising from the bank’s needs typi- (with respect to terms, conditions, and credit
cally arise when a bank enters into a swap or limits) to the majority of third-party customers
other derivative contract with a customer but engaged in the same business, and having com-
chooses not to hedge directly the market risk parable credit quality and size as the affiliate.
generated by the derivative contract or is unable Because a bank generally has the strongest
to hedge the risk directly because the bank is not credit rating within a holding company, the
authorized to hold the hedging asset. In order to Board generally would not expect an affiliate to
manage the market risk, the bank may have an obtain better terms and conditions from a mem-
affiliate acquire the hedging asset. The bank ber bank than the member bank receives from its
would then do a ‘‘bridging’’ derivative transac- major unaffiliated counterparties. In addition,
tion between itself and the affiliate maintaining market terms for derivatives among major finan-
the hedge. cial institutions generally include daily marks to
Other derivative transactions between a bank market and two-way collateralization above a
and its affiliate are affiliate-driven. A bank’s relatively small exposure threshold.
affiliate may enter into an interest-rate or foreign-
exchange derivative with the bank in order to
accomplish the asset-liability management goals
Covering Derivatives That Are the
of the affiliate. For example, a BHC may hold a
Functional Equivalent of a Guarantee
substantial amount of floating-rate assets but Although most derivatives are not treated as
issue fixed-rate debt securities to obtain cheaper covered transactions, section 223.33 of the rule
funding. The BHC may then enter into a fixed- provides that credit derivatives between a mem-
to-floating interest-rate swap with its subsidiary ber bank and a nonaffiliate in which the bank
bank to reduce the holding company’s interest- protects the nonaffiliate from a default on, or a
rate risk. decline in the value of, an obligation of an
Banks and their affiliates that seek to enter affiliate of the bank are covered transactions
into derivative transactions for hedging (or risk- under section 23A. Such derivative transactions
taking) purposes could enter into the desired are viewed as guarantees by a member bank on
derivatives with unaffiliated companies. Banks behalf of an affiliate (and, hence, are covered
and their affiliates often choose to use each other transactions) under section 23A.
as their derivative counterparties, however, in The rule provides that these credit derivatives
order to maximize the profits of and manage are covered transactions under section 23A and
risks within the consolidated financial group. gives several examples. 3j A member bank is not
Regulation W does not require most deriva-
tive transactions to meet the quantitative and 3j. In most instances, the covered-transaction amount for
collateral requirements of section 23A. Instead, such a credit derivative would be the notional principal
the rule requires the member bank to establish amount of the derivative.

Page 8.10
allowed to reduce its covered-transaction amount ties, $480 in corporate debt securities, and $130
for these derivatives to reflect hedging positions in real estate. The loan satisfies the collateral
established by the bank with third parties. A requirements of this section because $500 of the
credit derivative is treated as a covered transac- loan is 100 percent secured by obligations of the
tion only to the extent that the derivative pro- United States, $400 of the loan is 120 percent
vides credit protection with respect to obliga- secured by debt instruments, and $100 of the
tions of an affiliate of the member bank. loan is 130 percent secured by real estate. The
statute prohibits a member bank from counting a
low-quality asset toward section 23A’s collateral
Collateral requirements for credit transactions with
affiliates. 3n A member bank must maintain a
There are collateral requirements for certain perfected security interest at all times in the
transactions with affiliates. Each loan or exten- collateral that secures the credit transaction.
sion of credit to an affiliate or guarantee, accep-
tance, or letter of credit issued on behalf of an
affiliate 3k (herein referred to as credit transac- Collateral Requirements in Regulation W
tions) by a member bank or its subsidiary must
be secured at the time of the transaction by The collateral requirements for credit transac-
collateral. The required collateral, based on its tions are found in section 223.14 of the rule.
fair market value, varies according to a percent- Section 223.14(a) requires that a bank meet the
age of the credit extended, 3 l depending on the collateral requirements only at the inception of a
type of collateral used to secure the credit transaction with an affiliate.
transaction. 3m The specific collateral require-
ments are— Deposit account collateral. Under section 23A,
a member bank may satisfy the collateral
• 100 percent of the amount of the credit requirements of the statute by securing a credit
extended if the collateral is composed of transaction with an affiliate with a ‘‘segregated,
(1) obligations of the United States or its earmarked deposit account’’ maintained with
agencies; (2) obligations fully guaranteed by the bank in an amount equal to 100 percent of
the United States or its agencies as to principal the credit extended. 3o Member banks may secure
and interest; (3) notes, drafts, bills of exchange, covered transactions with omnibus deposit
or banker’s acceptances that are eligible for accounts so long as the member bank takes steps
rediscount or purchase by a Federal Reserve to ensure that the omnibus deposit accounts
Bank; or (4) a segregated, earmarked deposit fully secure the relevant covered transactions.
account with the member bank; Such steps might include substantial overcollat-
• 110 percent of the amount of the credit eralization or the use of subaccounts or other
extended if the collateral is composed of recordkeeping devices to match deposits with
obligations of any state or political subdivi- covered transactions. To obtain full credit for
sion of any state; any deposit accounts taken as section 23A
• 120 percent of the amount of the credit collateral, member banks must ensure that they
extended if the collateral is composed of other have a perfected, first-priority security interest
debt instruments, including receivables; or in the accounts. (See section 223.14(b)(1)(i)(D).)
• 130 percent of the amount of the credit
extended if the collateral is composed of Ineligible collateral. The purpose of section
stock, leases, or other real or personal 23A’s collateral requirements is to ensure that
property. member banks that engage in credit transactions
with affiliates have legal recourse, in the event
For example, a member bank makes a $1,000 of affiliate default, to tangible assets with a
loan to an affiliate. The affiliate posts as collat- value at least equal to the amount of the credit
eral for the loan $500 in U.S. Treasury securi- extended. The statute recognizes that certain
types of assets are not appropriate to serve as
collateral for credit transactions with an affiliate.
3k. 12 USC 371c(b)(7).
3l. ‘‘Credit extended’’ means the loan or extension of
credit, guarantee, acceptance, or letter of credit. 3n. 12 USC 371c(c)(3).
3m. 12 USC 371c(c)(1). 3o. 12 USC 371c(c)(1)(A)(iv).

Page 8.11
In particular, the statute provides that low- credit transaction because the sale might depress
quality assets and securities issued by an affiliate the price of the bank’s outstanding securities or
are not eligible collateral for such covered result in a change in control of the bank. In
transactions. 3p addition, to the extent that a member bank is
Under section 223.14(c) of the rule, intan- unable or unwilling to sell such securities
gible assets are not deemed acceptable to meet acquired through foreclosure, the transaction
the collateral requirements imposed by section would likely result in a reduction in the bank’s
23A.4 Intangible assets, including servicing capital, thereby offsetting any potential benefit
assets, are particularly hard to value, and a provided by the collateral.
member bank may have significant difficulty in
collecting and selling such assets in a reasonable Perfection and priority. Under section 223.14(d)
period of time. of the rule, a member bank’s security interest in
Section 23A(c) requires that credit transac- any collateral required by section 23A must be
tions with an affiliate be ‘‘secured’’ by collat- perfected in accordance with applicable law to
eral. A credit transaction between a member ensure that a member bank has good access to
bank and an affiliate supported only by a guar- the assets serving as collateral for its credit
antee or letter of credit from a third party does transactions with affiliates. This requirement
not meet the statutory requirement that the credit ensures that the member bank has the legal right
transaction be secured by collateral. Guarantees to realize on the collateral in the case of default,
and letters of credit often are subject to material including a default resulting from the affiliate’s
adverse change clauses and other covenants that insolvency or liquidation. A member bank also
allow the issuer of the guarantee or letter of is required to either obtain a first-priority secu-
credit to deny coverage. Letters of credit and rity interest in the required collateral or deduct
guarantees are not balance-sheet assets under from the amount of collateral obtained by the
GAAP and, accordingly, would not constitute bank the lesser of (1) the amount of any security
‘‘real or personal property’’ under section 23A. interests in the collateral that are senior to that
There is a particularly significant risk that a obtained by the bank or (2) the amount of any
member bank may have difficulty collecting on credits secured by the collateral that are senior
a guarantee or letter of credit provided by a to that of the bank. For example, if a member
nonaffiliate on behalf of an affiliate of the bank. bank lends $100 to an affiliate and takes as
Accordingly, guarantees and letters of credit are collateral a second lien on a parcel of real estate
not acceptable section 23A collateral. 4a worth $200, the arrangement would only satisfy
As noted above, section 23A prohibits a the collateral requirements of section 23A if the
member bank from accepting securities issued affiliate owed the holder of the first lien $70 or
by an affiliate as collateral for an extension of less (a credit transaction secured by real estate
credit to any affiliate. The rule clarifies that must be secured at 130 percent of the amount of
securities issued by the member bank itself also the transaction).
are not eligible collateral to secure a credit The rule includes the following example of
transaction with an affiliate. Equity securities how to compute the section 23A collateral value
issued by a lending member bank, and debt of a junior lien: A member bank makes a $2,000
securities issued by a lending member bank that loan to an affiliate. The affiliate grants the
count as regulatory capital of the bank, are not member bank a second-priority security interest
eligible collateral under section 23A. If a mem- in a piece of real estate valued at $3,000.
ber bank were forced to foreclose on a credit Another institution that previously lent $1,000
transaction with an affiliate secured by such to the affiliate has a first-priority security interest
securities, the bank may be unwilling to liqui- in the entire parcel of real estate. This transac-
date the collateral promptly to recover on the tion is not in compliance with the collateral
requirements of this section. Because of the
3p. 12 USC 371c(c)(3) and (4).
4. The rule does not confine the definition of intangible
existence of the prior third-party lien on the real
assets by reference to GAAP. estate, the effective value of the real estate
4a. The rule also provides that instruments ‘‘similar’’ to collateral for the member bank for purposes of
guarantees and letters of credit are ineligible collateral. For this section is only $2,000—$600 less than the
example, in the Board’s view, a member bank cannot satisfy
section 23A’s collateral requirements by purchasing credit
amount of real estate collateral required by this
protection in the form of a credit-default swap referencing the section for the transaction ($2,000 × 130 per-
affiliate’s obligation. cent = $2,600).

Page 8.12
Unused portion of an extension of credit. Sec- Any purchase of affiliate debt securities that
tion 23A requires that the ‘‘amount’’ of an qualifies for this exemption would still remain
extension of credit be secured by the statutorily subject to the quantitative limits of section 23A
prescribed levels of collateral. In general, if a and the market-terms requirement of section
member bank provides a line of credit to an 23B. In analyzing a member bank’s good faith
affiliate, it must secure the full amount of the under this exemption transaction, examiners
line of credit throughout the life of the credit. should look at the time elapsed between the
Section 223.14(f)(2) of the rule provides an original issuance of the affiliate’s debt securities
exemption to the collateral requirements of sec- and the bank’s purchase, the existence of any
tion 23A for the unused portion of an extension relevant agreements or relationships between
of credit to an affiliate so long as the member the bank and the third-party seller of the affili-
bank does not have any legal obligation to ate’s debt securities, any history of bank financ-
advance additional funds under the credit facil- ing of the affiliate, and any other relevant
ity until the affiliate has posted the amount of information.
collateral required by the statute with respect to
the entire used portion of the extension of Credit transactions with nonaffiliates that become
credit. 4b In such credit arrangements, securing affiliates. Banks sometimes lend money to, or
the unused portion of the credit line is unneces- issue guarantees on behalf of, unaffiliated com-
sary from a safety-and-soundness perspective panies that later become affiliates of the bank.
because the affiliate cannot require the member Section 223.21(b)(2) provides transition rules
bank to advance additional funds without post- that exempt credit transactions from the collat-
ing the additional collateral required by section eral requirements in situations in which the
23A. If a member bank voluntarily advances member bank entered into the transactions with
additional funds under such a credit arrange- the nonaffiliate at least one year before the
ment without obtaining the additional collateral nonaffiliate became an affiliate of the bank.
required under section 23A to secure the entire For example, a member bank with capital
used amount (despite its lack of a legal obliga- stock and surplus of $1,000 and no outstanding
tion to make such an advance), the Board views covered transactions makes a $120 unsecured
this action as a violation of the collateral require- loan to a nonaffiliate. The member bank does
ments of the statute. Even if the line of credit not make the loan in contemplation of the
does not need to be secured, the entire amount of nonaffiliate becoming an affiliate. Nine months
the line counts against the bank’s quantitative later, the member bank’s holding company pur-
limit. chases all the stock of the nonaffiliate, thereby
making the nonaffiliate an affiliate of the mem-
Purchasing affiliate debt securities in the sec- ber bank. The member bank is not in violation of
ondary market. A member bank’s investment in the quantitative limits of the rule’s section
the debt securities issued by an affiliate is an 223.11 or 223.12 at the time of the stock
extension of credit by the bank to the affiliate acquisition. The member bank is, however, pro-
and thus is subject to section 23A’s collateral hibited from engaging in any additional covered
requirements. Section 223.14(f)(3) of the rule transactions with the new affiliate at least until
provides an exemption that permits member such time as the value of the loan transaction
banks in certain circumstances to purchase debt falls below 10 percent of the member bank’s
securities issued by an affiliate without satisfy- capital stock and surplus. In addition, the mem-
ing the collateral requirements of section 23A. ber bank must bring the loan into compliance
The exemption is available where a member with the collateral requirements of section 223.14
bank purchases an affiliate’s debt securities from promptly after the stock acquisition.
a third party in a bona fide secondary-market
transaction. When a member bank buys an
affiliate’s debt securities in a bona fide secondary-
market transaction, the risk that the purchase is Exemptions from Section 23A
designed to shore up an ailing affiliate is reduced.
Section 23A authorizes the Board to grant
4b. This does not apply to guarantees, acceptances, and
exemptions from the statute’s restrictions if such
letters of credit issued on behalf of an affiliate. These exemptions are ‘‘in the public interest and con-
instruments must be fully collateralized at inception. sistent with the purposes of this section’’ (12

Page 8.13
USC 371c(f)(2)). The Board has approved a that covered transactions between sister banks
number of exemptions over the past several must be consistent with safe and sound banking
years, most of which involve corporate practices. 4d
reorganizations. The sister-bank exemption generally applies
Section 23A exempts several types of trans- only to transactions between insured depository
actions from the statute’s quantitative and col- institutions. 4e The rule’s definition of affiliate
lateral requirements and exempts other types of excludes uninsured depository institution sub-
transactions from the statute’s quantitative, col- sidiaries of a member bank. Covered transac-
lateral, and low-quality-asset requirements. 4c tions between a member bank and a parent
Regulation W, subpart E, sets forth the statutory uninsured depository institution or a commonly
exemptions, clarifies certain of these exemp- controlled uninsured depository institution, under
tions, and exempts a number of additional types the rule, generally would be subject to section
of transactions 23A whereas covered transactions between a
The Board reserves the right to revoke or member bank and a subsidiary uninsured deposi-
modify any additional exemption granted by the tory institution would not be subject to section
Board in Regulation W, if the Board finds that 23A. 4f
the exemption is resulting in unsafe or unsound The sister-bank exemption, by its terms, only
banking practices. The Board also reserves the exempts transactions by a member bank with a
right to terminate the eligibility of a particular sister-bank affiliate; hence, the sister-bank
member bank to use any such exemption if the exemption cannot exempt a member bank’s
bank’s use of the exemption is resulting in extension of credit to an affiliate that is not a
unsafe or unsound banking practices. sister bank (even if the extension of credit was
purchased from a sister bank). For example, a
member bank purchases from Sister-Bank
Covered Transactions Exempt from the Affiliate A a loan to Affiliate B in a purchase
Quantitative Limits and Collateral that qualifies for the sister-bank exemption in
Requirements section 23A. The member bank’s asset purchase
from Sister-Bank Affiliate A would be an exempt
Under the rule’s section 223.41, the quantitative covered transaction under section 223.41(b), but
limits (sections 223.11 and 223.12) and the the member bank also would have acquired an
collateral requirements (section 223.14) do not extension of credit to Affiliate B, which would
apply to the following transactions. The trans- be a covered transaction between the member
actions are, however, subject to the safety-and- bank and Affiliate B under section 223.3(h)(1)
soundness requirement (section 223.13) and the that does not qualify for the sister-bank
prohibition on the purchase of a low-quality exemption.
asset (section 223.15).
Internal corporate reorganizations. Section
• Parent institution/subsidiary institution trans- 223.41(d) of the rule provides an exemption for
actions. Transactions with a depository insti- asset purchases by a bank from an affiliate that
tution if the member bank controls 80 percent are part of a one-time internal corporate reorga-
or more of the voting securities of the deposi- nization of a banking organization. 4g The
tory institution or the depository institution exemption includes purchases of assets in con-
controls 80 percent or more of the voting nection with a transfer of securities issued by an
securities of the member bank.
• Purchase of loans on a nonrecourse basis 4d. 12 USC 371c(a)(4).
4e. A member bank and its operating subsidiaries are
from an affiliated depository institution. considered a single unit for purposes of section 23A. Under
the statute and the regulation, transactions between a member
Sister-bank exemption (section 223.41(b)). Regu- bank (or its operating subsidiary) and the operating subsidiary
lation W exempts transactions with a federally of a sister insured depository institution generally qualify for
the sister-bank exemption.
insured depository institution if the same com- 4f. The sister-bank exemption in section 23A does not
pany controls 80 percent or more of the voting allow a member bank to avoid any restrictions on sister-bank
securities of the member bank and the deposi- transactions that may apply to the bank under the prompt-
tory institution. In addition, the statute provides corrective-action framework set forth in section 38 of the FDI
Act (12 USC. 1831o) and regulations adopted thereunder by
the bank’s appropriate federal banking agency.
4c. 12 USC 371c(d). 4g. See 1998 Fed. Res. Bull. 985 and 1013–14.

Page 8.14
affiliate to a member bank, as described in to the following exempted transactions. (See

section 223.31(a). section 223.42.) The transactions are, however,
Under this exemption, a member bank would subject to the safety-and-soundness requirement
be permitted to purchase assets (other than (section 223.13). Detailed conditions or restric-
low-quality assets) from an affiliate (including tions pertaining to these exemptions are dis-
in connection with an affiliate share transfer that cussed after this list.
section 223.31 of the rule treats as a purchase of
assets) exempt from the quantitative limits of • making correspondent banking deposits in an
section 23A if the following conditions are met. affiliated depository institution (as defined in
First, the asset purchase must be part of an section 3 of the FDI Act (12 USC 1813) or an
internal corporate reorganization of a holding affiliated foreign bank that represent an ongo-
company that involves the transfer of all or ing, working balance maintained in the ordi-
substantially all of the shares or assets of an nary course of correspondent business
affiliate or of a division or department of an • giving immediate credit to an affiliate for
affiliate. 4h The asset purchase must not be part uncollected items received in the ordinary
of a series of periodic, ordinary-course asset course of business
transfers from an affiliate to a member bank. • transactions secured by cash or U. S. govern-
Second, the member bank’s holding company ment securities
must provide the Board with contemporaneous • purchasing securities of a servicing affiliate
notice of the transaction and must commit to the • purchasing certain liquid assets
Board to make the bank whole, for a period of • purchasing certain marketable securities
two years, for any transferred assets that become • purchasing certain municipal securities
low-quality assets. 4i Third, a majority of the • purchasing from an affiliate an extension of
member bank’s directors must review and credit subject to a repurchase agreement that
approve the transaction before consummation. was originated by a member bank and sold to
Fourth, the section 23A value of the covered the affiliate subject to a repurchase agreement
transaction must be less than 10 percent of the or with recourse
member bank’s capital stock and surplus (or up • asset purchases from an affiliate by a newly
to 25 percent of the bank’s capital stock and formed member bank, if the appropriate fed-
surplus with the prior approval of the bank’s eral banking agency for the member bank has
appropriate federal banking agency). Fifth, the approved the asset purchase in writing in
member bank’s holding company and all its connection with the review of the formation of
subsidiary depository institutions must be well the member bank
capitalized and well managed and must remain • transactions approved under the Bank Merger
well capitalized upon consummation of the Act that involve federally insured depository
transaction. institutions in U.S. branches and agencies of a
foreign bank
• purchasing, on a nonrecourse basis, an exten-
Covered Transactions Exempt from the sion of credit from an affiliate
Quantitative Limits, Collateral • intraday extensions of credit
Requirements, and Low-Quality-Asset • riskless-principal transactions
Prohibition
Correspondent banking. Section 23A exempts
The quantitative limits (sections 223.11 and from its quantitative limits and collateral require-
223.12), the collateral requirements (section ments any deposit by a member bank in an
223.14), and the prohibition on the purchase of affiliated bank or affiliated foreign bank that is
a low-quality asset (section 223.15) do not apply made in the ordinary course of correspondent
business, subject to any restrictions that the
4h. The notice also must describe the primary business
activities of the affiliate whose shares or assets are being
Board may impose. 4j Section 223.42(a) of the
transferred to the member bank and must indicate the antici- rule further provides that such deposits must
pated date of the reorganization. represent ongoing, working balances maintained
4i. The holding company can meet this criteria by either by the member bank in the ordinary course of
repurchasing the assets at book value plus any write-down that
has been taken or by making a quarterly cash contribution to
the bank equal to the book value plus any write-downs that
have been taken by the bank. 4j. 12 USC 371c(d)(2).

Page 8.15
conducting the correspondent business. 4k affiliate if the assets have a ‘‘readily identifiable
Although not required by section 23A or the and publicly available market quotation’’ and
Home Owners’ Loan Act (HOLA), the rule also are purchased at their current market
provides that correspondent deposits in an affili- quotation. 4m The rule (section 223.42(e)) limits
ated insured savings association are exempt if the availability of this exemption (the (d)(6)
they otherwise meet the requirements of the exemption) to purchases of assets with market
exemption. prices that are recorded in widely disseminated
publications that are readily available to the
Secured credit transactions. Section 23A and general public, such as newspapers with a
section 223.42(c) of the rule exempt any credit national circulation. Because as a general matter
transaction by a member bank with an affiliate only exchange-traded assets are recorded in
that is ‘‘fully secured’’ by U.S. government such publications, this test has ensured that the
obligations or by a ‘‘segregated, earmarked’’ qualifying assets are traded actively enough to
deposit account. 4 l A deposit account meets the have a true ‘‘market quotation’’ and that exam-
‘‘segregated, earmarked’’ requirement only if iners can verify that the assets are purchased at
the account exists for the sole purpose of secur- their current market quotation. The rule applies
ing credit transactions between the member if the asset is purchased at or below the asset’s
bank and its affiliates and is so identified. Under current market quotation.5
section 23A, if U.S. government obligations or If a member bank purchases from one affiliate
deposit accounts are sufficient to fully secure a securities issued by another affiliate, the bank
credit transaction, then the transaction is com- has engaged in two types of covered transac-
pletely exempt. If, however, the U.S. govern- tions. Under the rule, although the (d)(6) exemp-
ment obligations or deposit accounts represent tion may exempt the one-time asset purchase
less than full security for the credit transaction, from the first affiliate, it would not exempt the
then the amount of U.S. government obligations ongoing investment in securities issued by the
or deposits counts toward the collateral require- second affiliate.
ments of section 23A, but no part of the trans- The (d)(6) exemption may apply to a pur-
action is exempt from the statute’s quantitative chase of assets that are not traded on an
limits. exchange. In particular, purchases of foreign
An additional exemption provided in the rule exchange, gold, and silver, and purchases of
is consistent with the (d)(4) exemption in sec- over-the-counter (OTC) securities and deriva-
tion 23A. A credit transaction with an affiliate tive contracts whose prices are recorded in
will be exempt ‘‘to the extent that the transaction widely disseminated publications, may qualify
is and remains secured’’ by appropriate (d)(4) for the (d)(6) exemption.
collateral. If a member bank makes a $100
nonamortizing term loan to an affiliate that is Purchases of securities with a ready market
secured by $50 of U.S. Treasury securities and from a securities affiliate. Section 223.42(f) of
$75 of real estate, the value of the covered the rule expands the statutory (d)(6) exemption
transaction will be $50. If the market value of to allow a member bank to purchase securities
the U.S. Treasury securities falls to $45 during from an affiliate based on price quotes obtained
the life of the loan, the value of the covered from certain electronic screens so long as, among
transaction would increase to $55. The Board other things, (1) the selling affiliate is a broker-
expects member banks that use this expanded dealer registered with the SEC, (2) the securities
(d)(4) exemption to review the market value of are traded in a ready market and eligible for
their U.S. government obligations collateral regu- purchase by state member banks, (3) the secu-
larly to ensure compliance with the exemption. rities are not purchased within 30 days of an
underwriting (if an affiliate of the bank is an
Purchases of assets with readily identifiable
market quotes. Section 23A(d)(6) exempts the
4m. 12 USC 371c(d)(6).
purchase of assets by a member bank from an 5. The rule provides that a U.S. government obligation is
an eligible (d)(6) asset only if the obligation’s price is quoted
4k. Unlike the sister-bank exemption, the exemption for routinely in a widely disseminated publication that is readily
correspondent banking deposits applies to deposits placed by available to the general public. Although all U.S. government
a member bank in an uninsured depository institution or obligations have low credit risk, not all U.S. government
foreign bank. obligations trade in liquid markets at publicly available
4l. 12 USC 371c(d)(4). market quotations.

Page 8.16
underwriter of the securities), and (4) the secu- securities issued by another affiliate, it would
rities are not issued by an affiliate. not exempt the investment in securities issued
by the second affiliate, even though the (d)(6)
• Broker-dealer requirement and securities pur- exemption may exempt the asset purchase
chases from foreign broker-dealers. As stated from the first affiliate. The transaction would
above, the selling affiliate must be a registered be treated as a purchase of, or an investment
broker-dealer. Broker-dealers that are regis- in, securities issued by an affiliate.
tered with the SEC are subject to supervision • Price-verification methods. The (d)(6)
and examination by the SEC and are required exemption applies only in situations in which
by SEC regulations to keep and maintain the member bank is able to obtain price quotes
detailed records concerning each securities on the purchased securities from an unaffili-
transaction conducted by the broker-dealer. In ated electronic, real-time pricing service. The
addition, SEC-registered broker-dealers have Board reaffirms its position that it would not
experience in determining whether a security be appropriate to use independent dealer quo-
has a ‘‘ready market’’ under SEC regulations. tations to establish a market price for a secu-
The rule does not expand the exemption to rity under the new (d)(6) exemption. A secu-
include securities purchases from foreign rity that is not quoted routinely in a widely
broker-dealers. The rule explicitly provides, disseminated news source or a third-party
however, that a member bank may request electronic financial network may not trade in a
that the Board exempt securities purchases sufficiently liquid market to justify allowing a
from a particular foreign broker-dealer, and member bank to purchase unlimited amounts
the Board would consider these requests on a of the security from an affiliate.
case-by-case basis in light of all the facts and • Record retention. The rule expressly includes
circumstances. a two-year record-retention and supporting
• Securities eligible for purchase by a state information requirement that is sufficient to
member bank. The exemption requires that the enable the appropriate federal banking agen-
bank’s purchase of securities be eligible for cies to ensure that the member bank is in
purchase by a state member bank. The Board compliance with the terms of the (d)(6)
determined that a member bank may purchase exemption.
equity securities from an affiliate under the
(d)(6) exemption, if the purchase is made to Purchasing municipal securities. Section
hedge the bank’s permissible customer-driven 223.42(g) of the rule exempts a member bank’s
equity derivative transaction (and the pur- purchase of municipal securities from an affili-
chase meets all the other requirements of the ate if the purchase meets certain requirements. 5a
exemption). First, the member bank must purchase the
• No purchases within 30 days of an underwrit- municipal securities from a broker-dealer affili-
ing. The (d)(6) rule generally prohibits a ate that is registered with the SEC. Second, the
member bank from using the (d)(6) exemption municipal securities must be eligible for pur-
to purchase securities during an underwriting, chase by a state member bank, and the member
or within 30 days of an underwriting, if an bank must report the transaction as a securities
affiliate of the bank is an underwriter of the purchase in its call report. Third, the municipal
securities. This provision applies unless the securities must either be rated by a nationally
security is purchased as part of an issue of recognized statistical rating organization or must
obligations of, or obligations fully guaranteed be part of an issue of securities that does not
as to principal and interest by, the United exceed $25 million in size. Finally, the price for
States or its agencies. The rule includes the the securities purchased must be (1) quoted
30-day requirement because of the uncertain routinely on an unaffiliated electronic service
and volatile market values of securities during that provides indicative data from real-time
and shortly after an underwriting period and financial networks; (2) verified by reference to
because of the conflicts of interest that may
arise during and after an underwriting period, 5a. Municipal securities are defined by reference to section
especially if an affiliate has difficulty selling 3(a)(29) of the Securities Exchange Act. It defines municipal
its allotment. securities as direct obligations of, or obligations guaranteed as
to principal or interest by, a state or agency, instrumentality, or
• No securities issued by an affiliate. If a political subdivision thereof, and certain tax-exempt industrial
member bank purchases from one affiliate development bonds. (See 17 USC 78c(a)(29).)

Page 8.17
two or more actual independent dealer quotes on from section 23A’s quantitative limits pro-
the securities to be purchased or securities that vided that—
are comparable to the securities to be purchased; — the extension of credit is originated by the
or (3) in the case of securities purchased during affiliate;
the underwriting period, verified by reference to — the member bank makes an independent
the price indicated in the syndicate manager’s evaluation of the creditworthiness of the
written summary of the underwriting. 5b Under borrower before the affiliate makes or
any of the three pricing options, the member commits to make the extension of credit;
bank must purchase the municipal securities at and
or below the quoted or verified price. — the member bank does not make a blanket
advance commitment to purchase exten-
Purchases of assets by newly formed banks. sions of credit from the affiliate. (See
Section 223.42(i) of the rule exempts a purchase section 223.42(k) of the rule.)
of assets by a newly chartered member bank The rule also includes a 50 percent limit on
from an affiliate if the appropriate federal bank- the amount of loans a bank may purchase
ing agency for the bank has approved the from an affiliate under the purchase exemp-
purchase. This exemption allows companies to tion. When a member bank purchases more
charter a new bank and to transfer assets to the than half of the extensions of credit originated
bank free of the quantitative limits and low- by an affiliate, the purchases represent the
quality-asset prohibition of section 23A. principal ongoing funding mechanism for the
affiliate. The member bank’s status as the
Transactions approved under the Bank Merger predominant source of financing for the affili-
Act. The Bank Merger Act exemption applies to ate calls into question the availability of
transactions between a member bank and an alternative funding sources for the affiliate,
insured depository institution affiliate. Section places significant pressure on the bank to
223.42(j) exempts transactions between insured continue to support the affiliate through asset
depository institutions that are approved pursu- purchases, and reduces the bank’s ability to
ant to the Bank Merger Act. The rule makes the make independent credit decisions with respect
Bank Merger Act exemption available for merger to the asset purchases.
and other related transactions between a mem- • ‘‘Substantial, ongoing funding’’ test. The rule
ber bank and a U.S. branch or agency of an allows the appropriate federal banking agency
affiliated foreign bank, if the transaction has for a member bank to reduce the 50 percent
been approved by the responsible federal bank- threshold prospectively, on a case-by-case
ing agency pursuant to the Bank Merger Act, basis, in those situations in which the agency
and should help ensure that such transactions do believes that the bank’s asset purchases from
not pose significant risks to the member bank. an affiliate under the exemption may cause
There is no regulatory exemption for merger harm to the bank.
transactions between a national bank and its • Independent credit review by the bank. To
nonbank affiliate. Any member bank merging or qualify for the purchase exemption under
consolidating with a nonbank affiliate may be section 223.42(k), a member bank must inde-
able to take advantage of the regulatory exemp- pendently review the creditworthiness of each
tion for internal-reorganization transactions con- obligor before committing to purchase each
tained in section 223.41(d) of the rule. loan. Under established Federal Reserve guid-
ance, a state member bank is required to have
Purchases of extensions of credit—the purchase clearly defined policies and procedures to
exemption. ensure that it performs its own due diligence
in analyzing the credit and other risks inherent
• The purchase of an extension of credit on a in a proposed transaction. 5c This function is
nonrecourse basis from an affiliate is exempt not delegable to any third party, including
affiliates of the member bank or government-
5b. Under the Municipal Securities Rulemaking Board’s sponsored enterprises. Accordingly, to qualify
Rule G-11, the syndicate manager for a municipal bond for this exemption, the member bank, inde-
underwriting is required to send a written summary to all pendently and using its own credit policies
members of the syndicate. The summary discloses the aggre-
gate par values and prices of bonds sold from the syndicate
account. 5c. See, for example, SR-97-21.

Page 8.18
and procedures, must itself review and approve interest and consistent with the purposes of
each extension of credit before giving a pur- section 23A.
chase commitment to its affiliate.
• Purchase of loans from an affiliate must be
without recourse. In connection with a bank’s Exemptions from the Attribution Rule of
purchase of loans from an affiliate, the affiliate Section 23A
cannot retain recourse on the loans. The rule
(section 223.42(k)) specifies that the exemp- The attribution rule of section 23A provides that
tion does not apply in situations where the ‘‘a transaction by a member bank with any
affiliate retains recourse on the loans pur- person shall be deemed a transaction with an
chased by the member bank. The rule also affiliate to the extent that the proceeds of the
specifies that the purchase exemption only transaction are used for the benefit of, or trans-
applies in situations where the member bank ferred to, that affiliate’’ (12 USC 371c(a)(2)).
purchases loans from an affiliate that were One respective interpretation and three exemp-
originated by the affiliate. The exemption tions are discussed below.
cannot be used by a member bank to purchase
loans from an affiliate that the affiliate pur- Loans to a nonaffiliate that purchases securities
chased from another lender. The exemption is or other assets through a depository institution
designed to facilitate a member bank’s using affiliate agent or broker. The Board issued an
its affiliate as an origination agent, not to interpretation on an insured depository institu-
permit a member bank to take off an affiliate’s tion’s loan to a nonaffiliate that purchases assets
books loans that the affiliate purchased from a through an institution’s affiliate that is acting as
third party. agent. This interpretation confirms that section
23A of the FRA does not apply to extensions of
Intraday extensions of credit. Section 223.42(l) credit an insured depository institution grants to
of the rule provides that intraday credit exten- customers that use the loan proceeds to purchase
sions by a member bank to an affiliate are a security or other asset through an affiliate of
section 23A covered transactions but exempts the depository institution, so long as (1) the
all such intraday credit extensions from the affiliate is acting exclusively as an agent or
quantitative and collateral requirements of sec- broker in the transaction and (2) the affiliate
tion 23A if the member bank (1) maintains retains no portion of the loan proceeds as a fee
policies and procedures for the management of or commission for its services.
intraday credit exposure and (2) has no reason to Under this interpretation, the Board con-
believe that any affiliate receiving intraday credit cluded that when the affiliated agent or broker
would have difficulty repaying the credit in retains a portion of the loan proceeds as a fee or
accordance with its terms. The establishment of commission, the portion of the loan not retained
policies and procedures are for— by the affiliate as a fee or commission would
still be outside the coverage of section 23A. On
• monitoring and controlling the credit exposure the other hand, the portion of the loan retained
arising at any one time from the member by the affiliate as a fee or commission would be
bank’s intraday extensions of credit to each subject to section 23A because it represents
affiliate and all affiliates in the aggregate and proceeds of a loan by a depository institution to
• ensuring that any intraday extensions of credit a third party that are transferred to, and used for
by the member bank to an affiliate comply the benefit of, an affiliate of the institution. The
with the market-terms requirement of section Board, however, granted an exemption from
223.51 of the rule. section 23A for that portion of a loan to a third
party that an affiliate retains as a market-rate
Standard under which the board may grant brokerage or agency fee.
additional exemptions. Section 223.43 of the The interpretation would not apply if the
rule provides that exemption requests should securities or other assets purchased by the third-
(1) describe in detail the transaction or relation- party borrower through the affiliate of the deposi-
ship for which the member bank seeks exemp- tory institution were issued or underwritten by,
tion, (2) explain why the Board should exempt or sold from the inventory of, another affiliate of
the transaction or relationship, and (3) explain the depository institution. In that case, the pro-
how the exemption would be in the public ceeds of the loan from the depository institution

Page 8.19
would be transferred to, and used for the benefit used to purchase securities from the institution’s
of, the affiliate that issued, underwrote, or sold broker-dealer affiliate. The Board approved an
the assets on a principal basis to the third party. exemption from section 23A for loans by an
The above-mentioned transactions are subject insured depository institution to a nonaffiliate
to the market-terms requirement of section 23B, pursuant to a preexisting line of credit, in which
which applies to ‘‘any transaction in which an the loan proceeds are used to purchase securities
affiliate acts as an agent or broker or receives a from a broker-dealer affiliate. In more detail, the
fee for its services to the bank or any other Board exempted extensions of credit by an
person’’ (12 USC 371c-1(a)(2)(D)). A market- insured depository institution to its customers
rate brokerage commission or agency fee refers that use the credit to purchase securities from a
to a fee or commission that is no greater than registered broker-dealer affiliate of the institu-
that prevailing at the same time for comparable tion, so long as the extension of credit is made
agency transactions the affiliate enters into with pursuant to, and consistent with any conditions
persons who are neither affiliates nor borrowers imposed in, a preexisting line of credit. This line
from an affiliated depository institution. (See of credit should not have been established in
Regulation W at 12 CFR 223.16(b).) expectation of a securities purchase from or
through an affiliate of the institution. The pre-
Exemption—Loans to a nonaffiliate that pur- existing requirement is an important safeguard
chases securities from a depository institution to ensure that the depository institution did not
securities affiliate that acts as a riskless princi- extend credit for the purpose of inducing a
pal. The Board has granted an exemption from borrower to purchase securities from or issued
section 23A of the FRA for extensions of credit by an affiliate. The preexisting line of credit
by an insured depository institution to customers exemption may not be used in circumstances in
who use the loan proceeds to purchase a security which the line has merely been preapproved.
that is issued by a third party via a broker-dealer (See Regulation W at 12 CFR 223.16(c)(3).)
affiliate of the institution that acts as riskless
principal. The exemption for riskless-principal Exemption—Credit card transactions. An
transactions would not apply if the broker-dealer exemption is provided from section 23A’s attri-
affiliate sold to the third-party borrower securi- bution rule for general-purpose credit card trans-
ties that were issued or underwritten by, or sold actions that meet certain criteria. (See section
out of the inventory of, an affiliate of the 223.16(c)(4).) The rule defines a general-purpose
depository institution. Riskless-principal trades, credit card as a credit card issued by a member
although the functional equivalent of securities bank that is widely accepted by merchants that
brokerage transactions, involve the purchase of are not affiliates of the bank (such as a Visa card
a security by the depository institution’s broker- or Mastercard) if less than 25 percent of the
dealer affiliate. Accordingly, the broker-dealer aggregate amount of purchases with the card are
retains the loan proceeds at least for some purchases from an affiliate of the bank. Exten-
moment in time. sions of credit to unaffiliated borrowers pursuant
There is negligible risk that loans a depository to special-purpose credit cards (that is, credit
institution makes to borrowers to engage in cards that may only be used or are substantially
riskless-principal trades through a broker-dealer used to buy goods from an affiliate of the
affiliate of the depository institution would be member bank) are subject to the rule.
used to fund the broker-dealer. For this reason, The credit card exemption includes several
the Board adopted an exemption from section alternatives. First, several different methods are
23A to cover riskless-principal securities trans- provided for a member bank to demonstrate that
actions engaged in by depository institution its credit card meets the 25 percent test. If a
borrowers through broker-dealer affiliates of the member bank has no commercial affiliates (other
depository institution. This exemption is appli- than those permitted for an FHC under section 4
cable even if the broker-dealer retains a portion of the BHC Act), the bank would be deemed to
of the loan proceeds as a market-rate markup for satisfy the 25 percent test if the bank has no
executing the riskless-principal securities trade. reason to believe that it would fail the test. (A
(See Regulation W at 12 CFR 223.16(c)(1).) member bank could use this method of comply-
ing with the 25 percent test even if, for example,
Exemption—Loan to a nonaffiliate pursuant to a the bank’s FHC controls, under section 4(a)(2),
preexisting line of credit and the proceeds are 4(c)(2), or 4(k)(4)(H) of the BHC Act, several

Page 8.20
companies engaged in nonfinancial activities.) credit card that were used to purchase products
Such a member bank would not be obligated to or services from an affiliate of the member bank
establish systems to verify strict, ongoing com- would become covered transactions at such
pliance with the 25 percent test. Most BHCs and time.
FHCs should meet this test. If a member bank
has commercial affiliates (beyond those permit-
ted for an FHC under section 4 of the BHC Act),
the bank would be deemed to satisfy the 25 per- SECTION 23B OF THE FEDERAL
cent test if— RESERVE ACT
• the bank establishes systems to verify compli- Regulation W, subpart F, sets forth the principal
ance with the 25 percent test on an ongoing restrictions of section 23B. These include (1) a
basis and periodically validates its compliance requirement that most transactions between a
with the test, or member bank and its affiliates be on terms and
• the bank presents information to the Board circumstances that are substantially the same as
demonstrating that its card would comply with those prevailing at the time for comparable
the 25 percent test. (One way that a member transactions with nonaffiliates; (2) a restriction
bank could demonstrate that its card would on a member bank’s purchase as fiduciary of
comply with the 25 percent test would be to assets from an affiliate unless certain criteria are
show that the total sales of the bank’s affiliates met; (3) a restriction on a member bank’s
are less than 25 percent of the total purchases purchase, during the existence of an underwrit-
by cardholders.) ing syndicate, of any security if a principal
underwriter of the security is an affiliate; and
Second, for those member banks that fall out (4) a prohibition on publishing an advertisement
of compliance with the 25 percent test, there is or entering into an agreement stating that a
a three-month grace period to return to compli- member bank will be responsible for the obli-
ance before extensions of credit under the card gations of its affiliates. For the most part, sub-
become covered transactions. Third, member part F restates the operative provisions of sec-
banks that are required to validate their ongoing tion 23B. The following transactions with
compliance with the 25 percent test have a fixed affiliates are subject to restrictions:
method, time frames, and examples for comput-
ing compliance. • any covered transaction with an affiliate
• the sale of securities or other assets to an
Example of calculating compliance with the affiliate, including assets subject to repurchase
25 percent test. A member bank seeks to qualify • the payment of money or the furnishing of
a credit card as a general-purpose credit card services to an affiliate under contract, lease, or
under section 223.16, paragraph (c)(4)(ii)(A), of otherwise
the rule. The member bank assesses its compli- • any transaction in which an affiliate acts as an
ance under paragraph (c)(4)(iii) of this section agent or broker or receives a fee for its
on the 15th day of every month (for the preced- services to the bank or to any other person
ing 12 calendar months). The credit card quali- • any transaction or series of transactions with a
fies as a general-purpose credit card for at least third party—
three consecutive months. On June 15, 2005, — if an affiliate has a financial interest in the
however, the member bank determines that, for third party or
the 12-calendar-month period from June 1, 2004, — if an affiliate is a participant in this trans-
through May 31, 2005, 27 percent of the total action or series of transactions
value of products and services purchased with
the card by all cardholders were purchases of Any transaction by a member bank or its sub-
products and services from an affiliate of the sidiary with any person is deemed to be a
member bank. Unless the credit card returns to transaction with an affiliate of the bank if any of
compliance with the 25 percent limit by the the proceeds of the transaction are used for the
12-calendar-month period ending August 31, benefit of, or are transferred to, the affiliate. A
2005, the card will cease to qualify as a general- member bank and its subsidiaries may engage in
purpose credit card as of September 1, 2005. the transactions covered by section 23B of the
Any outstanding extensions of credit under the FRA only on terms and under circumstances,

Page 8.21
including credit standards, that are substantially section 23B any transaction that is exempt under
the same, or at least as favorable to the bank or section 23A(d). 5f
its subsidiary, as those prevailing at the time for The rule also excludes from section 23B any
comparable transactions with, or that in good covered transaction that is exempt from section
faith would be offered to, nonaffiliate companies. 23A under section 223.42(i) or (j) (that is, asset
Section 23B also restricts the following trans- purchases by a newly formed member bank and
actions with affiliates: transactions approved under the Bank Merger
Act). The Board excluded from section 23B this
• A member bank or its subsidiary cannot additional set of transactions because, in each
purchase as fiduciary any securities or other case, the appropriate federal banking agency for
assets from any affiliate unless the purchase is the member bank involved in the transaction
permitted— should ensure that the terms of the transaction
— under the terms of the instrument creating are not unfavorable to the bank.
the fiduciary relationship,
— by court order, or
— by the law of the jurisdiction governing Purchases of Securities for Which an
the fiduciary relationship.
• A member bank or its subsidiary, whether
Affiliate Is the Principal Underwriter
acting as principal or fiduciary, cannot know- The GLB Act amended section 23B to permit a
ingly purchase or acquire, during the exist- member bank to purchase securities during an
ence of any underwriting or selling syndicate, underwriting conducted by an affiliate if the
any security if a principal underwriter of that following two conditions are met. First, a
security is an affiliate of the bank. This limi- majority of the directors of the member bank
tation applies unless the purchase or acquisi- (with no distinction drawn between inside and
tion of the security has been approved before outside directors) must approve the securities
it is initially offered for sale to the public by a purchase before the securities are initially offered
majority of the directors of the bank. The to the public. Second, such approval must be
purchase should be based on a determination based on a determination that the purchase
that it is a sound investment for the bank would be a sound investment for the member
irrespective of the fact that an affiliate of the bank regardless of the fact that an affiliate of the
bank is a principal underwriter of the securities. bank is a principal underwriter of the securities. 5g
Section 223.53(b) includes this standard and
clarifies that if a member bank proposes to make
Transactions Exempt from such a securities purchase in a fiduciary capac-
Section 23B ity, then the directors of the bank must base their
approval on a determination that the purchase is
The market-terms requirement of section 23B a sound investment for the person on whose
applies to, among other transactions, any ‘‘cov- behalf the bank is acting as fiduciary.
ered transaction’’ between a member bank and A member bank may satisfy this director-
an affiliate. 5d Section 23B(d)(3) makes clear approval requirement by obtaining specific prior
that the term ‘‘covered transaction’’ in section director approval of each securities acquisition
23B has the same meaning as the term ‘‘covered otherwise prohibited by section 23B(b)(1)(B).
transaction’’ in section 23A, but does not include The rule clarifies, however, that a member bank
any transaction that is exempt under section also satisfies this director-approval requirement
23A(d)—for example, transactions between sis- if a majority of the directors of the bank approves
ter banks, transactions fully secured by a deposit appropriate standards for the bank’s acquisition
account or U.S. government obligations, and of securities otherwise prohibited by section
purchases of assets from an affiliate at a readily 23B(b)(1)(B) and each such acquisition meets
identifiable and publicly available market the standards adopted by the directors. In addi-
quotation. 5e Consistent with the statute, Regu- tion, a majority of the member bank’s directors
lation W’s section 223.52(a)(1) exempts from
5f. Regulation W will again be subsequently referred to as
the ‘‘rule’’ or by its specified section-numbered discussion of
5d. 12 USC 371c-1(a)(2)(A). section 23B provisions.
5e. 12 USC 371c-1(d)(3). 5g. GLB Act, section 738 (12 USC 371c-1(b)(2)).

Page 8.22
must periodically review such acquisitions to way be responsible for the obligations of its
ensure that they meet the standards and must affiliates unless the transaction satisfies the quan-
periodically review the standards to ensure they titative and collateral restrictions of section
meet the ‘‘sound investment’’ criterion of sec- 23A. 5k The rule clarifies that section 23B(c)
tion 23B(b)(2). The appropriate period of time does not prohibit a member bank from making
between reviews would vary depending on the reference to such a guarantee, acceptance, or
scope and nature of the member bank’s pro- letter of credit in a prospectus or other disclo-
gram, but such reviews should be conducted by sure document, for example, if otherwise required
the directors at least annually. Before the pas- by law.
sage of the GLB Act, Board staff informally
allowed member banks, based on the legislative
history of section 23B, to meet the director- OPERATIONS SUBSIDIARIES
approval requirement in this fashion, and there
is no indication that Congress in the GLB Act The Board has authorized member banks to
intended to alter the procedures that a member establish and own operations subsidiaries.
bank could use to obtain the requisite director ‘‘Operations subsidiaries’’ are organizations that
approval. 5h The rule codifies staff’s preexisting are, in effect, designed to serve as separately
approach to the director-approval requirement. 5i incorporated departments of a bank.
Definition of Affiliate Under Member Bank Purchases of Stock of

Section 23B Operations Subsidiaries
Section 23B states that the term ‘‘affiliate’’ The Board concluded in 1968 that ‘‘. . . a mem-
under section 23B has the meaning given to ber bank may purchase for its own account
such term in section 23A except that the term shares of a corporation to perform, at locations
‘‘affiliate’’ under section 23B does not include a at which the bank is authorized to engage in
‘‘bank,’’ as defined in section 23A. 5j In the case business, functions that the bank is empowered
of the sister-bank exemption, the rule’s section to perform directly’’ (12 CFR 250.141(i)). The
223.2(c) clarifies that the only companies that Board reasoned that this authority could reason-
qualify for the ‘‘bank’’ exception to section ably be interpreted as within a bank’s incidental
23B’s definition of affiliate are insured deposi- powers to ‘‘organize its operations in the man-
tory institutions. ner that it believes best facilitates the perfor-
mance thereof,’’ and that the subsidiary essen-
tially constitutes a separately incorporated
Advertising Restriction
division or department of the bank.
In section 23B(c), the ‘‘advertising restriction’’ No specific rule requires a state member bank
prohibits a member bank from publishing any to give the Board prior notice of, or to acquire
advertisement or entering into any agreement the Board’s approval for, the acquisition of an
stating or suggesting that the bank shall in any operations subsidiary to engage in activities that
the bank itself may lawfully perform. However,
section 208.3(d)(2) of Regulation H (12 CFR
5h. The conference report accompanying the Competitive 208.3(d)(2)) prohibits a state member bank from
Equality Banking Act of 1987 stated that the prior-approval causing or permitting a change in the general
requirement of section 23B(b) could be met ‘‘by the estab-
lishment in advance of specific standards by the outside
character of its business or in the scope of its
directors for such acquisitions. If the outside directors estab- corporate powers approved at the time of admis-
lish such standards, they must regularly review acquisitions to sion to membership, except with the permission
assure that the standards have been followed, and they must of the Board.
periodically review the standards to assure that they continue
to be appropriate in light of market and other conditions.’’ See
H.R. Conf. Rep. No. 100-261 at 133 (1987).
5i. The rule also provides, consistent with existing Board Transactions Between a Member State
interpretations, that a U.S. branch, agency, or commercial Bank and Its Operations Subsidiary
lending company of a foreign bank may comply with this
requirement by obtaining the required approvals and reviews
from either a majority of the directors or a majority of the The Board noted in 1970 that ‘‘[S]ince an
senior executive officers of the foreign bank.
5j. 12 USC 371c-1(d)(1). 5k. 12 USC 371c-1(c).

Page 8.23
operations subsidiary is in effect a part of, and

subject to the same restrictions as, its parent
bank, there is no reason to limit transactions
between the bank and such subsidiary any more
than transactions between departments of a
bank.’’ The Board concluded that ‘‘a credit
transaction by a member State bank with its
operations subsidiary . . . is not a ‘loan or . . .
extension of credit’ of the kind intended to be
restricted and regulated by section 23A and is,
therefore, outside the purview of that section’’
(12 CFR 223.2(b)(1)–(2)).
Operations Subsidiary Not Wholly

Owned
The previously mentioned 1968 interpretation
only expressly authorized state member banks to
establish wholly owned operations subsidiaries,

Page 8.24
in that a wholly owned subsidiary of a bank is terms of federal law (other than by section 9 of
functionally indistinguishable from a division or the FRA), such as an Edge Act subsidiary held
department of the bank. In enacting the GLB under section 25 of the FRA, or (2) a subsidiary
Act, Congress recognized the authority of na- that engages only in activities that the parent
tional and state member banks to own and bank could conduct directly and that are con-
control an operations subsidiary. The GLB Act ducted on the same terms and conditions that
recognized traditional operations subsidiaries by govern the conduct of the activity by the state
distinguishing them from financial subsidiaries. member bank. A financial subsidiary is autho-
A financial subsidiary is defined so as not to rized for national banks by section 5136A of the
include a company engaged solely in activities Revised Statutes (12 USC 24a) and for state
that a parent bank may perform, subject to the banks by section 46 of the Federal Deposit
limitations that govern the conduct of these Insurance Act (FDI Act) (12 USC 1831w). To
activities. implement the authorization for state member
The GLB Act also does not appear to require banks, a new subpart G was added to Regulation
that a state member bank own 100 percent of an H (12 CFR 208.71 et seq.).
operations subsidiary or a financial subsidiary.
The GLB Act defines the term ‘‘subsidiary’’ by
reference to the BHC Act. Under the BHC Act, Investing in or Controlling a Financial
a company is a ‘‘subsidiary’’ of a bank holding
company if the BHC (1) owns or controls
Subsidiary
25 percent or more of the company’s voting Under the GLB Act, a state member bank may
shares, or (2) controls the election of a majority control, or hold an interest in, a financial sub-
of the company’s directors.6 sidiary only if—
The Board thus believes that, as a result of the
GLB Act and consistent with section 5136 of the • the state member bank and each of its deposi-
Revised Statutes (12 USC 24 (seventh)) and the tory institution affiliates is well capitalized
Board’s 1968 interpretation, a state member and well managed;7
bank may acquire shares of a company that is • the aggregate consolidated total assets of all
not wholly owned and that (1) on consummation the bank’s financial subsidiaries do not exceed
of the acquisition would be a subsidiary of the the lesser of 45 percent of the consolidated
bank within the meaning of the BHC Act, and total assets of the bank or $50 billion;8
(2) engages only in activities in which the parent • the state member bank is one of the 100
bank may engage, at locations at which the bank largest insured banks and meets the following
may engage in the activities, subject to the same debt-rating or alternative debt-rating
limitations as if the bank were engaging in the requirements:
activities directly. — for the 50 largest insured banks, the bank
must have at least one issue of outstanding
eligible debt that is currently rated in one
FINANCIAL SUBSIDIARIES of the three highest investment-grade rat-
ing categories by a nationally recognized
Qualifying state member banks may control or statistical rating organization;9
hold an interest in a ‘‘financial subsidiary.’’ A
financial subsidiary is any company that is
7. An institution is ‘‘well capitalized’’ if it meets or
controlled by one or more insured depository exceeds the capital levels designated by the institution’s
institutions and engages in activities that are appropriate federal banking agency (section 38 of the FDI Act
financial in nature or incidental to a financial (12 USC 1831o)). A depository institution will be deemed
activity. A financial subsidiary does not include ‘‘well managed’’ by references to specific examination rat-
ings, or if its federal banking agency determines that the
(1) a subsidiary that the state member bank is managerial resources are satisfactory, or if it has not been
specifically authorized to hold by the express examined.
8. This dollar amount will be adjusted based on an index-
ing mechanism that is established jointly by the Federal
6. See 12 USC 1841(d). A company also is considered a Reserve Board and the Secretary of the Treasury.
subsidiary of a bank holding company if the Board deter- 9. ‘‘Eligible debt’’ refers to unsecured debt that has an
mines, after notice and opportunity for a hearing, that the bank initial maturity of more than 360 days. The debt must be
holding company directly or indirectly exercises a controlling issued and outstanding, may not be supported by any form of
influence over the managment or policies of the company. credit enhancement, and may not be held in whole or any

Page 9
— for the second 50 largest insured banks, of debt, nor does it reflect payment priority
the bank must meet the issuer-credit-rating or payment preferences among financial
requirement for the 50 largest insured obligations.
banks or the bank must meet the alterna- For this rule, the issuer credit rating must be
tive criteria established jointly by regula- assigned to the national or state member bank
tion by the Secretary of the Treasury and that controls or holds an interest in a financial
the Federal Reserve10 subsidiary. Issuer credit ratings that are assigned
(the debt-rating and alternative criteria are not to a subsidiary or affiliate of the parent bank,
applicable if the bank’s financial subsidiaries such as a subsidiary engaged in derivatives
engage in any newly authorized financial activities, do not meet the rule’s requirements.
activities solely as agent and not as principal); Rating organizations may issue long-term or
and short-term issuer credit ratings for the same
• the state member bank obtains the Federal bank and separate ratings for dollar-denominated
Reserve’s approval to engage in the activities and foreign-currency-denominated obligations.
of the financial subsidiary (using the notice Only long-term issuer ratings for dollar-
procedures in section 208.76 of Regulation denominated obligations satisfy the require-
H). The state member bank also must obtain ments of the rule. A ‘‘long-term credit rating’’
any necessary approvals from its state super- means a written opinion that is issued by a
visory authority. nationally recognized statistical rating organiza-
tion regarding the bank’s overall capacity and
willingness to pay on a timely basis its unse-
Issuer-Credit-Rating Requirement cured, dollar-denominated financial obligations
maturing in no less than one year.
The issuer-credit-rating requirement of the rule The Secretary of the Treasury and the Federal
(12 CFR 208.71) requires a long-term issuer Reserve have determined that certain types of
credit rating from a nationally recognized statis- ratings assigned by the rating agencies indicated
tical rating organization that is within the three in table 1 currently meet the requirements of the
highest investment-grade rating categories used rule, provided that the ratings assess the parent
by the organization. An ‘‘issuer credit rating’’ is bank’s ability and willingness to meet its finan-
one that assesses the bank’s overall capacity and cial obligations denominated in U.S. dollars.
willingness to pay, on a timely basis, its unse- Standard and Poor’s may modify its AA or A
cured financial obligations. An issuer credit ratings to include a plus (+) or minus (-) sign to
rating differs from a debt rating in that it does show relative standing within these rating cate-
not assess the bank’s ability or willingness to gories. Any rating from A minus to AAA would
make payments on any individual class or issue satisfy the long-term issuer-credit-rating require-
ment; an A minus would constitute the lowest
acceptable rating in the case of Standard &
significant part by affiliates or insiders of the bank or by any Poor’s and Fitch. Moody’s top three investment-
other person acting on behalf of or with funds from the bank grade categories for long-term issuer credit rat-
or an affiliate.
10. The size of an insured bank is determined based on the
ings are Aaa, Aa, or A, with Aaa denoting the
consolidated total assets of the bank as of the end of each highest rating. Moody’s applies numerical modi-
calendar year. fiers of 1, 2, and 3 in the Aa and A rating
Table 1—Acceptable Rating Organizations and Ratings

Rating Organization Type of Rating Rating
Standard & Poor’s Issuer credit rating (including AAA, AA, or A

a counterparty credit rating)
Moody’s Issuer credit rating Aaa, Aa, or A
Fitch International credit rating AAA, AA, or A

Page 10
categories, with 3 denoting the lowest end of the its risk-based, leverage, and tangible capital
letter-rating modifiers. Any rating from A-3 to ratios.
Aaa would satisfy the long-term issuer-credit-
rating requirement; a rating of A-3 would be the The bank must meet all capital requirements—
lowest acceptable rating in the case of Moody’s. including the ‘‘well-capitalized’’ requirement
(Regulation H, section 208.71) and the capital
levels established by the Board under section 38
of the FDI Act—after the adjustments described
Prudential Standards above.
The member bank must also establish and
A state member bank that owns a financial maintain policies and procedures to manage the
subsidiary must comply with certain prudential financial and operational risks associated with
safeguards. These standards pertain to the bank’s its ownership of a financial subsidiary. These
capital requirements and its establishment of procedures must identify and manage financial
policies and procedures arising from financial and operational risks with the bank and its
subsidiary ownership. financial subsidiaries. They must adequately
As for the capital requirements, the state protect the bank from such risks and preserve
member bank must ‘‘deconsolidate’’ the assets the bank’s separate corporate identity and the
and liabilities of all of its financial subsidiaries limited liability of the bank and its financial
from those of the bank. Although the GLB Act subsidiaries. In addition, a financial subsidiary
requires a bank to deconsolidate the assets and of a state member bank is considered a non-
liabilities of any financial subsidiary for regula- subsidiary affiliate of the bank for purposes of
tory capital purposes, a financial subsidiary sections 23A and 23B of the FRA and a subsid-
remains a subsidiary of a state member bank. iary of the BHC (and not a subsidiary of a bank)
The Board will continue to review the opera- for the purposes of the anti-tying prohibitions of
tions and financial and managerial resources of the Bank Holding Company Act Amendments
the bank on a consolidated basis as part of the of 1970.
supervisory process. The Board may take appro-
priate supervisory action if it believes that the
bank does not have the appropriate financial and
managerial resources (including capital resources Permissible Activities for a Financial
and risk-management controls) to conduct its Subsidiary
direct or indirect activities in a safe and sound
manner. A financial subsidiary can engage in three types
In addition to the deconsolidation described of permissible activities:
above, the bank must also deduct a specified
percentage of the aggregate amount of the equity 1. Those activities that are determined to be
investment (including retained earnings) (‘‘the financial in nature or incidental to financial
aggregate amount’’) in all financial subsidiaries activities under section 4(k)(4) of the BHC
from the bank’s capital and assets. Therefore, Act. These permissible activities include—
the bank must deduct—
• general insurance agency activities in any
• 50 percent of the aggregate amount from both location and travel agency activities;
the bank’s tier 1 capital and its tier 2 capital • underwriting, dealing in, and making a
for purposes of determining its risk-based market in all types of securities; and
capital ratios; • any activity that the Federal Reserve deter-
• 50 percent of the aggregate amount from the mined by regulation or order to be closely
bank’s tier 1 capital for purposes of determin- related to banking or managing or control-
ing its leverage ratios; and ling banks so as to be a proper incident
• 100 percent of the aggregate amount from its thereto and that was in effect on the effec-
tangible equity for purposes of determining its tive date of the GLB Act. (See section
tangible equity capital ratio. It must also 225.86 of the Board’s Regulation Y (12
deduct 100 percent of the aggregate amount CFR 225.86).)
from the bank’s risk-weighted assets, average 2. Activities that the Secretary of the Treasury,
total assets, and total assets when determining in consultation with the Board, determines to

Page 11
be financial in nature or incidental to finan- the notice must describe the company’s insur-
cial activities and permissible for financial ance activities and identify the states where the
subsidiaries of national banks pursuant to company holds an insurance license. A notice
section 5136A(b) of the Revised Statutes of will be considered approved on the fifteenth day
the United States (12 USC 24a(b)). after receipt of a complete notice by the appro-
3. Activities that the state member bank is priate Reserve Bank, unless before that date, the
permitted to engage in directly, subject to the notice is approved or disapproved or the bank is
same terms and conditions that govern the notified that additional time is needed to review
conduct of the activity by the state member the submitted notice.
bank (12 USC 24a(a)(2)(A)(ii)). The GLB Act permits a state member bank to
acquire an interest in or control a financial
subsidiary if the bank meets the criteria and
Impermissible Activities for a requirements set forth in the rule. The Board,
however, retains its general supervisory author-
Financial Subsidiary ity for state member banks and may restrict or
limit the activities of, or the acquisition or
A financial subsidiary may not engage as prin-
ownership of a subsidiary by, a state member
cipal in insurance underwriting (except to the
bank if the Board finds that the bank does not
extent permitted for national banks by the Comp-
have the appropriate financial and managerial
troller of the Currency as of January 1, 1999,
resources to conduct the activities or to acquire
and not subsequently overturned in certain grand-
or retain ownership of the company.
fathered titile insurance activities), providing or
issuing annuities, real estate investment or
development (except as expressly authorized by
law), and merchant banking and insurance com- AGRICULTURAL CREDIT
pany investment activities. CORPORATIONS
The increasing number of agricultural credit
Federal Reserve Approval corporations and their effect on parent banks
have intensified the need for their supervision.
Requirements Most agricultural credit corporations come under
the direct supervision of the district Federal
Federal Reserve approval of a financial subsid-
Intermediate Credit Bank (FICB) where the
iary involves a streamlined notice procedure. A
corporations discount most of their loans. How-
state member bank must file a notice with the
ever, a corporation may obtain funds exclusively
appropriate Reserve Bank before acquiring con-
in the open market and avoid FICB regulation.
trol of, or an interest in, a financial subsidiary, or
before engaging in an additional financial activ-
ity through an existing financial subsidiary. No
notice is required for a financial subsidiary to EDGE ACT AND AGREEMENT
engage in an additional activity that the parent CORPORATIONS
state member bank could conduct directly. The
notice must include basic information on the U.S.-based corporations and permissible activi-
financial subsidiary and its existing and pro- ties for their Edge Act and agreement corpora-
posed activities. In the case of an acquisition, tion subsidiaries are described in detail in the
the notice should include a description of the Board’s Regulation K (12 CFR 211). Edge Act
transaction through which the bank proposes to and agreement corporations provide banks with
acquire control of or an interest in the financial a vehicle for engaging in international banking
subsidiary. The notice also must contain a cer- or foreign financial operations. They also have
tification that the state member bank and its the power, with supervisory consent, to purchase
depository institution affiliates meet the capital, and hold the stock of foreign banks and other
management, and credit-rating requirements to international financial concerns. Edge Act and
own a financial subsidiary, as stated in the GLB agreement corporations are examined by the
Act and subpart G of Regulation H. If the notice Federal Reserve, and their respective reports of
is for the state member bank’s initial affiliation examination should be reviewed during each
with a company engaged in insurance activities, examination of a parent member bank. The

Page 12
Federal Reserve examination report and the ongoing compliance, (2) independent testing of
amount and quality of paper held by these compliance by the institution’s personnel or by
corporations must provide the basis for evaluat- an outside party, (3) the designation of an
ing the bank’s investment in them. individual or individuals responsible for coordi-
Transactions between the parent bank and the nating and monitoring day-to-day compleance,
bank’s Edge Act and agreement corporation and (4) training for appropriate personnel. (See
subsidiaries are not subject to the limitations in SR-06-7.)
section 23A. However, they are subject to limi-
tation under section 25 of the FRA (12 USC
601) and under the Board’s Regulation K. In
addition, transactions with such bank subsidi- FOREIGN BANKS
aries and the parent bank’s affiliates are aggre-
gated with transactions by the bank and its A foreign bank is an organization that is—
affiliates for purposes of section 23A limitations
and restrictions. Transactions between a bank • organized under the laws of a foreign country
and Edge Act and agreement corporation sub- and
sidiaries of the bank’s holding company are also • engages directly in the business of banking
subject to section 23A. outside the United States.
FOREIGN BANKING FOREIGN BANK OFFICES

ORGANIZATIONS
A foreign bank office consists of any branch,
Under section 211.21(o) of Regulation K (12 agency, representative office, or commercial
CFR 211.21(o)), the term a foreign banking lending company subsidiary of a foreign bank in
organization means— the United States.
• a foreign bank, as defined in section 1(b)(7) of

the International Banking Act (12 USC Branches of a Foreign Bank
3101(7)) that—
— operates a branch, agency, or commercial A branch of a foreign bank means any place of
lending company subsidiary in the United business of a foreign bank, located in any state,
States; at which deposits are received, and that is not an
— controls a bank in the United States; or agency.
— controls an Edge corporation acquired
after March 5, 1987; and
• any company of which the foreign bank is a
subsidiary. Agencies
On March 15, 2006, the Board approved a An agency of a foreign bank means any place of
revision to its Regulation K (effective April 19, business of a foreign bank, located in any state,
2006), incorporating the provisions of section at which credit balances are maintained, checks
208.63 of Regulation H by reference into sec- are paid, money is lent, or, to the extent not
tions 211.5 and 211.24 of Regulation K. Edge prohibited by state or federal law, deposits are
and agreement corporations and other foreign accepted from a person or entity that is not a
banking organizations (that is, U.S. branches, citizen or resident of the United States. Obliga-
agencies, and representative offices of foreign tions are not to be considered credit balances
banks that are supervised by the Federal Reserve) unless they are—
must establish and maintain procedures reason-
ably designed to ensure and monitor compliance • incidental to, or arise out of the exercise of,
with the Bank Secrecy Act and related regula- other lawful banking powers;
tions. Each of these banking organizations’ • to serve a specific purpose;
compliance programs must include, at a mini- • not solicited from the general public;
mum, (1) a system of internal controls to ensure • not used to pay routine operating expenses in

Page 13
the United States such as salaries, rent, or • the foreign bank also operates one or more
taxes; branches or agencies in the United States,
• withdrawn within a reasonable period of time • the loans approved at the representative office
after the specific purpose for which they were are made by a U.S. office of the bank, and
placed has been accomplished; and • the loan proceeds are not disbursed in the
• drawn upon in a manner reasonable in relation representative office.
to the size and nature of the account.
(See section 211.24(d)(1)(ii) of Regulation K
(12 CFR 211.24(d)(1)(ii)).)
Commercial Lending Company
A commercial lending company means any CORRESPONDENT BANKS
organization, other than a bank or an organiza-
tion operating under section 25 of the Federal A correspondent bank provides certain services
Reserve Act (FRA) (12 USC 601–604a), orga- to banks located in other countries that do not
nized under the laws of any state, that maintains have local offices or whose local office is pro-
credit balances permissible for an agency and hibited from engaging in certain activities. Such
engages in the business of making commercial a relationship allows a foreign bank to provide
loans. A commercial lending company includes trade-related and foreign-exchange services for
any company chartered under article XII of the its multinational customers in a foreign market
banking law of the state of New York. (See without having to establish a physical presence
Regulation K, section 211.21(g) (12 CFR in that market.
211.21(g)).)
PARALLEL-OWNED BANKING
Representative Office ORGANIZATIONS
A representative office means any office of a A parallel-owned banking organization is cre-

foreign bank that is located in any state and is ated when at least one U.S. depository institution
not a federal branch, federal agency, state branch, and a foreign bank 10a are controlled, either
state agency, or commercial lending company directly or indirectly, by the same person or
subsidiary. (See section 211.21(x) of Regulation group of persons 10b who are closely associated
K (12 CFR 211.21(x)).) A representative office in their business dealings or otherwise acting in
is usually established when a bank’s board of concert. Parallel-owned banking organizations
directors and management desire to establish a do not include structures in which one deposi-
physical presence in a foreign market and very tory institution is a subsidiary of the other or in
limited functions are to be (or can be made) which the organization is controlled by a com-
available. A representative office cannot provide pany subject to the BHC Act or the Savings and
traditional banking services, such as accepting Loan Holding Company Act. 10c The banking
deposits or making loans directly. The office agencies consider whether ‘‘control’’ of a deposi-
basically serves as a liaison and marketing tory institution exists when a person or group of
function for the parent bank. persons controls 10 percent or more of any class
A U.S. subsidiary of a foreign bank may be
10a. References to ‘‘foreign bank’’ or ‘‘foreign parallel
considered to be a representative office of the bank’’ also include a holding company of the foreign bank and
foreign bank when it holds itself out to the any U.S. or foreign affiliates of the foreign bank. References to
public as a representative of the foreign bank ‘‘U.S. depository institution’’ do not include a U.S. depository
that is acting on behalf of the foreign bank, even institution that is controlled by a foreign bank.
10b. The term ‘‘persons’’ includes both business entities
if the subsidiary engages in other nonbank and natural persons, which may or may not be U.S. citizens.
business. In addition, an individual or a unit of a 10c. A bank holding company or savings and loan holding
subsidiary that acts as a representative of a company, however, may be a component of a parallel-owned
foreign bank from the location of the nonbank banking organization. This situation may arise when a bank
holding company or savings and loan holding company
subsidiary may be treated as a representative controls the U.S. depository institution, and the holding
office. A representative office may make credit company, in turn, is controlled by a person or group of persons
decisions only if— who also controls a foreign bank.

Page 14
of the depository institution’s voting shares. consolidated supervision. Therefore, relation-

Parallel-owned banking organizations are estab- ships between the U.S. depository institution and
lished and maintained for a variety of reasons, other affiliates may be harder to understand and
including tax and estate planning and the poten- monitor. To reduce these risks, the U.S. banking
tial risks associated with nationalization. While agencies (1) work with appropriate non-U.S.
these reasons may be legitimate and not prohib- supervisors to better understand and monitor the
ited by U.S. or foreign law, the structure of such activities of the foreign affiliates and owners;
organizations creates or increases certain risks (2) share information, as appropriate, with for-
and may make it more difficult for supervisors to eign and domestic bank supervisory agencies;
monitor and address those risks. On April 23, and (3) impose special conditions or obtain
2002, the U.S. banking agencies (the Federal special commitments or representations related
Reserve System, the Office of the Comptroller to an application or an enforcement or other
of the Currency, the Federal Deposit Insurance supervisory action, when warranted.
Corporation, and the Office of Thrift Supervi- Parallel-owned banking organizations may
sion) issued a joint agency statement that foster additional management and supervisory
addresses the potential risks associated with risks:
parallel-owned banking organizations. The exist-
ence of one or more of the following factors • Officers and directors of the U.S. depository
may, depending on the circumstances, warrant institution may be unable or unwilling to
additional inquiry: exercise independent control to ensure that
transactions with the foreign parallel bank or
• An individual or group of individuals acting in affiliates are legitimate and comply with appli-
concert that controls a foreign bank also cable laws and regulations. As a result, the
controls any class of voting shares of a U.S. U.S. depository institution may be the conduit
depository institution, or financing for persons or participant in a transaction that violates
owning or controlling the shares is received U.S. law or the laws of a foreign country, or
from, or arranged by, the foreign bank, espe- that is designed to prefer a foreign bank or
cially if the shares of the U.S. depository nonbank entity in the group, to the detriment
institution are collateral for the stock-purchase of the U.S. depository institution.
loan. • Money-laundering concerns may be height-
• The U.S. depository institution has adopted ened due to the potential lack of arm’s-length
particular or unique policies or strategies simi- transactions between the U.S. depository insti-
lar to those of the foreign bank, such as tution and the foreign parallel bank. Specifi-
common or joint marketing strategies, sharing cally, the flow of funds through wires, pouch
of customer information, cross-selling of prod- activity, and correspondent accounts may
ucts, or linked web sites. be subject to less internal scrutiny by the
• An officer or director of the U.S. depository U.S. depository institution than usually is
institution either (1) serves as an officer or warranted. 10e This risk is greatly increased
director 10d of a foreign bank or (2) controls a
foreign bank or is a member of a group of 10e. On October 28, 2002, the U.S. Department of the
individuals acting in concert or with common Treasury’s regulation to implement sections 313 and 319(b) of
the USA Patriot Act became effective. (See 31 CFR 103.177
ties that controls a foreign bank. and 103.185.) The regulation implemented new provisions of
• The name of the U.S. depository institution is the Bank Secrecy Act that relate to foreign correspondent
similar to that of the foreign bank. accounts. A covered financial institution (CFI) (a financial
institution that is covered by the regulation) is prohibited from
Parallel-owned banking organizations present establishing, maintaining, administering, or managing a cor-
supervisory risks similar to those arising from respondent account in the United States for, or on behalf of, a
foreign shell bank (a foreign bank that has no physical
chain banking organizations in the United States. presence in any country) that is not affiliated with a U.S.-
The fundamental risk presented by these orga- domiciled financial institution or with a foreign bank that
nizations is that they may be acting in a de facto maintains a physical presence in the United States or a foreign
organizational structure that, because it is not country and that is supervised by its home-country banking
authority. A CFI must take reasonable steps to ensure that a
formalized, is not subject to comprehensive correspondent account of a foreign bank (an account estab-
lished by a CFI for a foreign bank to receive deposits from, to
10d. The sharing of a director, by itself, is unlikely to make payments or other disbursements on behalf of a foreign
indicate common control of the U.S. and foreign depository bank, or to handle other financial transactions related to the
institutions. foreign bank) is not being used to indirectly provide banking

Page 14.1
when the foreign parallel bank is located in an foreign country may affect the U.S. depository
offshore jurisdiction or other jurisdiction that institution. Events in the foreign country, such
limits exchange of information through bank as the intervention and assumption of control
secrecy laws, especially if the jurisdiction has of the foreign parallel bank by its supervisor,
been designated as a ‘‘non-cooperating coun- may trigger a rapid inflow or outflow of
try or territory’’ or the jurisdiction or the deposits at the U.S. depository institution,
foreign bank has been found to be of primary thereby affecting liquidity. Foreign events may
money-laundering concern under the Interna- increase reputational risk to the U.S. deposi-
tional Money Laundering Abatement and tory institution. In addition, these events may
Financial Anti-Terrorism Act of 2001. adversely affect the foreign bank owner’s
• Securities, custodial, and trust transactions financial resources and decrease the ability of
may be preferential to the extent that assets, the foreign bank owner to provide financial
earnings, and losses are artificially allocated support to the U.S. depository institution.
among parallel banks. Similarly, low-quality Foreign law may change without the U.S.
assets and problem loans can be shifted among depository institution or the banking agencies
parallel banks to manipulate earnings or losses becoming aware of the effect of legal changes
and avoid regulatory scrutiny. Also, if the on the parallel-owned banking organization,
foreign parallel bank were to begin experienc- including the U.S. depository institution.
ing financial difficulties, the foreign bank or • Parallel-owned banking organizations may
the common owners might pressure the U.S. seek to avoid legal lending limits or limita-
depository institution to provide credit support tions imposed by securities or commodities
or liquidity to an affiliate in excess of the legal exchanges or clearinghouses on transactions
limits of 12 USC 371c and 371c-1. by one counterparty, thereby unduly increas-
• The home country of the foreign parallel bank ing credit risk and other risks to the banking
may have insufficient mechanisms or author- organizations and others.
ity to monitor changes in ownership or to
ensure arm’s-length intercompany transac- To minimize risks, the U.S. banking agencies
tions between the foreign parallel bank and coordinate the supervision of a parallel-owned
other members of the group, including the banking organization’s U.S. operations. The
U.S. depository institution, or to monitor con- supervisory approach may include unannounced
centrations of loans or transactions with third coordinated examinations if more than one regu-
parties that may present safety-and-soundness lator has examination authority. Such examina-
concerns to the group. tions may be conducted if regulators suspect
• Capital may be generated artificially through irregular transactions between parallel-owned
the use of international stock-purchase loans. banks, such as the shifting of problem assets
Such loans can be funded by the U.S. deposi- between the depository institutions. Factors to
tory institution to the foreign affiliate or to a consider in determining whether to conduct
nonaffiliate with the purpose of supporting a coordinated reviews of an organization’s U.S.
loan back to the foreign affiliate and used to operations include intercompany and related
leverage the U.S. depository institution or vice transactions; strategy and management of the
versa. This concern is heightened for parallel- parallel-owned banking organization; political,
owned banking organizations if the foreign legal, or economic events in the foreign country;
bank is not adequately supervised. and compliance with commitments or represen-
• Political, legal, or economic events in the tations made or conditions imposed in the appli-
cation process or pursuant to prior supervisory
services to foreign shell banks. The regulation includes action.
recordkeeping requirements and required account-termination The U.S. depository institution’s board of
procedures that are to be used by CFIs having correspondent directors and senior management are expected
accounts of foreign banks. See SR-03-17, which discusses the
additional requirements of the regulation and provides addi-
to be cognizant of the risks associated with
tional Bank Secrecy Act examination procedures that are being part of a parallel-owned banking struc-
designed to focus on particular areas of risk. See also ture, especially with respect to diversion of a
SR-04-13, SR-05-9, and SR-01-29 (section 326 of the Patriot depository institution’s resources, conflicts of
Act) for a discussion of the Patriot Act requirements for a
financial institution’s customer identification program. A cus-
interest, and affiliate transactions. The deposi-
tomer identification program should part of an institution’s tory institution’s internal policies and proce-
overall anti-money-laundering and BSA compliance program. dures should provide guidance on how person-

Page 14.2
nel should treat affiliates. The Federal Reserve section 211.13 and reports submitted to foreign
and other U.S. banking agencies will expect to banking authorities must serve as the basis for
have access to such policies, as well as to the evaluating the bank’s investment.
results of any audits of compliance with the Additionally, Regulation K allows for invest-
policies. The agencies will seek an overview of ments in foreign companies to be made under
the entire organization, as well as a better the general-consent provisions without prior
understanding of how foreign bank affiliates are approval of the Board. These investments can be
supervised. Authorized bank regulatory supervi- sizable and can pose significant risk to the
sory staff will work with foreign supervisors to banking organization. Investments in foreign
better understand the activities of the foreign subsidiaries should be reviewed for compliance
affiliates and owners. As appropriate and fea- with the FRA and investment limitations in
sible, and in accordance with applicable law, Regulation K. (See Regulation K, sections 211.8
such authorized staff will share information and 211.9.)
regarding material developments with foreign
and domestic supervisory agencies that have
supervisory responsibility over relevant parts of
the parallel-owned banking organization. SIGNIFICANT SUBSIDIARIES
As used in the consolidation instructions for
certain regulatory reports, ‘‘significant subsidi-
aries’’ refers to subsidiaries that meet any one of
DOMESTIC AND FOREIGN the following tests:
SUBSIDIARIES
• a majority-owned subsidiary in which the
Domestic subsidiaries are any majority-owned bank’s direct and indirect investment and
companies, other than Edge Act or agreement advances represent 5 percent or more of the
corporations, domiciled in the United States and parent bank’s equity capital accounts
its territories and possessions. Foreign subsidi- • a majority-owned subsidiary whose gross
aries are any majority-owned or -controlled operating revenues amount to 5 percent or
companies domiciled in a foreign country or any more of the parent bank’s gross operating
Edge Act or agreement corporation. Section revenues
211.13 of Regulation K (12 CFR 211.13) • a majority-owned subsidiary whose ‘‘income
requires foreign subsidiaries to maintain effec- (loss) before income taxes and securities gains
tive systems of records, controls, and reports to or losses’’ amounts to 5 percent or more of the
keep bank management informed of their activi- parent bank’s ‘‘income (loss) before income
ties and conditions. In particular, these systems taxes and securities gains or losses’’
are to provide information on risk assets, expo-
• a majority-owned subsidiary that is the parent
sure to market risk, liquidity management,
of one or more subsidiaries that, when con-
operations, internal controls, and conformance
solidated, constitute a ‘‘significant sub-
with management policies. Reports on risk assets
sidiary’’ as defined above
must be sufficient enough to allow for an
appraisal of credit quality and an assessment of
exposure to loss; for that purpose, they must
provide full information on the condition of ASSOCIATED COMPANIES
material borrowers. Reports on the operations
and controls are to include internal and external Associated companies are those in which the
audits of the branch or subsidiary. bank directly or indirectly owns 20 percent to 50
On-site examinations of foreign subsidiaries percent of the outstanding common stock, unless
are sometimes precluded because of objections the bank can rebut to the Federal Reserve the
voiced by foreign directors, minority share- presumption of exercising significant influence.
holders, or local bank supervisors. In addition, However, as noted above, for purposes of sec-
secrecy laws in countries such as Switzerland, tion 23A, affiliation is defined by 25 percent
Singapore, Luxembourg, and the Bahamas some- share ownership. Because of the absence of
times preclude on-site examinations. When direct or indirect control, regulators have no
on-site examinations cannot be performed, for- legal authority to conduct full examinations of
eign subsidiary reports submitted according to this type of company. Investments in these

Page 14.3
companies are generally appraised in the same nation and its related REIT in order to determine
way as commercial loans, that is, by a credit conflicts of interest and contingent risks. In
analysis of the underlying financial information. several instances, REITs have encountered
serious financial problems and have attempted
to avoid failure by selling questionable assets to
or swapping these assets with their bank affili-
CHAIN BANKING SYSTEMS ates. In other instances, because of the adversary
relationship, REITs have been encouraged to
Chain banking systems exist when an individual
purchase assets of inferior quality from their
(or group of individuals) is a principal in two or
related organizations.
more banking institutions, in either banks or
bank holding companies or a combination of
both types of institutions. In these systems, the
possibility exists that problems in one or more FINANCIAL HOLDING
of the entities may adversely affect the safety COMPANIES
and soundness of the bank entities because of
pressure exerted by their common principal (or Section 4(k) of the BHC Act authorizes affilia-
principals). Examiners should determine whether tions among banks, securities firms, insurance
the bank is a member of a chain. If so, the extent firms, and other financial companies. It provides
of its relationship with other links of the chain for the formation of financial holding companies
should be determined, as well as the effects (FHCs) and allows a BHC or foreign bank that
these relationships have on the bank. qualifies as an FHC to engage in a broad range
of activities that are (1) defined by the GLB Act
to be financial in nature or incidental to a
REAL ESTATE INVESTMENT financial activity or (2) determined by the Board,
in consultation with the secretary of the Trea-
TRUSTS AND OTHER RELATED sury, to be financial in nature or incidental to a
ORGANIZATIONS financial activity or that are determined by the
Board to be complementary to a financial activ-
Although a bank, its parent holding company, or
ity and not to pose a substantial risk to the safety
its nonbank affiliate may not have a direct
and soundness of depository institutions or the
investment in an ‘‘other related organization,’’
financial system generally.
the bank may sponsor, advise, or influence the
Certain conditions must be met for a BHC or
activities of these companies. The most notable
a foreign bank to be deemed an FHC and to
examples are real estate investment trusts
engage in the expanded activities. BHCs that do
(REITs) or special-purpose vehicles (SPVs).
not qualify as FHCs are limited to engaging in
Transactions between the bank and REITs and
those nonbanking activities that are permissible
between other investment companies sponsored
under section 4(c)(8) of the BHC Act. Section
or advised by the bank are subject to the
4(k) of the BHC Act authorizes an FHC to
limitations in section 23A. In other cases,
engage in designated financial activities, includ-
because of nonownership or a less-than-majority
ing insurance and securities underwriting and
ownership, legal authority to conduct an exami-
agency activities, securities underwriting, mer-
nation does not exist.
chant banking, and insurance company portfolio
A REIT may be considered an affiliate if it is
investment activities.
sponsored and advised on a contractual basis by
the member bank or by any subsidiary or affili-
ate of the member bank. In these cases, trans-
actions between the bank and an affiliated REIT Supervisory Oversight
are subject to the requirements of section 23A.
Because a REIT frequently carries a name that The Federal Reserve has supervisory oversight
closely identifies it with its sponsoring bank or authority and responsibility for BHCs that
bank holding company, failure of the REIT operate as FHCs and for BHCs that are not
could have an adverse impact on public confi- FHCs. The GLB Act sets parameters for oper-
dence in the holding company and its subsidiaries. ating relationships between the Federal Reserve
The examiner should be aware of all signifi- and other regulators. The statute differentiates
cant transactions between the bank under exami- between the Federal Reserve’s relations with

Page 14.4
(1) depository institution regulators and (2) func-

tional regulators, which include insurance, secu-
rities, and commodities regulators. The Federal
Reserve’s relationships with functional regula-
tors will, in practice, depend on the extent to
which an FHC is engaged in functionally regu-
lated activities; those relationships will also be
influenced by existing working arrangements
between the Board and the functional regulator.
The Federal Reserve’s supervisory oversight
role is that of an umbrella supervisor concen-
trating on a consolidated or group-wide analysis

Page 14.5
of an organization. Umbrella supervision is not will review and assess internal policies, reports,
an extension of more traditional bank-like and procedures, as well as the effectiveness of
supervision throughout an FHC. The FHC frame- the FHC consolidated risk-management process.
work is consistent with and incorporates prin- The appropriate bank, thrift, or functional regu-
ciples that are well established for BHCs. The lator will continue to have primary responsibil-
FHC supervisory policy focuses on addressing ity for evaluating risks, hedging, and risk man-
supervisory practice for and relationships with agement at the legal-entity level for the entity or
FHCs, particularly those that are engaged in entities that it supervises.
securities or insurance activities. (See SR-00-13.)
The Federal Reserve is responsible for the
consolidated supervision of FHCs. The Federal Permissible Activities
Reserve thus assesses the holding company on a
consolidated or group-wide basis. The objective Permissible activities for FHCs include any
is to ensure that the holding company does not activity that the Board determined to be closely
threaten the viability of its depository institution related to banking under section 4(c)(8) of the
subsidiaries. Depository institution subsidiaries BHC Act by regulation or order that was in
of FHCs are supervised by their appropriate effect on November 12, 1999. This includes the
primary bank or thrift supervisor (federal and long-standing ‘‘laundry list’’ of nonbanking
state). However, the GLB Act did not change the activities for BHCs. (See section 225.28(b) of
Federal Reserve’s role as the federal bank hold- Regulation Y.) Section 225.86(a)(2) of Regula-
ing company supervisor. tion Y lists the nonbanking activities approved
Nonbank (or nonthrift) subsidiaries engaged for BHCs by Board order as of November 12,
in securities, commodities, or insurance activi- 1999.11
ties are to be supervised by their appropriate Section 4(k)(4)(G) of the BHC Act also
functional regulators. Examples of these func- defines ‘‘financial in nature’’ as any activity (1)
tionally regulated subsidiaries include a broker, in which a BHC may engage outside the United
dealer, investment adviser, and investment com- States, and (2) that the Board has determined, by
pany registered with and regulated by the Secu- regulation or interpretations issued under sec-
rities and Exchange Commission (SEC) (or, in tion (4)(c)(13) of the BHC Act that were in
the case of an investment adviser, registered effect on November 11, 1999, to be usual in
with any state); an insurance company or insur- conducting banking or other financial services
ance agent subject to supervision by a state abroad. Section 225.86(b) of Regulation Y lists
insurance regulator; and a nonbank subsidiary three activities that the Board has found to be
engaged in activities regulated by the Commod- usual in connection with the transaction of
ity Futures Trading Commission (CFTC). banking or other financial operations abroad.12
As the umbrella supervisor, the Federal The activities are providing management con-
Reserve will seek to determine that FHCs are sulting services; operating a travel agency; and
operated in a safe and sound manner so that their organizing, sponsoring, and managing a mutual
financial condition does not threaten the viabil- fund. The conduct of each activity has certain
ity of affiliated depository institutions. Over- prescribed limitations. Management consulting
sight of FHCs (particularly those engaged in a services must be advisory and not allow the
broad range of financial activities) at the con- FHC to control the person to whom the services
solidated level is important because the risks are provided. These services, however, may be
associated with an FHC’s activities can cut offered to any person on nonfinancial matters.
across legal entities and business lines. The An FHC may also operate a travel agency in
purpose of FHC supervision is to identify and connection with financial services offered by the
evaluate, on a consolidated or group-wide basis, FHC or others. Finally, a mutual fund organized,
the significant risks that exist in a diversified sponsored, or managed by an FHC may not
holding company to assess how these risks
might affect the safety and soundness of deposi-
tory institution subsidiaries. 11. Section 20 company activities are not included in this
The Federal Reserve’s focus will be on the list. Section 4(k)(4)(E) of the BHC Act authorizes FHCs to
engage in securities underwriting, dealing, and market-
financial strength and stability of FHCs, their making activities in a broader form than was previously
consolidated risk-management processes, and authorized by Board order.
overall capital adequacy. The Federal Reserve 12. See section 211.10 of Regulation K (12 CFR 211.10).

Page 15
exercise managerial control over the companies controls, or has power to vote 25 percent or
in which the fund invests, and the FHC must more of any class of voting securities of the
reduce its ownership of the fund, if any, to less bank or company; that controls in any manner
than 25 percent of the equity of the fund within the election of a majority of the directors or
one year of sponsoring the fund (or within such trustees of the bank or company; or that the
additional period as the Board permits). Board determines, after notice and opportunity
The activities that a BHC is authorized to for hearing, directly or indirectly exercises con-
engage in outside the United States under sec- trolling influence over the management or poli-
tion 211.10 of Regulation K have been either (1) cies of the bank or company. A bank and its
authorized for FHCs in a broader form by the parent holding company are considered affiliates
GLB Act (for example, underwriting, distribut- when the holding company controls the bank in
ing, and dealing in securities and underwriting a manner consistent with the definition of con-
various types of insurance) or (2) authorized in trol in section 23A of the FRA. Section 23A
the same or a broader form in Regulation Y (for exempts from the quantitative and collateral
example, data processing activities; real and requirements of the law all transactions (except
personal property leasing; and acting as agent, for the purchase of low-quality assets) between
broker, or adviser in leasing property). Section ‘‘sister’’ banks (banks with 80 percent or more
4(k)(4)(G) of the BHC Act and section 225.86 common ownership) in a bank holding company
of Regulation Y only authorize FHCs to engage system. A low-quality asset is any asset (1) clas-
in the activities that are listed in section 211.10 sified ‘‘substandard,’’ ‘‘doubtful,’’ or ‘‘loss’’ or
of Regulation K, as interpreted by the Board. treated as ‘‘other loans especially mentioned’’ in
The Board has also approved activities found in the most recent federal or state examination
individual orders issued under section 4(c)(13) report; (2) on nonaccrual status; (3) with prin-
of the BHC Act. Section 4(k)(4)(G) and Regu- cipal or interest payments more than 30 days
lation Y do not authorize an FHC to engage in past due; or (4) whose terms have been renego-
activities that the Board authorized a BHC to tiated or compromised due to the deteriorated
provide in individual orders issued under section financial condition of the borrower.
4(c)(13) of the BHC Act. Under the BHC Act, the Federal Reserve has
The remaining activities authorized by sec- authority to examine bank holding companies
tion 4(k)(4) of the BHC Act are those that are and their nonbank subsidiaries. The Federal
defined to be ‘‘financial in nature’’ under section Reserve requires periodic inspections of all bank
4(k)(4)(A) through (E), (H), and (I). (See section holding companies, the frequency of which is
225.86(c) of Regulation Y.) These activities based on the size, complexity, and condition of
include issuing annuity products and acting as the organization. Often a bank holding company
principal, agent, or broker for purposes of insur- is inspected at the same time as the examination
ing, guaranteeing, or indemnifying against loss, of its state member bank subsidiaries. In these
harm, damage, illness, disability, or death. Per- cases, the examiner at the bank should collabo-
missible insurance activities as principal include rate closely with inspection personnel on those
reinsuring insurance products. An FHC acting holding company issues that directly affect the
under section 4(k)(4) of the BHC Act may condition of the bank. When the BHC inspec-
conduct insurance activities without regard to tion is not conducted simultaneously with the
the restrictions on the insurance activities examination, the bank examiner should closely
imposed on BHCs under section 4(c)(8). (See review the most recent report of inspection and
section 3905.0 of the Bank Holding Company may also need to consult the Y-series of reports
Supervision Manual for more information per- regularly submitted to the Federal Reserve Sys-
taining to the activities of FHCs.) tem by bank holding companies.
Many banks are owned by bank holding
companies. To understand the effects of the
holding company structure on the subsidiary
BANK HOLDING COMPANIES bank, the examiner should evaluate the overall
financial support provided by the parent com-
As defined in section 2 of the BHC Act of 1956 pany, quality of supervision and centralized
(12 USC 1841 et seq.), a bank holding company functions provided, and appropriateness of in-
is any company that directly or indirectly, or tercompany transactions. Since financial and
acting through one or more other persons, owns, managerial issues at the bank holding company

Page 16
and subsidiary bank levels are so closely con- equity investment in the bank subsidiary is
nected, it is strongly recommended that a hold- financed by debt. Problems may arise when the
ing company inspection and its respective bank holding company must service its debt out of
examination (or examinations) be conducted at dividends from the subsidiary, and the subsidi-
the same time. A combined examination/ ary, if it encounters an earnings problem or is
inspection report, as discussed in SR-94-46, is prevented by regulatory agreement or action,
available to facilitate this coordination when the may not be able to pass dividends up to its
lead subsidiary is a state member bank. parent.
Another potential problem may develop when
the holding company sells its commercial paper
Financial Support and funds its subsidiary’s loans with those
proceeds. This may cause a liquidity problem if
The holding company structure can provide its the maturities of the commercial paper sold and
subsidiary bank with strong financial support loans funded are not matched appropriately and
because of its greater ability to attract and shift if the volume of such funding is large in relation
funds to less capital-intensive areas and to enter to the subsidiary’s overall operations.
markets in a wider geographic area than would On April 24, 1987, the Federal Reserve
otherwise be possible. Financial support may adopted a policy statement on the responsibility
take the form of capital (equity or debt) or of bank holding companies to act as sources of
funding of loans and investments. In general, the financial and managerial strength to their sub-
lower the parent bank holding company’s lever- sidiary banks. The Board’s statement reiterates a
age, the more it is able to serve as a source of general policy that has been expressed on
financial strength to its bank subsidiaries. This is numerous occasions, in accordance with author-
because less cash flow will be required from the ity that is provided under the BHC Act and the
banks for debt servicing, and the parent has enforcement provisions of the FDI Act.
more borrowing capacity, which could be used
to provide funds to the bank. When the financial
condition of the holding company or its non- BHC Supervision of Subsidiaries
banking subsidiaries is unsound, the operations
of its subsidiary bank can be adversely affected. Bank holding companies use a variety of meth-
To service its debt or provide support to another ods to supervise their bank subsidiaries,
subsidiary that is experiencing financial diffi- including—
culty, the holding company may involve its bank
subsidiary in the following imprudent actions:
• having holding company senior officers serve
as directors on the bank’s board;
• engaging in high-risk investments to obtain • establishing reporting lines from senior bank
increased yields management to corporate staff;
• purchasing or swapping its high-quality assets • formulating or providing input into key poli-
for the parent’s or other affiliate’s lower- cies; and
quality assets • establishing management information sys-
• entering into intercompany transactions that tems, including internal audit and loan review.
are detrimental because of inordinately high
fees or inadequate or unnecessary services
As part of the evaluation of bank management,
• paying excessive dividends the examiner should be aware of these various
• making improper tax payments or unfavorably control mechanisms and determine whether they
altering its tax situation are beneficial to the bank. Examiners should
keep in mind that, even in a bank holding
Even when the holding company’s structure company organization, the directors and senior
is financially sound, the holding company’s management of the bank are ultimately respon-
ability to sell short- or long-term debt and to sible for operating it in a safe and sound manner.
pass the proceeds down to its bank subsidiary in In addition, many bank functions (investment
the form of equity capital may still present management, asset/liability management, human
problems. That procedure is frequently referred resources, operations, internal audit, and loan
to as ‘‘double leveraging,’’ the amount of the review) may be performed on behalf of the bank

Page 17
by its parent bank holding company or by a company’s assets would therefore be sufficient.
nonbank affiliate. These functions are reviewed However, the opposite is often true. Even though
at inspections of the bank holding company. a bank’s investment in a subsidiary or associated
Examiners at the bank should be aware of the company is relatively small, the underlying
evaluation of these functions by inspection per- legal or moral obligation may be substantial and
sonnel, either at a concurrent inspection or in the may greatly exceed the total amount of the
report of a prior inspection. In addition, a review reported investment. If the subsidiary experi-
of these same issues at the level of the subsidi- ences large losses, the bank may have to recapi-
ary bank is useful to determine compliance with talize the subsidiary by injecting much more
corporate policies, corroborate inspection find- than its original investment to protect unaffili-
ings, and identify any inappropriate transactions ated creditors of the subsidiary or protect its
that may have been overlooked in the more own reputation.
general, top-down review at the parent level. When examining and evaluating the bank’s
investment in and loans to related organizations,
classified assets held by such companies should
first be related to the capital structure of the
EVALUATION OF company, and then be used as a basis for
classifying the bank’s investment in and loans to
INVESTMENTS IN AND that company.
LOANS TO BANK-RELATED One problem that examiners may encounter
ORGANIZATIONS when they attempt to evaluate the assets of some
subsidiaries and associated companies is inad-
To properly evaluate affiliates and other bank- equate on-premises information. This may be
related organizations13 relative to the overall especially true of foreign investments and asso-
condition of the bank, the examiner must— ciated companies in which the bank has less
than a majority interest. In those instances, the
• know the applicable laws and regulations that examiner should request that adequate informa-
define and establish limitations with respect to tion be obtained during the examination and
investments in and extensions of credit to should establish agreed-on standards for that
affiliates and information in the future. The examiner should
• analyze thoroughly the propriety of the related insist that the organization have adequate sup-
organizations’ carrying value, the nature of porting information readily obtainable or avail-
the relationships between the bank and its able in the bank and that the information be of
related organizations, and the effect of such sufficient quality to allow for an informed evalu-
relationships on the affairs and soundness of ation of the investment. Bank management, as
the bank. well as regulatory authorities, must be ade-
quately informed of the condition of the com-
The propriety of the carrying value of a panies in which the bank has an investment. For
bank’s investment in any related organization is subsidiary companies, it is necessary that bank
determined by evaluating the balance sheet and representatives be a party to policy decisions,
income statement of the company in which the have some on-premises control of the company
bank has the investment. At times, this may not (such as board representation), and have audit
seem important in relation to the overall condi- authority. In the case of an associated company,
tion of the bank because the amount invested the bank should participate in company affairs to
may be small relative to the bank’s capital. It the extent practicable. Information documenting
may appear that a cursory appraisal of the the nature, direction, and current financial status
of all such companies should be maintained at
the bank’s head office or maintained regionally
13. Information about related organizations and interlock-
for global companies. Full audits by reputable
ing directorates and officers can be obtained from the bank certified public accountants are often used to
holding company form FR Y-6 and SEC form 10-K, if provide much of this information.
applicable, or from other required domestic and foreign For foreign subsidiaries, in addition to the
regulatory reports. Further information on business interests
of directors and principal officers of the bank can be obtained
audited financial information prepared for man-
by reviewing information maintained by the bank in accor- agement, the bank should have on file the
dance with the Board’s Regulation O. following:

Page 18
• reports prepared according to the Board’s and the combined exposure exceeds 25 per-
Regulation K cent of total consolidated capital, the debt should
• reports prepared for foreign regulatory be detailed on the concentration page of the
authorities examination report. The consolidation proce-
• information on the country’s cultural and legal dures listed in the instructions for the prepara-
influence on banking activities, current eco- tion of Consolidated Reports of Condition and
nomic conditions, anticipated relaxation or Income should be used when consolidating the
strengthening of capital or exchange controls, figures of the corporation with those of its
fiscal policy, political goals, and the risk of parent.
expropriation
• adequate information to review compliance
with the investment provisions of Regulation INTERCOMPANY
K (For each investment, information should TRANSACTIONS
be provided on the type of investment (equity,
binding commitments, capital contributions, As with the supervision of subsidiaries, inter-
subordinated debt), dollar amount of the company transactions should be reviewed at
investment, percentage ownership, activities both the parent level during inspections and at
conducted by the company, legal authority for the subsidiary-bank level during examinations.
such activities, and whether the investment The transactions should comply with sections
was made under Regulation K’s general- 23A and 23B of the FRA and should not
consent, prior-notice, or specific-consent pro- otherwise adversely affect the financial condi-
cedures. With respect to investments made tion of the bank.
under the general-consent authority, informa-
tion also must be maintained that demon-
strates compliance with the various limits set Intercompany Tax Payments
out in section 211.9 of Regulation K. (See
Regulation K, sections 211.8 and 211.9.) As set forth in the policy statement regarding
For agricultural credit corporations, the intercorporate income tax accounting trans-
examiner-in-charge normally decides when to actions of bank holding companies and state-
examine such an entity. A complete analysis of chartered banks that are members of the Federal
the entity’s activities should always be per- Reserve System (September 20, 1978), Federal
formed if— Reserve policy relative to intercompany tax
payments is to treat the bank as a separate
• the corporation is not supervised by the Fed- taxpayer whose tax payments to its parent
eral Intermediate Credit Bank (FICB), should not exceed payments it would make on a
• the most recent FICB examination occurred separate-entity basis. Payments should not be
over a year ago, or made to the parent before the time payments
• the most recent FICB examination indicates are or would have been made to the Internal
that the corporation is in less than satisfactory Revenue Service. Refunds to the bank should be
condition. timely. Individual situations may result in com-
plicated issues, and the examiner should
The extent of any analysis should be based on consult with Reserve Bank personnel before
the examiner’s assessment of the corporation’s reaching conclusions concerning a particular
effect on the parent bank. That analysis should transaction. Bank holding company inspection
include, but not be limited to, a review of— report comments and bank examination report
comments should be consistent concerning
• asset quality; the nature and propriety of intercompany
• the volatility, maturity, and interest-rate sen- transactions.
sitivity of the asset and liability structures; and
• the bank’s liability for guarantees issued on
behalf of the corporation. Management and Other Fees
When the same borrower is receiving funds Banks often obtain goods and services from the
from both the corporation and the parent bank, parent bank holding company or an affiliated

Page 19
nonbank subsidiary. These arrangements may are not legitimate overhead expenses for a
benefit the bank, since the supplier may offer subsidiary bank.
lower costs because of economies of scale, such Generally, the payment of excessive fees is
as volume dealing. Furthermore, banks may be considered an unsafe and unsound practice.
able to purchase a package of services that When fees are not justified, appear excessive, do
otherwise might not be available. However, not serve legitimate needs, or are otherwise
because of the interrelationship between the abusive, the examiner should inform the board
bank and the supplier, examiners should ensure of directors through appropriate criticism in the
that the fees being paid represent reasonable report of examination.
reimbursement for goods and services received.
Fees paid by the bank to the parent or nonbank
affiliates should have a direct relationship to, Dividends
and be based solely on, the fair value of goods
and services provided and a reasonable profit. Dividends represent a highly visible cash out-
Fees should compensate the affiliated supplier flow by banks. If the dividend-payout ratio
only for providing goods and services that meet exceeds the level at which the growth of retained
the legitimate needs of the bank. earnings can keep pace with the growth of
Banks should retain satisfactory records that assets, the bank’s capital ratios will deteriorate.
substantiate the value of goods and services Examiners should evaluate the appropriateness
received, their benefit to the bank, and their cost of dividends relative to the bank’s financial
efficiencies. There are no other minimum condition, prospects, and asset-growth forecast.
requirements for records, but an examiner should
be able to review the records maintained and
determine that fees represent reasonable pay- Purchases or Swaps of Assets
ment. In general, the supplier will decide on the
amount to be charged by using one of three Asset purchases or swaps between affiliates
methods: create the potential for abuse. Regulatory con-
cern focuses on the fairness of such asset
• reimbursement for cost of goods or services transactions, their financial impact, and timing.
• cost plus a reasonable profit margin Fairness and financial considerations include the
• comparative fair-market value quality and collectibility of such assets and
liquidity effects. Asset exchanges may be a
Any of these methods may be acceptable as long mechanism to avoid regulations designed to
as the bank can substantiate that the fees paid protect subsidiary banks from becoming over-
are reasonable for the value received. Basing burdened with nonearning assets.
fees on costs may be the most common approach
since market comparisons often are difficult to
obtain. A holding company may be able to offer
a number of services on a cost basis to a Compensating Balances
subsidiary bank, any one of which might be
contracted elsewhere for less. However, in the A subsidiary bank may be required to maintain
aggregate, the services may be cost effective or excess balances at a correspondent bank that
produce economies of scale for the entire orga- lends to other parts of the holding company
nization. Nevertheless, having one or more sub- organization, possibly to the detriment of the
sidiary banks pay excessive fees for services to bank. The subsidiary bank may be foregoing
subsidize other unprofitable operations is not an earnings on such excess funds, which may
acceptable practice. adversely affect its financial condition.
When the servicer incurs overhead expenses,
recovery of those costs is acceptable to the
extent they represent a legitimate and integral Split-Dollar Life Insurance
part of the service rendered. Overhead includes
salaries and wages, occupancy expenses, utili- Split-dollar life insurance is a type of life
ties, payroll taxes, supplies, and advertising. insurance in which the purchaser of the policy
Debt-service requirements of holding compa- pays at least part of the insurance premiums and
nies, shareholders, or other related organizations is entitled to only a portion of the cash surrender

Page 20
value, or death benefit, or both. In some circum- potential for overdrafts, which are regarded as
stances, when the subsidiary bank pays all or unsecured extensions of credit to an affiliate by
substantially all of the insurance premiums, an the subsidiary bank. In general, a subsidiary
unsecured extension of credit from the bank to bank should be adequately compensated for its
its parent holding company generally results services or for the use of its facilities and
because the bank has paid the holding compa- personnel by other parts of the holding company
ny’s portion of the premium, and the bank will organization. In addition, a subsidiary bank
not be fully reimbursed until later. In other should not pay for expenses for which it does
arrangements, when the parent uses the insur- not receive a benefit (for example, the formation
ance policy as collateral for loans from the expenses of a one-bank holding company).
subsidiary bank, the loan may not meet the Situations sometimes arise in which more
collateral requirements of section 23A. In addi- than one legal entity in a banking organization
tion, split-dollar arrangements may not comply shares offices or staff. In certain cases, it can be
with section 23B if the return to the bank is not hard to determine whether a legal entity is
commensurate with the size and nature of its operating within the scope of its permissible
financial commitment. Finally, split-dollar activities. In addition, a counterparty may be
arrangements may be considered unsafe and unclear as to which legal entity an employee is
unsound, which could be the case if the bank is representing. Finally, there may be expense-
paying the entire premium but is not the bene- allocation problems and, thus, issues pertaining
ficiary, or if it receives less than the entire to sections 23A and 23B. Examiners should be
proceeds of the policy. (See SR-93-37.) aware of these concerns and make sure that
institutions have the proper records and internal
controls to ensure an adequate separation of
Other Transactions with Affiliates legal entities. (See SR-95-34.)
Checking accounts of the parent or nonbank
subsidiaries at subsidiary banks present the

Page 21
1. To determine if policies, procedures, and 5. To determine the relationships between

internal controls for bank-related organiza- the bank and its related organizations and
tions are adequate. the effects of those relationships on the
2. To determine if bank and affiliate manage- operations and safety and soundness of the
ment are complying with the established bank.
policies. 6. To initiate corrective action when policies,
3. To determine compliance with sections 23A practices, procedures, or internal controls are
and 23B of the Federal Reserve Act and other deficient or when violations of law or regu-
applicable laws and regulations involving lations have been noted.
intercompany and other transactions.
4. To evaluate the bank’s investment in and
loans to its related organizations, as well as
the propriety of those carrying values.

Page 1
PRE-EXAMINATION ANALYSIS Factors to be considered in making the

decision to coordinate the examination and
During the pre-examination analysis of the bank, inspection are as follows:
it should be determined which related organiza- a. dollar amount of loans or advances by
tions should be examined in depth. The criteria the bank
for that determination are as follows: b. nature of business of the nonbank affiliates
c. types and amount of intercompany
1. All operating subsidiaries should be exam- transactions
ined concurrently with the regular examina- d. types and amounts of participations and
tion of the parent bank, unless such exami- other assets purchased, sold, or swapped
nation is specifically waived by the Federal e. types of services performed for or by the
Reserve Bank. bank and fees paid or received
2. Other subsidiaries should be examined f. outstanding contingent liabilities by the
except when relationships between the sub- bank in favor of its parent or nonbank
sidiary, its parent, and other related organi- affiliates
zations are fully disclosed by material on Factors to be considered in determining
hand and when the subsidiary’s condition or whether to examine nonbanking subsidi-
operations are determined not to be detri- aries within the parent holding company
mental to the safety and soundness of the under inspection are detailed in the Bank
bank. Factors to be considered in making Holding Company Supervision Manual.
the determination to examine a subsidiary
are as follows:
a. the bank’s percent of ownership and
dollar amount of investment in the EXAMINATION PROCEDURES
subsidiary FOR RELATED ORGANIZATIONS
b. nature of the subsidiary’s business
c. types and amounts of intercompany The following procedural steps should be per-
transactions formed in all banks that have related
d. types and amounts of participations and organizations.
purchased, sold, or swapped assets
between the subsidiary and the bank or 1. If selected for implementation, complete or
other related organizations update the bank-related organizations sec-
e. types of services performed by the sub- tion of the internal control questionnaire.
sidiary for the bank or other related 2. Test for compliance with policies, practices,
organizations procedures, and internal controls in conjunc-
f. outstanding contingent liabilities by the tion with performing the remaining exami-
bank in favor of the subsidiary nation procedures.
g. the bank’s potential contingent liabili- 3. When appropriate, obtain the following
ties, moral or legal, as a result of litiga- reports or forms prepared or filed since the
tion, claims, or assessments pending preceding examination:
against the subsidiary a. annual report on SEC Form 10-K
3. If practical under the circumstances, the b. current report on SEC Form 8-K
parent holding company and nonbank affil- c. quarterly report on SEC Form 10-Q
iates should be inspected in conjunction d. quarterly report on Federal Reserve Form
with the examination of the lead state mem- Y-8
ber bank. The decision to coordinate the e. annual fiscal year-end report on Federal
timing of the bank holding company inspec- Reserve Form Y-6
tion and the state member bank examination f. annual report to shareholders
should be based on the nature and extent of g. required reports under Federal Reserve
interaction between the bank and its parent Regulation K and to foreign banking
holding company and nonbank affiliates. authorities for foreign subsidiaries

Page 1
4050.3 Bank-Related Organizations: Examination Procedures
h. subsidiary and affiliate reports prepared purchase, sale, or swap of assets

by examiners between the bank and the related orga-
i. federal reports of examination for non- nizations, as well as the propriety
banking subsidiaries of the transactions and related
4. Request that the bank provide a list of the considerations;
names of all related organizations; the list • the fees these organizations charge the
should set forth the loans to and invest- bank for services rendered and the
ments in these organizations and any man- reasonableness of those fees;
agement official interlocks among these • cash transfers to or from a related
organizations and the banks. organization in connection with a con-
5. Circulate a list of the names of the related solidated income tax obligation
organizations and the loans to and invest- (Amounts paid should be based on that
ments in these organizations. This list should amount due if a separate return was
be circulated among the examiners assigned filed. They should be paid only at such
to each bank department. The accuracy and time to reasonably permit required
completeness of this information should be estimated payments or final settle-
verified by the recipients. ments to be made to the IRS.);
6. Obtain, from the examiners assigned to • fees received by the bank from the
other assets and other liabilities, informa- organization for the use of bank per-
tion concerning receivables from or pay- sonnel, premises, marketing services,
ables to related organizations. and equipment, and the adequacy of
7. Review the bank’s files and reports obtained those fees; and
in step 3, and transcribe for the workpapers • any agreements, guarantees, pledges,
pertinent financial data and comments or hypothecations between the bank
regarding related organizations. and any related organization, if they
8. Review fees paid by the bank to related are properly reflected on the books of
organizations, bank insider–related organi- the bank, and whether there are any
zations, and stockholders. Determine that apparent conflicts of interest.
the fees represent reasonable reimburse- c. litigation, when the related organization
ment for goods and services received by— is a defendant in a suit and if the litiga-
a. determining the method used to compute tion could have an adverse effect on the
the charge to the bank for goods or bank (from SEC Form 10-K or another
services (cost, cost plus profit, fair mar- source)
ket value), d. each interlocking officer and/or director
b. reviewing documentation maintained by relationship as reflected by the informa-
the bank to substantiate the fair value of tion obtained in step 4. Determine—
the goods or services received, their • whether fees or salaries are excessive
benefit to the bank, and the cost efficien- for duties performed and
cies of the alternative selected, • if adequate time is devoted to manage-
c. comparing the schedule of fees currently ment responsibilities.
in effect with those in effect 12 months 10. Section 23A of the Federal Reserve Act (12
ago, and USC 371c), Relations with Affiliates, and
d. comparing the fees paid during the last the Board’s Regulation W. By coordinating
three months with those paid for the work with the examiners assigned to the
same period one year ago. various loan areas, determine compliance
9. On the basis of the information obtained with laws and regulations pertaining to
above, review the following for each related related organizations by performing the fol-
organization: lowing procedures.
a. the quality of loans, investments, and a. Obtain a listing of loans to affiliates.
future commitments to any related b. Compare the listing with the bank’s cus-
organization tomer liability records to determine the
b. the nature and volume of transactions list’s accuracy and completeness.
between the related organization and the c. Obtain a listing of other covered trans-
bank and— actions with affiliates (that is, purchase
• the extent of any participations and the of securities issued by an affiliate, pur-

Page 2
Bank-Related Organizations: Examination Procedures 4050.3
chase of assets, acceptance of securities sections 23A and 23B of the Federal
issued by an affiliate as collateral for a Reserve Act.
loan to any person or company, • Ensure the policies and procedures
or the issuance of a guarantee, accep- cover all relevant affiliates (e.g., finan-
tance, or letter of credit on behalf of an cial subsidiaries and joint ventures)
affiliate). and transactions covered by section
d. Conduct transaction testing of intercom- 23A, and verify that the bank treats
pany affiliate transactions1 for compli- ‘‘sponsored and advised’’ companies
ance with the limitations of section 23A as affiliates (‘‘Sponsored and advised’’
of the Federal Reserve Act and the companies would include, at a mini-
Board’s Regulation W (see SR-03-02) mum, any company that receives invest-
by— ment advice and administrative ser-
• reviewing— vices on a contractual basis from a
— the time elapsed between the origi- member bank, whose trustees or man-
nal issuance of the affiliate’s debt agers are selected by the bank, and that
securities and the bank’s purchase, has a name similar to that of the
— the existence of any relevant agree- bank.).
ments or relationships between the • Ensure that the policies and procedures
bank and the third-party seller of are comprehensive and include
the affiliate’s debt securities, adequate controls—
— any history of bank financing of — to identify covered transactions and
the affiliate, and — to ensure that necessary steps are
— any other relevant information; performed for identified transac-
• documenting any violations or poten- tions (e.g., the required collateral-
tial violations, and reaching an agree- ization of loans to affiliates).
ment with the directors and senior i. Covered transactions.
management to resolve violations • If the controls for section 23A are
quickly; and considered adequate, use the list of
• considering the inclusion of ‘‘other covered transactions provided by the
transfer-risk problem’’ (OTRP) assets bank.
in the evaluation of asset quality and • If controls are considered inadequate
capital adequacy. (See section 7040.1 (for example, for transactions testing),
for a discussion of OTRP credits.) review the bank’s general ledger to
e. Ensure that transactions with affiliates identify transactions that are covered
meet the collateral requirements of sec- transactions.
tion 23A. • Verify that covered transactions count
against required limits and are collat-
f. Ensure that low-quality loans have not
eralized when required.
been purchased from an affiliate.
• If the bank uses an internal rating
g. Determine that all transactions with
system for its assets, determine that the
affiliates are on terms and conditions that
bank has not deferred or altered an
are consistent with safe and sound bank-
asset’s rating to facilitate sale of the
ing practices.
asset to an affiliate.
h. Policies and procedures. • Review controls for monitoring com-
• Obtain the bank’s policies and proce- pliance with the established limits and
dures to determine compliance with for collateralizing required credit-
extension transactions.
• If controls are considered inadequate
1. Examples of affiliates include a bank holding company
and its nonbank subsidiaries, companies under the member
(for example, for transactions testing),
bank’s control (see Regulation W, section 223.3(g)), any ensure that covered transactions are
mutual fund advised by a member bank, merchant banking properly valued.
investments, a member bank or affiliate serving as a general • Verify that identified covered transac-
partner in a partnership, and affiliates’ subsidiaries. In addi-
tion, certain joint venture companies, ESOPs of banks and
tions comply with the limits of sec-
their affiliates, and special-purpose entities are affiliates if the tions 23A and 23B (If the covered
regulatory definitions of control are met. transactions do not comply with the

Page 3
limits, criticize the bank for inad- funding of loans and the purchase of
equate controls, and discuss what steps loans, ensure compliance with quanti-
the bank will use to correct the tative limits (for funding and compli-
violations.). ance with collateral requirements) as
• Obtain collateral listings, and verify follows:
that necessary covered transactions are — For credit card examinations, obtain
adequately collateralized: the ‘‘trial balances’’ of the outstand-
— Verify that the values of omnibus ing balances, and for mortgage
deposit accounts used to secure banking exams, obtain lists of the
covered transactions are sufficient loans sold.
to fully secure the relevant covered — Check that credit card amounts
transactions. generated by bank affiliates and
— Review collateral documentation to mortgage loans sold to the bank by
ensure that the bank’s interest is affiliates are included on the list of
adequately perfected and priori- covered transactions and in mea-
tized (Regulation W, section surements for compliance with the
223.14(d)). quantitative limits. If they are not
j. Corporate lending (funding). Ensure that included, ascertain why.
there is compliance with the collateral — If an exemption is being used,
requirements and quantitative limits: verify that its use is correct.
• Obtain the bank’s "trial balances" of — Verify that loans are collateralized
loans. (using collateral), and review the
• Check that loans to affiliates are documentation to ensure proper
included on the list of ‘‘covered trans- collateralization.
actions’’ and included in measure- • For the general-purpose credit card
ments for compliance with the quanti- exemption (Regulation W, section
tative limits. If some loans are not 223.16(c)(4)), verify, through review
included, ascertain why. of relevant documentation, that the
• If an exemption is being used, verify bank can demonstrate that its credit
that its application is correct. card meets the less than 25 percent
• Verify that the loans are collateralized test through one of three available
(using collateral listings), and review methods. (An exemption from the
the documentation to ensure proper attribution rule for extensions of credit
collateralization. under a general-purpose credit card is
k. Verification of exemptions. defined as one on which ‘‘less than
• For renewal of participations involving 25 percent of the aggregate amount of
problem loans (see Regulation W, sec- purchases are purchases from a bank
tion 223.15(b)) involving nondeposi- affiliate.’’)
tory affiliates, review supporting docu- — The bank has no commercial
mentation to ensure that— affiliates.
— the loan was not low quality at the — The bank establishes systems to
time the bank purchased the verify compliance with the less
participation, than 25 percent test on an ongoing
— the renewal is approved at the board basis.
committee or senior management — The bank presents information to
level as appropriate, and the Board of Governors to demon-
— the bank’s share of the renewal strate its card would comply.
does not exceed its original share • For purchases of extensions of credit—
by more than 5 percent (unless the ‘‘250.250 exemption’’ (Regulation
approved by an appropriate federal W, section 223.42(k))—review sup-
bank regulator) and that the bank porting documentation to ensure that—
notified the federal bank regulator — the member bank makes an inde-
within 20 days. pendent creditworthiness evalua-
• For retail lending (e.g., credit cards tion before the affiliate makes or
and mortgage banking) involving the commites to make the loan,

Page 4
— the bank commits to make the loan o. If the bank has used the expanded (d)(4)
purchase before the affiliate makes exemption, determine that the bank regu-
the loan, larly reviews the market value of its U.S.
— the bank does not make a blanket government obligations collateral.
advance commitment to purchase p. Determine that the bank’s program for
loans, and monitoring and controlling the credit
— the purchases from the affiliate by exposure from derivative transactions
the depository institution and all with affiliates includes, at a minimum,
depository institution affiliates in imposing appropriate credit limits,
the prior 12 months represent mark-to market requirements, and collat-
50 percent or less of all loans eral requirements.
originated by the affiliate during q. Determine that the limits and require-
such period. ments reflect the nature, volume, and
l. If the bank is critically undercapitalized complexity of the bank’s derivatives
(under prompt-corrective-action rules), transactions.
determine if the bank has engaged in any r. Determine that the limits and require-
covered transaction, as defined in section ments on credit exposures from deriva-
23A, without the prior approval of the tive transactions have been approved by
FDIC or FRS. the board of directors of the bank or an
m. Internal controls. appropriate board committee.
• Determine the bank’s methods for iden- s. Determine that the bank’s program for
tifying transactions subject to sections monitoring and controlling the credit
23A and 23B of the Federal Reserve exposure from intraday extensions of
Act. Determine if these methods credit to affiliates includes, at a mini-
adequately identify such transactions. mum, imposing appropriate credit limits
Consider the following information: (on a per-affiliate and aggregate basis)
— internal reports (Management and collateral requirements.
should document any covered trans- t. Determine that that the limits and require-
actions with affiliates.) ments imposed by the bank reflect the
— loan records volume of intraday credit transactions
— deposit accounts and the reasons for those transactions.
— accounts payable and receivable u. Determine that the limits and require-
— board minutes ments on intraday credit transactions have
• Determine if management understands been approved by the board of directors
what services its affiliates provide. of the bank or an appropriate board
• Determine the volume and frequency committee.
of inter-institution transactions, such 11. Section 23B of the Federal Reserve Act (12
as loan participations or sales, pur- USC 371c-1), Restrictions on Transactions
chases or sales of other assets, bank with Affiliates, and the Board’s Regulation
stock loans, insider transactions, and W.
contractual obligations for services. a. Determine that covered transactions with
Review these transactions for possible affiliates comply with the restrictions in
noncompliance or abusive practices. section 23B.
• Review any formal or informal agree- b. If the bank has derivative transactions
ments regarding covered transactions. with affiliates, determine that the bank
Determine if management adequately has treated the affiliate no better than a
documents the cost, fee structure, and similarly situated nonaffliate.
quality of services. c. Determine that management and other
• Determine the bank’s compliance with fees paid by the bank have a direct
any outstanding conditions of an relationship to the value of the actual
approved order or commitment issued goods and services rendered, based on
by the regulator. reasonable costs consistent with current
n. Determine if the affiliates are in compli- market values for such goods and services.
ance with the capital requirements of d. Review any mortgage banking activity
their functional regulator. and servicing contracts with affiliates, if

Page 5
applicable. Give particular attention to— term debt and passed the proceeds down to
• the capacity in which the affiliate is the bank in the form of equity, obtain or
acting, prepare the following schedules and for-
• the nature of the services provided, ward them to the examiner assigned to
• the billing arrangement, frequency of assessment of capital adequacy:
billing, method of computation, and a. amount, maturity, and repayment terms
the basis for fees, of long-term debt sold
• the method of compensating the bank b. amount of equity capital passed to bank
for balances maintained and net inter- c. expected minimum dividend payment
est earned on warehouse loans and required by bank to service the debt of
lines (This method should not be the parent
preferential.), 16. From the results of previous steps and
• the pricing of loan and servicing-right discussion with management, determine if
sales, there are any anticipated changes in the
• advertising restrictions (for noncompli- related organization–bank relationship that
ance). may possibly have adverse effects on the
12. Regulation O (12 CFR 215), Loans to affairs and soundness of the bank.
Executive Officers, Directors, and Principal 17. On the basis of the above steps, determine
Shareholders of Member Banks. the propriety of the carrying value and
a. Obtain lists of loans to executive officers nature of the relationship between the bank
and business interests of directors, execu- and its related organizations and the effect
tive officers, and principal shareholders of that relationship on the affairs and sound-
from the examiner assigned to duties and ness of the bank.
responsibilities of directors. 18. If, in the performance of the above proce-
b. Determine the accuracy and complete- dures, the full nature and extent of interac-
ness of the list as it concerns related tion between the bank and its related orga-
organizations by comparing it with infor- nizations cannot be determined, consider
mation obtained from management and the necessity of an in-depth examination of
other examiners. related organizations. Perform appropriate
c. Investigate to determine undisclosed affil- procedures in step 19, and develop addi-
iate relationships if there are several tional specific procedures based on the type
directors or officers who have a common and scope of activities being conducted.
interest in the same entity by— 19. The following procedures should be
• obtaining a listing of all directors for considered when an in-depth examination
the entity that are suspected of main- of a bank’s nonbank subsidiaries is deemed
taining an affiliate relationship, appropriate:
• reviewing authorizing signatures on a. Review and analyze the liability struc-
corporate resolutions to borrow, and ture of the nonbank subsidiaries.
• reviewing signatory authorities on • Review and appraise any funding
deposit signature cards. agreements with the parent bank.
13. If the bank engaged in an impermissible • Review all arrangements whereby the
nonbank activity, determine that it has bank purchases assets, pursuant to 12
divested itself of that activity. CFR 223.42(k).
14. If the bank is a subsidiary of a holding • Review and appraise any funding
company and the parent has sold commer- agreements with (including guaran-
cial paper and funded bank loans with the tees) and debt instruments issued to
proceeds, obtain or prepare the following outside creditors.
schedules and forward them to the examiner • Review agreements with third parties
assigned to funds management: involving the outright purchase of
a. amount and maturities of commercial assets to determine liability for the
paper outstanding repurchase of assets or any other con-
b. amount and maturity of the assets the tingent liabilities.
paper supports b. Analyze cash flow, earnings, and tax
15. If the bank is a subsidiary of a holding policies of the nonbank subsidiaries. Pre-
company and if the parent has sold long- pare cash-flow statements for the previ-

Page 6
ous three fiscal years and compare cur- comments for the examination report.
rent year-to-date with previous year-to- 21. Prepare, in appropriate report form, and
date. discuss with appropriate bank management
c. Review and evaluate capital adequacy the following:
by— a. the adequacy of written policies on related
• relating the consolidated classified organizations
assets of the subsidiaries against the b. the manner in which bank officers are
consolidated net worth, or by relating operating in conformance with estab-
classifieds proportionately to the par- lished policy
ent’s investment in and advances to c. violations of law or regulations
each subsidiary; d. the impropriety of any transaction between
• commenting on the overall capital the related organization and the bank
structure of both the parent bank and e. loans to or investments in related orga-
specific nonbank subsidiaries, as war- nizations that the examiner questions for
ranted; and any reason, such as their quality, carry-
• discussing the adequacy of capital with ing value, or ultimate collection
management, and noting management’s f. litigation, commitments, contingent
future plans to raise capital. liabilities, or current or anticipated
d. Review and evaluate management and changes between the bank and its related
control policies by— organizations that may have adverse
• reviewing board meeting minutes of effects on the affairs and soundness of
the parent corporation, and assessing the bank
director interest in and awareness of g. interlocking officer or director relation-
subsidiaries; ships that are detrimental to the bank
• reviewing and evaluating corporate man- under examination or to any of its related
agement’s internal audit procedures for organizations
those policies; h. any other information that will commu-
• reviewing ‘‘management letters’’ from nicate the condition of the related orga-
certified public accountants about those nization and the nature and effect of the
internal controls; and relationship between the related
• reviewing shareholder records, noting organization and the bank under
significant concentrations, and, when examination
officers or directors are involved, not- i. recommended corrective action when
ing any undue influence with regard to policies, practices, or procedures are
policies, practices, and procedures. deficient
e. Review management’s future operating 22. Consolidate information in the operating
plan for the subsidiary company. subsidiary report (or reports) for inclusion
• Analyze the subsidiary’s earnings and in the report of examination.
capital projections for one and five 23. Consolidate financial information and any
years. other comments concerning related organi-
• Obtain underlying assumptions for— zations for inclusion, when appropriate, in
— return on assets, the report of examination.
— dividend retention rate, 24. If material changes have occurred in related
— asset growth rate, and organizations since the most recent exami-
— capital growth rate. nation of the bank, and if the changes may
• Compare projections against past have a substantial impact on the bank, this
operating performance, and comment information should be communicated by
on the plan. separate memorandum to the Federal Reserve
20. Discuss findings and conclusions reached in Bank.
the examination of any nonbank subsidiary 25. Update the workpapers with any informa-
with the management of that entity. Prepare tion that will facilitate future examinations.

Page 7
Review the bank’s internal controls, policies, compliance with the investment limitations
practices, and procedures concerning related of Regulation K? (See Regulation K, sec-
organizations. The bank’s system should be tions 211.8 and 211.9.)
documented completely and concisely and 2. Does the bank maintain current records on
should include, where appropriate, narrative the form and status of each related organi-
descriptions, flowcharts, copies of forms used, zation (such a list should include name,
and other pertinent information. location, nature of business, manner of
affiliation, relationship with bank, amount
of loans, investments in and other exten-
POLICIES AND OBJECTIVES sions of credit, security pledged, obligations
of any affiliate that is used as collateral
1. Does the bank have written guidelines for security for advances made to others, com-
the expansion of services through the mitments, and litigation)?
formation or acquisition of related 3. Does the bank maintain a copy of all
organizations? internal or external audit reports, including
2. Are established objectives and policies management letters and responses, of the
adhered to? subsidiary or related company?
a. Is there an overall lending policy that
4. In the case of registered bank holding com-
would bring banking- and nonbanking-
panies and nonbank affiliates arising through
related organizations under a common
the holding company relationship, are cop-
set of controls?
ies of the Federal Reserve’s inspection
b. Are bank officials an integral part reports and forms 10-Q, 10-K, 8-K, Y-6,
of subsidiary or related-company and Y-8 available for review?
management?
c. Can operating procedures be monitored 5. In the case of Edge Act and agreement
from available internal or external audit corporations and foreign subsidiaries, are
reports? copies of Federal Reserve examination
reports and foreign regulatory reports avail-
3. Are periodic independent reviews per-
able for review?
formed to assess bank management’s
objectives and policies on the current 6. Do credit files of foreign subsidiaries include
status of their association with the related information regarding a particular country’s
organizations? cultural and legal influences on banking
4. Does bank management have an active role activities, current economic conditions,
in the related organizations’ audit commit- anticipated relaxation or strengthening of
tees, or does management retain the right to capital or exchange controls, fiscal policy,
examine the companies’ records, including political goals, and risk of expropriation?
the right to receive third-party letters from 7. Are adequate records maintained to deter-
the external auditors? mine compliance with the investment pro-
5. Are policies and procedures such that the visions of Regulation K, including informa-
effect on the bank’s liquidity is monitored tion on the type of investment (equity,
when commercial paper or other proceeds binding commitments, capital contribu-
are used to fund bank loans? tions, subordinated debt), the dollar amount
of the investment, the percentage owner-
ship, the activities conducted by the com-
RECORDS pany, the legal authority for such activities,
and whether the investment was made under
1. Are records maintained for the companies Regulation K’s general-consent, prior-
in which the bank has a capital investment, notice, or specific-consent procedures? (See
including foreign companies, so that a Regulation K, sections 211.8 and 211.9.)
determination can be made of the extent of 8. Is the carrying value of all subsidiaries and
bank control, quality of assets, profitability related companies accounted for on the
of the company, legality of operations, and equity basis and adjusted, at least quarterly,

Page 1
4050.4 Bank-Related Organizations: Internal Control Questionnaire
to reflect the reporting bank’s cumulative trols, that is, there are no significant defi-
share of the company’s earnings or losses? ciencies in areas not covered in this ques-
9. Is an objective review performed of the tionnaire that impair any controls? Explain
benefits or quality of assets received rela- negative answers briefly, and indicate any
tive to the cost incurred? additional examination procedures deemed
10. Are money transfers between the bank necessary.
and any related organization adequately
documented to justify the equity of the 2. Based on a composite evaluation, as evi-
transaction? denced by answers to the foregoing ques-
tions, internal control is considered (adequate/
inadequate).
CONCLUSION

Page 2
Information Technology
Banking organizations increasingly rely on importance of IT to the organization and any

information technology (IT) to conduct their unique characteristics or issues.
operations and manage risks. The use of IT can • Incorporate an analysis of IT activities into
have important implications for a banking orga- risk assessments, supervisory plans, and scope
nization’s financial condition, risk profile, and memoranda. An organization’s IT systems
operating performance and should be incorpo- should be considered in relation to the size,
rated into the safety-and-soundness assessment activities, and complexity of the organization,
of each organization. As a result, all safety-and- as well as the degree of reliance on these
soundness examinations (or examination cycles) systems across particular business lines.
conducted by the Federal Reserve should include Although IT concerns would clearly affect an
an assessment and evaluation of IT risks and institution’s operational risk profile, IT also
risk management. Further information about can affect other business risks (such as credit,
banks’ IT activities and examination methodol- market, liquidity, legal, and reputational risk),
ogy can be found in the FFIEC Information depending upon the specific circumstances,
Technology Examination Handbook (the IT and should be incorporated into these assess-
Handbook) and in supervisory guidance issued ments as appropriate.
by the Federal Reserve and the other federal • Assess the organization’s critical systems, that
banking agencies. is, those that support its major business activi-
ties, and the degree of reliance those activities
have on IT systems. The level of review
should be sufficient to determine that the
ASSESSING INFORMATION systems are delivering the services necessary
TECHNOLOGY IN THE for the organization to conduct its business in
RISK-FOCUSED SUPERVISORY a safe and sound manner.
FRAMEWORK • Determine whether the board of directors and
senior management are adequately identify-
The risk-focused supervisory process is evolving, measuring, monitoring, and controlling
ing to adapt to the changing role of IT in the significant risks associated with IT for the
banking organizations, with greater emphasis on overall organization and its major business
an assessment of IT’s effect on an organization’s activities.
safety and soundness. Accordingly, examiners
should explicitly consider IT when developing
risk assessments and supervisory plans. Exam- INTERAGENCY GUIDELINES
iners should use appropriate judgment in deter- ESTABLISHING INFORMATION
mining the level of review, given the character- SECURITY STANDARDS
istics, size, and business activities of the
organization. Moreover, to determine the scope The federal banking agencies jointly issued
of supervisory activities, close coordination is interagency guidelines establishing information
needed between general safety-and-soundness security standards (the information security stan-
examiners and IT specialists during the risk- dards), which became effective July 1, 2001.1
assessment and planning phase, as well as dur- (See appendix B of this section.) The Board of
ing on-site examinations. Given the variability Governors of the Federal Reserve System
of IT environments, the level of technical exper- approved amendments to the standards on
tise needed for a particular examination will December 16, 2004 (effective July 1, 2005). The
vary across institutions and should be identified amended information security standards imple-
during the planning phase of the examination. In ment sections 501 and 505 of the Gramm-Leach-
general, examiners should accomplish the fol- Bliley Act (15 USC 6801 and 6805) and section
lowing goals during a risk-focused examination: 216 of the Fair and Accurate Credit Transac-
• Develop a broad understanding of the organi-
1. See 66 Fed. Reg. 8616–8641 (February 1, 2001) and 69
zation’s approach to, and strategy and struc- Fed. Reg. 77610–77612 (December 28, 2004); Regulation H,
ture for, IT activities within and across busi- 12 CFR 208, appendix D-2; Regulation K, 12 CFR 211.9 and
ness lines. Determine also the role and 211.24; and Regulation Y, 12 CFR 225, appendix F.

Page 1
4060.1 Information Technology
tions Act of 2003 (15 USC 1681w). The Gramm- critical components of an effective information
Leach-Bliley Act requires the agencies to estab- security program. Financial institutions are
lish financial-institution information security required to oversee their service-provider
standards for administrative, technical, and arrangements in order to (1) protect the security
physical safeguards for customer records and of customer information maintained or pro-
information. (See SR-01-15.) cessed by service providers; (2) ensure that its
Under the information security standards, service providers properly dispose of custo-
institutions must establish an effective written mer and consumer information; and (3) where
information security program to assess and con- warranted, monitor its service providers to con-
trol risks to customer information. An institu- firm that they have satisfied their contractual
tion’s information security program should be obligations.
appropriate to its size and complexity and to the The Federal Reserve recognizes that banking
nature and scope of its operations. The board of organizations are highly sensitive to the impor-
directors should oversee the institution’s devel- tance of safeguarding customer information and
opment, implementation, and maintenance of the need to maintain effective information secu-
the information security program and also rity programs. Existing examination procedures
approve written information security policies and supervisory processes already address infor-
and programs. mation security. As a result, most banking orga-
The information security program should nizations may not need to implement any new
include administrative, technical, and physical controls and procedures.
safeguards appropriate to the size and complex- Examiners should assess compliance with the
ity of the bank and the nature and scope of its standards during each safety-and-soundness
activities. The program should be designed to examination, which may include targeted reviews
ensure the security and confidentiality of cus- of information technology. Ongoing compliance
tomer information;2 protect against anticipated with the standards should be monitored, as
threats or hazards to the security or integrity of needed, during the risk-focused examination
such information; protect against unauthorized process. Material instances of noncompliance
access to, or use of, such information that could should be noted in the examination report.
result in substantial harm or inconvenience to The information security standards apply to
any customer;3 and ensure the proper disposal of customer information maintained by, or on behalf
customer information and consumer informa- of, state member banks and bank holding com-
tion. Each institution must assess risks to cus- panies and the nonbank subsidiaries of each.4
tomer information and implement appropriate The information security standards also address
policies, procedures, training, and testing to standards for the proper disposal of consumer
manage and control these risks. Institutions information, pursuant to sections 621 and 628 of
must also report annually to the board of direc- the Fair Credit Reporting Act (15 USC 1681s
tors or a committee of the board of directors. and 1681w). To address the risks associated
The information security standards outline with identity theft, a financial institution is
specific security measures that banking organi- generally required to develop, implement, and
zations should consider in implementing a secu- maintain, as part of its existing information
rity program based on the size and complexity security program, appropriate measures to prop-
of their operations. Training and testing are also erly dispose of consumer information derived
from consumer reports.
Consumer information is defined as any record
2. Customer information is defined to include any record,
whether in paper, electronic, or other form, containing non-
about an individual, whether in paper, elec-
public personal information, as defined in Regulation P, about tronic, or other form, that is a consumer report
a financial institution’s customer that is maintained by, or on or is derived from a consumer report and that is
behalf of, the institution. maintained or otherwise possessed by or on
3. A customer is defined in the same manner as in
Regulation P: a consumer who has established a continuing
relationship with an institution under which the institution 4. The information security standards do not apply to
provides one or more financial products or services to the brokers, dealers, investment companies, and investment advis-
consumer to be used primarily for personal, family, or ers, or to persons providing insurance under the applicable
household purposes. The definition of customer does not state insurance authority of the state in which the person is
include a business, nor does it include a consumer who domiciled. The appropriate federal agency or state insurance
has not established an ongoing relationship with the financial authority regulates insurance entities under sections 501 and
institution. 505 of the GLB Act.

Page 2
Information Technology 4060.1
behalf of the bank for a business purpose. holding company is expected, however, to coor-
Consumer information also means a compilation dinate all the elements of its information secu-
of such records. rity program.
Institutions must exercise due diligence when
The following are examples of consumer infor- selecting service providers, including reviewing
mation: the service provider’s information security pro-
gram or the measures the service provider uses
• a consumer report that a bank obtains to protect the institution’s customer informa-
• information from a consumer report that the tion.5 All contracts must require that the service
bank obtains from its affiliate after the con- provider implement appropriate measures
sumer has been given a notice and has elected designed to meet the objectives of the standards.
not to opt out of that sharing Institutions must also conduct ongoing oversight
• information from a consumer report that the to confirm that the service provider maintains
bank obtains about an individual who applies appropriate security measures. An institution’s
for but does not receive a loan, including any methods for overseeing its service-provider
loan sought by an individual for a business arrangements may differ depending on the type
purpose of services or service provider or the level of
• information from a consumer report that the risk. For example, if a service provider is subject
bank obtains about an individual who guaran- to regulations or a code of conduct that imposes
tees a loan (including a loan to a business a duty to protect customer information consis-
entity) tent with the objectives of the standards, the
• information from a consumer report that the institution may consider that duty in exercising
bank obtains about an employee or prospec- its due diligence and oversight of the service
tive employee provider. In situations where a service provider
hires a subservicer (or subcontractor), the sub-
Consumer information does not include any servicer would not be considered a ‘‘service
record that does not personally identify an provider’’ under the guidelines.
individual, nor does it include the following:
• aggregate information, such as the mean score, Response Programs for Unauthorized
derived from a group of consumer reports Access to Customer Information and
• blind data, such as payment history on accounts Customer Notice
that are not personally identifiable, that may
be used for developing credit scoring-models Response programs specify actions that are to be
or for other purposes taken when a financial institution suspects or
• information from a consumer report that the detects that unauthorized individuals have gained
bank obtains about an individual who applies access to customer information systems, includ-
for but does not receive a loan, including any ing appropriate reports to regulatory and law
loan sought by an individual for a business enforcement agencies.6 A response program is
purpose the principal means for a financial institution to
• information from a consumer report that the protect against unauthorized ‘‘use’’ of customer
bank obtains about an individual who guaran- information that could lead to ‘‘substantial harm
tees a loan (including a loan to a business or inconvenience’’ to the institution’s customer.
entity) For example, customer notification is an impor-
• information from a consumer report that the tant tool that enables a customer to take steps to
bank obtains about an employee or prospec- prevent identity theft, such as by arranging to
tive employee have a fraud alert placed in his or her credit file.
The measures enumerated in the information
An institution or banking organization is not security standards include ‘‘response programs
required to implement a uniform information
security program. For example, a bank holding 5. A service provider is deemed to be a person or entity that
company may include subsidiaries within the maintains, processes, or is otherwise permitted access to
customer information through its provision of services directly
scope of its information security program, or the to the bank.
subsidiaries may implement separate informa- 6. See the information security standards, 12 CFR 208,
tion security programs. The institution or bank appendix D-2, section III.C.

Page 3
that specify actions to be taken when the bank to contain and control the incident to prevent
suspects or detects that unauthorized individuals further unauthorized access to or use of cus-
have gained access to customer information tomer information, such as by monitoring, freez-
systems, including appropriate reports to regu- ing, or closing affected accounts, while preserv-
latory and law enforcement agencies.’’7 Prompt ing records and other evidence; and (5) notifying
action by both the institution and the customer customers when warranted.
following the unauthorized access to customer The guidance does not apply to a financial
information is crucial to limiting identity theft. institution’s foreign offices, branches, or affili-
As a result, every financial institution should ates. However, a financial institution subject to
develop and implement a response program the information security standards is responsible
appropriate to its size and complexity and to the for the security of its customer information,
nature and scope of its activities. The program whether the information is maintained within or
should be designed to address incidents of outside of the United States, such as by a service
unauthorized access to customer information. provider located outside of the United States.
The Interagency Guidance on Response Pro- The guidance also applies to customer infor-
grams for Unauthorized Access to Customer mation, meaning any record containing ‘‘non-
Information and Customer Notice8 (the guid- public personal information’’ about a financial
ance) interprets section 501(b) of the Gramm- institution’s customer, whether the information
Leach-Bliley Act (the GLB Act) and the infor- is maintained in paper, electronic, or other form,
mation security standards.9 The guidance that is maintained by or on behalf of the
describes the response programs, including cus- institution.10 (See the Board’s privacy rule, Regu-
tomer notification procedures, that a financial lation P, at section 216.3(n)(2) (12 CFR 216.3
institution should develop and implement to (n)(2).) Consequently, the guidance applies only
address unauthorized access to or use of cus- to information that is within the control of the
tomer information that could result in substan- institution and its service providers. The guid-
tial harm or inconvenience to a customer. ance would not apply to information directly
When evaluating the adequacy of an institu- disclosed by a customer to a third party, for
tion’s information security program that is example, through a fraudulent web site.
required by the information security standards, The guidance also does not apply to informa-
examiners are to consider whether the institution tion involving business or commercial accounts.
has developed and implemented a response Instead, the guidance applies to nonpublic per-
program equivalent to the guidance. At a mini- sonal information about a customer, as that term
mum, an institution’s response program should is used in the information security standards,
contain procedures for (1) assessing the nature namely, a consumer who obtains a financial
and scope of an incident, and identifying what product or service from a financial institution to
customer information systems and types of cus- be used primarily for personal, family, or house-
tomer information have been accessed or mis- hold purposes and who has a continuing rela-
used; (2) notifying its primary federal regulator tionship with the institution.11
as soon as possible when the institution becomes
aware of an incident involving unauthorized
access to or use of sensitive customer informa- Response Programs
tion, as defined later in the guidance; (3) imme-
diately notifying law enforcement in situations Financial institutions should take preventative
involving federal criminal violations requiring measures to safeguard customer information
immediate attention; (4) taking appropriate steps against attempts to gain unauthorized access to
the information. For example, financial institu-
7. See the information security standards, section III.C.1.g. tions should place access controls on customer
8. The guidance was jointly issued on March 23, 2005 information systems and conduct background
(effective March 29, 2005), by the Board of Governors of the
Federal Reserve System, the Federal Deposit Insurance Cor-
checks for employees who are authorized to
poration, the Office of the Comptroller of the Currency, and
the Office of Thrift Supervision.
9. See 12 CFR 208, appendix D-2, and 12 CFR 225, 10. See the information security standards, 12 CFR 208,
appendix F. The Interagency Guidelines Establishing Infor- appendix D-2, section I.C.2.e.
mation Security Standards were formerly known as the 11. See the information security standards, 12 CFR 208,
Interagency Guidelines Establishing Standards for Safeguard- appendix D-2, section I.C.2.d., and the Board’s privacy rule
ing Customer Information. (Regulation P), section 216.3(h) (12 CFR 216.3(h)).

Page 4
access customer information.12 However, every to or use of sensitive customer information, as

financial institution should also develop and defined below
implement a risk-based response program to • consistent with the Suspicious Activity Report
address incidents of unauthorized access to cus- by Depository Institutions (SAR-DI) regula-
tomer information in customer information sys- tions,16 notifying appropriate law enforcement
tems13 that occur nonetheless. A response pro- authorities, in addition to filing a timely
gram should be a key part of an institution’s SAR-DI form in situations involving federal
information security program.14 The program criminal violations requiring immediate atten-
should be appropriate to the size and complexity tion, such as when a reportable violation is
of the institution and the nature and scope of its ongoing
activities. • taking appropriate steps to contain and control
In addition, each institution should be able to the incident to prevent further unauthorized
address incidents of unauthorized access to cus- access to or use of customer information, for
tomer information in customer information sys- example, by monitoring, freezing, or closing
tems maintained by its domestic and foreign affected accounts, while preserving records
service providers. Therefore, consistent with the and other evidence
obligations in the information security standards • notifying customers when warranted
that relate to these arrangements, and with
existing guidance on this topic issued by the Where an incident of unauthorized access to
agencies,15 an institution’s contract with its customer information involves customer infor-
service provider should require the service pro- mation systems maintained by an institution’s
vider to take appropriate actions to address service providers, it is the responsibility of the
incidents of unauthorized access to the financial financial institution to notify the institution’s
institution’s customer information, including customers and regulator. However, an institution
notification to the institution as soon as possible may authorize or contract with its service pro-
of any such incident, to enable the institution to vider to notify the institution’s customers or
expeditiously implement its response program. regulator on its behalf.
Components of a response program. At a mini-

mum, an institution’s response program should Customer Notice
contain procedures for the following:
Financial institutions have an affirmative duty to
• assessing the nature and scope of an incident, protect their customers’ information against
and identifying what customer information unauthorized access or use. Notifying customers
systems and types of customer information of a security incident involving the unauthorized
have been accessed or misused access or use of the customer’s information in
• notifying its primary federal regulator as soon accordance with the standard set forth below is
as possible when the institution becomes aware a key part of that duty. Timely notification of
of an incident involving unauthorized access customers is important to managing an institu-
tion’s reputation risk. Effective notice also may
12. Institutions should also conduct background checks of
reduce an institution’s legal risk, assist in main-
employees to ensure that the institution does not violate 12 taining good customer relations, and enable the
USC 1829, which prohibits an institution from hiring an institution’s customers to take steps to protect
individual convicted of certain criminal offenses or who is themselves against the consequences of identity
subject to a prohibition order under 12 USC 1818(e)(6).
13. Under the information security standards, an institu-
theft. When customer notification is warranted,
tion’s customer information systems consist of all the methods an institution may not forgo notifying its cus-
used to access, collect, store, use, transmit, protect, or dispose tomers of an incident because the institution
of customer information, including the systems maintained by
its service providers. See the information security standards,
12 CFR 208, appendix D-2, section I.C.2.f. 16. An institution’s obligation to file a SAR-DI form is set
14. See SR-97-32, ‘‘Sound Practices Guidance for Infor- out in SAR-DI form regulations and supervisory guidance.
mation Security for Networks,’’ for additional guidance on See 12 CFR 208.62 (state member banks); 12 CFR 211.5(k)
preventing, detecting, and responding to intrusions into finan- (Edge and agreement corporations); 12 CFR 211.24(f) (unin-
cial institution computer systems. sured state branches and agencies of foreign banks); and
15. See SR-00-04, ‘‘Outsourcing of Information and Trans- 12 CFR 225.4(f) (bank holding companies and their nonbank
action Processing,’’ and the subsection ‘‘Outsourcing Infor- subsidiaries). See SR-07-2 and its attachments and also
mation Technology.’’ SR-01-11, ‘‘Identity Theft and Pretext Calling.’’

Page 5
believes that it may be potentially embarrassed files has been accessed improperly but is unable
or inconvenienced by doing so. to identify which specific customers’ informa-
tion has been accessed. If the circumstances of
Standard for providing notice. When a financial the unauthorized access lead the institution to
institution becomes aware of an incident of determine that misuse of the information is
unauthorized access to sensitive customer infor- reasonably possible, it should notify all custom-
mation, the institution should conduct a reason- ers in the group.
able investigation to promptly determine the
likelihood that the information has been or will Content of customer notice. Customer notice
be misused. If the institution determines that should be given in a clear and conspicuous
misuse of its information about a customer has manner. The notice should describe the incident
occurred or is reasonably possible, it should in general terms and the type of customer
notify the affected customer as soon as possible. information that was the subject of unauthorized
Customer notice may be delayed if an appropri- access or use. It should also generally describe
ate law enforcement agency determines that what the institution has done to protect the
notification will interfere with a criminal inves- customers’ information from further unautho-
tigation and provides the institution with a rized access. In addition, it should include a
written request for the delay. However, the telephone number that customers can call for
institution should notify its customers as soon as further information and assistance.17 The notice
notification will no longer interfere with the also should remind customers of the need to
investigation. remain vigilant over the next 12 to 24 months,
and to promptly report incidents of suspected
Sensitive customer information. Under the infor- identity theft to the institution. The notice should
mation security standards, an institution must include the following additional items, when
protect against unauthorized access to or use of appropriate:
customer information that could result in sub-
stantial harm or inconvenience to any customer. • a recommendation that the customer review
Substantial harm or inconvenience is most likely account statements and immediately report
to result from improper access to sensitive any suspicious activity to the institution
customer information because this type of infor- • a description of fraud alerts and an explana-
mation is most likely to be misused, as in the tion of how the customer may place a fraud
commission of identity theft. For purposes of alert in the customer’s consumer reports to put
the guidance, sensitive customer information the customer’s creditors on notice that the
means a customer’s name, address, or telephone customer may be a victim of fraud
number, in conjunction with the customer’s • a recommendation that the customer periodi-
Social Security number, driver’s license number, cally obtain credit reports from each nation-
account number, credit or debit card number, or wide credit reporting agency and have infor-
a personal identification number or password mation relating to fraudulent transactions
that would permit access to the customer’s deleted
account. Sensitive customer information also
• an explanation of how the customer may
includes any combination of components of
obtain a credit report free of charge
customer information that would allow someone
to log onto or access the customer’s account, • information about the availability of the FTC’s
such as a user name and password or a password online guidance regarding steps a consumer
and an account number. can take to protect against identity theft (The
notice should encourage the customer to report
Affected customers. If a financial institution, on any incidents of identity theft to the FTC and
the basis of its investigation, can determine from should provide the FTC’s web site address
its logs or other data precisely which customers’ and toll-free telephone number that customers
information has been improperly accessed, it may use to obtain the identity theft guidance
may limit notification to those customers for
whom the institution determines that misuse of
17. The institution should, therefore, ensure that it has
their information has occurred or is reasonably reasonable policies and procedures in place, including trained
possible. However, there may be situations in personnel, to respond appropriately to customer inquiries and
which the institution determines that a group of requests for assistance.

Page 6
and to report suspected incidents of identity ‘‘covered accounts’’ must develop and imple-
theft.18 ment a written Identity Theft Prevention Pro-
gram (Program). 18d A Program is to be designed
Financial institutions are encouraged to notify to detect, prevent, and mitigate identity theft in
the nationwide consumer reporting agencies connection with the opening of a covered account
before sending notices to a large number of or any existing covered account. The Program
customers when those notices include contact must be tailored to the entity’s size, complexity,
information for the reporting agencies. and the nature and scope of its operations and
activities.
Delivery of customer notice. Customer notice The Board’s approval of the rule and guide-
should be delivered in any manner designed to lines was on October 16, 2007. The effective
ensure that a customer can reasonably be date for the joint final rules and guidelines is
expected to receive it. For example, the institu- January 1, 2008. The mandatory compliance
tion may choose to contact all affected custom- date for the rules is November 1, 2008. See
ers by telephone, by mail, or by electronic mail, section 222 of the Board’s Regulation V—Fair
in the case of customers for whom it has a valid Credit Reporting (12 CFR 222) and 72 Fed.
e-mail address and who have agreed to receive Reg. 63718- 63775, November 9, 2007.
communications electronically. This section incorporates certain financial
institution safety and soundness provisions of
the rule (Regulation V and its guidelines (Appen-
IDENTITY THEFT RED FLAGS dix J)). See also the October 10, 2008, Federal
Reserve Board letter (SR-08-7/CA-08-10) and
PROGRAM its interagency attachments.
The federal financial institution regulatory
agencies 18a and the Federal Trade Commission
(FTC) have issued joint regulations and guide- Risk Assessment
lines on the detection, prevention, and mitiga-
tion of identity theft in connection with opening Prior to the development of the Program, a
of certain accounts or maintaining certain exist- financial institution must initially and then peri-
ing accounts in response to the Fair and Accu- odically conduct a risk assessment to determine
rate Credit Transactions Act of 2003 (The FACT whether it offers or maintains covered accounts.
Act). 18b The regulations require (debit and credit) It must take into consideration: (1) the methods
card issuers to validate notifications of changes it provides to open its accounts, (2) the methods
of address under certain circumstances. The it provides to access accounts, and (3) its previ-
joint rules also provide guidelines regarding ous experiences with identity theft. If the finan-
reasonable policies and procedures that a user of cial institution has covered accounts, it must
consumer reports must employ when a con- evaluate its potential vulnerability to identity
sumer reporting agency sends the user a notice theft. The institution should also consider
of address discrepancy. Financial institutions or whether a reasonably foreseeable risk of identity
creditors 18c that offer or maintain one or more theft may exist in connection with the accounts
it offers or maintains and those that may be
opened or accessed remotely, through methods
18. The FTC website for the ID theft brochure and the FTC that do not require face-to-face contact, such as
hotline phone number are www.consumer.gov/idtheft/ and
1-877-IDTHEFT. The institution may also refer customers to through the internet or telephone. Financial
any materials developed pursuant to section 151(b) of the Fair institutions that offer or maintain business
and Accurate Credit Transactions Act of 2003 (the FACT Act)
(educational materials developed by the FTC to teach the
public how to prevent identity theft). mean a ‘‘financial institution or creditors’’ with regard to the
18a. The Board of Governors of the Federal Reserve Red Flags Program joint regulations and the accompanying
System (FRB), the Office of the Comptroller of the Currency interagency guidance.
(OCC), the Office of Thrift Supervision (OTS), the Federal 18d. ‘‘Covered accounts’’ are (1) accounts that a financial
Deposit Insurance Corporation (FDIC), and the National institution offers or maintains, primarily for personal, family,
Credit Union Administration (NCUA). or household purposes, that involves or is designed to permit
18b. Section 111 of the FACT Act defines ‘‘identity theft’’ multiple payments or transactions and (2) any other account
as ‘‘a fraud committed or attempted using the identifying that the financial institution offers or maintains for which there
information of another person.’’ is a reasonably foreseeable risk to customers or to the safety
18c. The term financial institution should be interpreted to and soundness of the financial institution from identity theft.

Page 7
accounts that have been the target of identity Identification of Red Flags
theft should factor those experiences with iden-
tity theft into their determination. A financial institution should incorporate rel-
If the financial institution determines that it evant Red Flags into the Program from sources
has covered accounts, the risk assessment will such as (1) incidents of identity theft that it has
enable it to identify which of its accounts the experienced, (2) methods of identity theft that
Program must address. If a financial institution have been identified as reflecting changes in
initially determines that it does not have covered identity theft risks, and (3) applicable supervi-
accounts, it must periodically reassess whether sory guidance.
it must develop and implement a Program in
light of changes in the accounts that it offers or
maintains. Categories of Red Flags
Section II of the Guidelines, ‘‘Categories of Red
Elements of the Program Flags,’’ provides some guidance in identifying
relevant Red Flags. A financial institution should
The elements of the actual Program will vary include, as appropriate, 18e
depending on the size and complexity of the
financial institution. A financial institution that • alerts, notifications, or other warnings received
determines that it is required to establish and from consumer reporting agencies or service
maintain an Identity Theft Prevention Program providers, such as fraud detection services
must (1) identify relevant Red Flags for its • the presentation of suspicious documents
covered accounts, (2) detect and respond to the • the presentation of suspicious personal iden-
Red Flags that have been incorporated into its tifying information, such as a suspicious
Program, and (3) respond appropriately to the address change
detected Red Flags. The Red Flags are patterns, • the unusual use of, or other suspicious activity
practices, or specific activities that indicate the related to, a covered account
possible existence of identity theft or the poten- • a notice received from customers, victims of
tial to lead to identity theft. A financial institu- identity theft, law enforcement authorities, or
tion must ensure that its Program is updated other persons regarding possible identity theft
periodically to address the changing risks asso- in connection with covered accounts held by
ciated with its customers and their accounts and the financial institution
to the safety and soundness of the financial
institution from identity theft. The above categories do not represent a com-
prehensive list of all types of Red Flags that may
indicate the possibility of identity theft. Institu-
tions must also consider specific business lines
Guidelines and any previous exposures to identity theft. No
specific Red Flag is mandatory for all financial
Each financial institution that is required to institutions. Rather, the Program should follow
implement a written Program must consider the the risk-based, nonprescriptive approach regard-
Guidelines for Identity Theft Detection, Preven- ing the identification of Red Flags.
tion, and Mitigation’s in Appendix J (12 CFR
222, Appendix J of the rule) (the Guidelines)
and include those guidelines that are appropriate
Detect the Program’s Red Flags
in its Program. Section I of the Guidelines, ‘‘The
Program,’’ discusses a Program’s design that In accordance with Section III of the Guidelines,
may include, as appropriate, existing policies, each financial institution’s Program should
procedures, and arrangements that control fore- address the detection of Red Flags in connection
seeable risks to the institution’s customers or to with the opening of covered accounts and exist-
the safety and soundness of the financial insti- ing covered accounts. A financial institution is
tution from identity theft. required to detect, prevent, and mitigate identity
18e. Examples of Red Flags from each of these categories

are appended as supplement A to appendix J.

Page 8
theft in connection with such accounts. The Program,’’ states that a financial institution
policies and procedures regarding opening a should periodically update its Program (includ-
covered account subject to the Program should ing its relevant Red Flags) to reflect any
explain how an institution could identify infor- changes in risks to its customers or to the safety
mation about, and verify the identity of, a person and soundness of the institution from identity
opening an account. 18f In the case of existing theft, based on (but not limited to) factors such
covered accounts, institutions could authenticate as
customers, monitor transactions, and verify the
validity of change of address requests. • the experiences of the financial institution
with identity theft;
• changes in methods of identity theft;
Respond Appropriately to any Detected • changes in methods to detect, prevent, and
Red Flags mitigate identity theft;
• changes in the types of accounts that the
A financial institution should consider precur- financial institution offers or maintains; and
sors to identity theft to stop identity theft before • changes in the financial institution’s structure,
it occurs. Section IV of the Guidelines, ‘‘Pre- including its mergers, acquisitions, joint ven-
vention and Mitigation,’’ states that an institu- tures, and any business arrangements, such as
tion’s procedures should provide for appropriate alliances and service provider arrangements.
responses to Red Flags that it has detected that
are commensurate with the degree of risk posed.
When determining an appropriate response, the
institution should consider aggravating factors Administration of Program
that may heighten its risk of identity theft. Such
factors may include (1) a data security incident A financial institution that is required to imple-
that results in unauthorized disclosures of non- ment a Program must provide for the continued
public personal information (NPPI), (2) records oversight and administration of its Program. The
the financial institution holds or that are held by following are the steps that are needed in the
another creditor or third party, or (3) notice that administration of a Red Flags Program:
the institution’s customer has provided informa-
tion related to its covered account to someone 1. Obtain approval from either the institution’s
fraudulently claiming to represent the financial board of directors or any appropriate com-
institution or creditor or to a fraudulent website. mittee of the board of directors of the initial
Appropriate responses may include the follow- written Program;
ing: (1) monitoring a covered account for evi- 2. Involve either the board of directors, a des-
dence of identity theft; (2) contacting the cus- ignated committee of the board of directors,
tomer; (3) changing any passwords, security or a designated senior-management-level
codes, or other security devices that permit employee in the oversight, development,
access to a secured account; (4) reopening a implementation, and administration of the
covered account with a new account number; Program. This includes
(5) not opening a new covered account; (6) clos- • assigning specific responsibility for the
ing an existing covered account; (7) not attempt- Program’s implementation,
ing to collect on a covered account or not selling • reviewing reports prepared by staff regard-
a covered account to a debt collector; (8) noti- ing the institution’s compliance (the reports
fying law enforcement; or (9) determining that should be prepared at least annually), and
no response is warranted under the particular • reviewing material changes to the Program
circumstances. as necessary to address changing identity
theft risks.
3. Train staff. The financial institution must
Periodically Updating the Program’s train relevant staff to effectively implement
Relevant Red Flags and monitor the Program. Training should be
provided as changes are made to the financial
Section V of the Guidelines, ‘‘Updating the institution’s Program based on its periodic
risk assessment.
18f. 31 USC 5318(l) (31 CFR 103.121) 4. Exercise appropriate and effective oversight

Page 8.1
of service provider arrangements. Section these institutions, some or all components of the
VI of the Guidelines, ‘‘Methods for Admin- URSIT rating may not be meaningful. In these
istering the Program,’’ indicates a financial cases, the assessment of IT activities may be
institution is ultimately responsible for com- incorporated directly into the safety-and sound-
plying with the rules and guidelines for out- ness rating for the institution, rather than through
sourcing an activity to a third-party service the assignment of an URSIT rating. The scope of
provider. Whenever a financial institution the IT assessment for such institutions should
engages a service provider to perform an evaluate the adequacy of the institution’s over-
activity in connection with one or more cov- sight of service providers for critical processing
ered accounts, the institution should ensure activities and should incorporate the results of
that the activity of the service provider is any relevant supervisory reviews of these service
conducted in accordance with reasonable providers. The assessment should also include
policies and procedures designed to detect, reviews of any significant in-house activities,
prevent, and mitigate the risk of identity such as management information systems and
theft. With regard to the institution’s over- local networks, and the implementation of new
sight of its Program, periodic reports from technologies, such as Internet banking. As noted
service providers are to be issued on the above, the assessment of IT should be reflected
Program’s development, implementation, in the overall safety-and- soundness examination
and administration. report and in the appropriate components of the
safety-and-soundness examination rating as-
signed to the institution, as well as in the
associated risk-profile analysis. (See SR-00-3.)
IT EXAMINATION FREQUENCY Targeted IT examinations may be conducted
AND SCOPE more frequently, if deemed necessary, by the
Reserve Bank. A composite URSIT rating should
All safety-and-soundness examinations (or be assigned for targeted reviews when possible.
examination cycles) of banking organizations In addition, institutions for which supervisory
conducted by the Federal Reserve should include concerns have been raised (normally those rated
an assessment and evaluation of IT risks and URSIT 3, 4, or 5) should be subject to more
risk management. The scope of the IT assess- frequent IT reviews, until such time as the
ment should generally be sufficient to assign a Reserve Bank is satisfied that the deficiencies
composite rating under the Uniform Rating have been corrected.
System for Information Technology (URSIT).
URSIT component ratings may be updated at
the examiner’s discretion, based on the scope of
the assessment. The scope would normally be RISK ELEMENTS
based on factors such as—
To provide a common terminology and consis-
• implementation of new systems or technolo- tent approach for evaluating the adequacy of an
gies since the last examination; organization’s IT, five IT elements are defined
• significant changes in operations, such as below. These elements may be used to evaluate
mergers or systems conversions; the IT processes at the functional business level
• new or modified outsourcing relationships for or for the organization as a whole and to
critical operations; determine the impact on the business risks
• targeted examinations of business lines whose outlined in SR-95-51, as well as their impact on
internal controls or risk-management systems the IT rating (URSIT) discussed below. (See
depend heavily on IT; and SR-98-9.)
• other potential problems or concerns that may
have arisen since the last examination or the 1. Management processes. Management pro-
need to follow up on previous examination or cesses encompass planning, investment,
audit issues. development, execution, and staffing of IT
from a corporate-wide and business-specific
Institutions that outsource core processing perspective. Management processes over IT
functions, although not traditionally subject to IT are effective when they are adequately and
examinations, are exposed to IT-related risks. For appropriately aligned with and support the

Page 8.2
organization’s mission and business objection commensurate with the value of the
tives. Management processes include strate- information. Security risk is managed effec-
gic planning; budgeting; management and tively when controls prevent unauthorized
reporting hierarchy; management succession; access, modification, destruction, or disclo-
and a regular, independent review function. sure of sensitive information during creation,
Examiners should determine if the IT strat- transmission, processing, maintenance, or
egy for the business activity or organization storage. Examiners should ensure that oper-
is consistent with the organization’s mission ating procedures and controls are commen-
and business objectives and whether the IT surate with the potential for and risks asso-
function has effective management processes ciated with security breaches, which may be
to execute that strategy. either physical or electronic, inadvertent or
2. Architecture. Architecture refers to the under- intentional, internal or external.
lying design of an automated information 5. Availability. Availability refers to the timely
system and its individual components. The delivery of information and processes to end-
underlying design encompasses both physi- users in support of business and decision-
cal and logical architecture, including oper- making processes and customer services. In
ating environments, as well as the organiza- assessing the management of availability risk,
tion of data. The individual components refer examiners should consider the capability of
to network communications, hardware, and IT functions to provide information to the
software, which includes operating systems, end-users from either primary or secondary
communications software, database- sources, as well as consider the ability of
management systems, programming lan- back-up systems, as presented in contingency
guages, and desktop software. Effective plans, to mitigate business disruption. Con-
architecture meets current and long-term tingency plans should set out a process for an
organizational objectives, addresses capacity organization to restore or replace its
requirements to ensure that systems allow information-processing resources; reconstruct
users to easily enter data at both normal and its information assets; and resume its busi-
peak processing times, and provides satisfac- ness activity from disruption caused by
tory solutions to problems that arise when human error or intervention, natural disaster,
information is stored and processed in two or or infrastructure failure (including loss of
more systems that cannot be connected elec- utilities and communication lines and the
tronically. When assessing the adequacy of operational failure of hardware, software,
IT architecture, examiners should consider and network communications).
the ability of the current infrastructure to
meet operating objectives, including the
effective integration of systems and sources UNIFORM RATING SYSTEM FOR
of data. INFORMATION TECHNOLOGY
3. Integrity. Integrity refers to the reliability,
accuracy, and completeness of information The Uniform Rating System for Information
delivered to the end-user. Integrity risk could Technology (URSIT) is an interagency exami-
arise from insufficient controls over systems nation rating system adopted by the Federal
or data, which could adversely affect critical Financial Institutions Examination Council
financial and customer information. Examin- (FFIEC) agencies to evaluate the IT activities of
ers should review and consider whether the financial institutions. The rating system includes
organization relies on information system component- and composite-rating descriptions
audits or independent reviews of applications and the explicit identification of risks and
to ensure the integrity of its systems. Exam- assessment factors that examiners consider in
iners should review the reliability, accuracy,
and completeness of information delivered in
key business lines.
4. Security. Security risk is the risk of unautho-
rized disclosure or destruction of critical or
sensitive information. To mitigate this risk,
physical access and logical controls are gen-
erally provided to achieve a level of protec-

Page 8.3
assigning component ratings. This rating system 2 exhibit safe and sound performance but may
helps examiners assess risk and compile exami- demonstrate modest weaknesses in operating
nation findings. However, the rating system performance, monitoring, management pro-
should not drive the scope of an examination. In cesses, or system development. Generally, senior
particular, not all assessment factors or management corrects weaknesses in the normal
component-rating areas are required to be course of business. Risk-management processes
assessed at each examination. Examiners should adequately identify and monitor risk relative to
use the rating system to help evaluate the the size, complexity, and risk profile of the
entity’s overall risk exposure and risk- entity. Strategic plans are defined but may require
management performance and to determine the clarification, better coordination, or improved
degree of supervisory attention believed neces- communication throughout the organization. As
sary to ensure that weaknesses are addressed a result, management anticipates, but responds
and that risk is properly managed. (See SR-99- less quickly to changes in the market, business,
8.) and technological needs of the entity. Manage-
The URSIT rating framework is based on a ment normally identifies weaknesses and takes
risk evaluation of four general areas: audit, appropriate corrective action. However, greater
management, development and acquisition, and reliance is placed on audit and regulatory inter-
support and delivery. These components are vention to identify and resolve concerns. While
used to assess the overall IT functions within an internal control weaknesses may exist, there are
organization and arrive at a composite URSIT no significant supervisory concerns. As a result,
rating. Examiners evaluate the areas identified supervisory action is informal and limited.
within each component to assess the institu- Financial institutions rated URSIT composite
tion’s ability to identify, measure, monitor, and 3 exhibit some degree of supervisory concern
control IT risks. due to a combination of weaknesses that may
In adopting the URSIT rating system, the range from moderate to severe. If weaknesses
FFIEC recognized that management practices persist, further deterioration in the condition and
vary considerably among financial institutions performance of the institution is likely. Risk-
depending on their size and sophistication, the management processes may not effectively iden-
nature and complexity of their business activi- tify risks and may not be appropriate for the
ties, and their risk profile. For less complex size, complexity, or risk profile of the entity.
information systems environments, detailed or Strategic plans are vaguely defined and may not
highly formalized systems and controls are not provide adequate direction for IT initiatives. As
required to receive the higher composite and a result, management often has difficulty
component ratings. responding to changes in the business, market,
and technological needs of the entity. Self-
assessment practices are weak and generally
reactive to audit and regulatory exceptions.
URSIT Composite-Rating Definitions Repeat concerns may exist, indicating that man-
agement may lack the ability or willingness to
Financial institutions rated URSIT composite 1 resolve concerns. While financial or operational
exhibit strong performance in every respect and failure is unlikely, increased supervision is nec-
generally have components rated 1 or 2. Weak- essary. Formal or informal supervisory action
nesses in IT functions are minor and are easily may be necessary to secure corrective action.
corrected during the normal course of business. Financial institutions rated URSIT composite
Risk-management processes provide a compre- 4 operate in an unsafe and unsound environment
hensive program to identify and monitor risk that may impair the future viability of the entity.
relative to the size, complexity, and risk profile Operating weaknesses are indicative of serious
of the entity. Strategic plans are well defined and managerial deficiencies. Risk-management pro-
fully integrated throughout the organization. cesses inadequately identify and monitor risk,
This allows management to quickly adapt to the and practices are not appropriate given the size,
changing market, business, and technology needs complexity, and risk profile of the entity. Stra-
of the entity. Management identifies weaknesses tegic plans are poorly defined and not coordi-
promptly and takes appropriate corrective action nated or communicated throughout the organi-
to resolve audit and regulatory concerns. zation. As a result, management and the board
Financial institutions rated URSIT composite are not committed to, or may be incapable of,

Page 9
ensuring that technological needs are met. Man- • the level of independence maintained by audit
agement does not perform self-assessments and and the quality of the oversight and support
demonstrates an inability or unwillingness to provided by the board of directors and
correct audit and regulatory concerns. Failure of management;
the financial institution may be likely unless IT • the adequacy of audit’s risk-analysis method-
problems are remedied. Close supervisory atten- ology used to prioritize the allocation of audit
tion is necessary and, in most cases, formal resources and to formulate the audit schedule;
enforcement action is warranted. • the scope, frequency, accuracy, and timeliness
Financial institutions rated URSIT composite of internal and external audit reports;
5 exhibit critically deficient operating perfor- • the extent of audit participation in application
mance and are in need of immediate remedial development, acquisition, and testing, to ensure
action. Operational problems and serious weak- the effectiveness of internal c

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Commercial Bank

Division of Banking Supervision and Regulation

Copies of this manual may be obtained from:

The manual is updated twice a year.

Summary of Changes ized daylight overdrafts. The section also

Commercial Bank Examination Manual April 2009

Table of Contents, pages 1-2 Table of Contents, pages 1-2

3020.1, pages 1-2 3020.1, pages 1-2

4060.1, pages 1-2 4060.1, pages 1-2

4125.1, pages 1-22 4125.1, pages 1-23

5017.1, pages 1-2

6010.1, pages 1-2 6010.1, pages 1-2

7000.0, page 1 7000.0, page 1

7010.1, pages 1-2 7010.1, pages 1-2

7040.1, pages 1-7 7040.1, pages 1-7

7040.2, pages 1-2 7040.2, page 1

7040.3, pages 1-8 7040.3, pages 1-7

7040.4, pages 1-2 7040.4, pages 1-2

Subject Index, pages 1-19 Subject Index, pages 1-20

April 2009 Commercial Bank Examination Manual

Summary of Changes prevention, and mitigation of identity theft

The section on ‘‘Asset Securitization’’ is revised

Commercial Bank Examination Manual October 2008

Table of Contents, pages 1–2 Table of Contents, pages 1–2

1000.1, pages 1–2 1000.1, pages 1–2

1010.1, pages 1–2 1010.1, pages 1–2

2020.1, pages 1–2 2020.1, pages 1–2

2040.1, pages 1–2 2040.1, pages 1–2

3010.1, pages 1–4 3010.1, pages 1–4

3010.3, pages 1–2 3010.3, pages 1–2

3020.1, pages 1–4 3020.1, pages 1–4

4030.1, pages 1–4 4030.1, pages 1–4

4060.1, pages 1–2 4060.1, pages 1–2

4060.2, page 1 4060.2, page 1

4060.3, pages 1–2 4060.3, pages 1–2

4060.4, pages 1–4 4060.4, pages 1–5

4090.3, pages 1–2 4090.3, pages 1–2

4128.1, pages 1–2 4128.1, pages 1–2

4140.1, pages 1–2 4140.1, pages 1–2

4150.1, pages 1–9 4150.1, pages 1–11

7030.3, pages 1–6 7030.3, pages 1–7

Subject Index, pages 1–19 Subject Index, pages 1–19

October 2008 Commercial Bank Examination Manual

Summary of Changes FDIC’s changes. For example, see footnote 4

1000.1, pages 1–10.1 1000.1, pages 1–10.2

1010.1, pages 1–6.1 1010.1, pages 1–6.2

2010.1, pages 1–3 2010.1, pages 1–3

Commercial Bank Examination Manual April 2008

2020.1, pages 1–2 2020.1, pages 1–2

3020.1, pages 1–2 3020.1, pages 1–2

4043.1, pages 1–2 4043.1, pages 1–2

4170.1, pages 1–9 4170.1, pages 1–9

5020.1, pages 1–6 5020.1, pages 1–6

6000.1, pages 1–16, 16.1–16.2

7010.1, pages 1–26 7010.1, pages 1–26

7100.1, pages 1–4 7100.1, pages 1–4

Subject Index, pages 1–19 Subject Index, pages 1–19

April 2008 Commercial Bank Examination Manual

Summary of Changes holding companies and their nonbank subsidiar-

Commercial Bank Examination Manual October 2007

Table of Contents, pages 1–2 Table of Contents, pages 1–2

1000.1, pages 1–4, 4.1–4.4 1000.1, pages 1–4, 4.1–4.4

2030.1, pages 1–6 2030.1, pages 1–6