Legal Risk Section 2070.1

An institution’s trading and capital-markets will prove unenforceable. Many trading activi- activities can lead to significant legal risks. ties, such as securities trading, commonly take Failure to correctly document transactions can place without a signed agreement, as each indi- result in legal disputes with counterparties over vidual transaction generally settles within a very the terms of the agreement. Even if adequately short time after the trade. The trade confirma- documented, agreements may prove to be unen- tions generally provide sufficient documentation forceable if the counterparty does not have the for these transactions, which settle in accor- authority to enter into the transaction or if the dance with market conventions. Other trading terms of the agreement are not in accordance activities involving longer-term, more complex with applicable law. Alternatively, the agree- transactions may necessitate more comprehen- ment may be challenged on the grounds that the sive and detailed documentation. Such documen- transaction is not suitable for the counterparty, tation ensures that the institution and its coun- given its level of financial sophistication, finan- terparty agree on the terms applicable to the cial condition, or investment objectives, or on transaction. In addition, documentation satisfies the grounds that the risks of the transaction were other legal requirements, such as the ‘‘statutes of not accurately and completely disclosed to the frauds’’ that may apply in many jurisdictions. investor. Statutes of frauds generally require signed, writ- As part of sound risk management, institu- ten agreements for certain classes of contracts, tions should take steps to guard themselves such as agreements with a duration of more than against legal risk. Active involvement of the one year (including both longer-term transac- institution’s legal counsel is an important ele- tions such as swaps and master or netting ment in ensuring that the institution has ade- agreements for transactions of any duration). quately considered and addressed legal risk. An Some states, such as New York, have provided institution’s policies and procedures should limited exceptions from their statutes of frauds include appropriate review by in-house or out- for certain financial contracts when other sup- side counsel as an integral part of the institu- porting evidence, such as confirmations or tape tion’s trading and capital-markets activities, recordings, is available. including new-product development, credit In the over-the-counter (OTC) derivatives approval, and documentation of transactions. markets, the prevailing practice has been for While some issues, such as the legality of a type institutions to enter into master agreements with of transaction, may be addressed on a jurisdiction- each counterparty. Master agreements are also wide basis, other issues, such as the enforceabil- becoming common for other types of transac- ity of multibranch netting agreements covering tions, such as repurchase agreements. Each mas- several jurisdictions, may require review of ter agreement identifies the type of products and individual contracts. specific legal entities or branches of the institu- An institution should have established proce- tion and counterparty that it will cover. Entering dures to ensure adequate legal review. For into a master agreement may help to clarify that example, review by legal counsel may be each subsequent transaction with the counter- required as part of the product-development or party will be made subject to uniform terms and credit-approval process. Legal review is also conditions. In addition, a master agreement that necessary for an institution to establish the types includes netting provisions may reduce the of agreements to be used in documenting trans- institution’s overall credit exposure to the actions, including any modifications to standard- counterparty. ized agreements that the institution considers appropriate. The institution should also ensure An institution should specify its documenta- that prior legal opinions are reviewed periodi- tion requirements for transactions and its proce- cally to determine if they are still valid. dures for ensuring that documentation is consis- tent with orally agreed-on terms. Transactions entered into orally, with documents to follow, DOCUMENTATION should be confirmed as soon as possible. Docu- mentation policies should address the terms that If the terms of a transaction are not adequately will be covered by confirmations for specific documented, there is a risk that the transaction types of transactions and what transactions are

Trading and Capital-Markets Activities Manual September 2002 Page 1 2070.1 Legal Risk covered by a master agreement; policies should available or may be artificially maintained at specify when additional documentation beyond nonmarket rates by a government seeking to the confirmation is necessary. When master preserve its currency. agreements are used, policies should cover the Contracts also should be clear as to whether permissible types of master agreements. Appro- cross-default provisions allow or require the priate controls should be in place to ensure that close-out of other contracts between the parties. the confirmations and agreements used satisfy Finally, close-out provisions should be reviewed the institution’s policies. Additional issues re- to determine what conditions need to be met lated to the enforceability of the netting provi- before the contract can be finally closed out. sions of master agreements are discussed below Formalities in some contracts may delay the in ‘‘Enforceability Issues.’’ close-out period significantly, further injuring a nondefaulting counterparty.

Trigger Events Netting Special attention should be given to the defini- tion of ‘‘trigger events,’’ which provide for To reduce settlement, credit, and liquidity risks, payment from one counterparty to another or institutions increasingly use netting agreements permit a counterparty to close out a transaction or master agreements that include netting pro- or series of transactions. In the ordinary course visions. ‘‘Netting’’ is the process of combining of events, contractual disputes can be resolved the payment or contractual obligations of two or by parties who wish to continue to enter into more parties into a single net payment or obli- transactions with one another, but these disputes gation. Institutions may have bilateral netting can become intractable if serious market disrup- agreements covering the daily settlement of tions occur. Indeed, the 1998 Russian market payments such as those related to check-clearing crisis raised calls for the establishment of an or foreign-exchange transactions. Bilateral mas- international dispute-resolution tribunal to handle ter agreements with netting provisions may the large volume of disputed transactions when cover OTC derivatives or other types of trans- the Russian government announced its debt actions, such as repurchase agreements. moratorium and restructuring. The Commodity Futures Trading Commis- sion (CFTC) has exempted a broad range of Trigger events need to be clearly and pre- OTC derivatives from the Commodity Exchange cisely defined. In the Russian crisis, the trigger Act, eliminating the risk that instruments meet- events in some master agreements did not include ing certain conditions would be found to be a rescheduling of or moratorium on the payment illegal off-exchange futures under U.S. law. The of sovereign debt. Even when sovereign debt is exemption nevertheless limits the use of multi- covered by the master agreement, it may be lateral netting and similar arrangements for appropriate to specify that not only debt directly reducing credit and settlement risk, and reserves issued by the sovereign, but also debt issued the CFTC’s enforcement authority with respect through governmental departments and agencies to fraud and market manipulation.1 or through other capital-raising vehicles, falls The CFTC’s exemption provides significant within the scope of the trigger event. Moreover, comfort with respect to the legality of most OTC when a trigger event has occurred, but the derivative instruments within the United States. contract expires before the expiration of a cure The risk that a transaction will be unenforceable period or before the completion of a debt because it is illegal may be higher in other restructuring, the nondefaulting party can lose jurisdictions, however. Jurisdictions outside the the protection of the contract absent clear pro- United States also may have licensing or other visions to the contrary. requirements that must be met before certain The occurrence of trigger events also may OTC derivatives or other trading activities can give rise to disputes regarding the appropriate be legally conducted. settlement rate at which to close out contracts. It maybedifficult to argue in favor of substitute settlement rates that were not referenced as a 1. See 17 CFR 35. Instruments covered by the CFTC’s pricing source in the original documentation. exemption are also excluded from the coverage of state However, original pricing sources may not be bucket-shop and gambling laws.

September 2002 Trading and Capital-Markets Activities Manual Page 2 Legal Risk 2070.1

Master Agreements ments covering multiple derivative transactions. When a bank has undertaken a number of Master agreements generally provide for routine contracts with a particular counterparty that are transaction and payment netting and for close- subject to a master agreement, the bank runs the out netting in the event of a default. Under the risk that, in the event of the counterparty’s transaction- and payment-netting provisions of failure, the receiver for the counterparty will such an agreement, all payments for the same refuse to recognize the validity of the netting date in the same currency for all covered trans- provisions. In such an event, the receiver could actions are netted, resulting in one payment in ‘‘cherry pick,’’ that is, repudiate individual con- each currency for any date on which payments tracts under which the counterparty was obli- are made under the agreement. Close-out netting gated to pay the bank while demanding payment provisions, on the other hand, generally are on those contracts on which the bank was triggered by certain default events, such as a obligated to pay the counterparty. The Financial failure to make payments or insolvency. Such Institutions Reform, Recovery, and Enforcement events may give the nondefaulting party the Act of 1990 (FIRREA) and amendments to the right to require early termination and close-out Bankruptcy Code, as well as the payment sys- of the agreement. Under close-out netting, the tem risk-reduction provisions of the Federal positive and negative current replacement val- Deposit Insurance Corporation Improvement Act ues for each transaction under the agreement are (FDICIA), have significantly reduced this risk netted for the nondefaulting counterparty to for financial institutions in the United States.2 obtain a single sum, either positive or negative. The enforceability of close-out netting remains a If the sum of the netting is positive (that is, the significant risk in dealing with non-U.S. coun- transactions under the agreement, taken as a terparties that are chartered or located in juris- whole, have a positive value to the nondefault- dictions where the legal status of netting agree- ing counterparty), then the defaulting counter- ments may be less well settled. Significant party owes that sum to the nondefaulting issues concerning enforcement and collection counterparty. under netting agreements also arise when the The results may differ if the net is negative, counterparty is an uninsured branch of a foreign that is, the contracts have a positive value to the bank chartered in a state, such as New York, that defaulting counterparty. Some master agree- has adopted a ‘‘ring-fencing’’ statute providing ments include so-called walk-away clauses, for the separate liquidation of such branches. under which a nondefaulting counterparty is not In evaluating the enforceability of a netting required to pay the defaulting counterparty for contract, an institution needs to consider a the positive value of the netting to the defaulting number of factors. First, the institution needs to counterparty. The current trend, however, has determine the legal entity that is its counter- been to require payments of any positive net party. For example, if the bank is engaging in value to either party, regardless of whether the transactions with a U.S. branch of a foreign party defaulted. Revisions to the Basel Capital bank, the relevant legal entity generally would Accord have reinforced this trend by not recog- be the foreign bank itself. Some master agree- nizing netting agreements that include a walk- ments, however, are designed to permit netting away clause, as discussed more fully below. of transactions with multiple legal entities. A further consideration is the geographic coverage of the agreement. In some instances, bank coun- Enforceability Issues terparties have structured their netting agree- ments to cover transactions entered into between The effectiveness of netting in reducing risk multiple branches of the counterparties in a depends on both the adequacy and enforceabil- variety of countries, thereby potentially subject- ity of the legal arrangements in place. The ing the agreements to a variety of legal regimes. unenforceability of a netting agreement may Finally, the range of transactions to be covered expose an institution to significant losses if it in a single agreement is an important consider- relies on the netting agreement to manage its credit risk or for capital purposes. A major concern for market participants has 2. Risks related to netting enforceability have not been completely eliminated in the United States. Validation of been the enforceability in bankruptcy of the netting under FDICIA is limited to netting among entities that close-out netting provisions of master agree- may be considered to be ‘‘financial institutions.’’

Trading and Capital-Markets Activities Manual September 2002 Page 3 2070.1 Legal Risk ation. While there is an incentive to cover a • the law of the jurisdiction in which the coun- broad range of contracts to achieve a greater terparty is chartered and, if a foreign branch of reduction of credit risk, overinclusion may be a counterparty is involved, then also under the counterproductive if contracts that could jeop- law of the jurisdiction in which the branch is ardize the enforceability of the entire agreement located; are included. Some institutions deal with this • the law that governs the individual transac- risk by having separate agreements for particu- tions; and lar products, such as currency contracts, or • the law that governs any contract or agree- separate master agreements covered by an over- ment necessary to effect the netting.4 all ‘‘master master agreement.’’ Regardless of the scope of a master agree- Under the accord, the bank also must have ment, clarity is an important factor in ensuring procedures in place to ensure that the legal the enforceability of netting provisions. The characteristics of netting arrangements are regu- agreement should clearly specify the types of larly reviewed in light of possible changes in deals to be netted, mechanisms for valuation and relevant law. To help determine whether to rely netting, locations covered, and the office through on a netting arrangement, many institutions which netting will be done. have procedures for internally assessing or ‘‘scor- ing’’ legal opinions from relevant jurisdictions. These legal opinions may be prepared by out- Reliance on Netting Agreements side or in-house counsel. A generic industry or standardized legal opinion may be used to sup- While netting agreements have the potential to port reliance on a netting agreement for a substantially reduce credit risk to a counterparty, particular jurisdiction. The institution should an institution should not rely on a netting have procedures for review of the terms of agreement for credit-risk-management purposes individual netting agreements, however, to unless it has adequate assurances that the agree- ensure that the agreement does not raise issues, ment would be legally enforceable in the event such as enforceability of the underlying trans- of a legal challenge. Further, netting will be actions, choice of law, and severability, that are recognized for capital purposes only if the bank not covered by the general opinion. has satisfied the requirements set forth in the Institutions also rely on netting arrangements Basel Capital Accord (the accord). To meet in managing credit risk to counterparties. Insti- these requirements, the netting contract or agree- tutions may rely on a netting agreement for ment with a counterparty must create a single internal risk-management purposes only if they legal obligation, covering all transactions to be have obtained adequate assurances on the legal netted, such that the bank would have either a enforceability of the agreement in the event of a claim to receive or an obligation to pay only the legal challenge. Such assurances generally would net amount of the individual transactions if a be obtained by acquiring legal opinions that counterparty fails to perform because of default, meet the requirements of the accord. bankruptcy, liquidation, or other similar circum- stances.3 Netting contracts that include a walk- away clause are not recognized for capital pur- Multibranch Agreements poses under the accord. To demonstrate that a netting contract meets A multibranch master netting agreement covers the requirements of the accord, the bank must transactions entered into between multiple obtain written and reasoned legal opinions that, branches of an institution or its counterparty that in the event of a legal challenge, the relevant are located in a variety of countries. These courts and administrative authorities would find agreements may cover branches of the institu- the bank’s exposure to be the net amount under— 4. A netting contract generally must be found to be 3. The agreement may cover transactions excluded from enforceable in all of the relevant jurisdictions in order for an the risk-based capital calculations, such as exchange-rate institution to rely on netting under the contract for capital contracts with an original maturity of 14 calendar days or less purposes. For those jurisdictions in which the enforceability of or instruments traded on exchanges requiring daily margin. netting may be in doubt, however, an institution may be able, The institution may consistently choose either to include or in appropriate circumstances, to rely on opinions that the exclude the mark-to-market values of such transactions when choice of governing law made by the counterparties to the determining net exposure. agreement will be respected.

September 2002 Trading and Capital-Markets Activities Manual Page 4 Legal Risk 2070.1 tion or counterparty located in jurisdictions lateral is not required until the level of exposure where multibranch netting is not enforceable, has reached a certain threshold. creating the risk that including these branches While collateral may be a useful tool for may render the entire netting agreement unen- reducing credit exposure, a financial institution forceable for all transactions. To rely on a should not rely on collateral to manage its credit netting agreement for transactions in any juris- risk to a counterparty and for risk-based capital diction, an institution must obtain legal opinions purposes, unless it has adequate assurances that that conclude (1) that transactions with branches its claim on the collateral will be legally enforce- in user-unfriendly jurisdictions are severable able in the event the counterparty defaults, and (2) that the multibranch master agreement particularly for collateral provided by a foreign would be enforceable, despite the inclusion of counterparty or held by an intermediary outside these branches. of the United States. To rely on collateral Currently, the risk-based capital rules do not arrangements where such cross-border issues specify how the net exposure should be calcu- arise, a financial institution generally should lated when a branch in a netting-unfriendly obtain written and reasoned legal opinions that jurisdiction is included in a multibranch master (1) the collateral arrangement is enforceable in netting agreement. In the meantime, institutions all relevant jurisdictions, including the jurisdic- are using different practices, which are under tion in which the collateral is located, and (2) the review with the goal of providing additional collateral will be available to cover all transac- guidance. Some institutions include the amount tions covered by the netting agreement in the owed by branches of the counterparty in netting- event of the counterparty’s default. unfriendly jurisdictions when calculating the global net exposure. Others completely sever these amounts from calculations, as if transac- Operational Issues tions with these branches were not subject to the netting agreement. With respect to transaction The effectiveness of netting in reducing risks with branches in netting-unfriendly jurisdic- also depends on how the arrangements are tions, some institutions add on the amounts they implemented. The institution should have pro- owe in such jurisdictions (which are liabilities) cedures to ensure that the operational implemen- to account for the risk of double payment,5 tation of a netting agreement is consistent with while other institutions add on the amounts its provisions. owed to them in such jurisdictions (which are Netting agreements also may require that assets). The approach an institution uses should someofafinancial institution’s systems be reflect the specifics of the legal opinions it adapted. For example, the interface between the receives concerning the severability of transac- front-office systems and back-office payment tions in netting-unfriendly jurisdictions. and receipt functions needs to be coordinated to allow trading activity to take place on a gross basis while the ultimate processing of payments Collateral Agreements and receipts by the back-office is on a net basis. In particular, an internal netting facility needs Financial institutions are increasingly using col- to— lateral agreements in connection with OTC derivatives transactions to limit their exposure • segregate deals to be netted, to the credit risk of a counterparty. Depending • compute the net amounts due to each party, on the counterparties’ relative credit strength, • generate trade confirmations on the trade date requirements for posting collateral may be for each trade, mutual or imposed on only one of the counter- parties. Under most agreements, posting of col- • generate netted confirmations shortly after the agreed-on netting cut-off time, • generate net payment and receipt messages, 5. The risk of double payment is the risk that the institution • generate appropriate nostro and accounting must make one payment to a counterparty’s main receiver entries, and under a multibranch master agreement and a second payment • provide for the cancellation of any gross to the receiver of the counterparty’s branch in the netting- unfriendly jurisdiction for transactions entered into in that payment or receipt messages in connection jurisdiction. with the netted trades.

Trading and Capital-Markets Activities Manual September 2002 Page 5 2070.1 Legal Risk

Nondeliverable Forwards the risk that a legal challenge could result in a court finding that the contract is ultra vires and An area of growing concern for legal practitio- therefore unenforceable. Significant losses in ners has been the documentation of nondeliver- OTC derivatives markets resulted from a finding able forward (NDF) foreign-exchange transac- that swap agreements with municipal authorities tions. The NDF market is a small portion of the in the United Kingdom were ultra vires. Issues foreign-exchange market, but is a large part of concerning the authority of municipal and other the market for emerging-country currencies. An government units to enter into derivatives con- NDF contract uses an indexed value to represent tracts have been raised in some U.S. jurisdic- the value of a currency that cannot be delivered tions, as well. Other types of entities, such as due to exchange restrictions or the lack of pension plans and insurance companies, may systems to properly account for the receipt of need specific regulatory approval to engage in the currency. NDF contracts are settled net in the derivatives transactions. settlement currency, which is a hard currency A contract may be unenforceable in some such as U.S. dollars or British pounds sterling. circumstances if the person entering into the An NDF contract must be explicitly identified contract on behalf of the counterparty is not as such—foreign-exchange contracts are pre- authorized to do so. Many entities, including sumed to be deliverable. The index should be corporations, have placed more extensive restric- clearly defined, especially for countries in which tions on the authority of the corporation or its dual exchange rates exist, that is, the official employees to enter into certain types of deriva- government rate versus the unofficial ‘‘street’’ tives and securities transactions. rate. To address issues related to counterparty NDF contracts often provide for cancellation authority, an institution’s procedures should pro- if certain disruption events specified in the vide for an analysis, under the law of the master agreement occur. Disruption events can counterparty’s jurisdiction, of the counterparty’s include sovereign events (the nationalization of power to enter into and the authority of a trading key industries or defaults on government obli- representative of the counterparty to bind the gations), new exchange controls, the inability to counterparty to particular transactions. It also is obtain valid price quotes with which to deter- common to look at whether boards of directors mine the indexed value of the contract, or or trustees are authorized to enter into specific a benchmark-obligation default. Under a types of transactions. Depending on the proce- benchmark-obligation default, a particular issue dures of the particular institution, issues relating is selected and, if that issue defaults during the to counterparty capacity may be addressed in the term of the contract, the contract is cancelled. context of the initial credit-approval process or Cancellation events should be specifically through a more general review of classes of described in order to minimize disputes about counterparties. whether an event has occurred. In addition, overly broad disruption events could cause the cancellation of a contract that both counterpar- Suitability ties wish to execute. The International Swaps and Derivatives A counterparty on the losing end of a derivatives Association (ISDA) has established an NDF transaction may claim that a banking organiza- project to develop standard documentation for tion recommended or structured an unsuitable these transactions. The ISDA documentation transaction, given the counterparty’s level of establishes definitions that are unique to NDF financial sophistication, financial condition, or transactions and provides sample confirmations investment objectives, or it may claim that the that can be adapted to reflect disruption events. transaction and its risks were inaccurately or incompletely disclosed. Banking organizations that recommend or structure derivatives transac- LEGAL ISSUES tions for clients, especially transactions contain- ing nonstandard terms, should make reasonable Capacity efforts to know their counterparties in order to avoid such claims. Moreover, banking organiza- If a counterparty does not have the legal author- tions should fully explain to counterparty per- ity to enter into a transaction, the institution runs sonnel with the requisite knowledge and expe-

September 2002 Trading and Capital-Markets Activities Manual Page 6 Legal Risk 2070.1 rience to evaluate a transaction what the structure keted to institutional customers being made and risks of any derivatives transaction are. available to retail customers) and existing prod- Banking organizations should also understand ucts that have been significantly modified. The their counterparties’ business purpose for enter- definition of a new product should be consistent ing into derivatives transactions with the insti- with the size, complexity, and sophistication of tution. Understanding the underlying business the institution. Small changes in the payment rationale for the transaction allows the institu- formulas or other terms of products can greatly tion to evaluate the credit, legal, and reputa- alter their risk profiles and justify designation as tional risks that may arise if the counterparty has a new product. entered into the transaction to evade taxes, hide The authority of the bank to enter into the losses, or circumvent legal or regulatory new or modified transaction or market the new restrictions. product in all relevant jurisdictions should be established, and any limitations on that authority fully reviewed. Legal review is also necessary New-Product Approval for an institution to establish the types of agree- ments to be used in documenting the transac- Legal counsel, either in-house or outside, should tion, including any modifications to standard- be involved in the new-product approval pro- ized documentation. The institution should cess. New-product reviews should include prod- ensure that prior legal opinions and standard ucts being offered for the first time in a new agreements are reviewed periodically and that jurisdiction or to a new category of counterpar- they reflect changes in law or the manner in ties (for example, a product traditionally mar- which transactions are structured.

Trading and Capital-Markets Activities Manual September 2002 Page 7 Legal Risk Examination Objectives Section 2070.2

1. To determine if the institution’s internal poli- of the bank are effectively implementing the cies and procedures adequately identify provisions of netting agreements. potential legal risks and ensure appropriate 5. To determine whether the unique risks of legal review of documentation, counterpar- nondeliverable forward (NDF) contracts have ties, and products. been considered and reflected in the institu- 2. To determine whether appropriate documen- tion’s policies and procedures, if appropriate. tation requirements have been established 6. To determine whether the institution’s inter- and that procedures are in place to ensure that nal policies and procedures adequately address transactions are documented promptly. the need to review the suitability of transac- 3. To determine whether adequate assurances tions for a counterparty. of legal enforceability have been obtained 7. To determine whether the institution’s inter- for netting agreements or collateral arrange- nal policies and procedures adequately address ments relied on for risk-based capital pur- the approval of new products, including a poses or credit-risk management. requirement for appropriate reviews by legal 4. To determine whether the operational areas counsel.

Trading and Capital-Markets Activities Manual September 2002 Page 1 Legal Risk Examination Procedures Section 2070.3

Examiners should use the following guidelines completed and pending documentation? to assist in their review of the institution’s How does the institution follow up on trading activities with respect to legal risk. This outstanding documentation? should not be considered to be a complete g. What controls does the institution have in checklist of subjects to be examined. place pending execution of required docu- mentation, for example, legal-approval 1. Obtain copies of policies and procedures that requirements? (Documentation has not outline appropriate legal review for new been executed until it has been signed by products. appropriate personnel of both parties to a. Does the institution require legal review the transaction.) of new products, including significant h. In practice, is required documentation revisions or modifications to existing executed in a timely manner? products, as part of the product-review i. Who has the authority to approve excep- process? tions to existing documentation b. Do the procedures provide for review requirements? of existing products offered in new juris- j. Do the procedures ensure that documen- dictions or to new classes of counterparties? tation is reviewed for consistency with the 2. Obtain copies of policies and procedures institution’s policies? that outline review requirements for new k. Who reviews documentation? counterparties. l. Does the institution specify the terms to a. Does the institution require review of new be covered by confirmations for differ- counterparties to ensure that the counter- ent types of transactions, including party has adequate authority to enter into transactions that are subject to master proposed transactions? agreements? b. Do the institution’s procedures include an m. If the institution engages in nondeliver- assessment of the suitability of any trans- able forward (NDF) transactions, does the actions recommended to or structured by documentation address the index to be the institution for the counterparty? used and clearly specify that the contract c. Do the institution’s procedures ensure fur- is for a nondeliverable currency? Are ther review of counterparty authority if disruption events, if any, specifically new types of transactions are entered into? described? 3. Obtain copies of policies and procedures that 4. Obtain copies of policies and procedures establish documentation requirements. concerning the review of the enforceability of netting agreements and master agreements a. Has the institution established documen- with netting provisions. tation requirements for all types of trans- actions in the trading area? a. Does the institution have procedures to ensure that legal opinions have been b. When are master agreements required for obtained addressing the enforceability of a over-the-counter (OTC) derivative or other netting agreement under the laws of all transactions with a counterparty? relevant jurisdictions before relying on c. Does the institution require legal review the netting agreement for capital purposes for new agreement forms, including net- or in managing credit exposure to the ting agreements and master agreements counterparty? with netting provisions? b. Do the procedures include guidelines for d. Who has authority to approve the use of determining the relevant jurisdictions for new agreement forms, including new mas- which opinions should be obtained? Opin- ter agreement forms or agreement terms? ions should cover the enforceability of e. How does the institution ensure that docu- netting under (1) the law of the jurisdic- ments are executed in a timely manner for tion in which the counterparty is char- new counterparties and new products? tered, (2) the law of any jurisdiction in f. Does the institution have an adequate which a branch of the counterparty that is document-management system to track a party to the agreement is located, (3) the

Trading and Capital-Markets Activities Manual September 2002 Page 1 2070.3 Legal Risk: Examination Procedures

law that governs any individual trans- enforceability of collateral arrangements action under the netting agreement, and must be obtained before the institution (4) the law that governs the netting relies on such arrangements for risk- agreement itself. based capital or credit-risk-management c. When generic or industry opinions are purposes? relied on, do the procedures of the insti- b. Who reviews the above opinions? tution ensure that individual agreements c. Who determines when a collateral arrange- are reviewed for additional issues that ment may be relied on by the institution might be raised? for credit-risk-management or risk-based d. Does the institution have procedures for capital purposes? evaluating or ‘‘scoring’’ the legal opinions d. Do the procedures ensure that legal opin- it receives concerning the enforceability ions relied on by the institution are of netting agreements? reviewed periodically? e. Who reviews the above opinions? How 6. Obtain samples of master agreements, con- do they communicate their views on firmations for transactions under such agree- the enforceability of netting under an ments, and related legal opinions. agreement? a. Does the institution maintain in its files f. Who determines when master netting the master agreements, legal opinions, and agreements will be relied on for risk- related documentation and translations based capital and credit-risk-management relied on for netting purposes? purposes? b. Have the master agreements and confir- g. Who determines whether certain transac- mations been executed by authorized tions should be excluded from the net- personnel? ting, such as transactions in connection c. Have master agreements been executed by with a branch in a netting-unfriendly counterparty personnel that the institution jurisdiction? has determined are authorized to execute h. When the institution nets transactions for such agreements? capital purposes, are any transactions that d. Does the institution maintain records evi- are not directly covered by a close-out dencing that master agreements and netting provision of a master agreement related legal opinions have been reviewed included? If so, does the institution obtain in accordance with the institution’s poli- legal opinions supporting the inclusion of cies and procedures? such transactions? For example, if the 7. Obtain copies of the institution’s policies and institution includes in netting calculations procedures concerning the implementation of foreign-exchange transactions between netting agreements. branches of the institution or counterparty a. Do the procedures ensure that the terms of not covered by a master agreement, ask netting agreements are accurately and counsel if the institution has an agree- effectively acted on by the trading, credit, ment and legal opinion that support this and operations or payments-processing practice. areas of the institution? i. Does the institution have procedures to b. Does the institution have adequate con- ensure that the legal opinions on which it trols over the operational implementation relies are periodically reviewed? of its master netting agreements? j. Does the institution have procedures in c. Who determines whether specific transac- place to ensure that existing master agree- tions are to be netted for risk-based capital ments are regularly monitored to deter- and credit-risk-management purposes? mine whether they meet the requirements d. When is legal approval for the netting for recognition under the institution’s net- of particular transactions under a netting ting policies? agreement required? 5. Obtain copies of policies and procedures e. How are the relevant details of netting concerning the review of the enforceability agreements communicated to the trading, of collateral arrangements. credit, and payments areas? a. Does the institution have guidelines that f. How does each area incorporate relevant establish when and from what jurisdic- netting information into its systems? tions legal opinions concerning the g. What mechanism does the institution have

September 2002 Trading and Capital-Markets Activities Manual Page 2 Legal Risk: Examination Procedures 2070.3

to link netting information with credit- calculations, what method does the insti- exposure information and to monitor tution use to calculate net exposure under netting information in relation to credit- the agreement for capital purposes, and is exposure information? that method used consistently? h. Do periodic settlement amounts reflect k. If a master agreement includes transac- payments or deliveries netted in accor- tions that do not qualify for netting, such dance with details of netting agreements? as transactions in a netting-unfriendly i. How does the institution calculate its credit jurisdiction, how does the institution deter- exposure to each counterparty under the mine what method to use to calculate net relevant master netting agreements? exposure under the agreement for capital j. If the master agreement includes transac- purposes? tions excluded from risk-based capital

Trading and Capital-Markets Activities Manual September 2002 Page 3 Financial Performance Section 2100.1

The evaluation of financial performance, or time decay, or other appropriate factors. Similar profitability analysis, is a powerful and neces- methodologies for allocating reserves should sary tool for managing a financial institution and also be established where appropriate. is particularly important in the control and Proper segregation of duties and clear report- operation of trading activities. Profitability analy- ing lines help ensure the integrity of profitability sis identifies the amount and variability of earn- and performance reports. Accordingly, the mea- ings, evaluates earnings in relation to the nature surement and analysis of financial performance and size of risks taken, and enables senior and the preparation of management reports are management to judge whether the financial per- usually the responsibility of a financial-control formance of business units justifies the risks or other nontrading function. This responsibility taken. Moreover, profitability analysis is often includes revaluing or marking to market the used to determine individual or team compen- trading portfolio and identifying the various sation for marketing, trading, and other business- sources of revenue. Some banks have begun to line staff engaged in trading activities. The place operations and some other control staff in following four elements are necessary to effec- the business line, with separate reporting to the tively assess and manage the financial perfor- business head. Examiners should satisfy them- mance of trading operations: selves that duties are adequately segregated and that the operations staff is sufficiently indepen- • valuing or marking positions to market prices dent from trading and risk-taking functions. • assigning appropriate reserves for activities and risks • reporting results through appropriate chains of command VALUATION • attributing income to various sources and products The valuation process involves the initial and ongoing pricing or ‘‘marking to market’’ of Valuation of the trading portfolio is critical to positions using either observable market prices effective performance measurement since the or, for less liquid instruments, fair-value pricing accuracy and integrity of performance reports conventions and models. An institution’s writ- are based primarily on the market price or fair ten policies and procedures should detail the value of an institution’s holdings and the pro- range of acceptable practices for the initial cess used to determine those prices. The valua- pricing, daily mark-to-market, and periodic tion process is often complex, as the pricing of independent revaluation of trading positions. At certain financial instruments can require the use a minimum, the bank’s policies should specifi- of highly sophisticated pricing models and other cally define the responsibilities of the partici- estimators of fair value. The chief financial pants involved in the trading function (for exam- officer (CFO) and other senior officers of the ple, trading operations, financial-control, and bank must receive comprehensive and accurate risk-management staff) to ensure reliable and information on capital-markets and trading consistent financial reporting. Pricing method- activities to accurately measure financial perfor- ologies should be clearly defined and docu- mance, assess risks, and make informed busi- mented to ensure that they are consistently ness decisions. Internal profitability reports applied across financial products and business should indicate to the CFO and other senior lines. Proper controls should be in place to management the sources of capital-markets and ensure that pricing feeds are accurate, timely, trading income, and assign profits and losses to and not subject to unauthorized revisions. the appropriate business units or products (for Additionally, the firm should have comprehen- example, foreign exchange, corporate bond trad- sive policies and procedures specifically for ing or interest-rate swaps). To prepare these creating, validating, revising, and reviewing the reports, an institution should specify its meth- pricing models used in the valuation process. odologies for attributing both earnings and risks Inadequate policies and procedures raise doubts to their appropriate sources such as interest about the institution’s trading profits and its income, bid/offer spreads, customer mark-up, ability to manage the risks of its trading activities.

Trading and Capital-Markets Activities Manual February 1998 Page 1 2100.1 Financial Performance

Initial Pricing monthly. In these cases, written policies should specify which types of transactions, if any, are The initial pricing of positions or transactions is exempt from daily revaluation and how often generally the responsibility of the trader who these transactions must be marked to market. originates the deal, although a marketer will often be involved in the process. For those instruments that trade in fairly liquid markets, the price is usually based on the quoted bid/offer Independent Price Testing and price plus an origination ‘‘value-added’’ spread Revaluation that may include, for example, a credit premium or estimated hedge cost, depending on the char- In addition to the mark-to-market process per- acteristics of the product. The prices of less formed daily, banks should perform an indepen- liquid instruments are generally priced at theo- dent review and revaluation of the trading port- retical market prices, usually determined by folio periodically to verify that trading positions pricing models. Regardless of the type of trans- reflect fair value, check the reasonableness of action, an independent control function should pricing inputs, and assess profitability. The review all new-deal pricing for reasonableness review must be performed by a control function and ensure that pricing mechanics are consistent that is independent from the trading func- with those of existing transactions and approved tion. Usually this independent revaluation pro- methodologies. Significant differences, as defined cess is performed monthly; however, it may be in written policies, should be investigated by the prudent to independently revalue certain illiquid control function. and harder-to-price transactions, and transac- tions that are not marked to market daily, more frequently. The scope of the testing process will differ Daily Mark-to-Market Process across institutions depending on the size and sophistication of the trading activities con- Trading accounts should be revalued, or ‘‘marked ducted. In many institutions, revaluation of an to market,’’ at least daily to reflect fair value and entire portfolio of relatively simple, generic determine the profit or loss on the portfolio for instruments may be too time consuming to be financial-reporting and risk-management pur- efficient, and price validation may be conducted poses. Trading positions are usually marked to on a sampling basis. In contrast, more complex market as of the close of business using inde- transactions may be revalued in their entirety. pendent market quotes. Most institutions are Alternatively, an institution may choose to able to determine independent market prices revalue holdings based on materiality (for exam- daily for most positions, including many exotic ple, all transactions over a dollar threshold). An and illiquid products. Many complex instru- institution’s policies should clearly define the ments can be valued using the independent scope of its periodic valuation-testing process, market prices of various elementary components and reasonable justification should be provided or risk factors. Automatic pricing feeds should for excluding certain transactions from the test- be used to update positions whenever feasible. ing process. When automatic pricing feeds are not feasible, a If the value of the portfolios as determined by separate control function (for example, the the periodic (for example, monthly) independent middle- or back-office function) should be re- revaluation is significantly different from the sponsible for inputting appropriate pricing data book value of these portfolios, further investi- or parameters into the appropriate accounting gation is warranted. The materiality threshold and measurement systems, even though traders for investigation should be specifically defined may have some responsibility for determining in written policies (such as ‘‘all discrepancies those prices and parameters. above $x thousand must be investigated to Daily revaluation may not be feasible for determine the source of the difference’’). When some illiquid instruments, particularly those that the reason for the discrepancy is discovered, the are extremely difficult to model or not widely institution should determine whether the finan- traded. Institutions may revalue these types of cial reports need to be adjusted. Based on the transactions less often, possibly weekly or magnitude and pattern of the pricing inconsis-

February 1998 Trading and Capital-Markets Activities Manual Page 2 Financial Performance 2100.1 tencies, changes to the pricing process or pricing Also, some organizations may value positions models may be required. on the conservative side of midmarket by taking Results of the month-end valuation process a discount or adding a premium to the midmar- should be formally documented in sufficient ket price to act as a ‘‘holdback reserve.’’ Firms detail to provide a complete audit trail. In that use a conservative midmarket valuation addition, a summary of the results of the inde- system may mark all positions in this manner or pendent revaluation should be communicated to may only value some less liquid positions this appropriate management and control functions. way. Bank policies should clearly specify which Reports should be generated to inform manage- valuation methodologies are appropriate for dif- ment of the results of the periodic price-testing ferent types of transactions. process and should include, at a minimum, the The bid/offer price should be considered a scope of the testing process, any material dis- limit on instrument values, net of any reserves. crepancies between the independent valuations Net instrument values recorded on the books at and the reported valuations, and any actions market value should not be below or above the taken in response to them. market’s bid/offer price, as these are the values at which a position can be closed. Some insti- tutions have automated programs that use prices obtained from traders to check whether the fair Liquid Instruments and Transactions values recorded on the firm’s financial state- ments fall within the bid/offer price. While these For transactions that trade on organized programs can help ensure appropriate pricing exchanges or in liquid over-the-counter (OTC) regardless of the specific method used, a firm markets, market prices are relatively easy to should still have a sound, independent daily determine. Trading positions are simply updated revaluation that does not rely solely on traders to reflect observable market prices obtained marking their positions to market. from either the exchange on which the instru- ment is listed or, in the case of OTC transac- Whether bid/offer or midmarket pricing is tions, from automated pricing services or as used, banks should use consistent time-of-day quotes from brokers or dealers that trade the cutoffs when valuing transactions. For example, product. When observable market prices are instruments and their related hedges should be available for a transaction, two pricing method- priced as of the same time even if the hedging ologies are primarily used—bid/offer or midmar- item trades on an exchange with a different ket. Bid/offer pricing involves assigning the closing time than the exchange on which the lower of bid or offer prices to a long position hedged item trades. Also, all instruments in the and the higher of bid or offer prices to short same trading portfolio should be valued at the positions. Midmarket pricing involves assigning same time even if they are traded at different the price that is midway between bid and offer locations. Price quotes should be current as of prices. Most institutions use midmarket pricing the time of pricing and should be consistent with schemes, although some firms may still use other trades that were transacted close to the bid/offer pricing for some products or types of same time. trading. Midmarket pricing is the method rec- For liquid exchange-traded or OTC products, ommended by the accounting and reporting the monthly revaluation process may simply subcommittee of the Group of Thirty’s Global entail a comparison of book values with Derivatives Study Group, and it is the method exchange or broker-dealer quotations. In these market practitioners currently consider the most cases, it should be known whether the party sound. providing the valuation is a counterparty to the Some institutions may use bid/offer pricing transaction that generated the holding or is being for some transactions and midmarket pricing for paid for providing the valuation as an indepen- others. For example, bid/offer pricing may be dent pricing service. Firms should be aware that used for proprietary and arbitrage transactions in broker-dealer quotes may not necessarily be the which the difference between bid and offer same values used by that dealer for its internal prices and the midmarket price is assumed not to purposes and may not be representative of other be earned. Midmarket pricing may be used for ‘‘market’’ or model-based valuations. Therefore, transactions in which the firm is a market maker institutions should satisfy themselves that the and the bid/offer to midmarket spread is earned. external valuations provided are appropriate.

Trading and Capital-Markets Activities Manual April 2003 Page 3 2100.1 Financial Performance

Illiquid Instruments and Transactions and pricing models may again be used for this purpose. Illiquid, nontraditional, and user-specific or cus- When conducting the monthly revaluation, tomized transactions pose particular pricing chal- the validity of portfolio prices can be tested by lenges because independent third-party prices reviewing them for historical consistency or by are generally unavailable. For illiquid products comparing actual close-out prices or the perfor- that are traded on organized exchanges, but for mance of hedge positions to model predictions. which trades occur infrequently and available In some instances, controllers may run parallel quotes are often not current, mark-to-market pricing models as a check on the valuations valuations based on the illiquid market quotes derived by trader models. This method is usu- may be adjusted by a holdback reserve that is ally only used for the more exotic, harder-to- created to reflect the product’s reduced liquidity. price products. (See ‘‘Holdback Reserves’’ below.) For illiquid OTC transactions, broker quotes may be avail- able, albeit infrequently. When broker quotes Pricing Models are available, the bank may use several quotes to determine a final representative valuation. For Pricing models can either be purchased from example, the bank may compute a simple aver- vendors or developed internally, and they can be age of quotes or eliminate extreme prices and mainframe- or PC-based. Internally developed average the remaining quotes. In such cases, models are either built from scratch or devel- internal policies should clearly identify the meth- oped using existing customized models that odology to be used. traders modify and manipulate to incorporate When the middle or back office is responsible the specific characteristics of a transaction. for inputting broker quotes directly, the traders The use of pricing models introduces the should also be responsible for reporting their potential for model risk into the valuation pro- positions to the middle- or back-office function cess. Model risk arises when an institution uses as an added control. Any differences in pricing mathematical models to value and hedge com- should be reconciled. When brokers are respon- plex financial securities that are in relatively sible for inputting data directly, it is crucial that illiquid markets and for which price-discovery the middle or back office verify these data for mechanisms are inefficient. In these circum- accuracy and appropriateness. stances, the models an institution uses may rely For many illiquid or customized transactions, on assumptions that are inconsistent with market such as highly structured or leveraged instru- realities; employ erroneous input parameters; or ments and more complex, nonstandard notes or be calibrated, applied, or implemented incor- securities, reliable independent market quotes rectly. Accordingly, effective policies and pro- are usually not available, even infrequently. In cedures related to model development, model such instances, other valuation techniques must validation, and model control are necessary to be used to determine a theoretical, end-of-day limit model risk. At a minimum, policies for market value. These techniques may involve controlling model risk should address the insti- assuming a constant spread over a reference rate tution’s process for developing, implementing, or comparing the transaction in question with and revising pricing models. The responsibili- similar transactions that have readily available ties of staff involved in the model-development prices (for example, comparable or similar trans- and model-validation process should be clearly actions with different counterparties). More defined. likely, though, pricing models will be used to In some institutions, only one department or price these types of customized transactions. group may be authorized to develop pricing Even when exchange prices exist for a financial models. In others, model development may be instrument, there may be market anomalies in initiated in any of several areas related to the pricing; these anomalies make consistent trading. Regardless of the bank function respon- pricing across the instrument difficult. For exam- sible for model development and control, insti- ple, timing differences may exist between the tutions should ensure that modeling techniques close of the cash market and futures markets, and assumptions are consistent with widely causing a divergence in pricing. In these cases, it acceptable financial theories and market prac- may be appropriate to use theoretical pricing, tices. When modeling activities are conducted in

April 2003 Trading and Capital-Markets Activities Manual Page 4 Financial Performance 2100.1 separate business units or are decentralized, ensure their integrity and prevent unauthorized business-unit policies governing model develop- revisions. The control function should maintain ment and use should be consistent with overall copies of all models used by the traders in case corporate policies on model-risk management. the copies used on the trading floor are corrupted. As part of these policies, institutions should Models should be reviewed or reassessed at ensure that models are properly documented. some specified frequency, and the most impor- Documentation should be created and main- tant or complex models should be reviewed at tained for all models used, and a model- least once a year. In addition, models should be inventory database should be maintained on a reviewed whenever major changes are made to corporate-wide or business-line basis. them. The review process should be performed Before models are authorized for use, they by a group independent from the traders, such as should be validated by individuals who are not a control or risk-analysis function. As appropri- directly involved in the development process or ate, model reviews should consider changes in do not have methodological input to the model. the types of transactions handled by the model, A sound model-validation process rigorously as well as changes in generally accepted mod- and comprehensively evaluates the sensitivity of eling conventions and techniques. Model reviews models to material sources of model risk and should incorporate an investigation of actual identifies, reviews, and approves new models or versus expected performance and should fully enhancements to existing models. Ideally, mod- incorporate an assessment of any hedging activ- els should be validated by an independent ity. Significant deviation in expected versus financial-control or risk-management function. actual performance and unexplainable volatility Independent model validation is a key control in in the profits and losses of trading activities may the model-development process and should be indicate that market-defined hedging and pricing specifically addressed in a firm’s policies. Man- relationships are not being adequately captured agement should be satisfied that the underlying in a model. The model-review process should be methodologies for all models are conceptually clearly defined and documented, and these poli- sound, mathematically and statistically correct, cies should be communicated to the appropriate and appropriate for the model’s purpose. A parties throughout the organization. model should have the same basic mathematical In addition to the periodic scheduled reviews, properties as the instrument being modeled. models should always be reviewed when new Pricing methodologies should be consistent products are introduced or changes in valuations across business lines. In addition, the technical are proposed. Model review may also be expertise of the model validators should be prompted by a trader who feels that a model sufficient to ensure that the basic approach of the should be updated to reflect the significant model is appropriate. development or maturing of a market. The All model revisions should be performed in a model-validation and new-product-approval controlled environment, and changes should be functions should work closely with the model either made or verified by a control function. developer to establish a common understanding When traders are able to make changes to of what constitutes a new product that warrants models outside of a controlled environment, an either model refinements or the development of inappropriate change may result in inaccurate an entirely new model. A new product may also valuation. Under no circumstances should trad- entail enhancing or modifying an existing prod- ers be able to determine valuations of trading uct or introducing an existing product in a new positions by making changes to a model unless market. When a new product warrants a new or those changes are subject to the same review revised model, the model-validation and new- process as a new type of transaction. Accord- product-approval functions should ensure that ingly, written policies should specify when senior management and the board (or an appro- changes to models are acceptable and how those priate board committee) understand the key revisions should be accomplished. Controls features and risks of the new product and the should be in place to prevent inappropriate model. changes to models by traders or other unautho- In some cases, models may start out as a rized personnel. For example, models can be PC-based spreadsheet model and be subse- coded or date-marked so that it is obvious when quently transformed to a mainframe model. changes are made to those models. Rigorous Whenever this occurs, the model should be controls on spreadsheet-based models should reviewed and any resulting changes in valuation

Trading and Capital-Markets Activities Manual April 2003 Page 5 2100.1 Financial Performance should be monitored. Banks should continually determining the input to be used from multiple monitor and compare their actual cash flows quotes (such as the average or median). with model projections, and significant discrep- ¥ Risk factors. Pricing models generally decom- ancies should prompt a model review. pose instruments into elementary components, Activities in business lines for which models such as specific interest rates, currencies, have not yet been reviewed and validated should commodities, and equity types. Interest rates be subject to special limits designed to minimize and yield curves are particularly important risks, pending review and validation of models. pricing-model risk factors. Institutions should These limits may include dollar limits, Greek ensure that the risk factors and, in particular, limits, counterparty limits, or some combination the yield curves used in pricing instruments thereof. are sufficiently robust (have sufficient estima- The use of vendor models can present special tion points). Moreover, the same types of yield challenges, as vendors often claim proprietary curves (spot, forward, yield-to-maturity) should privilege to avoid disclosing information about be used to price similar products. their models. However, vendors should provide ¥ Assumptions. The key assumptions underlying adequate information on how the model was the model should be validated by examining constructed and validated so that management whether the mathematical model is a reason- has reasonable assurances that the model works able representation of the financial instrument as intended. Institutions should validate vendor or transaction. Assumptions may be internally models in addition to their internally generated or externally generated. Either source may be models. appropriate; an institution should determine whether information derived from its own Pricing-Model Inputs customer base or market-wide information is more reflective of its risks. In either case, the Pricing models require various types of inputs, choice between the use of internal or external including hard data, readily observable param- assumptions should be documented. Assump- eters such as spot or futures prices, and both tions should be compared with actual portfolio quantitatively and qualitatively derived assump- performance and available market information tions. All inputs should be subject to controls and should be updated to reflect changing that ensure they are reasonable and consistent market conditions. across business lines, products, and geographic locations. Inputs should be verified through a During the periodic revaluation process, many vetting process that validates data integrity— institutions may perform a formal verification of this process is especially important for illiquid model-pricing inputs, including volatilities, cor- products for which model risk may be height- relation matrices, and yield curves. ened. Assumptions and inputs regarding expected future volatilities and correlations, and the speci- fication of model-risk factors such as yield Pricing-Model Outputs curves, should be subject to specific control and oversight and to frequent review. Important A model’s output data should be compared considerations in each of these areas are as against that of comparable models, market prices, follows: or other available benchmarks. Reports pro- duced from model outputs should clearly inter- ¥ Volatilities. Both historically determined and pret the results for decision makers, explaining implied volatilities should be derived using any model limitations and summarizing key generally accepted and appropriately docu- assumptions. Management reports should also mented techniques. Implied volatilities should include independent reviews of the theory under- be reviewed for reasonableness and derived lying the model and the results of model stress from closely related instruments. tests or scenario analyses that may alert decision ¥ Correlations. Correlations should be well makers to the model’s limitations. Stress testing documented and estimated as consistently as the model, or examining some limit scenarios, practicable across products and business lines. will provide a range of parameter values for If an institution relies on broker quotes, it which the model produces accurate pricing. should have an established methodology for Management decision makers need to fully

April 2003 Trading and Capital-Markets Activities Manual Page 6 Financial Performance 2100.1 understand the meaning and limitations of these (2) the methodologies to be used to calculate model outputs. them, and (3) acceptable practices for recogniz- Models should be subject to rigorous and ing the reserves into the profits and losses of the comprehensive stress tests; in addition to simu- institution. lating extreme market events, these tests should General policies for holdback reserves should reflect the unique characteristics of the institu- be developed by a group independent from the tion’s portfolio. Idiosyncratic risks, such as business units, such as the financial-control area. basis risk, that are not adequately captured by This group may also be responsible for devel- value-at-risk measures should be emphasized in oping and implementing the policy. Alterna- scenario analyses and stress tests. Scenarios tively, individual business lines may be respon- should be reviewed for relevance and appropri- sible for developing an implementation policy. ateness in light of the banking organization’s If implementation policies are developed by activities and risk profile. A range of time individual business lines, the policies should be horizons should be used to maximize the com- periodically reviewed and approved by an inde- prehensiveness of the institution’s stress-testing pendent operating group. Most importantly, the results. traders or business units should not be able to determine the level of holdback reserves and, hence, be able to determine the fair value of HOLDBACK RESERVES trading positions. In general, reserving policies should be formula-based or have well-specified Mark-to-market gains and losses on trading and procedures to limit subjectivity in the determi- derivatives portfolios are recognized in the unit’s nation of fair value. Reserve policies should be profits and losses and incorporated into the reviewed periodically and revised as necessary. value of trading assets and liabilities. Often a bank will ‘‘hold back,’’ or defer, the recognition of a certain portion of first-day profits on a Reserve Adequacy transaction for some period of time. Holdback reserves are usually taken to reflect uncertainty An insufficient level of holdback reserves may about the pricing of a transaction or the risks cause current earnings to be overstated. How- entailed in actively managing the position. These ever, excess holdback reserves may cause cur- reserves are deferred gains that may or may not rent earnings to be understated and subject to be realized, and they are usually not released manipulation. Accordingly, institutions should into income until the close or maturity of the develop policies detailing acceptable practices contract. for the creation, maintenance, and release of Holdback reserves can also be taken to better holdback reserves. The level of holdback match trading revenues with expenses. Certain reserves should be periodically reviewed for costs associated with derivatives transactions, appropriateness and reasonableness by an inde- such as credit, operational, and administrative pendent control function and, if deemed neces- costs, may be incurred over the entire lives of sary, the level should be adjusted to reflect the instruments involved. In an effort to match changing market conditions. Often, the reason- revenue with expenses, an institution may defer ableness of reserves will be checked in conjunc- a certain portion of the initial profit or loss tion with the month-end revaluation process. generated by a transaction and then release the reserve into income over time. By deferring a portion of the profits or losses, holdback reserves Creating Reserves may avoid earnings overstatement and more accurately match revenues and expenses. All holdback reserves should be recognized in Reserving methodologies and the types of the internal reports and financial statements of reserves created vary among institutions. Even the institution, whether they are represented as within firms, the reserving concept may not be ‘‘pricing adjustments’’ or as a specified hold- consistent across business lines, or the concept back of a transaction’s profit or loss. Any type of may not be applied consistently. At a minimum, holdback reserve that is not recorded in the policies for holdback reserves should define financial records should be avoided. Reserves (1) the universe of risks and costs that are to be may be taken either on a transaction-by- considered when creating holdback reserves, transaction basis or on an overall portfolio basis.

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Written policies should clearly specify the types on the general-ledger account as a contra trading of holdback reserves that are appropriate for asset (as a reduction in unrealized gains), but different portfolios and transactions. some banks record them as a liability. Alterna- While holdback reserves may be created for a tively, reserves for some risks may be recorded variety of risks and costs, the following are the as a contra asset, and reserves for other risks most common types: recorded as a liability. Holdback reserves can be netted against ‘‘trading assets,’’ included in ¥ Administrative-cost reserves. These reserves ‘‘other liabilities,’’ or disclosed separately in the are intended to cover the estimated future published financial statements. Institutions should costs of maintaining portfolio positions to ensure that they have clear policies indicating maturity. Administrative-cost reserves are typi- the method to be used for portraying reserves in cally determined as a set amount per transac- reports and financial statements. tion based on historical trends. ¥ Credit-cost reserves. These reserves provide for the potential change in value associated Releasing Reserves with general credit deterioration in the port- folio and with counterparty defaults. They are An institution’s policies should clearly indicate typically calculated by formulas based on the the appropriate procedure for releasing reserves counterparty credit rating, maturity of the as profits or losses. Holdback reserves created as transaction, collateral, netting arrangements, a means of matching revenues and expenses are and other credit factors. usually amortized into income over the lives of ¥ Servicing-cost reserves. These reserves pro- the individual derivative contracts. Reserves vide for anticipated operational costs related that are created to reflect the risk that recognized to servicing the existing trading positions. gains may not be realized because of mispricing ¥ Market-risk reserves. These reserves are cre- or unexpected hedging costs are usually released ated to reflect a potential loss on the open risk in their entirety at the close or maturity of the position given adverse market movements and contract, or as the portfolio changes in structure. an inability to hedge (or the high cost of If reserves are amortized over time, a straight- hedging) the position. These reserves include line amortization schedule may be followed, dynamic hedging costs for options. with reserves being released in equal amounts ¥ Liquidity-risk reserves. These reserves are over the life of the transaction or the life of the usually a subjective estimate of potential risk. Alternatively, individual amortization sched- liquidity losses (given an assumed change in ules may be determined for each transaction. value of a position) because of the bank’s inability to obtain bid/offer in the market. They are intended to cover the expected cost of liquidating a particular transaction or port- INCOME ATTRIBUTION folio or of arranging hedges that would elimi- nate any residual market risk from that trans- Profits and losses (P&L’s) from trading accounts action or portfolio. can arise from several factors. Firms attempt to ¥ Model-risk reserves. These reserves are cre- determine the underlying reasons for value ated for the expected profit and loss impact of changes in their trading portfolios by attributing unforeseen inaccuracies in existing models. the profits and losses on each transaction to For new models, reserves are usually based on various sources. For example, profits and losses an assessment of the level of model can be attributed to the ‘‘capture’’ of the bid/ sophistication. offer spread—the primary aim of market mak- ing. Another example is the attribution of profit to ‘‘origination,’’ the difference between the fair value of the created instrument and the con- Recording Reserves tracted transaction price. Profit and loss can also result from proprietary position taking. Proper Holdback reserves may be separately recorded attribution of trading revenues is crucial to in the general-ledger accounts of each business understanding the risk profile of trading activi- entity, or they may be tracked on a corporate- ties. The ability of an institution to accurately wide basis. These reserves are usually recorded determine the sources of daily P&L on different

April 2003 Trading and Capital-Markets Activities Manual Page 8 Financial Performance 2100.1 types of financial instruments is considered a break out their daily P&L with reference to the key control to ensure that trading-portfolio valu- actual risks being managed—for example delta, ations are reasonable. The discipline of measur- gamma, theta, rho, and vega. Institutions should ing and attributing P&L performance also ensure that they provide an independent review ensures that risks are accurately measured and for the reasonableness of all revenue splits. monitored. The income-attribution process should be car- ried out by a group independent from the trad- Unexplained Profits and Losses ers; in most larger institutions, attribution is the responsibility of the risk-management or middle- Unexplained profits and losses is defined as the office function. The designated group is respon- difference between actual P&L and explained sible for conducting analysis of the institution’s P&L. If the level of unexplained P&L is con- transactions and identifying the various sources sidered significant, the control function should of trading P&L for each product or business investigate the reason for the discrepancy. It line. These analyses may cover only certain may be necessary to make changes to the pricing types of transactions, but increasingly they are process as a result of the investigation. For being applied to all products. The income- example, models may be modified or the choice attribution process should be standardized and of pricing inputs, such as volatilities and corre- consistently applied across all business units. lations, may be challenged. The level of unex- The goal of income-attribution analyses is to plained P&L that is considered significant will attribute, or ‘‘explain,’’ as much of the daily vary among institutions, with some firms spe- trading P&L as possible. A significant level of cifically defining a threshold for investigation ‘‘unexplained’’ P&L or an unusual pattern of (for example, ‘‘unexplained P&L above $x thou- attribution may indicate that the valuation pro- sand dollars will be investigated’’). Some insti- cess is flawed, implying that the bank’s reported tutions permit risk-control units to decide what income may be either under- or overstated. It is significant on a case-by-case basis. Alterna- may also point to unexplained risks that are not tively, management ‘‘triggers,’’ such as contract adequately identified and estimated. limits, may identify particular movements in P&L that should be reviewed.

Explained Profits and Losses REPORTS TO MANAGEMENT Profits and losses that can be attributed to a risk AND DISCLOSURES TO source are considered ‘‘explained P&L.’’ Insti- CUSTOMERS tutions that have significant trading activities should ensure they have appropriate methodolo- Reports to Management gies and policies to attribute as much revenue as practicable. For example, some institutions may An independent control function should prepare define first-day profit as the difference between daily P&L breakout reports and official month- the midmarket or bid/offer price and the price at end P&L breakout reports that are distributed to which the transaction was executed. This senior management. Daily reports that identify first-day profit may then be allocated among the profits and losses of new deals should be sources such as the sales desk, origination desk, provided to appropriate management and staff, and proprietary trading desk, as well as to including trading-desk managers. These reports holdback reserves. Any balance in the first-day should include P&L explanations by source and profit may then be assigned to the business or risks for each trading book. New-deal reports product line that acquired the position. As the may also be generated periodically to provide position is managed over time, subsequent P&L information on all new deals transacted during attributions are made based on the effectiveness the period. This information may include the of a trading desk’s management of the position. customer names, maturities, notional amounts, In turn, the trading desk may further attribute portfolio values, holdback reserves, and new- P&L to risk sources and other factors such as deal profits and losses. At a minimum, senior spread movements, tax sensitivity, time decay, management should receive the formal month- or basis carry. Many trading desks go on to end P&L explanation reports.

Trading and Capital-Markets Activities Manual April 2003 Page 9 2100.1 Financial Performance

Providing Valuations to Customers If internally validated models are used to deter- mine a transaction value, this fact should be Trading institutions are often asked to provide made clear, and the underlying valuation assump- valuations of transacted products to their cus- tions should be provided. tomers. Quotes may be provided on a daily, When making any price quotes, institutions weekly, monthly, or less frequent basis at the should include a disclaimer stating the true customer’s request. Even when valuations are nature of any quote—such as ‘‘indication only’’ not requested by the client, sales personnel may or ‘‘transaction price.’’ Disclosures should state follow the clients’ positions and notify them of the characteristics of any valuation provided (for changes in the valuation of their positions caused example, midmarket, indicative, or firm price). by market movements. Some firms will provide In markets that have specific conventions for quotes for all of the positions in their customers’ determining valuations, firms should usually portfolios—not just the transactions executed supply valuations using those conventions unless with the firm. Firms may also formally offer to otherwise agreed to by the customer. give valuations to certain customers for certain Although traders and marketers should receive lower-risk products. and review all valuations distributed to custom- Generally, price quotes are taken from the ers, customer valuations should be provided same systems or models used to generate end- primarily by a back- or middle-office function to of-day mark-to-market values for the firm’sown maintain segregation from the front office. reports and financial records, usually at midmar- Internal auditors may review valuations pro- ket. Holdback reserves are generally not included vided to clients to ensure consistency with the in the valuation given to customers. In all cases, values derived from the independent pricing price quotes should be accompanied by infor- models and consistency with internal mark-to- mation that describes how the value was derived. market processes.

April 2003 Trading and Capital-Markets Activities Manual Page 10 Financial Performance Examination Objectives Section 2100.2

1. To review the institution’s internal reporting a. reasonableness, of revenues and expenses to ensure that these b. consistency, reports are prepared in a manner that accu- c. consistency with management’s stated rately measures capital-markets and trading strategy and budget assumptions, results and are generally consistent with d. the trend in earnings, industry norms. e. the volatility of earnings, and 2. To review management information reports f. the risk-reward profile of specific products for content, clarity, and consistency. To ensure and business units. that reports contain adequate and accurate 5. To review management’s monitoring of financial data for sound decision making, capital-markets and trading volumes. particularly by the chief financial officer and 6. To assess whether the institution’s market- other senior management. risk-measuring system adequately captures and reports to senior management the major 3. To assess whether the institution adequately risks of the capital-markets and trading attributes income to its proper sources and activities. risks. To assess whether the allocation meth- 7. To determine the extent that capital-markets odology is sufficient. and trading activities contribute to the overall 4. To review the level of profits, risk positions, profitability and risk profile of the institution. and specific types of transactions that result 8. To recommend corrective action when poli- in revenues or losses (by month or quarter) cies, procedures, practices, or internal reports since the prior examination to ascertain— or controls are found to be deficient.

Trading and Capital-Markets Activities Manual February 1998 Page 1 Financial Performance Examination Procedures Section 2100.3

These procedures represent a list of processes reflect all significant income and expenses and activities that may be reviewed during a contributing to a business line or group’s full-scope examination. The examiner-in-charge internally reported income. will establish the general scope of examination 5. Check whether internal reporting practices and work with the examination staff to tailor are in line with industry norms and identify specific areas for review as circumstances war- the rationale for any significant differences. rant. As part of this process, the examiner 6. Check whether amortization and deprecia- reviewing a function or product will analyze and tion costs and other overhead costs are evaluate internal-audit comments and previous appropriately allocated among the appropri- examination workpapers to assist in designing ate business areas. the scope of examination. In addition, after a 7. Determine whether reserves for credit risk general review of a particular area to be exam- and other risks are sufficient to cover any ined, the examiner should use these procedures, reasonably expectable losses and costs. to the extent they are applicable, for further 8. Review the institution’s progress in imple- guidance. Ultimately, it is the seasoned judg- menting or updating the methodology for ment of the examiner and the examiner-in- attributing income to the appropriate sources. charge as to which procedures are warranted in 9. Analyze the quality of earnings. Review the examining any particular activity. level of profits and specific types of trans- actions that result in revenues or losses (by 1. Obtain all profitability reports which are month or quarter) since the prior examina- relevant to each business line or group. For tion to determine— each line or group, identify the different a. reasonableness, subcategories of income that are used in b. consistency, internal profit reports. c. consistency with management’s stated 2. Assess the institution’s methodology for strategy and budgeted levels, attributing income to its sources. Check d. the trend in earnings, whether the allocation methodology makes sufficient deductions or holdbacks from the e. the volatility of earnings, and business line to account for the efforts of f. the risk/reward profile of specific prod- sales, origination, and proprietary trading, ucts or business units. and whether it properly adjusts for hedging 10. Review the volume of transactions and costs, credit risks, liquidity risks, and other positions taken by the institution for reason- risks incurred. An adequate methodology ableness, and check that the institution has a should cover each of these factors, but an system for effectively monitoring its capital- institution need not make separate reserve markets and trading volumes. categories for each risk incurred. However, 11. Determine whether the market-risk- such institutions should be making efforts to measuring system provides the chief finan- allocate income more precisely among these cial officer and other senior management different income sources and risks. with a clear vision of the financial institu- 3. Review management information reports tion’s market portfolio and risk profile. for content, clarity, and consistency. Deter- 12. Determine the extent that trading activities mine if reports contain adequate financial contribute to the overall profitability of the data for sound decision making. institution. Determine how the trend has 4. Review internal trading-income reports to changed since the prior examination. ensure that they accurately reflect the earn- 13. Recommend corrective action when meth- ings results of the business line or group. odologies, procedures, practices, or internal Check whether internal profitability reports reports or controls are found to be deficient.

Trading and Capital-Markets Activities Manual February 1998 Page 1 Financial Performance Internal Control Questionnaire Section 2100.4

1. How does the institution define trading the business unit overly dependent on income? Does it cover interest, overhead, income generated from one particular and other expenses related to the business customer or related group of customers? line in that line’s income reports? Do inter- How diverse is the generation of product nal income reports accurately reflect the and customer profitability? results of the business line? Is the break- c. Is the institution taking an undue amount down of business-line income into compo- of credit risk or market risk to generate nents sufficient to identify the main sources its profits? Is the institution ‘‘intermedi- of profitability and expenses? What varia- ating’’ in transactions for a credit tions are there from the general market ‘‘spread’’? What is the credit quality of practice for internal reporting of business- the customers in which the institution is line income? taking credit risk in the trading unit? 2. What is the methodology for allocating 6. How does the institution monitor and con- income to its sources? Do the allocations trol its business-line and overall volume of make sufficient deductions or holdbacks to capital-markets and trading activities? account for the efforts of sales, origination, 7. Does the market-risk-measuring system and proprietary trading? Do they properly adequately capture and report to the chief adjust for hedging costs, credit risks, liquid- financial officer and senior management the ity risks, and other risks incurred? major risks from the capital-markets and 3. What steps is the institution taking to trading activities? enhance its income-allocation system? 4. How frequently are earnings reported to 8. Does the market-risk-measuring system pro- middle and senior management? Are the vide the chief financial officer and other reports comprehensive enough for the level senior management with a clear vision of of activity? Can they be used for planning the financial institution’s market portfolio and trend analysis? How often and under and risk profile? How does management what circumstances are these reports sent to compare the profitability of business lines the chief financial officer, the president, and with the underlying market risks? members of the board of directors? 9. What is the contribution of trading activities 5. Evaluate the sources of earnings. Are earn- to the overall profitability of the institution? ings highly volatile? What economic events How has the trend changed since the prior or market conditions led to this volatility? examination? a. Are there any large, nonrecurring income/ 10. Evaluate the earnings of new-product or expense items? If so, why? new-business initiatives. What is the earn- b. Is profitability of the business unit ings performance and risk profile for these dependent on income generated from areas? What are management’s goals and one particular product? Is profitability of plans for these areas?

Trading and Capital-Markets Activities Manual February 1998 Page 1 Capital Adequacy Section 2110.1

Like all risk-bearing activities, the risk exposures requirements generally sensitive to differences a banking organization assumes in its trading, in risk profiles among banking organizations; derivative, and capital-markets activities should (2) factor off-balance-sheet exposures into the be fully supported by an adequate capital posi- assessment of capital adequacy; (3) minimize tion. Accordingly, banking organizations should disincentives to holding liquid, low-risk assets; ensure that their capital positions are sufficiently and (4) achieve greater consistency in the evalu- strong to support all trading and capital-markets ation of the capital adequacy of major banks risks on a fully consolidated basis and that throughout the world. The risk-based capital adequate capital is maintained in all affiliated measure focuses primarily on the credit risk entities engaged in these activities. Institutions associated with the nature of banking organiza- with significant trading activities should have tions’ on- and off-balance-sheet exposures and reasonable methods to measure the risks of their on the type and quality of their capital. It activities and allocate capital against the eco- provides a definition of capital and a framework nomic substance of those risks. To that extent, for calculating risk-weighted assets by assigning regulatory capital requirements should be viewed assets and off-balance-sheet items to broad cate- as minimum requirements, and those institutions gories of credit risk. A banking organization’s exposed to a high or inordinate degree of risk or risk-based capital ratio is calculated by dividing forms of risk that may not be fully addressed in its qualifying capital by its risk-weighted assets. regulatory requirements are expected to operate The risk-based capital measure sets forth mini- above minimum regulatory standards consistent mum supervisory capital standards that apply to with the economic substance of the risks entailed. all banking organizations on a consolidated For bank supervisors, the baseline for capital basis. adequacy assessment is an organization’s risk- The risk-based capital ratio focuses princi- based capital ratio (the ratio of qualifying capital pally on broad categories of credit risk. For most to assets and off-balance-sheet items that have banking organizations, the ratio does not incor- been ‘‘risk weighted’’ according to their per- porate other risk factors that may affect the ceived credit risk). Supervisors also focus on the organization’s financial condition. These factors tier 1 leverage ratio to help assess capital may include overall interest-rate exposure; adequacy. For banking organizations that have liquidity, funding, and market risks; the quality significant trading activities, the risk-based capi- and level of earnings; investment or loan port- tal ratio also takes into account an institution’s folio concentrations; the effectiveness of loan exposure to market risk.1 and investment policies; the quality of assets; and management’s ability to monitor and con- trol financial and operating risks. An overall RISK-BASED CAPITAL MEASURE assessment of capital adequacy must take into account these other factors and may differ sig- The principal objectives of the risk-based capital nificantly from conclusions that might be drawn measure 2 are to (1) make regulatory capital solely from the level of an organization’s risk- based capital ratio.

1. The market-risk capital rules are mandatory for certain Definition of Capital banking organizations that have significant exposure to mar- ket risk. See ‘‘Market-Risk Measure’’ later in this section. 2. The risk-based capital measure is based on a framework For risk-based capital purposes, a banking orga- developed jointly by supervisory authorities from the G-10 nization’s capital consists of two major compo- countries. The Federal Reserve implemented the risk-based nents: core capital elements (tier 1 capital) and measure in January 1989. This section provides a brief overview of the current risk-based capital measure. More supplementary capital elements (tier 2 capital). detailed discussions can be found in the Federal Reserve’s Core capital elements include common equity Commercial Bank Examination Manual. Specific guidelines including capital stock, surplus, and undivided for calculating the risk-based capital ratio are found in profits; qualifying noncumulative perpetual pre- Regulation H (12 CFR 208, appendixes A and E) for state member banks and in Regulation Y (12 CFR 225, appendixes ferred stock (or, for bank holding companies, A and E) for bank holding companies. cumulative perpetual preferred stock, the aggre-

Trading and Capital-Markets Activities Manual April 2003 Page 1 2110.1 Capital Adequacy gate of which may not exceed 25 percent of ing of dividends and other distributions. Conse- tier 1 capital); and minority interest in the equity quently, common equity is the basis on which accounts of consolidated subsidiaries. Tier 1 most market judgments of capital adequacy are capital is generally defined as the sum of core made. capital elements less any amounts of goodwill, Consideration of the capacity of an institu- certain other intangible assets, disallowed tion’s capital structure to absorb losses should deferred tax assets, interest-only strips, nonfi- also take into account how that structure could nancial equity investments, investments in finan- be affected by changes in the institution’s per- cial subsidiaries that do not qualify within capi- formance. For example, an institution experienc- tal, and any other investments in subsidiaries ing a net operating loss—perhaps because of the that the Federal Reserve determines should be realization of unexpected losses—will face not deducted from tier 1 capital. Tier 1 capital only a reduction in its retained earnings but also represents the highest form of capital, namely possible constraints on its access to capital permanent equity. Tier 2 capital consists of a markets. These constraints could be exacerbated limited amount of the allowance for loan and if conversion options are exercised to the detri- lease losses, perpetual preferred stock that does ment of the institution. A decrease in common not qualify as tier 1 capital, mandatory convert- equity, the key element of tier 1 capital, may ible securities and other hybrid capital instru- have further unfavorable implications for an ments, long-term preferred stock with an origi- organization’s regulatory capital position. The nal term of 20 years or more, and limited eligible amounts of most types of tier 1 pre- amounts of term subordinated debt, intermediate- ferred stock and tier 2 or tier 3 capital ele- term preferred stock, unrealized holding gains ments may be reduced because current capital on qualifying equity securities, and unrealized regulations limit the amount of these elements gains (losses) on other assets. See section 3020.1, that can be included in regulatory capital to ‘‘Assessment of Capital Adequacy,’’ in the Com- a maximum percentage of tier 1 capital. Such mercial Bank Examination Manual for a com- adverse magnification effects could be further plete definition of capital elements. accentuated if adverse events take place at Capital investments in unconsolidated bank- critical junctures for raising or maintaining capi- ing and finance subsidiaries and reciprocal hold- tal, for example, as limited-life capital instru- ings of other banking organizations’ capital ments are approaching maturity or as new capi- instruments are deducted from an organization’s tal instruments are being issued. capital. The sum of tier 1 and tier 2 capital less any deductions makes up total capital, which is the numerator of the risk-based capital ratio. In assessing an institution’s capital adequacy, Risk-Weighted Assets supervisors and examiners should consider the capacity of the institution’s paid-in equity and Each asset and off-balance-sheet item is assigned other capital instruments to absorb economic to one of four broad risk categories based on the losses. In this regard, the Federal Reserve’s obligor or, if relevant, the guarantor or type of long-standing view is that common equity (that collateral. The risk categories are 0, 20, 50, and is, common stock and surplus and retained 100 percent. The standard risk category, which earnings) should be the dominant component of includes the majority of items, is 100 percent. a banking organization’s capital structure and The appropriate dollar value of the amount in that organizations should avoid undue reliance each category is multiplied by the risk weight on nonÐcommon equity capital elements.3 Com- associated with that category. The weighted mon equity allows an organization to absorb values are added together and the resulting sum losses on an ongoing basis and is permanently is the organization’s risk-weighted assets, the 4 available for this purpose. Further, this element denominator of the risk-based capital ratio. of capital best allows organizations to conserve Off-balance-sheet items are incorporated into resources when they are under stress because it the risk-based capital ratio by first being con- provides full discretion in the amount and tim- verted into a ‘‘credit-equivalent’’ amount. To accomplish this, the face amount of the item is

3. The Basel Committee on Banking Supervision affirmed this view in a release issued in October 1998, which stated that 4. See the Commercial Bank Examination Manual for a common shareholders’ funds are the key element of capital. complete discussion of risk-weighted assets.

April 2003 Trading and Capital-Markets Activities Manual Page 2 Capital Adequacy 2110.1 multiplied by a credit-conversion factor (0, 20, Banking organizations are expected to meet 50, or 100 percent). The credit-equivalent amount a minimum ratio of capital to risk-weighted is then assigned to a risk category in the same assets of 8 percent, with at least 4 percent taking manner as on-balance-sheet items. For over-the- the form of tier 1 capital. Organizations that counter (OTC) derivative transactions, the credit- do not meet the minimum ratios, or that are equivalent amount is determined by multiplying considered to lack sufficient capital to support the notional principal amount of the underlying their activities, are expected to develop and contract by a credit-conversion factor and add- implement capital plans for achieving adequate ing the resulting product (which is an estimate levels of capital. These plans must be acceptable of potential future exposure) to the positive to the Federal Reserve. mark-to-market value of the contract (which is the current exposure). A contract with a negative mark-to-market value is treated as having a TIER 1 LEVERAGE RATIO current exposure of zero. (See ‘‘Credit- Equivalent Computations for Derivative Con- The principal objective of the tier 1 leverage tracts’’ later in this section.) measure is to place a constraint on the maximum The primary determinant of the appropriate degree to which a banking organization can risk category for a particular off-balance-sheet leverage its equity capital base.6 A banking item is the obligor. Collateral or guarantees organization’s tier 1 leverage ratio is calculated may be used to a limited extent to assign an by dividing its tier 1 capital by its average total item to a lower risk category than would be consolidated assets. Generally, average total con- available to the obligor. The forms of collateral solidated assets are defined as the quarterly generally recognized for risk-based capital average total assets reported on the organiza- purposes are cash on deposit in the lending tion’s most recent regulatory reports of financial institution; securities issued or guaranteed condition, less goodwill, certain other intangible by central governments of the Organization assets, disallowed deferred tax assets, interest- for Economic Cooperation and Development only strips, nonfinancial equity investments, and (OECD) countries,5 U.S. government agencies, investments in financial subsidiaries that do not or U.S. governmentÐsponsored agencies; and qualify within capital. securities issued by multilateral lending institu- The Federal Reserve has adopted a minimum tions or regional development banks in which tier 1 leverage ratio of 3 percent for the most the U.S. government is a shareholder or contrib- highly rated banks. A state member bank oper- uting member. The only guarantees recognized ating at or near this level is expected to have are those provided by central or state and local well-diversified risk, including no undue interest- governments of the OECD countries, U.S. gov- rate-risk exposure; have excellent asset quality; ernment agencies, U.S. governmentÐsponsored have high liquidity; have good earnings; and in agencies, multilateral lending institutions or general be considered a strong banking organi- regional development banks in which the United zation rated a composite 1 under the CAMELS States is a shareholder or contributing member, rating system for banks. Other state member U.S. depository institutions, and foreign banks. banks are expected to have a minimum tier 1 leverage ratio of 4 percent. Bank holding com- panies rated a composite 1 under the BOPEC 5. OECD countries are defined to include all full members rating system and those that have implemented of the Organization for Economic Cooperation and Develop- ment regardless of entry date, as well as countries that have the Board’s risk-based capital measure for mar- concluded special lending arrangements with the International ket risk must maintain a minimum tier 1 lever- Monetary Fund (IMF) associated with the IMF’s General age ratio of 3 percent. Other bank holding Arrangements to Borrow, but excludes any country that has companies are expected to have a minimum tier rescheduled its external sovereign debt within the previous five years. As of May 1999, the OECD countries were 1 leverage ratio of 4 percent. In all cases, Australia, Austria, Belgium, Canada, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Ice- land, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, the 6. The tier 1 leverage measure, intended to be a supplement Netherlands, New Zealand, Norway, Poland, Portugal, Spain, to the risk-based capital measure, was adopted by the Federal Sweden, Switzerland, Turkey, the United Kingdom, and the Reserve in 1990. Guidelines for calculating the tier 1 leverage United States. Saudi Arabia has concluded special lending ratio are found in Regulation H (12 CFR 208, appendix B) for arrangements with the IMF associated with the IMF’s General state member banks and in Regulation Y (12 CFR 225, Arrangements to Borrow. appendix D) for bank holding companies.

Trading and Capital-Markets Activities Manual April 2003 Page 3 2110.1 Capital Adequacy banking organizations should hold capital com- require daily receipt and payment of cash- mensurate with the level and nature of all risks variation margin may be excluded from the to which they are exposed. risk-based ratio calculation. Gold contracts are accorded the same treatment as exchange-rate contracts except that gold contracts with an CREDIT-EQUIVALENT original maturity of 14 or fewer calendar days COMPUTATIONS FOR are included in the risk-based ratio calculation. OTC options purchased are included and treated DERIVATIVE CONTRACTS in the same way as other derivative contracts. Applicable Derivative Contracts

Credit-equivalent amounts are computed for Calculation of Credit-Equivalent each of the following off-balance-sheet contracts: Amounts

¥ interest-rate contracts The credit-equivalent amount of a derivative — single-currency interest-rate swaps contract (excluding credit derivatives) that is not — basis swaps subject to a qualifying bilateral netting contract — forward rate agreements is equal to the sum of— — interest-rate options purchased (including caps, collars, and floors purchased) ¥ the current exposure (sometimes referred to as — any other instrument linked to interest rates the replacement cost) of the contract and that gives rise to similar credit risks (includ- ¥ an estimate of the potential future credit ing when-issued securities and forward exposure of the contract. forward deposits accepted) ¥ exchange-rate contracts The current exposure is determined by the — cross-currency interest-rate swaps mark-to-market value of the contract. If the — forward foreign-exchange-rate contracts mark-to-market value is positive, then the cur- — currency options purchased rent exposure is equal to that mark-to-market — any other instrument linked to exchange value. If the mark-to-market value is zero or rates that gives rise to similar credit risks negative, then the current exposure is zero. ¥ equity derivative contracts Mark-to-market values are measured in dollars, — equity-linked swaps regardless of the currency or currencies speci- — equity-linked options purchased fied in the contract, and should reflect changes in — forward equity-linked contracts the relevant rates as well as in counterparty — any other instrument linked to equities that credit quality. gives rise to similar credit risks The potential future credit exposure of a ¥ commodity (including precious metal) deriva- contract, including a contract that has a negative tive contracts mark-to-market value, is estimated by multiply- — commodity-linked swaps ing the notional principal amount of the contract by a credit-conversion factor. Banking organi- — commodity-linked options purchased zations should use, subject to examiner review, — forward commodity-linked contracts the effective rather than the apparent or stated — any other instrument linked to commodi- notional amount in this calculation. The conver- ties that gives rise to similar credit risks sion factors (in percent) are listed in table 1. The ¥ credit derivatives Board has noted that these conversion factors, — credit-default swaps which are based on observed volatilities of the — total-rate-of-return swaps particular types of instruments, are subject to — other types of credit derivatives review and modification in light of changing volatilities or market conditions. Exceptions

Exchange-rate contracts that have an original maturity of 14 or fewer calendar days and derivative contracts traded on exchanges that

April 2003 Trading and Capital-Markets Activities Manual Page 4 Capital Adequacy 2110.1

Table 1—Conversion-Factor Matrix

Foreign- exchange rate and Precious Other Remaining maturity Interest rate gold Equity metals commodity

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

For a contract that is structured such that on or commodity contracts is subject to the same specified dates any outstanding exposure is conversion factors as a commodity, excluding settled and the terms are reset so that the market precious metals. value of the contract is zero, the remaining No potential future credit exposure is calcu- maturity is equal to the time until the next reset lated for a single-currency interest-rate swap in date. For an interest-rate contract with a remain- which payments are made based on two floating- ing maturity of more than one year that meets rate indexes, so-called floating/floating or basis these criteria, the minimum conversion factor is swaps. The credit exposure on these contracts is 0.5 percent. evaluated solely on the basis of their mark-to- For a contract with multiple exchanges of market values. principal, the conversion factor is multiplied by Examples of the calculation of credit- the number of remaining payments in the con- equivalent amounts for selected instruments are tract. A derivative contract not included in the in table 2. definitions of interest-rate, exchange-rate, equity,

Table 2—Calculating Credit-Equivalent Amounts for Derivative Contracts

Notional Potential Mark- Current Credit- principal Conversion exposure to- exposure equivalent Type of Contract amount factor (dollars) market (dollars) amount

(1) 120-day forward foreign exchange 5,000,000 .01 50,000 100,000 100,000 150,000 (2) 4-year forward foreign exchange 6,000,000 .05 300,000 −120,000 0 300,000 (3) 3-year single- currency fixed- and floating-interest-rate swap 10,000,000 .005 50,000 200,000 200,000 250,000 (4) 6-month oil swap 10,000,000 .10 1,000,000 −250,000 0 1,000,000 (5) 7-year cross- currency floating and floating- interest-rate swap 20,000,000 .075 1,500,000 −1,500,000 0 1,500,000

TOTAL 2,900,000 + 300,000 3,200,000

Trading and Capital-Markets Activities Manual April 2000 Page 5 2110.1 Capital Adequacy

Avoidance of Double Counting Netting of Swaps and Similar Contracts In certain cases, credit exposures arising from derivative contracts may be reflected, in part, on Netting refers to the offsetting of positive and the balance sheet. To avoid double counting negative mark-to-market values in the determi- these exposures in the assessment of capital nation of a current exposure to be used in the adequacy and, perhaps, assigning inappropriate calculation of a credit-equivalent amount. Any risk weights, examiners may need to exclude legally enforceable form of bilateral netting counterparty credit exposures arising from the (that is, netting with a single counterparty) of derivative instruments covered by the guidelines derivative contracts is recognized for purposes from balance-sheet assets when calculating a of calculating the credit-equivalent amount pro- banking organization’s risk-based capital ratios. vided that— This exclusion will eliminate the possibility that an organization could be required to hold capital • the netting is accomplished under a written against both an off-balance-sheet and on-balance- netting contract that creates a single legal sheet amount for the same item. This treatment obligation, covering all included individual is not accorded to margin accounts and accrued contracts, with the effect that the organization receivables related to interest-rate and exchange- would have a claim to receive, or an obliga- rate contracts. tion to receive or pay, only the net amount of The aggregate on-balance-sheet amount the sum of the positive and negative mark-to- excluded from the risk-based capital calculation market values on included individual con- is equal to the lower of— tracts if a counterparty, or a counterparty to whom the contract has been validly assigned, • each contract’s positive on-balance-sheet fails to perform due to default, insolvency, amount or liquidation, or similar circumstances; • its positive market value included in the off- balance-sheet risk-based capital calculation. • the banking organization obtains written and reasoned legal opinions that in the event of a For example, a forward contract that is marked legal challenge—including one resulting from to market will have the same market value on default, insolvency, liquidation, or similar the balance sheet as is used in calculating the circumstances—the relevant court and admin- credit-equivalent amount for off-balance-sheet istrative authorities would find the banking exposures under the guidelines. Therefore, the organization’s exposure to be such a net on-balance-sheet amount is not included in the amount under— risk-based capital calculation. When either the — the law of the jurisdiction in which the contract’s on-balance-sheet amount or its mar- counterparty is chartered or the equivalent ket value is negative or zero, no deduction from location in the case of noncorporate on-balance-sheet items is necessary for that entities, and if a branch of the counterparty contract. is involved, then also under the law of If the positive on-balance-sheet asset amount the jurisdiction in which the branch is exceeds the contract’s market value, the excess located; (up to the amount of the on-balance-sheet asset) — the law that governs the individual con- should be included in the appropriate risk- tracts covered by the netting contract; and weight category. For example, a purchased — the law that governs the netting contract; option will often have an on-balance-sheet amount equal to the fee paid until the option • the banking organization establishes and main- expires. If that amount exceeds market value, tains procedures to ensure that the legal char- the excess of carrying value over market value acteristics of netting contracts are kept under would be included in the appropriate risk-weight review in light of possible changes in relevant category for purposes of the on-balance-sheet law; and portion of the calculation. • the banking organization maintains documen- tation in its files that is adequate to support the netting of rate contracts, including a copy of the bilateral netting contract and necessary legal opinions.

April 2000 Trading and Capital-Markets Activities Manual Page 6 Capital Adequacy 2110.1

A contract containing a walkaway clause is not ognized through the application of a formula eligible for netting for purposes of calculating that results in an adjusted add-on amount (Anet). the credit-equivalent amount. The formula, which employs the ratio of net By netting individual contracts for the pur- current exposure to gross current exposure pose of calculating credit-equivalent amounts of (NGR), is expressed as: derivative contracts, a banking organization rep- resents that it has met the requirements of the Anet = (0.4 × Agross) + 0.6(NGR × Agross) risk-based measure of the capital adequacy guidelines for bank holding companies and that The NGR may be calculated in accordance all the appropriate documents are in the organi- with either the counterparty-by-counterparty zation’s files and available for inspection by approach or the aggregate approach. Under the the Federal Reserve. The Federal Reserve may counterparty-by-counterparty approach, the NGR determine that a banking organization’s files are is the ratio of the net current exposure for a inadequate or that a netting contract, or any of netting contract to the gross current exposure of its underlying individual contracts, may not be the netting contract. The gross current exposure legally enforceable. If such a determination is is the sum of the current exposures of all made, the netting contract may be disqualified individual contracts subject to the netting con- from recognition for risk-based capital pur- tract. Net negative mark-to-market values for poses, or underlying individual contracts may be individual netting contracts with the same coun- treated as though they are not subject to the terparty may not be used to offset net positive netting contract. mark-to-market values for other netting con- The credit-equivalent amount of contracts tracts with the same counterparty. that are subject to a qualifying bilateral netting Under the aggregate approach, the NGR is contract is calculated by adding— the ratio of the sum of all the net current exposures for qualifying bilateral netting con- • the current exposure of the netting contract tracts to the sum of all the gross current expo- (net current exposure) and sures for those netting contracts (each gross • the sum of the estimates of the potential future current exposure is calculated in the same credit exposures on all individual contracts manner as in the counterparty-by-counterparty subject to the netting contract (gross potential approach). Net negative mark-to-market values future exposure) adjusted to reflect the effects for individual counterparties may not be used to of the netting contract. offset net positive current exposures for other counterparties. The net current exposure of the netting contract A banking organization must consistently use is determined by summing all positive and either the counterparty-by-counterparty approach negative mark-to-market values of the indi- or the aggregate approach to calculate the NGR. vidual contracts included in the netting contract. Regardless of the approach used, the NGR If the net sum of the mark-to-market values is should be applied individually to each qualify- 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 of cash nonqualifying contracts should be treated as variation margin—an institution may elect to individual contracts that are not subject to the either include or exclude all mark-to-market netting contract. values of such contracts when determining net Gross potential future exposure or Agross is current exposure, provided the method chosen is calculated by summing the estimates of poten- applied consistently. tial future exposure for each individual contract Examiners are to review the netting of off- subject to the qualifying bilateral netting con- balance-sheet derivative contractual arrange- tract. The effects of the bilateral netting contract ments used by banking organizations when on the gross potential future exposure are rec- calculating or verifying risk-based capital ratios

Trading and Capital-Markets Activities Manual April 2000 Page 7 2110.1 Capital Adequacy to ensure that the positions of such contracts are to the obligor of the reference asset or any reported gross unless the net positions of those collateral. On the other hand, a bank that owns contracts reflect netting arrangements that comply the underlying asset upon which effective credit with the netting requirements listed previously. protection has been acquired through a credit derivative may, under certain circumstances, assign the unamortized portion of the underlying CAPITAL TREATMENT OF asset to the risk category appropriate to the CREDIT DERIVATIVES guarantor (for example, the 20 percent risk category if the guarantor is an OECD bank).9 Credit derivatives are off-balance-sheet arrange- Whether the credit derivative is considered an ments that allow one party (the beneficiary) to eligible guarantee for purposes of risk-based transfer credit risk of a reference asset—which capital depends on the degree of credit protec- the beneficiary may or may not own—to another tion actually provided, which may be limited party (the guarantor). Many banks increasingly depending on the terms of the arrangement. For use these instruments to manage their overall example, a relatively restrictive definition of a credit-risk exposure. In general, credit deriva- default event or a materiality threshold that tives have three distinguishing features: requires a comparably high percentage of loss to occur before the guarantor is obliged to pay 1. the transfer of the credit risk associated with could effectively limit the amount of credit risk a reference asset through contingent pay- actually transferred in the transaction. If the ments based on events of default and, usu- terms of the credit derivative arrangement sig- ally, the prices of instruments before, at, and nificantly limit the degree of risk transference, shortly after default (reference assets are then the beneficiary bank cannot reduce the risk most often traded sovereign and corporate weight of the ‘‘protected’’ asset to that of the debt instruments or syndicated bank loans) guarantor. On the other hand, even if the transfer 2. the periodic exchange of payments or the of credit risk is limited, a banking organization payment of a premium rather than the pay- providing limited credit protection through a ment of fees customary with other off- credit derivative should hold appropriate capital balance-sheet credit products, such as letters against the underlying exposure while the orga- of credit nization is exposed to the credit risk of the 3. the use of an International Swap Derivatives reference asset. Association (ISDA) master agreement and Banking organizations providing a guarantee the legal format of a derivatives contract through a credit derivative may mitigate the credit risk associated with the transaction by For risk-based capital purposes, total-rate-of- entering into an offsetting credit derivative with return swaps and credit-default swaps generally another counterparty, a so-called ‘‘back-to- should be treated as off-balance-sheet direct back’’ position. Organizations that have entered credit substitutes.7 The notional amount of a into such a position may treat the first credit contract should be converted at 100 percent to derivative as guaranteed by the offsetting trans- determine the credit-equivalent amount to be action for risk-based capital purposes. Accord- included in the risk-weighted assets of a guar- ingly, the notional amount of the first credit antor.8 A bank that provides a guarantee through derivative may be assigned to the risk category a credit derivative transaction should assign its appropriate to the counterparty providing credit credit exposure to the risk category appropriate protection through the offsetting credit deriva- tive arrangement (for example, to the 20 percent 7. Unlike total-rate-of-return swaps and credit-default risk category if the counterparty is an OECD swaps, credit-linked notes are on-balance-sheet assets or bank). liabilities. A guarantor bank should assign the on-balance- In some instances, the reference asset in the sheet amount of the credit-linked note to the risk category credit derivative transaction may not be iden- appropriate to either the issuer or the reference asset, which- ever is higher. For a beneficiary bank, cash consideration tical to the underlying asset for which the received in the sale of the note may be considered as collateral for risk-based capital purposes. 8. A guarantor bank that has made cash payments repre- 9. In addition to holding capital against credit risk, a bank senting depreciation on reference assets may deduct such that is subject to the market-risk rule (see ‘‘Market-Risk payments from the notional amount when computing credit- Measure,’’ below) must hold capital against market risk for equivalent amounts for capital purposes. credit derivatives held in its trading account.

April 2000 Trading and Capital-Markets Activities Manual Page 8 Capital Adequacy 2110.1 beneficiary has acquired credit protection. For category appropriate to the assets in the basket. example, a credit derivative used to offset the In addition to holding capital against credit risk, credit exposure of a loan to a corporate cus- a bank that is subject to the market-risk rule (see tomer may use a publicly traded corporate bond below) must hold capital against market risk for of the customer as the reference asset, whose credit derivatives held in its trading account. credit quality serves as a proxy for the on- (For a description of market-risk capital require- balance-sheet loan. In such a case, the under- ments, see SR-97-18). lying asset will still generally be considered guaranteed for capital purposes as long as both the underlying asset and the reference asset CAPITAL TREATMENT OF are obligations of the same legal entity and SYNTHETIC COLLATERALIZED have the same level of seniority in bankruptcy. In addition, banking organizations offsetting LOAN OBLIGATIONS credit exposure in this manner would be obli- Credit derivatives can be used to synthetically gated to demonstrate to examiners that there replicate collateralized loan obligations (CLOs). is a high degree of correlation between the Banking organizations can use CLOs and their two instruments; the reference instrument is synthetic variants to manage their balance sheets a reasonable and sufficiently liquid proxy for and, in some instances, transfer credit risk to the the underlying asset so that the instruments capital markets. These transactions allow eco- can be reasonably expected to behave similarly nomic capital to be allocated more efficiently, in the event of default; and, at a minimum, the resulting in, among other things, improved share- reference asset and underlying asset are subject holders’ returns. A CLO is an asset-backed to cross-default or cross-acceleration provisions. security that is usually supported by a variety of A banking organization that uses a credit deriva- assets, including whole commercial loans, tive that is based on a reference asset that differs revolving credit facilities, letters of credit, bank- from the protected underlying asset must docu- er’s acceptances, or other asset-backed securi- ment the credit derivative being used to offset ties. In a typical CLO transaction, the sponsor- credit risk and must link it directly to the asset or ing banking organization transfers the loans and assets whose credit risk the transaction is other assets to a bankruptcy-remote special- designed to offset. The documentation and the purpose vehicle (SPV), which then issues asset- effectiveness of the credit derivative transaction backed securities consisting of one or more are subject to examiner review. Banking orga- classes of debt. The CLO enables the sponsoring nizations providing credit protection through institution to reduce its leverage and risk-based such arrangements must hold capital against the capital requirements, improve its liquidity, and risk exposures that are assumed. manage credit concentrations. Some credit derivative transactions provide The first synthetic CLO issued in 1997 used credit protection for a group or basket of refer- credit-linked notes (CLNs).10 Rather than trans- ence assets and call for the guarantor to absorb fer assets to the SPV, the sponsoring bank issued losses on only the first asset that defaults. Once CLNs to the SPV, individually referencing the the first asset in the group defaults, the credit payment obligation of a particular company or protection for the remaining assets covered by ‘‘reference obligor.’’ In that particular transac- the credit derivative ceases. If examiners deter- tion, the notional amount of the CLNs issued mine that (1) the credit risk for the basket of equaled the dollar amount of the reference assets assets has effectively been transferred to the the sponsor was hedging on its balance sheet. guarantor and (2) the beneficiary banking orga- Since that time, other structures have evolved nization owns all of the reference assets included that also use credit-default swaps to transfer in the basket, then the beneficiary may assign credit risk and create different levels of risk the asset with the smallest dollar amount in the exposure, but that hedge only a portion of the group—if less than or equal to the notional notional amount of the overall reference port- amount of the credit derivative—to the risk category appropriate to the guarantor. Con- versely, a banking organization extending credit 10. CLNs are obligations whose principal repayment is protection through a credit derivative on a bas- conditioned upon the performance of a referenced asset or portfolio. The assets’ performance may be based on a variety ket of assets must assign the contract’s notional of measures, such as movements in price or credit spread or amount of credit exposure to the highest risk the occurrence of default.

Trading and Capital-Markets Activities Manual April 2003 Page 9 2110.1 Capital Adequacy folio. In most traditional CLO structures, assets folio, an SPV acquires the credit risk on a are actually transferred into the SPV. In syn- reference portfolio by purchasing CLNs issued thetic securitizations, the underlying exposures by the sponsoring banking organization. The that make up the reference portfolio remain in SPV funds the purchase of the CLNs by issuing the institution’s banking book. The credit risk is a series of notes in several tranches to third- transferred into the SPV through credit-default party investors. The investor notes are in effect swaps or CLNs. In this way, the institution is collateralized by the CLNs. Each CLN repre- able to avoid sensitive client-relationship issues sents one obligor and the bank’s credit-risk arising from loan-transfer notification require- exposure to that obligor, which may take the ments, loan-assignment provisions, and loan- form of, for example, bonds, commitments, participation restrictions. Client confidentiality loans, and counterparty exposures. Since the also can be maintained. noteholders are exposed to the full amount of Under the risk-based capital guidelines, cor- credit risk associated with the individual refer- porate credits are typically assigned to the ence obligors, all of the credit risk of the 100 percent risk category and are assessed reference portfolio is shifted from the sponsor- 8 percent capital. In the case of high-quality ing bank to the capital markets. The dollar investment-grade corporate exposures, the 8 per- amount of notes issued to investors equals the cent capital requirement may exceed the eco- notional amount of the reference portfolio. If nomic capital that a bank sets aside to cover the there is a default of any obligor linked to a CLN credit risk of the transaction. Clearly, one of the in the SPV, the institution will call the individual motivations behind CLOs and other securitiza- note and redeem it based on the repayment tions is to more closely align the sponsoring terms specified in the note agreement. The term institution’s regulatory capital requirements with of each CLN is set such that the credit exposure the economic capital required by the market. to which it is linked matures before the maturity The introduction of synthetic CLOs has raised of the CLN. This ensures that the CLN will be in questions about their treatment for purposes of place for the full term of the exposure to which calculating the leverage and risk-based capital it is linked. ratios of the Federal Reserve and other banking An investor in the notes issued by the SPV is agencies.11 In this regard, supervisors and exposed to the risk of default of the underlying examiners should consider the capital treatment reference assets, as well as to the risk that the of synthetic CLOs from the perspective of both sponsoring institution will not repay principal at investors and sponsoring banking organizations the maturity of the notes. Because of the linkage for three types of transactions: (1) the sponsor- between the credit quality of the sponsoring ing banking organization, through a synthetic institution and the issued notes, a downgrade of CLO, hedges the entire notional amount of a the sponsor’s credit rating most likely will result reference asset portfolio; (2) the sponsoring in the notes also being downgraded. Thus, a banking organization hedges a portion of the banking organization investing in this type of reference portfolio and retains a high-quality, synthetic CLO should assign the notes to the senior risk position that absorbs only those higher of the risk categories appropriate to the credit losses in excess of the junior-loss posi- underlying reference assets or the issuing entity. tions; and (3) the sponsoring banking organiza- For purposes of risk-based capital, the spon- tion retains a subordinated position that absorbs soring banking organizations may treat the cash first losses in a reference portfolio. Each of these proceeds from the sale of CLNs that provide transactions is explained more fully below. protection against underlying reference assets as cash collateralizing these assets.12 This treat- ment would permit the reference assets, if car- Entire Notional Amount of the ried on the sponsoring institution’s books, to be Reference Portfolio Is Hedged 12. The CLNs should not contain terms that would signifi- In a synthetic securitization that hedges the cantly limit the credit protection provided against the under- entire notional amount of the reference port- lying reference assets, for example, a materiality threshold that requires a relatively high percentage of loss to occur before CLN payments are adversely affected or a structuring of CLN post-default payments that does not adequately pass 11. For more information, see SR-99-32, ‘‘Capital Treat- through credit-related losses on the reference assets to inves- ment for Synthetic Collateralized Obligations.’’ tors in the CLNs.

April 2003 Trading and Capital-Markets Activities Manual Page 10 Capital Adequacy 2110.1 assigned to the zero percent risk category to the There may be several levels of loss in this extent that their notional amount is fully collat- type of synthetic securitization. The first-loss eralized by cash. This treatment may be applied position may be a small cash reserve, sufficient even if the cash collateral is transferred directly to cover expected losses, that accumulates over into the general operating funds of the institu- a period of years and is funded from the excess tion and is not deposited in a segregated account. of the SPV’s income (that is, the yield on the The synthetic CLO would not confer any bene- Treasury securities plus the credit-default-swap fits to the sponsoring banking organization for fee) over the interest paid to investors on the purposes of calculating its tier 1 leverage ratio notes. The investors in the SPV assume a because the reference assets remain on the second-loss position through their investment in organization’s balance sheet. the SPV’s senior and junior notes, which tend to be rated AAA and BB, respectively. Finally, the sponsoring banking organization retains a high- High-Quality, Senior Risk Position in quality, senior risk position that would absorb the Reference Portfolio Is Retained any credit losses in the reference portfolio that exceed the first- and second-loss positions. Typi- In some synthetic CLOs, the sponsoring bank- cally, no default payments are made until the ing organization uses a combination of credit- maturity of the overall transaction, regardless of default swaps and CLNs to essentially transfer when a reference obligor defaults. While opera- the credit risk of a designated portfolio of its tionally important to the sponsoring banking credit exposures to the capital markets. This organization, this feature has the effect of ignor- type of transaction allows the sponsoring insti- ing the time value of money. Thus, when the tution to allocate economic capital more effi- reference obligor defaults under the terms of the ciently and to significantly reduce its regulatory credit derivative and the reference asset falls capital requirements. In this structure, the spon- significantly in value, the sponsoring banking soring banking organization purchases default organization should, in accordance with gener- protection from an SPV for a specifically iden- ally accepted accounting principles, make tified portfolio of banking-book credit expo- appropriate adjustments in its regulatory reports sures, which may include letters of credit and to reflect the estimated loss relating to the time loan commitments. The credit risk on the iden- value of money. tified reference portfolio (which continues to For risk-based capital purposes, banking remain in the sponsor’s banking book) is trans- organizations investing in the notes must assign ferred to the SPV through the use of credit- them to the risk weight appropriate to the default swaps. In exchange for the credit pro- underlying reference assets.14 A banking orga- tection, the sponsoring institution pays the SPV nization sponsoring such a transaction must an annual fee. The default swaps on each of the include in its risk-weighted assets its retained obligors in the reference portfolio are structured senior exposures in the reference portfolio, to to pay the average default losses on all senior the extent these are held in its banking book. unsecured obligations of defaulted borrowers. The portion of the reference portfolio that is To support its guarantee, the SPV sells CLNs to collateralized by the pledged Treasury securities investors and uses the cash proceeds to purchase may be assigned a zero percent risk weight. The Treasury notes from the U.S. government. The remainder of the portfolio should be risk SPV then pledges the Treasuries to the sponsor- weighted according to the obligor of the expo- ing banking organization to cover any default sures, unless certain stringent minimum condi- losses.13 The CLNs are often issued in multiple tions are met. (See the following paragraph.) tranches of differing seniority and in an aggre- When the sponsoring institution has virtually gate amount that is significantly less than the eliminated its credit-risk exposure to the refer- notional amount of the reference portfolio. The ence portfolio through the issuance of CLNs, amount of notes issued typically is set at a level and when the other stringent minimum sufficient to cover some multiple of expected losses but well below the notional amount of the 14. Under this type of transaction, if a structure exposes reference portfolio being hedged. investing banking organizations to the creditworthiness of a substantive issuer (for example, the sponsoring institution), then the investing institutions should assign the notes to the 13. The names of corporate obligors included in the refer- higher of the risk categories appropriate to the underlying ence portfolio may be disclosed to investors in the CLNs. reference assets or the sponsoring institution.

Trading and Capital-Markets Activities Manual April 2003 Page 11 2110.1 Capital Adequacy requirements are met, the institution may assign risk profile and capital adequacy. A failure on the uncollateralized portion of its retained senior the part of the sponsoring banking organization position in the reference portfolio to the 20 per- to require the investors in the CLNs to absorb cent risk weight. To the extent that the reference the credit losses that they contractually agreed portfolio includes loans and other balance-sheet to assume may be considered an unsafe assets in the banking book, a banking organiza- and unsound banking practice. In addition, this tion that sponsors this type of synthetic securi- failure generally would constitute ‘‘implicit tization would not realize any benefits when recourse’’ or support to the transaction that determining its leverage ratio. would result in the sponsoring banking organi- The stringent minimum requirements, which zation losing the preferential capital treatment are discussed more fully in the attachment to on its retained senior position. SR-99-32, are that (1) the probability of loss on If an organization sponsoring a synthetic the retained senior position be extremely low securitization does not meet the stringent mini- due to the high credit quality of the reference mum criteria outlined in SR-99-32, it still may portfolio and the amount of prior credit protec- reduce the risk-based capital requirement on the tion; (2) market discipline be injected into the senior risk position retained in the banking book process through the sale of CLNs into the by using a credit derivative to transfer the market, the most senior of which must be rated remaining credit risk to a third-party OECD AAA by a nationally recognized credit rating bank. Provided the credit derivative transaction agency; and (3) the sponsoring institution per- qualifies as a guarantee under the risk-based forms rigorous and robust stress testing and capital guidelines, the risk weight on the senior demonstrates that the level of credit enhance- position may be reduced from 100 percent to ment is sufficient to protect itself from losses 20 percent. Institutions may not enter into non- under scenarios appropriate to the specific trans- substantive transactions that transfer banking- action. The Federal Reserve may impose other book items into the trading account in order to requirements as deemed necessary to ensure that obtain lower regulatory capital requirements.15 the sponsoring institution has virtually elimi- nated all of its credit exposure. Furthermore, Retention of a First-Loss Position supervisors and examiners retain the discretion to increase the risk-based capital requirement In certain synthetic transactions, the sponsoring assessed against the retained senior exposure in banking organization may retain the credit risk these structures, if the underlying asset pool associated with a first-loss position and, through deteriorates significantly. the use of credit-default swaps, pass the second- Based on a qualitative review, Federal Reserve and senior-loss positions to a third-party entity, staff will determine on a case-by-case basis most often an OECD bank. The third-party whether the senior retained portion of a spon- entity, acting as an intermediary, enters into soring banking organization’s synthetic securi- offsetting credit-default swaps with an SPV. The tization qualifies for the 20 percent risk weight. swaps transfer the credit risk associated with the The sponsoring institution must be able to dem- second-loss position to the SPV but the credit onstrate that virtually all of the credit risk of the risk of the senior position is retained.16 As reference portfolio has been transferred from the described in the second transaction type above, banking book to the capital markets. As is the the SPV then issues CLNs to the capital markets case with organizations engaging in more tradi- for a portion of the reference portfolio and tional securitization activities, examiners must purchases Treasury collateral to cover some carefully evaluate whether the institution is fully capable of assessing the credit risk it retains in 15. For instance, a lower risk weight would not be applied its banking book and whether the institution is to a nonsubstantive transaction in which the sponsoring adequately capitalized given its residual risk institution enters into a credit derivative to pass the credit risk exposure. Supervisors will require the sponsor- of the senior retained portion held in its banking book to an OECD bank and then enters into a second credit derivative ing organization to maintain higher levels of transaction with the same OECD bank in order to reassume capital if it is not deemed to be adequately into its trading account the credit risk initially transferred. capitalized given the retained residual risks. In 16. Because the credit risk of the senior position is not addition, an institution sponsoring synthetic transferred to the capital markets but instead remains with the intermediary bank, the sponsoring banking organization should securitizations must adequately disclose to the ensure that its counterparty is of high credit quality, for marketplace the effect of the transaction on its example, at least investment grade.

April 2003 Trading and Capital-Markets Activities Manual Page 12 Capital Adequacy 2110.1 multiple of expected losses on the underlying depending on whether the reference portfolio exposures. consists primarily of loans to private obligors, or Two alternative approaches could be used to undrawn long-term commitments. These com- determine how the sponsoring banking organi- mitments generally have an effective risk-based zation should treat the overall transaction for capital requirement that is one-half the require- risk-based capital purposes. The first approach ment for loans, since they are converted to an employs an analogy to the low-level capital rule on-balance-sheet credit-equivalent amount using for assets sold with recourse. Under this rule, a the 50 percent conversion factor. If the reference transfer of assets with recourse that is contrac- pool consists primarily of drawn loans to com- tually limited to an amount less than the effec- mercial obligors, then the capital requirement on tive risk-based capital requirements for the trans- the senior-loss position would be significantly ferred assets is assessed a total capital charge higher than if the reference portfolio contained equal to the maximum amount of loss possible only undrawn long-term commitments. As a under the recourse obligation. If this rule was result, the capital charge for the overall transac- applied to a sponsoring banking organization tion could be greater than the dollar-for-dollar retaining a one percent first-loss position on a capital requirement set forth in the first approach. synthetically securitized portfolio that would Sponsoring institutions are required to hold otherwise be assessed 8 percent capital, the capital against a retained first-loss position in a organization would be required to hold dollar- synthetic securitization. The capital should equal for-dollar capital against the one percent first- the higher of the two capital charges resulting loss risk position. The sponsoring institution from the sponsoring institution’s application of would not be assessed a capital charge against the first and second approaches outlined above. the second and senior risk positions.17 Further, although the sponsoring banking orga- The second approach employs a literal read- nization retains only the credit-risk associated ing of the capital guidelines to determine the with the first-loss position, it still should con- sponsoring banking organization’s risk-based tinue to monitor all the underlying credit expo- capital charge. In this instance, the one percent sures of the reference portfolio to detect any first-loss position retained by the sponsoring changes in the credit-risk profile of the counter- institution would be treated as a guarantee, that parties. This is important to ensure that the is, a direct credit substitute, which would be institution has adequate capital to protect against assessed an 8 percent capital charge against its unexpected losses. Examiners should determine face value of one percent. The second-loss whether the sponsoring bank has the capability position, which is collateralized by Treasury to assess and manage the retained risk in its securities, would be viewed as fully collateral- credit portfolio after the synthetic securitization ized and subject to a zero percent capital charge. is completed. For risk-based capital purposes, The senior-loss position guaranteed by the banking organizations investing in the notes intermediary bank would be assigned to the must assign them to the risk weight appropriate 20 percent risk category appropriate to claims to the underlying reference assets.19 guaranteed by OECD banks.18 It is possible that this approach may result in a higher risk-based capital requirement than the dollar-for-dollar capital charge imposed by the first approach— ASSESSING CAPITAL ADEQUACY AT LARGE, COMPLEX BANKING 17. A banking organization that sponsors this type of synthetic securitization would not realize any benefits in the ORGANIZATIONS determination of its leverage ratio since the reference assets themselves remain on the sponsoring institution’s balance Supervisors should place increasing emphasis sheet. on banking organizations’ internal processes for 18. If the intermediary is a banking organization, then it could place both sets of credit-default swaps in its trading account and, if subject to the Federal Reserve’s market-risk capital rules, use its general market-risk model and, if 19. Under this type of transaction, if a structure exposes approved, specific-risk model to calculate the appropriate investing banking organizations to the creditworthiness of a risk-based capital requirement. If the specific-risk model has substantive issuer (for example, the sponsoring institution), not been approved, then the sponsoring banking organization then the investing institutions should assign the notes to the would be subject to the standardized specific-risk capital higher of the risk categories appropriate to the underlying charge. reference assets or the sponsoring institution.

Trading and Capital-Markets Activities Manual April 2000 Page 13 2110.1 Capital Adequacy assessing risks and for ensuring that capital, the results of this evaluation in the examination liquidity, and other financial resources are ade- or inspection report. quate in relation to the organization’s overall For those banking organizations actively risk profiles. This emphasis is necessary in part involved in complex securitizations, other because of the greater scope and complexity of secondary-market credit activities, or other com- business activities, particularly those related to plex transfers of risk, examiners should expect ongoing financial innovation, at many banking a sound internal process for capital adequacy organizations. In this setting, one of the most analysis to be in place immediately as a matter challenging issues bankers and supervisors face of safe and sound banking. Secondary-market is how to integrate the assessment of an institu- credit activities generally include loan syndica- tion’s capital adequacy with a comprehensive tions, loan sales and participations, credit deriva- view of the risks it faces. Simple ratios— tives, and asset securitizations, as well as the including risk-based capital ratios—and tradi- provision of credit enhancements and liquidity tional ‘‘rules of thumb’’ no longer suffice in facilities to such transactions. These activi- assessing the overall capital adequacy of many ties are described further in SR-97-21, ‘‘Risk banking organizations, especially large institu- Management and Capital Adequacy of Expo- tions and others with complex risk profiles, such sures Arising from Secondary-Market Credit as those that are significantly engaged in secu- Activities.’’ ritizations or other complex transfers of risk. Examiners should evaluate whether an orga- Consequently, supervisors and examiners nization is making adequate progress in assess- should evaluate internal capital-management pro- ing its capital needs on the basis of the risks cesses to judge whether they meaningfully tie arising from its business activities, rather than the identification, monitoring, and evaluation focusing its internal processes primarily on of risk to the determination of an institution’s compliance with regulatory standards or com- capital needs. The fundamental elements of a parisons with the capital ratios of peer institu- sound internal analysis of capital adequacy tions. In addition to evaluating an organization’s include measuring all material risks, relating current practices, supervisors and examiners capital to the level of risk, stating explicit capital should take account of plans and schedules to adequacy goals with respect to risk, and assess- enhance existing capital-assessment processes ing conformity to an institution’s stated objec- and related risk-measurement systems, with tives. It is particularly important that large appropriate sensitivity to transition timetables institutions and others with complex risk pro- and implementation costs. Evaluation of adher- files be able to assess their current capital ence to schedules should be part of the exam- adequacy and future capital needs systemati- ination and inspection process. Regardless of cally and comprehensively, in light of their risk planned enhancements, supervisors should expect profiles and business plans. For more informa- current internal processes for capital adequacy tion, see SR-99-18, ‘‘Assessing Capital Ade- assessment to be appropriate to the nature, size, quacy in Relation to Risk at Large Banking and complexity of an organization’s activities, Organizations and Others with Complex Risk and to its process for determining the allowance Profiles.’’ for credit losses. The practices described in this subsection The results of the evaluation of internal pro- extend beyond those currently followed by most cesses for assessing capital adequacy should large banking organizations to evaluate their currently be reflected in the institution’s ratings capital adequacy. Therefore, supervisors and for management. Examination and inspection examiners should not expect these institutions reports should contain a brief description of the to immediately have in place a comprehensive internal processes involved in internal analysis internal process for assessing capital adequacy. of the adequacy of capital in relation to risk, an Rather, examiners should look for efforts to assessment of whether these processes are ade- initiate such a process and thereafter make quate for the complexity of the institution and its steady and meaningful progress toward a com- risk profile, and an evaluation of the institution’s prehensive assessment of capital adequacy. efforts to develop and enhance these processes. Examiners should evaluate an institution’s Significant deficiencies and inadequate progress progress at each examination or inspection, in developing and maintaining capital-assessment considering progress relative to both the institu- procedures should be noted in examination and tion’s former practice and its peers, and record inspection reports. As noted above, examiners

April 2000 Trading and Capital-Markets Activities Manual Page 14 Capital Adequacy 2110.1 should expect those institutions already engaged to ensure objectivity and consistency and that in complex activities involving the transfer of all material risks, both on- and off-balance- risk, such as securitization and related activi- sheet, are adequately addressed. ties, to have sound internal processes for ana- Banking organizations should conduct lyzing capital adequacy in place immediately as detailed analyses to support the accuracy or a fundamental component of safe and sound appropriateness of the risk-measurement tech- operation. As these processes develop and niques used. Similarly, inputs used in risk become fully implemented, supervisors and measurement should be of good quality. examiners should also increasingly rely on Those risks not easily quantified should be internal assessments of capital adequacy as an evaluated through more subjective, qualita- integral part of an institution’s capital adequacy tive techniques or through stress testing. rating. If these internal assessments suggest that Changes in an institution’s risk profile should capital levels appear to be insufficient to support be incorporated into risk measures on a the risks taken by the institution, examiners timely basis, whether the changes are due to should note this finding in examination and new products, increased volumes or changes inspection reports, discuss plans for correcting in concentrations, the quality of the bank’s this insufficiency with the institution’s directors portfolio, or the overall economic environ- and management, and initiate supervisory actions, ment. Thus, measurement should not be ori- as appropriate. ented to the current treatment of these trans- actions under risk-based capital regulations. When measuring risks, institutions should perform comprehensive and rigorous stress Fundamental Elements of a Sound tests to identify possible events or changes in Internal Analysis of Capital Adequacy markets that could have serious adverse effects in the future. Institutions should also Because risk-measurement and -management give adequate consideration to contingent issues are evolving rapidly, it is currently neither exposures arising from loan commitments, possible nor desirable for supervisors to pre- securitization programs, and other transac- scribe in detail the precise contents and structure tions or activities that may create these of a sound and effective internal capital- exposures for the bank. assessment process for large and complex insti- 2. Relating capital to the level of risk. The tutions. Indeed, the attributes of sound practice amount of capital held should reflect not only will evolve over time as methodologies and the measured amount of risk, but also an capabilities change, and will depend signifi- adequate ‘‘cushion’’ above that amount to cantly on the individual circumstances of each take account of potential uncertainties in risk institution. Nevertheless, a sound process for measurement. A banking organization’s capi- assessing capital adequacy should include four tal should reflect the perceived level of pre- fundamental elements: cision in the risk measures used, the poten- tial volatility of exposures, and the relative 1. Identifying and measuring all material risks. importance to the institution of the activities A disciplined risk-measurement program producing the risk. Capital levels should also promotes consistency and thoroughness in reflect that historical correlations among assessing current and prospective risk pro- exposures can rapidly change. Institutions files, while recognizing that risks often can- should be able to demonstrate that their not be precisely measured. The detail and approach to relating capital to risk is concep- sophistication of risk measurement should be tually sound and that outputs and results are appropriate to the characteristics of an insti- reasonable. An institution could use sensitiv- tution’s activities and to the size and nature ity analysis of key inputs and peer analysis in of the risks that each activity presents. At a assessing its approach. One credible method minimum, risk-measurement systems should for assessing capital adequacy is for an insti- be sufficiently comprehensive and rigorous tution to consider itself adequately capital- to capture the nature and magnitude of risks ized if it meets a reasonable and objectively faced by the institution, while differentiating determined standard of financial health, tem- risk exposures consistently among risk cate- pered by sound judgment—for example, a gories and levels. Controls should be in place target public-agency debt rating or even a

Trading and Capital-Markets Activities Manual April 2000 Page 15 2110.1 Capital Adequacy

statistically measured maximum probability to maintain its overall desired capacity to of becoming insolvent over a given time absorb potential losses. Failure to recognize horizon. In effect, this latter method is the this relationship could lead an institution foundation of the Basel Accord’s treatment to overestimate the strength of its capital of capital requirements for market foreign- position. exchange risk. 4. Assessing conformity to the institution’s 3. Stating explicit capital adequacy goals with stated objectives. Both the target level and respect to risk. Institutions need to establish composition of capital, along with the pro- explicit goals for capitalization as a standard cess for setting and monitoring such targets, for evaluating their capital adequacy with should be reviewed and approved periodi- respect to risk. These target capital levels cally by the institution’s board of directors. might reflect the desired level of risk cover- age or, alternatively, a desired credit rating for the institution that reflects a desired Risks Addressed in a Sound Internal degree of creditworthiness and, thus, access Analysis of Capital Adequacy to funding sources. These goals should be reviewed and approved by the board of Sound internal risk-measurement and capital- directors. Because risk profiles and goals assessment processes should address the full may differ across institutions, the chosen range of risks faced by an institution. The four target levels of capital may differ signifi- risks listed below do not represent an exhaustive cantly as well. Moreover, institutions should list of potential issues that should be addressed. evaluate whether their long-run capital tar- The capital regulations of the Federal Reserve gets might differ from short-run goals, based and other U.S. banking agencies refer to many on current and planned changes in risk pro- specific factors and other risks that institutions files and the recognition that accommodating should consider in assessing capital adequacy. new capital needs can require significant lead time. • Credit risk. Internal credit-risk-rating systems In addition, capital goals and the monitor- are vital to measuring and managing credit ing of performance against those goals should risk at large banking organizations. Accord- be integrated with the methodology used to ingly, a large institution’s internal ratings identify the adequacy of the allowance for system should be adequate to support the credit losses (the allowance). Although both identification and measurement of risk for its the allowance and capital represent the abil- lending activities and adequately integrated ity to absorb losses, insufficiently clear dis- into the institution’s overall analysis of capital tinction of their respective roles in absorbing adequacy. Well-structured credit-risk-rating losses can distort analysis of their adequacy. systems should reflect implicit, if not explicit, For example, an institution’s internal stan- judgments of loss probabilities or expected dard of capital adequacy for credit risk could loss, and should be supported where possible reflect the desire that capital absorb ‘‘unex- by quantitative analyses. Definitions of risk pected losses,’’ that is, some level of poten- ratings should be sufficiently detailed and tial losses in excess of that level already descriptive, applied consistently, and regularly estimated as being inherent in the current reviewed for consistency throughout the insti- portfolio and reflected in the allowance.20 In tution. SR-98-25, ‘‘Sound Credit-Risk Man- this setting, an institution that does not main- agement and the Use of Internal Credit-Risk tain its allowance at the high end of the range Ratings at Large Banking Organizations,’’ of estimated credit losses would require more discusses the need for banks to have suffi- capital than would otherwise be necessary ciently detailed, consistent, and accurate risk ratings for all loans, not only for criticized or problem credits. It describes an emerging 20. In March 1999, the banking agencies and the Securities and Exchange Commission issued a joint interagency letter to sound practice of incorporating such ratings financial institutions stressing that depository institutions information into internal capital frameworks, should have prudent and conservative allowances that fall recognizing that riskier assets require higher within an acceptable range of estimated losses. The Federal capital levels. Reserve has issued additional guidance on credit-loss allow- ances to supervisors and bankers in SR-99-13, ‘‘Recent Banking organizations should also take full Developments Regarding Loan-Loss Allowances.’’ account of credit risk arising from securitiza-

April 2000 Trading and Capital-Markets Activities Manual Page 16 Capital Adequacy 2110.1

tion and other secondary-market credit activi- the importance of assessing interest-rate risk ties, including credit derivatives. Maintaining to the economic value of a banking organiza- detailed and comprehensive credit-risk mea- tion’s capital and, in particular, sound practice sures is most necessary at institutions that in selecting appropriate interest-rate scenarios conduct asset securitization programs, due to be applied for capital adequacy purposes. to the potential of these activities to greatly • Operational and other risks. Many banking change—and reduce the transparency of—the organizations see operational risk—often risk profile of credit portfolios. SR-97-21, viewed as any risk not categorized as credit or ‘‘Risk Management and Capital Adequacy of market risk—as second in significance only to Exposures Arising from Secondary-Market credit risk. This view has become more widely Credit Activities,’’ states that such changes held in the wake of recent, highly visible have the effect of distorting portfolios that breakdowns in internal controls and corporate were previously ‘‘balanced’’ in terms of credit governance by internationally active institu- risk. As used here, the term ‘‘balanced’’ refers tions. Although operational risk does not eas- to the overall weighted mix of risks assumed ily lend itself to quantitative measurement, it in a loan portfolio by the current regulatory can have substantial costs to banking organi- risk-based capital standard. This standard, for zations through error, fraud, or other perfor- example, effectively treats the commercial mance problems. The great dependence of loan portfolios of all banks as having ‘‘typi- banking organizations on information tech- cal’’ levels of risk. The current capital stan- nology systems highlights only one aspect of dard treats most loans alike; consequently, the growing need to identify and control this banks have an incentive to reduce their regu- operational risk. latory capital requirements by securitizing or otherwise selling lower-risk assets, while increasing the average level of remaining credit risk through devices like first-loss posi- Examiner Review of Internal Analysis tions and contingent exposures. It is impor- of Capital Adequacy tant, therefore, that these institutions have the ability to assess their remaining risks and hold Supervisors and examiners should review inter- levels of capital and allowances for credit nal processes for capital assessment at large and losses. These institutions are at the frontier of complex banking organizations, as well as the financial innovation, and they should also be adequacy of their capital and their compliance at the frontier of risk measurement and inter- with regulatory standards, as part of the regular nal capital allocation. supervisory process. In general, this review • Market risk. The current regulatory capital should assess the degree to which an institution standard for market risk (see ‘‘Market-Risk has in place, or is making progress toward Measure,’’ below) is based largely on a bank’s implementing, a sound internal process to assess own measure of value-at-risk (VAR). This capital adequacy as described above. Examiners approach was intended to produce a more should briefly describe in the examination or accurate measure of risk and one that is also inspection report the approach and internal pro- compatible with the management practices of cesses used by an institution to assess its capi- banks. The market-risk standard also empha- tal adequacy with respect to the risks it takes. sizes the importance of stress testing as a Examiners should then document their evalua- critical complement to a mechanical VAR- tion of the adequacy and appropriateness of based calculation in evaluating the adequacy these processes for the size and complexity of of capital to support the trading function. the institution, along with their assessment • Interest-rate risk. Interest-rate risk within the of the quality and timing of the institution’s banking book (that is, in nontrading activities) plans to develop and enhance its processes for should also be closely monitored. The bank- evaluating capital adequacy with respect to risk. ing agencies have emphasized that banks In all cases, the findings of this review should be should carefully assess the risk to the eco- considered in determining the institution’s nomic value of their capital from adverse supervisory rating for management. Over time, changes in interest rates. The ‘‘Joint Policy this review should also become an integral Statement on Interest-Rate Risk,’’ SR-96-13, element of assessing and assigning a supervi- provides guidance in this matter that includes sory rating for capital adequacy as the institution

Trading and Capital-Markets Activities Manual April 2000 Page 17 2110.1 Capital Adequacy develops appropriate processes for establishing of tier 1 limitations, adverse capital-market capital targets and analyzing its capital ade- responses, and other such magnification effects. quacy as described above. If an institution’s Finally, supervisors should consider the quality internal assessments suggest that capital levels of the institution’s management information appear to be insufficient to support its risk reporting and systems, the manner in which positions, examiners should note this finding in business risks and activities are aggregated, and examination and inspection reports, discuss plans management’s record in responding to emerging for correcting this insufficiency with the institu- or changing risks. tion’s directors and management, and, as appro- In performing this review, supervisors and priate, initiate follow-up supervisory actions. examiners should be careful to distinguish Supervisors and examiners should assess the between (1) a comprehensive process that seeks degree to which internal targets and processes to identify an institution’s capital requirements incorporate the full range of material risks faced on the basis of measured economic risk, and by a banking organization. Examiners should (2) one that focuses only narrowly on the also assess the adequacy of risk measures used calculation and use of allocated capital (also in assessing internal capital adequacy for this known as ‘‘economic value added’’ or EVA) for purpose, and the extent to which these risk individual products or business lines for internal measures are also used operationally in setting profitability analysis. The latter approach, which limits, evaluating business-line performance, and measures the amount by which operations or evaluating and controlling risk more generally. projects return more or less than their cost of Measurement systems that are in place but are capital, can be important to an organization in not integral to an institution’s risk management targeting activities for future growth or cut- should be viewed with some skepticism. Super- backs. However, it requires that the organization visors and examiners should review whether an first determine by some method the amount of institution treats similar risks across products capital necessary for each activity or business and/or business lines consistently, and whether line. Moreover, an EVA approach often is unable changes in the institution’s risk profile are fully to meaningfully aggregate the allocated capital reflected in a timely manner. Finally, supervisors across business lines and risk types as a tool for and examiners should consider the results of evaluating the institution’s overall capital ade- sensitivity analyses and stress tests conducted quacy. Supervisors and examiners should there- by the institution, and how these results relate to fore focus on the first process above and should capital plans. not be confused with related efforts of manage- In addition to being in compliance with reg- ment to measure relative returns of the firm or of ulatory capital ratios, banking organizations individual business lines, given an amount of should be able to demonstrate through internal capital already invested or allocated. analysis that their capital levels and composition are adequate to support the risks they face, and that these levels are properly monitored and reviewed by directors. Supervisors and examin- MARKET-RISK MEASURE ers should review this analysis, including the target levels of capital chosen, to determine In August 1996, the Federal Reserve amended whether it is sufficiently comprehensive and its risk-based capital framework to incorporate a relevant to the current operating environment. measure for market risk. (See 12 CFR 208, Supervisors and examiners should also consider appendix E, for state member banks and 12 CFR the extent to which an institution has provided 225, appendix E, for bank holding companies.) for unexpected events in setting its capital lev- As described more fully below, certain institu- els. In this connection, the analysis should cover tions with significant exposure to market risk a sufficiently wide range of external conditions must measure that risk using their internal and scenarios, and the sophistication of tech- value-at-risk (VAR) measurement model and, niques and stress tests used should be commen- subject to parameters contained in the market- surate with the institution’s activities. Consider- risk rules, hold sufficient levels of capital to ation of such conditions and scenarios should cover the exposure. The market-risk amendment take appropriate account of the possibility that is a supplement to the credit risk-based capital adverse events may have disproportionate effects rules: An institution applying the market-risk on overall capital levels, such as the effect rules remains subject to the requirements of the

April 2000 Trading and Capital-Markets Activities Manual Page 18 Capital Adequacy 2110.1 credit-risk rules, but must adjust its risk-based ated by the Federal Reserve to ensure compli- capital ratio to reflect market risk.21 ance with the rules.

Covered Banking Organizations Covered Positions

The market-risk rules apply to any insured state For supervisory purposes, a covered banking member bank or bank holding company whose organization must hold capital to support its trading activity (on a worldwide consolidated exposure to general market risk arising from basis) equals (1) 10 percent or more of its total fluctuations in interest rates, equity prices, assets or (2) $1 billion or more. For purposes of foreign-exchange rates, and commodity prices these criteria, a banking organization’s trading (general market risk includes the risk associated activity is defined as the sum of its trading assets with all derivative positions). In addition, the and trading liabilities as reported in its most institution’s capital must support its exposure to recent Consolidated Report of Condition and specific risk arising from changes in the market Income (call report) for a bank or in its most value of debt and equity positions in the trading recent Y-9C report for a bank holding company. account caused by factors other than broad Total assets means quarter-end total assets as market movements (specific risk includes the most recently reported by the institution. When credit risk of an instrument’s issuer). An insti- addressing this capital requirement, bank hold- tution’s covered positions include all of its ing companies should include any securities trading-account positions as well as all foreign- subsidiary that underwrites and deals in corpo- exchange and commodity positions, whether or rate securities, as well as any other subsidiaries not they are in the trading account. consolidated in their FR Y-9 reports. For market-risk capital purposes, an institu- On a case-by-case basis, the Federal Reserve tion’s trading account is defined in the instruc- may require an institution that does not meet the tions to the banking agencies’ call report. In applicability criteria to comply with the market- general, the trading account includes on- and risk rules if deemed necessary for safety-and- off-balance-sheet positions in financial instru- soundness reasons. The Federal Reserve may ments acquired with the intent to resell in order also exclude an institution that meets the appli- to profit from short-term price or rate move- cability criteria if its recent or current exposure ments (or other price or rate variations). All is not reflected by the level of its ongoing positions in the trading account must be marked trading activity. Institutions most likely to be to market and reflected in an institution’s earn- exempted from the market-risk capital require- ings statement. Debt positions in the trading ment are small banks whose reported trading account include instruments such as fixed or activities exceed the 10 percent criterion but floating-rate debt securities, nonconvertible pre- whose management of trading risks does not ferred stock, certain convertible bonds, or raise supervisory concerns. Such banks may be derivative contracts of debt instruments. Equity focused on maintaining a market in local positions in the trading account include instru- municipal securities but are not otherwise ments such as common stock, certain convert- actively engaged in trading or position-taking ible bonds, commitments to buy or sell equities, activities. However, before making any excep- or derivative contracts of equity instruments. An tions to the criteria, Reserve Banks should institution may include in its measure for gen- consult with Board staff. An institution that does eral market risk certain nonÐtrading account not meet the applicability criteria may, subject instruments that it deliberately uses to hedge to supervisory approval, comply voluntarily with trading activities. Those instruments are not the market-risk rules. An institution applying subject to a specific-risk capital charge but the market-risk rules must have its internal- instead continue to be included in risk-weighted model and risk-management procedures evalu- assets under the credit-risk framework. The market-risk capital charge applies to all of an institution’s foreign-exchange and com- 21. An institution adjusts its risk-based capital ratio by modities positions. An institution’s foreign- removing certain assets from its credit-risk weight categories and instead including those assets (and others) in the measure exchange positions include, for each currency, for market risk. items such as its net spot position (including

Trading and Capital-Markets Activities Manual April 2003 Page 19 2110.1 Capital Adequacy ordinary assets and liabilities denominated in a charge for specific risk. The VAR-based capital foreign currency), forward positions, guarantees charge is the larger of either (1) the average that are certain to be called and likely to be VAR measure for the last 60 business days, unrecoverable, and any other items that react calculated under the regulatory criteria and primarily to changes in exchange rates. An increased by a multiplication factor ranging institution may, subject to examiner approval, from three to four, or (2) the previous day’s exclude from the market-risk measure any struc- VAR calculated under the regulatory criteria but tural positions in foreign currencies. For this without the multiplication factor. An institu- purpose, structural positions include transac- tion’s multiplication factor is three unless its tions designed to hedge an institution’s capital backtesting results or supervisory judgment indi- ratios against the effect of adverse exchange-rate cate that a higher factor or other action is movements on (1) subordinated debt, equity, or appropriate.22 minority interests in consolidated subsidiaries The numerator of an institution’s risk-based and capital assigned to foreign branches that are capital ratio consists of a combination of core denominated in foreign currencies and (2) any (tier 1) capital, supplemental (tier 2) capital, and positions related to unconsolidated subsidiaries a third tier of capital (tier 3), which may only and other items that are deducted from an be used to meet market-risk capital require- institution’s capital when calculating its capital ments. To qualify as capital, instruments must base. An institution’s commodity positions be unsecured and may not contain or be covered include all positions, including derivatives, that by any covenants, terms, or restrictions that are react primarily to changes in commodity prices. inconsistent with safe and sound banking prac- tices. Tier 3 capital is subordinated debt with an original maturity of at least two years. It must be fully paid up and subject to a lock-in clause that Adjustment to the Risk-Based Capital prevents the issuer from repaying the debt even Calculation at maturity if the issuer’s capital ratio is, or with repayment would become, less than the mini- An institution applying the market-risk rules mum 8 percent risk-based capital ratio. must measure its market risk and, on a daily For purposes of overall capital, at least 50 per- basis, hold capital to maintain an overall mini- cent of an institution’s total qualifying capital mum 8 percent ratio of total qualifying capital to must be tier 1 capital (that is, tier 2 capital plus risk-weighted assets adjusted for market risk. tier 3 capital may not exceed 100 percent of tier The denominator of an institution’s risk- 1 capital). In addition, term subordinated debt based capital ratio is its adjusted credit-risk (excluding mandatory convertible debt) and weighted assets plus its market-risk-equivalent intermediate-term preferred stock (and related assets. Adjusted risk-weighted assets are risk- surplus) included in tier 2 capital may not weighted assets, as determined under the credit- exceed 50 percent of tier 1 capital. For the risk-based capital standards, less the risk- purposes of the market-risk capital calculation, weighted amounts of all covered positions other an institution must meet a further restriction: than foreign-exchange positions outside the trad- The sum of tier 2 capital and tier 3 capital ing account and OTC derivatives. (In other allocated for market risk may not exceed words, an institution should not risk weight (or 250 percent of tier 1 capital allocated for market could risk weight at zero percent) any nonderiva- risk.23 tive debt, equity, or foreign-exchange positions in its trading account and any nonderivative 22. One year after an institution begins to apply the commodity positions whether in or out of the market-risk rules, it must begin ‘‘backtesting’’ its VAR mea- trading account. These positions are no longer sures generated for internal risk-management purposes against subject to a credit-risk capital charge.) An insti- actual trading results to assist in evaluating the accuracy of its tution’s market-risk-equivalent assets is its mea- internal model. 23. The market-risk rules (12 CFR 208, appendix E, sure for market risk (determined as discussed in section 3(b)(2)) discuss ‘‘allocating’’ capital to cover credit the following sections) multiplied by 12.5 (the risk and market risk. The allocation terminology is only reciprocal of the minimum 8 percent capital relevant for the limit on tier 3 capital. Otherwise, as long as ratio). the condition that tier 1 capital constitutes at least 50 percent of total qualifying capital is satisfied, there is no requirement An institution’s measure for market risk is a that an institution must allocate or identify its capital for credit VAR-based capital charge plus an add-on capital or market risk.

April 2003 Trading and Capital-Markets Activities Manual Page 20 Capital Adequacy 2110.1

Internal Models

An institution applying the market-risk rules must use its internal model to measure its daily VAR in accordance with the rule’s requirements. However, institutions can and will use different assumptions and modeling techniques when determining their VAR measures for internal

Trading and Capital-Markets Activities Manual April 2003 Page 20.1 Capital Adequacy 2110.1 risk-management purposes. These differences and risk-management committees and minutes. often reflect distinct business strategies and The review of committee minutes provides approaches to risk management. For example, insights into the level of discussion of market- an institution may calculate VAR using an risk issues by senior management and, in some internal model based on variance-covariance cases, by outside directors of the institution. matrices, historical simulations, Monte Carlo An institution must have an internal model simulations, or other statistical approaches. In that is fully integrated into its daily manage- all cases, however, the model must cover the ment, must have policies and procedures for institution’s material risks.24 Where shortcom- conducting appropriate stress tests and backtests ings exist, the use of the model for the calcula- and for responding to the results of those tests, tion of general market risk may be allowed, and must conduct independent reviews of its subject to certain conditions designed to cor- risk-management and -measurement systems at rect deficiencies in the model within a given least annually. An institution should develop timeframe. and use those stress tests appropriate to its The market-risk rules do not specify model- particular situation. Thus, the market-risk rules ing parameters for an institution’s internal risk- do not include specific stress-test methodologies. management purposes. However, the rules do An institution’s stress tests should be rigorous include minimum qualitative requirements for and comprehensive enough to cover a range of internal risk-management processes, as well as factors that could create extraordinary losses in certain quantitative requirements for the param- a trading portfolio, or that could make the eters and assumptions for internal models used control of risk in a portfolio difficult. The review to measure market-risk exposure for regulatory of stress testing is important, given that VAR- capital purposes. Examiners should verify that based models are designed to measure market an institution’s risk-measurement model and risk in relatively stable markets (for example, at risk-management system conform to the mini- a 99 percent confidence interval, as prescribed in mum qualitative and quantitative requirements the market-risk amendment to the capital rules). discussed below. However, sound risk-management practices require analyses of wider market conditions. Examiners should review the institution’s poli- Qualitative Requirements cies and procedures for conducting stress tests and assess the timeliness and frequency of stress The qualitative requirements reiterate several tests, the comprehensive capture of traded posi- basic components of sound risk management tions and parameters (for example, changes in discussed in earlier sections of this manual. For risk factors), and the dissemination and use of example, an institution must have a risk-control testing results. Examiners should pay particular unit that reports directly to senior management attention to whether stress tests result in an and is independent from business-trading func- effective management tool for controlling expo- tions. The risk-control unit is expected to con- sure and their ‘‘plausibility’’ in relation to the duct regular backtests to evaluate the model’s institution’s risk profile. Stress testing continues accuracy and conduct stress tests to identify the to be more of an art than a science, and the role impact of adverse market events on the institu- of the examiner is to ensure that institutions tion’s portfolio. An in-depth understanding of have the appropriate capabilities, processes, and the risk-control unit’s role and responsibilities is management oversight to conduct meaningful completed through discussions with the institu- stress testing. tion’s market-risk and senior management teams Stress tests should be both qualitative and and through the review of documented policies quantitative, incorporate both market risk and and procedures. In addition, examiners should liquidity aspects of market disturbances, and review the institution’s organizational structure reflect the impact of an event on positions with either linear or nonlinear price characteristics. 24. For institutions using an externally developed or out- Examiners should assess whether banks are in a sourced risk-measurement model, the model may be used for position to conduct three types of broad stress risk-based capital purposes provided it complies with the tests—those incorporating (1) historical events, requirements of the market-risk rules, management fully using market data from the respective time understands the model, the model is integrated into the institution’s daily risk management, and the institution’s periods; (2) hypothetical events, using ‘‘market overall risk-management process is sound. data’’ constructed by the institution to model

Trading and Capital-Markets Activities Manual April 2000 Page 21 2110.1 Capital Adequacy extreme market events that would pose a sig- example, its treatment of nonlinear risks or its nificant financial risk to the institution; and approach to stress testing) and its ongoing com- (3) institution-specific analysis, based on the pliance with the market-risk capital rule. These institution’s portfolios, that identifies key vul- discussions are particularly important during nerabilities. When stress tests reveal a particular turbulent markets where exposures and capital vulnerability, the institution should take effec- may be affected by dramatic swings in market tive steps to appropriately manage those risks. volatility. An institution’s independent review of its In order to monitor compliance with the risk-management process should include the market-risk amendment and to further their activities of business-trading units and the risk- understanding of market-risk exposures, super- control unit. Examiners should verify that an visors should make quarterly requests to insti- institution’s review includes assessing whether tutions subject to the market-risk amendment for its risk-management system is fully integrated the following information: into the daily management process and whether the system is adequately documented. Examiner • total trading gain or loss for the quarter (net assessments of the integration of risk models interest income from trading activities plus into the daily market-risk-management process realized and unrealized trading gain or loss) is a fundamental component of the review for • average risk-based capital charge for market compliance with the market-risk capital rule. As risk during the quarter a starting point, examiners should review the • market-risk capital charge for specific risk risk reports that are generated by the institu- during the quarter tion’s internal model to assess the ‘‘stratifica- • market-risk capital charge for general risk tion,’’ or level of detail of information provided during the quarter to different levels of management, from head • average one-day VAR for the quarter traders to senior managers and directors. The review should evaluate the organizational struc- • maximum one-day VAR for the quarter ture of the risk-control unit and analyze the • largest one-day loss during the quarter and the approval process for risk-pricing models and VAR for the preceding day valuation systems. The institution’s review • the number of times the loss exceeded the should consider the scope of market risks cap- one-day VAR during the quarter, and for each tured by the risk-measurement model; accuracy occurrence, the amount of the loss and the and completeness of position data; verification prior day’s VAR of the consistency, timeliness, and reliability of • the cause of backtesting exceptions, either by data sources used to run the internal model; portfolio or major risk factor (for example, accuracy and appropriateness of volatility and volatility in the S&P 500) correlation assumptions; and validity of valua- • the market-risk multiplier currently in use tion and risk-transformation calculations. Exam- iners should assess the degree to which the If significant deficiencies are uncovered, exam- institution’s methodology serves as the basis for iners may require the institution’s audit group to trading limits allocated to the various trading- enhance the scope and independence of its business units. Examiners should review this market-risk review processes. If the audit or limit structure to assess its coverage of risk independent review function lacks expertise in sensitivities within the trading portfolio. In addi- this area, examiners may require that the insti- tion, examiners should assess the limit- tution outsource this review to a qualified inde- development and -monitoring mechanisms to pendent consultant. Follow-up discussions are ensure that positions versus limits and exces- held with the institution once appropriate review sions are appropriately documented and scopes are developed and upon the completion approved. of such reviews. In addition to formal reviews, examiners and specialist teams may hold regular discussions with institutions regarding their market-risk exposures and the methodologies they employ Quantitative Requirements to measure and control these risks. These dis- cussions enable supervisors to remain abreast of To ensure that an institution with significant the institution’s changes in methodology (for market risk holds prudential levels of capital and

April 2000 Trading and Capital-Markets Activities Manual Page 22 Capital Adequacy 2110.1 that regulatory capital charges for market risk • VAR measures may incorporate empirical cor- are consistent across institutions with similar relations (calculated from historical data on exposures, an institution’s VAR measures must rates and prices) both within and across broad meet the following quantitative requirements: risk categories, subject to examiner confirma- tion that the model’s system for measuring • The VAR methodology must be commensu- such correlation is sound. If an institution’s rate with the nature and size of the insti- model does not incorporate empirical correla- tution’s trading activities and risk profile. tions across risk categories, then the institu- Because the capital rules do not prescribe a tion must calculate the VAR measures by particular VAR methodology, the institution summing the separate VAR measures for the can use generally accepted techniques, such as broad risk categories (that is, interest rates, variance-covariance, historical simulation, and equity prices, foreign-exchange rates, and com- Monte Carlo simulations. modity prices). • VAR measures must be computed each busi- ness day based on a 99 percent (one-tailed) During the examination process, examiners confidence level of estimated maximum loss. should review an institution’s risk-management • VAR measures must be based on a price shock process and internal model to ensure that it equivalent to a 10-day movement in rates and processes all relevant data and that modeling prices. The Federal Reserve believes that and risk-management practices conform to the shorter periods do not adequately reflect the parameters and requirements of the market- price movements that are likely during periods risk rule. When reviewing an internal model of market volatility and that they would sig- for risk-based capital purposes, examiners may nificantly understate the risks embedded in consider reports and opinions about the accu- options positions, which display nonlinear racy of an institution’s model that have been price characteristics. The Board recognizes, generated by external auditors or qualified however, that it may be overly burdensome consultants. for institutions to apply precise 10-day price If a banking institution does not fully comply or rate movements to options positions at this with a particular standard, examiners should time and, accordingly, will permit institutions review the banking institution’s plan for meet- to estimate one-day price movements using ing the requirement of the market-risk amend- the ‘‘square root of time’’ approach.25 As ment. These reviews should be tailored to the banks enhance their modeling techniques, institution’s risk profile (for example, its level of examiners should consider whether they are options activity) and methodologies. making substantive progress in developing In reviewing the model’s ability to capture adequate and more robust methods for identi- optionality, examiners’ reviews should identify fying nonlinear price risks. Such progress is the subportfolios in which optionality risk is particularly important at institutions with siz- present and review the flow of deal data to the able options positions. risk model and the capture of higher-order risks • VAR measures must be based on a minimum (for example, gamma and vega) within VAR. historical observation period of one year Where options risks are not fully captured, the for estimating future price and rate changes. institutions should identify and quantify these If historical market movements are not risks and identify corrective-action plans to weighted evenly over the observation period, incorporate the risks. Examiners should review the weighted average for the observation the calculation of volatilities (implied or histori- period must be at least six months, which is cal), sources of this data (liquid or illiquid equivalent to the average for the minimum markets), and measurement of implied price one-year observation period. volatility along varying strike prices. The under- • An institution must update its model data at standing of the institution’s determination of least once every three months and more fre- volatility smiles and skewness is a basic tenet quently if market conditions warrant. in assessing a VAR model’s reasonableness if optionality risk is material. Volatility smiles reflect the phenomenon that out-of-the-market 25. For example, under certain statistical assumptions, an and in-the-market options both have higher institution can estimate the 10-day price volatility of an instrument by multiplying the volatility calculated on one-day volatilities than at-the-market options. Volatility changes by the square root of 10 (approximately 3.16). skew refers to the differential patterns of implied

Trading and Capital-Markets Activities Manual April 2000 Page 23 2110.1 Capital Adequacy volatilities between out-of-the-market calls and may use the market-risk factors it has deter- out-of-the-market puts. mined affect the value of its positions and the The examiners should review the institution’s risks to which it is exposed. However, examin- methodology for aggregating VAR estimates ers should confirm that an institution is using across the entire portfolio. The institution should sufficient risk factors to cover the risks inherent have well-documented policies and procedures in its portfolio. For example, examiners should governing its aggregation process, including the verify that interest-rate-risk factors correspond use of correlation assumptions. The inspection to interest rates in each currency in which the of correlation assumptions is accomplished institution has interest-rate-sensitive positions. through a review of the institution’s documented The risk-measurement system should model the testing of correlation assumptions and select- yield curve using one of a number of generally transaction testing when individual portfolios accepted approaches, such as by estimating are analyzed to gauge the effects of correlation forward rates or zero-coupon yields, and should assumptions. Although the summation of port- incorporate risk factors to capture spread risk. folio VARs is permitted under the capital rules, The yield curve should be divided into various the aggregation of VAR measures generally maturity segments to capture variation in the overstates risk and may represent an ineffective volatility of rates along the yield curve. For risk-management tool. Examiners should encour- material exposure to interest-rate movements in age institutions to develop more rigorous and the major currencies and markets, modeling appropriate correlation estimates to arrive at a techniques should capture at least six segments more meaningful portfolio VAR. of the yield curve. The aggregation processes utilized by bank- The internal model should incorporate risk ing institutions may also be subject to certain factors corresponding to individual foreign cur- ‘‘missing risks,’’ resulting in an understatement rencies in which the institution’s positions are of risk in the daily VAR. Examiners should denominated, each of the equity markets in understand the aggregation process through dis- which the institution has significant positions (at cussions with risk-management personnel and a minimum, a risk factor should capture market- reviews of models-related documents. Examin- wide movements in equity prices), and each of ers should identify key control points, such as the commodity markets in which the institution timely updating and determination of correlation has significant positions. Risk factors should statistics, that may result in the misstatement of measure the volatilities of rates and prices under- portfolio VAR. lying options positions. An institution with a Examiners should evaluate the institution’s large or complex options portfolio should mea- systems infrastructure and its ability to support sure the volatilities of options positions by the effective aggregation of risk across trading different maturities. The sophistication and portfolios. They should also review the systems nature of the modeling techniques should corre- architecture to identify products that are cap- spond to the level of the institution’s exposure. tured through automated processes and those that are captured in spreadsheets or maintained in disparate systems. This review is important in order to understand the aggregation processes, Backtesting including the application of correlations, and its impact on the timeliness and accuracy of risk- One year after beginning to apply the market- management reports. risk rules, an institution will be required to backtest VAR measures that have been calcu- lated for its internal risk-management purposes. The results of the backtests will be used to Market-Risk Factors evaluate the accuracy of the institution’s internal model, and may result in an adjustment to the For risk-based capital purposes, an institution’s institution’s VAR multiplication factor used for internal model must use risk factors that address calculating regulatory capital requirements. Spe- market risk associated with interest rates, equity cifically, the backtests must compare the insti- prices, exchange rates, and commodity prices, tution’s daily VAR measures calculated for including the market risk associated with options internal purposes, calibrated to a one-day move- in each of these risk categories. An institution ment in rates and prices and a 99 percent

April 2000 Trading and Capital-Markets Activities Manual Page 24 Capital Adequacy 2110.1

(one-tailed) confidence level, against the insti- mentation of the size and cause of the exception tution’s actual daily net trading profit or loss for and any corrective action taken to improve the the past year (that is, the preceding 250 business assumptions or risk factor inputs underlying the days). In addition to recording daily gains and VAR model. losses arising from changes in market valuations of the trading portfolio, net trading profits (or losses) may include items such as fees and commissions and earnings from bid/ask spreads. Specific Risk These backtests must be performed each quarter. Examiners should review the institution’s back- An institution may use its internal model to testing results at both the portfolio and subport- calculate specific risk if it can demonstrate that folio (for example, business-line) levels. Although the model sufficiently captures the changes in not required under the capital rules, subportfolio market values for covered debt and equity backtesting provides management and exam- instruments and related derivatives (for exam- iners with deeper insight into the causes of ple, credit derivatives) that are caused by factors exceptions. It also gives examiners a framework other than broad market movements. These for discussing with risk managers the adequacy factors include idiosyncratic price variation and of the institution’s modeling assumptions and event/default risk. The capital rules also stipu- issues of position valuation and profit attribution late that the model should explain the historical at the business-line level. Examiners should price variation in the portfolio and capture review the profit-and-loss basis of the backtest- potential concentrations, including magnitude ing process, including actual trading profits and and changes in composition. Finally, the model losses (that is, realized and unrealized profits or should be sufficiently robust to capture the losses on end-of-day portfolio positions) and fee greater volatility caused by adverse market con- income and commissions associated with trad- ditions. If the bank’s internal model cannot meet ing activities. these requirements, the bank must use the stan- If the backtest reveals that an institution’s dardized approach to measuring specific risk daily net trading loss exceeded the correspond- under the capital rules. The capital charge for ing VAR measure five or more times, the insti- specific risk may be determined either by apply- tution’s multiplication factor should begin to ing standardized measurement techniques (the increase—from three to as high as four if 10 or standardized approach) or using an institution’s more exceptions are found. However, the deci- internal model. sion on the specific size of any increase to the institution’s multiplier may be tempered by examiner judgment and the circumstances sur- Standardized Approach rounding the exceptions. In particular, special consideration may be granted for exceptions that Under the standardized approach, trading- are produced by abnormal changes in interest account debt instruments are categorized as rates or changes in exchange rates as a result of ‘‘government,’’ ‘‘qualifying,’’ or ‘‘other,’’ based major political events or other highly unusual on the type of obligor and, in the case of market events. Examiners may also consider instruments such as corporate debt, on the credit factors such as the magnitude of an exception rating and remaining maturity of the instrument. (that is, the difference between the VAR mea- Each category has a specific-risk weighting sure and the actual trading loss) and the institu- factor. The specific-risk capital charge for debt tion’s response to the exception. Examiners may positions is calculated by multiplying the cur- determine that an institution does not need to rent market value of each net long or short increase its multiplication factor if it has taken position in a category by the appropriate risk- adequate steps to address any modeling deficien- weight factor. An institution must risk weight cies or has taken other actions that are sufficient derivatives (for example, swaps, futures, for- to improve its risk-management process. The wards, or options on certain debt instruments) Federal Reserve will monitor industry progress according to the relevant underlying instrument. in developing backtesting methodologies and For example, in a forward contract, an institu- may adjust the backtesting requirements in the tion must risk weight the market value of the future. When the backtest reveals exceptions, effective notional amount of the underlying examiners should review the institution’s docu- instrument (or index portfolio). Swaps must be

Trading and Capital-Markets Activities Manual April 2003 Page 25 2110.1 Capital Adequacy included as the notional position in the under- Table 3—Specific-Risk Weighting lying debt instrument or index portfolio; the Factors receiving side is treated as a long position and the paying side treated as a short position. Options, whether long or short, are included by Risk-weight risk weighting the market value of the effective Remaining maturity factor notional amount of the underlying instrument or 6 months or less 0.25% index multiplied by the option’s delta. An insti- Over 6 months to 24 months 1.00% tution may net long and short positions in Over 24 months 1.60% identical debt instruments that have the same issuer, coupon, currency, and maturity. An insti- tution may also net a matched position in a The specific-risk charge for equity positions derivative instrument and the derivative’s cor- is based on an institution’s gross equity position responding underlying instrument. for each national market. Gross equity position The government category includes general is defined as the sum of all long and short equity obligation debt instruments of central govern- positions, including positions arising from ments of OECD countries, as well as local derivatives such as equity swaps, forwards, currency obligations of non-OECD central gov- futures, and options. The current market value ernments to the extent the institution has liabili- of each gross equity position is weighted by a ties booked in that currency. The risk-weight designated factor, and the relevant underlying factor for the government category is zero instrument is used to determine risk weights of percent. equity derivatives. For example, swaps are The qualifying category includes debt instru- included as the notional position in the under- ments of U.S. governmentÐsponsored agencies, lying equity instrument or index portfolio; the general obligation debt instruments issued by receiving side is treated as a long position and states and other political subdivisions of OECD the paying side as a short position. countries, multilateral development banks, and The specific-risk charge is 8 percent of the debt instruments issued by U.S. depository gross equity position, unless the institution’s institutions or OECD banks that do not qualify portfolio is both liquid and well diversified, in as capital of the issuing institution. Qualifying which case the capital charge is 4 percent. A instruments also may be corporate debt and portfolio is liquid and well diversified if (1) it is revenue instruments issued by states and politi- characterized by a limited sensitivity to price cal subdivisions of OECD countries that are changes of any single equity or closely related (1) rated as investment grade by at least two group of equity issues; (2) the volatility of the nationally recognized credit rating firms; (2) rated portfolio’s value is not dominated by the vola- as investment grade by one nationally recog- tility of equity issues from any single industry or nized credit rating firm and not less than invest- economic sector; (3) it contains a large number ment grade by any other credit rating agency; or of equity positions, and no single position rep- (3) if unrated and the issuer has securities listed resents a substantial portion of the portfolio’s on a recognized stock exchange, deemed to be total market value;26 and (4) it consists mainly of comparable investment quality by the report- of issues traded on organized exchanges or in ing institution, subject to review by the Federal well-established OTC markets. Reserve. The risk-weighting factors for qualify- For positions in an index comprising a broad- ing instruments vary according to the remaining based, diversified portfolio of equities, the maturity of the instrument as set in table 3. specific-risk charge is 2 percent of the net long Other debt instruments not included in the or short position in the index. In addition, a government or qualifying categories receive a 2 percent specific-risk charge applies to only risk weight of 8 percent. one side (long or short) in the case of certain futures-related arbitrage strategies (for instance, long and short positions in the same index at different dates or in different market centers and long and short positions at the same date in

26. For practical purposes, examiners may interpret ‘‘sub- stantial’’ as meaning more than 5 percent.

April 2003 Trading and Capital-Markets Activities Manual Page 26 Capital Adequacy 2110.1 different, but similar indexes). Finally, under ¥ be validated through backtesting aimed at certain conditions, futures positions on a broad- assessing whether specific risk is being accu- based index that are matched against positions rately captured. in the equities composing the index are subject to a specific-risk charge of 2 percent against In addition, the institution must be able to each side of the transaction. demonstrate that it has methodologies in place that allow it to adequately capture event and default risk for its trading positions. In assessing Internal-Models Approach the model’s robustness, examiners review the banking institution’s testing of the model, includ- Institutions using models will be permitted to ing regression analysis testing (that is, ‘‘goodness- base their specific-risk capital charge on mod- of-fit’’), stress-test simulations of ‘‘shocked’’ eled estimates if they meet all of the qualitative market conditions, and changing credit-cycle and quantitative requirements for general risk conditions. Examiners evaluate the scope of models as well as the additional criteria set out testing (for example, what factors are shocked below. Institutions that are unable to meet these and to what degree, as well as what the resultant additional criteria will be required to base their changes in risk exposures are), the number of specific-risk capital charge on the full amount of tests completed, and the results of these tests. If the standardized specific-risk charge. Condi- testing is deemed insufficient or the results are tional permission for the use of specific-risk unclear, the banking institution is expected to models is discouraged. Institutions should use address these concerns before supervisory rec- the standardized approach for a particular port- ognition of the model. folio until they have fully developed a model to As previously noted, the review of models is accurately measure the specific risk inherent in conducted after supervisory recognition of the that portfolio. banking institution’s general market-risk meth- The criteria for applying modeled estimates odology. The examiner reviews are generally of specific risk require that an institution’s conducted on a subportfolio basis (for example, model— investment-grade corporate debt, credit deriva- tives, etc.), focusing on the modeling methodol- ¥ explain the historical price variation in the ogy, validation, and backtesting process. The portfolio,27 portfolio-level approach addresses the case in ¥ demonstrably capture concentration (magni- which a banking institution’s model adequately tude and changes in composition),28 captures specific risk within its investment- ¥ be robust to an adverse environment,29 and grade corporate debt portfolio but not within its high-yield corporate debt portfolio. In this case, the banking institution would generally be 27. The key ex ante measures of model quality are ‘‘goodness-of-fit’’ measures that address the question of how granted internal-models treatment for the much of the historical variation in price value is explained by investment-grade debt portfolio and continue to the model. One measure of this type that can often be used is apply the standardized approach to its high-yield an R-squared measure from regression methodology. If this debt portfolio. measure is to be used, the institution’s model would be expected to be able to explain a high percentage, such as 90 Examiner assessments of the adequacy of a percent, of the historical price variation or to explicitly include banking institution’s specific-risk modeling estimates of the residual variability not captured in the factors address the following major points: included in this regression. For some types of models, it may not be feasible to calculate a goodness-of-fit measure. In such an instance, a bank is expected to work with its national ¥ the type, size, and composition of the modeled supervisor to define an acceptable alternative measure that portfolio and other relevant information (for would meet this regulatory objective. example, market data) 28. The institution would be expected to demonstrate that ¥ the VAR-based methodology and relevant the model is sensitive to changes in portfolio construction and that higher capital charges are attracted for portfolios that have assumptions applicable to the modeled port- increasing concentrations. folio and a description of how the methodol- 29. The institution should be able to demonstrate that the ogy captures the key specific-risk areas— model will signal rising risk in an adverse environment. This could be achieved by incorporating in the historical estimation period of the model at least one full credit cycle and by ensuring that the model would not have been inaccurate in the onstrating rising risk is through the simulation of historical or downward portion of the cycle. Another approach for dem- plausible worst-case environments.

Trading and Capital-Markets Activities Manual April 2003 Page 27 2110.1 Capital Adequacy

idiosyncratic variation and event and default ¥ the VAR measures of subportfolios of debt risk and equity positions that contain specific risk.31 ¥ the backtesting analysis performed by the banking institution that demonstrates the mod- Institutions using the second option are required el’s ability to capture specific risk within the to identify their subportfolio structure ahead of identified portfolio (This backtesting is spe- time and should not change it without supervi- cific to the modeled portfolio, not the entire sory consent. trading portfolio.) Institutions that apply modeled estimates of ¥ additional testing (for example, stress testing) specific risk are required to conduct backtesting performed by the banking institution to dem- aimed at assessing whether specific risk is being onstrate the model’s performance under market- accurately captured. The methodology an insti- stress events tution should use for validating its specific-risk estimates is to perform separate backtests on Institutions that meet the criteria set out above subportfolios using daily data on subportfolios for models but that do not have methodologies subject to specific risk. The key subportfolios in place to adequately capture event and default for this purpose are traded debt and equity risk will be required to calculate their specific- positions. However, if an institution itself risk capital charge based on the internal-model decomposes its trading portfolio into finer cate- measurements plus an additional prudential sur- gories (for example, emerging markets or traded charge as defined in the following paragraph. corporate debt), it is appropriate to keep these The surcharge is designed to treat the modeling distinctions for subportfolio backtesting pur- of specific risk on the same basis as a general poses. Institutions are required to commit to a market-risk model that has proven deficient subportfolio structure and stick to it unless the during backtesting. That is, the equivalent of a institution can demonstrate to the supervisor that scaling factor of four would apply to the esti- changing the structure would make sense. mate of specific risk until such time as an Institutions are required to have in place a institution can demonstrate that the methodolo- process to analyze exceptions identified through gies it uses adequately capture event and default the backtesting of specific risk. This process is risk. Once an institution is able to demonstrate intended to serve as the fundamental way in that, the minimum multiplication factor of three which institutions correct their models of spe- can be applied. However, a higher multiplication cific risk if they become inaccurate. Models that factor of four on the modeling of specific risk incorporate specific risk are presumed unaccept- would remain possible if future backtesting able if the results at the subportfolio level results were to indicate a serious deficiency with produce 10 or more exceptions. Institutions that the model. For institutions applying the surcharge, the total of the market-risk capital requirement will Bonds equal a minimum of three times the internal model’s general- and specific-risk measure plus The market should be identified with a reference curve for the a surcharge in the amount of either— currency concerned. For example, the curve might be a government bond yield curve or a swap curve; in any case, the curve should be based on a well-established and liquid ¥ the specific-risk portion of the VAR measure, underlying market and should be accepted by the market as a which should be isolated according to super- reference curve for the currency concerned. visory guidelines30 or Institutions may select their own technique for identifying the specific-risk component of the VAR measure for purposes of applying the multiplier of four. Techniques would include— 30. Techniques for separating general market risk and specific risk would include the following: ¥ using the incremental increase in VAR arising from the modeling of specific-risk factors, Equities ¥ using the difference between the VAR measure and a measure calculated by substituting each individual equity ¥ The market should be identified with a single factor that is position by a representative index, or representative of the market as a whole, for example, a ¥ using an analytic separation between general market risk widely accepted, broadly based stock index for the country and specific risk implied by a particular model. concerned. ¥ Institutions that use factor models may assign one factor of 31. This surcharge would apply to subportfolios containing their model, or a single linear combination of factors, as positions that would be subject to specific risk under the their general market-risk factor. standardized-based approach.

April 2003 Trading and Capital-Markets Activities Manual Page 28 Capital Adequacy 2110.1 have unacceptable specific-risk models are debt and equity positions. For instance, if the expected to take immediate action to correct the model addressed the specific risk of debt posi- problem in the model and ensure that there is a tions but not equity positions, then the institu- sufficient capital buffer to absorb the risk that tion could use the model-based specific-risk the backtest showed had not been adequately charge (subject to the limitation described ear- captured. lier) for debt positions, but must use the full Examiners must confirm with the institution standard specific-risk charge for equity positions. that its model incorporates specific risk for both

Trading and Capital-Markets Activities Manual April 2003 Page 29 Accounting Section 2120.1

The securities and financial contracts that make work for trading activities up an institution’s trading portfolio are generally ¥ general framework for derivative instruments, marked to market, and gains or losses on the including hedges positions are recognized in the current period’s ¥ specific accounting principles for derivative income. A single class of financial instrument instruments, including domestic futures; that can meet trading, investment, or hedging foreign-currency instruments; forward con- objectives may have a different accounting treat- tracts (domestic), including forward rate agree- ment applied to it depending on management’s ments; interest-rate swaps; and options purpose for holding it. Therefore, an examiner reviewing trading activities should be familiar with the different accounting methods to ensure ACCOUNTING STANDARDS that the particular accounting treatment being used is appropriate for the purpose of holding a The Federal Reserve has long viewed account- financial instrument and the economic substance ing standards as a necessary step to efficient of the related transaction. market discipline and bank supervision. Account- The accounting principles that apply to secu- ing standards provide the foundation for cred- rities portfolios, including trading accounts and ible and comparable financial statements and derivative instruments are complex; their other financial reports. Accurate information, authoritative standards and related banking prac- reported in a timely manner, provides a basis for tices have evolved over time. This section sum- the decisions of market participants. The effec- marizes the major aspects of the accounting tiveness of market discipline, to a very consid- principles for trading and derivative activities erable degree, rests on the quality and timeliness for both financial and regulatory reporting pur- of reported financial information. poses. Accordingly, this section does not set Financial statements and regulatory financial forth new accounting policies or list or explain reports perform a critical role for depository the detailed line items of financial reports that institution supervisors. Supervisory agencies must be reported for securities portfolios or have monitoring systems in place which enable derivative instruments. Examiners should con- them to follow, off-site, the financial develop- sult the sources of generally accepted account- ments at depository institutions. When reported ing principles (GAAP) and regulatory reporting financial information indicates that an institu- requirements that are referred to in this section tion’s financial condition has deteriorated, these for more detailed guidance. systems can signal the need for on-site exami- Examiners should be aware that accounting nations and any other appropriate actions. In practices in foreign countries may differ from short, the better the quality of reported financial those followed in the United States. Neverthe- information from institutions, the greater the less, foreign institutions are required to submit ability of agencies to monitor and supervise regulatory reports prepared in accordance with effectively. regulatory reporting instructions for U.S. bank- ing agencies, which are generally consistent with GAAP. This section will focus on reporting Accounting Principles for Financial requirements of the United States. Reporting The major topics covered in this section are listed below. The discussion of specific types of Financial statements provide information needed balance-sheet instruments (such as securities) to evaluate an institution’s financial condition and derivative instruments (for example, swaps, and performance. GAAP must be followed for futures, forwards, and options) is interwoven financial-reporting purposes—that is, for annual with these discussions. and quarterly published financial statements. The standards in GAAP for trading activities ¥ sources of GAAP accounting standards and and derivative instruments are based on pro- regulatory reporting requirements nouncements issued by the Financial Account- ¥ the broad framework for accounting for secu- ing Standards Board (FASB); the American rities portfolios, including the general frame- Institute of Certified Public Accountants

Trading and Capital-Markets Activities Manual April 2002 Page 1 2120.1 Accounting

(AICPA); and, for publicly traded companies, other reports that are filed with the Board the Securities and Exchange Commission (SEC). by state member banks that are subject to the GAAP pronouncements usually take the forms reporting requirements of the SEC.1 The other described in table 1. requirement involves the regulatory financial statements for state member banks, other feder- ally insured commercial banks, and federally Table 1—GAAP Pronouncements and insured savings banks—the Reports of Condi- Abbreviations tion and Income, commonly referred to as call reports. The call reports, the form and content of Source Major Pronouncements which are developed by the Federal Financial Institutions Examination Council (FFIEC), are FASB Statements of Financial currently required to be filed in a manner gen- Accounting Standards erally consistent with GAAP.2 For purposes of (FAS) preparing the call reports, the guidance in the FASB Interpretations (FIN) instructions (including related glossary items) to Technical Bulletins (TB) the Reports of Condition and Income should be followed. U.S. banking agencies require foreign AICPA Audit and Accounting Guides banking organizations operating in the United Industry Audit Guides States to file regulatory financial reports pre- Statements of Position (SOP) pared in accordance with relevant regulatory Accounting Interpretations reporting instructions. Issues Papers* Various Y-series reports submitted to the Federal Reserve by bank holding companies SEC Financial Reporting Releases have long been prepared in accordance with (FRR) GAAP. Section 112 of the Federal Deposit Regulation S-X Insurance Corporation Improvement Act of 1991 Guide 3 to Regulation S-X, (FDICIA) mandates that state member banks Article 9 with total consolidated assets of $500 million or Staff Accounting Bulletins more have to submit to the Federal Reserve (SAB) annual reports containing audited financial state- ments prepared in accordance with GAAP. Emerging Consensus positions by a group Alternatively, the financial-statement requirement Issues Task of leading accountants from can be satisfied by filing consolidated financial Force (EITF) industry and the accounting statements of the bank holding company. Thus, profession the summary of GAAP that follows will be relevant for purposes of (1) financial statements * These are generally nonauthoritative. of state member banks and bank holding com- panies, (2) call reports of banks, (3) Y-series The SEC requires publicly traded banking reports of bank holding companies, and (4) the organizations and other public companies to follow GAAP in preparing their form 10-Ks, annual reports, and other SEC financial reports. These public companies must also follow spe- 1. Generally, pursuant to section 12(b) or 12(g) of the Securities Exchange Act of 1934, state member banks whose cial reporting requirements mandated by the securities are subject to registration are required to file with SEC, such as the guidance listed above, when the Federal Reserve Board annual reports, quarterly financial preparing their financial reports. statements, and other financial reports that conform with SEC reporting requirements. 2. The importance of accounting standards for regulatory Accounting Principles for Regulatory reports is recognized by section 121 of the Federal Deposit Insurance Corporation Act of 1991. Section 121 requires Reporting that accounting principles applicable to regulatory financial reports filed by federally insured banks and thrifts with their Currently, state member banks are subject to federal banking agency must be consistent with GAAP. two main regulatory requirements to file finan- However, under section 121, a federal banking agency may require institutions to use accounting principles ‘‘no less cial statements with the Federal Reserve. One stringent than GAAP’’ when the agency determines that requirement involves financial statements and GAAP does not meet supervisory objectives.

April 2002 Trading and Capital-Markets Activities Manual Page 2 Accounting 2120.1 section 112 annual reports of state member recover substantially all of its recorded invest- banks and bank holding companies. ment must be recorded as either available-for- sale or trading. Reclassifications of held-to- maturity securities as a result of the initial ACCOUNTING FOR SECURITIES application of FAS 140 would not call into PORTFOLIOS question an entity’s intent to hold other secu- rities to maturity in the future. • Trading account. Debt and equity securities Treatment Under FASB Statement that are bought and held principally for the No. 115 purpose of selling them in the near term are classified as trading securities and reported at Statement of Financial Accounting Standards fair value, with unrealized gains and losses No. 115 (FAS 115), ‘‘Accounting for Certain included in earnings. Trading generally reflects Investments in Debt and Equity Securities,’’ as active and frequent buying and selling, and amended by Statement of Financial Accounting trading securities are generally used with the Standards No. 140 (FAS 140), ‘‘Accounting for objective of generating profits on short-term Transfers and Servicing of Financial Assets and differences in price. Extinguishments of Liabilities,’’ is the authori- • Available-for-sale account. Debt and equity tative guidance for accounting for equity secu- securities not classified as either held-to- rities that have readily determinable fair values maturity securities or trading securities are and for all debt securities.3 (FAS 140 replaces classified as available-for-sale securities and FAS 125, which had the same title.) Investments reported at fair value, with unrealized gains subject to FAS 115 are to be classified in three and losses excluded from earnings and reported categories and accounted for as follows: as a net amount in a separate component of shareholders’ equity. • Held-to-maturity account. Debt securities that the institution has the positive intent and Under FAS 115, mortgage-backed securities ability to hold to maturity are classified as that are held for sale in conjunction with mort- held-to-maturity securities and reported at gage banking activities should be reported at fair amortized cost. FAS 140 amended FAS 115 to value in the trading account. FAS 115 does not require that securities that can contractually be apply to loans, including mortgage loans, that prepaid or otherwise settled in such a way that have not been securitized. the holder of the security would not Upon the acquisition of a debt or equity security, an institution must place the security 3. FAS 115 does not apply to investments in equity into one of the above three categories. At each securities accounted for under the equity method nor to reporting date, the institution must reassess investments in consolidated subsidiaries. This statement does whether the balance-sheet classification 4 contin- not apply to institutions whose specialized accounting prac- tices include accounting for substantially all investments in ues to be appropriate. debt and equity securities at market value or fair value, with Proper classification of securities is a key changes in value recognized in earnings (income) or in the examination issue. As stated above, instruments change in net assets. Examples of those institutions are that are intended to be held principally for the brokers and dealers in securities, defined benefit pension plans, and investment companies. purpose of selling them in the near term should FAS 115 states that the fair value of an equity security is be classified as trading assets. Reporting secu- readily determinable if sales prices or bid-and-asked quota- rities held for trading purposes as available-for- tions are currently available on a securities exchange regis- sale or held-to-maturity would result in the tered with the SEC or in the over-the-counter market, pro- vided that those prices or quotations for the over-the-counter improper deferral of unrealized gains and losses market are publicly reported by the National Association of from earnings and regulatory capital. Accord- Securities Dealers’ automated quotation systems or by the ingly, examiners should scrutinize institutions National Quotation Bureau. Restricted stock does not meet that exhibit a pattern or practice of selling that definition. The fair value of an equity security traded only in a foreign securities from the available-for-sale or held-to- market is readily determinable if that foreign market is of a maturity accounts after a short-term holding breadth and scope comparable to one of the U.S. markets referred to above. The fair value of an investment in a mutual fund is readily determinable if the fair value per share (unit) is determined and published and is the basis for current 4. In this context, ‘‘classification’’ refers to the security’s transactions. balance-sheet category, not the credit quality of the asset.

Trading and Capital-Markets Activities Manual September 2001 Page 3 2120.1 Accounting period, particularly if significant amounts of accounted for as sales.) However, all sales and losses on securities in these accounts have not transfers of held-to-maturity securities must been recognized. be disclosed in the footnotes to the financial FAS 115 recognizes that certain changes in statements. circumstances may cause the institution to An institution must not classify a debt secu- change its intent to hold a certain security to rity as held-to-maturity if the institution intends maturity without calling into question its intent to hold the security for only an indefinite period.5 to hold other debt securities to maturity in the Consequently, a debt security should not, for future. Thus, the sale or transfer of a held-to- example, be classified as held-to-maturity if the maturity security due to one of the following banking organization or other company antici- changes in circumstances will not be viewed pates that the security would be available to be as inconsistent with its original balance-sheet sold in response to— classification: • changes in market interest rates and related • evidence of a significant deterioration in the changes in the security’s prepayment risk, issuer’s creditworthiness • needs for liquidity (for example, due to the • a change in tax law that eliminates or reduces withdrawal of deposits, increased demand for the tax-exempt status of interest on the debt loans, surrender of insurance policies, or pay- security (but not a change in tax law that ment of insurance claims), revises the marginal tax rates applicable to interest income) • changes in the availability of and the yield on • a major business combination or major dispo- alternative investments, sition (such as the sale of a segment) that • changes in funding sources and terms, and necessitates the sale or transfer of held-to- • changes in foreign-currency risk. maturity securities to maintain the institu- tion’s existing interest-rate risk position or According to FAS 115, an institution’s asset- credit-risk policy liability management may consider the maturity • a change in statutory or regulatory require- and repricing characteristics of all investments ments significantly modifying either what con- in debt securities, including those held to matu- stitutes a permissible investment or the maxi- rity or available for sale, without tainting or mum level of investments in certain kinds of casting doubt on the standard’s criterion that securities, thereby causing an institution to there be a ‘‘positive intent to hold until matu- dispose of a held-to-maturity security rity.’’ However, to demonstrate its ongoing • a significant increase by the regulator in the intent and ability to hold the securities to matu- industry’s capital requirements that causes the rity, management should designate the held-to- institution to downsize by selling held-to- maturity securities as not available for sale for maturity securities purposes of the ongoing adjustments that are a • a significant increase in the risk weights of necessary part of its asset-liability management. debt securities used for regulatory risk-based Further, liquidity can be derived from the held- capital purposes. to-maturity category by the use of repurchase agreements that are classified as financings, but Furthermore, FAS 115 recognizes other events not sales. that are isolated, nonrecurring, and unusual for the reporting institution and that could not have been reasonably anticipated may cause the in- 5. In summary, under FAS 115, sales of debt securities that stitution to sell or transfer a held-to-maturity meet either of the following two conditions may be considered security without necessarily calling into ques- as ‘‘maturities’’ for purposes of the balance-sheet classifica- tion its intent to hold other debt securities to tion of securities: (1) The sale of a security occurs near enough maturity. EITF 96-10, as amended by FAS 140, to its maturity date (or call date if exercise of the call is probable)—for example, within three months—that interest- provides that transactions that are not accounted rate risk has been substantially eliminated as a pricing factor. for as sales under FAS 140 would not contradict (2) The sale of a security occurs after the institution has the entity’s intent to hold that security, or any already collected at least 85 percent of the principal outstand- other securities, to maturity. (See paragraph nine ing at acquisition from either prepayments or scheduled payments on a debt security payable in equal installments over of FAS 140 for additional guidance on criteria its term (variable-rate securities do not need to have equal which would require such transactions to be payments).

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Transfers of a security between investment up if there are any subsequent recoveries in fair categories should be accounted for at fair value. value. FAS 115 requires that, at the date of transfer, the security’s unrealized holding gain or loss must be accounted for as follows: Other Sources of Regulatory Reporting Guidance • For a security transferred from the trading category, the unrealized holding gain or loss at As mentioned above, FAS 115 has been adopted the date of transfer will already have been for regulatory reporting purposes. Call report recognized in earnings and should not be instructions are another source of guidance, reversed. particularly, the glossary entries on— • For a security transferred into the trading category, the unrealized holding gain or loss at • coupon stripping, Treasury receipts, and the date of transfer should be recognized in STRIPS; earnings immediately. • fails; • For a debt security transferred into the • foreign debt exchange transactions; available-for-sale category from the held-to- • market value of securities; maturity category, the unrealized holding gain • nonaccrual status; or loss at the date of transfer should be • premiums and discounts; recognized in a separate component of share- • short positions; holders’ equity. • transfers of financial assets; • For a debt security transferred into the held- • trading accounts; to-maturity category from the available-for- • trade-date and settlement-date accounting;6 sale category, the unrealized holding gain or and loss at the date of transfer should continue to • when-issued securities transactions. be reported in a separate component of share- holders’ equity but also should be amortized over the remaining life of the security as an adjustment of its yield in a manner consistent Traditional Model Under GAAP with the amortization of any premium or discount. The traditional model was used to account for investment and equity securities before FAS Transfers from the held-to-maturity category 115. However, the traditional model still applies should be rare, except for transfers that are to assets that are not within the scope of FAS caused by the changes in circumstances dis- 115 (for example, equity securities that do not cussed above. According to the standard, trans- have readily determinable fair values). fers into or from the trading category should Under the traditional accounting model for also be rare. securities portfolios and certain other assets, FAS 115 requires that institutions determine debt securities are placed into the following whether a decline in fair value below the amor- three categories on the basis of the institution’s tized cost for individual securities in the intent and ability to hold them: available-for-sale or held-to-maturity accounts is ‘‘other than temporary’’ (that is, whether this • Investment account. Investment assets are car- decline results from permanent impairment). ried at amortized cost. A bank must have the For example, if it is probable that the investor intent and ability to hold these securities for will be unable to collect all amounts due accord- long-term investment purposes. The market ing to the contractual terms of a debt security value of the investment account is fully that was not impaired at acquisition, an other- disclosed in the footnotes to the financial than-temporary impairment should be consid- statements. ered to have occurred. If the decline in fair value • Trading account. Trading assets are marked is judged to be other than temporary, the cost to market. Unrealized gains and losses are basis of the individual security should be written down to its fair value, and the write-down 6. As described in this glossary entry, for call report should be accounted in earnings as a realized purposes, the preferred method for reporting securities trans- loss. This new cost basis should not be written actions is recognition on the trade date.

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recognized in income. Trading is character- tions, often involve the use of valuation tech- ized by a high volume of purchase and sale niques and estimates to determine the value of activity. each component and any gain or loss on the • Held-for-sale account. Assets so classified are transaction. FAS 140 requires that entities rec- carried at the lower of cost or market value ognize newly created (acquired) assets and (LOCOM). Unrealized losses on these securi- liabilities, including derivatives, at fair value. It ties are recognized in income. This account also requires all assets sold and the portion of is characterized by intermittent sales of any assets retained to be valued by allocating the securities. previous carrying value of the assets based on their relative fair value. Under GAAP, the traditional model has been Financial assets that can be prepaid contrac- generally followed for other assets as well. tually or that can otherwise be settled in such a Thus, loans that are held for trading purposes way that the holder would not recover substan- would be marked to market, and loans that are tially all of its recorded investments should be held for sale would be carried at LOCOM. measured in the same way as investments in debt securities—as either available-for-sale or trading under FAS 115. Examples include some SECURITIZATIONS interest-only strips, retained interests in securi- tizations, loans, other receivables, or other finan- FAS 140 covers the accounting treatment for the cial assets. However, financial instruments cov- securitization of receivables. The statement ered under the scope of Statement of Financial addresses (1) when a transaction qualifies as a Accounting Standards No. 133 (FAS 133), sale for accounting purposes and (2) the treat- ‘‘Accounting for Derivative Instruments and ment of the various financial components (iden- Hedging Activities,’’ as amended by Statement tifiable assets and liabilities) that are created in of Financial Accounting Standards Nos. 137 and the securitization process. 138 (FAS 137 and FAS 138), should follow that To identify whether a transfer of assets quali- guidance. fies as a sale for accounting purposes, FAS 140 focuses on control of the assets while taking a ‘‘financial components approach.’’ The standard requires that an entity surrender control to ACCOUNTING FOR REPURCHASE ‘‘derecognize’’ the assets or take the assets off AGREEMENTS its balance sheet. Under FAS 140, control is considered to be surrendered and, therefore, a In addition to securitizations, FAS 140 deter- transfer is considered a sale if all of the follow- mines the accounting for repurchase agree- ing conditions are met: ments. A repurchase agreement is accounted for as either a secured borrowing or as a sale and • The transferred assets have been put beyond subsequent repurchase. The treatment depends the reach of the transferor, even in bankruptcy. on whether the seller has surrendered control of • Either (1) the transferee has the right to pledge the securities as described in the above ‘‘Secu- or exchange the transferred assets or (2) the ritizations’’ subsection. If control is maintained, transferee is a qualifying special-purpose the transaction should be accounted for as a entity, and the holder of beneficial interests in secured borrowing. If control is surrendered, the that entity has the right to pledge or exchange transaction should be accounted for as a sale and the transferred assets. subsequent repurchase. Control is generally con- • The transferor does not maintain control over sidered to be maintained if the security being the transferred assets through (1) an agree- repurchased is identical to the security being ment that entitles and obligates the transferor sold. to repurchase or redeem them before their In a dollar-roll transaction, an institution maturity or (2) an agreement that entitles the agrees to sell a security and repurchase a similar, transferor to repurchase or redeem transferred but not identical, security. If the security being assets that are not readily obtainable. repurchased is considered to be ‘‘substantially the same’’ as the security sold, the transaction The financial components approach recognizes should be reported as a borrowing. Otherwise, that complex transactions, such as securitiza- the transaction should be reported as a sale and

April 2003 Trading and Capital-Markets Activities Manual Page 6 Accounting 2120.1 subsequent repurchase. The AICPA Audit and attributable to the risk being hedged. Accounting Guide for Banks and Savings Insti- • If the derivative is determined to be a hedge of tutions establishes criteria that must be met for a exposure to variable cash flows of a forecasted security to be considered ‘‘substantially the transaction (cash-flow hedge), the gains or same’’; these criteria include having the same losses based on changes in fair value are obligor, maturity, form, and interest rate. included in other comprehensive income out- Generally, a bank surrenders control if the side of net income. repurchase agreement does not require the repur- • If the derivative represents a hedge of the chase of the same or substantially the same foreign-currency exposure of a net investment security. In such cases, the bank accounts for the in foreign operation, an unrecognized firm transaction as a sale (with gain or loss) and a commitment, an available-for-sale security, or forward contract to repurchase the securities. a foreign currency–denominated forecasted When a repurchase agreement is not a sale (for transaction (foreign-currency hedge), the gains example, it requires the repurchase of the same or losses based on changes in fair value are or substantially the same security), the transac- included in comprehensive income, outside of tion is accounted for as a borrowing. However, net income, as part of the cumulative transla- repurchase agreements that extend to the secu- tion adjustment. rity’s maturity date, and repurchase agreements in which the seller has not obtained sufficient This general framework is set forth in FAS 133. collateral to cover the replacement cost of the This statement, issued in June 1998 and amended security, should be accounted for as sales. by FAS 137 and FAS 138, became effective for fiscal years beginning after June 15, 2000. Thus, banks operating on a calendar year adopted the guidance on January 1, 2001. ACCOUNTING FOR DERIVATIVE FAS 133 as amended comprehensively changes INSTRUMENTS accounting and disclosure standards for deriva- tives. It amends Statement of Financial Account- As discussed in the previous subsection, the ing Standards No. 52 (FAS 52), ‘‘Foreign Cur- general accounting framework for securities port- rency Translation,’’ to permit special accounting folios divides them into three categories: held- for foreign-currency hedges and makes the fol- to-maturity (accounted for at amortized cost), lowing standards obsolete: available-for-sale (accounted for at fair value, with unrealized changes in fair value recorded in • FAS 80 Accounting for Futures Contracts equity), and trading securities (accounted for at • FAS 105 Disclosure of Information About fair value, with changes in fair value recorded in Financial Instruments with Off Bal- earnings). ance Sheet Risk and Financial In- In contrast, derivative instruments can be struments with Concentrations of classified in one of the following categories: Credit Risk (1) no hedge designation, (2) fair-value hedge, • FAS 107 Disclosures About Fair Value of (3) cash-flow hedge, and (4) foreign-currency Financial Instruments hedge. The general accounting framework for • FAS 119 Disclosure About Derivative derivative instruments under GAAP is set forth Financial Instruments and Fair below: Value of Financial Instruments

• If the derivative does not have a hedge desig- FAS 133 as amended requires entities to recog- nation, the gains or losses based on changes in nize all derivatives on the balance sheet as either the fair value of the derivative instrument are assets or liabilities and to report them at their included in current income. fair value. The accounting recognition of changes • If the derivative is determined to be a hedge of in the fair value of a derivative (gains or losses) exposure to changes in the fair value of a depends on the intended use of the derivative recognized asset or liability or an unrecog- and the resulting designation. For qualifying nized firm commitment (fair-value hedge), the hedges, an entity is required to establish at the gains or losses based on changes in fair value inception of the hedge the method it will use for are included in current net income with the assessing the effectiveness of the hedging offsetting gain or loss on the hedged item derivative and the measurement approach for

Trading and Capital-Markets Activities Manual April 2003 Page 7 2120.1 Accounting determining the ineffective aspect of the hedge. contracts of the same delivery month on the The methods applied should be consistent with same underlying instrument on the same the entity’s approach to managing risk. FAS 133 exchange, or the covering of a short sale of as amended also precludes designating a non- futures through the purchase of an equal number derivative financial instrument as a hedge of an of contracts of the same delivery month on the asset, a liability, an unrecognized firm commit- same underlying instrument on the same ment, or a forecasted transaction, except if any exchange. of these are denominated in a foreign currency. Proper classification of derivative instruments is a key examination issue. Inappropriately clas- Special Types of Derivatives sifying a derivative instrument as a hedge would result in the improper treatment of gains and Credit derivatives are financial instruments that losses in earnings and regulatory capital. Insti- permit one party (the beneficiary) to transfer the tutions should retain adequate documentation to credit risk of a reference asset, which it typically support their hedge activity. Examiners should owns, to another party (the guarantor) without scrutinize any institutions that do not comply actually selling the assets. Credit derivatives with these GAAP requirements. that provide for payments to be made only to reimburse the guaranteed party for a loss incurred because the debtor fails to pay when payment is due (financial guarantees), which is an identifi- Definitions able event, are not considered derivatives for accounting purposes under FAS 133 as amended. A derivative instrument is a financial instrument Those credit derivatives not accounted for under or other contract with all three of the following FAS 133 would not be recorded in the financial characteristics: statements as assets or liabilities at fair value but, if material, would typically be disclosed in • It has one or more underlyings and one or the financial statements. Credit derivatives not more notional amounts or payment provisions considered financial guarantees, as defined or both. above, are reported as derivatives as determined • It requires no initial net investment or an by FAS 133 as amended. initial net investment that is smaller than what Equity derivatives are derivatives that are would be required for other types of contracts linked to various indexes and individual securi- expected to have a similar response to changes ties in the equity markets. FAS 133 as amended in market factors. covers the accounting treatment for equity • Its terms require or permit net settlement, it derivatives that are not indexed to an institu- can be readily settled net by means outside the tion’s own stock. Equity derivatives indexed to contract, or it provides for delivery of an asset the institution’s own stock are determined in that puts the recipient in a position not sub- accordance with APB No. 18, ‘‘The Equity stantially different from net settlement. Method of Accounting for Investments in Com- mon Stock,’’ and Statement of Financial Account- An underlying is a specified interest rate, secu- ing Standards No. 123 (FAS 123), ‘‘Accounting rity price, commodity price, foreign-exchange for Stock-Based Compensation.’’ rate, index of prices or rates, or other variable. An underlying may be a price or rate of an asset or liability but it is not the asset or liability itself. A notional amount is a number of currency Hedging Activities units, shares, bushels, pounds, or other units specified in the contract. Accounting for Fair-Value Hedges A payment provision specifies a fixed or determinable settlement to be made if the under- A fair-value hedge is a derivative instrument lying behaves in a specified manner. that hedges exposure to changes in the fair value A hedge is an identifiable asset, liability, firm of an asset or a liability, or an identified portion commitment, or anticipated transaction. thereof, that is attributable to a particular risk. Offset is the liquidating of a purchase of To qualify for fair-value-hedge accounting, the futures through the sale of an equal number of hedge must meet both of the following criteria:

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• At the inception of the hedging relationship, hedged is the risk of changes in the fair value formal documentation must be made of the of the entire hedged asset or liability. institution’s risk-management objective and • If the hedged item is a financial asset or strategy for undertaking the hedge. This docu- liability, a recognized loan-servicing right, or mentation should include the hedged instru- a nonfinancial firm commitment with financial ment, the hedged item, the nature of the risk, components, the designated risk being hedged and how the hedge’s effectiveness in offset- is— ting the exposure to changes in the fair value — the risk of changes in the overall fair value will be assessed. of the entire hedged item, • Assessment is required whenever financial — the risk of changes in its fair value attrib- statements or earnings are reported, and at utable to changes in market interest rates, least every three months, to ensure the hedge — the risk of changes in its fair value attrib- relationship is highly effective in achieving utable to changes in the related foreign- offsetting changes in fair value to the hedged currency exchange rates, or risk. — the risk of changes in its fair value attrib- An asset or liability is eligible for designation as utable to changes in the obligor’s credit- a hedged item in a fair-value hedge if all of the worthiness. following criteria are met: An institution is subject to applicable GAAP • The hedged item is specifically identified as requirements for assessment of impairment for an asset, a liability, or a firm commitment. The assets or for recognition of an increased obliga- hedged item can be a single asset, liability, or tion for liabilities. An institution shall also firm commitment or a portfolio of similar discontinue the accounting treatment for a finan- assets, liabilities, or firm commitments. cial instrument as a fair-value hedge if any of • The hedged item is not one of the following: the following conditions occurs: — an asset or liability that is already reported at fair value • Any criterion of the fair-value hedge or hedged — an investment accounted for by the equity item is no longer met. method • The derivative expires or is sold, terminated, — a minority interest in one or more consoli- or exercised. dated subsidiaries • The institution removes the designation of the — an equity investment in a consolidated fair-value hedge. subsidiary — a firm commitment either to enter into a business combination or to acquire or Accounting for Cash-Flow Hedges dispose of a subsidiary, a minority interest, or an equity-method investee A cash-flow hedge is a derivative hedging the — an equity instrument issued by the institu- exposure to variability in expected cash flows tion and classified as stockholders’ equity attributed to a particular risk. That exposure may in the statement of financial position be associated with an existing asset or liability • If the hedged item is all or a portion of a debt (that is, variable-rate debt) or a forecasted trans- security classified as held-to-maturity, the des- action (that is, a forecasted purchase or sale). ignated risk being hedged is the risk of changes Designated hedging instruments and hedged in its fair value attributable to changes in the items or transactions qualify for cash-flow- obligor’s creditworthiness. If the hedged item hedge accounting if all of the following criteria is an option component of a held-to-maturity are met: security that permits its repayment, the desig- nated risk being hedged is the risk of changes • Formal documentation is required at the in the entire fair value of that option inception of the hedging relationship, and the component. institution’s risk-management objective and • If the hedged item is a nonfinancial asset or strategy for undertaking the hedge must be liability or is not a recognized loan-servicing documented as noted above in ‘‘Accounting right or a nonfinancial firm commitment with for Fair-Value Hedges.’’ financial components, the designated risk being • The hedge’s effectiveness must be assessed as

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described in ‘‘Accounting for Fair-Value exchange rates, or Hedges.’’ — the risk of changes in cash flows attribut- • If an instrument is used to hedge the variable able to default or the risk of change in the interest rates associated with a financial asset obligor’s creditworthiness. or liability, the hedging instrument must be clearly linked to the financial asset or liability As required for fair-value-hedge accounting, an and highly effective in achieving offset. institution shall discontinue the accounting for cash-flow hedges if— A forecasted transaction is eligible for designa- — any criterion for a cash-flow hedge or the tion as a hedged item in a cash-flow hedge if all hedged forecasted transaction is no longer of the following additional criteria are met: met; — the derivative expires or is sold, termi- • The forecasted transaction is specifically iden- nated, or exercised; or tified as a single transaction or a group of — the institution removes the designation of individual transactions. the cash-flow hedge. • The occurrence of the forecasted transaction is probable. If cash-flow-hedge accounting is discontin- • The forecasted transaction is with a party that is external to the reporting institution. • The forecasted transaction is not the acquisi- tion of an asset or incurrence of a liability that will subsequently be remeasured and whose changes in fair value will be attributed to the hedged risk currently reported in earnings. • If the variable cash flows of the forecasted transaction relate to a debt security that is classified as held-to-maturity, the risk being hedged is the risk of changes in the cash flows attributable to default or the risk of changes in the obligor’s creditworthiness. • The forecasted transaction does not involve a business combination subject to the provi- sions of Statement of Financial Accounting Standards No. 141 (FAS 141), ‘‘Business Combinations,’’ and is not a transaction involving— — a parent company’s interest in consoli- dated subsidiaries, — a minority interest in a consolidated subsidiary, — an equity-method investment, or — an institution’s own equity instruments. • If the hedged transaction is the forecasted purchase or sale of a financial asset or liability or the variable cash inflow or outflow of an existing financial asset or liability, the desig- nated risk being hedged is— — the risk of changes in the cash flows of the entire asset or liability, — the risk of changes in its cash flows attributable to changes in market interest rates, — the risk of changes in the cash flows of the equivalent functional currency attributable to changes in the related foreign-currency

April 2003 Trading and Capital-Markets Activities Manual Page 10 Accounting 2120.1 ued, the accumulated amount in other compre- Foreign-Currency Translations hensive income remains and is reclassified into earnings when the hedged forecasted transaction Translation is the conversion of the financial affects earnings. Existing GAAP for impairment statements of a foreign operation (a branch, of an asset or recognition of an increased liabil- division, or subsidiary) denominated in the ity applies. operation’s functional currency to U.S. dollars, generally for inclusion in consolidated financial Accounting for Foreign-Currency Hedges statements. The balance sheets of foreign opera- tions are translated at the exchange rate in effect Consistent with the functional-currency concept on the statement date, while income-statement of FAS 52 (discussed below), FAS 133 indicates amounts are generally translated at an appropri- that an institution may designate the following ate weighted amount. Meeting this criterion will types of hedges as hedges of foreign-currency be particularly difficult when an anticipated exposure: transaction is not expected to take place in the near future. • a fair value of an unrecognized firm commit- Detailed guidance for determining the func- ment or an available-for-sale security tional currency is set forth in appendix 1 of FAS • a cash-flow hedge of a forecasted foreign- 52: ‘‘An entity’s functional currency is the currency-denominated transaction or a fore- currency of the primary economic environment casted intercompany foreign-currency- in which the entity operates; normally, that is the denominated transaction currency of the environment in which an entity • a hedge of a net investment in a foreign primarily generates and expends cash. The func- operation tional currency of an entity is, in principle, a matter of fact. In some cases, the facts will Foreign-currency fair-value hedges and cash- clearly identify the functional currency; in other flow hedges are generally subject to the fair- cases, they will not.’’ value-hedge and cash-flow-hedge accounting FAS 52 indicates the salient economic indi- requirements discussed in those respective cators and other possible factors that should be subsections. considered both individually and collectively when determining the functional currency: cash flow, price and market sales indicators, expense ACCOUNTING FOR indicators, financing indicators, intercompany FOREIGN-CURRENCY transactions and arrangements, and other factors. INSTRUMENTS

The primary source of authoritative guidance for Foreign-Currency Transactions accounting for foreign-currency translations and foreign-currency transactions is FAS 52. The Gains or losses on foreign-currency transac- standard encompasses futures contracts, forward tions, in contrast to translation, are recognized in agreements, and currency swaps as they relate to income as they occur, unless they arise from a foreign-currency hedging. FAS 52 draws a dis- qualifying hedge. FAS 52 provides guidance tinction between foreign-exchange ‘‘transla- about the types of foreign-currency transactions tion’’ and ‘‘transactions.’’ Translation, generally, for which gain or loss is not currently recog- focuses on the combining of foreign and domes- nized in earnings. Gains and losses on the tic entities so they can be presented and reported following foreign-currency transactions should in the consolidated financial statements in one not be included in determining net income but currency. Foreign-currency transactions, in con- should be reported in the same manner as trast, are transactions (such as purchases or translation adjustments: sales) by an operation in currencies other than • foreign-currency transactions that are desig- its ‘‘functional currency.’’ For U.S. depository nated and effective as economic hedges of a institutions, the functional currency will gener- net investment in a foreign entity, commenc- ally be the dollar for its U.S. operations and the ing as of the designation date local currency of wherever its foreign operations • intercompany foreign-currency transactions transact business. that are long-term investments (that is, settle-

Trading and Capital-Markets Activities Manual September 2001 Page 11 2120.1 Accounting

ment is not planned or anticipated in the Under FIN 39, offsetting, or the netting of foreseeable future), when the entities to the assets and liabilities, is not permitted unless all transaction are consolidated, combined, or of the following four criteria are met: accounted for by the equity method in the reporting institution’s financial statements. • Two parties must owe each other determin- able amounts. • The reporting entity must have a right to set NETTING OR OFFSETTING off its obligation with the amount due to it. ASSETS AND LIABILITIES • The reporting entity must actually intend to set off these amounts. FASB Interpretation 39 (FIN 39), ‘‘Offsetting of • The right of setoff must be enforceable at law. Amounts Related to Certain Contracts,’’ pro- vides guidance on the netting of assets and When all four criteria are met, a bank or other liabilities arising from (1) traditional activities, company may offset the related asset and liabil- such as loans and deposits, and (2) derivative ity and report the net amount in its GAAP instruments. The assets and liabilities from financial statements. On the other hand, if any derivatives are primarily the fair values, or one of these criteria is not met, the fair value of estimated market values, for swaps and other contracts in a loss position with a given coun- contracts, and the receivables and payables on terparty will not be offset against the fair value these instruments. FIN 39 clarifies the definition of contracts in a gain position with that coun- of a ‘‘right of setoff’’ that GAAP has long terparty, and organizations will be required to indicated must exist before netting of assets and record gross unrealized gains on such contracts liabilities can occur in the balance sheet. One of as assets and to report gross unrealized losses as the main purposes of FIN 39 was to clarify that liabilities. However, FIN 39 relaxes the third FASB’s earlier guidance on the netting of assets criterion (the parties’ intent requirement) to and liabilities (Technical Bulletin 88-2) applies permit the netting of fair values of OBS deriva- to amounts recognized for OBS derivative tive contracts executed with the same counter- instruments as well. party under a legally enforceable master netting 8 Balance-sheet items arise from off-balance- agreement. A master netting arrangement exists sheet interest-rate and foreign-currency instru- if the reporting institution has multiple con- ments in primarily two ways. First, those bank- tracts, whether for the same type of conditional ing organizations and other companies that or exchange contract or for different types of engage in various trading activities involving contracts, with a single counterparty that are OBS derivative instruments (for example, subject to a contractual agreement that provides interest-rate and currency swaps, forwards, and for the net settlement of all contracts through a options) are required by GAAP to mark to single payment in a single currency in the event market these positions by recording their fair of default or termination of any one contract. values (estimated market values) on the balance FIN 39 defines ‘‘right of setoff’’ and specifies sheet and recording any changes in these fair conditions that must be met to permit offsetting values (unrealized gains and losses) in earnings. for accounting purposes. FASB’s Interpretation Second, interest-rate and currency swaps have receivables and payables that accrue over time, netting agreement, the accrual components in fair value are reflecting expected cash inflows and outflows also netted. 8. The risk-based capital guidelines provide generally that that must periodically be exchanged under these a credit-equivalent amount is calculated for each individual contracts, and these receivables and payables interest-rate and exchange-rate contract. The credit-equivalent must be recorded on the balance sheet as assets amount is determined by summing the positive mark-to- and liabilities, respectively.7 market values of each contract with an estimate of the potential future credit exposure. The credit-equivalent amount is then assigned to the appropriate risk-weight category. Netting of swaps and similar contracts is recognized for 7. In contrast, the notional amounts of off-balance-sheet risk-based capital purposes only when accomplished through derivative instruments, or the principal amounts of the under- ‘‘netting by novation.’’ This is defined as a written bilateral lying asset or assets to which the values of the contracts are contract between two counterparties under which any obliga- indexed, are not recorded on the balance sheet. Note, however, tion to each other is automatically amalgamated with all other that if the OBS instrument is carried at market value, that obligations for the same currency and value date, legally value will include any receivable or payable components. substituting one single net amount for the previous gross Thus, for those OBS instruments that are subject to a master obligations.

September 2001 Trading and Capital-Markets Activities Manual Page 12 Accounting 2120.1

41 (FIN 41), ‘‘Offsetting of Amounts Relating to receivables that represent repurchase agree- Certain Repurchase and Reverse Repurchase ments and reverse repurchase agreements under Agreements,’’ was issued in December 1994. certain circumstances in which net settlement is This interpretation modifies FIN 39 to permit not feasible. (See FIN 41 for further information.) offsetting in the balance sheet of payables and

Trading and Capital-Markets Activities Manual April 2001 Page 13 Accounting Examination Objectives Section 2120.2

1. To determine whether the organization’s writ- ments are netted for only those counterpar- ten accounting policies relating to trading ties whose contracts conform with specific and hedging with derivatives instruments criteria permitting such setoff. have been approved by senior management 6. To determine whether management’s asser- for conformance with generally accepted tions that financial instruments are hedges accounting practices. To determine that such meet the necessary criteria for exclusion policies conform with regulatory reporting from classification as trading instruments. principles. 7. To ascertain whether the organization has 2. To determine whether capital-markets and adequate support that a purported hedge trading activities appear in regulatory reports, reduces risk in conformance with Statement as reported by accounting personnel, and of Financial Accounting Standards No. 133 conform with written accounting policies. (FAS 133), as amended by Statement of 3. To determine whether securities held in Financial Accounting Standards Nos. 137 available-for-sale or held-to-maturity accounts and 138 (FAS 137 and FAS 138). meet the criteria of Statement of Financial 8. To determine whether the amount and recog- Accounting Standards No. 115 (FAS 115) nition of deferred losses arising from hedg- and are, therefore, properly excluded from ing activities are properly recorded and being the trading account. amortized appropriately. 4. To determine whether market values of traded 9. To recommend corrective action when poli- assets are accurately reflected in regulatory cies, procedures, practices, internal controls, reports. or management information systems are 5. To determine whether, for financial and regu- found to be deficient or when violations of latory reporting purposes, financial instru- law, rulings, or regulations have been noted.

Trading and Capital-Markets Activities Manual April 2003 Page 1 Accounting Examination Procedures Section 2120.3

These procedures list a number of processes and in the trading account and compare the activities to be reviewed during a full-scope reported market value against outside quota- examination. The examiner-in-charge will estab- tions or compare valuation assumptions lish the general scope of examination and will against market data. work with the examination staff to tailor specific 4. Review the organization’s controls over areas for review as circumstances warrant. As reporting of certain financial instruments on part of this process, the examiner reviewing a a net basis. Using a sample of transactions, function or product will analyze and evaluate review the contractual terms to determine internal-audit comments and previous examina- that the transactions qualify for netting for tion workpapers to assist in designing the scope financial reporting and regulatory reporting of examination. In addition, after a general purposes, according to the criteria specified review of a particular area to be examined, the by FASB Interpretations 39 and 41 (FIN 39 examiner should use these procedures, to the and FIN 41) or regulatory reporting extent they are applicable, for further guidance. requirements. Ultimately, it is the seasoned judgment of the 5. Review the organization’s methods for iden- examiner and the examiner-in-charge as to which tifying and quantifying risk for purposes procedures are warranted in examining any of hedging. Review the adequacy of docu- particular activity. mented risk reduction (pursuant to Statement of Financial Accounting Standards Nos. 52 1. Obtain a copy of the organization’s account- and 133 (FAS 52 and FAS 133)—FAS 133 ing policies and review them for conform- was amended by Statement of Financial ance with the relevant sections of authorita- Accounting Standards Nos. 137 and 138) and tive pronouncements by the Financial the enterprise or business-unit risk reduction Accounting Standards Board (FASB) and (FAS 133) that are necessary conditions to American Institute of Certified Public applying hedge accounting treatment. Accountants (AICPA) (for Y-series reports) 6. Obtain schedules of the gains or losses result- and for conformance with the call report ing from hedging activities and review instructions. whether the determination was appropriate 2. Using a sample of securities purchase and and reasonable. sales transactions, check the following: a. Securities subledgers accurately state the 7. Determine if accounting reversals are well cost, and the market values of the securi- documented. ties agree to outside quotations. 8. Determine if accounting profits and losses b. Securities are properly classified among prepared by control staff are reviewed by the trading, available-for-sale, and held-to- appropriate level of management and that the maturity classifications. senior staff in the front office (head trader, c. Transactions that transfer securities from treasurer) has agreed with accounting num- the trading account to either held-to- bers. Determine if the frequency of review by maturity or available-for-sale are autho- senior managers is adequate for the institu- rized and conform with authoritative tion’s volume and level of earnings. accounting guidance (such transfers should 9. Recommend corrective action when policies, be rare, according to Statement of Finan- procedures, practices, internal controls, or cial Accounting Standards No. 115 (FAS management information systems are found 115)). to be deficient or when violations of law, 3. Obtain a sample of financial instruments held rulings, or regulations have been noted.

Trading and Capital-Markets Activities Manual April 2003 Page 1 Accounting Internal Control Questionnaire Section 2120.4

1. Does the organization have a well-staffed 4. Do the revaluation rates used for a sample of accounting unit that is responsible for follow- financial instruments held in the trading ing procedures and instructions for recording account appear within range when compared transactions; marking to market when appro- with supporting documentation of market priate; filing regulatory and stockholder rates? reports; and dealing with regulatory, tax, and 5. Do the contractual terms of a sample of accounting issues? transactions qualify for netting for financial 2. Do the organization’s accounting policies reporting and regulatory reporting purposes, conform to the relevant sections (that is, according to the criteria specified by FASB those sections regarding trading and hedging Interpretations 39 and 41 (FIN 39 and 41) or transactions) of authoritative pronounce- regulatory reporting requirements? ments by the Financial Accounting Standards 6. Does the financial institution have proce- Board (FASB) and American Institute of dures to document risk reduction (pursuant to Certified Public Accountants (AICPA), and Statement of Financial Accounting Standards do the organization’s policies conform to the Nos. 52 and 133 (FAS 52 and FAS 133— call report instructions? If the organization is FAS 133 was amended by Statement of a foreign institution, does the organization Financial Accounting Standards Nos. 137 have appropriate policies and procedures to and 138), and does it have enterprise or convert foreign accounting principles to U.S. business-unit risk-reduction (FAS 133) con- reporting guidance? Is there an adequate ditions to apply hedge accounting treatment? audit trail to reconcile the financial state- Do the procedures apply to the full range of ments to regulatory reports? applicable products used for investment? Is 3. For revaluation— record retention adequate for this process? a. do securities subledgers accurately state 7. Are the methods for assessing gains or losses the cost, and do market values of the resulting from hedging activities appropriate securities agree to outside quotations, and and reasonable? b. are securities properly classified among 8. Are accounting reversals justified by super- trading, available-for-sale, and held-to- visory personnel, and are reversals well maturity classifications? documented? Evaluate the transfer of securities from the 9. Are profits and losses prepared by control trading account to either held-to-maturity or staff reviewed by the appropriate level of available-for-sale for authorization in con- management and senior staff (head trader, formance with authoritative accounting guid- treasurer) for agreement? Is the frequency of ance. Are such transfers rare? (According to review by senior managers adequate for the Statement of Financial Accounting Standards institution’s volume and level of earnings? No. 115 (FAS 115), such transfers should be rare.)

Trading and Capital-Markets Activities Manual April 2003 Page 1 Accounting Appendix—Related Financial-Statement Disclosures Section 2120.5

SECURITIES PORTFOLIO • the basis on which cost was determined in DISCLOSURES UNDER FAS 115 computing realized gain or loss (that is, specific identification, average cost, or other For securities classified as available-for-sale and method used), separately for securities classified as held-to- • the gross gains and gross losses included in maturity, all reporting institutions should dis- earnings from transfers of securities from the close the aggregate fair value, gross unrealized available-for-sale category into the trading holding gains, gross unrealized holding losses, category, and amortized cost basis by major security type • the change in net unrealized holding gain or as of each date for which a statement of financial loss on available-for-sale securities that has position is presented. Financial institutions been included in the separate component of should include the following major security shareholders’ equity during the period, and types in their disclosure, though additional types • the change in net unrealized holding gain or may be included as appropriate: loss on trading securities that has been included in earnings during the period. • equity securities • debt securities issued by the U.S. Treasury and For any sales of or transfers from securities other U.S. government corporations and classified as held-to-maturity, the amortized cost agencies amount of the sold or transferred security, the • debt securities issued by states of the United related realized or unrealized gain or loss, and States and political subdivisions of the states the circumstances leading to the decision to sell or transfer the security should be disclosed in • debt securities issued by foreign governments the notes to the financial statements for each • corporate debt securities period for which the results of operations are • mortgage-backed securities presented. Such sales or transfers should be rare, • other debt securities except for sales and transfers caused by the changes in circumstances as previously dis- For investments in debt securities classified as cussed in section 2120.1. available-for-sale and separately for securities classified as held-to-maturity, all reporting insti- tutions should disclose information about the contractual maturities of those securities as of ACCOUNTING DISCLOSURES the date of the most recent statement of financial FOR DERIVATIVES AND position presented. Maturity information may be HEDGING ACTIVITIES combined in appropriate groupings. In comply- ing with this requirement, financial institutions Under Statement of Financial Accounting Stan- should disclose the fair value and the amortized dards No. 133 (FAS 133), as amended by cost of debt securities based on at least four Statement of Financial Accounting Standards maturity groupings: (1) within one year, (2) after Nos. 137 and 138 (FAS 137 and FAS 138), one year through five years, (3) after five years institutions that hold or issue derivative instru- through ten years, and (4) after ten years. ments or nonderivative instruments qualifying Securities not due at a single maturity date, such as hedge instruments should disclose their as mortgage-backed securities, may be disclosed objectives for holding or issuing the instruments separately rather than allocated over several and their strategies for achieving the objectives. maturity groupings; if allocated, the basis for Institutions should distinguish whether the allocation also should be disclosed. For each derivative instrument is to be used as a fair- period for which the results of operations are value, cash-flow, or foreign-currency hedge. presented, an institution should disclose— The description should include the risk- management policy for each of the types of • the proceeds from sales of available-for-sale hedges. Institutions not using derivative instru- securities and the gross realized gains and ments as hedging instruments should indicate gross realized losses on those sales, the purpose of the derivative activity.

Trading and Capital-Markets Activities Manual April 2003 Page 1 2120.5 Accounting: Appendix—Related Financial-Statement Disclosures

Fair-Value Hedges may give rise to foreign-currency-transaction gains or losses under Statement of Financial For foreign-currency-transaction gains or losses Accounting Standards No. 52 (FAS 52), and that that qualify as fair-value hedges, report— have been designated as and qualify for foreign- currency hedges, the net amount of gains or • the net gain or loss recognized in earnings losses included in the cumulative translation during the reporting period, which represents adjustment during the reporting period should the amount of hedge ineffectiveness and the be disclosed. component of gain or loss, if any, excluded from the assessment of hedge effectiveness, and a description of where the net gain or loss Reporting Changes in Other is reported in the income statement and Comprehensive Income • the amount of net gain or loss recognized in earnings when a hedged firm commitment no Institutions should show as a separate classifi- longer qualifies as a fair-value hedge. cation within OCI the net gain or loss on derivative instruments designated and qualify- ing as cash-flow hedges. Additionally, pursuant Cash-Flow Hedges to Statement of Financial Accounting Standards No. 130, ‘‘Reporting Comprehensive Income’’ For cash-flow gains or losses that qualify as (FAS 130), institutions should disclose the cash-flow hedges, report— beginning and ending accumulated derivative gain or loss, the related net change associated • the net gain or loss recognized in earnings with current-period hedging transactions, and during the reporting period, which represents the net amount of any reclassification into the amount of ineffectiveness and the compo- earnings. nent of the derivative’s gain or loss, if any, excluded from the assessment of hedge effec- tiveness, and a description of where the net SEC Disclosure Requirements for gain or loss is reported in the income Derivatives statement; • a description of the transactions or other In the first quarter of 1997, the Securities and events that will result in the reclassification Exchange Commission (SEC) issued rules into earnings of gains and losses that are requiring the following expanded disclosures for reported in accumulated other comprehensive derivative and other financial instruments for income (OCI), and the estimated net amount public companies: of the existing gains or losses at the reporting date that is expected to be reclassified into • in the footnotes of the financial statements, earnings within the next 12 months; improved descriptions of accounting policies • the maximum length of time over which the for derivatives entity is hedging its exposure to the variability • outside of the footnotes to the financial state- in further cash flows for forecasted transac- ments, disclosure of quantitative and qualita- tions, excluding those forecasted transactions tive information about derivatives and other related to the payment of variable interest on financial instruments existing financial instruments; and — For the quantitative disclosures about • the amount of gains and losses reclassified market-risk-sensitive instruments, regis- into earnings as a result of the discontinuance trants must follow one of three methodolo- of cash-flow hedges because it is probable that gies and distinguish between instruments the original forecasted transactions will not used for trading purposes and instruments occur by the end of the originally specified used for purposes other than trading. The time period or within an additional time period three disclosure methodology alternatives as outlined in FAS 133 as amended. are (1) tabular presentation of fair values and contract terms, (2) sensitivity analysis, Foreign-Currency Hedges or (3) value-at-risk disclosures. Registrants must disclose separate quantitative infor- For derivatives, as well as nonderivatives, that mation for each type of market risk to

April 2003 Trading and Capital-Markets Activities Manual Page 2 Accounting: Appendix—Related Financial-Statement Disclosures 2120.5

which the entity is exposed (for example, as compared with the previous reporting interest-rate or foreign-exchange rate). period. — The qualitative disclosures about market • disclosures about derivative financial instru- risk must include the registrant’s primary ments with any financial instruments, firm market-risk exposures at the end of the commitments, commodity positions, and reporting period, how those exposures are anticipated transactions that are being hedged managed, and changes in primary risk by such items (these are included to avoid exposures or how those risks are managed misleading disclosures).

Trading and Capital-Markets Activities Manual April 2003 Page 3 Regulatory Reporting Section 2130.1

The internal-control function is critical in the is filed with the appropriate self-regulatory assessment of an institution’s regulatory report- organization (SRO), and the SEC furnishes ing. The examiner must gain a thorough under- microdata to the Board for bank-affiliated secu- standing of (1) the information flows from the rities dealers. The Y-20, another FRB report, execution of a transaction to its inclusion in the summarizes the FOCUS data and segregates appropriate regulatory report, (2) the design and revenues from eligible and ineligible securities. performance of critical internal-control pro- The Y-20 report is only filed by securities cedures, and (3) the adherence to regulatory subsidiaries that are still operating pursuant to reporting standards. section 4(c)(8) of the Bank Holding Company Examiners, report processors, and economists Act, and are therefore subject to the Board’s who analyze regulatory reports or otherwise use revenue test designed to prevent violation of the the data contained in them depend on the data’s former Glass-Steagall Act. Other bank holding accuracy. False reporting is punishable by civil company subsidiaries that trade eligible securi- monetary penalties as prescribed in the Finan- ties also file the FOCUS report with the SEC cial Institutions Recovery, Reform, and and the appropriate SRO. The appendix to this Enhancement Act of 1989 (FIRREA). section describes frequently used regulatory reports.

OVERVIEW OF REPORTS SOUND PRACTICES Several types of regulatory reports contain trad- ing data: the Report of Condition (FFIEC 031– • Every organization should have procedures to 034), the Report of Assets and Liabilities of U.S. prepare regulatory reports. When conversion Branches and Agencies of Foreign Banks (FFIEC from foreign accounting principles to gener- 002), and financial statements of the securities ally accepted accounting principles (GAAP) is subsidiaries. required, a mapping should document an audit The Federal Reserve Board (FRB) and Fed- trail. This documentation is particularly eral Financial Institutions Examination Council important as the degree to which reconcilia- (FFIEC) require financial institutions to summa- tion is automated declines. rize their gross positions outstanding in traded • Every institution should maintain clear and products on the Report of Condition and Income concise records with special emphasis on as well as on the Report of Assets and Liabilities documenting adjustments. (collectively, the call reports). These regulatory • Every organization should have a procedure to reports vary according to the size and type of ensure that current reporting instructions are institution. For example, the reports required by maintained and understood by control staff. the FFIEC include the 002 for U.S. branches and • To ensure correct classification of new prod- agencies of foreign banks and a series of reports ucts, every organization should have a proce- for domestic banks, while the FRB requires the dure whereby staff who are preparing regula- Y-series to cover bank holding companies. tory reports are consulted if new products are Section 20 subsidiaries show their securities introduced. revenue and capitalization in detail on the Finan- • Every organization should have a procedure, cial and Operational Combined Uniform Single such as contacting the appropriate statistics (FOCUS) report as required by the Securities units within the Federal Reserve System, to and Exchange Commission (SEC). This report resolve questions when they arise.

Trading and Capital-Markets Activities Manual April 2001 Page 1 Regulatory Reporting Examination Objectives Section 2130.2

The examiner’s principal objective when review- 3. To assess the effectiveness of the system of ing the regulatory reporting function is to verify internal controls over the regulatory report- the accuracy and consistency of reporting ing function. To identify, document, and test requirements. The examiner’s review of regula- internal-control procedures that are critical to tory reporting, as it applies to trading activities the accurate, reliable, and complete reporting of the institution, should be coordinated with of trading transactions in regulatory reports. overall trading-examination objectives. To assess 4. To determine the effectiveness of the internal the accuracy of regulatory reports, examiners controls over financial reporting, which can should review appropriate supporting docu- have an impact on the extent of examination ments, such as workpapers, general ledgers, procedures that need to be applied to verify subsidiary ledgers, and other information used the accuracy of regulatory reports. (For exam- to prepare the regulatory reports. ple, if an examiner has determined that an organization has very effective internal con- The reports must meet the following objectives: trols over financial reporting, then the extent of detailed testing procedures applied to 1. To confirm that the trading data are as of the verifying the accuracy of regulatory reports report date and that they match the records of will be less extensive than the procedures the traders and include all material post- applied to an institution that has ineffective closing adjustments to the general ledger. controls or a system of controls with poten- 2. To check that the data conform to the require- tial weaknesses.) ments of the report instructions. (‘‘Account- 5. To review the Financial and Operational ing requirements’’ refers to how a transaction Combined Uniform Single (FOCUS) report should be valued. It also prescribes when to evaluate capital adequacy. (For section 20 transactions should be reported (for example, subsidiaries, the examiner reviews the FR the rules regarding trade-date accounting). Y-20 report to ensure that revenue from The reports required by the Board are gener- ineligible securities does not exceed 10 per- ally consistent with generally accepted cent of total revenue.) accounting principles (GAAP).

Trading and Capital-Markets Activities Manual April 2001 Page 1 Regulatory Reporting Examination Procedures Section 2130.3

These procedures list processes and activities latory reports in order to check the descrip- that may be reviewed during a full-scope exami- tions of each transaction included in the line nation. The examiner-in-charge will establish items. These details must match the instruc- the general scope of examination and work with tions for the corresponding lines. the examination staff to tailor specific areas for 4. The examiner should reconcile the regulatory review as circumstances warrant. As part of this reports to the institution’s official records, process, the examiner reviewing a function or especially the general ledger, and to reports product will analyze and evaluate internal-audit of the area in charge of trading. The recon- comments and previous examination workpa- ciliation process begins with a review of the pers to assist in designing the scope of exami- regulatory report through a spot check of the nation. In addition, after a general review of a regulatory report against the preparer’s particular area to be examined, the examiner sources. The examiner may be able to avoid should use these procedures, to the extent they line-by-line reconciliation if accuracy runs are applicable, for further guidance. Ultimately, high in the spot check or if the examiner it is the seasoned judgment of the examiner and verifies that the institution has an approved, the examiner-in-charge as to which procedures independently verified reconciliation process. are warranted in examining any particular 5. The examiner should ensure that post-closing activity. adjustments and all accounting and timing differences, if any, between the regulatory 1. Early in the examination, the examiner should reporting requirements and generally accepted review trading data for arithmetic mistakes, accounting principles (GAAP) have been general accounting errors, and any misunder- effected. standing of the regulatory reporting instruc- tions. Common conceptual errors include Call report data are the basis for the balance incorrect recognition of income on traded sheet, off-balance-sheet items or activities, products, incorrect valuation of trading- income statement, and risk-based capital sched- account securities, omission of securities not ules of the Report of Examination. Corrections yet settled, and reporting of currency swaps to the data made during the reconcilement of the as interest-rate swaps. regulatory reports must be reflected in Report of 2. The examiner should ensure that previously Examination schedules. In the rare instance noted exceptions (either in the prior Report when the dates of the regulatory reports and the of Examination or by auditors) have been examination do not coincide, data as of the properly addressed. examination date must be compiled in accor- 3. The examiner should review the workpapers dance with call report instructions. of the person responsible for preparing regu-

Trading and Capital-Markets Activities Manual April 2001 Page 1 Regulatory Reporting Internal Control Questionnaire Section 2130.4

1. Before reports are submitted to the regula- that are handled outside of normal pro- tory authorities, are all regulatory reports cesses or automated systems may be omitted reviewed for accuracy by a person who is if procedures and adequate communication independent of the preparation process? exist between the reporting and trading 2. Does internal audit at the institution review functions. the process of regulatory reporting, includ- 7. Do reporting personnel have an adequate ing the accuracy of the trading data on understanding of trading instruments, trad- regulatory reports? ing transactions, and reporting requirements 3. Are internal controls in place that provide to ensure accurate and reliable regulatory reasonable assurances of the accuracy, relia- reporting? bility, and completeness of reported trading 8. Does the preparer or reviewer maintain the information? most current instructions for the reports he 4. Are the internal controls documented and or she is responsible for? tested by internal audit? If not, examination personnel should document and test critical 9. Does the accounting department have pro- internal controls in this area to the extent cedures to ensure that the preparer or appropriate to satisfy examination objectives. reviewer investigates questions from the 5. Does supporting documentation include FRB report analysts? (Report analysts ask sources of information and reconciliation to the accounting department over the tele- the general or subsidiary ledgers, and are phone to explain arithmetic discrepancies reconciling items handled appropriately? and large variances from prior periods.) 6. Are procedures in place to capture exotic 10. What knowledge does the signatory have instruments or other transactions that require regarding the report he or she is signing and special handling? Off-balance-sheet items the controls in place to ensure accuracy?

Trading and Capital-Markets Activities Manual April 2001 Page 1 Regulatory Reporting Appendix—Reports for Trading Instruments Section 2130.5

REPORTS LISTED BY TYPE OF detail by product type, while others only have INSTITUTION data aggregated for selected products. Before undertaking a review of any trading instruments, Listed below, according to the type of respon- examiners should become familiar with the data dent, are the regulatory reports that include data available to them in the reports filed by the on traded products. Some of the reports show entity under examination.

Bank Holding Company Reports

1. FR Y-9C Consolidated financial statements for top-tier bank holding companies with total consolidated assets of $150 million or more and lower-tier bank holding companies that have total consolidated assets of $1 billion or more. In addition, FR Y-9C reports are filed by all multibank bank holding companies with debt outstanding to the general public or that are engaged in certain nonbank activities, regardless of size.

Frequency: quarterly

Each of the instruments listed below is captured on this report. See the report instructions/glossary for the treatment of each instrument. See schedule HC-R for risk-based capital components.

Schedule HC-B

Securities U.S. Treasuries Municipal Mortgage-backed Asset-backed Foreign governments Corporations LDC debt Equities

Schedule HC-L

Futures and forwards Forward rate agreements Interest-rate swaps Foreign exchange Currency swaps Options (interest-rate, currency) Commodities Index-linked activities Hybrids

Trading and Capital-Markets Activities Manual April 2001 Page 1 2130.5 Regulatory Reporting: Appendix—Reports for Trading Instruments

2. FR Y-9SP Parent-company-only financial statements for one-bank holding companies with total consolidated assets of less than $150 million.

Frequency: semiannually

Typically, examiners will encounter only securities (for example, U.S. Treasur- ies, obligations of states and municipalities, and mortgage-backed securities) when reviewing this report. No off-balance-sheet items are captured on this report.

3. FR Y-9LP Parent-company-only financial statements for each bank holding company that files the FR Y-9C. In addition, for tiered bank holding companies, parent- company-only financial statements for each lower-tier bank holding company if the top-tier bank holding company files the FR Y-9C.

Frequency: quarterly

Typically, examiners will encounter only securities transactions (for example, U.S. Treasuries, municipal, and mortgage-backed) when reviewing this report. No off-balance-sheet items are captured on this report.

4. FR Y-8 Bank Holding Company Report of Insured Depository Institutions’ Section 23A Transactions with Affiliates.

Frequency: quarterly

This report collects information on transactions between an insured depository institution and its affiliates that are subject to section 23A of the Federal Reserve Act (FRA). The information is used to enhance the Federal Reserve’s ability to monitor bank exposures to affiliates and to ensure compliance with section 23A of the FRA. Section 23A is one of the most important statutes on limiting exposures to individual institutions and protecting the federal safety net. Reporters include all top-tier bank holding companies (BHCs), including financial holding companies (FHCs). In addition, all foreign banking organiza- tions that directly own a U.S. subsidiary bank must file this report. Participation is mandatory.

5. FR Y-20 Financial statements for a bank holding company subsidiary engaged in ineligible securities underwriting and dealing.

Frequency: quarterly only by firms that continue to function as ‘‘section 20 subsidiaries’’

Schedules SUD and SUD-A capture securities transactions (for example, U.S. Treasuries, municipal, foreign, and asset-backed securities) as well as transac- tions involving equities, futures and forwards, and options.

April 2001 Trading and Capital-Markets Activities Manual Page 2 Regulatory Reporting: Appendix—Reports for Trading Instruments 2130.5

6. FR Y-11Q Financial statements for each individual nonbank subsidiary of a bank holding company with total consolidated assets of $150 million or more in which the nonbank subsidiary has total assets of 5 percent or more of the top-tier bank holding company’s consolidated tier 1 capital, or in which the nonbank subsidiary’s total operating revenue equals 5 percent or more of the top-tier bank holding company’s consolidated total operating revenue.

Frequency: quarterly

Each of the instruments listed below is captured on this report.

Balance-Sheet Items Securities

Off-Balance-Sheet Items Futures and forwards Forward rate contracts Interest-rate swaps Foreign exchange Currency swaps Option contracts

7. FR Y-11I Financial statements for each individual nonbank subsidiary that is owned or controlled by a bank holding company with total consolidated assets of less than $150 million or with total consolidated assets of $150 million or more if (1) the total assets of the nonbank subsidiary are less than 5 percent of the top-tier bank holding company’s consolidated tier 1 capital and (2) the total operating revenue is less than 5 percent of the top-tier bank holding company’s consolidated total operating revenue.

Frequency: annually

Each of the instruments listed below is captured on this report.

Balance-Sheet Items Securities

Off-Balance-Sheet Items Futures and forwards Forward rate contracts Interest-rate swaps Foreign exchange Currency swaps Option contracts

Trading and Capital-Markets Activities Manual April 2003 Page 3 2130.5 Regulatory Reporting: Appendix—Reports for Trading Instruments

8. FR Y-12 Report filed by top-tier domestic bank holding companies that file the FR Y-9C or FR Y-9SP and that meet the reporting thresholds. The FR Y-12 collects information on these companies’ equity investments in nonfinancial companies on three schedules: Type of Investments, Type of Securities, and Type of Entity within the Banking Organization.

Frequency: quarterly for FR Y-9C filers, semiannually for FR Y-9SP filers

Each of the instruments listed below is captured on this report.

Balance-Sheet Items Direct and indirect equity investments

Off-Balance-Sheet Items Unused equity commitments

9. FFIEC 009 Country Exposure Report filed by U.S. commercial banks and/or bank holding companies that meet the reporting criteria specified in the instructions to this report.

Frequency: quarterly

9a. FFIEC 009a Country Exposure Information Report supplements the FFIEC 009 and is intended to detail significant exposures as defined in the instructions to this report.

Frequency: quarterly

These reports show country distribution of foreign claims held by U.S. banks and bank holding companies. They also include foreign securities in the aggregate assets of the countries shown.

These reports may also be filed by U.S.-chartered insured commercial banks, Edge Act and agreement corporations, and other banking organizations.

10. X-17A-5 FOCUS Report.

Frequency: quarterly

This report collects data on securities and spot commodities owned by broker-dealers. In addition, it reflects the haircuts the broker-dealers are required to take, when applicable, pursuant to SEC rule 15c3-1(f).

April 2003 Trading and Capital-Markets Activities Manual Page 4 Regulatory Reporting: Appendix—Reports for Trading Instruments 2130.5

Bank Reports

1. FFIEC 031 Consolidated reports of condition and income for a bank with domestic and foreign offices.

Frequency: quarterly

Each of the instruments listed below is captured on this report. See the report instructions for the treatment of each instrument. See schedule RC-R for risk-based capital computation.

Schedules RC-B and RC-D Securities U.S. Treasury Municipal Mortgage-backed Asset-backed Foreign government Equity All others

Trading and Capital-Markets Activities Manual April 2003 Page 4.1 Regulatory Reporting: Appendix—Reports for Trading Instruments 2130.5

Schedule RC-L Futures and forwards Forward rate agreements Interest-rate swaps Foreign exchange Currency swaps Options (interest-rate, currency) Commodities Index-linked activities Hybrids Credit derivatives

The FFIEC 032, 033, and 034 reports of condition and income capture information on the same instruments as the FFIEC 031.

2. FFIEC 030 Report of condition for foreign branch of U.S. bank.

Frequency: annually for all overseas branch offices of insured U.S. commercial banks quarterly for significant branches with either total assets of at least $2 billion or commitments to purchase foreign currencies and U.S. dollar exchange of at least $5 billion

This is a two-page report that captures information on balance-sheet data as well as selected off-balance-sheet data (options, foreign exchange, interest-rate swaps, and futures and forward contracts).

Reports for U.S. Branches and Agencies of Foreign Banks

1. FFIEC 002 Report of assets and liabilities of U.S. branches and agencies of foreign banks.

Frequency: quarterly

This report captures information pertaining to balance-sheet and off-balance- sheet transactions reported by all branches and agencies.

Schedule RAL Securities U.S. Treasuries Government agencies All others

Schedules L and M—part 5 Futures and forwards Forward rate agreements Interest-rate swaps Foreign exchange Currency swaps Options (interest-rate, currency)

Trading and Capital-Markets Activities Manual April 2001 Page 5 2130.5 Regulatory Reporting: Appendix—Reports for Trading Instruments

2. FR 2069 Weekly report of assets and liabilities for large U.S. branches and agencies of foreign banks.

Frequency: as of the close of business every Wednesday

Securities are included in this abbreviated report of assets and liabilities, which resembles schedule RAL on FFIEC 002.

3. FFIEC 019 Country exposure for U.S. branches and agencies of foreign banks.

Frequency: quarterly

This report shows country distribution of foreign claims held by branches and agencies. It includes foreign securities in the aggregate assets of the countries shown.

The FFIEC 009 (filed by banks, bank holding companies, and Edge Act and agreement corporations) is similar to this form.

Other Reports

1. FR 2314a Report of condition for foreign subsidiaries of U.S. banking organizations (to be filed by companies with total assets exceeding U.S. $100 million as of the report date).

Frequency: annually quarterly for significant subsidiaries with either total assets greater than $2 billion or $5 billion in commitments to purchase and sell foreign currencies

1a. FR 2314b Report of condition for foreign subsidiaries of U.S. banking organizations (to be filed by companies with total assets between U.S. $50–100 million as of the report date).

Frequency: annually

1b. FR 2314c Report of Condition for Foreign Subsidiaries of U.S. Banking Organizations (to be filed by companies with total assets less than U.S. $50 million as of the report date).

Frequency: annually

These three schedules are intended to capture financial information on the overseas subsidiaries of U.S. banking organizations (that is, bank holding companies, banks, and Edge Act corporations). The level of detail reported will depend on the asset size of the reporting entity. The FR 2314a and FR 2314b capture information on balance-sheet and off-balance-sheet transactions. The FR 2314c report cannot be used to track individual categories as the other two reports can.

April 2001 Trading and Capital-Markets Activities Manual Page 6 Regulatory Reporting: Appendix—Reports for Trading Instruments 2130.5

2. FR 2886b Report of condition for Edge Act and agreement corporations.

Frequency: quarterly

This report reflects the consolidation of all Edge and agreement operations, except for those majority-owned Edge or agreement subsidiaries. The latter are accounted for within a single line item, claims on affiliates. Asset instruments (securities and LDC debt) are reflected in the securities and loan lines, respectively, of this report. Off-balance-sheet items are grouped except for foreign-exchange and options contracts.

Trading and Capital-Markets Activities Manual April 2001 Page 7 Regulatory Compliance Section 2140.1

The trading activities and related instruments tional regulator of securities firms. Only under discussed in this manual are covered by various certain specified circumstances may a banking securities, commodities, or banking laws and regulator conduct an examination of a broker- regulations. Trading and other activities relating dealer. Thus, bank examiners need to become to securities are regulated under a variety of familiar with the regulatory environment in statutes, including the Securities Act of 1933, which securities broker-dealers have tradition- Securities Exchange Act of 1934, and Govern- ally operated. This section will focus on that ment Securities Act of 1986. In addition to goal, deferring to existing material in the fol- regulation by the Securities and Exchange Com- lowing manuals: Commercial Bank Examina- mission (SEC) and U.S. Treasury Department, tion Manual, Merchant and Investment Bank various self-regulatory organizations (SROs) are Examination Manual, and Bank Holding Com- responsible for oversight of securities broker- pany Supervision Manual. dealers. The SROs include the Municipal Secu- Activities involving instruments other than rities Rulemaking Board (MSRB), the National securities also may be subject to a variety of Association of Securities Dealers (NASD), and regulatory provisions. Commodities futures and exchanges such as the New York Stock Exchange options are regulated primarily by the Commod- (NYSE). ity Futures Trading Commission (CFTC), with Bank activities in the trading of securities are the activities of futures commission merchants subject to further regulation from the various (FCMs) subject to regulation by the CFTC as banking regulators. One of the more important well as the rules of the National Futures Asso- statutory provisions governing securities activi- ciation (an SRO) and various exchanges on ties of banks was the Banking Act of 1933 (the which trading is conducted. Most over-the- Glass-Steagall Act), which provided that mem- counter derivative instruments (for example, ber banks could purchase only certain limited foreign-exchange contracts, forward rate agree- types of securities (referred to as ‘‘eligible ments, and interest-rate swaps) are exempt from securities’’) and prohibited member banks from general CFTC regulation, either by statute in the affiliating with entities that were engaged prin- case of foreign exchange or under CFTC regu- cipally in the business of underwriting or issuing latory exemptions in the case of other types of ineligible securities. Securities underwriting and swaps and related transactions. While these dealing activities were authorized for separately instruments are not themselves subject to regu- incorporated nonbank entities owned, directly or lation, the activities of regulated entities in these indirectly, by bank holding companies. These instruments are subject to oversight by the so-called section 20 subsidiaries (after section banking or other regulators. 20 of the Glass-Steagall Act) operated pursuant to a number of restrictions, including limitations In addition to laws and regulations issued by on the annual revenue derived from dealing in the regulatory authorities, industry trade groups bank-ineligible securities. such as the International Swaps and Derivatives Under the provisions of the Gramm-Leach- Association (ISDA) or the Public Securities Bliley Act (GLB Act) enacted in 1999, financial Association (PSA) have developed industry holding companies are permitted to establish guidelines or standards in some areas. Addition- broker-dealer subsidiaries engaged in underwrit- ally, organizations such as the Financial Account- ing, dealing, and market making in securities, ing Standards Board (FASB) and the American without the restrictions that were applicable to Institute of Certified Public Accountants (AICPA) section 20 subsidiaries. The GLB Act provisions issue opinions and standards that relate to a also permit financial subsidiaries of banks to financial institution’s trading activities and finan- engage in comparable activities, subject to cial disclosure.1 certain bank capital limitations and deduc- tions. Permissible equity trading activities of foreign and Edge corporation subsidiaries of 1. For example, FASB’s Statement of Financial Account- U.S. banks are governed under the Board’s ing Standards No. 80 outlines accounting requirements relat- Regulation K. ing to futures contracts, while Practice Bulletin 4 of the AICPA addresses accounting issues concerning debt-for- The GLB Act requires banking regulators to equity swaps involving less developed country (LDC) rely to the greatest extent possible on the func- obligations.

Trading and Capital-Markets Activities Manual April 2003 Page 1 2140.1 Regulatory Compliance

PRINCIPLES OF SUPERVISION is subject to harsh restrictions on its operations. Net capital is generally defined as the broker- The SEC’s main principles of securities regula- dealer’s net worth plus subordinated borrow- tion are the protection of investors (especially ings, minus nonliquid (nonallowable) assets, the small and unsophisticated) and maintenance certain operational deductions, and required of the integrity and liquidity of the capital deductions (‘‘haircuts’’) from the market value markets. These principles are not unlike the of securities inventory and commitments. The goals of banking regulators, who seek to pro- level of the haircut depends on the type and mote a stable banking system. However, securi- duration of the security; the greater the duration ties and banking regulators differ in how they and risk (or volatility), the greater the haircut. apply these goals to an institution that is encoun- tering problems. Capital adequacy rules for securities are liquidity based and designed to ensure that a troubled broker-dealer can promptly CREDIT RESTRICTIONS pay off all customers in the event of liquidation. Banking regulators face a different set of con- Various credit and concentration restrictions are straints when dealing with troubled banks and imposed on a securities broker-dealer if the are less inclined to rely as quickly on the dealer is unduly concentrated in a given issue. liquidation process. Additionally, the Federal Reserve’s Regula- tion T imposes limits on the amount of credit that may be extended by broker-dealers to cus- tomers purchasing securities. This restriction REGISTRATION varies with the type of security. Securities broker-dealers generally must register with the SEC before conducting business. While broker-dealer activities undertaken by a bank REGULATORY REQUIREMENTS itself generally are exempt from registration requirements, bank subsidiaries and bank hold- ing companies or subsidiaries that are broker- Regulatory Examinations dealers must register with the SEC. Registered securities broker-dealers also are registered with All securities broker-dealers are required to the NASD or another SRO, such as an exchange, publish annual financial statements audited and are required to have their sales and super- by independent accountants. The SEC has the visory personnel pass written examinations. authority to conduct examinations, including Broker-dealers that engage in transactions examinations for compliance with sales-practice involving municipal or government securities and customer securities custody-protection rules, generally are registered with the SEC, but are recordkeeping and internal controls, and regula- subject to somewhat different requirements than tory reporting. In most cases, the SEC delegates the general registration requirements. When the this examination responsibility to the NYSE or bank itself acts as a government securities the appropriate SRO. The NASD also conducts broker-dealer, the bank is required to notify its all examinations of firms, except banks, that appropriate bank regulatory authority that it is engage strictly in municipal or government acting in that capacity. securities trading. In the case of banks, bank regulators are responsible for the examination.

CAPITAL REQUIREMENTS Regulatory Reporting Registered securities broker-dealers are subject to minimum net capital requirements pursuant to Securities broker-dealers are required to file a SEC Rule 15c3-1 or the U.S. Treasury’s rules monthly Financial and Operational Combined for government securities dealers (17 CFR 402). Uniform Single (FOCUS) report with their Requirements in excess of the minimum are also examining authority. This report contains finan- established by NYSE, NASD, and other SROs. cial statements and computations for the net If any of these minimums are breached, the firm capital rule, segregated funds held on behalf

April 2003 Trading and Capital-Markets Activities Manual Page 2 Regulatory Compliance 2140.1 of commodity futures customers, and a reserve and information on the institutions’ trading- account designed to protect customer balances.2 account securities. Government securities dealers file a somewhat similar report, the G-405 or ‘‘FOG’’ report, unless they are banks. Bank dealers file their FOREIGN SECURITIES normal call reports. Although FOCUS and FOG ACTIVITIES reports are generally confidential, securities broker-dealers will often make them available to Foreign-owned securities firms in the United large customers for credit reasons. States are subject to the same rules as domesti- U.S. commercial banks and branches and cally owned firms. In general, offshore activities agencies of foreign banks are required to file call conducted by U.S. broker-dealers that are located reports with the appropriate federal bank regu- entirely outside of U.S. jurisdiction and do not latory agency. The call report includes schedules involve U.S. persons are not subject to U.S. that detail various off-balance-sheet instruments securities regulation. Moreover, for FOCUS and FOG reporting purposes, the securities broker- dealer is not required to consolidate foreign 2. SEC Rule 15c3-3 restricts the use of customers’ funds (or domestic) subsidiaries unless the assets and and fully paid securities for proprietary transactions. liabilities have been guaranteed by the parent.

Trading and Capital-Markets Activities Manual April 2003 Page 3 Regulatory Compliance Examination Objectives Section 2140.2

The overall objective is to determine if the tory compliance aspect of its various trading institution’s trading activities are in compliance activities. with applicable laws, regulations, and super- 2. To determine if the bank has in place risk- visory guidelines. Specified senior management, management procedures and controls that as well as the regulatory reporting area of the provide management with accurate and timely bank, must be thoroughly familiar with regula- information on all trading positions and their tory requirements. Whenever possible, the bank potential impact on the institution’s financial examiner uses the examination results of the and regulatory position. securities regulators and FOCUS/FOG reports 3. To ascertain whether the institution’s person- to help assess the firm’s overall compliance nel involved in trading activities are aware of record. and knowledgeable about laws, regulations, and supervisory and other standards applica- 1. To determine if the institution’s internal con- ble to these activities. trols and audit program address the regula-

Trading and Capital-Markets Activities Manual February 1998 Page 1 Ethics Section 2150.1

The board of directors and senior management Conflicts of Interest of a financial institution should establish ethical standards and codes of conduct governing its Institutions should ensure that capital-markets employees’ activities. These standards are personnel do not allow self-interest to influence intended to protect the institution’s integrity and or give the appearance of influencing any activ- standing in the market as well as protect the ity conducted on behalf of the institution. Proper institution from legal and reputational risks. The oversight mechanisms, internal controls, and orderly operation of financial markets depends internal-audit procedures for monitoring compli- greatly on an overall level of trust among all ance and addressing conflicts of interest should market participants. At all times, traders and be in place. Safeguards should include specific marketing and support staff must conduct them- restrictions on trading for the employee’s per- selves with unquestionable integrity to protect sonal account and on the acceptance of gratu- the institution’s reputation with customers and ities and entertainment. When developing com- market participants. pensation programs, institutions should recognize and guard against any potential conflicts that may arise between compensation structures and the institution’s ethical standards and code of CODES OF CONDUCT AND conduct. ETHICAL STANDARDS Fee-based activities, securitization, underwrit- ing, and secondary-market trading activities in a To ensure that employees understand all ethical number of traditional bank assets may create the and legal implications of trading activities, potential for conflicts of interests if there is no institutions should have comprehensive codes of clear segregation of duties and responsibilities. conduct and ethical standards for capital-markets Conflicts of interest may arise when access to and trading activities—especially in areas where inside information gives an institution an unfair the complexity, speed, competitive environ- advantage over other market participants. ment, and volume of activity could create the Accordingly, policies should ensure that employ- potential for abuse and misunderstandings. At a ees conduct themselves consistent with legal minimum, policies and standards should address and regulatory restrictions on the use of inside potential conflicts of interest, confidentiality and information. the use of insider information, and customer sales practices. Ethical standards and codes of conduct in these areas should conform with applicable laws, industry conventions, and other Confidentiality and Insider bank policies. They should also provide proper Information oversight mechanisms for monitoring staff com- pliance and dealing with violations and cus- The maintenance of confidentiality and cus- tomer complaints. Internal controls, including tomer anonymity is critical for the operation of the role of internal and external audits, should an efficient trading environment. No client be appropriate to ensure adherence to corporate information should be divulged outside the ethical standards of conduct. An institution’s institution without the client’s authorization policies and procedures should provide for on- unless the information is required by law or going staff training. Policies and procedures regulatory authorities acting in their official should also provide for at least an annual review, capacities. Managers are responsible for ensur- revision, and approval of the ethical standards ing that their staffs are aware of what constitutes and code of conduct to ensure that they incor- confidential information and that they know porate new products, business initiatives, and how to deal appropriately with situations that market developments. To ensure that all employ- require customer anonymity. ees understand the ethical, legal, and reputa- Many institutions have established appropri- tional risk implications of bank activities, ethi- ate policies (so-called Chinese walls or fire- cal standards and codes of conduct should be walls) that separate those areas of the institution communicated throughout the organization and that routinely have access to confidential or reinforced by periodic training. insider information from those areas that are

Trading and Capital-Markets Activities Manual April 2003 Page 1 2150.1 Ethics legally restricted from having access to the institutions that provide investment advice to information. Any conflicts between an institu- clients or use discretionary authority to trade on tion’s risk-management or marketing structures a client’s behalf should formalize and set forth and its Chinese walls should be formally recog- the boundaries of these relationships. Formal nized and managed. advisory relationships may entail significantly different legal and business obligations between an institution and its customers than less formal agency relationships. The authority, rights, and Sales Practices responsibilities of both parties should be docu- mented in a written agreement. It is a sound business practice for managers to Marketing personnel should receive proper establish policies and procedures governing stan- guidance and training on how to delineate and dards for dealing with counterparties. These maintain appropriate client relationships. Sales guidelines and policies preserve the institution’s and trading personnel should receive guidance reputation in the marketplace by avoiding situ- about avoiding the implication of an advisory ations that create unjustified expectations on the relationship when none is intended. part of a counterparty or client or that expose the For its own protection, a financial institution institution to legal or reputational risk arising should take steps to ensure that its counterpar- from a customer’s use of bank products and ties understand the nature and risks inherent in services. agreed-upon transactions. These procedures may vary with the type and sophistication of a counterparty. When a counterparty is unsophis- Customer Suitability ticated, either generally or with respect to a particular type of transaction, the financial insti- When determining the responsibilities of sales tution should take additional steps to adequately and marketing staff, management should take disclose the attendant risks of specific types of into account the sophistication of a counterparty, transactions. Furthermore, a financial institution the nature of the relationship, and the type of that recommends specific transactions to an transaction being contemplated or executed. In unsophisticated counterparty should have addition, certain regulated entities and markets adequate information on which to base its may have specific legal or regulatory require- recommendation—and the recommendation ments governing sales and marketing practices, should be consistent with the needs of the which marketers and sales personnel must be counterparty as known to the financial institu- aware of. tion. The institution also should ensure that its Financial institutions should take steps to recommendations are consistent with any restric- ascertain the character and financial sophistica- tions imposed by a counterparty’s management tion of their counterparties. An appropriate level or board of directors on the types or amounts of of due diligence should be performed on all transactions it may enter into. counterparties that the institution deals with. Institutions should establish policies govern- Financial institutions should also determine that ing the content of sales materials provided to their counterparties have the legal authority to their customers. Typically, these policies call for enter into, and will be legally bound by the sales materials that accurately describe the terms terms of, the transaction. of the proposed transaction and fairly represent When an advisory relationship does not exist the risks involved. To help a customer adequately between a financial institution and its counter- assess the risk of a transaction, an institution’s party, the transaction is assumed to be con- policies may identify the types of analysis to be ducted at ‘‘arm’s length,’’ and the counterparty provided to the customer. Often these analyses is generally considered to be wholly responsible include stress tests of the proposed instrument or for the transactions it chooses to enter. At times, transaction over a sufficiently broad range of clients may not wish to make independent invest- possible outcomes. Some institutions use stan- ment or hedging decisions and instead may wish dardized disclosure statements and analyses to to rely on a financial institution’s recommenda- inform customers of the risks involved and tions and investment advice. Similarly, clients suggest that the customer independently obtain may give a financial institution the discretionary advice about the tax, accounting, legal, and authority to trade on their behalf. Financial other aspects of a proposed transaction.

April 2003 Trading and Capital-Markets Activities Manual Page 2 Ethics 2150.1

Institutions should also ensure that proce- tives before executing a transaction recom- dures and mechanisms to document analyses of mended to the customer. For institutional cus- transactions and disclosures to clients are ade- tomers, an NASD interpretation of its suitability quate and that internal controls ensure ongoing rule requires that a member determine (1) the adherence to disclosure and customer- institutional customer’s capability for evaluating appropriateness policies and procedures. Man- investment risk generally and evaluating the risk agement should clearly communicate to capital- of the particular instruments offered and markets and all other relevant personnel any (2) whether the customer is exercising indepen- specific standards that the institution has estab- dent judgment in making investment decisions. lished for sales materials. The NASD interpretation cites factors relevant Many customers request periodic valuations to determining these two requirements. of their positions. Institutions that provide peri- odic valuations of customers’ holdings should have internal policies and procedures governing the manner in which such quotations are derived LEGAL AND REPUTATIONAL and transmitted to the customer, including the RISKS nature and form of disclosure and any disclaim- ers. Price quotes can be either indicative, meant The increasingly complex relationships between to give a general level of market prices for a banking organizations and their customers can transaction, or they can be firm, which represent subject a bank to legal and reputational risks. prices at which the institution is willing to Although banking organizations are not directly execute a transaction. When providing a quote accountable for the actions of their customers, to a counterparty, institutions should be careful these organizations should recognize that—to that the counterparty does not confuse indicative the extent their name or product is associated quotes with firm prices. Firms receiving dealer with a customer’s misconduct—additional legal quotes should be aware that these values may and reputational risks may arise. Such risks may not be the same as those used by the dealer for lead to significant costs that may place down- its internal purposes and may not represent other ward pressure on earnings and the price of the ‘‘market’’ or model-based valuations. institution’s stock and upward pressure on the When securities trading activities are con- institution’s cost of funds. In an extreme case, ducted in a registered broker-dealer that is a these costs may have a negative impact on the member of the National Association of Securi- overall safety and soundness of the institution. ties Dealers (NASD), the broker-dealer will Legal and reputational risks are often associ- have obligations to its customers under the ated with new products. Generally, banking NASD’s business-conduct and suitability rules. organizations have established new-product pro- The banking agencies have adopted identical cesses that are designed to independently vet all rules governing the sales of government securi- risks. However, modifications to an existing ties in financial institutions. The business- product or new uses of a product after its initial conduct rule requires an NASD member to approval may also constitute a ‘‘new’’ product. ‘‘observe high standards of commercial honor, An institution’s product-approval process should and just and equitable principles of trade’’ in the incorporate re-reviews of these new products to conduct of its business. The suitability rule verify that all risks associated with the product requires that, in recommending a transaction to are understood and incorporated in the risk- a customer, an NASD member must have ‘‘rea- management framework. sonable grounds for believing that the recom- Ultimately, the corporate culture of a banking mendation is suitable for the customer upon the organization determines the effectiveness of its basis of facts, if any, disclosed by the customers risk-management procedures and its susceptibil- as to the customer’s other securities holdings ity to legal and reputational risk. The board of and as to the customer’s financial situation and directors and executive management of a bank- needs.’’ ing organization are responsible for establishing The suitability rule further provides that, for and maintaining an appropriate corporate cul- customers who are not institutional customers, ture and the corresponding business practices. an NASD member must make reasonable efforts The culture of a banking organization should to obtain information concerning the customer’s encourage the escalation of legal- and financial and tax status and investment objec- reputational-risk issues through policies and pro-

Trading and Capital-Markets Activities Manual April 2003 Page 3 2150.1 Ethics cedures that ensure these issues are vetted and COMPLIANCE MEASURES resolved at an appropriate level of seniority. The board of directors should be advised of any Personnel affirmations and disclosures are valu- material issues involving legal and reputational able tools for ensuring compliance with an risk. institution’s code of conduct and ethical stan- dards. Procedures for obtaining appropriate affirmations and disclosures where and when MANAGEMENT OVERSIGHT they are required, as well as the development of the forms on which these statements are made, Management should monitor any pattern of are particularly important. At a minimum, complaints concerning trading, capital-markets, employees should be asked to acknowledge and sales personnel that originates from outside annually that they have read and understand the the institution, such as from customers, other institution’s ethical standards and code of con- trading institutions, or intermediaries. Patterns duct. Some companies also require that this of broker usage should be monitored to alert annual affirmation contain a covenant that management to unusual concentrations. Bro- employees will report any noted violations. kers’ entertainment of traders should be fully Several major financial institutions have adopted documented, reviewed, and approved by man- additional disclosure procedures to enforce the agement. In addition, excessive entertainment of personal financial responsibilities set out in their brokers by traders should be prohibited. codes. They require officers to file with the Management should also be well acquainted compliance manager an annual statement on with the institution’s trading activities and cor- their families’financial matters or, in some responding reports so that, upon regular review, cases, a statement of indebtedness. Finally, many they can determine unusual patterns or concen- institutions require traders to conduct their per- trations of trading activity or transactions with a sonal trading through a designated account at customer that are not consistent with the cus- the institution. Adequate internal controls, tomer’s usual activities. Management should including review by internal audit and, when clearly and regularly communicate all prohib- appropriate, external audit, are critical for ited practices to capital-markets and all other ensuring compliance with an institution’s ethical relevant personnel. standards.

April 2003 Trading and Capital-Markets Activities Manual Page 4 Ethics Examination Objectives Section 2150.2

1. To determine if the institution has adequate reporting and dealing with violations are codes of conduct and ethical standards spe- adequate. To determine if the supervision of cific to its capital-markets and trading activi- staff is adequate for the level of business ties, that their scope is comprehensive, and conducted. that they are periodically updated. 4. To determine that management has adequate 2. To review and ensure the adequacy of the new-product processes that are designed to institution’s policies, procedures, and internal- evaluate independently the risks of products control mechanisms used to avoid potential that have been modified or products for conflicts of interest, prevent breaches in cus- which new uses have been developed. tomer confidentiality, and ensure ethical sales 5. To determine that the board of directors and practices across the institution’s trading senior management recognize the potential activities. To determine if the institution has legal and reputational risks that arise from a established appropriate and effective firewall customer’s misuse of bank products. policies where needed. 6. To recommend corrective actions when poli- 3. To determine that management has adequate cies, procedures, practices, or internal con- policing mechanisms and internal controls to trols are found to be deficient or when monitor compliance with the code of conduct violations of law, rulings, or regulations have and ethical standards and that procedures for been noted.

Trading and Capital-Markets Activities Manual April 2003 Page 1 Ethics Examination Procedures Section 2150.3

These procedures list processes and activities action documents are clearly identified. Do that may be reviewed during a full-scope exami- these standards address an appropriate range nation. The examiner-in-charge will establish of transactions, customers, and customer the general scope of the examination and work relationships? with the examination staff to tailor specific areas 5. Evaluate the adequacy of oversight mecha- for review as circumstances warrant. As part of nisms, internal controls, and internal-audit this process, the examiner reviewing a function procedures for monitoring compliance and or product will analyze and evaluate internal- addressing conflicts of interests. Review the audit comments and previous examination work- institutions’s firewall policies that segregate papers to assist in designing the scope of the its trading and advisory activities from those examination. In addition, after a general review areas that have access to material nonpublic of a particular area to be examined, the examiner or ‘‘insider information.’’ Are employees should use these procedures, to the extent they aware of the requirements of the law are applicable, for further guidance. Ultimately, restricting the use of such information, spe- it is the seasoned judgment of the examiner and cifically section 10(b) of the Securities the examiner-in-charge as to which procedures Exchange Act of 1934 and SEC Rule are warranted in examining any particular 10(b)5? activity. 6. Identify the officer within the institution who is designated as the compliance man- 1. Obtain copies of the institution’s written ager. Are trading personnel required to con- code of conduct, ethical standards, and firm in writing their acknowledgment of the related policies and guidance. Determine if institution’s various codes and to report there are codes specific to all relevant trad- violations? Are they required to file annual ing and marketing activities. Determine if statements of indebtedness and outside there is a general policy concerning viola- affiliations? Check to see that adherence to tions of the code. Is there a specific proce- these reporting requirements is being moni- dure for reporting violations to senior man- tored by the compliance manager. agement and the general auditor? Does this 7. Determine how compliance with sales- procedure detail the grounds for disciplin- practice policies is monitored by the insti- ary action? tution. Are personnel outside the trading 2. Obtain any procedures that are used to help area reviewing sales documents and disclo- staff develop new accounts or prepare sales sures for their compliance with policies? presentations and documents. Review and evaluate the findings of internal 3. Evaluate the adequacy and scope of the and external audits conducted in this area. various codes and policies. Are prohibited 8. Conduct limited transaction testing of sales practices clearly identified? Prohibited prac- documentation to review compliance with tices may include but are not limited to the financial institution policies and sound following: practices. a. altering clients’ orders without their 9. Determine the adequacy of the new-product- permission approval process, including the policies and b. using the names of others when submit- procedures for the review of modified prod- ting bids ucts for which new uses have been developed. c. compensating clients for losses on trades 10. Determine whether there are adequate poli- d. submitting false price information to pub- cies, procedures, and internal controls to lic information services protect the institution from legal and repu- e. churning managed client accounts tational risks that arise from a customer’s f. altering official books and records with- misuse of bank products. out legitimate business purposes 11. Recommend corrective action when poli- g. trading in instruments that are prohibited cies, procedures, practices, or internal con- by regulatory authorities trols are found to be deficient or when 4. Determine if standards for the content of violations of law, rulings, or regulations sales presentations and the offering of trans- have been noted.

Trading and Capital-Markets Activities Manual April 2003 Page 1 Ethics Internal Control Questionnaire Section 2150.4

1. Does the institution have a written code of — periodically check whether employ- conduct and written ethical standards? Are ees maintain sound personal finan- there specific codes for capital-markets staff? cial conduct and avoid excessive a. Is there a statement on the intention of the debts or risks? code and standards to conform with U.S. — monitor employee business interac- laws or the laws of other countries where tion with other staff members, fam- the institution has operations? ily, or organizations in which an b. Do the code and standards cover the employee has a financial interest? whole institution, including subsidiaries? — prohibit employee use of confiden- If not, are there codes and standards that tial information for personal gain? apply to those particular areas? — provide adequate control over c. Do the code and standards address spe- employee trading in personal cific activities that are unique to this accounts? particular institution? Do other areas of — require periodic disclosure and the institution with a higher potential for approval of outside directorships and conflicts of interest have more explicit business associations? policies? ¥ For personal and corporate political d. Do the code and standards address the activities, the illegality of corporate following issues: political activities (for example, contri- ¥ Employee relationships with present or butions of goods, services, or other prospective customers and suppliers? support)? Has the institution conducted an appro- ¥ The necessity to avoid what might only priate inquiry of customer integrity? appear to be a possible conflict of Does the institution’s code properly interest? address the following employee- 2. Does management have the necessary mecha- customer or -supplier issues? nism in place to monitor compliance with the — safeguarding confidential information code of conduct and the ethical standards? — borrowings a. Are officers and staff members required to — favors sign an acknowledgment form that veri- — acceptance of gifts fies they have indeed seen and read the — outside activities code of conduct and the ethical standards? — kickbacks, bribes, and other ¥ Is there a periodic program to make staff remunerations aware of and acknowledge the impor- — integrity of accounting records tance of adhering to the code and — candor in dealings with auditors, standards? examiners, and legal counsel — appropriate background check and ¥ To identify a potential conflict of inter- assessment of the credit quality and est, are officers required to disclose their financial sophistication of new borrowing arrangements with other customers financial institutions? — appropriate sales practices b. What departments and which officers are — an understanding of the customer’s responsible for monitoring compliance business purposes for entering into with the code of conduct, ethical stan- complex or structured transactions dards, and related policies? What mecha- ¥ Internal employee relationships between nisms do these officers employ, and are specific areas of the bank? the mechanisms adequate? — Do policies exist to cover the sharing c. How is information in the code and stan- of information between trading and dards relayed to staff? other areas of the bank? ¥ Have there been any breaches of the — Is the confidentiality of account code and standards? If so, what was the relationships addressed? situation and how was it resolved? ¥ Personal employee activities outside the ¥ Do bank personnel avail themselves of corporation? Does the institution— the resources outlined in the code and

Trading and Capital-Markets Activities Manual April 2003 Page 1 2150.4 Ethics: Internal Control Questionnaire

standards when there is a question 3. Are there resources for an employee to obtain regarding a potential conflict of inter- an opinion on the legitimacy of a particular est? If not, why? circumstance outlined in the code of conduct ¥ Are all employees aware of the exist- or in the ethical standards? ence of the code and standards? If not, a. Does the code emphasize the need for why? employees to report questionable activi- ¥ Does the bank’s management generally ties even when the issues are not their believe that all potential conflicts of particular responsibility? Are the proper interest have been anticipated and are channels of action outlined for these types adequately covered in the code and of cases? standards? b. Does the code outline penalties or reper- ¥ Are internal auditors involved in moni- cussions, such as the following, for toring the code and standards? breaches of the code of conduct and the ¥ Does the organization’s culture encour- ethical standards? age officers and employees to follow the ¥ potential to lose one’s job standards established by the code and to escalate legal- and reputational-risk ¥ potential for civil or legal action issues? Are these issues vetted and ¥ eventual damage to the corporation’s resolved at an appropriate level of reputation seniority? Is the board of directors 4. Are the code of conduct and ethical standards advised of material issues involving updated frequently to encompass new legal and reputational risk? activities?

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