Deposit Accounts Section 3000.1

Deposit Accounts Effective date April 2011 Section 3000.1

Deposits are funds that customers place with a • the adequacy of current operations (staffing bank and that the bank is obligated to repay on and systems) and the location and size of demand, after a specific period of time or after banking quarters relative to the bank’s volume expiration of some required notice period. of business, Deposits are the primary funding source for • the degree of competition from banks and most banks and, as a result, have a significant nonbank financial institutions and their pro- effect on a bank’s liquidity. Banks use deposits grams to attract deposit customers, and in a variety of ways, primarily to fund loans and • the effects of the national economy and the investments. Management should establish a monetary and fiscal policies of the federal procedure for determining the volatility and government on the bank’s service area. composition of the deposit structure to ensure that funds are employed profitably, while allow- The bank’s size and the composition of its ing for their potential withdrawal. Therefore, a market determine how formal its deposit pro- bank’s management should implement program should be. After a bank develops its grams to retain and prudently expand the bank’s deposit program, management must continue to deposit base. monitor the above factors and correlate any Bankers place great significance on the deposit findings to determine if adjustments are needed. structure because favorable operating results The long-term success of any deposit program depend, in part, on a core deposit base. Because relates directly to the ability of management to of competition for funds, the need for most make adjustments at the earliest possible time. individuals and corporations to minimize idle funds, and the effect of disintermediation (the movement of deposits to other higher-yielding markets) on a bank’s deposit base, bank man- DEPOSIT STRUCTURE agement should adopt and implement a development and retention program for all types of Management should look not only at deposit deposits. growth but also at the nature of the deposit structure. To invest deposited funds properly in view of anticipated or potential withdrawals, management must be able to determine what DEPOSIT DEVELOPMENT AND percentage of the overall deposit structure is RETENTION PROGRAM centered in core deposits, in fluctuating or seasonal deposits, and in volatile deposits. It is Important elements of the examination process important that internal reports with information are the review of a bank’s deposit development concerning the composition of the deposit struc- and retention program and the methods used to ture be provided to management periodically. determine the volatility and composition of the Management’s lack of such knowledge could deposit structure. A bank’s deposit development lead to an asset-liability mismatch, causing prob- and retention program should include— lems at a later date. In analyzing the deposit structure, informa- • a marketing strategy, tion gathered by the various examination proce- • projections of deposit structure and associated dures should be sufficient to allow the examiner costs, and to evaluate the composition of both volatile and • a formula for comparing results against core deposits. Ultimately, the examiner should projections. be satisfied with management’s efforts to plan for the bank’s future. To structure a deposit program properly, bank Examiners must analyze the present and management must consider many factors, some potential effect deposit accounts have on the of which include— financial condition of the bank, particularly with regard to the quality and scope of management’s • the composition of the market-area economic planning. The examiner’s efforts should be base, directed to the various types of deposit accounts • the ability to employ deposits profitably, that the bank uses for its funding base. The

Commercial Bank Examination Manual April 2016 Page 1 3000.1 Deposit Accounts examiners assigned to the areas of funds man- the basis on which service charges on dormant agement and to the analytical review of the accounts are assessed and should document the bank’s income and expenses should be informed review. There have been occasions when exces- of any signiﬁcant change in interest-bearing sive servicing charges have resulted in no pro- deposit-account activity. ceeds being remitted at the time the account became subject to escheat requirements. In these cases, courts have required banks to reimburse COST OF FUNDS the state. (See also the ‘‘Dormant Accounts’’ discussion later in this section.) Interest paid on deposits is generally the largest expense to a bank. As a result, interest-bearing deposit accounts employed in a marginally prof- Bank Secrecy Act itable manner could have signiﬁcant and lasting effects on bank earnings. The examiner should consider the following in evaluating the effect of Examiners should be aware of the Bank Secrecy interest-bearing deposit accounts on a bank’s Act when examining the deposit area and should earnings: follow up on any unusual activities or arrangements noted. The act was implemented by the • an estimated change in interest expense result- Treasury Department’s Financial Recordkeep- ing from a change in interest rates on deposit ing and Reporting of Currency and Foreign accounts or a shift in funds from one type of Transactions Regulation. For further informa- account to another tion, see the FFIEC Bank Secrecy Act Examina- • service-charge income tion Manual, section 208.63 of the Federal • projected operating costs Reserve’s Regulation H, and the Financial • changes in required reserves Crimes Enforcement Network (FinCEN)’s Bank • promotional and advertising costs Secrecy Act regulations at 31 CFR Chapter X. • the quality of management’s planning Prior to March 1, 2011, FINCEN’s regulation was at 31 CFR 103.

SPECIAL DEPOSIT-RELATED ISSUES Banking Hours and Processing of Demand Deposits The examiner should keep the following issues in mind during an examination to ensure the The Board’s Regulation CC (12 CFR 229), bank is in compliance, where applicable. ‘‘Availability of Funds and Collection of Checks,’’ and the Uniform Commercial Code (UCC) govern banking-day cutoff hours and the processing Abandoned-Property Law of deposits. A ‘‘banking day’’ is that part of a day on which an ofﬁce of the bank is open to the State abandoned-property laws generally are public for carrying out substantially all of its called escheat laws. Although escheat laws vary banking functions. Saturdays, Sundays, and cer- from state to state, they normally require a bank tain speciﬁed holidays are not banking days to remit the proceeds of any deposit account to under Regulation CC, although such days might the state treasurer when— be banking days under the UCC if a bank is open for substantially all of its functions on • the deposit account has been dormant for a those days. certain number of years and Regulation CC requires a bank to make • the owner of the account cannot be located. deposited funds available for withdrawal within a certain period after the banking day on which Service charges on dormant accounts should they are received. Cash deposits, wire transfers, bear a direct relationship to the cost of servicing and certain check deposits that pose little risk to the accounts, which ensures that the charges are the depositary bank (such as Treasury checks not excessive. A bank’s board of directors (or a and cashier’s checks) generally are to be made committee appointed by the board) should review available for withdrawal by the business day

April 2016 Commercial Bank Examination Manual Page 2 Deposit Accounts 3000.1 after the day of deposit. The time when the The joint interagency statement advises bank- depositary bank must make other check deposits ing organizations that the decision to accept or available for withdrawal depends on whether the reject an embassy or foreign government account check is local or nonlocal to the depositary bank. is theirs alone to make. The statement advises As of September 1, 1990, proceeds of local and that financial institutions should be aware that nonlocal checks must be available for with- there are varying degrees of risk associated with drawal by the second and fifth business day such accounts, depending on the customer and following deposit, respectively. However, Regu- the nature of the services provided. Institutions lation CC allows a bank to set, within certain should take appropriate steps to manage such limits, cutoff hours, after which the bank will risks consistent with sound practices and appli- deem funds to be received on the next banking cable anti-money-laundering laws and regula- day for purposes of calculating the availability tions. The advisory also encourages banking date (12 CFR 229.19). Different cutoff-hour organizations to direct questions about embassy limits apply to different types of deposits. banking to their primary federal bank regulators. For the purpose of allowing banks to process (See SR-04-10.) checks, the UCC provides that a bank may set a On March 24, 2011, an interagency advisory cutoff hour of 2 p.m. or later and that items was issued to supplement SR-04-10, ‘‘Banking received after that time will be considered Accounts for Foreign Governments, Embassies, received as of the next banking day (UCC and Political Figures.’’ The supplemental advi- section 4-108). Under both the UCC and Regu- sory provides information to financial institu- lation CC, both the banking day on which a bank tions regarding the provision of account services is deemed to have received a check and the to foreign embassies, consulates and to foreign cutoff hour affect the time frames within which missions in a manner that fulfills the needs of a bank must send the check through the forward- those foreign governments while complying collection and return processes. with the provisions of the Bank Secrecy Act A bank that fails to set its cutoff hour appro- (BSA). It advises that financial institutions are priately, does not make funds available within expected to demonstrate the capacity to conduct the appropriate time frames, or processes checks appropriate risk assessments and implement the in an untimely manner may be subject to civil requisite controls and oversight systems to effec- liability for not performing its duties in accor- tively manage the risk identified in these rela- dance with various provisions of Regulation CC tionships with foreign missions. The advisory and the UCC. also confirms that it is the financial institution’s decision to accept or reject a foreign mission account. (See SR-11-6 and the attached supplemental interagency advisory.) Banking Accounts for Foreign Governments, Embassies, Missions, and Political Figures Interagency Advisory on Accessing Accounts from Foreign Governments, On June 15, 2004, an interagency advisory Embassies, and Foreign Political Figures concerning the embassy banking business and related banking matters was issued by the fed- The 2004 interagency advisory answers ques- eral banking and thrift agencies (the Board of tions on whether financial institutions should Governors of the Federal Reserve System, the conduct business with foreign embassies and Federal Deposit Insurance Corporation, the whether institutions should establish account Office of the Comptroller of the Currency, the services for foreign governments, foreign embas- Office of Thrift Supervision, and the National sies, and foreign political figures. As it would Credit Union Administration (the agencies)). with any new account, an institution should The advisory was issued in coordination with evaluate whether or not to accept a new account the U.S. Department of the Treasury’s Financial for a foreign government, embassy, or political Crimes Enforcement Network. The purpose of figure. That decision should be made by the the advisory is to provide general guidance to institution’s management, under standards and banking organizations regarding the treatment guidelines established by the board of directors, of accounts for foreign governments, foreign and should be based on the institution’s own embassies, and foreign political figures. business objectives, its assessment of the risks

Commercial Bank Examination Manual April 2011 Page 3 3000.1 Deposit Accounts associated with particular accounts or lines of Foreign-Currency Deposits business, and its capacity to manage those risks. The agencies will not, in the absence of extraor- Domestic depository institutions are permitted dinary circumstances, direct or encourage any to accept deposits denominated in foreign cur- institution to open, close, or refuse a particular rency. Institutions should notify customers that account or relationship. such deposits are subject to foreign-exchange risk. The bank should convert such accounts to Providing financial services to foreign gov- the U.S. dollar equivalent for purposes of report- ernments and embassies and to foreign political ing to the Federal Reserve. Examination staff figures can, depending on the nature of the should ascertain that all reports are in order and customer and the services provided, involve should evaluate the bank’s use of such funds and varying degrees of risk. Such services can range its management of the accompanying foreign- from account relationships that enable an exchange risk. Accounts denominated in foreign embassy to handle the payment of operational currency are not subject to the requirements of expenses, for example, payroll, rent, and utili- Regulation CC. (See SR-90-03 (IB), ‘‘Foreign ties, to ancillary services or accounts provided to (Non–U.S.) Currency Denominated Deposits embassy staff or foreign government officials. Offered at Domestic Depository Institutions.’’) Each of these relationships potentially poses different levels of risk. Institutions are expected to assess the risks involved in any such relationships and to take steps to ensure both that such International Banking Facilities risks are appropriately managed and that the An international banking facility (IBF) is a set institution can do so in full compliance with its of asset and liability accounts segregated on the obligations under the BSA, as amended by the books of a depository institution. IBF activities USA Patriot Act, and the regulations promul- are essentially limited to accepting deposits gated thereunder. from and extending credit to foreign residents When an institution elects to establish finan- (including banks), other IBFs, and the institu- cial relationships with foreign governments, tions establishing the IBF. IBFs are not required embassies, or foreign political figures, the agen- to maintain reserves against their time deposits cies, consistent with their usual practice of or loans. The examiner should follow the special risk-based supervision, will make their own examination procedures in the international sec- assessment of the risks involved in such busi- tion of this manual when examining an IBF. ness. As is the case with all accounts, the institution should expect appropriate scrutiny by examiners that is commensurate with the level of risk presented by the account relationship. As Deposits Insured by the Federal in any case where higher risks are presented, the Deposit Insurance Corporation institution should expect an increased level of review by examiners to ensure that the institu- The Federal Deposit Insurance Corporation tion has in place controls and compliance over- (FDIC) is an independent agency of the U.S. sight systems that are adequate to monitor and government. The FDIC protects depositors manage such risks, as well as personnel trained against the loss of their insured deposits due to in the management of such risks and in the the failure of an insured bank, savings bank, requirements of applicable laws and regulations. savings association, insured branch of a foreign Institutions that have or are considering tak- bank, or other depository institution whose ing on relationships with foreign governments, deposits are insured pursuant to the Federal embassies, or political figures should ensure that Deposit Insurance Corporation Act. If a deposi- such customers are aware of the requirements of tor’s accounts at one FDIC-insured depository U.S. laws and regulations to which the institu- institution total up to $250,000 (or the standard tion is subject. Institutions should, to the maxi- maximum deposit insurance amount [SMDIA]), mum extent feasible, seek to structure such the funds are fully insured and protected. A relationships in order to conform them to con- depositor can have more than the SMDIA at one ventional U.S. domestic banking relationships so insured depository institution and still be fully as to reduce the risks that might be presented by insured provided the accounts meet certain such relationships. requirements. In addition, federal law currently

April 2011 Commercial Bank Examination Manual Page 4 Deposit Accounts 3000.1 provides for insurance coverage of up to accounts,3 and any plan described in section $250,000 or the SMDIA. 401(d) of the IRC, to the extent that participants The FDIC insurance covers all types of depos- and beneficiaries under such plans have a right its received at an insured depository institution, to direct the investment of assets held in indi- including deposits in checking, negotiable order vidual accounts maintained on their behalf by of withdrawal (NOW), and savings accounts; the plans. money market deposit accounts; and time depos- Third, the Reform Act provided per-participant its such as certificates of deposit (CDs). FDIC insurance coverage to employee benefit plan deposit insurance covers the balance of each accounts, even if the depository institution at depositor’s account, dollar-for-dollar, up to the which the deposits are placed is not authorized SMDIA, including the principal and any accrued to accept employee benefit plan deposits. The interest through the date of an insured deposi- cost-of-living adjustment is to be calculated tory institution’s closing. according to the Personal Consumption Expen- Deposits in separate branches of an insured ditures Chain-type Price Index published by the depository institution are not separately insured. U.S. Department of Commerce and rounded Deposits in one insured institution are insured down to the nearest $10,000. separately from deposits in another insured insti- The Conforming Amendments Act created tution. Deposits maintained in different catego- the term government depositor in connection ries of legal ownership at the same depository with public funds described in and insured institution can be separately insured. Therefore, pursuant to section 11(a)(2) of the Federal it is possible to have deposits of more than the Deposit Insurance Act (FDIA). (See 12 USC SMDIA at one insured institution and still be 1821(a)(2).) The Conforming Amendments Act fully insured. provides that the deposits of a government depositor are insured in an amount up to the SMDIA, subject to the inflation adjustment Deposit Insurance Reform Acts described previously.

On March 14, 2006, the FDIC amended its deposit insurance regulations (effective April 1, Deposit Insurance Rule Amendments 2006) by issuing an interim rule with a request Retirement and Employee Benefit Plan for public comment on or before May 22, 2006. Accounts (See 71 Fed. Reg. 14631, 71 Fed. Reg. 53550 (Sept. 12, 2006) and 12 CFR Part 330.) The When deposits from a retirement or employee interim rule implemented applicable revisions to benefit plan (EBP)—such as a 401(k) retirement the Federal Deposit Insurance Act made by the account, Keogh plan account, corporate pension Federal Deposit Insurance Reform Act of 2005 plan, or profit-sharing program—are entitled to (Reform Act) and the Federal Deposit Insurance pass-through insurance, the SMDIA on FDIC Reform Conforming Amendments Act of 2005 insurance does not apply to the entire EBP (the Conforming Amendments Act). The Reform account balance. Rather, the FDIC insurance Act provided for consideration of inflation adjust- coverage ‘‘passes through’’ to each owner or ments (cost-of-living adjustment) to increase the beneficiary, and the deposited funds of each current SMDIA on a five-year cycle beginning individual EBP participant are insured up to the on April 1, 2010. SMDIA. Second, the Reform Act increased the deposit The Reform Act and the Conforming Amend- insurance limit for accounts up to $250,000, also ments Act, and the FDIC’s March 23, 2006, subject to inflation adjustments. The types of interim rule eliminated the previous requirement accounts included are individual retirement that pass-through coverage for employee benefit accounts (IRAs),1 eligible deferred compensa- plan accounts be dependent on the capital level tion plan accounts,2 and individual account plan of a depository institution where such deposits are placed. Pass-through coverage for employee benefit plan deposits was not available if the 1. IRAs described in section 408(a) of the Internal Revenue Code (IRC). (See 26 USC 408(a).) 3. Individual account plan accounts such as those defined 2. Eligible deferred compensation plan accounts described in section 3(34) of the Employee Retirement Income Security in section 457 of the IRC. (See 26 USC 457.) Act.

Commercial Bank Examination Manual April 2011 Page 5 3000.1 Deposit Accounts deposits were placed with an institution that was all deposits that are not transaction accounts, not permitted to accept brokered deposits because such as (1) savings deposits, that is, money of the capital requirements. Insured institutions market deposit accounts and other savings depos- that are not ‘‘well capitalized’’ or ‘‘adequately its, and (2) time deposits, that is, time certifi- capitalized’’ are now prohibited by the Reform cates of deposit and time deposits, open account. Act from accepting employee benefit plan depos- See Regulation D for specific definitions of the its. Under the Reform Act, employee benefit various deposit accounts. plan deposits accepted by an insured depository institution, even those prohibited from accepting such deposits, are nonetheless eligible for pass- Treasury Tax and Loan Accounts through deposit insurance coverage. The rule’s amendment (see 12 CFR 330.14) applies to all Member banks may select either the ‘‘remittance- employee benefit plan deposits, including em- option’’ or the ‘‘note-option’’ method to forward ployee benefit plan deposits placed before April deposited funds to the U.S. Treasury. With the 1, 2006. The rule’s other requirements in section remittance option, the bank remits the Treasury 330.14 continue to apply. In particular, only the Tax and Loan (TT&L) account deposits to the ‘‘noncontingent’’ interests of plan participants in Federal Reserve Bank the next business day an applicable plan are eligible for pass-through after deposit. The remittance portion is not coverage. A ‘‘noncontingent interest’’ is an interest-bearing. interest that can be determined without the The note option permits the bank to retain the evaluation of contingencies other than life expec- TT&L deposits. With the note option, the bank tancy. The maximum coverage for accounts is debits the TT&L remittance account for the up to $250,000 or the SMDIA. These accounts amount of the previous day’s deposit and simul- continue to be made up of individual retirement taneously credits the note-option account. Thus, accounts (the traditional IRAs and the Roth TT&L funds are now purchased funds evi- IRAs); section 457 deferred compensation plan denced by an interest-bearing, variable-rate, accounts, ‘‘self-directed’’ Keogh plan accounts open-ended, secured note callable on demand by (or HR 10 accounts); and ‘‘self-directed’’ defined Treasury. Rates paid are 1⁄4 of 1 percent less than contribution plan accounts, which are primarily the average weekly rate on federal funds. Inter- 40l(k) plan accounts. The term self-directed est is calculated on the weekly average daily means that the plan participants have the right to closing balance in the TT&L note-option account. direct how their funds are invested, including Although there is no required maximum note- the ability to direct that the funds be invested at option ceiling, banks may establish a maximum an FDIC-insured institution. balance by providing written notice to the Fed- eral Reserve Bank. As per 31 CFR 203.24, the TT&L balance requires the bank to pledge collateral to secure these accounts, usually from Reserve Requirements its investment portfolio. The note option is not included in reserve-requirement computations The Monetary Control Act of 1980 and the and is not subject to deposit insurance because it Federal Reserve’s Regulation D, ‘‘Reserve is classified as a demand note issued to the U.S. Requirements of Depository Institutions,’’ estab- Treasury, a type of borrowing. lish two categories of deposits for reserve- requirement purposes. The first category is the transaction account, which represents a deposit or account from which the depositor or account POTENTIAL PROBLEM AREAS holder is permitted to make orders of withdrawals by negotiable instrument, payment orders of The following types of deposit accounts and withdrawal, telephone transfer, or similar devices related activities have above-average risk and, for making payments to a third party or others. therefore, require the examiner’s special Transaction accounts include demand deposits, attention. NOW accounts, automatic transfer (ATS) accounts, and telephone or preauthorized transfer accounts. The second category is the non- transaction deposit account, which includes

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Bank-Controlled Deposit Accounts loss. The risk lies in inefficiency or misuse if the accounts become overdrawn or if funds are Bank-controlled deposit accounts, such as sus- diverted for other purposes, such as the payment pense, official checks, cash-collateral, dealer of principal or interest on bank loans. Funds reserves, and undisbursed loan proceeds, are deposited to these accounts should be used only used to perform many necessary banking func- for their stated purposes. tions. However, the absence of sound administrative policies and adequate internal controls can cause significant loss to the bank. To ensure Brokered Deposits that such accounts are properly administered and controlled, the directorate must ensure that As defined in Federal Deposit Insurance Corpo- operating policies and procedures are in effect ration (FDIC) regulations, brokered deposits are that establish acceptable purpose and use; funds a depository institution obtains, directly or appropriate entries; controls over posting indirectly, from or through the mediation or entries; and the length of time an item may assistance of a deposit broker, for deposit into remain unrecorded, unposted, or outstanding. one or more deposit accounts (12 CFR 337.6). Internal controls that limit employee access to Thus, brokered deposits include both those in bank-controlled accounts, determine the respon- which the entire beneficial interest in a given sibility for frequency of reconcilement, discour- bank deposit account or instrument is held by a age improper posting of items, and provide for single depositor and those in which the deposit periodic internal supervisory review of account broker pools funds from more than one investor activity are essential to efficient deposit for deposit in a given bank deposit account. administration. Section 29 of the Federal Deposit Insurance The deposit suspense account is used to Act (the FDI Act) (12 USC 1831f(g)(1)) and the process unidentified, unposted, or rejected items. FDIC’s regulations (12 CFR 337.6 (a)(5)) define Characteristically, items posted to such accounts deposit broker to mean— clear in one business day. The length of time an item remains in control accounts often reflects • any person engaged in the business of placing on the bank’s operational efficiency. This deposit deposits, or facilitating the placement of depos- type has a higher risk potential because the its, of third parties with insured depository transactions are incomplete and require manual institutions or the business of placing deposits processing to be completed. As a result of the with insured depository institutions for the need for human interaction and the exception purpose of selling interests in those deposits to nature of these transactions, the possibility of third parties; and misappropriation exists. • an agent or a trustee who establishes a deposit Official checks, a type of demand deposit, account to facilitate a business arrangement include bank checks, cashier’s checks, expense with an insured depository institution to use checks, interest checks, dividend-payment the proceeds of the account to fund a prear- checks, certified checks, money orders, and ranged loan. traveler’s checks. Official checks reflect the bank’s promise to pay a specified sum upon The term deposit broker does not include — presentation of the bank’s check. Because accounts are controlled and reconciled by bank • an insured depository institution, with respect personnel, it is important that appropriate inter- to funds placed with that depository institution; nal controls are in place to ensure that account • an employee of an insured depository institu- reconcilement is segregated from check origination, with respect to funds placed with the tion. Operational inefficiencies, such as unre- employing depository institution; corded checks that have been issued, can result • a trust department of an insured depository in a significant understatement of the bank’s institution, if the trust or other fiduciary rela- liabilities. Misuse of official checks may result tionship in question has not been established in substantial losses through theft. for the primary purpose of placing funds with Cash-collateral, dealer differential or reserve, insured depository institutions; undisbursed loan proceeds, and various loan • the trustee of a pension or other employee escrow accounts are also sources of potential benefit plan, with respect to funds of the plan;

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• a person acting as a plan administrator or an large amounts of funds through the issuance of investment adviser in connection with a pen- insured obligations undercuts market discipline. sion plan or other employee benefit plan The use of brokered deposits by sound, provided that person is performing managerial well-managed banks can play a legitimate role in functions with respect to the plan; the asset-liability management of a bank and • the trustee of a testamentary account; enhance the efficiency of financial markets. 4 • the trustee of an irrevocable trust, as long as However, the use of brokered deposits also can the trust in question has not been established contribute to the weakening of a bank by for the primary purpose of placing funds with allowing it to grow at an unmanageable or insured depository institutions; imprudent pace and can exacerbate the condition • a trustee or custodian of a pension or profit- of a troubled bank. Consequently, without proper sharing plan qualified under section 401(d) or monitoring and management, brokered and other 403(a) of the Internal Revenue Code of 1986 highly rate-sensitive deposits, such as those (26 USC 401(d), 503(a)); or obtained through the Internet, certificate of • an agent or a nominee whose primary purpose deposit (CD) listing services, and similar adver- is not the placement of funds with depository tising programs, may be unstable sources of institutions; or funding for an institution. • an insured depository institution acting as an intermediary or agent of a U.S. government Deposits attracted over the Internet, through department or agency for a government- CD listing services, or through special advertis- sponsored minority or women-owned deposi- ing programs offering premium rates to custom- tory institution deposit program. ers without another banking relationship, require special monitoring. Although these deposits may A small- or medium-sized bank’s dependence not fall within the technical definition of ‘‘bro- on the deposits of customers who reside or kered’’ in 12 USC 1831f and 12 CFR 337.6, conduct their business outside of the bank’s their inherent risk characteristics are similar to normal service area should be closely monitored brokered deposits. That is, such deposits are by the bank and analyzed by the examiner. Such typically attractive to rate-sensitive customers deposits may be the product of personal rela- who may not have significant loyalty to the tionships or good customer service; however, bank. Extensive reliance on funding products of large out-of-area deposits are sometimes attracted this type, especially those obtained from outside by liberal credit accommodations or signifi- a bank’s geographic market area, has the poten- cantly higher interest rates than competitors tial to weaken a bank’s funding position. offer. Deposit growth that is due to liberal credit Some banks have used brokered and Internet- accommodations generally proves costly in terms based funding to support rapid growth in loans of the credit risks taken relative to the benefits and other assets. In accordance with the safety- received from corresponding deposits, which and-soundness standards, a bank’s asset growth may be less stable. Banks outside dynamic should be prudent and its management must metropolitan areas are limited in growth because consider the source, volatility, and use of the they usually can maintain stable deposit growth funds generated to support asset growth. (See 12 only as a result of prudent reinvestment in the CFR 208 appendix D-1.) bank’s service area. Deposit development and To compensate for the high rates typically retention policies should recognize the limits offered for brokered deposits, institutions hold- imposed by prudent competition and the bank’s ing them tend to seek assets that carry commen- service area. surately high yields. These assets can often Historically, most banking organizations have involve excessive credit risk or cause the bank not relied on funds obtained through deposit to take on undue interest-rate risk through a brokers to supplement their traditional funding mismatch in the maturity of assets and liabili- sources. A concern regarding the activities of ties. The FDI Act (12 USC 1831f) includes deposit brokers is that the ready availability of certain restrictions on the use of brokered deposits to prohibit undercapitalized insured depository institutions from accepting funds obtained, 4. This exception does not apply to an agent or a trustee directly or indirectly, by or through any deposit who establishes a deposit account to facilitate a business arrangement with an insured depository institution to use the broker for deposit into one or more deposit proceeds of the account to fund a prearranged loan. accounts.

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Capital Categories • does not meet the definition of a well capitalized bank. For the purposes of section 29 of the FDI Act, the regulations of the FDIC and the Federal An adequately capitalized insured depository Reserve (for the FDIC, 12 CFR 325.103 and for institution may not accept, renew, or roll over the Federal Reserve, 12 CFR 208.43) provide any brokered deposit unless it has applied for the definitions of well-capitalized, adequately and been granted a waiver of this prohibition by capitalized, and undercapitalized financial insti- the FDIC. If the insured depository institution tutions (banks). These definitions are tied to has been granted a waiver by the FDIC, the percentages of leverage and risk-based capital. institution may accept, renew, or roll over a Section 29 of the FDI Act limits the rates of brokered deposit. The institution may not pay an interest on brokered deposits that may be offered effective yield on the deposit that exceeds, by by insured depository institutions that are more than 75 basis points: (1) the effective yield adequately capitalized or undercapitalized. paid on deposits of comparable size and maturity, and for deposits accepted, within the institution’s normal market area5 or (2) the ‘‘national Well-capitalized bank. A bank is deemed to be rate’’ paid on deposits of comparable size and well capitalized if it— maturity for deposits accepted outside the institution’s normal market area. The national rate is • has a total risk-based capital ratio of 10.0 either 120 or 130 basis points of the current percent or greater; yield on similar-maturity U.S. Treasury obliga- • has a tier 1 risk-based capital ratio of 6.0 tions, depending on whether the deposit is FDIC percent or greater; insured or more than half uninsured (the portion • has a leverage ratio of 5.0 percent or greater; of the deposit that is in excess of the FDIC- and insured limit, as detailed in the rule). • is not subject to any written agreement, order, If an FDIC-insured bank is adequately capi- capital directive, or prompt-corrective-action talized and does not have a waiver from the directive issued by the Board pursuant to FDIC, it may not use a broker to obtain deposits. section 8 of the FDI Act (12 USC 1818), the The following rate restrictions on deposits also International Lending Supervision Act of 1983 apply: (1) the deposit rates may be no more than (12 USC 3907), or section 38 of the FDI Act 75 basis points over the effective yield on (12 USC 1831o), or any regulation thereunder, deposits of comparable size and maturity within to meet and maintain a specific capital level the bank’s normal market area and (2) the for any capital measure. deposit rates may not be based on a ‘‘national’’ rate. A well-capitalized insured depository institution may solicit and accept, renew, or roll over any Undercapitalized bank brokered deposit without restriction. . A bank is deemed to be undercapitalized if it—

Adequately capitalized bank. A bank is • has a total risk-based capital ratio that is less deemed to be adequately capitalized if it— than 8.0 percent; • has a tier 1 risk-based capital ratio that is less • has a total risk-based capital ratio of 8.0 per- than 4.0 percent; cent or greater; • has a leverage ratio that is less than 4.0 per- 6 • has a tier 1 risk-based capital ratio of 4.0 percent; or cent or greater; • has a leverage ratio that is less than 3.0 per- • has— — a leverage ratio of 4.0 percent or greater or 5. For deposits obtained through Internet solicitations, the determination of the bank’s ‘‘normal market area’’ is particu- — a leverage ratio of 3.0 percent or greater if larly problematic and difficult. the bank is rated composite 1 under the 6. An exception is available when (1) the bank the (the CAMELS rating system in the most recent insured depository institution) has a leverage ratio of 3.0 examination of the bank and is not expe- percent or greater, (2) the bank is rated composite 1 under the CAMELS rating system following its most-recent bank exami- riencing or anticipating significant growth; nation, and (3) the bank is not experiencing or anticipating and significant growth.

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cent, if the bank is rated composite 1 under the Risk-Management Expectations for CAMELS rating system in the most recent Brokered Deposits examination of the bank and is not experiencing or anticipating significant growth. On May 11, 2001, the Federal Reserve Board and the other federal banking agencies (the agencies) An undercapitalized insured depository institu- issued a Joint Agency Advisory on Brokered and tion may not accept, renew, or roll over any Rate-Sensitive Deposits. The advisory sets forth brokered deposit. Also, an undercapitalized the following risk-management guidelines for insured depository institution (and any employee brokered deposits. The bank’s management is of the institution) may not solicit deposits by expected to implement risk-management sys- offering an effective yield that exceeds by more tems that are commensurate in complexity with than 75 basis points the prevailing effective the liquidity and funding risks that the bank yields on insured deposits of comparable matu- undertakes. (See SR-01-14.) Such systems should rity in the institution’s normal market area or in incorporate the following principles: the market area in which such deposits are being solicited. • Proper funds-management policies. A good policy should generally provide for forward Each examination should include a review for planning, establish an appropriate cost struc- compliance with the FDIC’s limitations on the ture, and set realistic limitations and business acceptance of brokered deposits and guidelines strategies. It should clearly convey the board’s on interest payments. The use of brokered depos- risk tolerance and should not be ambiguous its should be reviewed during all on-site exami- about who holds responsibility for funds- nations, even in those institutions not subject to management decisions. the FDIC’s restrictions. Given the potential risks involved in using brokered deposits, the exami- • Adequate due diligence when assessing deposit nation should focus on the— brokers. Bank management should implement adequate due diligence procedures before • rate of growth and the credit quality of the entering any business relationship with a loans or investments funded by brokered deposit broker. The agencies do not regulate deposits; deposit brokers. • corresponding quality of loan files, documentation, and customer credit information; • Due diligence in assessing the potential risk to earnings and capital associated with brokered • ability of bank management to adequately or other rate-sensitive deposits, and prudent evaluate and administer these credits and strategies for their use. Bankers should man- manage the resulting growth; age highly sensitive funding sources carefully, avoiding excessive reliance on funds that may • degree of interest-rate risk involved in the be only temporarily available or which may funding activities and the existence of a pos- require premium rates to retain. sible mismatch in the maturity or rate sensitivity of assets and liabilities; • Reasonable control structures to limit funding • composition and stability of the deposit concentrations. Limit structures should con- sources and the role of brokered deposits in sider typical behavioral patterns for depositors the bank’s overall funding position and or investors and be designed to control exces- strategy; and sive reliance on any significant source(s) or type of funding. This includes brokered funds • effect of brokered deposits on the bank’s and other rate-sensitive or credit-sensitive financial condition and whether the use of deposits obtained through the Internet or other brokered deposits constitutes an unsafe and types of advertising. unsound banking practice. • Management information systems (MIS) that The examiner should identify relevant concerns clearly identify nonrelationship or higher-cost in the examination report when brokered depos- funding programs and allow management to its amount to 5 percent or more of the bank’s track performance, manage funding gaps, and total deposits. monitor compliance with concentration and

April 2011 Commercial Bank Examination Manual Page 10 Deposit Accounts 3000.1

other risk limits. At a minimum, MIS should tionship deposits and an aggressive growth include a listing of funds obtained through strategy each significant program, rates paid on each • inadequate internal audit coverage instrument and an average per program, infor- • inadequate information systems or controls mation on maturity of the instruments, and • identified or suspected fraud concentration or other limit monitoring and • high on- or off-balance-sheet growth rates reporting. Management also should ensure • use of rate-sensitive funds not in keeping with that brokered deposits are properly reported in the bank’s strategy the bank’s Consolidated Reports of Condition • inadequate consideration of risk, with man- and Income.7 agement focus exclusively on rates • significant funding shifts from traditional fund- • Contingency funding plans that address the ing sources risk that these deposits may not ‘‘roll over’’ • the absence of adequate policy limitations on and provide a reasonable alternative funding these kinds of funding sources strategy. Contingency funding plans should • high loan delinquency rate or deterioration in factor in the potential for changes in market other asset-quality indicators acceptance if reduced rates are offered on • deterioration in the general financial condition rate-sensitive deposits. The potential for trig- of the institution gering legal limitations that restrict the bank’s • other conditions or circumstances warranting access to brokered deposits under Prompt the need for administrative action Corrective Action (PCA) standards, and the effect that this would have on the bank’s liability structure, should also be factored into the plan. Check Kiting

Examiners should assess carefully the liquidity- Check kiting occurs when— risk management framework at all banks. Banks with meaningful reliance on brokered or other • a depositor with accounts at two or more rate-sensitive deposits should receive the appro- banks draws checks against the uncollected priate level of supervisory attention. Examiners balance at one bank to take advantage of the should not wait for PCA provisions to be trig- float—that is, the time required for the bank of gered or the viability of the bank to come into deposit to collect from the paying bank, and question, before raising relevant safety-and- • the depositor initiates the transaction with the soundness issues with regard to the use of these knowledge that sufficient collected funds will funding sources. If a determination is made that not be available to support the amount of the a bank’s use of these funding sources is not safe checks drawn on all of the accounts. and sound, or that these risks are excessive or that they adversely affect the bank’s condition, The key to this deceptive practice, the most then the examiner or central point of contact prevalent type of check fraud, is the ability to should recommend to the Reserve Bank man- draw against uncollected funds. However, draw- agement that it consider taking immediate appro- ing against uncollected funds in and of itself priate supervisory action. The following repre- does not necessarily indicate kiting. Kiting only sent potential red flags that may indicate the occurs when the aggregate amount of drawings need to take such action to ensure the risks exceeds the sum of the collected balances in all associated with brokered or other rate-sensitive accounts. Nevertheless, since drawing against funding sources are managed appropriately: uncollected funds is the initial step in the kiting process, management should closely monitor • ineffective management or the absence of this activity. The requirements of Regulation appropriate expertise CC, Availability of Funds and Collection of • a newly chartered institution with few rela- Checks, increased the risk of check kiting, and should be addressed in a bank’s policies and procedures. By allowing a borrower to draw against 7. See the FFIEC bank Call Report and Instructions for Consolidated Reports of Condition and Income, Schedule uncollected funds, the bank is extending credit RC-E—Deposit Liabilities. that should be subject to an appropriate approval

Commercial Bank Examination Manual April 2011 Page 11 3000.1 Deposit Accounts process. Accordingly, management should tices are conducted prudently. If undue or promptly investigate unusual or unauthorized undocumented credit risk is disclosed or if activity since the last bank to recognize check lending limits are exceeded, appropriate correc- kiting and pay on the uncollected funds suffers tive action should be taken. the loss. Check kiting is illegal and all suspected or known check kiting operations should be reported pursuant to established Federal Reserve policy. Banks should maintain internal controls Deposit Sweep Programs or to preclude loss from kiting, and the examiner Master-Note Arrangements should remember that in most cases kiting is not covered under Blanket Bond Standard Form 24. Deposit sweep programs or master-note arrangements (sweep programs) can be implemented on a bank level or on a parent bank holding company (BHC) level. On a bank level, these Delayed Disbursement Practices sweep programs exist primarily to facilitate the cash-management needs of bank customers, Although Regulation CC, Availability of Funds thereby retaining customers who might other- and Collection of Checks, stipulates time frames wise move their account to an entity offering for funds availability and return of items, delayed higher yields. On a BHC level, the sweep disbursement practices (also known as remote programs are maintained with customers at the disbursement practices) can present certain risks, bank level, and the funds are upstreamed to the especially concerning cashier’s checks, which parent as part of the BHC’s funding strategy. have next-day availability. Delayed disburse- Sweep programs use an agreement with the ment is a common cash management practice bank’s deposit customers (typically corporate that consists of arrangements designed to delay accounts) that permits these customers to rein- the collection and final settlement of checks by vest amounts in their deposit accounts above a drawing checks on institutions located substan- designated level in overnight obligations of the tial distances from the payee or on institutions parent bank holding company, another affiliate located outside the Federal Reserve cities when of the bank, or a third party. These obligations alternate and more efficient payment arrange- include instruments such as commercial paper, ments are available. Such practices deny deposi- program notes, and master-note agreements. tors the availability of funds to the extent that (See SR-90-31.) funds could otherwise have been available ear- The disclosure agreement regarding the sale lier. A check drawn on an institution remote of the nondeposit debt obligations should include from the payee often results in increased possi- a statement indicating that these instruments are bilities of check fraud and in higher processing not federally insured deposits or obligations of and transportation costs for return items. or guaranteed by an insured depository institu- Delayed disbursement arrangements could tion. In addition, banks and their subsidiaries give rise to supervisory concerns because a bank that have issued or plan to issue nondeposit debt may unknowingly incur significant credit risk obligations should not market or sell these through such arrangements. The remote location instruments in any public area of the bank where of institutions offering delayed disbursement retail deposits are accepted, including any lobby arrangements often increases the collection time area of the bank. This requirement exists to for checks by at least a day. The primary risk is convey the impression or understanding that the payment against uncollected funds, which could purchase of such obligations by retail depositors be a method of extending unsecured credit to a of the subsidiary bank can, in the event of depositor. Absent proper and complete docu- default, result in losses to individuals who mentation regarding the creditworthiness of the believed they had acquired federally insured or depositor, paying items against uncollected funds guaranteed obligations. could be considered an unsafe or unsound banking practice. Furthermore, such loans, even if Bank Policies and Procedures properly documented, might exceed the bank’s legal lending limit for loans to one customer. Banking organizations with sweep programs Examiners should routinely review a bank’s should have adequate policies, procedures, and practices in this area to ensure that such prac- internal controls in place to ensure that the

April 2011 Commercial Bank Examination Manual Page 12 Deposit Accounts 3000.1 activity is conducted in a manner consistent with Funding Strategies safe and sound banking principles and in accordance with all banking laws and regulations. A key principle underlying the Federal Reserve’s Bank policies and procedures should further supervision of banking organizations is that ensure that deposit customers participating in a BHCs operate in a way that promotes the sweep program are given proper disclosures and soundness of their subsidiary banks. BHCs are information. When a sweep program is used as expected to avoid funding strategies or practices part of a funding strategy for a BHC or a that could undermine public confidence in the nonbank affiliate, examiners should ensure that liquidity or stability of their banks. Any funding liquidity and funding strategies are carried out in strategy should maintain an adequate degree of a prudent manner. liquidity at both the parent level and the subsidiary bank level. Bank management should avoid, to the extent possible, allowing sweep programs Application of Deposit Proceeds to serve as a source of funds for inappropriate uses at the BHC or at an affiliate. Concerns exist In view of the extremely short-term maturity of in this regard because funding mismatches can most swept funds, banks and BHCs are expected exacerbate an otherwise manageable period of to exercise great care when investing the pro- financial stress and, in the extreme, undermine ceeds. Banks, from whom deposit funds are public confidence in a banking organization’s swept, have a fiduciary responsibility to their viability. customers to ensure that such transactions are conducted properly. Appropriate uses of the proceeds of deposit sweep funds are limited to Funding Programs short-term bank obligations, short-term U.S. government securities, or other highly liquid, In developing and carrying out funding pro- readily marketable, investment-grade assets that grams, BHCs should give special attention to can be disposed of with minimal loss of princi- the use of overnight or extremely short-term pal.8 When deposit sweep funds are invested in liabilities, since a loss of confidence in the U.S. government securities, appropriate agree- issuing organization could lead to an immediate ments must be in place, required disclosures funding problem. Thus BHCs relying on over- must be made, and daily confirmations must be night or extremely short-term funding sources provided to the customer in accordance with the should maintain a sufficient level of superior- requirements of the Government Securities Act quality assets (at a level at least equal to the of 1986. Use of such proceeds to finance mis- amount of the funding sources’) that can be matched asset positions, such as those involving immediately liquidated or converted to cash leases, loans, or loan participations, can lead to with minimal loss. liquidity problems and are not considered appropriate. The absence of a clear ability to Dormant Accounts redeem overnight or extremely short-term liabilities when they become due should generally be A dormant account is one in which customer- viewed as an unsafe and unsound banking originated activity has not occurred for a prede- activity. termined period of time. Because of this inac- tivity, dormant accounts are frequently the target of malfeasance and should be carefully con- 8. Some banking organizations have interpreted language trolled by a bank. Bank management should in a 1987 letter signed by the secretary of the Board as condoning funding practices that may not be consistent with establish standards that specifically outline the the principles set forth in a subsequent supervisory letter dated bank’s policy for the effective control of dor- September 21, 1990, as well as with prior Board rulings. The mant accounts, addressing— 1987 letter involved a limited set of facts and circumstances that pertained to a particular banking organization; it did not establish or revise Federal Reserve policies on the proper use • the types of deposit categories that could of the proceeds of short-term funding sources. In any event, contain dormant accounts, including demand, banking organizations should no longer rely on the 1987 letter savings, and official checks; to justify the manner in which they use the proceeds of sweep • the length of time without customer-originated programs. Banking organizations employing sweep programs are expected to ensure that these programs conform with the activity that qualifies an account to be identi- policies in this manual section. fied as dormant;

Commercial Bank Examination Manual April 2011 Page 13 3000.1 Deposit Accounts

• the controls exercised over the accounts and Payable-Through Accounts their signature cards, that is, prohibiting release of funds by a single bank employee; A payable-through account is an accommoda- and tion offered to a correspondent bank or other • the follow-up by the bank when ordinary bank customer by a U.S. banking organization whereby mailings, such as account statements and drafts drawn against client subaccounts at the advertising ﬂyers, are returned to the bank correspondent are paid upon presentation by the because of changed addresses or other reasons U.S. banking institution. The subaccount holders for failure to deliver. of the payable-through bank are generally non– U.S. residents or owners of businesses located outside of the United States. Usually the con- Employee Deposit Accounts tract between the U.S. banking organization and the payable-through bank purports to create a Historically, examiners have discovered various contractual relationship solely between the two irregularities and potential malfeasance through parties to the contract. Under the contract, the review of employee deposit accounts. As a payable-through bank is responsible for screen- result, bank policy should establish standards ing subaccount holders and maintaining ade- that segregate or specially encode employee quate records with respect to such holders. The accounts and should encourage periodic internal examiner should be aware of the potential effect supervisory review. In light of these concerns, of money laundering. examiners should review related bank procedures and practices, taking appropriate measures when warranted. Public Funds

Overdrafts Public funds generally represent deposits of the U.S. government, as well as state and political The size, frequency, and duration of deposit- subdivisions, and typically require collateral in account overdrafts are matters that should be the form of securities to be pledged against governed by bank policy and controlled by them. A bank’s reliance upon public funds can adequate internal controls, practices, and cause potential liquidity concerns if the aggre- procedures. Overdraft authority should be gate amount, as a percentage of total deposits, is approved in the same manner as lending author- material relative to the bank’s asset-liability ity and should never exceed the employee’s management practices. Another factor that can lending authority. Systems for monitoring and cause potential liquidity concerns relates to the reporting overdrafts should emphasize a second- volatile nature of these deposits. ary level of administrative control that is This volatility occurs because the volume of distinct from other lending functions so account public funds normally fluctuates on a seasonal officers who are less than objective do not allow basis due to timing differences between tax influential customers to exploit their overdraft collections and expenditures. A bank’s ability to privileges. A bank’s payment of overdrafts of attract public funds is typically based upon the executive officers and directors of the bank is government entity’s assessment of three key generally prohibited under Regulation O. (See points: 12 CFR 215.4(e).) It is the board of directors’ • the safety and soundness of the institution responsibility to review overdrafts as they with which the funds have been placed would any other extension of credit. Overdrafts • the yield on the funds being deposited outstanding for more than 60 days, lacking • that such deposits are placed with a bank that mitigating circumstances, should be considered can provide or arrange the best banking ser- for charge-off. See SR-05-3/CA-05-2 and sec- vice at the least cost tion 2130.1 on the February 18, 2005, Interagency Joint Guidance on Overdraft Additionally, banks that offer competitive inter- Protection Programs. est rates and provide collection, financial advisory, underwriting, and data processing services at competitive costs are frequently chosen as depositories. Public funds deposits acquired

April 2011 Commercial Bank Examination Manual Page 14 Deposit Accounts 3000.1 through political influence should be regarded as demand deposit account at the same bank used particularly volatile. As a result, an examiner to cover deficits or channel surplus funds should pay particular attention to assessing the relative to the ZBA; or volatility of such funds in conjunction with the • extended settlement, a cash-management review of liquidity. arrangement that does not require the corporate customer to provide same-day funds for payment of its checks. Zero-Balance Accounts Because checks are covered before the close Zero-balance accounts (ZBAs) are demand of business on the day they arrive, the bank’s deposit accounts used by a bank’s corporate exposure is not reflected in the financial state- customers through which checks or drafts are ment. The bank, however, assumes risk by received for either deposit or payment. The total paying against uncollected funds, thereby creat- amount received on any particular day is offset ing unsecured extensions of credit during the by a corresponding debit or credit to the account day (which is referred to as a daylight overdraft before the close of business to maintain the between the account holder and the bank). If balance at or near zero. ZBAs enable a corporate treasurer to effectively monitor cash receipts and these checks are not covered, an overdraft occurs, disbursements. For example, as checks arrive which will be reflected on the bank’s financial for payment, they are charged to a ZBA with the statement. understanding that funds to cover the checks The absence of prudent safeguards and a lack will be deposited before the end of the banking of full knowledge of the creditworthiness of day. Several common methods used to cover the depositor may expose the bank to large, checks include— unwarranted, and unnecessary risks. Moreover, the magnitude of unsecured credit risk may • wire transfers; exceed prudent limits. Examiners should rou- • depository transfer checks, a bank-prepared tinely review cash-management policies and payment instrument used to transfer money procedures to ensure that banks do not engage from a corporate account in one bank to in unsafe and unsound banking practices, mak- another bank; ing appropriate comments in the report of • concentration accounts, a separate corporate examination, as necessary.

Commercial Bank Examination Manual April 2011 Page 15 Deposit Accounts Examination Objectives Effective date November 2006 Section 3000.2

1. To determine if the policies, practices, pro- 4. To determine if bank officers and employees cedures, and internal controls regarding are operating in conformance with the bank’s deposit accounts are adequate. established guidelines. 2. To determine if the bank’s management 5. To evaluate the deposit structure and deter- implemented adequate risk-management sys- mine its characteristics and volatility. tems for brokered and rate-sensitive deposits 6. To determine the scope and adequacy of the that are commensurate with the liquidity and audit function. funding risks the bank has undertaken. 3. To determine if the bank’s policies, practices, 7. To determine compliance with applicable procedures, and internal controls (including laws and regulations. compliance oversight, management report- 8. To initiate corrective action when policies, ing, and staff training) for account relation- practices, procedures, or internal controls are ships involving foreign governments, foreign deficient, or when violations of laws or embassies, and foreign political figures (as regulations are noted. well as foreign-currency customer deposit accounts) are adequate for the varied risks posed by these accounts.

Commercial Bank Examination Manual November 2006 Page 1 Deposit Accounts Examination Procedures Effective date April 2012 Section 3000.3

1. Determine the scope of the examination of • matured certificates of deposit without the deposit-taking function. In so doing, an automatic renewal feature consider the findings of prior examinations, • large-balance report related work prepared by internal and b. For official checks: external auditors, deficiencies in internal • trial balance(s) controls noted within other bank functions, • exception list and the requirements of examiners assigned c. For savings accounts: to review the asset/liability management • trial balance and interest-rate risk aspects of the bank. • unposted items 2. If required by the scope, implement the • overdrafts ‘‘Deposit Accounts’’ internal control • dormant accounts questionnaire. • public funds 3. Test the deposit function for compliance • trust department funds with policies, procedures, and internal con- • large-balance report trols in conjunction with performing the d. For other time deposits: remaining examination procedures. Also, • trial balance(s) obtain a listing of any deficiencies noted in • large-balance report the latest internal or external audit review, • unposted items then determine if appropriate corrections • public funds have been made. • trust department funds 4. In conducting the examination, use avail- • money market accounts able bank copies of printouts plus transac- e. For certificates of deposit: tions journals or other visual media to • trial balance(s) minimize expense to the bank. However, if • unposted items copies of these reports are not available, • public funds determine what information is necessary to • certificates of $100,000 or more complete the examination procedures and • negotiable certificates of deposit request that information from the bank. • maturity reports Obtain or prepare, as applicable, the • matured certificates of deposit reports indicated below, which are used for f. For deposit sweep programs or master- a variety of purposes, including the note arrangements, list individually by assessment of deposit volatility and liquidity, deposit type and amount. the assessment of the adequacy of internal g. For brokered deposits, list individually controls, the verification of information on by deposit type, including amount and required regulatory reports, and the assess- rate. ment of loss. h. For bank-controlled accounts: a. For demand deposits and other transac- • reconcilement records for all such tion accounts: accounts • trial balance • names and extensions of individuals • overdrafts authorized to make entries to such accounts • unposted items • name and phone extension of recon- • nonsufficient-funds (NSF) report cilement clerk(s) • dormant accounts i. For the bank’s foreign-currency cus- • public funds tomer deposit accounts and the deposit • uncollected funds accounts for foreign governments, embassies, and political figures: • due to banks • list of accounts and currency type • trust department funds • list of currency transactions over • significant activity $10,000 for each account, and the • suspected kiting report copies of their Currency Transaction

Commercial Bank Examination Manual April 2012 Page 1 3000.3 Deposit Accounts: Examination Procedures

Report or its equivalent, since the pre- • officer-approval limits have been vious examination (See 31 CFR established, and 1010.330 and its examples.) • a formal system of review and approval • the most recent internal audit report is in effect. covering the review of those accounts, b. Determine whether the depository insti- the risks associated with the accounts, tution has an overdraft-protection pro- the internal controls over those gram and if it has adequate written poli- accounts, and the staff’s completion of cies and procedures to address the credit, the Currency Transaction Report operational, and other risks associated • the completed copies of the Report of with those programs. See the February Foreign (Non-U.S.) Currency Depos- 18, 2005, interagency Joint Guidance on its, Form 2915, that have been submit- Overdraft Protection Programs (SR-05- ted since the previous examination 3/CA-05-2). If the bank provides over- 5. Review the reconcilement of all types of draft protection, perform the following deposit accounts. Verify the balances to procedures: department controls and the general ledger. • Obtain a master list of all depositors a. Determine if reconciliation items are with formal overdraft protection. legitimate and if they clear within a • Obtain a trial balance indicating reasonable time frame. advances outstanding and compare it b. Retain custody of all trial balances until with the master list to ensure compli- items outstanding are resolved. ance with approved limits. 6. Review the reconciliation process for bank- • Cross-reference the trial balance or controlled accounts, such as official checks master list to examiner loan line sheets. and escrow deposits, by— • Review credit files on significant for- a. determining if reconciling items are mal agreements not cross-referenced legitimate and if they clear within a above. reasonable time frame; • Ascertain whether there is ongoing b. scanning activity in such accounts to monitoring of overdrafts to identify determine the potential for improper customers who may pose an undue diversion of funds for various uses, such credit risk to the bank. as— • Find out if the bank has incorporated into its overdraft-protection program • political contributions, prudent risk-management practices per- • loan payments (principal and interest), taining to account repayment and the or suspension of a customer’s overdraft- • personal use; and protection services when the customer c. determining if checks are being pro- does not satisfy repayment and eligi- cessed before their related credits. bility requirements. 7. Review the bank’s operating procedures • Determine whether overdrafts are prop- and reconciliation process relative to sus- erly and accurately reported according pense accounts. Determine if— to generally accepted accounting prin- a. the disposition process of unidentified ciples on the bank’s financial state- items is completed in a timely fashion; ments and on its Reports of Condition b. reports are generated periodically to and Income (Call Reports). Verify that inform management of the type, age, and overdrafts are reported as loans on the amount of items in such accounts; and Report of Condition. c. employees responsible for clearing • Verify the existence of the bank’s suspense-account items are not shifting loss-estimation procedures for over- the items between accounts. draft and fee balances. Determine if 8. Evaluate the effectiveness of the written the procedures are adequately rigorous policies and procedures and of manage- and if losses are properly accounted ment’s reporting methods regarding over- for as part of (1) the allowance for loan drafts and drawings against uncollected and lease losses (ALLL) or (2) the loss funds. allowance for uncollectible fees (alter- a. Concerning overdrafts, determine if— natively, the bank may recognize only

April 2012 Commercial Bank Examination Manual Page 2 Deposit Accounts: Examination Procedures 3000.3

that portion of earned fees estimated to loan line sheets; be collectible), if applicable.1 • review the credit files of depositors • When applicable, validate (1) whether with significant overdrafts, if avail- the bank’s overdraft commitments have able, or the credit files of depositors been assigned the correct conversion who frequently draw significant factor, (2) whether they are accurately amounts against uncollected funds, for risk- weighted by obligor, and (3) if those depositors not cross-referenced the commitment terms comply with in the preceding step; the risk-based capital guidelines. • request management to charge off over- • Determine whether the bank has drafts deemed to be uncollectible; and obtained assurances from its legal • submit a list of the following items to counsel that its overdraft-protection the appropriate examiner: program is fully compliant with all — overdrafts considered loss, indicat- applicable federal and state laws and ing borrower and amount regulations, including the Federal Trade — aggregate amounts overdrawn Commission Act. 30 days or more past due, for • When the bank contracts with third- inclusion in past-due statistics party vendors to do information tech- 9. Review the bank’s deposit development and nology work, determine if the bank retention policy, which is often included in conducted proper due diligence before the funds-management policy. entering into the contract and that it a. Determine if the policy addresses the followed the November 28, 2000, deposit structure and related interest guidance on the Risk Management of costs, including the percentages of time Outsourced Technology Services. (See deposits and demand deposits of— SR-00-17.) • individuals, c. Concerning drawings against uncol- • corporations, and lected funds, determine if— • public entities. • the uncollected-funds report reflects b. Determine if the policy requires periodic balances as uncollected until they are reports to management comparing the actually received; accuracy of projections with results. • management is comparing reports of c. Assess the reasonableness of the policy, significant changes in balances and and ensure that it is routinely reviewed activity volume with uncollected-funds by management. reports; 10. If a deposit sweep program or master-note • management knows the reasons why a arrangement exists, review the minutes of depositor is frequently drawing against the board of directors for approval of related uncollected funds; policies and procedures. • a reporting system to inform senior 11. For banks with deposit sweep programs or management of significant activity in master-note arrangements (sweep programs), the uncollected-funds area has been compare practices for adherence to approved instituted; and policies and procedures. Review the • appropriate employees clearly under- following: stand the mechanics of drawing against a. The purpose of the sweep program: Is it uncollected funds and the risks strictly a customer-accommodation trans- involved, especially in the area of action, or is it intended to fund certain potential check-kiting operations. assets at the holding company level or d. After completing steps 8.a., 8.b., and at an affiliate? Review funding trans- 8.c.— actions in light of liquidity and fund- • cross-reference overdraft and ing needs of the banking organization by uncollected-funds reports to examiner referring to section 4020.1. b. The eligibility requirements used by the bank to determine the types of customers 1. Institutions may charge off uncollectible overdraft fees and accounts that may participate in a against the ALLL if such fees are recorded with overdraft balances as loans and if estimated credit losses on the fees are sweep program, including— provided for in the ALLL. • a list of customers participating in

Commercial Bank Examination Manual April 2012 Page 3 3000.3 Deposit Accounts: Examination Procedures

sweep programs, with dollar amounts the confirmation confirms specific of deposit funds swept on the date of securities. If any other securities are examination, and substituted that result in a change of • the name of the recipient(s) of swept issuer, maturity date, par amount, or funds. coupon rate, another confirmation must — If the recipient is an affiliate of the be issued at the end of the day during bank, include a schedule of the which the substitution occurred. instruments into which the funds Because the confirmation or safekeep- were swept, including the effective ing receipt must list specific securities, maturity of these instruments. ‘‘pooling’’ of securities for any type of — If the recipient is an unaffiliated sweep program involving government third party, determine if the bank securities is not permitted. Addition- adequately evaluates the third ally, if funds are swept into other party’s financial condition at least instruments, similar confirmation pro- annually. Also, verify if a fee is cedures should be applied.) received by the bank for the trans- • Conditions of the sweep program are action. If so, determine that the stated clearly, including the dollar fee is disclosed in customer amount (minimum or maximum documentation. amounts and incremental amounts), c. Whether the proceeds of sweep pro- time frame of sweep, time of day the grams are invested only in short-term sweep transaction occurs, fees pay- bank obligations; short-term U.S. govern- able, transaction confirmation notice, ment securities; or other highly liquid, prepayment terms, and termination readily marketable, investment-grade notice. assets that can be disposed of with mini- • The length of any single transaction mal loss of principal. under sweep programs in effect has not d. Whether the bank and its subsidiaries exceeded 270 days and the amount is have issued or plan to issue nondeposit $25,000 or more (as stipulated by SEC debt obligations in any public area of policy). Ongoing sweep-program dis- the bank where retail deposits are closures should occasionally be sent to accepted, including any lobby area of the customer to ensure that the terms the bank. of the program are updated and the e. Completed sweep-program documents to customer understands the terms. determine the following: f. Samples of advertisements (newspaper, • Signed documents boldly disclose that radio, television spots, etc.) by the bank the instrument into which deposit funds for sweep programs to determine if the will be swept is not insured by the advertisements— FDIC and is not an obligation of, or • boldly disclose that the instrument into guaranteed by, the bank. which deposit funds are swept is not • Proper authorization for the instrument insured by the FDIC and is not an exists between the customer and an obligation of, or guaranteed by, the authorized representative of the bank. bank, and • Signed documents properly disclose • are not enclosed with insured deposit the name of the obligor and the type of statements mailed to customers. instrument into which the depositor’s g. Whether the sweep program has had a funds will be swept. If funds are being negative effect on bank liquidity or has swept into U.S. government securities the potential to undermine public confi- held by the banking organization, dence in the bank. verify that adequate confirmations are • Review the bank’s federal funds and provided to customers in accordance borrowing activities to ascertain with the Government Securities Act of whether borrowings appear high. If so, 1986. (This act requires that all trans- compare the bank’s borrowing activity actions subject to a repurchase agree- with daily balances of aggregate sweep ment be confirmed in writing at the transactions on selected dates to see if end of the day of initiation and that a correlation exists.

April 2012 Commercial Bank Examination Manual Page 4 Deposit Accounts: Examination Procedures 3000.3

• If sweep activity is significant, compare • whether the bank is paying current the rates being paid on swept deposits market rates on CDs; with the yields received on the invested • the dollar amount of brokered CDs, if funds and with the rates on other any; and overnight funding instruments, such as • the dollar volume of deposits obtained federal funds, to determine if they are as a result of special promotions. reasonable. b. Federal Deposit Insurance Corporation 12. Forward the following to the examiner Improvement Act of 1991 (12 USC assigned to asset/liability management: 1831F). a. the amount of any deposit decline or • If the bank is undercapitalized, as deposit increase anticipated by manage- defined in the FDIC’s regulation on ment (the time period will be determined brokered deposits, ensure that it is not by the examiner performing asset/liability accepting brokered deposits. (See 12 management) CFR 337.6.) b. a listing by name and amount of any • If the bank is only adequately capital- depositor controlling more than 1 per- ized, as defined in the FDIC’s regula- cent of total deposits tion and is accepting brokered depos- c. a listing, if available, by name and its, ensure that a waiver authorizing amount of any deposits held solely acceptance of such deposits has been because of premium rates paid (brokered obtained from the FDIC and that the deposits) bank is in compliance with the interest- d. the aggregate amount of brokered rate restrictions. (See 12 CFR deposits 337.6(b)(2) and (3).) e. a maturity schedule of certificates of c. Determine if the bank has risk- deposit, detailing maturities within the management systems to monitor and con- next 30, 60, 90, 180, and 360 days trol its liquidity and funding risks that f. an assessment of the overall characteris- are associated with the bank’s brokered tics and volatility of the deposit structure and rate-sensitive deposits. 13. Analyze UBPR data on deposits and related d. Ascertain if the bank’s risk- expense ratios, and compare with peer- management systems for its brokered group norms to determine— and rate-sensitive deposits are adequate a. variations from the norm, and and if they are commensurate with the b. trends in the deposit structure with complexity of its liquidity and funding respect to— risks. Determine if the bank has the • growth patterns, and following: • shifts between deposit categories. • proper funds-management policies; 14. Assess the volatility and the composition of • adequate due diligence when assess- the bank’s deposit structure. ing the risks associated with deposit a. Review the list of time certificates of brokers; deposit of $100,000 or more and related • due diligence in assessing the potential management reports, including those on risk to earnings and capital associated brokered deposits, to determine— with brokered or other rate-sensitive • whether concentrations of maturing deposits, and prudent strategies for deposits exist; their use; • whether a concentration of deposits to • reasonable control structures to limit a single entity exists; funding concentrations; • the aggregate dollar volume of accounts • management information systems (MIS) of depositors outside the bank’s nor- that clearly identify nonrelationship or mal service area, if significant, and the higher-cost funding programs that allow geographic areas from which any sig- management to track performance, nificant volume emanates; manage funding gaps, and monitor • the aggregate dollar volume of CDs compliance with concentration and that have interest rates higher than other risk limits; and current publicly quoted rates within • contingency funding plans that ad- the market; dress the risk that these deposits may

Commercial Bank Examination Manual April 2012 Page 5 3000.3 Deposit Accounts: Examination Procedures

not ‘‘roll over’’ and provide a reason- compliance with the applicable laws and able alternative funding strategy. regulations listed below: e. Review public funds and the bank’s a. Regulation O (12 CFR 215), Loans to method of acquiring such funds to assess Executive Officers, Directors, and Prin- whether the bank uses competitive bid- cipal Shareholders of Member Banks. ding in setting the interest rate paid on Review the overdraft listing to ensure public deposits. If so, does the bank that the bank has not paid an overdraft on consider variables in addition to rates any account of an executive officer or paid by competition in determining pric- director, unless the payment is made ing for bidding on public deposits? according to— f. Review appropriate trial balances for all • a written, preauthorized, interest- other deposits (demand, savings, and bearing extension of a credit plan that other time deposits). Review manage- provides a method of repayment, or ment reports that relate to large deposits • a written, preauthorized transfer from for individuals, partnerships, corpora- another account of that executive offi- tions, and related deposit accounts to cer or director. determine whether a deposit concentra- Payment of inadvertent overdrafts in an tion exists. aggregate amount of $1,000 or less is not • Select, at a minimum, the 10 largest prohibited, provided the account is not accounts to determine if the retention overdrawn more than five business days of those accounts depends on— and the executive officer or director is — criticizable loan relationships; charged the same fee charged to other — liberal service accommodations, customers in similar circumstances. Over- such as permissive overdrafts and drafts are extensions of credit and must drawings against uncollected funds; be included when considering each insid- — interbank correspondent relation- er’s lending limits and other extension- ships; of-credit restrictions, as well as when — deposits obtained as a result of considering the aggregate lending limit special promotions; and for all outstanding extensions of credit — a recognizable trend with respect by the bank to all insiders and their to— related interests. • frequent significant balance b. 12 USC 1972(2), Loans to Executive fluctuations, Officers, Directors, and Principal Share- • seasonal fluctuations, and holders of Correspondent Banks. Review • nonseasonal increases or de- the overdraft listing to ensure that no creases in average balances. preferential overdrafts exist from the bank g. Elicit management’s comments to deter- under examination to the executive offi- mine, to the extent possible— cers, directors, or principal shareholders • the potential renewal of large CDs that of the correspondent bank. mature within the next 12 months; c. Section 22(e) of the Federal Reserve Act • if public fund deposits have been (12 USC 376), Interest on Deposits of obtained through political influence; Directors, Officers, and Employees. • if a significant dollar volume of Obtain a list of deposit accounts, with accounts is concentrated in customers account numbers, of directors, officers, engaged in a single business or indus- attorneys, and employees. Review the try; and accounts for any exceptions to standard • if there is a significant dollar volume policies on service charges and interest of deposits from customers who do not rates paid that would suggest self-dealing reside within the bank’s service area. or preferential treatment. 15. Obtain information on competitive pres- d. Sections 23A and 23B of the Federal sures and economic conditions and evaluate Reserve Act (12 USC 371c), and Regu- that information, along with current deposit lation W. Determine the existence of trends, to estimate its effect on the bank’s any non-intraday overdrawn affiliate deposit structure. accounts. If such overdrawn accounts are 16. Perform the following procedures to test for identified, review for compliance with

April 2012 Commercial Bank Examination Manual Page 6 Deposit Accounts: Examination Procedures 3000.3

sections 23A and 23B of the act and with foreign-exchange risk associated with Regulation W. foreign-currency deposits. e. Regulation D (12 CFR 204), Reserve 18. For a bank that accepts accounts from Requirements of Depository Institutions. foreign governments, embassies, and politi- Review the accuracy of the deposit data cal figures, evaluate— used in the bank’s reserve-requirement a. the existence and effectiveness of the calculation for the examination date. bank’s policies, procedures, compliance When a bank issues nondeposit, unin- oversight, and management reporting sured obligations that are classified as with regard to such foreign accounts; ‘‘deposits’’ in the calculation of reserve b. whether the bank and its staff have the requirements, examiners should deter- necessary controls, as well as the ability, mine if these items are properly catego- to manage the risks associated with such rized. Ascertain that the TT&L remit- foreign accounts; tance option is included in the c. whether the bank’s board of directors computations for reserve requirements. and staff can ensure full compliance with f. 12 USC 501 and 18 USC 1004, False its obligations under the Bank Secrecy Certification of Checks. Compare several Act, as amended by the USA Patriot Act, certified checks by date, amount, and and its regulations; purchaser with the depositors’ names d. the adequacy of the level of training of appearing on uncollected-funds and over- the bank’s personnel responsible for man- draft reports of the same dates to deter- aging the risks associated with such for- mine that the checks were certified eign accounts and for ensuring that the against collected funds. bank is and remains in compliance with g. Uniform Commercial Code 4-108, Bank- the requirements of the applicable laws ing Hours and Processing of Items. and regulations; and • Determine the bank’s cutoff hour, e. the effectiveness of the bank’s program after which items received are that communicates its policies and pro- included in the processing for the next cedures for such foreign accounts to ‘‘banking day,’’ to ensure that the cutoff ensure that foreign government, embassy, hour is not earlier than 2:00 p.m. and political-figure customers are fully • If the bank’s cutoff hour is before 2:00 informed of the requirements of applica- p.m., advise management that fail- ble U.S laws and regulations. ure to process items received before a 19. Discuss overall findings with bank manage- 2:00 p.m. cutoff may result in civil ment. Prepare report comments on— liability for delayed handling of those items. a. policy deficiencies, h. Local escheat laws. Determine if the b. noncompliance with policies, bank is adhering to the local escheat laws c. weaknesses in supervision and reporting, with regard to all forms of dormant d. violations of laws and regulations, and deposits, including official checks. e. possible conflicts of interest. 17. If applicable, determine if the bank is 20. Update workpapers with any information appropriately monitoring and limiting the that will facilitate future examinations.

Commercial Bank Examination Manual April 2012 Page 7 Deposit Accounts Internal Control Questionnaire Effective date November 2004 Section 3000.4

Review the bank’s internal controls, policies, tories of new-account documents and CDs, practices, and procedures for demand and time and do the inventories include an account- deposit accounts. The bank’s systems should be ability of numbers issued out of sequence documented completely and concisely and or canceled prior to issuance? should include, where appropriate, narrative *4. Are CDs signed by a properly authorized descriptions, flow charts, copies of forms used, individual? and other pertinent information. 5. Are new-account applications and signa- For large institutions or those institutions that ture cards reviewed by an officer? have individual demand and time deposit bookkeeping functions, the examiner should consider administering this questionnaire separately for CLOSING DEPOSIT ACCOUNTS each function, as applicable. Questions pertain to both demand and time 1. Are signature cards for closed accounts deposits unless otherwise indicated. Negative promptly pulled from the active-account responses to the questions in this section should file and placed in a closed file? be explained, and additional procedures deemed 2. Are closed-account lists prepared? If so, necessary should be discussed with the examiner- how frequently? in-charge. Items marked with an asterisk require 3. Is the closed-account list circulated to substantiation by observation or testing. appropriate management? 4. Is verification of closed accounts, in the form of statements of ‘‘goodwill’’ letters, OPENING DEPOSIT ACCOUNTS required? Are such letters mailed under the control of someone other than a teller *1. Are new-account documents prenumbered? or an individual who can make internal a. Are new-account documents issued in entries to an account (such as a private strict numerical sequence? banker or branch manager)? b. Are the opening of new accounts and *5. For redeemed CDs: access to unused new-account records a. Are the CDs stamped paid? and certificate of deposit (CD) forms b. Is the disposition of proceeds docu- handled by an employee who is not a mented to provide a permanent record teller or who cannot make internal as well as a clear audit trail? entries to customer accounts or the c. Are penalty calculations on CDs and on general ledger? other time deposits that are redeemed *2. Does the institution have a written ‘‘know- before maturity rechecked by a second your-customer’’ policy? employee? a. Do new-account applications require *6. Except for deposit-account agreements that sufficient information to clearly identify authorize the transfer of deposited funds to the customer? other nondemand deposit accounts, are b. Are ‘‘starter’’ checks issued only matured CDs that are not automatically after the verification of data on new renewable classified as demand deposits transaction-account applications? on the Call Report and on the Report of c. Are checkbooks and statements mailed Transaction Accounts, Other Deposits and only to the address of record? If not, is Vault Cash (FR 2900)? a satisfactory explanation and description obtained for any other mailing address (post office boxes, a friend or DEPOSIT-ACCOUNT RECORDS relative, etc.)? d. Are the employees responsible for open- *1. Does the institution have documentation ing new accounts trained to screen supporting a current reconcilement of each depositors for signs of check kiting? deposit-account category recorded on its *3. Does the bank perform periodic inven- general ledger, including customer accounts

Commercial Bank Examination Manual November 2004 Page 1 3000.4 Deposit Accounts: Internal Control Questionnaire

and bank-controlled accounts such as 10. If the bank’s bookkeeping system is not dealer reserves, escrow, Treasury tax and automated, are deposit bookkeepers loan, etc.? (Prepare separate workpapers rotated? for demand and time accounts, listing each 11. Does the bank segregate the deposit account and the date and frequency of account files of— reconcilement, the general-ledger balance, a. employees and officers? the subsidiary-ledger balance, adjustments, b. directors? and unexplained differences.) c. the business interests of employees and *2. Are reconciliations performed by an indi- officers, or interests controlled by vidual or group not directly engaged in employees and officers? accepting or preparing transactions or in d. the business interests of directors, or data entry to customers’ accounts? interests controlled by directors? *3. If the size of the bank precludes full e. foreign goverments, embassies, and separation of duties between data entry political figures? and reconcilement, are reconcilement *12. Are posting and check filing separated duties rotated on a formal basis, and is a from statement preparation? record maintained to support such action? 13. Are statements mailed or delivered to all *4. Are reconciliations reviewed by appropri- customers as required by the bank’s ate independent management, especially in deposit-account agreement? circumstances when full separation of *14. Are customer transaction and interest state- duties is not evident? ments mailed in a controlled environment *5. Are periodic reports prepared for manage- that precludes any individual from receiv- ment, and do the reports provide an aging ing any statement not specifically autho- of adjustments and differences and detail rized by the customer or the institution’s the status of significant adjustments and policy (for example, dormant-account differences? statements)? *6. Has management adequately addressed any significant or long-outstanding adjustments or differences? *7. Is the preparation of input and the posting DORMANT ACCOUNTS AND of subsidiary demand deposit records per- RETURNED MAIL formed or adequately reviewed by persons who do not also— *1. Does the bank have formal policies and a. accept or generate transactions? procedures for the handling of customers’ b. issue official checks or handle funds- transaction and interest statements that are transfer transactions? returned as undeliverable? Does the c. prepare or authorize internal entries policy— (return items, reversals, and direct a. require that statements be periodically charges, such as loan payments)? mailed on dormant accounts? If so, how d. prepare supporting documents required often? for disbursements from an account? b. prohibit the handling of dormant- e. perform maintenance on the accounts, account statements by (1) employees of such as changes of address, stop pay- the branch where the account is assigned, ments, holds, etc.? (2) the account officer, and (3) other *8. Are in-process, suspense, interoffice, and individuals with exclusive control of other accounts related to deposit accounts accounts? controlled or closely monitored by persons c. require positive action to follow up on who do not have posting or reconcilement obtaining new addresses? duties? d. place statements and signature cards for *9. Are periodic reports prepared for manage- accounts for which contact cannot be ment on open items in suspense and on re-established (the mail is returned more in-process, interoffice, overdrawn, and than once or is marked ‘‘deceased’’) other deposit accounts, and do the reports into a controlled environment? include aging of items and the status of e. require the bank to change the address significant items? on future statements to the department

November 2004 Commercial Bank Examination Manual Page 2 Deposit Accounts: Internal Control Questionnaire 3000.4

of the bank (the controlled environ- c. require the customer to sign a statement ment) designated to receive returned describing the purpose of the request mail? and the proposed times for pickup, and f. require a written request from the cus- designate the individuals authorized to tomer and verification of the customer’s pick up the statement? signature before releasing an account d. require the maintenance of signature from the controlled environment? cards for individuals authorized to pick *2. Are accounts for which contact cannot be up statements, and compare the autho- re-established and that do not reflect recent rized signatures with those who sign for activity removed from active files and statements held for pickup? clearly classified as dormant? e. prohibit the delivery of statements to *3. Before returning a dormant account to officers and employees requiring spe- active status, are transactions reactivating cial attention unless it is part of the the account verified, and are independent formal ‘‘hold-mail’’ function? confirmations obtained directly from the *2. Is a central record of hold-mail arrange- customer? ments maintained in a control area that *4. Does transfer from dormant to active sta- does not originate entries to customers’ tus require the approval of an officer who accounts? Does the record identify each cannot approve transactions on dormant hold-mail arrangement, the designated accounts? location for pickup, and the scheduled pickup times? Does the control area— a. maintain current signature cards of INACTIVE ACCOUNTS individuals authorized to pick up statements? 1. Are demand accounts that have been inac- b. obtain signed receipts showing the date tive for one year, and time accounts that of pickup, and compare the receipts have been inactive for three years, classi- with the signature cards? fied as inactive? If not, state the time c. follow up on the status of statements period for classifying a demand or time not picked up as scheduled? account as inactive. *3. Does management review activity in hold- 2. Does the bank periodically review the mail accounts that have not been picked up inactive accounts to determine if they for extended periods of time (for example, should be placed in a dormant status, and one year), and, when there is no activity, are decisions to keep such accounts in place the accounts in a dormant status? active files documented?

HOLD MAIL OVERDRAFTS

*1. Does the institution have a formal policy *1. Are overdraft authorization limits for offi- and procedure for handling statements and cers formally established? documents that a customer requests not to *2. Does the bank require an authorized offi- be mailed but that will be picked up at a cer to approve overdrafts? location within the institution? Does the *3. Is an overdraft listing prepared daily for policy— demand deposit and time transaction a. require that statements will not be held accounts? by an individual (an account officer, 4. For banks processing overdrafts that are branch manager, bookkeeper, etc.) who not automatically approved (a ‘‘pay none’’ could establish exclusive control over system), is the nonsufficient-funds report entries to and the delivery of statements circulated among bank officers? for customer accounts? *5. Are overdraft listings circulated among b. discourage such pickup arrangements the officers? and grant them only after the customer 6. Are the statements of accounts with large provides a satisfactory reason for the overdrafts reviewed for irregularities and arrangement? prompt repayment?

Commercial Bank Examination Manual November 2004 Page 3 3000.4 Deposit Accounts: Internal Control Questionnaire

7. Is an aged record of large overdrafts eign accounts or lines of business, included in the monthly report to the board and of directors or its committee, and does the • capacity to manage those risks? report include the overdraft origination c. Does the bank have adequate internal date? controls and compliance oversight sys- 8. Is there an established schedule of service tems to monitor and manage the vary- charges? ing degrees of risks associated with such foreign accounts? Do these internal controls and compliance systems ensure full compliance with the Bank UNCOLLECTED FUNDS Secrecy Act, as amended by the USA Patriot Act, and its respective *1. Does the institution generate a daily report regulations? of drawings against uncollected funds for d. Does the bank have personnel that are demand deposit and time transaction sufficiently trained in the management accounts? of such risks and in the requirements of a. Is the computation of uncollected funds applicable laws and regulations? positions based on reasonable check- e. Does the bank have policies and proce- collection criteria? dures for ensuring that such foreign- b. Can the reports, or a separate account account customers receive adequate activity report, be used to detect potential communications from the bank? Com- kiting conditions? munications should ensure that these c. If reports are not generated for time customers are made fully aware of the transaction accounts, is a system in requirements of U.S laws and regula- place to control drawings against uncol- tions to which the bank is subject. lected funds? f. Does the bank seek to structure its *2. Do authorized officers review the relationships with such foreign-account uncollected-funds reports and approve customers so as to minimize the vary- drawings against uncollected funds within ing degrees of risks these customers established limits? may pose? *3. Are accounts that frequently appear on the uncollected-funds or kite-suspect reports reviewed regardless of account balances? (For example, accounts with simultaneous OTHER MATTERS large debits and credits can reflect low balances.) *1. Are account-maintenance activities (changes of address, status changes, rate changes, etc.) separated from data entry and reconciling duties? ACCOUNTS FOR FOREIGN *2. Do all internal entries other than service GOVERNMENTS, EMBASSIES, charges require the approval of appropri- AND POLITICAL FIGURES ate supervisory personnel? *3. If not included in the internal or external 1. For bank relationships with a foreign gov- audit program, are employees’ and offi- ernment, embassy, or political figure: cers’ accounts, accounts of employees’ a. Has the board of directors established and officers’ business interests, and accounts standards and guidelines for manage- controlled by employees and officers peri- ment to use when evaluating whether or odically reviewed for unusual or prohib- not the bank should accept such new ited activity? accounts? *4. For unidentified deposits: b. Are the standards and guidelines con- a. Are deposit slips kept under dual sistent with the bank’s— control? • own business objectives, b. Is the disposition of deposit slips • assessment of the varying degrees of approved by an appropriate officer? risks associated with particular for- *5. For returned checks, unposted items, and

November 2004 Commercial Bank Examination Manual Page 4 Deposit Accounts: Internal Control Questionnaire 3000.4

other rejects: ‘‘hold-mail’’ program and kept under a. Are daily listings of such items dual control? prepared? e. Are customers prohibited from with- b. Are all items reviewed daily, and is drawing funds without a passbook? If disposition of items required within a not, state the policy. reasonable time period? If so, indicate 13. For withdrawals from savings or other the time period. time accounts: c. Are reports prepared for management a. Are withdrawal tickets canceled daily? that show items not disposed of within b. Are procedures in place to preclude the established time frames? overdrafts? 6. Are customers immediately notified in writ- c. Are procedures in effect to place holds ing of deposit errors? on, and to check for holds on, withdraw- 7. Does the bank require a customer’s signa- als over a stated amount? If so, indicate ture for stop-payment orders? the amount. 8. For automatic transfer accounts: 14. For signature cards on demand and time a. Are procedures in effect that require accounts: officer approval for transfers in excess a. Are procedures in effect to guard against of the savings balance? the substitution of false signatures? b. For nonautomated systems, are trans- Describe the procedures. fers made by employees who do not b. Are signature cards stored to preclude also handle cash, execute external funds physical damage? transfers, issue official checks singly, or c. Are signatures compared for withdraw- post subsidiary records? als and cashed checks? Describe the 9. For telephone transfer accounts: procedures. a. Do depositors receive an individual identification code for use in making transfers? b. Are transfers made by employees who OFFICIAL CHECKS, MONEY do not also handle cash, execute exter- ORDERS, AND CERTIFIED nal funds transfers, issue official checks CHECKS singly, or post subsidiary records? *10. If not included in the internal or external *1. Are separate general-ledger accounts main- audit program, are accrual balances for the tained for each type of official check? various types of deposits verified periodi- *2. For each type of check issued: cally by an authorized official? If so, a. Are multicopy checks and certified- indicate how often. check forms used? If not, are *11. Are accounts with a ‘‘hold-balance’’ detailed registers of disbursed checks status—those accounts on which court maintained? orders have been placed, those pledged as b. Are all checks prenumbered and issued security to customers’ loans, those pend- in sequence? ing the clearing of a large check, those for c. Is check preparation and issuance which the owner is deceased, and those for separate from recordkeeping? which the passbook has been lost—‘‘locked d. Is the signing of checks in advance out’’ for transactions unless the transaction prohibited? is approved by appropriate management? e. Do procedures prohibit the issuance of 12. For passbook accounts: a check before the credit is processed? a. Do all entries to passbooks contain *3. Is the list authorizing bank personnel to teller identification? sign official checks kept current? Does the b. Under a window-posting system, are list include changes in authorization limits, recording media and passbooks posted delete employees who no longer work at simultaneously? the bank, and indicate employees added to c. Are tellers prohibited from holding cus- the list? tomers’ savings passbooks? *4. Are appropriate controls in effect over d. If customers’ passbooks are held, are check-signing machines (if used) and cer- they maintained under the institution’s tification stamps?

Commercial Bank Examination Manual November 2004 Page 5 3000.4 Deposit Accounts: Internal Control Questionnaire

*5. Are voided checks and voided certified- business day after deposit? check forms promptly defaced and filed *3. Has the TT&L-account reconcilement with paid checks? been completed in a timely manner and *6. If reconcilements are not part of the over- approved by a supervisor? all deposit-reconciliation function— 4. Has adequate collateral been pledged to a. are outstanding checks listed and rec- secure the TT&L account? onciled regularly to the general ledger? If so, state how often. b. is permanent evidence of reconcilements maintained? AUDIT c. is there clear separation between the preparation of checks, data entry, and *1. Are deposit-account activities audited on a check reconcilement? sufficiently frequent basis? d. are the reconcilements reviewed regu- *2. Does the scope of the audit program larly by an authorized officer? require, and do audit records support, sub- e. are reconcilement duties rotated on a stantive testing or quantitative measure- formal basis in institutions where size ments of deposit-account activities that, at precludes the full separation of duties a minimum, include the matters set forth in between data entry and reconcilement? this questionnaire? f. are authorized signatures and endorse- *3. Does the audit program include a compre- ments checked by the filing clerk? hensive confirmation program with the *7. For supplies of official checks: customers of each deposit category main- a. Are records of unissued official checks tained by the institution? maintained centrally and at each loca- *4. Do audit department records support the tion storing them? execution of the confirmation program, b. Are periodic inventories of unissued and do the records reflect satisfactory checks independently performed? follow-up of responses and of requests c. Do the inventories include a description returned as undeliverable? of all checks issued out of sequence? *5. Are audit and prior-examination recom- d. If users are assigned a supply, is that mendations for deposit-account activities supply replenished on a consignment appropriately addressed? basis? *8. Are procedures in effect to preclude certification of checks drawn against uncol- CONCLUSION lected funds? *1. Does the foregoing information provide an adequate basis for evaluating internal con- TREASURY TAX AND LOAN trol in that deficiencies in areas not cov- ACCOUNTS (31 CFR 203) ered by this questionnaire do not significantly impair any controls? Explain 1. Do transfers from the remittance-option negative answers briefly, and indicate any account to the Federal Reserve Bank occur additional examination procedures deemed the next business day after deposit? necessary. 2. When the note option is used, do transfers *2. Are internal controls adequate on the basis from the Treasury Tax and Loan (TT&L) of a composite evaluation, as evidenced by demand deposit account occur the next answers to the foregoing questions?

November 2004 Commercial Bank Examination Manual Page 6 Borrowed Funds Effective date October 2008 Section 3010.1

Borrowed funds are a common and practical its own merit to determine its purpose, effective- method for banks of all sizes to meet customers’ ness, and stability. Some of the more frequently needs and enhance banking operations. For the used sources of borrowings are discussed below. purposes of this section, borrowings exclude long-term subordinated debt, such as capital notes and debentures (discussed in ‘‘Assessment of Capital Adequacy,’’ section 3020.1). Borrow- COMMON SOURCES OF ings may exist in a number of forms, both on a BORROWINGS direct and indirect basis. Common sources of direct bank borrowings include Federal Home Loan Bank credit lines, federal funds purchased, Federal Home Loan Bank Borrowings loans from correspondent banks, repurchase agreements, negotiable certificates of deposit, and borrowings from the Federal Reserve dis- The Federal Home Loan Bank (FHLB) origi- count window. These are discussed in some nally served solely as a source of borrowings to detail below. Other borrowings include bills savings and loan companies. With the imple- payable to the Federal Reserve, interest-bearing mentation of the Financial Institutions Reform, demand notes issued to the U.S. Treasury (the Recovery, and Enforcement Act of 1989 Treasury tax and loan note option account), (FIRREA), FHLB’s lending capacity was mortgages payable, due bills, and other types of expanded to include banks. borrowed securities. Indirect forms of borrow- Compared with borrowings from the discount ings include customer paper rediscounted and window of the Reserve Banks, borrowings from assets sold with the bank’s endorsement or the FHLB have fewer conditions. Both short- guarantee or subject to a repurchase agreement. term and long-term borrowings, with maturities The primary reasons a bank may borrow ranging from overnight to 30 years, are avail- include the following: able to institutions at generally competitive interest rates. The flexibility of the facility • To meet the temporary or seasonal loan or enables bank management to use this source of deposit withdrawal needs of its customers, if funds for the purpose of asset/liability manage- the borrowing period is temporary and the ment, and it allows management to secure a bank is quickly restored to a position in which favorable interest-rate spread. For example, the quantity of its principal earning assets and FHLB borrowings may provide a lower-cost cash reserves is in proper relation to the alternative to the conventional deposit, particu- requirements of its normal deposit larly in a highly competitive local market. volume. Management should be capable of explaining • To meet large and unanticipated deposit with- the purpose of the borrowing transaction. The drawals that may arise during periods of borrowing transaction should then be analyzed economic distress. The examiner should dis- to determine whether the arrangement achieved tinguish between ‘‘large and unanticipated the stated purpose or whether the borrowings are deposit withdrawals’’ and a predeterminable a sign of liquidity deficiencies. Further, the contraction of deposits, such as the cessation borrowing agreement between the institution of activities in a resort community or the and the FHLB should be reviewed to determine withdrawal of funds on which the bank the asset collateralizing the borrowings and the received adequate prior withdrawal notice. potential risks presented by the agreement. In Those situations should be met through ample some instances, the borrowing agreement may cash reserves and readily convertible assets provide for collateralization by all assets not rather than borrowing. already pledged for other purposes. • To manage liabilities effectively. Generally, The types of collateral necessary to obtain an the effective use of this type of continuous FHLB loan include residential mortgage loans borrowing is limited to money-center or large and mortgage-backed securities. The composite regional banks. rating of an institution is a factor in both the approval for obtaining an FHLB loan and the It is important to analyze each borrowing on level of collateral required.

Commercial Bank Examination Manual October 2008 Page 1 3010.1 Borrowed Funds

Federal Funds Purchased periods of time. Agency-based federal funds transactions are discussed in ‘‘Bank Dealer The day-to-day use of federal funds is a rather Activities,’’ section 2030.1. common occurrence, and federal funds are considered an important money market instrument. Many regional and money-center banks, acting Loans from Correspondent Banks in the capacity of correspondents to smaller community banks, function as both providers Small and medium-sized banks often negotiate and purchasers of federal funds and, in the loans from their principal correspondent banks. process of these transactions, often generate a The loans are usually for short periods and may small return. be secured or unsecured. A brief review of bank reserves is essential to a discussion of the federal funds market. As a condition of membership in the Federal Reserve Repurchase Agreements System, member banks are required to maintain a portion of their deposits as reserves. Reserves The terms ‘‘repurchase agreement’’1 (repo) and can take the form of vault cash and deposits in ‘‘reverse repurchase agreement’’ refer to a type the Reserve Bank. The amount of these reserve of transaction in which a money market partici- balances is reported weekly or quarterly and pant acquires immediately available funds by computed on the basis of the daily average selling securities and simultaneously agreeing to deposit balances. For institutions that report repurchase the securities after a specified time at their reserves on a weekly basis, required a given price, which typically includes interest reserves are computed on the basis of daily at an agreed-on rate. Such a transaction is called average balances of deposits and Eurocurrency a repo when viewed from the perspective of the liabilities during a 14-day period ending every supplier of the securities (the borrower), and a second Monday. Institutions that report their reverse repo or matched sale-purchase agree- reserves on a quarterly basis compute their ment when described from the point of view of reserve requirement on the basis of their daily the supplier of funds (the lender). average deposit balances during a seven-day Frequently, instead of resorting to direct bor- computation period that begins on the third rowings, a bank may sell assets to another bank Tuesday of March, June, September, and Decem- or some other party and simultaneously agree to ber. (See 12 CFR 204.3(c)–(d).) repurchase the assets at a specified time or after Since member banks do not receive interest certain conditions have been met. Bank securi- on the reserves, banks prefer to keep excess ties as well as loans are often sold under a repo balances at a minimum to achieve the maximum to generate temporary working funds. These utilization of funds. To accomplish this goal, kind of agreements are often used because the banks carefully analyze and forecast their daily rate on this type of borrowing is less than the reserve position. Changes in the volume of rate on unsecured borrowings, such as federal required reserves occur frequently as the result funds purchased. of deposit fluctuations. Deposit increases require The usual terms for the sale of securities member banks to maintain more reserves; con- under a repo require that, after a stated period of versely, deposit decreases require less reserves. time, the seller repurchase the securities at a The most frequent type of federal funds predetermined price or yield. A repo commonly transaction is unsecured for one day and repay- includes a near-term maturity (overnight or a able the following business day. The rate is few days) and is usually arranged in large-dollar usually determined by overall money market amounts. The lender or buyer is entitled to rates as well as by the available supply of and receive compensation for use of the funds pro- demand for funds. In some instances, when the vided to its counterparty. The interest rate paid selling and buying relationship between two on a repo is negotiated based on the rates on the banks is quite continuous, something similar to underlying securities. U.S. government and a line of credit may be established on a funds- agency securities are the most common type of availability basis. Although the most common federal funds transaction is unsecured, the selling of funds can also be secured and for longer 1. See sections 2015.1, 2020.1, and 4170.1.

October 2008 Commercial Bank Examination Manual Page 2 Borrowed Funds 3010.1 instruments sold under repurchase agreements, financial condition of those institutions and since those types of repos are exempt from brokers with whom they engage in repurchase reserve requirements. transactions. Although standard overnight and term repo ‘‘Retail repurchase agreements’’ (retail repos)2 arrangements in Treasury and federally related for a time were a popular vehicle for some agency securities are most prevalent, market commercial banks to raise short-term funds and participants sometimes alter various contract compete with certain instruments offered by provisions to accommodate specific investment nonbanking competitors. For booking purposes, needs or to provide flexibility in the designation a retail repo is a debt incurred by the issuing of collateral. For example, some repo contracts bank that is collateralized by an interest in a allow substitutions of the securities subject to security that is either a direct obligation of or the repurchase commitment. These are called guaranteed as to principal and interest by the ‘‘dollar repurchase agreements’’ (dollar rolls), U.S. government or an agency thereof. Retail and the initial seller’s obligation is to repurchase repos are issued in amounts not exceeding securities that are substantially similar, but not $100,000 for periods of less than 90 days. With identical, to the securities originally sold. the advent of money market certificates issued Another common repo arrangement is called a by commercial banks, the popularity of the retail ‘‘flex repo,’’ which, as implied by the name, repo declined. provides a flexible term to maturity. A flex repo Both retail and large-denomination, whole- is a term agreement between a dealer and a sale repurchase agreements are in many respects major customer in which the customer buys equivalent to short-term borrowings at market securities from the dealer and may sell some of rates of interest. Therefore, banks engaging in them back before the final maturity date. repurchase agreements should carefully evaluate Bank management should be aware of certain their interest-rate-risk exposure at various matu- considerations and potential risks of repurchase rity levels, formulate policy objectives in light agreements, especially when entering into large- of the institution’s entire asset and liability mix, dollar-volume transactions with institutional and adopt procedures to control mismatches investors or brokers. Both parties in a term repo between assets and liabilities. The degree to arrangement are exposed to interest-rate risk. It which a bank borrows through repurchase agree- is a fairly common practice to have the collateral ments also should be analyzed with respect to its value of the underlying securities adjusted daily liquidity needs, and contingency plans should to reflect changes in market prices and to main- provide for alternative sources of funds. tain the agreed-on margin. Accordingly, if the market value of the repo securities declines appreciably, the borrower may be asked to Negotiable Certificates of Deposit provide additional collateral. Conversely, if the market value of the securities rises substantially, Certificates of deposit (CDs) have not been the lender may be required to return the excess legally defined as borrowings and continue to be collateral to the borrower. If the value of the reflected as deposits for reporting purposes. underlying securities exceeds the price at which However, the fundamental distinction between a the repurchase agreement was sold, the bank negotiable money market CD as a deposit or as could be exposed to the risk of loss if the buyer a borrowing is nebulous at best; in fact, the is unable to perform and return the securities. negotiable money market CD is widely recog- This risk would obviously increase if the secu- nized as the primary borrowing vehicle for rities are physically transferred to the institution many banks. Dependence on CDs as sources of or broker with which the bank has entered into funds is discussed in ‘‘Deposit Accounts,’’ sec- the repurchase agreement. Moreover, if the tion 3000.1. securities are not returned, the bank could be exposed to the possibility of a significant write- off, to the extent that the book value of the securities exceeds the price at which the securities were originally sold under the repurchase agreement. For this reason, banks should avoid pledging excessive collateral and obtain sufficient financial information on and analyze the 2. See sections 2015.1, 2020.1, and 4170.1.

Commercial Bank Examination Manual October 2008 Page 3 3010.1 Borrowed Funds

Borrowings from the Federal Reserve Primary Credit

In accordance with the Board’s Regulation A Reserve Banks may extend primary credit on a very short term basis (typically overnight) to (12 CFR 201), the Federal Reserve Banks gen- depository institutions that the Reserve Banks erally make credit available through the pri- judge to be in generally sound financial condi- mary, secondary, and seasonal credit programs tion. Reserve Banks extend primary credit at a to any depository institution that maintains trans- 3 rate above the target federal funds rate of the action accounts or nonpersonal time deposits. Federal Open Market Committee. Minimal However, the Federal Reserve expects deposi- administrative requirements apply to requests tory institutions to rely on market sources of for overnight primary credit, unless some aspect funds for their ongoing funding needs and to use of the credit request appears inconsistent with these credit programs as a backup source of the conditions of primary credit (for example, if funding rather than a routine one. An institution a pattern of behavior indicates strongly that an that borrows primary credit may use those funds institution is using primary credit other than as a to finance sales of federal funds, but secondary backup source of funding). Reserve Banks also and seasonal credit borrowers may not act as the may extend primary credit to eligible institu- medium or agent of another depository institutions for periods of up to several weeks if such tion in receiving Federal Reserve credit except funding is not available from other sources. with the permission of the lending Federal However, longer-term extensions of primary Reserve Bank. credit will be subject to greater administration A Federal Reserve Bank is not obligated to than are overnight loans. extend credit to any depository institution but Reserve Banks determine eligibility for pri- may lend to a depository institution either by mary credit according to a uniform set of criteria making an advance secured by acceptable col- that also is used to determine eligibility for lateral or by discounting certain types of paper daylight credit under the Board’s Policy State- described in the Federal Reserve Act. Although ment on Payments System Risk. These criteria Reserve Banks now always extend credit in the are based mainly on examination ratings and form of an advance, the Federal Reserve’s credit capitalization, although Reserve Banks also may facility nonetheless is known colloquially as the use supplementary information, including market- ‘‘discount window.’’ Before lending to a deposi- based information when available. Specifically, tory institution, a Reserve Bank can require any an institution that is at least adequately capital- information it believes is appropriate to ensure ized and rated CAMELS 1 or 2 (or SOSA 1 and that the assets tendered as collateral are accept- ROCA 1, 2, or 3) almost certainly would be able. A Reserve Bank also should determine eligible for primary credit. An institution that is prior to lending whether the borrowing institu- at least adequately capitalized and rated CAMELS 3 (or SOSA 2 and ROCA 1, 2, or 3) generally tion is undercapitalized or critically undercapi- would be eligible. An institution that is at least talized. Operating Circular No. 10, ‘‘Lending,’’ adequately capitalized and rated CAMELS 4 (or establishes the credit and security terms for SOSA 1 or 2 and ROCA 4 or 5) would be borrowings from the Federal Reserve. eligible only if an ongoing examination indicated a substantial improvement in condition. An institution that is not at least adequately capitalized, or that is rated CAMELS 5 (or 3. In unusual and exigent circumstances and after consul- SOSA 3 regardless of the ROCA rating), would tation with the Board, a Reserve Bank may extend credit to individuals, partnerships, and corporations that are not deposi- not be eligible for primary credit. tory institutions if, in the judgment of the Reserve Bank, credit is not available from other sources and failure to obtain credit would adversely affect the economy. A Reserve Bank may extend credit to a nondepository entity in the form of an Secondary Credit advance only if the advance is secured by a direct obligation of the United States or a direct obligation of, or an obligation Secondary credit is available to institutions that that is fully guaranteed as to principal and interest by, any do not qualify for primary credit. Secondary agency of the United States. An extension of credit secured by credit is available as a backup source of liquidity any other type of collateral must be in the form of a discount and must be authorized by an affirmative vote of at least five on a very short term basis, provided that the loan members of the Board. is consistent with a timely return to a reliance on

October 2008 Commercial Bank Examination Manual Page 4 Borrowed Funds 3010.1 market sources of funds. Longer-term secondary house arrangement. Collateral may also be held credit is available if necessary for the orderly at the borrowing institution’s correspondent or resolution of a troubled institution, although any another third party. All book-entry collateral such loan would have to comply with additional must be held at the Federal Reserve Bank. requirements for lending to undercapitalized and Definitive collateral, not in bearer form, must be critically undercapitalized institutions. Unlike properly assigned and endorsed. the primary credit program, secondary credit is not a minimal administration facility because Reserve Banks must obtain sufficient informa- Lending to Undercapitalized and tion about a borrower’s financial situation to Critically Undercapitalized Depository ensure that an extension of credit complies with Institutions the conditions of the program. Secondary credit is available at a rate above the primary credit Credit from any Reserve Bank to an institution rate. that is ‘‘undercapitalized’’ may be extended or outstanding for no more than 60 days during which the institution is undercapitalized in any Seasonal Credit 120-day period.4 An institution is considered undercapitalized if it is not critically undercapi- Seasonal credit is available under limited con- talized under section 38 of the Federal Deposit ditions to meet the needs of depository institu- Insurance Act (the FDI Act) but is either deemed tions that have seasonal patterns of movement in undercapitalized under that provision and its deposits and loans but that lack ready access to implementing regulations or has received a com- national money markets. In determining a deposi- posite CAMELS rating of 5 as of the most tory institution’s eligibility for seasonal credit, recent examination. A Reserve Bank may make Reserve Banks consider not only the institu- or have outstanding advances or discounts to an tion’s historical record of seasonal fluctuations institution that is deemed ‘‘critically undercapi- in loans and deposits, but also the institution’s talized’’ under section 38 of the FDI Act and its recent and prospective needs for funds and its implementing regulations only during the five-day liquidity conditions. Generally, only very small period beginning on the date the institution institutions with pronounced seasonal funding became critically undercapitalized or after con- needs will qualify for seasonal credit. Seasonal sultation with the Board. credit is available at a flexible rate that takes into account the rate for market sources of funds.

Collateral Requirements INTERNATIONAL BORROWINGS

All loans advanced by the Reserve Bank must International borrowings may be direct or indi- be secured to the satisfaction of the Reserve rect. Common forms of direct international bor- Bank. Collateral requirements are governed by rowings include loans and short-term call money Operating Circular No. 8. Reserve Banks re- from foreign banks, borrowings from the Export- quire a perfected security interest in all collat- Import Bank of the United States, and over- eral pledged to secure loans. Satisfactory collat- drawn nostro (due from foreign banks—demand) eral generally includes U.S. government and accounts. Indirect forms of borrowing include federal-agency securities, and, if they are of notes and trade bills rediscounted with the acceptable quality, mortgage notes covering one- central banks of various countries; notes, accep- to four-family residences; state and local gov- tances, import drafts, or trade bills sold with the ernment securities; and business, consumer, and bank’s endorsement or guarantee; notes and other customer notes. Traditionally, collateral is other obligations sold subject to repurchase held in the Reserve Bank vault. Under certain agreements; and acceptance pool participations. circumstances, collateral may be retained on the borrower’s premises under a borrower-in- custody arrangement, or it may be held on the 4. Generally, a Reserve Bank also may lend to an undercapitalized institution during 60 calendar days after receipt of borrower’s premises under the Reserve Bank’s a certiﬁcate of viability from the Chairman of the Board of exclusive custody and control in a ﬁeld ware- Governors or after consultation with the Board.

Commercial Bank Examination Manual May 2003 Page 5 3010.1 Borrowed Funds

ANALYZING BORROWINGS do not generally have ready access to alternative sources of funds available to larger institutions If a bank borrows extensively or in large through the money and capital markets. Bro- amounts, the examiner should thoroughly ana- kered deposits generally carry higher interest lyze the borrowing activity. An effective analy- rates than alternative sources, and they tend to sis includes a review of the bank’s reserve be particularly susceptible to interest-rate changes records, both required and maintained, to deter- in the overall financial market. For further mine the frequency of deficiencies at the closing discussion of brokered deposits, see ‘‘Deposit of reserve periods. The principal sources of Accounts,’’ section 3000.1. borrowings, range of amounts, frequency, length Other indicators of deterioration in a bank’s of time indebted, cost, and reasons for the borrowing ability and overall creditworthiness borrowings should be explored. The actual use include, but are not limited to, requests for of the funds should be verified. collateral on previously unsecured credit lines or Examiners should also analyze changes in a increases in collateral margins, the payment of bank’s borrowing position for signs of deterio- above-market interest rates, or a shortening of ration in its borrowing ability and overall cred- maturities that is inconsistent with manage- itworthiness. One indication of deterioration is ment’s articulated balance-sheet strategies. If the payment of large fees to money brokers to the examiner finds that a bank’s borrowing obtain funds because the bank is having diffi- position is not properly managed, appropriate culty obtaining access to conventional sources comments should be included in the report of of borrowings. These ‘‘brokered deposits’’ are examination. usually associated with small banks since they

May 2003 Commercial Bank Examination Manual Page 6 Borrowed Funds Examination Objectives Effective date May 1996 Section 3010.2

1. To determine if the policies, practices, pro- 4. To determine compliance with laws and cedures, and internal controls for borrowed regulations. funds are adequate. 5. To initiate corrective action when policies, 2. To determine if bank ofﬁcers are operating in practices, procedures, or internal controls are conformance with the established guidelines. deﬁcient or when violations of laws or regu- 3. To determine the scope and adequacy of the lations have been noted. audit function.

Commercial Bank Examination Manual May 1996 Page 1 Borrowed Funds Examination Procedures Effective date October 2008 Section 3010.3

1. If selected for implementation, complete or rowing agreements for indications of update the Borrowed Funds section of the deteriorating credit position by noting— Internal Control Questionnaire. • recent substantive changes in borrow- 2. Based on the evaluation of internal controls ing agreements, and the work performed by the internal/ • increases in collateral to support bor- external auditors, determine the scope of the rowing transactions, examination. • general shortening of maturities, 3. Test for compliance with policies, practices, • interest rates exceeding prevailing mar- procedures, and internal controls in conjunc- ket rates, tion with performing the remaining exami- • frequent changes in lenders, and nation procedures. Also obtain a listing of • large fees paid to money brokers. any audit deficiencies noted in the latest c. If the bank has obtained funds from review done by internal/external auditors money brokers (brokered deposits), from the examiner assigned to ‘‘Internal determine— Control’’ and determine if appropriate cor- • why such deposits were originally rections have been made. obtained, 4. Obtain the listing of accounts related to • who the deposits were obtained from, domestic and international borrowed funds • what the funds are used for, from the examiner assigned to ‘‘Examina- • the relative cost of brokered deposits tion Strategy.’’ in comparison to alternate sources of 5. Prepare or obtain a listing of borrowings, by funds, and type, and— • the overall effect of the use of a. agree or reconcile balances to depart- brokered deposits on the bank’s con- ment controls and general ledger, and dition and whether there appear to be b. review reconciling items for reason- any abuses related to the use of such ableness. deposits. 6. From consultation with the examiners d. If there is an indication that the bank’s assigned to the various loan areas, deter- credit position has deteriorated, ascertain mine that the following schedules were why. reviewed in the lending departments and 9. If the bank engages in the issuance of retail that there was no endorsement, guarantee, repurchase agreements (retail repos), check or repurchase agreement which would for compliance with section 4170.1; also constitute a borrowing: 2015.1 and 2020.1. 10. Determine the purpose of each type of a. participations sold borrowing and conclude whether the bank’s b. loans sold in full since the preceding borrowing posture is justified in light of examination its financial condition and other relevant 7. Based on the information obtained in steps circumstances. 5 and and 6, and through observation and 11. Provide the examiner assigned to ‘‘Asset/ discussion with management and other Liability Management’’ the following examining personnel, determine that all bor- information: rowings are properly reflected on the books a. A summary and an evaluation of the of the bank. bank’s borrowing policies, practices, and 8. If the bank engages in any form of borrow- procedures. The evaluation should give ing which requires written borrowing consideration to whether the bank— agreement(s), complete the following: • evaluates interest-rate-risk exposure at a. Prepare or update a carry-forward work- various maturity levels; paper describing the major terms of each • formulates policy objectives in light of borrowing agreement, and determine that the entire asset and liability mix, and the bank is complying with those terms. liquidity needs; b. Review terms of past and present bor- • has adopted procedures to control mis-

Commercial Bank Examination Manual October 2008 Page 1 3010.3 Borrowed Funds: Examination Procedures

matches between assets and liabilities; b. low point and c. average amounts outstanding • has contingency plans for alternate d. frequency of borrowing and lending activ- sources of funds in the event of a ity, expressed in terms of number of days run-off of current funding sources. 13. Prepare, in appropriate report form, and b. An evaluation of the bank’s adherence to discuss with appropriate management— established policies and procedures. a. the adequacy of written policies regard- c. A repricing maturity schedule of ing borrowings; borrowings. b. the manner in which bank officers are d. A listing of prearranged federal funds operating in conformance with estab- lines and other lines of credit. Indicate lished policy; the amount currently available under c. the existence of any unjustified borrow- those lines, i.e., the unused portion of the ing practices; lines. d. any violation of laws or regulations; and e. The amount of any anticipated decline in e. recommended corrective action when borrowings over the next policies, practices, or procedures are day period. (The time period will be deficient; violations of laws or regula- determined by the examiner assigned to tions exist; or when unjustified borrow- ‘‘Asset/Liability Management.’’) ing practices are being pursued. 12. Prepare a list of all borrowings by category, 14. Update the workpapers with any informa- on a daily basis for the period since the tion that will facilitate future examinations. last examination. Also, include on the list 15. Review the market value of collateral and short-term or overnight money market collateral-control arrangements for repur- lending activities such as federal funds chase agreements to ensure that excessive sold and securities purchased under resale collateral has not been pledged and that the agreement. For each category on the list, bank is not exposed to excessive credit compute for the period between risks. examinations— a. high point

October 2008 Commercial Bank Examination Manual Page 2 Borrowed Funds Internal Control Questionnaire Effective date March 1984 Section 3010.4

Review the bank’s controls, policies, practices c. Prepare all supporting documents and procedures for obtaining and servicing bor- required for payment of debt? rowed funds. The bank’s system should be *4. Are subsidiary borrowed funds records documented in a complete and concise manner reconciled with the general ledger accounts and should include, where appropriate, narrative at an interval consistent with borrowing descriptions, ﬂowcharts, copies of forms used activity, and are the reconciling items and other pertinent information. Items marked investigated by persons, who do not also: with an asterisk require substantiation by obser- a. Handle cash? vation or testing. b. Prepare or post to the subsidiary borrowed funds records?

POLICY INTEREST 1. Has the board of directors approved a written policy which: *5. Are individual interest computations a. Outlines the objectives of bank checked by persons who do not have borrowings? access to cash? b. Describes the bank’s borrowing philos- 6. Is an overall test of the total interest paid ophy relative to risk considerations, made by persons who do not have access i.e., leverage/growth, liquidity/income? to cash? c. Provides for risk diversification in terms 7. Are payees on the checks matched to of staggered maturities rather than solely related records of debt, note or debenture on cost? owners? d. Limits borrowings by amount outstand- 8. Are corporate resolutions properly pre- ing, specific type or total interest pared as required by creditors and are expense? copies on file for reviewing personnel? e. Limits or restricts execution of borrow- 9. Are monthly reports furnished to the board ings by bank officers? of directors reflecting the activity of bor- f. Provides a system of reporting require- rowed funds, including amounts outstand- ments to monitor borrowing activity? ing, interest rates, interest paid to date and g. Requires subsequent approval of anticipated future activity? transactions? h. Provides for review and revision of established policy at least annually? CONCLUSION

10. Is the foregoing information an adequate RECORDS basis for evaluating internal control in that there are no significant deficiencies in *2. Does the bank maintain subsidiary records areas not covered in this questionnaire for each type of borrowing, including that impair any controls? Explain negative proper identification of the obligee? answers briefly, and indicate any addi- *3. Is the preparation, addition and posting of tional examination procedures deemed the subsidiary borrowed funds records per- necessary. formed or adequately reviewed by persons 11. Based on a composite evaluation, as who do not also: evidenced by answers to the foregoing a. Handle cash? questions, internal control is considered b. Issue official checks and drafts? (adequate/inadequate).

Commercial Bank Examination Manual March 1994 Page 1 Complex Wholesale Borrowings Effective date May 2001 Section 3012.1

Commercial banks rely on wholesale borrow- the borrowing (or borrowings), and (3) identify ings obtained from a number of financial inter- the potential risks presented by the agreement. mediaries, including Federal Home Loan Banks, (See SR-01-8.) other commercial banks, and securities firms. In addition to determining if a bank follows These borrowings frequently have attractive fea- the sound-practice guidance for bank liability tures and pricing. If properly assessed and management and funding in general, supervisors prudently managed, they can enhance a bank’s should take the following steps, as appropriate, funding options and assist in controlling interest- when assessing a bank that has material amounts rate and liquidity risks. Some of the reasons that of wholesale borrowings: banks use these types of borrowings include the initial low cost of funds when compared with ¥ Review the bank’s borrowing contracts for other liabilities with similar maturities. At the embedded options or other features that may same time, certain wholesale borrowings have affect the bank’s liquidity and sensitivity to become more complex, and some structures market risks. In addition, examiners should include various types of embedded options.1 If review the collateral agreements for fees, not thoroughly assessed and prudently managed, collateral-maintenance requirements (includ- these more complex funding instruments have ing triggers for increases in collateral), and the potential over time to significantly increase a other features that may affect the bank’s bank’s sensitivity to market and liquidity risks. liquidity and earnings. Maturity mismatches or the embedded options ¥ Assess the bank’s management processes for themselves can, in some circumstances, ad- identifying and monitoring the risks of the versely affect a bank’s financial condition, espe- various terms of each borrowing contract, cially when the terms and conditions of the including penalties and option features over borrowings are misunderstood. the expected life of the contract. Examiners A growing use of wholesale borrowings, should review for evidence that the bank’s combined with the risks associated with the management, or an independent third party, complex structures of some of these borrowings, completed stress tests (1) before the bank makes it increasingly important for bank super- entered into the borrowing agreement (or visors to assess the risks and risk-management agreements) and (2) periodically thereafter. If processes associated with these sources of funds. the bank relies on independent third-party The supervisory guidance provided below supple- testing, examiners should verify that manage- ments and expands upon existing general guid- ment reviewed and accepted the underlying ance on bank funding and borrowings.2 Where assumptions and test results. In any case, appropriate, examiners should (1) review the management should not be relying solely on provisions of each significant borrowing agree- the wholesaler’s stress-test results. Also, the ment between the bank and the wholesale insti- stress tests employed should cover a reason- tution, (2) determine what assets collateralize able range of contractual triggers and external events. Such triggers or events include interest- rate changes that may result in the exercise of 1. Wholesale borrowings with embedded options may have variable interest payments or average lives or redemption embedded options or the bank’s termination values that depend on external measures such as reference of the agreement, which may entail prepay- rates, indexes, or formulas. Embedded options include putable, ment penalties. In general, stress-test results callable, convertible, and variable rate advances with caps, should depict the potential impact of these floors, collars, step-ups, or amortizing features. In addition, these types of borrowings may contain prepayment penalties. variables on the individual borrowing facility, 2. See the supervisory guidance for ‘‘Borrowed Funds,’’ as well as on the overall earnings and liquidity section 3010.1; ‘‘Asset/Liability Management,’’ section 4020.1; position of the bank. and ‘‘Interest-Rate Risk Management,’’ section 4090.1. See ¥ Evaluate management processes for control- also the Trading and Capital-Markets Activities Manual, sections 2030.1, ‘‘Liquidity Risk,’’ and 3010.1, ‘‘Interest-Rate ling risks, including interest-rate risks arising Risk Management.’’ In general, this guidance collectively from the borrowings and liquidity risks. Proper calls for supervisors to analyze the purpose, effectiveness, controls include (1) hedges or other plans for concentration exposure, and stability of borrowings and to minimizing the adverse effects of penalties or assess bank management’s understanding of liquidity and interest-rate risks associated with borrowing and funding interest-rate changes and other triggers for strategies. embedded options and (2) contingent funding

Commercial Bank Examination Manual May 2001 Page 1 3012.1 Complex Wholesale Borrowings

plans if borrowings or lines are terminated plex wholesale borrowings should not be before the original expected maturity. using this funding. ¥ Determine whether the asset/liability management committee or board of directors, as Reliance on wholesale borrowings is consistent appropriate, is fully informed of the risks and with safe and sound banking when management ramiﬁcations of complex wholesale-borrowing understands the risks of these activities and has agreements before engaging in the transac- systems and procedures in place to properly tions and on an ongoing basis. monitor and control the risks. Supervisors and ¥ Determine whether funding strategies for examiners, however, should take appropriate wholesale borrowings, especially those with steps to follow up on institutions that use com- embedded options, are consistent with both plex funding instruments without adequately the portfolio objectives of the bank and the understanding their risks or without proper risk- level of sophistication of the bank’s risk management systems and controls. Examiners management. Banks without the technical should also seek corrective action when funding knowledge and whose risk-management sys- mechanisms or strategies are inconsistent with tems are insufﬁcient to adequately identify, prudent funding needs and objectives. assess, monitor, and control the risks of com-

May 2001 Commercial Bank Examination Manual Page 2 Complex Wholesale Borrowings Examination Objectives Effective date May 2001 Section 3012.2

1. To review the terms of wholesale-borrowing 3. To determine if the bank’s board of directors contracts to identify embedded options or or its asset/liability management committee other features that may affect the bank’s is fully aware of the risks associated with and liquidity and sensitivity to market risks. ramiﬁcations of engaging in complex 2. To assess management’s technical knowl- wholesale-borrowing agreements. edge, systems, and processes for identifying, 4. To ascertain whether the bank’s wholesale- assessing, monitoring, and controlling the borrowing funding and hedging strategies are risks (including liquidity risk and interest- consistent with its portfolio objectives and rate risk) associated with wholesale borrow- the level of management’s sophistication. ing, and to assess the bank’s stress-testing practices and contingency-funding plans.

Commercial Bank Examination Manual May 2001 Page 1 Complex Wholesale Borrowings Examination Procedures Effective date May 2001 Section 3012.3

1. Review the bank’s borrowing contracts to reviewed and accepted the underlying identify embedded options or other features assumptions and test results. that may affect the bank’s liquidity and 3. Evaluate the management processes for con- sensitivity to market risks. Also review the trolling risks, including (1) interest-rate risks collateral agreements to determine what fees, arising from the borrowings and (2) liquidity collateral-maintenance requirements (includ- risks. ing triggers for increases in collateral), and 4. Determine if the asset/liability management other agreed-upon features may affect the committee or board of directors, as appropri- bank’s liquidity and earnings. ate, is fully informed of the risks and rami- 2. Assess the bank’s management processes for ﬁcations of complex wholesale-borrowing identifying and monitoring the risks of the agreements both before engaging in the trans- various terms of each borrowing contract, actions and on an ongoing basis. including penalties and option features over 5. Determine if funding strategies for whole- the expected life of the contract. sale borrowings, especially those with a. Obtain and examine evidence to deter- embedded options, are consistent with both mine whether the bank’s management, or the portfolio objectives of the bank and the an independent third party, completed level of sophistication of the bank’s risk stress tests before the bank entered into management. the borrowing agreement (or agreements) 6. Seek the corrective action taken by the insti- and periodically thereafter. tution when funding mechanisms or strate- b. If the bank relies on independent third- gies are inconsistent with prudent funding party testing, verify that management needs and objectives.

Commercial Bank Examination Manual May 2001 Page 1 Deferred Compensation Agreements Effective date May 2005 Section 3015.1

As part of their executive compensation and tax benefit payments and the amount initially retention programs, banks and other financial invested to purchase the BOLI in the notional institutions (collectively referred to in this sec- amount, the hypothetical earnings reflect an tion as ‘‘institutions’’) often enter into deferred estimate of what the institution could have compensation agreements with selected employ- earned if it had not invested in the BOLI or ees. These agreements are generally structured entered into the IRP with the employee. Each as nonqualified retirement plans for federal employee’s IRP may have a different notional income tax purposes and are based on individual amount on which the index is based. The indi- agreements with selected employees. vidual IRP agreements also specify the retire- Institutions often purchase bank-owned life ment age and vesting provisions, which can vary insurance (BOLI) in connection with many of from employee to employee. their deferred compensation agreements. (See An IRP agreement typically requires the sections 4042.1 and 2210.1 for an explanation of excess earnings that accrue before an employ- the accounting for BOLI transactions). BOLI ee’s retirement to be recorded in a separate may produce attractive tax-equivalent yields liability account. Once the employee retires, the that offset some or all of the costs of the balance in the liability account is generally paid agreements. to the employee in equal, annual installments Deferred compensation agreements are com- over a set number of years (for example, 10 or monly referred to as indexed retirement plans 15 years). These payments are commonly (IRPs) or as revenue-neutral plans. The institu- referred to as the primary benefit or pre- tion’s designated management and accounting retirement benefit. staff that is responsible for the institution’s An employee may also receive the excess financial reporting must regularly review the earnings that are earned after his or her retire- accounting for deferred compensation agreement. This benefit may continue until the ments to ensure that the obligations under the employee’s death and is commonly referred to agreements are appropriately measured and as the secondary benefit or post-retirement bene- reported in accordance with generally accepted fit. The secondary benefit is paid annually, once accounting principles (GAAP). In so doing, the the employee has retired, and is in addition to management and accounting staff should apply the primary benefit. and follow Accounting Principles Board Opin- Examiners should be aware that some insti- ion No. 12, ‘‘Omnibus Opinion—1967,’’ as tutions may not be correctly accounting for the amended by Statement of Financial Accounting obligations under an IRP. Because many insti- Standards No. 106 (FAS 106), ‘‘Employers’ tutions were incorrectly accounting for IRPs, the Accounting for Postretirement Benefits Other federal banking and thrift agencies issued on Than Pensions’’ (hereafter referred to as APB February 11, 2004, an Interagency Advisory on 12). Accounting for Deferred Compensation Agree- IRPs are one type of deferred compensation ments and Bank-Owned Life Insurance. (See agreement that institutions enter into with SR-04-4.) The guidance is stated here, except selected employees. IRPs are typically designed for the information on the reporting of deferred so that the spread each year, if any, between the compensation agreement obligations in the bank tax-equivalent earnings on the BOLI covering Call Reports and on changes in accounting for an individual employee and a hypothetical earn- those agreements. Examiners should determine ings calculation is deferred and paid to the whether an institution’s deferred compensation employee as a post-retirement benefit. This agreements are correctly accounted for. If the spread is commonly referred to as excess earn- accounting is incorrect, assurance should be ings. The hypothetical earnings are computed on obtained from the institution’s management that the basis of a predefined variable index rate (for corrections will be made in accordance with example, the cost of funds or the federal funds GAAP and the advisory’s instructions for rate) times a notional amount. The notional changes in accounting. The examiner’s findings amount is typically the amount the institution should be reported in the examination report. initially invested to purchase the BOLI plus Also report the nature of the accounting errors subsequent after-tax benefit payments actually and the estimated financial impact that correct- made to the employee. By including the after- ing the errors will have on the institution’s

Commercial Bank Examination Manual May 2005 Page 1 3015.1 Deferred Compensation Agreements

financial statements, including its earnings and the current rate of return on high-quality fixed- capital position. income debt securities2 should be the acceptable discount rates to measure deferred compensation agreement obligations. An institution must ACCOUNTING FOR DEFERRED select and consistently apply a discount-rate COMPENSATION AGREEMENTS, policy that conforms with GAAP. For each IRP, an institution should calculate INCLUDING IRPs the present value of the expected future benefit payments under the IRP at the employee’s full Deferred compensation agreements with select eligibility date. The expected future benefit employees under individual contracts generally payments can be reasonably estimated. They do not constitute post-retirement income plans should be based on reasonable and supportable (that is, pension plans) or post-retirement health assumptions and should include both the pri- and welfare benefit plans. The accounting for mary benefit and, if the employee is entitled to individual contracts that, when taken together, excess earnings that are earned after retirement, do not represent a post-retirement plan should the secondary benefit. The estimated amount of follow APB 12. If the individual contracts, taken these benefit payments should be discounted together, are equivalent to a plan, the plan because the benefits will be paid in periodic should be accounted for under Statement of installments after the employee retires. The Financial Accounting Standards No. 87, number of periods the primary and any second- ‘‘Employers’ Accounting for Pensions,’’ or under ary benefit payments should be discounted may FAS 106. differ because the discount period for each type APB 12 requires that an employer’s obliga- of benefit payment should be based on the tion under a deferred compensation agreement length of time during which each type of benefit be accrued according to the terms of the indi- will be paid, as specified in the IRP. vidual contract over the required service period After the present value of the expected future to the date the employee is fully eligible to benefit payments has been determined, the insti- receive the benefits, or the full eligibility date. tution should accrue an amount of compensation Depending on the individual contract, the full expense and a liability each year from the date eligibility date may be the employee’s expected the employee enters into the IRP until the full retirement date, the date the employee entered eligibility date. The amount of these annual into the contract, or a date between these two accruals should be sufficient to ensure that a dates. APB 12 does not prescribe a specific deferred compensation liability equal to the accrual method for the benefits under deferred present value of the expected benefit payments compensation contracts, stating only that the is recorded by the full eligibility date. Any ‘‘cost of those benefits shall be accrued over that method of deferred compensation accounting period of the employee’s service in a systematic that does not recognize some expense for the and rational manner.’’ The amounts to be accrued primary benefit and any secondary benefitin each period should result in a deferred compen- each year from the date the employee enters into sation liability at the full eligibility date that the IRP until the full eligibility date is not equals the then-present value of the estimated considered to be systematic and rational. benefit payments to be made under the indi- Vesting provisions should be reviewed to vidual contract. ensure that the full eligibility date is properly APB 12 does not specify how to select the determined because this date is critical to the discount rate to measure the present value of the measurement of the liability estimate. Because estimated benefit payments. Therefore, other APB 12 requires that the present value of the relevant accounting literature must be consid- expected benefit payments be recorded by the ered in determining an appropriate discount rate. full eligibility date, institutions also need to An institution’s incremental borrowing rate1 and consider changes in market interest rates to appropriately measure deferred compensation 1. Accounting Principles Board Opinion No. 21, ‘‘Interest on Receivables and Payables,’’ paragraph 13, states in part 2. FAS 106, paragraph 186, states that ‘‘[t]he objective of that ‘‘the rate used for valuation purposes will normally be at selecting assumed discount rates is to measure the single least equal to the rate at which the debtor can obtain financing amount that, if invested at the measurement date in a portfolio of a similar nature from other sources at the date of the of high-quality debt instruments, would provide the necessary transaction.’’ future cash flows to pay the accumulated benefits when due.’’

May 2005 Commercial Bank Examination Manual Page 2 Deferred Compensation Agreements 3015.1 liabilities. Therefore, to comply with APB 12, Example 1: Fully Eligible at institutions should periodically review both their Agreement Inception estimates of the expected future benefits under IRPs and the discount rates used to compute the A company enters into a deferred compensation present value of the expected benefit payments, agreement with a 55-year-old employee who has and revise those estimates and rates, when worked five years for the company. The agree- appropriate. ment states that, in exchange for the employee’s Deferred compensation agreements, includ- past and future services and for his or her ing IRPs, may include noncompete provisions service as a consultant for two years after or provisions requiring employees to perform retirement, the company will pay an annual consulting services during post-retirement years. benefit of $20,000 to the employee, commenc- If the value of the noncompete provisions can- ing on the first anniversary of the employee’s not be reasonably and reliably estimated, no retirement. The employee is fully eligible for the value should be assigned to the noncompete deferred compensation benefit payments at the provisions in recognizing the deferred compen- inception of the agreement, and the consulting sation liability. Institutions should allocate a services are not substantive. portion of the future benefit payments to consulting services to be performed in post- Other key facts and assumptions used in deter- retirement years only if the consulting services mining the benefits payable under the agreement are determined to be substantive. Factors to and in determining the liability and expense the consider in determining whether post-retirement company should record in each period are sum- consulting services are substantive include but marized in the following table: are not limited to (1) whether the services are required to be performed, (2) whether there is an economic benefit to the institution, and (3) whether the employee forfeits the benefits Expected retirement age 60 under the agreement for failure to perform such Number of years to expected services. retirement age 5 Discount rate (%) 6.75 Expected mortality age based on present age 70 APPENDIX—EXAMPLES OF ACCOUNTING FOR DEFERRED COMPENSATION AGREEMENTS At the employee’s expected retirement date, the present value of a lifetime annuity of $20,000 The following are examples of the full-eligibility- that begins on that date is $142,109 (computed date accounting requirements for a basic deferred as $20,000 times 7.10545, the factor for the compensation agreement. The assumptions used present value of 10 annual payments at 6.75 in these examples are for illustrative purposes percent). At the inception date of the agreement, only. An institution must consider the terms of the present value of that annuity of $102,514 its specific agreements, the current interest-rate (computed as $142,109 times 0.721375, the environment, and current mortality tables in factor for the present value of a single payment determining appropriate assumptions to use in in five years at 6.75 percent) is recognized as measuring and recognizing the present value of compensation expense because the employee is the benefits payable under its deferred compen- fully eligible for the deferred compensation sation agreements. benefit at that date. Institutions that enter into deferred compen- The following table summarizes one system- sation agreements with employees, particularly atic and rational method of recognizing the more-complex agreements (such as IRPs), should expense and liability under the deferred com- consult with their external auditors and their pensation agreement: respective Federal Reserve Bank to determine the appropriate accounting for their specific agreements.

Commercial Bank Examination Manual May 2005 Page 3 3015.1 Deferred Compensation Agreements

AB CDEF (B+C) (E+D– A)

Beginning- End- Beneﬁt Service Interest Compensation of-year of-year Year payment ($) component ($) component ($) expense ($) liability ($) liability ($)

0 – 102,514 – 102,514 – 102,514 1 ––6,920 6,920 102,514 109,434 2 ––7,387 7,387 109,434 116,821 3 ––7,885 7,885 116,821 124,706 4 ––8,418 8,418 124,706 133,124 5 ––8,985 8,985 133,124 142,109 6 20,000 – 9,593 9,593 142,109 131,702 7 20,000 – 8,890 8,890 131,702 120,592 8 20,000 – 8,140 8,140 120,592 108,732 9 20,000 – 7,339 7,339 108,732 96,071 10 20,000 – 6,485 6,485 96,071 82,556 11 20,000 – 5,572 5,572 82,556 68,128 12 20,000 – 4,599 4,599 68,128 52,727 13 20,000 – 3,559 3,559 52,727 36,286 14 20,000 – 2,449 2,449 36,286 18,735 15 20,000 – 1,265 1,265 18,735 0 Totals 200,000 102,514 97,486 200,000

The following entry would be made at the inception date of the agreement (the ﬁnal day of year 0) to record the service component of the compensation expense and related deferred compensation agreement liability:

Debit Credit Compensation expense $102,514 Deferred compensation liability $102,514

[To record the column B service component]

In each period after the inception date of the tion of the agreement, and revise the assump- agreement, the company would adjust the tions and rate, as appropriate. deferred compensation liability for the interest Assuming that no changes were necessary to component and any benefit payment. In addi- the assumptions used to determine the expected tion, the company would reassess the assump- future benefits under the agreement or to the tions used in determining the expected future discount rate used to compute the present value benefits under the agreement and the discount of the expected benefits, the following entry rate used to compute the present value of the would be made in year 1 to record the interest expected benefits in each period after the incep- component of the compensation expense:

May 2005 Commercial Bank Examination Manual Page 4 Deferred Compensation Agreements 3015.1

Debit Credit Compensation expense $6,920 Deferred compensation liability $6,920

[To record the column C interest component (computed by multiplying the prior-year column F balance by the discount rate)]

Similar entries (but for different amounts) would be made in year 2 through year 15 to record the interest component of the compensation expense. The following entry would be made in year 6 to record the payment of the annual beneﬁt:

Debit Credit Deferred compensation liability $20,000 Cash $20,000

[To record the column A beneﬁt payment]

Similar entries would be made in year 7 through year 15 to record the payment of the annual benefit. Example 2: Fully Eligible at 5.72213, the factor for the future value of five Retirement Date annual payments at 6.75 percent). Other key facts and assumptions used in If the terms of the contract described in example determining the benefits payable under the agree- 1 had stated that the employee is only entitled to ment and in determining the liability and expense receive the deferred compensation benefitifthe the company should record in each period are sum of the employee’s age and years of service summarized in the following table: equals 70 or more at the date of retirement, the employee would be fully eligible for the deferred compensation benefit at age 60, after rendering Expected retirement age 60 five more years of service. At the employee’s Number of years to expected expected retirement date, the present value of a retirement age 5 lifetime annuity of $20,000 that begins on the Discount rate (%) 6.75 first anniversary of that date is $142,109 (computed as $20,000 times 7.10545, the factor for Expected mortality age based on the present value of 10 annual payments at 6.75 present age 70 percent). The company would accrue this amount in a systematic and rational manner over the five-year period from the date it entered into the The following table summarizes one systematic agreement to the date the employee is fully and rational method of recognizing the expense eligible for the deferred compensation benefit. and liability under the deferred compensation Under one systematic and rational method, the agreement: annual service component accrual would be $24,835 (computed as $142,109 divided by

Commercial Bank Examination Manual May 2005 Page 5 3015.1 Deferred Compensation Agreements

AB CDEF (B+C) (E+D– A)

Beginning- End- Beneﬁt Service Interest Compensation of-year of-year Year payment ($) component ($) component ($) expense ($) liability ($) liability ($)

1 – 24,835 – 24,835 – 24,835 2 – 24,835 1,676 26,511 24,835 51,346 3 – 24,835 3,466 28,301 51,346 79,647 4 – 24,835 5,376 30,211 79,647 109,858 5 – 24,835 7,416 32,251 109,858 142,109 6 20,000 – 9,593 9,593 142,109 131,702 7 20,000 – 8,890 8,890 131,702 120,592 8 20,000 – 8,140 8,140 120,592 108,732 9 20,000 – 7,339 7,339 108,732 96,071 10 20,000 – 6,485 6,485 96,071 82,556 11 20,000 – 5,572 5,572 82,556 68,128 12 20,000 – 4,599 4,599 68,128 52,727 13 20,000 – 3,559 3,559 52,727 36,286 14 20,000 – 2,449 2,449 36,286 18,735 15 20,000 – 1,265 1,265 18,735 0 Totals 200,000 124,175 75,825 200,000

No entry would be made at the inception date of the agreement. The following entry would be made in year 1 to record the service component of the compensation expense and related deferred compensation agreement liability:

Debit Credit Compensation expense $24,835 Deferred compensation liability $24,835

[To record the column B service component]

Similar entries would be made in year 2 through tion liability for the interest component and any year 5 to record the service component of the benefit payment. In addition, the company would compensation expense. reassess the assumptions used in determining In each subsequent period, until the date the the expected future benefits under the agreement employee is fully eligible for the deferred com- and the discount rate used to compute the pensation benefit, the company would adjust the present value of the expected benefits in each deferred compensation liability for the total period after the inception of the agreement, and expense (the service and interest components). revise the assumptions and rate, as appropriate. In each period after the full eligibility date, the Assuming no changes were necessary to the company would adjust the deferred compensa- assumptions used to determine the expected

May 2005 Commercial Bank Examination Manual Page 6 Deferred Compensation Agreements 3015.1 future beneﬁts under the agreement or to the discount rate used to compute the present value of the expected beneﬁts, the following entry would be made in year 2 to record the interest component of the compensation expense:

Debit Credit Compensation expense $1,676 Deferred compensation liability $1,676

[To record the column C interest component (computed by multiplying the prior-year column F balance by the discount rate)]

Similar entries (but for different amounts) would be made in year 3 through year 15 to record the interest component of the compensation expense. The following entry would be made in year 6 to record the payment of the annual beneﬁt:

Debit Credit Deferred compensation liability $20,000 Cash $20,000

[To record the column A beneﬁt payment]

Similar entries would be made in year 7 through year 15 to record the payment of the annual beneﬁt.

Commercial Bank Examination Manual May 2005 Page 7 Assessment of Capital Adequacy Effective date April 2011 Section 3020.1

Although both bank directors and bank regula- definition of capital and a framework for calcu- tors must look carefully at the quality of bank lating risk-weighted assets by assigning assets assets and management and at the ability of the and off-balance-sheet items to broad categories bank to control costs, evaluate risks, and main- of credit risk. A bank’s risk-based capital ratio is tain proper liquidity, capital adequacy is the area calculated by dividing its qualifying capital (the that triggers the most regulatory action, espe- numerator of the ratio) by its risk-weighted cially in view of prompt corrective action. The assets (the denominator). The definition of primary function of capital is to support the qualifying capital is outlined below, as are the bank’s operations, act as a cushion to absorb procedures for calculating risk-weighted assets. unanticipated losses and declines in asset values The major objectives of the risk-based capital that could otherwise cause a bank to fail, and guidelines are to make regulatory capital require- provide protection to uninsured depositors and ments more sensitive to differences in credit-risk debt holders in the event of liquidation. A profiles among banking organizations; to factor bank’s solvency promotes public confidence in off-balance-sheet exposures into the assessment the bank and the banking system as a whole by of capital adequacy; to minimize disincentives providing continued assurance that the bank to holding liquid, low-risk assets; and to achieve will continue to honor its obligations and pro- greater consistency in the evaluation of the vide banking services. By exposing stockhold- capital adequacy of major banking organizations ers to a larger percentage of any potential loss, worldwide. higher capital levels also reduce the subsidy The guidelines set forth minimum supervi- provided to banks by the federal safety net. sory capital standards that apply to all state Capital regulation is particularly important member banks on a consolidated basis. Most because deposit insurance and other elements of banks are expected to operate with capital levels the federal safety net provide banks with an above the minimum ratios. Banking organiza- incentive to increase their leverage beyond tions that are undertaking significant expansion what the market—in the absence of depositor or that are exposed to high or unusual levels of protection—would permit. Additionally, higher risk are expected to maintain capital well above capital levels can reduce the need for regulatory the minimum ratios; in such cases, the Federal supervision, thereby lowering costs to the bank- Reserve may specify a higher minimum require- ing industry and the government. ment. In addition, the risk-based capital ratio is The Federal Reserve uses two ratios to help used as a basis for categorizing institutions for assess the capital adequacy of state members: purposes of prompt corrective action.1 the risk-based capital ratio and the tier 1 lever- For most institutions, the risk-based capital age ratio. State member banks may also be ratio focuses principally on broad categories of subject to separate capital requirements imposed credit risk, although the framework for assign- by state banking supervisors. ing assets and off-balance-sheet items to risk categories does incorporate elements of transfer risk as well as limited instances of interest-rate OVERVIEW OF THE RISK-BASED and market risk.2 The framework incorporates CAPITAL MEASURE FOR STATE risks arising from traditional banking activities MEMBER BANKS as well as risks arising from nontraditional activities. The ratio does not, however, incorpo- The Federal Reserve’s risk-based capital guide- rate other factors that can affect an institution’s lines (the guidelines) focus principally on the financial condition. These factors include over- credit risk associated with the nature of banks’ all interest-rate exposure; liquidity, funding, and on- and off-balance-sheet exposures and on the market risks; the quality and level of earnings; type and quality of banks’ capital. The risk- based capital guidelines apply to all state mem- 1. See section 4133.1, ‘‘Prompt Corrective Action.’’ ber banks. The information provided in this 2. A small number of institutions are required to hold section should be used in conjunction with the capital to support their exposure to market risk. For more guidelines, which are found in Regulation H information, see the ‘‘Market-Risk Measure’’ subsection below, SR-09-1, ‘‘Application of the Market Risk Rule in BHCs and (12 CFR 208, appendix A). SMBs,’’ or the Federal Reserve’s Trading and Capital- The risk-based capital guidelines provide a Markets Activities Manual, section 2110.1, ‘‘Capital Adequacy.’’

Commercial Bank Examination Manual April 2011 Page 1 3020.1 Assessment of Capital Adequacy investment, loan portfolio, and other concentra- capital and may consist of the following items tions of credit; certain risks arising from nontra- that are defined as core capital elements: ditional activities; the effectiveness of loan and investment policies; and management’s overall 1. Common stockholders’ equity, ability to monitor and control financial and 2. Qualifying noncumulative perpetual pre- operating risks, including the risks presented by ferred stock (including related surplus), and concentrations of credit and nontraditional 2. Minority interest in the equity accounts of activities. An overall assessment of capital consolidated subsidiaries. adequacy must take into account these other factors, including, in particular, the level and Tier 1 capital is generally defined as the sum of severity of problem and classified assets as well core capital elements less any amounts of good- as a bank’s exposure to declines in the economic will, other intangible assets, interest-only strips value of its capital due to changes in interest receivables and nonfinancial equity investments rates. For this reason, the final supervisory that are required to be deducted. judgment on a bank’s capital adequacy may differ significantly from conclusions that might Common stockholders’ equity. For purposes of be drawn solely from the level of its risk-based calculating the risk-based capital ratio, common capital ratio. stockholders’ equity is limited to common stock; related surplus; and retained earnings, including capital reserves and adjustments for the cumu- DEFINITION OF CAPITAL lative effect of foreign currency translation, net of any treasury stock; less net unrealized hold- For the purpose of risk-based capital, a bank’s ing losses on available-for-sale equity securities total capital consists of two types of compo- with readily determinable fair values. For this nents: ‘‘core capital elements’’ (which are purpose, net unrealized holding gains on such included in tier 1 capital) and ‘‘supplementary equity securities and net unrealized holding capital elements’’ (which are included in tier 2 gains (losses) on available-for-sale debt securi- capital). To qualify as an element of tier 1 or ties are not included in common stockholders’ tier 2 capital, a capital instrument must be equity. unsecured and may not contain or be covered by any covenants, terms, or restrictions that are Perpetual preferred stock. Perpetual preferred inconsistent with safe and sound banking stock is defined as preferred stock that does not practices. have a maturity date, that cannot be redeemed at Tier 1 capital is generally defined as the sum the option of the holder of the instrument, and of core capital elements. Core capital elements that has no other provisions that will require consist of common stock; related surplus; and future redemption of the issue. Consistent with retained earnings, including capital reserves and these provisions, any perpetual preferred stock adjustments for the cumulative effect of foreign with a feature permitting redemption at the currency translation, net of any treasury stock; option of the issuer may qualify as capital only less net unrealized holding losses on available- if the redemption is subject to prior approval of for-sale equity securities with readily determin- the Federal Reserve. In general, preferred stock able fair values. For this purpose, net unrealized will qualify for inclusion in capital only if it can holding gains on such equity securities and net absorb losses while the issuer operates as a unrealized holding gains (losses) on available- going concern (a fundamental characteristic of for-sale debt securities are not included in com- equity capital) and only if the issuer has the mon stockholders’ equity. ability and legal right to defer or eliminate preferred dividends. The only form of perpetual preferred stock that state member banks may consider as an The Components of Qualifying element of tier 1 capital is noncumulative per- Capital petual preferred. While the guidelines allow for the inclusion of noncumulative perpetual pre- Core capital elements (tier 1 capital). The tier 1 ferred stock in tier 1, it is desirable from a component of a bank’s qualifying capital must supervisory standpoint that voting common represent at least 50 percent of qualifying total stockholders’ equity remain the dominant form

April 2011 Commercial Bank Examination Manual Page 2 Assessment of Capital Adequacy 3020.1 of tier 1 capital. Thus, state member banks direct claims on (including securities, loans, and should avoid overreliance on preferred stock or leases), and the portions of claims that are non-voting equity elements within tier 1. Tier 1 directly and unconditionally guaranteed by, the capital elements represent the highest form of central governments of the Organisation for capital, namely, permanent equity. Economic Co-operation and Development Tier 2 capital consists of a limited amount of (OECD) countries and U.S. government agen- the allowance for loan and lease losses; per- cies, as well as all direct local currency claims petual preferred stock and related surplus that do on, and the portions of local currency claims that not qualify for inclusion in tier 1 capital; certain are directly and unconditionally guaranteed by, other hybrid capital instruments; mandatory con- the central governments of non-OECD coun- vertible securities; and limited amounts of term tries, to the extent that the bank has liabilities subordinated debt, intermediate-term preferred booked in that currency. A claim is not consid- stock, including related surplus, long-term pre- ered to be unconditionally guaranteed by a ferred stock with an original term of 20 years or central government if the validity of the guar- more, and unrealized holding gains on qualify- antee depends on some affirmative action by the ing equity securities. holder or a third party. Generally, securities Capital investments in unconsolidated bank- guaranteed by the U.S. government or its agen- ing and finance subsidiaries, and reciprocal cies that are actively traded in financial markets, holdings of other banking organizations’ capital such as Government National Mortgage Asso- instruments, are deducted from a bank’s capital. ciation (GNMA) securities, are considered to be The sum of tier 1 and tier 2 capital less any unconditionally guaranteed. This zero percent deductions makes up total capital, which is the category also includes claims collateralized numerator of the total risk-based capital ratio. (1) by cash on deposit in the bank or (2) by The maximum amount of tier 2 capital that may securities issued or guaranteed by OECD central be included in a bank’s qualifying total capital is governments or (3) by U.S. government agen- limited to 100 percent of tier 1 capital (net of cies for which a positive margin of collateral is goodwill, other intangible assets, and interest- maintained on a daily basis, fully taking into only strips receivables and nonfinancial equity account any change in the bank’s exposure to investments that are required to be deducted). the obligor or counterparty under a claim in relation to the market value of the collateral held RISK-WEIGHTING PROCESS in support of that claim.

Each asset and off-balance-sheet item is assigned to one of four broad risk categories based on the Category 2: 20 percent perceived credit risk of the obligor or, if rel- Category 2 includes cash items in the process of evant, the guarantor or type of collateral. These collection, both foreign and domestic; short- risk categories are assigned weights of 0 per- term claims on (including demand deposits), cent, 20 percent, 50 percent, and 100 percent. and the portions of short-term claims that are The majority of items fall into the 100 percent guaranteed by, U.S. depository institutions and risk-weight category. A brief explanation of the foreign banks; and long-term claims on, and the components of each category follows. For more portions of long-term claims that are guaranteed detailed information, see the capital adequacy by, U.S. depository institutions and OECD banks. guidelines. This category also includes the portions of claims that are conditionally guaranteed by Risk Categories OECD central governments and U.S. government agencies, as well as the portions of local Category 1: Zero Percent currency claims that are conditionally guaranteed by non-OECD central governments, to the Category 1 includes cash (domestic and foreign) extent that the bank has liabilities booked in that owned and held in all ofﬁces of the bank or in currency. In addition, this category includes transit, as well as gold bullion held in the bank’s claims on, and the portions of claims that are own vaults or in another bank’s vaults on an guaranteed by, U.S. government–sponsored agen- allocated basis to the extent it is offset by gold cies and claims on, and the portions of claims bullion liabilities. The category also includes all guaranteed by, the International Bank for

Commercial Bank Examination Manual April 2011 Page 3 3020.1 Assessment of Capital Adequacy

Reconstruction and Development (the World parent company and the parent company has Bank), the International Finance Corporation, such a rating. If ratings are available from more the Inter-American Development Bank, the than one rating agency, the lowest rating will be Asian Development Bank, the African Develop- used to determine whether the rating requirement Bank, the European Investment Bank, the ment has been met. This category also includes European Bank for Reconstruction and Devel- a collateralized claim on a qualifying securities opment, the Nordic Investment Bank, and other firm in such a country, without regard to satis- multilateral lending institutions or regional faction of the rating standard, provided that the development banks in which the U.S. govern- claim arises under a contract that (1) is a ment is a shareholder or contributing member. reverse-repurchase/repurchase agreement or General obligation claims on, or portions of securities-lending/borrowing transaction exe- claims guaranteed by the full faith and credit of, cuted using standard industry documentation; states or other political subdivisions of the (2) is collateralized by debt or equity securities United States or other countries of the OECD- that are liquid and readily marketable; (3) is based group are also assigned to this category. marked to market daily; (4) is subject to a daily Category 2 also includes the portions of claims margin-maintenance requirement under the stan- (including repurchase transactions) that are dard industry documentation; and (5) can be (1) collateralized by cash on deposit in the bank liquidated, terminated, or accelerated immedi- or by securities issued or guaranteed by OECD ately in bankruptcy or a similar proceeding, and central governments or U.S. government agen- the security or collateral agreement will not be cies that do not qualify for the zero percent stayed or avoided, under applicable law of the risk-weight category; (2) collateralized by secu- relevant jurisdiction. 3c rities issued or guaranteed by U.S. government– sponsored agencies; or (3) collateralized by Category 3: 50 percent securities issued by multilateral lending institutions or regional development banks in which Category 3 includes loans fully secured by first the U.S. government is a shareholder or contrib- liens on one- to four-family residential proper- uting member. ties (either owner-occupied or rented), or on 3a This risk category also includes claims on, multifamily residential properties, that meet cer- or guaranteed by, a qualifying securities firm tain criteria. To be included in category 3, loans incorporated in the United States or other coun- must have been made in accordance with pru- tries that are members of the OECD-based dent underwriting standards, be performing in 3b group of countries provided that (1) the quali- accordance with their original terms, and not be fying securities firm has a long-term issuer 90 days or more past due or carried in nonac- credit rating, or a rating on at least one issue of crual status. For the purposes of the 50 percent long-term debt, in one of the three highest risk category, a loan modified on a permanent or investment-grade rating categories from a trial basis solely pursuant to the U.S. Depart- nationally recognized statistical rating organiza- ment of the Treasury’s Home Affordable Mort- tion or (2) the claim is guaranteed by the firm’s gage Program will be considered to be performing in accordance with its original terms. The 3a. Claims on a qualifying securities firm that are instru- following additional criteria must be applied to a ments the firm, or its parent company, uses to satisfy its loan secured by a multifamily residential prop- applicable capital requirements are not eligible for this risk erty that is included in this category: (1) all weight. 3b. With regard to securities firms incorporated in the principal and interest payments on the loan must United States, qualifying securities firms are those securities have been made on time for at least the year firms that are broker–dealers registered with the Securities and Exchange Commission (SEC) and are in compliance with the SEC’s net capital rule, 17 CFR 240.15c3-1. With regard to 3c. For example, a claim is exempt from the automatic stay securities firms incorporated in any other country in the in bankruptcy in the United States if it arises under a securities OECD-based group of countries, qualifying securities firms contract or a repurchase agreement subject to section 555 or are those securities firms that a bank is able to demonstrate are 559 of the Bankruptcy Code, respectively (11 USC 555 or subject to consolidated supervision and regulation (covering 559); a qualified financial contract under section 11(e)(8) of their direct and indirect subsidiaries, but not necessarily their the Federal Deposit Insurance Act (12 USC 1821(e)(8)); or a parent organizations) comparable to that imposed on banks in netting contract between financial institutions under sections OECD countries. Such regulation must include risk-based 401–407 of the Federal Deposit Insurance Corporation capital requirements comparable to those applied to banks Improvement Act of 1991 (12 USC 4401–4407) or the under the Basel Accord. Board’s Regulation EE (12 CFR 231).

April 2011 Commercial Bank Examination Manual Page 4 Assessment of Capital Adequacy 3020.1 preceding placement in this category, or, in the included in the 50 percent category, unless they case of an existing property owner who is are backed by collateral or guarantees that allow refinancing a loan on that property, all principal them to be placed in a lower risk category. and interest payments on the loan being refi- nanced must have been made on time for at least the year preceding placement in this category; Category 4: 100 percent (2) amortization of the principal and interest must occur over a period of not more than 30 All assets not included in the categories above years, and the minimum original maturity for are assigned to category 4, which comprises repayment of principal must not be less than standard risk assets. The bulk of the assets seven years; and (3) the annual net operating typically found in a loan portfolio would be income (before debt service) generated by the assigned to the 100 percent category. property during its most recent fiscal year must Category 4 includes long-term claims on, and not be less than 120 percent of the loan’s current the portions of long-term claims that are guar- annual debt service (115 percent if the loan is anteed by, non-OECD banks, and all claims on based on a floating interest rate) or, in the case of non-OECD central governments that entail some a cooperative or other not-for-profit housing degree of transfer risk. This category includes project, the property must generate sufficient all claims on foreign and domestic private- cash flow to provide comparable protection to sector obligors not included in the categories the institution. Also included in category 3 are above (including loans to nondepository finan- privately issued mortgage-backed securities, pro- cial institutions and bank holding companies); vided that (1) the structure of the security meets claims on commercial firms owned by the public the criteria described in section III.B.3. of the sector; customer liabilities to the bank on accep- risk-based measure of the capital guidelines (12 tances outstanding that involve standard risk CFR 208, appendix A); (2) if the security is claims; investments in fixed assets, premises, backed by a pool of conventional mortgages on and other real estate owned; common and pre- one- to four-family residential or multifamily ferred stock of corporations, including stock residential properties, each underlying mortgage acquired for debts previously contracted; all meets the criteria described above for eligibility stripped mortgage-backed securities and similar for the 50 percent risk category at the time the instruments; and commercial and consumer loans pool is originated; (3) if the security is backed (except those assigned to lower risk categories by privately issued mortgage-backed securities, due to recognized guarantees or collateral and each underlying security qualifies for the 50 per- loans secured by residential property that qualify cent risk category; and (4) if the security is for a lower risk weight). This category also backed by a pool of multifamily residential includes claims representing capital of a quali- mortgages, principal and interest payments on fying securities firm. the security are not 30 days or more past due. This category also includes industrial- Privately issued mortgage-backed securities that development bonds and similar obligations do not meet these criteria or that do not qualify issued under the auspices of states or political for a lower risk weight are generally assigned to subdivisions of the OECD-based group of coun- the 100 percent risk category. tries for the benefit of a private party or enter- Also assigned to category 3 are revenue prise when that party or enterprise, not the (nongeneral obligation) bonds or similar obliga- government entity, is obligated to pay the prin- tions, including loans and leases, that are obli- cipal and interest. All obligations of states or gations of states or other political subdivisions political subdivisions of countries that do not of the United States (for example, municipal belong to the OECD-based group are also revenue bonds) or other countries of the OECD- assigned to category 4. The following assets are based group, but for which the government assigned a risk weight of 100 percent if they entity is committed to repay the debt with have not been deducted from capital: invest- revenues from the specific projects financed, ments in unconsolidated companies, joint ven- rather than from general tax funds. Credit- tures, or associated companies; instruments that equivalent amounts of derivative contracts qualify as capital that are issued by other bank- involving standard risk obligors (that is, obli- ing organizations; and any intangibles, includ- gors whose loans or debt securities would be ing those that may have been grandfathered into assigned to the 100 percent risk category) are capital.

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Application of the Risk Weights bonds, warranties, standby letters of credit related to particular transactions, and perfor- The appropriate aggregate dollar value of the mance standby letters of credit, as well as amount in each risk category is multiplied by the acquisitions of risk participations in perfor- risk weight associated with that category. The mance standby letters of credit. In addition, resulting weighted values for each of the risk this credit-conversion factor includes unused categories are added together. The resulting sum portions of commitments, including eligible is the bank’s total risk-weighted assets and is the ABCP liquidity facilities, with an original denominator of the risk-based capital ratio. maturity exceeding one year; revolving- underwriting facilities; note-issuance facilities; and other similar arrangements. • Items with a 100 percent credit-conversion Risk Weighting of Off-Balance-Sheet factor include, except as otherwise provided Items within the risk-based capital guidelines, direct- credit substitutes, recourse obligations, sale Off-balance-sheet items are incorporated into and repurchase agreements, ineligible ABCP the risk-based capital ratio through a two-step liquidity facilities, and forward agreements, as process. First, an on-balance-sheet ‘‘credit- well as securities lent where the securities equivalent amount’’ is calculated, generally by lender is at risk of loss. multiplying the face amount of the item by a credit-conversion factor (except for direct-credit See the risk-based capital guidelines for more subsitutes and recourse obligations). Most off- information on the use, treatment, and applica- balance-sheet items are assigned to one of the tion of credit-conversions factors for off-balance- five credit-conversion factors: 0 percent, 10 per- sheet items and transactions. cent, 20 percent, 50 percent, or 100 percent. For derivative contracts, the credit-equivalent These factors are intended to reflect the risk amount for each contract is determined by characteristics of the activity in terms of an multiplying the notional principal amount of the on-balance-sheet equivalent. Second, once the underlying contract by a credit-conversion fac- credit-equivalent amount of the off-balance- tor and adding the resulting product (which is an sheet item is calculated, the resultant credit- estimate of potential future exposure) to the equivalent amount is assigned to the appropriate positive mark-to-market value of the contract risk category according to the obligor or, if (which is the current exposure). A contract with relevant, the guarantor, the nature of any collat- a negative mark-to-market value is treated as eral, or external credit ratings. Briefly, the credit- having a current exposure of zero. Where conversion factors are as follows: appropriate, a bank may offset positive and negative mark-to-market values of derivative • Items with a zero percent credit-conversion contracts entered into with a single counterparty factor include unused portions of commit- subject to a qualifying, legally enforceable, ments (with the exception of asset-backed bilateral netting arrangement. commercial paper (ABCP) liquidity facilities) As a general rule, if the terms of a claim can with an original maturity of one year or less, change, the claim should be assigned to the risk or which are unconditionally cancelable at any category appropriate to the highest risk option time, provided a separate credit decision is available under the terms of the claim. For made before each drawing under the facility. example, in a collateralized loan where the • Items with a 10 percent credit-conversion borrower has the option to withdraw the collat- factor include unused portions of eligible eral before the loan is due, the loan would be ABCP liquidity facilities with an original treated as an uncollateralized claim for risk- maturity of one year or less. based capital purposes. Similarly, a commitment • Items with a 20 percent credit-conversion that can be drawn down in the form of a loan or factor include short-term, self-liquidating a standby letter of credit would be treated as a trade-related contingencies that arise from the commitment to make a standby letter of credit, movement of goods. the higher risk option available under the terms • Items with a 50 percent credit-conversion of the commitment. factor include transaction-related contingen- When an item may be assigned to more than cies, which include bid bonds, performance one category, that item generally is assigned to

April 2011 Commercial Bank Examination Manual Page 6 Assessment of Capital Adequacy 3020.1 the lowest eligible risk category. For example, a for which a positive margin (that is, greater than mortgage originated by the bank for which a 100 percent of the claim) of recognized collat- 100 percent Federal Housing Administration eral is maintained daily may qualify for a guarantee has been obtained would be assigned zero percent risk weight. The full amount of a the 20 percent risk weight that is appropriate to claim that is 100 percent secured by recognized claims conditionally guaranteed by a U.S. gov- collateral may be assigned to the 20 percent risk ernment agency, rather than the 100 percent risk category. For partially secured obligations, the weight that is appropriate to high loan-to-value secured portion is assigned a 20 percent risk single-family mortgages. weight. Any unsecured portion is assigned the While the primary determinant of the risk risk weight appropriate for the obligor or guar- category of a particular on-balance-sheet asset antor, if any. The extent to which an off-balance- or off-balance-sheet credit-equivalent amount is sheet item is secured by collateral is determined the obligor, collateral or guarantees may be used by the degree to which the collateral covers the to a limited extent to assign an item to a lower face amount of the item before it is converted to risk category than would be available to the a credit-equivalent amount and assigned to a obligor. The only forms of collateral that are risk category. For derivative contracts, this recognized for risk-based capital purposes are determination is made in relation to the credit- cash on deposit in the lending bank;4 securities equivalent amount. issued or guaranteed by the central governments The only guarantees that are recognized for of the OECD-based group of countries,5 U.S. risk-based capital purposes are those provided government agencies, or U.S. government– by central or state and local governments of the sponsored agencies; and securities issued by OECD-based group of countries, U.S. govern- multilateral lending institutions or regional ment agencies, U.S. government–sponsored development banks in which the U.S. govern- agencies, multilateral lending institutions or ment is a shareholder or contributing member. regional development banks in which the United In order for a claim to be considered collateral- States is a shareholder or contributing member, ized for risk-based capital purposes, the under- U.S. depository institutions, and foreign banks. lying arrangements must provide that the claim If an obligation is partially guaranteed, the will be secured by recognized collateral through- portion that is not fully covered is assigned the out its term. A commitment may be considered risk weight appropriate to the obligor or to any collateralized for risk-based capital purposes to collateral. An obligation that is covered by two the extent that its terms provide that advances types of guarantees having different risk weights made under the commitment will be secured is apportioned between the two risk categories throughout their term. appropriate to the guarantors. The extent to which qualifying securities are recognized as collateral is determined by their current market value. The full amount of a claim Minimum Risk-Based Capital Ratios

4. There is a limited exception to the rule that cash must be Banks are expected to meet a minimum ratio of on deposit in the lending bank to be recognized as collateral. A bank participating in a syndicated credit secured by cash on capital to risk-weighted assets of 8 percent, with deposit in the lead bank may treat its pro rata share of the at least 4 percent taking the form of tier 1 credit as collateralized, provided that it has a perfected interest capital. Banks that do not meet the minimum in its pro rata share of the collateral. risk-based capital ratios, or that are considered 5. The OECD-based group of countries comprises all full members of the Organization for Economic Cooperation and to lack sufficient capital to support their activi- Development (OECD), as well as countries that have con- ties, are expected to develop and implement cluded special lending arrangements with the International capital plans acceptable to the Federal Reserve Monetary Fund (IMF) associated with the Fund’s General for achieving adequate levels of capital.6 Such Arrangements to Borrow. The OECD’s thirty member countries include Australia, Austria, Belgium, Canada, Czech plans should satisfy the provisions of the guide- Republic, Denmark, Finland, France, Germany, Greece, Hun- lines or established arrangements that the Fed- gary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, eral Reserve has agreed on with designated Mexico, Netherlands, New Zealand, Norway, Poland, Portu- gal, Slovak Republic, Spain, Sweden, Switzerland, Turkey, United Kingdom, and United States. Any country that has 6. Under the prompt-corrective-action framework, banks rescheduled its external sovereign debt within the previous that do not meet the minimum risk-based capital ratio are five years is not considered to be part of the OECD-based considered undercapitalized and must file capital-restoration group of countries for risk-based capital purposes. plans that meet certain requirements.

Commercial Bank Examination Manual April 2011 Page 7 3020.1 Assessment of Capital Adequacy banks. In addition, such banks should avoid also exclude an institution that meets the criteria any actions, including increased risk taking or if such exclusion is deemed to be consistent with unwarranted expansion, that would lower or safe and sound banking practices. further erode their capital positions. In these The market-risk rule supplements the risk- cases, examiners are to review and comment on based capital rules for credit risk; an institution banks’ capital plans and their progress in meet- applying the market-risk rule remains subject to ing, and continuing to maintain, the minimum the requirements of the credit-risk rules but must risk-based capital requirements. adjust its risk-based capital ratio to reflect mar- The bank’s board of directors and senior ket risk. In January 2009, the Board issued management should be encouraged to establish SR-09-1, ‘‘Application of the Market Risk Rule capital levels and ratios that are consistent with in Bank Holding Companies and State Member the bank’s overall financial profile. When assess- Banks,’’ which reiterated some of the marketing the bank’s capital adequacy, it is appropriate risk rule’s core requirements, provided guidance to include comments on risk-based capital in the on certain technical aspects of the rule, and open section of the examination report. Exam- clarified several issues. SR-09-1 discusses (1) the iner comments should address the adequacy of core requirements of the market-risk rule, (2) the the bank’s plans and progress toward meeting market-risk rule capital computational require- the relevant target ratios. ments, and (3) the communication and Federal Reserve requirements in order for a bank to use its VaR models. A bank that is applying the Market-Risk Rule market-risk rule must hold capital to support its exposure to two types of risk: (1) general market Institutions are responsible for identifying their risk arising from broad fluctuations in interest trading and other market risks and for imple- rates, equity prices, foreign exchange rates, and menting a sound risk-management program com- commodity prices, including risk associated with mensurate with those risks. Such programs all derivative positions, and (2) specific risk should include appropriate quantitative metrics arising from changes in the market value of debt as well as ongoing qualitative analysis per- and equity positions in the trading account due formed by competent, independent risk- to factors other than broad market movements, management staff. At a minimum, institutions including the credit risk of an instrument’s should reassess annually and adjust their market- issuer. A bank’s covered positions include all risk management programs, taking into account trading-account positions as well as all foreign- changing firm strategies, market developments, exchange and commodity positions, whether or organizational incentive structures, and evolv- not they are in the trading account. Banks that ing risk-management techniques. are subject to the market-risk capital rules are In August 1996, the Federal Reserve amended precluded from applying those rules to positions its risk-based capital framework to incorporate a held in the bank’s trading book that act, in form measure for market risk for state member banks. or in substance, as liquidity facilities supporting The market-risk rule is found in Regulation H asset-backed commercial paper (ABCP). (See (12 CFR 208), appendix E. Under the market- the definition of covered positions in appendix risk rule, certain institutions with significant E, section 2(a).) Any facility held in the trading exposure to market risk must measure that risk book whose primary function, in form or in using their internal value-at-risk (VaR) measure- substance, is to provide liquidity to ABCP— ment model and, subject to parameters in the even if the facility does not qualify as an eligible market-risk rule, hold sufficient levels of capital ABCP liquidity facility under the rule—will be to cover the exposure. The market-risk rule subject to the banking-book risk-based capital applies to any insured state member bank whose requirements. Specifically, organizations will be trading activity (the gross sum of its trading required to convert the notional amount of all assets and liabilities) equals (1) 10 percent or trading-book positions that provide liquidity to more of its total assets or (2) $1 billion or more. ABCP to credit-equivalent amounts by applying On a case-by-case basis, the Federal Reserve the appropriate banking-book credit-conversion may require an institution that does not meet factors. For example, the full notional amount of these criteria to comply with the market-risk all eligible ABCP liquidity facilities with an rule if deemed necessary for safety-and- original maturity of one year or less will be soundness reasons. The Federal Reserve may subject to a 10 percent conversion factor, as

April 2011 Commercial Bank Examination Manual Page 8 Assessment of Capital Adequacy 3020.1 described previously, regardless of whether the AMA Interagency Guidance for facility is carried in the trading account or the Operational Risk banking book. On June 3, 2011, the federal banking agencies (the agencies) issued Interagency Guidance on Market Risk Rule Provisions for the Advanced Measurement Approaches for Securities Lending Operational Risk to address and clarify implementation issues related to the AMA in applying On February 6, 2006, the Board approved a the agencies’ advanced capital adequacy frame- revision to Regulation H for its market-risk work. This guidance focuses on the combination measure of the capital adequacy guidelines. (See and use of the required AMA data elements— 12 CFR 208, appendix E.) The amendment (1) internal operational loss event data; (2) exter- lessened and aligned the capital requirement of nal operational loss event data; (3) business state member banks (those that have adopted the environment and internal control factors; and market-risk rule) to the risk involved with cer- (4) scenario analysis, which is discussed in tain cash collateral that is posted in connection greater detail. Governance and validation are with securities-borrowing transactions. 6a It also also discussed since they ensure the integrity of broadened the scope of counterparties for which a bank’s AMA framework. (See SR-11-8 and its favorable capital treatment would be applied. attachment.) (See 71 Fed. Reg. 8932, February 22, 2006.) For a detailed description of the market-risk measure, see the Federal Reserve’s Trading and Establishment of a Risk-Based Capital Capital-Markets Activities Manual, section Floor 2110.1. Section 171(b)(2) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd- Frank Act) requires the agencies to establish Advanced Approaches Rule minimum leverage and risk-based capital requirements on a consolidated basis for insured deposi- The Board adopted an advanced capital adequacy tory institutions, depository institution holding framework, effective April 1, 2008, that imple- companies, 6c and nonbank financial companies ments, in the United States, the revised interna- supervised by the Board. These capital require- tional capital framework (Basel II) developed by ments cannot be less than the generally applica- the Committee on Banking Supervision (See 12 ble capital requirements that apply to insured CFR 208, appendix F or 72 Fed. Reg. 69287). depository institutions. 6d The rule provides a risk-based capital frame- On June 28, 2011, the agencies published a work that permits state member banks (SMBs) final rule (effective July 28, 2011) that amended to use an internal ratings-based approach to the advanced approaches rules with a permanent calculate credit-risk capital requirements and floor equal to the minimum risk-based capital advanced measurement approaches (AMA) in requirements under the general risk-based capi- order to calculate regulatory operational-risk capital requirements. See also the revisions effective March 29, 2010, at 75 Fed. Reg. 6c. Section 171 of the Dodd-Frank Act (Pub. L. 111-203, 4636. 6b section 171, 124 Stat. 1376, 1435-38 (2010)) defines ‘‘depository institution holding company’’ to mean a bank holding company or a savings and loan holding company (as those terms are defined in section 3 of the Federal Deposit Insurance 6a. See the Board staff’s August 21, 2007, legal interpre- Act) that is organized in the United States, including any bank tation as to the appropriate risk-based capital risk weight to be or savings and loan holding company that is owned or applied to certain collateralized loans of cash. controlled by a foreign organization, but does not include the 6b. The revisions address the Financial Accounting Stan- foreign organization. (See section 171 of the Dodd-Frank Act, dards Board’s adoption of Statements of Financial Accounting 12 USC 5371.) Standards Nos. 166 (ASC topic 860, ‘‘Transfers and Servic- 6d. The ‘‘generally applicable’’ capital requirements are ing’’) and 167 (ASC subtopic 810-10, ‘‘Consolidation— those established by the federal banking agencies to apply to Overall’’). These accounting standards make substantive insured depository institutions, regardless of total asset size or changes to how banking organizations account for many foreign exposure, under the prompt corrective action provi- items, including securitized assets, that had been previously sions of the Federal Deposit Insurance Act. See 12 USC excluded from these organizations’ balance sheets. 5371(a).

Commercial Bank Examination Manual October 2011 Page 9 3020.1 Assessment of Capital Adequacy tal rules. (See the Board’s press release and 76 sis of these requirements and factors may have Fed. Reg. 37620, June 28, 2011.) Banking a material impact on the amount of capital banks organizations subject to the advanced approaches must hold to appropriately support certain rules are required to, each quarter, calculate and activities for on- and off-balance-sheet items, compare their minimum tier 1 and total risk- and this analysis must be used in assessing based capital ratios as calculated under the compliance with the guidelines. The require- general risk-based capital rules with the same ments and factors to be considered relate to ratios as calculated under the advanced certain capital elements, capital adjustments, approaches risk-based capital rules. They are to balance-sheet activities, off-balance-sheet activi- compare the lower of the two tier 1 risk-based ties, and the overall assessment of capital capital ratios and the lower of the two total adequacy. capital ratios to the minimum tier 1 ratio requirement and total capital ratio requirement of the advanced approaches rules to determine whether Federal Reserve Review of a Capital the minimum capital requirements are met. 6e Instrument The amendment prevents the minimum capital requirements for a banking organization that has If the terms and conditions of a particular adopted the advanced approaches rule from instrument cause uncertainty as to how the declining below the minimum capital require- instrument should be treated for capital pur- ments that apply to insured depository institutions. poses, it may be necessary to consult with Federal Reserve staff for a final determination. The Federal Reserve will, on a case-by-case Documentation basis, determine whether a capital instrument has characteristics that warrant its inclusion in Banks are expected to have adequate systems tier 1 or tier 2 capital, as well as determine any in place to compute their risk-based capital quantitative limit on the amount of an instru- ratios. Such systems should be sufficient to ment that will be counted as an element of tier 1 document the composition of the ratios to be used or tier 2 capital. In making this determination, for regulatory reporting and other supervisory the Federal Reserve will consider the similarity purposes. Generally, supporting documentation of the instrument to instruments explicitly treated will be expected to establish how banks track and in the guidelines, the ability of the instrument to report their capital components and on- and absorb losses while the bank operates as a going off-balance-sheet items that are assigned prefer- concern, the maturity and redemption features ential risk weights, that is, risk weights less than of the instrument, and other relevant terms and 100 percent. Where a bank has inadequate factors. documentation to support its assignment of a preferential risk weight to a given item, it may be necessary for examiners to assign an appropriate Redemptions of Capital higher weight to that item. Examiners are expected to verify that banks are correctly Redemptions of permanent equity or other capi- reporting the information requested on the tal instruments before their stated maturity could Reports of Condition and Income, which are used have a significant impact on a bank’s overall in computing banks’ risk-based capital ratios. capital structure. Consequently, a bank considering such a step should consult with the Federal Reserve before redeeming any equity or debt SUPERVISORY CONSIDERATIONS capital instrument (before maturity) if its FOR CALCULATING AND redemption could have a material effect on the EVALUATING RISK-BASED level or composition of the institution’s capital CAPITAL base.7

Certain requirements and factors should be considered in assessing the risk-based capital ratios 7. Consultation would not ordinarily be necessary if an and the overall capital adequacy of banks. Analy- instrument was redeemed with the proceeds of, or replaced by, a like amount of a similar or higher-quality capital instrument and if the organization’s capital position is considered fully 6e. 12 CFR 208, appendix F, section 3. adequate by the Federal Reserve.

October 2011 Commercial Bank Examination Manual Page 10 Assessment of Capital Adequacy 3020.1

Capital Elements Perpetual Preferred Stock

This subsection discusses the characteristics of The risk-based capital guidelines define perpetual preferred stock as preferred stock that has the principal types of capital elements. It also no maturity date, cannot be redeemed at the covers terms and conditions that may disqualify option of the holder, and has no other provisions an instrument from inclusion in a particular that will require future redemption of the issue. element of capital. Perpetual preferred stock qualifies for inclusion in capital only if it can absorb losses while the Common Stockholders’ Equity issuer operates as a going concern and only if the issuer has the ability and legal right to defer Common stockholders’ equity includes common or eliminate preferred dividends. stock; related surplus; and retained earnings, Perpetual preferred stock with a feature per- including capital reserves and adjustments for mitting redemption at the option of the issuer the cumulative effect of foreign-currency trans- may qualify for tier 1 or unlimited tier 2 capital lation, net of any treasury stock. A capital only if the redemption is subject to prior approval instrument that is not permanent or that has of the Federal Reserve. An issue that is convert- preference with regard to liquidation or the ible at the option of the issuer into another issue payment of dividends is not deemed to be of perpetual preferred stock or a lower form of common stock, regardless of whether it is called capital, such as subordinated debt, is considered common stock. Other preferences may also call to be redeemable at the option of the issuer. into question whether the capital instrument is Accordingly, such a conversion must be subject common stock. Close scrutiny should be paid to to prior Federal Reserve approval. the terms of common-stock issues of banks that Banks may include perpetual preferred stock have issued more than one class of common in tier 1 capital only if the stock is noncumula- stock. If preference features are found in one of tive. A noncumulative issue may not permit the the classes, that class generally should not be accruing or payment of unpaid dividends in any treated as common stock. form, including the form of dividends payable in common stock. Perpetual preferred stock that From a supervisory standpoint, it is desirable calls for the accumulation and future payment of that voting common stockholders’ equity remain unpaid dividends is deemed to be cumulative, the dominant form of tier 1 capital. Accordingly, regardless of whether it is called noncumulative, the risk-based capital guidelines state that banks and it is generally includable in tier 2 capital. should avoid overreliance on nonvoting equity Perpetual preferred stock (including auction- elements in tier 1 capital. Nonvoting equity rate preferred) in which the dividend rate is reset elements can arise in connection with common periodically based, in whole or in part, on the stockholders’ equity when a bank has two classes bank’s financial condition or credit standing is of common stock, one voting and the other excluded from tier 1 capital but may generally nonvoting. Alternatively, one class may have be included in tier 2 capital. The obligation so-called super-voting rights entitling the holder under such instruments to pay out higher divi- to substantially more votes per share than the dends when a bank’s condition deteriorates is other class. In this case, the super-voting shares inconsistent with the essential precept that capi- may have so many votes per share that the tal should provide both strength and loss- voting power of the other shares is effectively absorption capacity to a bank during periods of overwhelmed. adversity. Banks that have nonvoting, or effectively Ordinarily, fixed-rate preferred stock and tra- nonvoting, common equity and tier 1 perpetual ditional floating- or adjustable-rate preferred preferred stock in excess of their voting com- stock—in which the dividend rate adjusts in mon stock are clearly overrelying on nonvoting relation to an independent index based solely on equity elements in tier 1 capital. In such cases, it general market interest rates and is in no way may be appropriate to reallocate some of the tied to the issuer’s financial condition—do not nonvoting equity elements from tier 1 capital to raise significant supervisory concerns, espe- tier 2 capital. cially when the adjustable-rate instrument is accompanied by reasonable spreads and cap rates. Such instruments may generally be

Commercial Bank Examination Manual October 2011 Page 10.1 3020.1 Assessment of Capital Adequacy included in tier 1 capital, provided they are clearly overrelying on perpetual preferred stock noncumulative. in tier 1 capital. In such cases, it may be Some preferred-stock issues incorporate cer- appropriate to reallocate the excess amount of tain features that raise serious questions about perpetual preferred stock from tier 1 capital to whether these issues will truly serve as a tier 2 capital. permanent, or even long-term, source of capital. Such features include so-called exploding-rate mechanisms, or similar mechanisms, in which, Forward Equity Transactions after a specified period, the dividend rate automatically increases to a level that could create Banking organizations have engaged in various an incentive for the issuer to redeem the instru- types of forward transactions involving the repur- ment. Perpetual preferred stock with this type of chase of their common stock. In these transac- feature could cause the issuing bank to be faced tions, the banking organization enters into an with higher dividend requirements at a future arrangement with a counterparty, usually an date when the bank may be experiencing finan- investment bank or another commercial bank, cial difficulties; it is generally not includable in under which the counterparty purchases com- tier 1 capital. mon shares of the banking organization, either Traditional convertible perpetual preferred in the open market or directly from the institu- stock, which the holder can convert into a fixed tion. The banking organization agrees that it will number of common shares at a preset price, repurchase those shares at an agreed-on forward ordinarily does not raise supervisory concerns price at a later date (typically three years or less and generally qualifies as tier 1 capital, provided from the execution date of the agreement). the stock is noncumulative. However, forms of These transactions are used to ‘‘lock in’’ stock preferred stock that the holder must or can repurchases at price levels that are perceived to convert into common stock at the market price be advantageous, and they are a means of prevailing at the time of conversion do raise managing regulatory capital ratios. supervisory concerns. Such preferred stock may Some banking organizations have treated be converted into an increasing number of shares under forward equity arrangements as tier common shares as the bank’s condition deterio- 1 capital. However, because these transactions rates and as the market price of the common can impair the permanence of the shares and stock falls. The potential conversion of such typically have certain features that are undesir- preferred stock into common stock could pose a able from a supervisory point of view, shares threat of dilution to the existing common share- covered by these arrangements have qualities holders. The threat of dilution could make the that are inconsistent with tier 1 capital status. issuer reluctant to sell new common stock, or it Accordingly, any common stock covered by could place the issuer under strong market forward equity transactions entered into after the pressure to redeem or repurchase the convertible issuance of SR-01-27 (November 9, 2001), other preferred stock. Such convertible preferred stock than those specified for deferred compensation should generally be excluded from tier 1 capital. or other employee benefit plans, will be excluded Perpetual preferred stock issues may include from the tier 1 capital of a state member bank, other provisions or pricing mechanisms that even if executed under a currently existing would provide significant incentives or pres- master agreement. The amount to be excluded is sures for the issuer to redeem the stock for cash, equal to the common stock, surplus, and retained especially at a time when the issuer is in a earnings associated with the shares. This guid- weakened financial condition. As a general mat- ance does not apply to shares covered under ter, an issue that contains such features would be traditional stock buyback programs that do not ineligible for tier 1 treatment. involve forward agreements. While no formal limit is placed on the amount of noncumulative perpetual preferred stock that may be included in tier 1 capital, the guidelines Minority Interest in Equity Accounts of state that banks should avoid overreliance on Consolidated Subsidiaries preferred stock and other nonvoting equity elements in tier 1 capital. A bank that includes in Minority interest in equity accounts of consoli- tier 1 capital perpetual preferred stock in an dated subsidiaries is included in tier 1 capital amount in excess of its voting common stock is because, as a general rule, this interest repre-

October 2011 Commercial Bank Examination Manual Page 10.2 Assessment of Capital Adequacy 3020.1 sents equity that is freely available to absorb the stock is unsecured. Even if the bank’s losses in operating subsidiaries whose assets are accountants have permitted the bank to account included in a bank’s risk-weighted asset base. for perpetual preferred stock issued through an While not subject to an explicit sublimit within SPE as stock of the bank, rather than as minority tier 1, banks are expected to avoid using minor- interest in the equity accounts of a consolidated ity interest as an avenue for introducing into subsidiary, the stock may not be included in their capital structures elements that might not tier 1 capital and most likely is not includable in otherwise qualify as tier 1 capital (such as tier 2 capital. cumulative or auction-rate perpetual preferred Banks may also use operating or nonoperat- stock) or that would, in effect, result in an ing subsidiaries to issue subordinated debt. As excessive reliance on preferred stock within with perpetual preferred stock issued through tier 1 capital. If a bank uses minority interest in such subsidiaries, a possibility exists that such these ways, supervisory concerns may warrant debt is in effect secured and therefore not reallocating some of the bank’s minority interest includable in capital. in equity accounts of consolidated subsidiaries from tier 1 to tier 2 capital. Whenever a bank has included perpetual Minority Interests in Small Business preferred stock of an operating subsidiary Investment Companies in minority interest, a possibility exists that such capital has been issued in excess of the subsid- Minority interests in small business investment iary’s needs, for the purpose of raising cheaper companies (SBICs), in investment funds that capital for the bank. Stock issued under these hold nonfinancial equity investments, and in circumstances may, in substance if not in legal subsidiaries engaged in nonfinancial activities form, be secured by the subsidiary’s assets. are not included in a bank’s tier 1 or total capital If the subsidiary fails, the outside preferred base if the bank’s interest in the company or investors would have a claim on the subsidiary’s fund is held under the legal authorities listed in assets that is senior to the claim that the bank, section II.B.5.b. of the capital guidelines (12 as a common shareholder, has on those assets. CFR 208, appendix A). Therefore, as a general matter, issuances in excess of a subsidiary’s needs do not qualify for inclusion in capital. The possibility that a Allowance for Loan and Lease Losses secured arrangement exists should be considered if the subsidiary on-lends significant The allowance for loan and lease losses is a amounts of funds to the parent bank, is unusu- reserve that has been established through a ally well capitalized, has cash flow in excess charge against earnings to absorb anticipated, of its operating needs, holds a significant but not yet identified, losses on loans or lease- amount of assets with minimal credit risk financing receivables. The allowance excludes (for example, U.S. Treasury securities) that are allocated transfer-risk reserves and reserves cre- not consistent with its operations, or has issued ated against identified losses. Neither of these preferred stock at a significantly lower rate than two types of reserves is includable in capital. the parent could obtain for a direct issue. The amount of the allowance for loan and lease Some banks may use a nonoperating subsid- losses that is includable in tier 2 capital is iary or special-purpose entity (SPE) to issue limited to 1.25 percent of risk-weighted assets. perpetual preferred stock to outside investors. Such a subsidiary may be set up offshore so a bank can receive favorable tax treatment for the Net Unrealized Holding Gains (Losses) dividends paid on the stock. In such arrange- on Securities Available for Sale ments, a strong presumption exists that the stock is, in effect, secured by the assets of the subsid- The Financial Accounting Standards Board’s iary. It has been agreed internationally that a Statement No. 115 (FAS 115), ‘‘Accounting for bank may not include in its tier 1 capital Certain Investments in Debt and Equity Securi- minority interest in the perpetual preferred stock ties,’’ created a new common stockholders’ of nonoperating subsidiaries. Furthermore, such equity account known as ‘‘net unrealized hold- minority interest may not be included in tier 2 ing gains (losses) on securities available for capital unless a bank can conclusively prove that sale.’’ Although this equity account is consid-

Commercial Bank Examination Manual October 2011 Page 10.3 3020.1 Assessment of Capital Adequacy ered to be part of a bank’s GAAP equity capital, this account should not be included in a bank’s regulatory capital calculations. There are exceptions, however, to this rule. A bank that legally holds equity securities in its available-for-sale portfolio8 may include up to 45 percent of the

8. Although banks are generally not allowed to hold equity securities except in lieu of debts previously contracted and certain mutual fund holdings, some banks have grandfathered holdings of equity securities in accordance with provisions of the National Bank Act, passed in the 1930s.

October 2011 Commercial Bank Examination Manual Page 10.4 Assessment of Capital Adequacy 3020.1 pretax net unrealized holding gains on those tions should be included in capital as subordi- securities in tier 2 capital. These equity securi- nated debt, subject to amortization in the last ties must be valued in accordance with generally five years of its life and limited, together with accepted accounting principles and have readily other subordinated debt and intermediate-term determinable fair values. Unrealized holding preferred stock, to 50 percent of tier 1 capital. gains may not be included in tier 2 capital if the For example, a bank has an outstanding equity Federal Reserve determines that the equity contract note for $1 million and issues $300,000 securities were not prudently valued. Moreover, of common stock, dedicating the proceeds to the if a bank experiences unrealized holding losses retirement of the note. The bank would include in its available-for-sale equity portfolio, these the $300,000 of common stock in its tier 1 losses must be deducted from tier 1 capital. capital. The $700,000 of the equity contract note not covered by the dedication would be treated as an unlimited element of the bank’s tier 2 Mandatory Convertible Debt Securities capital. The $300,000 of the note covered by the dedication would be treated as subordinated Mandatory convertible debt securities are essen- debt. tially subordinated-debt securities that receive In some cases, the indenture of a mandatory special capital treatment because a bank has convertible debt issue may require the bank to committed to repay the principal from proceeds set up segregated trust funds to hold the pro- obtained through the issuance of equity. Banks ceeds from the sale of equity securities dedi- may include such securities (net of any stock cated to pay off the principal of the manda- issued that has been dedicated to their retire- tory convertibles at maturity. The portion of ment) in the form of equity contract notes or mandatory convertible securities covered by equity commitment notes9 issued before May the amount of such segregated trust funds is 15, 1985, as unlimited elements of tier 2 capital, considered secured and may therefore not be provided that the criteria set forth in 12 CFR included in capital. The maintenance of such 225, appendix B, are met. Consistent with these a separate segregated fund for the redemption criteria, mandatory convertible notes are subject of mandatory convertibles exceeds the require- to a maximum maturity of 12 years, and a bank ments of 12 CFR 225, appendix B. Accord- must receive Federal Reserve approval before ingly, if a bank, with the agreement of the redeeming (or repurchasing) such securities debtholders, seeks regulatory approval to elimi- before maturity. The terms of the securities nate the fund, the approval normally should be should note that such approval is required. given unless supervisory concerns warrant If a bank has issued common or perpetual otherwise. preferred stock and dedicated the proceeds to the retirement or redemption of mandatory convertibles,10 the portion of mandatory convert- Subordinated Debt and Intermediate-Term ibles covered by the dedication no longer carries Preferred Stock a commitment to issue equity and is effectively rendered into ordinary subordinated debt. To qualify as supplementary capital, subordi- Accordingly, the amount of the stock dedicated nated debt and intermediate-term preferred is netted from the amount of mandatory convert- stock must have an original average maturity of ibles includable as unlimited tier 2 capital. The at least five years. The average maturity of an portion of such securities covered by dedica- obligation whose principal is repayable in scheduled periodic payments (for example, a 9. Equity contract notes are debt securities that obligate the so-called ‘‘serial-redemption issue’’) is the holder to take common or perpetual preferred stock for weighted average of the maturities of all such repayment of principal. Equity commitment notes are redeem- scheduled repayments. If the holder has the able only with the proceeds from the sale of common or option to require the issuer to redeem, repay, or perpetual preferred stock. 10. Such a dedication generally must be made in the repurchase the instrument before the original quarter in which the new common or perpetual preferred stock stated maturity, maturity is defined as the earli- is issued. There are no restrictions on the actual use of the est possible date on which the holder can put the proceeds of dedicated stock. For example, stock issued under instrument back to the issuing bank. This date dividend-reinvestment plans or issued to finance acquisitions may be dedicated to the retirement of mandatory convertible may be much earlier than the instrument’s stated debt securities. maturity date. In the last five years before the

Commercial Bank Examination Manual May 2002 Page 11 3020.1 Assessment of Capital Adequacy maturity of a limited-life instrument, the out- the bank. Other events of default, such as standing amount includable in tier 2 capital change of control of the bank or disposal of a must be discounted by 20 percent a year. The bank subsidiary, may limit the flexibility of aggregate amount of subordinated debt and management or banking supervisors to work out intermediate-term preferred stock that may be the problems of a troubled bank. Still other included in tier 2 capital is limited to 50 percent events of default, such as failure to maintain of tier 1 capital. certain capital ratios or rates of return or to limit Consistent with longstanding Federal Reserve the amount of nonperforming assets or charge- policy, a bank may not repay, redeem, or repur- offs to a certain level, may be intended to allow chase a subordinated debt issue without the prior the debtholder to be made whole before a written approval of the Federal Reserve. The deteriorating institution becomes truly troubled. terms of the debt indenture should note that Debt issues that include any of these types of such approval is required. The Federal Reserve events of default are not truly subordinated and requires this approval to prevent a deteriorating should not be included in capital. Likewise, institution from redeeming capital at a time banks should not include debt issues in capital when it needs to conserve its resources and to that otherwise contain terms or covenants that ensure that subordinated debtholders in a failing could adversely affect the liquidity of the issuer; bank are not paid before depositors. unduly restrict management’s flexibility to run Close scrutiny should be given to terms that the organization, particularly in times of finan- permit the holder to accelerate payment of cial difficulty; or limit the regulator’s ability to principal upon the occurrence of certain events. resolve problem-bank situations. The only acceleration clauses acceptable in a Debt issues, including mandatory convertible subordinated-debt issue included in tier 2 capital securities, in which interest payments are tied to are those that are triggered by the issuer’s the financial condition of the borrower should insolvency, that is, the appointment of a receiver. generally not be included in capital. The interest Terms that permit the holder to accelerate payments may be linked to the financial condi- payment of principal upon the occurrence of tion of an institution through various ways, such other events jeopardize the subordination of the as (1) an auction-rate mechanism; (2) a preset debt since such terms could permit debtholders schedule mandating interest-rate increases, either in a troubled institution to be paid out before as the credit rating of the bank declines or over the depositors. In addition, debt whose terms the passage of time;11 or (3) a term that raises permit holders to accelerate payment of princi- the interest rate if payment is not made in a pal upon the occurrence of events other than timely fashion. These debt issues raise concerns insolvency does not meet the minimum five- because as the financial condition of a bank year maturity requirement for debt capital declines, it faces ever-increasing payments on instruments. Holders of such debt have the right its credit-sensitive subordinated debt at a time to put the debt back to the issuer upon the when it most needs to conserve its resources. occurrence of the named events, which could Thus, credit-sensitive debt does not provide happen on a date well in advance of the debt’s the support expected of a capital instrument to stated maturity. an institution whose financial condition is Close scrutiny should also be given to the deteriorating; rather, the credit-sensitive feature terms of those debt issues in which an event of can accelerate depletion of the institution’s default is defined more broadly than insolvency resources and increase the likelihood of default or a failure to pay interest or principal when due. There is a strong possibility that such terms are 11. Although payment on debt whose interest rate increases inconsistent with safe and sound banking prac- over time may not on the surface appear to be directly linked tice, so the debt issue should not be included to the financial condition of the issuing bank, such debt in capital. Concern is heightened where an (sometimes referred to as expanding- or exploding-rate debt) event of default gives the holder the right to has a strong potential to be credit-sensitive in substance. Banks whose financial condition has strengthened are more accelerate payment of principal or where other likelytobeabletorefinance the debt at a lower rate than that borrowings exist that contain cross-default mandated by the preset increase, whereas banks whose con- clauses. Some events of default, such as issuing dition has deteriorated are less likely to do so. Moreover, just jumbo certificates of deposit or making addi- when these latter institutions would be in the most need of conserving capital, they would be under strong pressure to tional borrowings in excess of a certain amount, redeem the debt as an alternative to paying higher rates and may unduly restrict the day-to-day operations of would therefore accelerate the depletion of their resources.

May 2002 Commercial Bank Examination Manual Page 12 Assessment of Capital Adequacy 3020.1 on the debt. While such terms may be acceptable retained) that may be included in capital cannot in perpetual preferred stock qualifying for tier 2 exceed 25 percent of tier 1 capital. Amounts of capital, they are not acceptable in a capital debt MSAs, NMSAs, PCCRs, and credit-enhancing issue because a bank in a deteriorating financial I/Os (both retained and purchased) in excess of condition does not have the option available in these limitations, as well as all other identifiable equity issues of eliminating the higher payments intangible assets, including core deposit intan- without going into default. gibles and favorable leaseholds, are to be When a bank has included subordinated debt deducted from a bank’s core capital elements in issued by an operating or nonoperating subsid- determining tier 1 capital. However, identifiable iary in its capital, a possibility exists that the intangible assets (other than MSAs and PCCRs) debt is in effect secured, and thus not includable acquired on or before February 19, 1992, gen- in capital. Further details on arrangements erally will not be deducted from capital for regarding a bank’s issuance of capital instru- supervisory purposes, although they will con- ments through subsidiaries are discussed in an tinue to be deducted for applications purposes. earlier subsection, ‘‘Minority Interest in Equity For purposes of calculating the limitations on Accounts of Consolidated Subsidiaries.’’ MSAs, NMSAs, PCCRs, and credit-enhancing I/Os, tier 1 capital is defined as the sum of core capital elements, net of goodwill and net of all Capital Adjustments identifiable intangible assets other than MSAs, NMSAs, and PCCRs. This calculation of tier 1 is Intangible Assets before the deduction of any disallowed MSAs, any disallowed NMSAs, any disallowed Goodwill and other intangible assets. Certain PCCRs, any disallowed credit-enhancing I/Os intangible assets are deducted from a bank’s (both purchased and retained), any disallowed capital for the purpose of calculating the risk- deferred tax assets, and any nonfinancial equity based capital ratio.12 Those assets include good- investments. will and certain other identifiable assets. These Banks may elect to deduct disallowed mort- assets are deducted from the sum of the core gage servicing assets, disallowed non-mortgage capital components (tier 1 capital). servicing assets, and disallowed credit-enhancing The only identifiable intangible assets that are I/Os (both purchased and retained) on a basis that eligible to be included in—that is, not deducted is net of any associated deferred tax liability. from—a bank’s capital are marketable mortgage- Deferred tax liabilities netted in this manner servicing assets (MSAs), nonmortgage-servicing cannot also be netted against deferred tax assets assets (NMSAs), and purchased credit-card when determining the amount of deferred tax relationships (PCCRs).13 The total amount of assets that are dependent on future taxable MSAs and PCCRs that may be included in a income. bank’s capital, in the aggregate, cannot exceed Banks must review the book value of goodwill 100 percent of tier 1 capital. The total amount of and other intangible assets at least quarterly and NMSAs and PCCRs is subject to a separate make adjustments to these values as necessary. aggregate sublimit of 25 percent of tier 1 capital. The fair value of MSAs, NMSAs, and PCCRs In addition, the total amount of credit-enhancing must also be determined at least quarterly. This interest-only strips (I/Os) (both purchased and determination of fair value should include adjustments for any significant changes in original valuation assumptions, including changes 12. Negative goodwill is a liability and is therefore not in prepayment estimates or account-attrition taken into account in the risk-based capital framework. Accordingly, a bank may not offset goodwill to reduce the rates. Examiners will review both the book value amount of goodwill it must deduct from tier 1 capital. and fair value assigned to these assets, as well as 13. Purchased mortgage-servicing rights (PMSRs) no lon- supporting documentation during the examina- ger exist under the most recent accounting rules that apply to tion process. The Federal Reserve may require, servicing of assets. Under these rules (Financial Accounting Standards Board statements No. 122, ‘‘Accounting for Mort- on a case-by-case basis, an independent valua- gage Servicing Rights,’’ and No. 140, ‘‘Accounting for Trans- tion of a bank’s intangible assets or credit- fers and Servicing of Financial Assets and Extinguishments of enhancing I/Os. Liabilities’’), organizations are required to recognize separate servicing assets (or liabilities) for the contractual obligation to service financial assets that entities have either sold or Value limitation. The amount of eligible servic- securitized with servicing retained. ing assets and PCCRs that a bank may include in

Commercial Bank Examination Manual April 2011 Page 13 3020.1 Assessment of Capital Adequacy capital is further limited to the lesser of 90 per- credit enhancement, the Federal Reserve will cent of their fair value, or 100 percent of their look to the economic substance of the book value, as adjusted for capital purposes in transaction. accordance with the instructions in the commercial bank Consolidated Report of Condition and Income (call report). The amount of I/Os that a Disallowed Deferred Tax Assets bank may include in capital shall be its fair In response to the Financial Accounting Stan- value. If both the application of the limits on dards Board’s Statement No. 109 (FAS 109), MSAs, NMSAs, and PCCRs and the adjustment of the balance-sheet amount for these assets ‘‘Accounting for Income Taxes,’’ the Federal would result in an amount being deducted from Reserve adopted a limit on the amount of certain capital, the bank would deduct only the greater deferred tax assets that may be included in (that of the two amounts from its core capital ele- is, not deducted from) tier 1 capital for risk- ments in determining tier 1 capital. based and leverage capital purposes. Under the Consistent with longstanding Federal Reserve rule, certain deferred tax assets can only be policy, banks experiencing substantial growth, realized if an institution earns taxable income in whether internally or by acquisition, are expected the future. Those deferred tax assets are limited, to maintain strong capital positions substantially for regulatory capital purposes, to the amount above minimum supervisory levels, without that the institution expects to realize within one significant reliance on intangible assets or year of the quarter-end report date (based on its credit-enhancing I/Os. projections of future taxable income for that An arrangement whereby a bank enters into a year) or to 10 percent of tier 1 capital, whichever licensing or leasing agreement or similar trans- is less. action to avoid booking an intangible asset The reported amount of deferred tax assets, should be subject to particularly close scrutiny. net of any valuation allowance for deferred tax Normally, such arrangements will be dealt with assets, in excess of the lesser of these two by adjusting the bank’s capital calculation amounts is to be deducted from a bank’s core appropriately. In making an overall assessment capital elements in determining tier 1 capital. of a bank’s capital adequacy for applications For purposes of calculating the 10 percent limi- purposes, the institution’s quality and composi- tation, tier 1 capital is defined as the sum of core tion of capital are considered together with its capital elements, net of goodwill and net of all holdings of tangible and intangible assets. identifiable intangible assets other than MSAs, NMSAs, and PCCRs, but before the deduction Credit-enhancing interest-only strips receiv- of any disallowed MSAs, any disallowed ables (I/Os). Credit-enhancing I/Os are on- NMSAs, any disallowed PCCRs, any disal- balance-sheet assets that, in form or substance, lowed credit-enhancing I/Os, any disallowed represent the contractual right to receive some deferred tax assets, and any nonfinancial equity or all of the interest due on transferred assets. investments. I/Os expose the bank to credit risk directly or To determine the amount of expected deferred indirectly associated with transferred assets that tax assets realizable in the next 12 months, a exceeds a pro rata share of the bank’s claim on bank should assume that all existing temporary the assets, whether through subordination pro- differences fully reverse as of the report date. visions or other credit-enhancement techniques. Projected future taxable income should not Such I/Os, whether purchased or retained and include net operating-loss carry-forwards to be including other similar ‘‘spread’’ assets, may be used during that year or the amount of existing included in, that is, not deducted from, a bank’s temporary differences a bank expects to reverse capital subject to the fair value and tier 1 within the year. Such projections should include limitations. (See sections II.B.1.d. and e. of the the estimated effect of tax-planning strategies capital guidelines (12 CFR 208, appendix A).) that the organization expects to implement to Both purchased and retained credit- realize net operating losses or tax-credit carry- enhancing I/Os, on a non-tax-adjusted-basis, are forwards that would otherwise expire during the included in the total amount that is used for pur- year. A new 12-month projection does not have poses of determining whether a bank exceeds to be prepared each quarter. Rather, on interim the tier 1 limitation. In determining whether an report dates, the future-taxable-income projec- I/O or other types of spread assets serve as a tions may be used for their current fiscal year,

April 2011 Commercial Bank Examination Manual Page 14 Assessment of Capital Adequacy 3020.1 adjusted for any significant changes that have financial activities under section 4(k) of the occurred or are expected to occur. Bank Holding Company Act (12 USC 1843(k)). Deferred tax assets that can be realized from The rule does not apply to investments made in taxes paid in prior carry-back years or from companies that engage solely in banking and future reversals of temporary differences are financial activities, nor does it apply to invest- generally not limited. For banks that have a ments made by a state bank under the authority parent, however, this amount may not exceed in section 24(f) of the Federal Deposit Insurance the amount the bank could reasonably expect its Act (FDI Act). The higher capital charges also parent to refund. The disallowed deferred tax do not apply to equity securities acquired and assets are subtracted from tier 1 capital and also held by a bank as a bona fide hedge of an equity from risk-weighted assets. derivatives transaction it entered into lawfully, or to equity securities that are acquired in Nonfinancial Equity Investments satisfaction of a debt previously contracted and that are held and divested in accordance with In general, a bank must deduct from its core applicable law. The adjusted carrying value of capital elements the sum of the appropriate these investments is not included in determining percentages (as determined below) of the the total amount of nonfinancial equity invest- adjusted carrying value of all nonfinancial equity ments held by the bank. (See SR-02-4 for a investments held by it or its direct or indirect general discussion of the risk-based and lever- subsidiaries. An equity investment includes the age capital rule changes.) purchase, acquisition, or retention of any equity The bank must deduct from its core capital instrument (including common stock, preferred elements the sum of the appropriate percentages, stock, partnership interests, interests in limited- as stated in table 1, of the adjusted carrying liability companies, trust certificates, and war- value of all nonfinancial equity investments held rants and call options that give the holder the by the bank or its direct or indirect subsidiaries. right to purchase an equity instrument), any The amount of the percentage deduction increases equity feature of a debt instrument (such as a as the aggregate amount of nonfinancial equity warrant or call option), and any debt instrument investments held by the bank increases as a that is convertible into equity.14 The Federal percentage of its tier 1 capital. Reserve may treat any other instrument (includ- The ‘‘adjusted carrying value’’ of investments ing subordinated debt) as an equity investment is the aggregate value at which the investments if, in its judgment, the instrument is the func- are carried on the balance sheet of the bank, tional equivalent of equity or exposes the state reduced by (1) any unrealized gains on those member bank to essentially the same risks as an investments that are reflected in such carrying equity instrument. value but excluded from the bank’s tier 1 capital A nonfinancial equity investment, subject to and (2) associated deferred tax liabilities. For the risk-based capital rule (the rule), is an equity example, for investments held as available-for- investment in a nonfinancial company made sale (AFS), the adjusted carrying value of the under the following authorities: investments would be the aggregate carrying value of the investments (as reflected on the • the authority to invest in SBICs under section consolidated balance sheet of the bank) less any 302(b) of the Small Business Investment Act unrealized gains on those investments that are of 1958 (15 USC 682(b)) included in other comprehensive income and not • the portfolio investment provisions of Regu- reflected in tier 1 capital, and associated deferred lation K (12 CFR 211.8(c)(3)), including the tax liabilities.15 The total adjusted carrying value authority to make portfolio investments through of any nonfinancial equity investment that is Edge and agreement corporations subject to deduction is excluded from the bank’s risk-weighted assets and for purposes of com- A nonfinancial company is an entity that engages puting the denominator of the bank’s risk-based in any activity that has not been determined to be permissible for the bank to conduct directly, or to be financial in nature or incidental to 15. Unrealized gains on AFS equity investments may be included in supplementary capital to the extent permitted by 14. This requirement generally does not apply to invest- the capital guidelines. In addition, the unrealized losses on ments in nonconvertible senior or subordinated debt. AFS equity investments are deducted from tier 1 capital.

Commercial Bank Examination Manual April 2011 Page 15 3020.1 Assessment of Capital Adequacy

Table 1—Deduction for Nonﬁnancial Equity Investments

Aggregate adjusted carrying value of all nonﬁnancial equity investments held directly or indirectly by the Deduction from core capital elements (as bank (as a percentage a percentage of the adjusted carrying of the tier 1 capital of the bank)1 value of the investment)

Less than 15 percent 8 percent 15 percent to 24.99 percent 12 percent 25 percent and above 25 percent

1. For purposes of calculating the adjusted carrying value the deduction for any disallowed MSAs, any disallowed of nonfinancial equity investments as a percentage of tier 1 NMSAs, any disallowed PCCRs, any disallowed credit capital, tier 1 capital is defined as the sum of core capital enhancing I/Os (both purchased and retained), any disallowed elements net of goodwill and net of all identifiable intangible deferred tax assets, and any nonfinancial equity investments. assets other than MSAs, NMSAs, and PCCRs, but before capital ratio.16 The total adjusted carrying With respect to consolidated SBICs, some value is also deducted from average total con- equity investments may be in companies that are solidated assets when computing the leverage consolidated for accounting purposes. For invest- ratio. ments in a nonfinancial company that is consoli- The deductions are applied on a marginal dated for accounting purposes under GAAP, the basis to the portions of the adjusted carrying bank’s adjusted carrying value of the investment value of nonfinancial equity investments that is determined under the equity method of fall within the specified ranges of the parent accounting (net of any intangibles associated bank’s tier 1 capital. The rule sets forth a with the investment that are deducted from the ‘‘stair-step’’ approach under which each tier of bank’s core). Even though the assets of the capital charges applies, on a marginal basis, to nonfinancial company are consolidated for the adjusted carrying value of the bank’s aggre- accounting purposes, these assets (as well as the gate nonfinancial equity investment portfolio credit-equivalent amounts of the company’s off- that falls within the specified ratios of the balance-sheet items) should be excluded from organization’s tier 1 capital. The stair-step the bank’s risk-weighted assets for regulatory approach reflects the fact that the financial risks capital purposes. to a bank from equity investment activities The capital adequacy guidelines for state increase as the level of these activities accounts member banks establish minimum risk-based for a larger portion of the bank’s capital, earn- capital ratios. Banks are at all times expected to ings, and activities. For example, if the adjusted maintain capital commensurate with the level carrying value of all nonfinancial equity invest- and nature of the risks to which they are ments held by a bank equals 20 percent of its tier exposed. The risk to a bank from nonfinancial 1 capital, then the amount of the deduction equity investments increases with its concentra- would be 8 percent of the adjusted carrying tion in such investments, and strong capital value of all investments up to 15 percent of the levels above the minimum requirements are bank’s tier 1 capital, and 12 percent of the particularly important when a bank has a high adjusted carrying value of all investments in degree of concentration in nonfinancial equity excess of 15 percent of the bank’s tier 1 investments (for example, in excess of 50 per- capital. cent of tier 1 capital). The Federal Reserve will monitor banks and apply heightened supervision, as appropriate, to 16. For example, if 8 percent of the adjusted carrying value equity investment activities, including where the of a nonfinancial equity investment is deducted from tier 1 bank has a high degree of concentration in capital, the entire adjusted carrying value of the investment nonfinancial equity investments, to ensure that will be excluded from risk-weighted assets when calculating each bank maintains capital levels that are the denominator for the risk-based capital ratio, and from average total consolidated assets when computing the lever- appropriate in light of its equity investment age ratio. activities. In addition, the Federal Reserve may

April 2011 Commercial Bank Examination Manual Page 16 Assessment of Capital Adequacy 3020.1 impose capital levels established by the capital which no deduction is required) must be included adequacy rules, in light of the nature or perfor- in determining, for purposes of table 1, the total mance of a particular organization’s equity amount of nonfinancial equity investments held investments or the sufficiency of the organiza- by the bank in relation to its tier 1 capital. tion’s policies, procedures, and systems to monitor and control the risks associated with its Grandfather provisions. No deduction is required equity investments. to be made for the adjusted carrying value of any nonfinancial equity investment (or portion SBIC investments. Investments may be made by of such an investment) that the bank made banks in or through SBICs under section 4(c)(5) before March 13, 2000, or that the bank made on of the BHC Act and section 302(b) of the Small or after this date pursuant to a binding written Business Investment Act. No deduction is commitment18 entered into before March 13, required for nonfinancial equity investments that 2000, provided that in either case the bank has are held by a bank (1) through one or more continuously held the investment since the rel- SBICs that are consolidated with the bank or evant investment date.19 A nonfinancial equity (2) in one or more SBICs that are not consoli- investment made before March 13, 2000, dated with the bank, to the extent that all such includes any shares or other interests the bank investments, in the aggregate, do not exceed received through a stock split or stock dividend 15 percent of the bank’s tier 1 capital. Any on an investment made before March 13, 2000, nonfinancial equity investment that is held provided the bank provides no consideration for through or in an SBIC and that is not required to the shares or interests received and the transac- be deducted from tier 1 capital will be assigned tion does not materially increase the bank’s a 100 percent risk weight and included in the proportional interest in the company. The exer- bank’s consolidated risk-weighted assets.17 cise on or after March 13, 2000, of options or To the extent the adjusted carrying value of warrants acquired before March 13, 2000, is not all nonfinancial equity investments that a bank considered to be an investment made before holds through one or more SBICs that are March 13, 2000, if the bank provides any consolidated with the bank, or in one or more consideration for the shares or interests received SBICs that are not consolidated with the bank, upon exercise of the options or warrants. Any exceeds, in the aggregate, 15 percent of the nonfinancial equity investment (or portion bank’s tier 1 capital, the appropriate percentage thereof) that is not required to be deducted from of such amounts (as set forth in table 1) must be tier 1 capital must be included in determining deducted from the bank’s core capital elements. the total amount of nonfinancial equity invest- In addition, the aggregate adjusted carrying ments held by the bank in relation to its tier 1 value of all nonfinancial equity investments held through a consolidated SBIC and in a noncon- 18. A ‘‘binding written commitment’’ means a legally solidated SBIC (including any investments for binding written agreement that requires the bank to acquire shares or other equity of the company, or make a capital contribution to the company, under terms and conditions set 17. If a bank has an investment in an SBIC that is forth in the agreement. Options, warrants, and other agree- consolidated for accounting purposes but that is not wholly ments that give a bank the right to acquire equity or make an owned by the bank, the adjusted carrying value of the bank’s investment, but do not require the bank to take such actions, nonfinancial equity investments through the SBIC is equal to are not considered a binding written commitment for purposes the bank’s proportionate share of the adjusted carrying value of this provision. of the SBIC’s equity investments in nonfinancial companies. 19. For example, if a bank made an equity investment in The remainder of the SBIC’s adjusted carrying value (that is, 100 shares of a nonfinancial company before March 13, 2000, the minority interest holders’ proportionate share) is excluded the adjusted carrying value of that investment would not be from the risk-weighted assets of the bank. If a bank has an subject to a deduction. However, if the bank made any investment in an SBIC that is not consolidated for accounting additional equity investment in the company after March 13, purposes, and the bank has current information that identifies 2000, such as by purchasing additional shares of the company the percentage of the SBIC’s assets that are equity invest- (including through the exercise of options or warrants acquired ments in nonfinancial companies, the bank may reduce the before or after March 13, 2000) or by making a capital adjusted carrying value of its investment in the SBIC propor- contribution to the company, and such investment was not tionately to reflect the percentage of the adjusted carrying made pursuant to a binding written commitment entered into value of the SBIC’s assets that are not equity investments in before March 13, 2000, the adjusted carrying value of the nonfinancial companies. If a bank reduces the adjusted carry- additional investment would be subject to a deduction. In ing value of its investment in a nonconsolidated SBIC to addition, if the bank sold and repurchased, after March 13, reflect financial investments of the SBIC, the amount of the 2000, 40 shares of the company, the adjusted carrying value of adjustment will be risk-weighted at 100 percent and included those 40 shares would be subject to a deduction under this in the bank’s risk-weighted assets. provision.

Commercial Bank Examination Manual April 2011 Page 17 3020.1 Assessment of Capital Adequacy capital for purposes of table 1. In addition, any portion (50 percent) of the investment allocated nonfinancial equity investment (or portion to it, the remainder (up to 100 percent) is to be thereof) that is not required to be deducted from deducted from tier 1 capital. tier 1 capital will be assigned a 100 percent risk Advances to banking and finance subsidiaries weight and included in the bank’s consolidated (that is, loans, extensions of credit, guarantees, risk-weighted assets. The following example commitments, or any other credit exposures) not illustrates these calculations. considered as capital are included in risk- A bank has $1 million in tier 1 capital and has weighted assets at the 100 percent risk weight nonfinancial equity investments with an aggre- (unless recognized collateral or guarantees dic- gate adjusted carrying value of $375,000. Of tate weighting at a lower percentage). However, this amount, $100,000 represents the adjusted such advances may be deducted from the parent carrying value of investments made before bank’s consolidated capital where examiners March 13, 2000, and an additional $175,000 find that the risks associated with the advances represents the adjusted carrying value of invest- are similar to the risks associated with capital ments made through the bank’s wholly owned investments, or if such advances possess risk SBIC. The $100,000 in investments made before factors that warrant an adjustment to capital for March 13, 2000, and $150,000 of the bank’s supervisory purposes. These risk factors could SBIC investments would not be subject to the include the absence of collateral support or the rule’s marginal capital charges. These amounts clear intention of banks to allow the advances to are considered for purposes of determining the serve as capital to subsidiaries regardless of marginal charge that applies to the bank’s cov- form. ered investments (including the $25,000 of non- Although the Federal Reserve does not auto- exempt SBIC investments). In this case, the total matically deduct investments in other unconsoli- amount of the bank’s tier 1 capital deduction dated subsidiaries or investments in joint ven- would be $31,250. This figure is 25 percent of tures and associated companies,22 the level and $125,000, which is the amount of the bank’s nature of such investments should be closely total nonfinancial equity portfolio subject to the monitored. Resources invested in these entities rule’s marginal capital charges. The average tier support assets that are not consolidated with the 1 capital charge on the bank’s entire nonfinan- rest of the bank and therefore may not be cial equity portfolio would be 8.33 percent. generally available to support additional leverage or absorb losses of affiliated institutions. Close monitoring is also necessary because Investments in Unconsolidated Banking experience has shown that banks often stand and Finance Subsidiaries and Other behind the losses of affiliated institutions to Subsidiaries protect the reputation of the organization as a whole. In some cases, this support has led to Generally, debt and equity capital investments losses that have exceeded the investments in and any other instruments deemed to be capital such entities. in unconsolidated banking and finance subsidi- Accordingly, for risk-based capital purposes, aries20 are to be deducted from the consolidated a bank may be required, on a case-by-case basis, capital of the parent bank, regardless of whether to (1) deduct such investments from total capi- the investment is made by the parent bank or its tal; (2) apply an appropriate risk-weighted charge direct or indirect subsidiaries.21 Fifty percent of against the bank’s pro rata share of the assets the investment is to be deducted from tier 1 of the affiliated entity; (3) consolidate the entity capital and 50 percent from tier 2 capital. When on a line-by-line basis; or (4) operate with a tier 2 capital is not sufficient to absorb the risk-based capital ratio above the minimum. In determining the appropriate capital treatment for such actions, the Federal Reserve will 20. A banking and finance subsidiary is generally defined generally take into account whether (1) the bank as any company engaged in banking or finance in which the parent organization holds directly or indirectly more than has significant influence over the financial or 50 percent of the outstanding voting stock, or any such company which is otherwise controlled or capable of being controlled by the parent organization. 22. Such entities are defined in the instructions to the call 21. An exception to this deduction is to be made for shares report. Associated companies and joint ventures are generally acquired in the regular course of securing or collecting a debt defined as companies in which the bank owns 20 to 50 percent previously contracted in good faith. of the voting stock.

April 2011 Commercial Bank Examination Manual Page 18 Assessment of Capital Adequacy 3020.1 managerial policies or operations of the affili- ment or a U.S. government agency are also ated entity, (2) the bank is the largest investor in assigned to the zero percent risk category. Claims the entity, or (3) other circumstances prevail that are directly but conditionally guaranteed are (such as the existence of significant guaran- assigned to the 20 percent risk category. A claim tees from the bank) that appear to closely tie is considered to be conditionally guaranteed by the activities of the affiliated company to the a central government if the validity of the bank. guarantee depends on some affirmative action by the holder or a third party. Generally, secu- Reciprocal Holdings of Banking rities guaranteed by the U.S. government or its Organizations’ Capital Instruments agencies that are actively traded in financial markets are considered to be unconditionally Reciprocal holdings are intentional cross- guaranteed. These include Government National holdings resulting from formal or informal Mortgage Association (GNMA or Ginnie Mae) arrangements between banking organizations to and Small Business Administration (SBA) swap or exchange each other’s capital instru- securities. ments. Such holdings of other banking organi- A limited number of U.S. government agency– zations’ capital instruments are to be deducted guaranteed loans are deemed to be uncondition- from the total capital of an organization for the ally guaranteed and can be assigned to the zero purpose of determining the total risk-based percent risk category. These include most loans guaranteed by the Export-Import Bank (Exim- capital ratio. Holdings of other banking organi- 23 zations’ capital instruments taken in satisfac- bank), loans guaranteed by the U.S. Agency tion of debts previously contracted or that for International Development (AID) under its constitute stake-out investments that comply Housing Guaranty Loan Program, SBA loans with the Federal Reserve’s policy statement on subject to a secondary participation guaranty in nonvoting equity investments (12 CFR 225.143) accordance with SBA form 1086, and Farmers are not deemed to be intentional cross-holdings Home Administration (FmHA) loans subject to and are therefore not deducted from a bank’s an assignment guaranty agreement in accor- capital. dance with FmHA form 449-36. Apart from the exceptions noted in the preceding paragraph, loans guaranteed by the U.S. government or its agencies are considered to be On-Balance-Sheet Activities conditionally guaranteed. The guaranteed portion of such loans is assigned to the 20 percent Claims on, and Guaranteed by, OECD risk category. These include, but are not limited Central Governments to, loans guaranteed by the Commodity Credit Corporation (CCC), the Federal Housing The risk-based capital guidelines assign a zero Administration (FHA), the Overseas Private percent risk weight to all direct claims (including Investment Corporation (OPIC), the Department securities, loans, and leases) on the central of Veterans Affairs (VA), and, except as indi- governments of the OECD-based group of cated above, the FmHA and SBA. Loan guaran- countries and U.S. government agencies. Gen- tees offered by OPIC often guarantee against erally, the only direct claims banks have on the political risk. However, only that portion of a U.S. government and its agencies take the form loan guaranteed by OPIC against commercial or of Treasury securities. Zero-coupon, that is, credit risk may receive a preferential 20 percent single-payment, Treasury securities trading un- risk weight. The portion of government trust der the U.S. Treasury’s Separately Traded certificates issued to provide funds for the refi- Registered Interest and Principal (STRIP) pro- nancing of foreign military sales loans made by gram are assigned to the zero percent risk the Federal Financing Bank or the Defense category. A security that has been stripped by a Security Assistance Agency that are indirectly private-sector entity, such as a brokerage firm, is guaranteed by the U.S. government also qualify considered an obligation of that entity and is for the 20 percent risk weight. accordingly assigned to the 100 percent risk category. 23. Loans guaranteed under Eximbank’s Working Capital Claims that are directly and unconditionally Guarantee Program, however, receive a 20 percent risk guaranteed by an OECD-based central govern- weight.

Commercial Bank Examination Manual April 2011 Page 19 3020.1 Assessment of Capital Adequacy

Most guaranteed student loans are guaranteed guidelines. Also eligible for the 50 percent risk by a state agency or nonprofit organization that weight are loans to builders with substantial does not have the full faith and credit backing project equity for the construction of one- to of the state. The loans are then indirectly guar- four-family residences that have been presold anteed or reinsured by the U.S. government’s under firm contracts to purchasers who have Guaranteed Student Loan Program. Under the obtained firm commitments for permanent quali- program, a minimum percentage of the loan is fying mortgage loans and have made substantial reinsured, but a higher percentage could be earnest-money deposits. guaranteed if the bank has experienced an over- In addition, qualifying multifamily residential all low default rate on guaranteed student loans. loans that meet certain criteria may be assigned Only the portion of the loan covered by the to the 50 percent risk category. These criteria are minimum guarantee under the program may be as follows: All principal and interest payments assigned to the 20 percent risk category; the must have been made on time for at least one remainder should be assigned a 100 percent risk year preceding placement in the 50 percent risk weight. category, amortization of the principal and interest must occur within 30 years, the minimum original maturity for repayment of princi- Claims on, or Guaranteed by, a U.S. pal cannot be less than seven years, and annual Government–Sponsored Agency net operating income (before debt service) generated by the property during the most recent U.S. government–sponsored agencies are agen- fiscal year must not be less than 120 percent of cies originally established or chartered by the the loan’s current annual debt service (115 per- federal government to serve public purposes cent if the loan is based on a floating interest specified by the U.S. Congress. Such agencies rate). In the case of cooperative or other not-for- generally carry out functions performed directly profit housing projects, the property must gen- by the central government in other countries. erate sufficient cash flow to provide comparable The obligations of government-sponsored agen- protection to the bank. cies generally are not explicitly guaranteed by To ensure that only qualifying residential the full faith and credit of the U.S. government. mortgage loans are assigned to this preferential Claims (including securities, loans, and leases) risk weight, examiners are to review the one- on, or guaranteed by, such agencies are assigned to four-family and multifamily residential real to the 20 percent risk category. U.S. government– estate loans that are included in the 50 percent sponsored agencies include, but are not limited risk category. Such loans are not eligible for to, the College Construction Loan Insurance preferential treatment unless they meet the fol- Association, Farm Credit Administration, Fed- lowing criteria: The loans are made subject to eral Agricultural Mortgage Corporation, Federal prudent underwriting standards, the loans are Home Loan Bank System, Federal Home Loan performing in accordance with their original Mortgage Corporation (FHLMC or Freddie terms and are not delinquent for 90 days or more Mac), Federal National Mortgage Association or carried on nonaccrual status, and the loan-to- (FNMA or Fannie Mae), Financing Corporation value ratios are conservative.24 For the purpose (FICO), Postal Service, Resolution Funding Cor- of this last criterion, the loan-to-value ratio poration (REFCORP), Student Loan Marketing should be based on the value of the property Association (SLMA or Sallie Mae), Smithso- determined by the most current appraisal or, if nian Institution, and Tennessee Valley Authority appropriate, the most current evaluation. Nor- (TVA). mally, this would be the appraisal or evaluation performed at the time the loan was originated.25 If a bank has assigned a 50 percent risk Loans Secured by First Liens on One- to weight to residential mortgage loans made for Four-Family Residential Properties and Multifamily Residential Properties 24. A conservative loan-to-value ratio for loans secured by multifamily residential property must not exceed 80 percent Qualifying loans on one- to four-family residen- (or 75 percent if the loan is based on a floating interest rate). tial properties, either owner-occupied or rented 25. When both first and junior liens are held by the bank and no intervening liens exist, these transactions are treated as (as defined in the instructions to the call report), single loans secured by a first lien for the purpose of are accorded a 50 percent risk weight under the determining the loan-to-value ratio.

April 2011 Commercial Bank Examination Manual Page 20 Assessment of Capital Adequacy 3020.1 the purpose of speculative real estate develop- Transfers and Servicing of Financial Assets and ment or whose eligibility for such preferential Extinguishments of Liabilities.’’ These criteria treatment is otherwise questionable, and the are summarized in the definition of ‘‘transfers of amounts of nonqualifying loans are readily iden- financial assets’’ in the glossary to the commer- tifiable, such loans should be reassigned to the cial bank Call Report instructions. If a transfer 100 percent risk-weight category. If material of assets does not meet these criteria, the assets evidence exists that a bank has assigned a must remain on the bank’s balance sheet and are preferential risk weight to residential mortgage subject to the standard risk-based capital charge. loans of questionable eligibility, but the amount If a transfer of assets qualifies as a sale under of the inappropriately weighted amount cannot GAAP but the bank retains any risk of loss or be readily identified, the overall evaluation of obligation for payment of principal or interest, the bank’s capital adequacy should reflect a then the transfer is considered to be a sale with higher capital requirement than would otherwise recourse. A more detailed definition of an asset be the case. sale with recourse may be found in the definition of ‘‘sales of assets for risk-based capital purposes’’ in the glossary to the commercial bank Accrued Interest Call Report instructions. Although the assets are removed from a bank’s balance sheet in an asset Banks normally report accrued interest on loans sale with recourse, the credit-equivalent amount and securities in ‘‘Other Assets’’ on the Call is assigned to the risk category appropriate to Report. The majority of banks will risk-weight the obligor in the underlying transaction, after the entire amount of accrued interest at 100 per- considering any associated guaranties or collat- cent. However, for risk-based capital purposes, eral. This assignment also applies when the a bank is permitted to allocate accrued interest contractual terms of the recourse agreement among the risk categories associated with the limit the seller’s risk to a percentage of the value underlying claims, provided the bank has sys- of the assets sold or to a specific dollar amount. tems in place to carry out such an allocation If, however, the risk retained by the seller is accurately. limited to some fixed percentage of any losses that might be incurred and there are no other provisions resulting in the direct or indirect Off-Balance-Sheet Activities retention of risk by the seller, the maximum amount of possible loss for which the selling Off-balance-sheet transactions include recourse bank is at risk (the stated percentage times the obligations, direct-credit substitutes, residual amount of assets to which the percentage applies) interests, and asset- and mortgage-backed secu- is subject to risk-based capital requirements. rities. The treatments for direct-credit substi- The remaining amount of assets transferred tutes, assets transferred with recourse, and secu- would be treated as a sale that is not subject to rities issued in connection with asset the risk-based capital requirements. For exam- securitizations and structured financings are ple, a seller would treat a sale of $1 million in described later in this section. The terms asset assets with a recourse provision that the seller securitizations or securitizations, as used in this and buyer proportionately share in losses incurred subsection, include structured financings, as well on a 10 percent and 90 percent basis, respec- as asset-securitization transactions. tively, and with no other retention of risk by the seller, as a $100,000 asset sale with recourse and a $900,000 sale not subject to Assets Sold with Recourse risk-based capital requirements. There are several exceptions to the general For risk-based capital adequacy purposes, a reporting rule for recourse transactions. The first bank must hold capital against assets sold with exception applies to recourse transactions for recourse if the bank retains any risk of loss. To which the amount of recourse the institution is qualify as an asset sale with recourse, a transfer contractually liable for is less than the capital of assets must first qualify as a sale according to requirement for the assets transferred under the the GAAP criteria set forth in paragraph 14 of recourse agreement. For such transactions, a the Financial Accounting Standards Board’s bank must hold capital equal to its maximum Statement No. 140 (FAS 140), ‘‘Accounting for contractual recourse obligation. For example,

Commercial Bank Examination Manual November 2004 Page 21 3020.1 Assessment of Capital Adequacy assume an institution transfers a $100 pool of servicing rights, it customarily makes represen- commercial loans and retains a recourse obliga- tations and warranties concerning those assets. tion of 2 percent. Ordinarily, the bank would be When a bank purchases loan-servicing rights, subject to an 8 percent capital charge, or $8. it may also assume representations and warran- Because the recourse obligation is only 2 per- ties made by the seller or a prior servicer. These cent, however, the bank would be required to representations and warranties give certain rights hold capital of $2 against the recourse exposure. to other parties and impose obligations on the This capital charge may be reduced further by seller or servicer of the assets. To the extent a the balance of any associated noncapital GAAP bank’s representations and warranties function recourse liability account. as credit enhancements to protect asset purchas- A second exception to the general rule applies ers or investors from credit risk, they are con- to the transfer of small-business loans and to the sidered as recourse or direct-credit substitutes. transfer of leases on personal property with The Federal Reserve’s risk-based capital recourse. A bank that is considered to be well adequacy rule is consistent with the agencies’ capitalized according to the Federal Reserve’s long-standing recourse treatment of representa- prompt-corrective-action framework should tions and warranties that effectively guarantee include in risk-weighted assets only the amount the performance or credit quality of transferred of retained recourse—instead of the entire loans. However, banks typically make a number amount of assets transferred—in connection with of factual warranties that are unrelated to the a transfer of small-business loans or a transfer of ongoing performance or credit quality of trans- leases on personal property with recourse, pro- ferred assets. These warranties entail opera- vided two conditions are met. First, the transactional risk, as opposed to the open-ended credit tion must be treated as a sale under GAAP; risk inherent in a financial guaranty, and are second, the bank must establish a noncapital not considered recourse or a direct-credit sub- reserve that is sufficient to cover the bank’s stitute. Warranties that create operational risk estimated liability under the recourse arrange- include warranties that assets have been under- ment. With the Board’s approval, this exception written or collateral appraised in conformity may also apply to a bank that is considered to be with identified standards, as well as warranties adequately capitalized under the prompt- that provide for the return of assets in instances corrective-action framework. The total outstand- of incomplete documentation, fraud, or ing amount of recourse retained under such misrepresentation. transactions may not exceed 15 percent of a Warranties can impose varying degrees of bank’s total risk-based capital without Board operational risk. For example, a warranty that approval. asset collateral has not suffered damage from potential hazards entails a risk that is offset to some extent by prudent underwriting practices Definitions requiring the borrower to provide hazard insurance to the bank. A warranty that asset collateral The capital adequacy guidelines provide special is free of environmental hazards may present treatment for recourse obligations, direct-credit acceptable operational risk for certain types substitutes, residual interests, and asset- and of properties that have been subject to environ- mortgage-backed securities involved in asset- mental assessment, depending on the circum- securitization activities. A brief discussion of stances. The appropriate limits for these opera- some of the primary definitions follows. tional risks are monitored through supervision of a bank’s loan-underwriting, -sale, and Credit derivatives. Credit derivative means a -servicing practices. Also, a bank that pro- contract that allows one party (the protection vides warranties to loan purchasers and inves- purchaser) to transfer the credit risk of an asset tors must include associated operational risks in or off-balance-sheet credit exposure to another its risk management of exposures arising from party (the protection provider). The value of a loan-sale or securitization-related activities. credit derivative is dependent, at least in part, on Banks should be prepared to demonstrate to the credit performance of a ‘‘reference asset.’’ examiners that operational risks are effectively managed. Credit-enhancing representations and warran- Recourse or direct-credit-substitute treatment ties. When a bank transfers assets, including is required for warranties providing assurances

November 2004 Commercial Bank Examination Manual Page 22 Assessment of Capital Adequacy 3020.1 about the actual value of asset collateral, includ- expired, the early-default clause will no longer ing that the market value corresponds to its trigger recourse treatment, provided there are no appraised value or that the appraised value will other provisions that constitute recourse. be realized in the event of foreclosure and sale. Warranties such as these, which make represen- Direct-credit substitutes. The term direct-credit tations about the future value of a loan or related substitute refers to an arrangement in which a collateral, constitute an enhancement of the bank assumes, in form or in substance, credit loan transferred, and thus are recourse arrange- risk associated with an on- or off-balance-sheet ments or direct-credit substitutes. When a seller asset or exposure that was not previously owned represents that it ‘‘has no knowledge’’ of cir- by the bank (third-party asset), and the risk cumstances that could cause a loan to be other assumed by the bank exceeds the pro rata share than investment quality, the representation is not of its interest in the third-party asset. If the bank recourse. Banks may limit recourse exposure has no claim on the third-party asset, then the with warranties that directly address the condi- bank’s assumption of any credit risk on the tion of the asset at the time of transfer (that third-party asset is a direct-credit substitute. is, creation of an operational warranty) and The term direct-credit substitute explicitly by monitoring compliance with stated underwrit- includes items such as purchased subordinated ing standards. Alternatively, banks might create interests, agreements to cover credit losses that warranties with exposure caps that would permit arise from purchased loan-servicing rights, credit it to take advantage of the low-level-recourse derivatives, and lines of credit that provide rule. credit enhancement. Some purchased subordi- The definition of credit-enhancing represen- nated interests, such as credit-enhancing I/O tations and warranties excludes warranties— strips, are also residual interests for regulatory such as early-default clauses and similar war- capital purposes. ranties that permit the return of, or premium- Direct-credit substitutes include, but are not refund clauses covering, one- to four-family limited to— residential first mortgage loans that qualify for a 50 percent risk weight for a maximum period of •financial standby letters of credit that support 120 days from the date of transfer. These war- financial claims on a third party that exceed a ranties may cover only those loans that were bank’s pro rata share of losses in the financial originated within one year of the date of transfer. claim; A premium-refund clause is a warranty that • guarantees, surety arrangements, credit deriva- obligates a seller who has sold a loan at a price tives, and similar instruments backing finan- in excess of par, that is, at a premium, to refund cial claims that exceed a bank’s pro rata share the premium, either in whole or in part, if the in the financial claim; loan defaults or is prepaid within a certain • purchased subordinated interests or securities period of time. Premium-refund clauses that that absorb more than their pro rata share of cover assets guaranteed, in whole or in part, by losses from the underlying assets; the U.S. government, a U.S. government agency, • credit derivative contracts under which the or a government-sponsored enterprise are not bank assumes more than its pro rata share of included in the definition of credit-enhancing credit risk on a third-party exposure; representations and warranties, provided the • loans or lines of credit that provide credit premium-refund clauses are for a period not to enhancement for the financial obligations of exceed 120 days from the date of transfer. The an account party; definition also does not include warranties that • purchased loan-servicing assets if the servicer permit the return of assets in instances of is responsible for credit losses or if the ser- misrepresentation, fraud, or incomplete vicer makes or assumes credit-enhancing rep- documentation. resentations and warranties with respect to the loans serviced (mortgage-servicer cash Early-default clauses. Early-default clauses typi- advances that meet the conditions of section cally give the purchaser of a loan the right to III.B.3.a.x. of the guidelines (12 CFR 208, return the loan to the seller if the loan becomes appendix A) are not direct-credit substitutes); 30 or more days delinquent within a stated • clean-up calls on third-party assets (clean-up period after the transfer, for example, four calls that are 10 percent or less of the original months after transfer. Once the stated period has pool balance that are exercisable at the option

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of the bank are not direct-credit substitutes); remaining loans in a pool when the balance of and those loans is equal to or less than 10 percent of • liquidity facilities that provide liquidity sup- the original pool balance. This treatment will port to ABCP (other than eligible ABCP also apply to clean-up calls written with refer- liquidity facilities). ence to less than 10 percent of the outstanding principal amount of securities. If, however, an Clean-up calls. A clean-up call is an option that agreement permits the remaining loans to be permits a servicer or its affiliate (which may be repurchased when their balance is greater than the originator) to take investors out of their 10 percent of the original pool balance, the positions in a securitization before all of the agreement is considered to be a recourse obli- transferred loans have been repaid. The servicer gation or a direct-credit substitute. The exemp- accomplishes this by repurchasing the remain- tion from recourse or direct-credit-substitute ing loans in the pool once the pool balance has treatment for a clean-up call of 10 percent or fallen below some specified level. This option in less recognizes the real market need to be able to a securitization raises long-standing agency con- call a transaction when the costs of keeping it cerns that a bank may implicitly assume a outstanding are burdensome. However, to mini- credit-enhancing position by exercising the mize the potential for using such a feature as a option when the credit quality of the securitized means of providing support for a troubled port- loans is deteriorating. An excessively large folio, a bank that exercises a clean-up call clean-up call facilitates a securitization servic- should not repurchase any loans in the pool that er’s ability to take investors out of a pool to are 30 days or more past due. Alternatively, the protect them from absorbing credit losses, and bank should repurchase the loans at the lower of thus may indicate that the servicer has retained their estimated fair value or their par value plus or assumed the credit risk on the underlying accrued interest. pool of loans. Banks that repurchase assets pursuant to a Generally, clean-up calls (whether or not they clean-up call may do so based on an aggregate are exercised) are treated as recourse and direct- fair value for all repurchased assets. Banks do credit substitutes. The purpose of treating large not have to evaluate each individual loan remain- clean-up calls as recourse or direct-credit sub- ing in the pool at the time a clean-up call is stitutes is to ensure that a bank is not able to exercised to determine fair value. Rather, the provide credit support to the trust investors by overall repurchase price should reflect the aggre- repaying its investment when the credit quality gate fair value of the assets being repurchased so of the pool is deteriorating without holding that the bank is not overpaying for the assets capital against the exposure. The focus should and, in so doing, providing credit support to the be on the arrangement itself and not the exercise trust investors. Examiners will review the terms of the call. Thus, the existence, not the exercise, and conditions relating to the repurchase arrange- of a clean-up call that does not meet the requirements in clean-up calls to ensure that transac- ments of the risk-based capital rule will trigger tions are done at the lower of fair value or par treatment as a recourse obligation or a direct- value plus accrued interest. Banks should be credit substitute. A clean-up call can function as able to support their fair-value estimates. If the a credit enhancement because its existence pro- Federal Reserve concludes that a bank has vides the opportunity for a bank (as servicer or repurchased assets at a price that exceeds the an affiliate of a servicer) to provide credit lower of these two amounts, the clean-up call support to investors by taking an action that is provisions in its future securitizations may be within the contractual terms of the securitization treated as recourse obligations or direct-credit documents. substitutes. Regardless of the size of the clean-up Because clean-up calls can also serve an call, the Federal Reserve will closely scrutinize administrative function in the operation of a and take appropriate supervisory action for any securitization, a limited exemption exists for transaction in which the bank repurchases dete- these options. When an agreement permits a riorating assets for an amount greater than a bank that is a servicer or an affiliate of the reasonable estimate of their fair value. servicer to elect to purchase loans in a pool, the agreement is not considered a recourse obliga- Eligible ABCP liquidity facility. An eligible tion or a direct-credit substitute if the agreement ABCP liquidity facility is a liquidity facility that permits the banking organization to purchase the supports ABCP, in form or in substance, and is

November 2004 Commercial Bank Examination Manual Page 24 Assessment of Capital Adequacy 3020.1 subject to an asset-quality test at the time of derived from assets an organization has sold into draw that precludes funding against assets that a securitization. In those cases, the spread are 90 days or more past due or in default. In account is considered to be a ‘‘credit-enhancing addition, if the assets that an eligible ABCP interest-only strip’’ and is subject to the concen- liquidity facility is required to fund against are tration limit. (See SR-02-16.) However, any externally rated assets or exposures at the incep- portion of a spread account that represents an tion of the facility, the facility can be used to interest in cash that has already been collected fund only those assets or exposures that are and is held by the trustee is a ‘‘residual interest’’ externally rated investment grade at the time of subject to dollar-for-dollar capital, but is not a funding. Notwithstanding the eligibility require- credit-enhancing interest-only strip subject to ments set forth in the two preceding sentences, a the concentration limit. For example, assume liquidity facility will be considered an eligible that a bank books a single spread-account asset ABCP liquidity facility if the assets that are that is derived from two separate cash-flow funded under the liquidity facility and which do streams: not meet the eligibility requirements are guaranteed, either conditionally or unconditionally, • A receivable from the securitization trust that by the U.S. government or its agencies or by the represents cash that has already accumulated central government of an OECD country. in the spread account. In accordance with the securitization documents, the cash will be Externally rated. Externally rated is a term returned to the bank at some date in the future which means that an instrument or obligation after having been reduced by amounts used to has received a credit rating from a nationally reimburse investors for credit losses. Based on recognized statistical rating organization. the date when the cash is expected to be paid out to the bank, the present value of this asset Face amount. The face amount is the notional is currently estimated to be $3. principal, or face value, amount of an off- • A projection of future cash flows that are balance-sheet item; the amortized cost of an expected to accumulate in the spread account. asset not held for trading purposes; and the fair In accordance with the securitization docu- value of a trading asset. ments, the cash, to the extent collected, will also be returned to the bank at some date in Financial asset. A financial asset is cash or other the future after having been reduced by monetary instrument, evidence of debt, evidence amounts used to reimburse investors for credit of an ownership interest in an entity, or a losses. Based on the date when the cash is contract that conveys a right to receive or expected to be paid out to the bank, the exchange cash or another financial instrument present value of this asset is currently esti- from another party. mated to be $2.

Financial standby letters of credit. A finan- Both components of the above spread account cial standby letter of credit means a letter are considered to be residual interests under the of credit or similar arrangement that represents current capital standards because both represent an irrevocable obligation to a third-party on-balance-sheet assets subject to more than beneficiary— their pro rata share of losses on the underlying portfolio of sold assets. However, the $2 asset • to repay money borrowed by, advanced to, or that represents the bank’s retained interest in for the account of a second party (the account future cash flows exposes the organization to a party), or greater degree of risk because the $2 asset • to make payment on behalf of the account presents additional uncertainty as to whether it party, in the event that the account party fails will ever be collected. This additional uncer- to fulfill its obligation to the beneficiary. tainty associated with the recognition of future subordinated excess cash flows results in the $2 Spread accounts that function as credit- asset being treated as a credit-enhancing interest- enhancing interest-only strips. A spread account only strip, a subset of residual interests. is an on-balance-sheet asset that functions as a The face amount of all of the bank’s credit- credit enhancement and that can represent an enhancing interest-only strips is first subject to a interest in expected interest and fee cash flows 25 percent of tier 1 capital concentration limit.

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Any portion of this face amount that exceeds spread-related assets as credit-enhancing I/O 25 percent of tier 1 capital is deducted from tier strips on a case-by-case basis. For example, 1 capital. This limit will affect both a bank’s including some principal payments with interest risk-based and leverage capital ratios. The and fee cash ﬂows will not otherwise negate the remaining face amount of the bank’s credit- regulatory capital treatment of that asset as a enhancing interest-only strips, as well as the credit-enhancing I/O strip. Credit-enhancing I/O face amount of the spread-account receivable strips include both purchased and retained for cash already held in the trust, is subject to the interest-only strips that serve in a credit- dollar-for-dollar capital requirement established enhancing capacity, even though purchased I/O for residual interests, which affects only the strips generally do not result in the creation of risk-based capital ratios. capital on the purchaser’s balance sheet.

Credit-enhancing interest-only strips. A credit- Loan-servicing arrangements. The definitions enhancing interest-only (I/O) strip is an of recourse and direct-credit substitute cover on-balance-sheet asset that, in form or substance, loan-servicing arrangements if the bank, as ser- (1) represents the contractual right to receive vicer, is responsible for credit losses associated some or all of the interest due on transferred with the serviced loans. However, cash advances assets and (2) exposes the bank to credit risk that made by residential mortgage servicers to ensure exceeds its pro rata claim on the underlying an uninterrupted flow of payments to investors assets, whether through subordination provi- or the timely collection of the mortgage loans sions or other credit-enhancing techniques. Thus, are specifically excluded from the definitions of credit-enhancing I/O strips include any balance- recourse and direct-credit substitute, provided sheet asset that represents the contractual right the residential mortgage servicer is entitled to to receive some or all of the remaining interest reimbursement for any significant advances and cash flow generated from assets that have been this reimbursement is not subordinate to other transferred into a trust (or other special-purpose claims. To be excluded from recourse and direct- entity), after taking into account trustee and credit-substitute treatment, the bank, as servicer, other administrative expenses, interest payments should make an independent credit assessment to investors, servicing fees, reimbursements to of the likelihood of repayment of the servicer investors for losses attributable to the beneficial advance before advancing funds, and should interests they hold, and reinvestment income only make such an advance if prudent lending and ancillary revenues26 on the transferred assets. standards are met. Risk-based capital is assessed Credit-enhancing I/O strips are generally carried only against the amount of the cash advance, on the balance sheet at the present value of the and the advance is assigned to the risk-weight expected net cash flow that the banking organi- category appropriate to the party obligated to zation reasonably expects to receive in future reimburse the servicer. periods on the assets it has securitized, adjusted If a residential mortgage servicer is not entitled for some level of prepayments if relevant to that to full reimbursement, then the maximum pos- asset class, and discounted at an appropriate sible amount of any nonreimbursed advances on market interest rate. Typically, when assets are any one loan must be contractually limited to an transferred in a securitization transaction that is insignificant amount of the outstanding principal accounted for as a sale under GAAP, the account- on that loan. Otherwise, the servicer’s obligation ing recognition given to the credit-enhancing to make cash advances will not be excluded I/O strip on the seller’s balance sheet results in from the definitions of recourse and direct-credit the recording of a gain on the portion of the substitute. Banks that act as servicers should transferred assets that has been sold. This gain is establish policies on servicer advances and use recognized as income, thus increasing the bank’s discretion in determining what constitutes an capital position. The economic substance of a ‘‘insignificant’’ servicer advance. The Federal transaction will be used to determine whether a Reserve will exercise its supervisory authority particular interest cash flow functions as a credit- to apply recourse or direct-credit-substitute treat- enhancing I/O strip, and the Federal Reserve ment to servicer cash advances that expose a reserves the right to identify other cash flows or bank, acting as servicer, to excessive levels of credit risk. 26. According to FAS 140, ancillary revenues include such revenues as late charges on the transferred assets. Liquidity facility. A liquidity facility refers to a

November 2004 Commercial Bank Examination Manual Page 26 Assessment of Capital Adequacy 3020.1 legally binding commitment to provide liquidity ing the third-party enhancement. Second mort- support to ABCP by lending to, or purchasing gages or home equity loans generally will not be assets from, any structure, program, or conduit considered recourse arrangements unless they in the event that funds are required to repay actually function as credit enhancements. maturing ABCP. Third-party enhancements (for example, insurance protection) purchased by the origina- Mortgage-servicer cash advance. A mortgage- tor of a securitization for the benefit of investors servicer cash advance represents funds that a also do not generally constitute recourse. The residential mortgage loan servicer advances to purchase of enhancements for a securitization, ensure an uninterrupted flow of payments, when the bank is completely removed from any including advances made to cover foreclosure credit risk, will not, in most instances, constitute costs or other expenses to facilitate the timely recourse. However, if the purchase or premium collection of the loan. price is paid over time and the size of the A mortgage-servicer cash advance is not a payment is a function of the third-party’s loss recourse obligation or a direct-credit substitute experience on the portfolio, such an arrange- if— ment indicates an assumption of credit risk and would be considered recourse. • the servicer is entitled to full reimbursement Recourse may also exist implicitly if a bank and this right is not subordinated to other provides credit enhancement beyond any con- claims on the cash flows from the underlying tractual obligation to support assets it has sold. asset pool; or The following are examples of recourse arrange- • for any one loan, the servicer’s obligation to ments: make nonreimbursable advances is contractually limited to an insignificant amount of the • credit-enhancing representations and warran- outstanding principal balance of that loan. ties made on the transferred assets • loan-servicing assets retained pursuant to an Nationally recognized statistical rating organi- agreement under which the bank will be zation (NRSRO). An NRSRO is an entity that is responsible for credit losses associated with recognized by the Division of Market Regula- the loans being serviced (mortgage-servicer tion of the Securities and Exchange Commission cash advances that meet the conditions of (or any successor division) (the commission) as section III.B.3.a.x. of the guidelines (12 CFR a nationally recognized statistical rating organi- 208, appendix A) are not recourse zation for various purposes, including the com- arrangements) mission’s uniform net capital requirements for • retained subordinated interests that absorb brokers and dealers. more than their pro rata share of losses from the underlying assets Recourse. Recourse means the retention by a • assets sold under an agreement to repurchase, bank, in form or in substance, of any credit risk if the assets are not already included on the directly or indirectly associated with an asset it balance sheet has transferred that exceeds a pro rata share of • loan strips sold without contractual recourse, the bank’s claim on the asset. If a bank has no when the maturity of the transferred loan is claim on a transferred asset, then the retention of shorter than the maturity of the commitment any risk of credit loss is recourse. A recourse under which the loan is drawn obligation typically arises when a bank transfers • credit derivatives issued that absorb more than assets and retains an explicit obligation to repur- the bank’s pro rata share of losses from the chase the assets or absorb losses due to a default transferred assets on the payment of principal or interest or any • clean-up calls at inception that are greater than other deficiency in the performance of the under- 10 percent of the balance of the original pool lying obligor or some other party. The definition of transferred loans (clean-up calls that are of recourse is consistent with the banking agen- 10 percent or less of the original pool balance cies’ long-standing use of this term, and incor- that are exercisable at the option of the bank porates existing agency practices regarding reten- are not recourse arrangements) tion of risk in asset sales. • liquidity facilities that provide liquidity sup- Second-lien positions do not, in most circum- port to ABCP (other than eligible ABCP stances, constitute recourse for the bank receiv- liquidity facilities)

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Residual interests. Residual interests are defined future credit losses within the loan pools that as any on-balance-sheet asset (1) that represents they support, and thus are subject to valuation an interest (including a beneficial interest) inaccuracies. Spread accounts and overcollater- created by a transfer that qualifies as a sale (in alizations that do not meet the definition of accordance with GAAP) of financial assets, credit-enhancing I/O strips generally do not whether through a securitization or otherwise, expose a bank to the same level of risk as and (2) that exposes a bank to credit risk directly credit-enhancing I/O strips, and thus are excluded or indirectly associated with the transferred from the concentration limit. assets that exceeds a pro rata share of The capital treatment for a residual interest the bank’s claim on the asset, whether through applies when a bank effectively retains the risk subordination provisions or other credit- associated with that residual interest, even if the enhancement techniques. Residual interests gen- residual is sold. The economic substance of the erally do not include interests purchased from a transaction will be used to determine whether third party, except for credit-enhancing I/O strips. the bank has transferred the risk associated with Examples of residual interests (assets) include the residual-interest exposure. Banks that trans- credit-enhancing I/Os; spread accounts; cash- fer the risk on residual interests, either directly collateral accounts; retained subordinated inter- through a sale or indirectly through guarantees ests; accrued but uncollected interest on trans- or other credit-risk-mitigation techniques, and ferred assets that, when collected, will be then reassume this risk in any form will be available to serve in a credit-enhancing capac- required to hold risk-based capital as though the ity; and similar on-balance-sheet assets that residual interest remained on the bank’s books. function as a credit enhancement. The functional- For example, if a bank sells an asset that is an based definition reflects the fact that securitiza- on-balance-sheet credit enhancement to a third tion structures vary in the way they use certain party and then writes a credit derivative to cover assets as credit enhancements. Residual interests the credit risk associated with that asset, the therefore include any retained on-balance-sheet selling bank must continue to risk-weight, and asset that functions as a credit enhancement in a hold capital against, that asset as a residual securitization, regardless of how a bank refers to interest as if the asset had not been sold. the asset in financial or regulatory reports. In general, the definition of residual interests Risk participation. Risk participation means a includes only an on-balance-sheet asset that participation in which the originating party represents an interest created by a transfer of remains liable to the beneficiary for the full financial assets treated as a sale under GAAP, in amount of an obligation (for example, a direct- accordance with FAS 140. Interests retained in a credit substitute) notwithstanding that another securitization or transfer of assets accounted for party has acquired a participation in that as a financing under GAAP are generally obligation. excluded from the definition of residual interest. In the case of GAAP financings, the transferred Securitization. Securitization is the pooling and assets remain on the transferring bank’s balance repackaging by a special-purpose entity of assets sheet and are, therefore, directly included in or other credit exposures into securities that can both the leverage and risk-based capital calcu- be sold to investors. Securitization includes lations. Further, when a transaction is treated as transactions that create stratified credit-risk posi- a financing, no gain is recognized from an tions whose performance is dependent on an accounting standpoint. underlying pool of credit exposures, including Sellers’ interests generally do not function as loans and commitments. a credit enhancement. Thus, if a seller’s interest shares losses on a pro rata basis with investors, Sponsor. A sponsor refers to a bank that estab- such an interest would not be considered a lishes an ABCP program; approves the sellers residual interest. However, banks should recog- permitted to participate in the program; approves nize that sellers’ interests that are structured to the asset pools to be purchased by the program; absorb a disproportionate share of losses will be or administers the program by monitoring the considered residual interests. assets, arranging for debt placement, compiling The definition of residual interest also includes monthly reports, or ensuring compliance with overcollateralization and spread accounts because the program documents and with the program’s these accounts are susceptible to the potential credit and investment policy.

November 2004 Commercial Bank Examination Manual Page 28 Assessment of Capital Adequacy 3020.1

Structured finance program. A structured finance Risk-Weight Factor for Off-Balance-Sheet program refers to a program where receivable Recourse Obligations and Direct-Credit interests and asset-backed securities issued by Substitutes multiple participants are purchased by a special- purpose entity that repackages those exposures To determine the bank’s risk-weight factor for into securities that can be sold to investors. off-balance-sheet recourse obligations and direct- Generally, structured finance programs allocate credit substitutes, the credit-equivalent amount credit risks between the participants and the is assigned to the risk category appropriate to credit enhancement provided to the program. the obligor in the underlying transaction, after considering any associated guarantees or collateral. For a direct-credit substitute that is an on-balance-sheet asset (for example, a pur- Recourse Obligations, Direct-Credit chased subordinated security), a bank must cal- Substitutes, Residual Interests, and culate risk-weighted assets using the amount of Asset- and Mortgage-Backed the direct-credit substitute and the full amount Securities of the assets it supports, that is, all the more senior positions in the structure. Direct-credit substitutes that have been syndicated or in The risk-based capital treatment for recourse which risk participations have been conveyed or obligations, direct-credit substitutes, and asset- acquired are considered off-balance-sheet items and mortgage-backed securities in connection that are converted at a 100 percent conversion with asset securitizations and structured financ- factor. (See section III.D.1. of the guidelines (12 ings is described below. The capital treatment CFR 208, appendix A) for more capital-treatment described in this subsection applies to the bank’s details.) own positions.27 For banks that comply with the market-risk rules, except for liquidity facilities supporting Ratings-Based Approach—Externally ABCP (in form or in substance), positions in the Rated Positions trading book that arise from asset securitizations, including recourse obligations, residual Each loss position in an asset-securitization interests, and direct-credit substitutes, should be structure functions as a credit enhancement for treated according to the market-risk rules. How- the more senior loss positions in the structure. A ever, these banks remain subject to the 25 per- multilevel ratings-based approach is used to cent concentration limit for credit-enhancing I/O assess capital requirements on recourse obliga- strips. tions, residual interests (except credit-enhancing I/O strips), direct-credit substitutes, and senior and subordinated securities in asset securitiza- Credit-Equivalent Amount tions. The approach uses credit ratings from the rating agencies to measure relative exposure to The credit-equivalent amount for a recourse credit risk and determine the associated risk- obligation or a direct-credit substitute is the full based capital requirement. Using these credit amount of the credit-enhanced assets for which ratings provides a way to use determinations of the bank directly or indirectly retains or assumes credit quality that are relied on by investors and credit risk, multiplied by a 100 percent conver- other market participants to differentiate the sion factor. This treatment, however, does not regulatory capital treatment for loss positions apply to externally rated positions, senior posi- representing different gradations of risk. tions not externally rated, residual interests, Under the ratings-based approach, the capital certain internally rated positions, and certain requirement for a position is computed by mul- small-business loans and leases on personal tiplying the face amount of the position by the property transferred with recourse. appropriate risk weight, determined in accordance with the following tables.28 Table 2 maps

28. The rating designations (for example, AAA, BBB, A-1, 27. The treatment also applies to banks that hold positions and P-1) used in the tables are illustrative only and do not in their trading book but that are not otherwise subject to the indicate any preference for, or endorsement of, any particular market-risk rules. rating-agency designation system.

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Table 2—Risk-Weight Assignments for Externally Rated Long-Term Positions Rating-designation Long-term rating category examples Risk weight Highest or second-highest investment grade AAA, AA 20 percent Third-highest investment grade A 50 percent Lowest investment grade BBB 100 percent One category below investment grade BB 200 percent

Table 3—Risk-Weight Assignments for Externally Rated Short-Term Positions Rating-designation Short-term rating category examples Risk weight Highest investment grade A-1, P-1 20 percent Second-highest investment grade A-2, P-2 50 percent Lowest investment grade A-3, P-3 100 percent long-term ratings to the appropriate risk weights. enhancing I/O strips) retained, assumed, or issued Table 3 maps short-term ratings for asset-backed in connection with a securitization or structured commercial paper to the appropriate risk weights. finance program qualify for the ratings-based The Federal Reserve has the authority, however, approach. to override the use of certain ratings or the Corporate debt instruments, municipal bonds, ratings on certain instruments, either on a case- and other securities that are not related to a by-case basis or through broader supervisory securitization or structured finance program do policy, if necessary or appropriate to address the not meet these definitions, and thus do not risk that an instrument poses to a bank. qualify for the ratings-based approach. The ratings-based approach can be used for certain designated asset-backed securities (including asset-backed commercial paper), recourse obligations, direct-credit substitutes, Traded Positions and residual interests (other than credit- enhancing I/O strips). Credit-enhancing I/O strips A traded position is only required to be rated by have been excluded from the ratings-based one rating agency. A traded position is defined approach because of their high risk profile. as a position that is externally rated and is While the ratings-based approach is available retained, assumed, or issued in connection with for both traded and untraded positions, the an asset securitization, where there is a reason- approach applies different requirements to each able expectation that, in the near future, the type of position. rating will be relied on by unaffiliated investors to purchase the position or will be relied on by an unaffiliated third party to enter into a transaction involving the position, such as a pur- Ratings-Based Qualification for chase, loan, or repurchase agreement. Corporate Bonds or Other Securities For a traded position that has received an external rating on a long-term position that is Corporate bonds or other securities not related one grade below investment grade or better, or in any way to a securitization or structured that has received a short-term rating that is finance program do not qualify for the ratings- investment grade, the bank multiplies the face based approach. Only mortgage- and asset-backed amount of the position by the appropriate risk securities, recourse obligations, direct-credit sub- weight, determined in accordance with tables 2 stitutes, and residual interests (except credit- and 3. Stripped mortgage-backed securities and

November 2004 Commercial Bank Examination Manual Page 30 Assessment of Capital Adequacy 3020.1 other similar instruments, such as interest-only lower. Similarly, if a portion of an instrument is or principal-only strips that are not credit unrated, the entire position will be treated as if it enhancements, must be assigned to the 100 per- was unrated. In addition to this regulatory capi- cent risk category. If a traded position has tal treatment, the Federal Reserve may also, as received more than one external rating, the appropriate, adversely classify and require write- lowest single rating will apply. Moreover, if a downs for an other-than-temporary impairment rating changes, the bank must use the new on unrated and below-investment-grade securi- rating. ties, including split or partially rated securities. Table 3, for short-term ratings, is not identical (See SR-02-16.) to table 2, for long-term ratings, because the rating agencies do not assign short-term ratings using the same methodology as they use for Senior Positions Not Externally Rated long-term ratings. Each short-term rating category covers a range of longer-term rating cate- A position that is not externally rated (an gories.29 For example, a P-1 rating could map to unrated position), but that is senior or preferred a long-term rating that is as high as Aaa or as in all respects (including collateralization and low as A3. maturity) to a rated position that is traded, is treated as if it had the rating assigned to the rated position. The bank must satisfy the Federal Externally Rated, Nontraded Positions Reserve that such treatment is appropriate. Senior unrated positions qualify for the risk weighting For a rated, but untraded, position to be eligible of the subordinated rated positions in the same for the ratings-based approach, it must meet securitization transaction as long as the subor- certain conditions. To qualify, the position dinated rated position (1) is traded and (2) remains (1) must be rated by more than one rating outstanding for the entire life of the unrated agency; (2) must have received an external position, thus providing full credit support until rating on a long-term position that is one grade the unrated position matures. below investment grade or better or, for Recourse obligations and direct-credit substi- a short-term position, a rating that is investment tutes (other than residual interests) that do not grade or better by all rating agencies providing a qualify for the ratings-based approach (or for the rating; (3) must have ratings that are publicly internal-ratings, program-ratings, or computer- available; and (4) must have ratings that are program-ratings approaches outlined below) based on the same criteria used to rate traded receive ‘‘gross-up’’ treatment, that is, the bank securities. If the ratings are different, the lowest holding the position must hold capital against single rating will determine the risk- the amount of the position, plus all more senior weight category to which the position will be positions, subject to the low-level-exposure assigned. This treatment does not apply to a requirement.30 This grossed-up amount is placed credit-enhancing I/O strip. into a risk-weight category according to the obligor or, if relevant, according to the guarantor or nature of the collateral. The grossed-up Split or Partially Rated Instruments amount multiplied by both the risk weight and 8 percent is never greater than the full capital For instruments that have been assigned sepa- charge that would otherwise be imposed on the rate ratings for principal and interest (split or partially rated instruments), the Federal Reserve 30. Gross-up treatment means that a position is combined will apply to the entire instrument the risk with all more senior positions in the transaction. The result is weight that corresponds to the lowest compo- then risk-weighted based on the obligor or, if relevant, the nent rating. For example, a purchased subordi- guarantor or the nature of the collateral. For example, if a bank nated security whose principal component is retains a ﬁrst-loss position (other than a residual interest) in a pool of mortgage loans that qualify for a 50 percent risk rated BBB, but whose interest component is weight, the bank would include the full amount of the assets rated B, is subject to the gross-up treatment in the pool, risk-weighted at 50 percent, in its risk-weighted accorded to direct-credit substitutes rated B or assets for purposes of determining its risk-based capital ratio. The low-level-exposure rule provides that the dollar amount of risk-based capital required for assets transferred with 29. See, for example, Moody’s Global Ratings Guide, June recourse should not exceed the maximum dollar amount for 2001, p.3. which a bank is contractually liable.

Commercial Bank Examination Manual November 2004 Page 31 3020.1 Assessment of Capital Adequacy assets if they were on the banking organization’s Transactions that, in substance, result in the balance sheet.31 retention of credit risk associated with a transferred residual interest will be treated as if the residual interest was retained by the bank and Residual Interests not transferred. When the aggregate capital requirement for Credit-Enhancing I/O Strips residual interests and other recourse obligations in connection with the same transfer of assets After applying the concentration limit to credit- exceeds the full risk-based capital requirement enhancing I/O strips (both purchased and for those assets, a bank must maintain risk-based retained), a bank must maintain risk-based capi- capital equal to the greater of the risk-based tal for a credit-enhancing I/O strip (both pur- capital requirement for the residual interest or chased and retained), regardless of the external the full risk-based capital requirement for the rating on that position, equal to the remaining assets transferred. amount of the credit-enhancing I/O strip (net of any existing associated deferred tax liability), even if the amount of risk-based capital required to be maintained exceeds the full risk-based Accrued Interest Receivables Held on capital requirement for the assets transferred. Credit Card Securitizations Transactions that, in substance, result in the retention of credit risk associated with a trans- In a typical credit card securitization, an insti- ferred credit-enhancing I/O strip will be treated tution transfers a pool of credit card receivables as if the credit-enhancing I/O strip was retained to a trust, as well as the rights to receive future by the bank and not transferred. payments of principal, interest, and fee income from those receivables. If a securitization transaction qualifies as a sale under FAS 140, the Other Residual Interests selling institution removes the receivables that were sold from its reported assets and continues Residual interests that are not eligible for the to carry any retained interests in the transferred ratings-based approach receive dollar-for-dollar receivables on its balance sheet; the right to treatment. Dollar-for-dollar treatment means, these future cash flows should be reported as an effectively, that one dollar in total risk-based accrued interest receivable (AIR) asset.33 ,34 Any capital must be held against every dollar of a accrued amounts (cash flows) the institution residual interest retained on the balance sheet collects (for example, accrued fees and finance (net of any existing associated deferred tax charges) generally must be transferred to the liability), even if the amount of risk-based trust and will be used first by the trustee for the capital required to be maintained exceeds the benefit of third-party investors to satisfy more full risk-based capital requirement for the assets senior obligations and for the payment of trust transferred. This capital treatment applies to all expenses (such as servicing fees, investor- residual interests, except for credit-enhancing certificate interest, and investor-principal charge- I/O strips that have already been deducted from offs). Any remaining excess fee and finance 32 tier 1 capital under the concentration limit. charges will flow back to the seller. Because the AIR asset constitutes a subordi- 31. For assets that are assigned to the 100 percent risk- nated residual (retained) interest in the trans- weight category, the minimum capital charge is 8 percent of the amount of assets transferred, and banking organizations are required to hold 8 cents of capital for every dollar of assets transferred with recourse. For assets that are assigned to the 33. The AIR represents fees and finance charges that have 50 percent risk-weight category, the minimum capital charge been accrued on receivables that the institution has securitized is 4 cents of capital for every dollar of assets transferred with and sold to other investors. For example, in credit card recourse. securitizations, this accrued interest receivable asset may 32. Residual interests that are retained or purchased credit- include both finance charges billed but not yet collected and enhancing I/O strips are first subject to a capital concentration finance charges accrued but not yet billed on the securitized limit of 25 percent of tier 1 capital. For risk-based capital receivables. purposes (but not for leverage capital purposes), once this 34. Some institutions may categorize part or all of this concentration limit is applied, a banking organization must receivable as a loan, a ‘‘due from trust’’ account, a retained then hold dollar-for-dollar capital against the face amount of interest in the trust, or as part of an interest-only strip credit-enhancing I/O strips remaining. receivable.

November 2004 Commercial Bank Examination Manual Page 32 Assessment of Capital Adequacy 3020.1 ferred securitized assets, it meets the definition these approaches, the bank must satisfy the of recourse exposure for risk-based capital pur- Federal Reserve that the use of the approach is poses. Recourse exposures (such as the AIR appropriate for the particular bank and for the asset) require risk-based capital against the full, exposure being evaluated. The risk weight that risk-weighted amount of the assets transferred may be applied to an exposure under these with recourse, subject to the low-level-recourse alternative approaches is limited to a minimum rule.35 The AIR asset serves as a credit of 100 percent. enhancement to protect third-party investors in the securitization from credit losses, and it meets the definition of a residual interest under the Internal Risk-Rating Systems for risk-based capital adequacy rules for the treat- Asset-Backed Commercial Paper ment of recourse arrangements. Under those Programs rules, an institution must hold dollar-for-dollar capital against residual interests, even if that A bank that has a qualifying internal risk-rating amount exceeds the full equivalent risk-based system can use that system to apply the ratings- capital charge on the transferred assets.36 The based approach to its unrated direct-credit sub- institution is expected to hold risk-based capital stitutes in asset-backed commercial paper pro- in an amount consistent with the subordinated grams. Internal risk ratings could be used to nature of the AIR asset. qualify such a credit enhancement for a risk In accounting for the sale, the AIR asset is weight of 100 percent or 200 percent under the treated as a subordinated retained interest of ratings-based approach, but not for a risk weight credit card receivables when computing the gain of less than 100 percent. or loss on sale. Consistent with GAAP, this Most sophisticated banking organizations that means that the value of the AIR, at the date of participate extensively in the asset-securitization transfer, must be adjusted based on its relative business assign internal risk ratings to their fair (market) value. This adjustment will typi- credit exposures, regardless of the form of the cally result in the carrying amount of the AIR exposure. Usually, internal risk ratings more being lower than its book (face) value prior to finely differentiate the credit quality of a bank- securitization. The AIR should be reported in ing organization’s exposures than the categories regulatory reports as ‘‘Other Assets’’ and not as the banking agencies use to evaluate credit risk a loan receivable. (See SR-02-12 and SR-02-22). during bank examinations (pass, substandard, doubtful, or loss). An individual bank’s internal risk ratings may be associated with a certain Other Unrated Positions probability of default, loss in the event of default, and loss volatility. A position (but not a residual interest) main- The credit enhancements that sponsors obtain tained in connection with a securitization and for their commercial paper conduits are rarely that is not rated by a rating agency may be rated or traded. If an internal risk-ratings risk-weighted based on the bank’s internal approach were not available for these unrated determination of the credit rating of the position, credit enhancements, the provider of the as specified in table 4, multiplied by the face enhancement would have to obtain two ratings amount of the position. The bank may use three solely to avoid the gross-up treatment that would approaches to determine the capital require- otherwise apply to nontraded positions in asset ments for certain unrated direct-credit substi- securitizations for risk-based capital purposes. tutes and recourse obligations. Under each of However, before a provider of an enhancement decides whether to provide a credit enhancement for a particular transaction (and at what 35. The low-level-recourse rule limits the maximum risk- price), the provider will generally perform its based capital requirement to the lesser of a banking organi- own analysis of the transaction to evaluate the zation’s maximum contractual exposure or the full capital charge against the outstanding amount of assets transferred amount of risk associated with the enhancement. with recourse. An internal risk-ratings approach, therefore, is 36. For a complete description of the appropriate capital potentially less costly than a ratings-based treatment for recourse, residual interests, and credit-enhancing approach that relies exclusively on ratings by interest-only strips, see ‘‘Recourse, Direct Credit Substitutes, and Residual Interests in Asset Securitizations,’’ 66 Fed. Reg. the rating agencies for the risk weighting of 59614 (November 29, 2001). these positions.

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Table 4—Risk-Weight Assignments for Unrated Positions Using the Alternative Approaches1 Rating-designation Rating category examples Risk weight Highest or second-highest investment grade AAA, AA 100 percent Third-highest investment grade A 100 percent Lowest investment grade BBB 100 percent One category below investment grade BB 200 percent

1. such as the internal ratings approach

Internal risk ratings that correspond to the ers, as well as the risk associated with the rating categories of the rating agencies can be specific positions in a securitization transaction. mapped to risk weights under the Federal • The ratings identify gradations of risk among Reserve’s capital standards. This mapping can ‘‘pass’’ assets, and not just among assets that be done in a way that would make it possible to have deteriorated to the point that they fall differentiate the riskiness of various unrated into ‘‘watch’’ grades. Although it is not nec- direct-credit substitutes in asset-backed commer- essary for a bank to use the same categories as cial paper programs based on credit risk. The the rating agencies, its internal ratings must use of internal risk ratings, however, may raise correspond to the ratings of the rating agen- concerns about the accuracy and consistency of cies so that the Federal Reserve can determine the ratings, especially because the mapping of which internal risk rating corresponds to each ratings to risk-weight categories will give banks rating category of the rating agencies. A bank an incentive to rate their risk exposures in a way would be responsible for demonstrating, to the that minimizes the effective capital requirement. satisfaction of the Federal Reserve, how these A bank engaged in asset-backed commercial ratings correspond with the rating-agency stan- paper securitization activities that wishes to use dards that are used as the framework for the the internal risk-ratings approach must therefore asset-securitization portion of the risk-based be able to demonstrate to the satisfaction of the capital rule. This correlation is necessary so Federal Reserve, before relying on its internal that the mapping of credit ratings to risk- ratings, that the bank’s internal credit-risk rating weight categories in the ratings-based approach system is adequate. Adequate internal risk- can be applied to internal ratings. rating systems usually have the following • The ratings classify assets into each risk grade characteristics: using clear, explicit criteria, even for subjective factors. • The internal risk ratings are an integral part of • Independent credit-risk-management or loan- an effective risk-management system that review personnel assign or review the credit- explicitly incorporates the full range of risks risk ratings. These personnel should have arising from the bank’s participation in secu- adequate training and experience to ensure ritization activities. The system must also that they are fully qualified to perform this fully take into account the effect of such function. activities on the bank’s risk profile and capital • An internal audit procedure periodically veri- adequacy. fies that internal risk ratings are assigned • The ratings link to measurable outcomes, such in accordance with the bank’s established as the probability that a position will experi- criteria.37 ence any losses, the expected losses on that position in the event of default, and the degree 37. The audit may be performed by any group within the of variance in losses given default on that organization that is qualified to audit the system and is position. independent of both the group that makes the decision to extend credit to the asset-backed commercial paper program • The ratings separately consider the risk asso- and the groups that develop and maintain the internal credit- ciated with the underlying loans and borrow- risk rating system. (See SR-02-16.)

November 2004 Commercial Bank Examination Manual Page 34 Assessment of Capital Adequacy 3020.1

• The performance of internal ratings is tracked rating obtained by the sponsor of the program. over time to evaluate how well risk grades are Banks with limited involvement in securitiza- being assigned, make adjustments to the rat- tion activities may find the above alternative to ing system when the performance of the rated be useful. In addition, some banks extensively positions diverges from assigned ratings, and involved in securitization activities already rely adjust individual ratings accordingly. on ratings of the credit-risk positions under their • Credit-risk rating assumptions are consistent securitization programs as part of their risk- with, or more conservative than, the credit- management practices. Such banks can rely on risk rating assumptions and methodologies of these ratings for regulatory capital purposes if the rating agencies. the ratings are part of a sound overall risk- management process and the ratings reflect the If it determines that a bank’s rating system is risk of nontraded positions to the banks. not adequate, the Federal Reserve may preclude This approach in a structured financing pro- the bank from applying the internal risk-ratings gram can be used to qualify a direct-credit approach to new transactions for risk-based substitute or recourse obligation (but not a capital purposes until the deficiencies have been residual interest) for a risk weight of 100 percent remedied. Additionally, depending on the sever- or 200 percent of the face value of the position ity of the problems identified, the Federal under the ratings-based approach, but not for a Reserve may decline to rely on the internal risk risk weight of less than 100 percent. ratings that the bank had applied to previous transactions for purposes of determining its regulatory capital requirements. Credit-Assessment Computer Programs

A bank (particularly a bank with limited involve- Ratings of Specific Unrated Positions in ment in securitization activities) may use an Structured Financing Programs internal ratings-based approach if it is using an acceptable credit-assessment computer pro- A bank may also use a rating obtained from a gram, developed by a rating agency, to deter- rating agency for an unrated direct-credit sub- mine the rating of a direct-credit substitute or a stitute or recourse obligation (other than a recourse obligation (but not a residual interest) residual interest) that is assumed or retained in issued in connection with a structured finance connection with a structured finance program, if program. To be used by a bank for risk-based a rating agency has reviewed the terms of the capital purposes, a computer program must have program (according to the specifications set by been developed by a rating agency. Further, the the rating agency) and stated a rating for posi- bank must demonstrate to the satisfaction of the tions associated with the program. If the pro- Federal Reserve that the computer program’s gram has options for different combinations of credit assessments correspond credibly and reli- assets, standards, internal credit enhancements, ably to the rating standards of the rating agen- and other relevant factors, and if the rating cies for traded positions in securitizations and agency specifies ranges of rating categories to with the rating of traded positions in the finan- them, the bank may apply the rating category cial markets. The latter would generally be that corresponds to the bank’s position. To rely shown if investors and other market participants on a program rating, the bank must demonstrate significantly used the computer program for to the Federal Reserve’s satisfaction that the risk-assessment purposes. In addition, the bank credit-risk rating assigned to the program meets must demonstrate to the Federal Reserve’s sat- the same standards generally used by rating isfaction that the program was designed to apply agencies for rating traded positions. to its particular direct-credit substitute or recourse The bank must also demonstrate to the Fed- exposure and that it has properly implemented eral Reserve’s satisfaction that the criteria under- the computer program. In general, sophisticated lying the rating agency’s assignment of ratings banks with extensive securitization activities for the structured financing program are satisfied should use this approach only if the computer for the particular position. If a bank participates program is an integral part of their risk- in a securitization sponsored by another party, management systems and if the bank’s systems the Federal Reserve may authorize the bank to fully capture the risks from its securitization use this approach based on a programmatic activities. This computer-program approach can

Commercial Bank Examination Manual April 2011 Page 35 3020.1 Assessment of Capital Adequacy be used to qualify a direct-credit substitute or similar arrangements with embedded recourse recourse obligation (but not a residual interest) obligations or direct-credit substitutes, both the for a risk weight of 100 percent or 200 percent on-balance-sheet assets and the related recourse of the face value of the position under the obligations and direct-credit substitutes must be ratings-based approach, but not for a risk weight separately risk-weighted and incorporated into of less than 100 percent. the risk-based capital calculation.

Asset-Backed Commercial Paper Program Limitations on Risk-Based Capital Assets and Related Minority Interests Requirements An asset-backed commercial paper (ABCP) program typically is a program through which a Low-Level Exposure bank provides funding to its corporate customers by sponsoring and administering a If a bank’s maximum contractual exposure to bankruptcy-remote special-purpose entity that loss retained or assumed in connection with a purchases asset pools from, or extends loans to, recourse obligation or a direct-credit substitute, those customers.38 The asset pools in an ABCP except for a residual interest, is less than the program might include, for example, trade effective risk-based capital requirement for the receivables, consumer loans, or asset-backed enhanced assets, the risk-based capital require- securities. The ABCP program raises cash to ment is limited to the maximum contractual provide funding to the bank’s customers, pri- exposure, less any recourse liability account marily (that is, more than 50 percent of the established in accordance with GAAP. This ABCP’s issued liabilities) through the issuance limitation does not apply when a bank provides of externally rated commercial paper into the credit enhancement beyond any contractual obli- market. Typically, the sponsoring bank provides gation to support assets it has sold. liquidity and credit enhancements to the ABCP program. These enhancements aid the program Mortgage-Related Securities or in obtaining high credit ratings that facilitate the Participation Certificates Retained in a issuance of the commercial paper.39 Mortgage Loan Swap Under the Board’s risk-based capital rule, a bank that qualifies as a primary beneficiary and If a bank holds a mortgage-related security or a must consolidate an ABCP program that is participation certificate as a result of a mortgage defined as a variable interest entity under GAAP loan swap with recourse, capital is required to may not exclude the consolidated ABCP pro- support the recourse obligation plus the percent- gram’s assets from risk-weighted assets when it age of the mortgage-related security or partici- consolidates ABCP program assets. The bank pation certificate that is not covered by the must assess the appropriate risk-based capital recourse obligation. The total amount of capital charge against any exposures of the bank arising required for the on-balance-sheet asset and the in connection with such ABCP programs, includ- recourse obligation, however, is limited to the ing direct-credit substitutes, recourse obliga- capital requirement for the underlying loans, tions, residual interests, liquidity facilities, and calculated as if the bank continued to hold the loans, in accordance with sections III.B.5., III.C., loans as on-balance-sheet assets. and III.D. of the risk-based capital rule (12 CFR

38. The deﬁnition of ABCP program generally includes Related On-Balance-Sheet Assets structured investment vehicles (entities that earn a spread by issuing commercial paper and medium-term notes and using If a recourse obligation or a direct-credit substi- the proceeds to purchase highly rated debt securities) and tute also appears as a balance-sheet asset, the securities arbitrage programs. 39. A bank is considered the sponsor of an ABCP program balance-sheet asset is not included in a bank’s if it establishes the program; approves the sellers permitted to risk-weighted assets to the extent the value of participate in the program; approves the asset pools to be the balance-sheet asset is already included in the purchased by the program; or administers the program by off-balance-sheet credit-equivalent amount for monitoring the assets, arranging for debt placement, compiling monthly reports, or ensuring compliance with the program the recourse obligation or direct-credit substi- documents and with the program’s credit and investment tute. In the case of loan-servicing assets and policy.

April 2011 Commercial Bank Examination Manual Page 36 Assessment of Capital Adequacy 3020.1

208, appendix A). A bank sponsoring a program recourse obligations or direct-credit substitutes issuing ABCP that does not meet the rule’s for the purposes of the Board’s risk-based capi- definition of an ABCP program must include the tal guidelines. program’s assets in the institution’s risk- The resulting credit-equivalent amount would weighted asset base. then be risk-weighted according to the underlying assets or the obligor, after considering any Liquidity facilities supporting ABCP. Liquidity collateral or guarantees, or external credit rat- facilities supporting ABCP often take the form ings, if applicable. For example, if an eligible of commitments to lend to, or purchase assets short-term liquidity facility providing liquidity from, the ABCP programs in the event that support to ABCP covered an asset-backed secu- funds are needed to repay maturing commercial rity (ABS) externally rated AAA, then the paper. Typically, this need for liquidity is due to notional amount of the liquidity facility would a timing mismatch between cash collections on be converted at 10 percent to an on-balance- the underlying assets in the program and sched- sheet credit-equivalent amount and assigned to uled repayments of the commercial paper issued the 20 percent risk-weight category appropriate by the program. for AAA-rated ABS.40 A bank that provides liquidity facilities to ABCP is exposed to credit risk regardless of Overlapping exposures to an ABCP program. A the term of the liquidity facilities. For example, bank may have multiple overlapping exposures an ABCP program may require a liquidity fa- to a single ABCP program (for example, both a cility to purchase assets from the program at program-wide credit enhancement and multiple the first sign of deterioration in the credit qual- pool-specific liquidity facilities to an ABCP ity of an asset pool, thereby removing such program that is not consolidated for risk-based assets from the program. In such an event, a capital purposes). A bank must hold risk-based draw on the liquidity facility exposes the bank capital only once against the assets covered by to credit risk. the overlapping exposures. Where the overlap- Short-term commitments with an original ping exposures are subject to different risk- maturity of one year or less expose banks to a based capital requirements, the bank must apply lower degree of credit risk than longer-term the risk-based capital treatment that results in commitments. This difference in the degree of the highest capital charge to the overlapping credit risk is reflected in the risk-based capital portion of the exposures. requirement for the different types of exposure. For example, assume a bank provides a The Board’s capital guidelines impose a 10 per- program-wide credit enhancement that would cent credit-conversion factor on eligible short- absorb 10 percent of the losses in all of the term liquidity facilities supporting ABCP. A underlying asset pools in an ABCP program and 50 percent credit-conversion factor applies to pool-specific liquidity facilities that cover eligible long-term ABCP liquidity facilities. 100 percent of each of the underlying asset These credit-conversion factors apply regardless pools. The bank would be required to hold of whether the structure issuing the ABCP meets capital against 10 percent of the underlying asset the rule’s definition of an ABCP program. For pools because it is providing the program-wide example, a capital charge would apply to an credit enhancement. The bank would also be eligible short-term liquidity facility that pro- required to hold capital against 90 percent of vides liquidity support to ABCP where the the liquidity facilities it is providing to each of ABCP constitutes less than 50 percent of the the underlying asset pools. securities issued by the program, thus causing If different banks have overlapping exposures the issuing structure not to meet the rule’s to an ABCP program, however, each organiza- definition of an ABCP program. However, if a tion must hold capital against the entire maxi- bank (1) does not meet this definition and must mum amount of its exposure. As a result, while include the program’s assets in its risk-weighted duplication of capital charges will not occur for asset base or (2) otherwise chooses to include individual banks, some systemic duplication the program’s assets in risk-weighted assets, may occur where multiple banking organiza- then no risk-based capital requirement will be assessed against any liquidity facilities provided 40. See section 4030.1 and also the Board staff’s October by the bank that support the program’s ABCP. 12, 2007, legal interpretation regarding the risk-based capital Ineligible liquidity facilities will be treated as treatment of ABCP liquidity facilities.

Commercial Bank Examination Manual April 2011 Page 37 3020.1 Assessment of Capital Adequacy tions have overlapping exposures to the same recourse obligation or a direct-credit substitute ABCP program. and generally will be converted at 100 percent.

Asset-quality test. For a liquidity facility, either short- or long-term, that supports ABCP not Risk-Based Capital Treatment of to be considered a recourse obligation or a direct-credit substitute, it must meet the rule’s Certain Off-Balance-Sheet Items and definition of an eligible ABCP liquidity facil- Certain Other Types of Transactions ity. An eligible ABCP liquidity facility must meet a reasonable asset-quality test that, among Distinction Between Financial and other things, precludes funding assets that are Performance Standby Letters of Credit 90 days or more past due or in default. When assets are 90 days or more past due, they typi- For risk-based capital purposes, the vast major- cally have deteriorated to the point where there ity of standby letters of credit a bank issues are is an extremely high probability of default. considered financial in nature. On the one hand, Assets that are 90 days past due, for example, often must be placed on nonaccrual status in ac- in issuing a financial standby letter of credit, a cordance with the agencies’ Uniform Retail bank guarantees that the account party will Credit Classification and Account Management fulfill a contractual financial obligation that Policy.41 Further, they generally must also be involves payment of money. On the other hand, classified substandard under that policy. in issuing a performance standby letter of credit, The rule’s asset-quality test specifically a bank guarantees that the account party will allows a bank to reflect certain guarantees fulfill a contractual nonfinancial obligation, that providing credit protection to the bank provid- is, an obligation that does not entail the payment ing the liquidity facility. In particular, the of money. For example, a standby letter of credit ‘‘days-past- due limitation’’ is not applied with that guarantees that an insurance company will respect to assets that are either conditionally or pay as required under the terms of a policy is unconditionally guaranteed by the U.S. govern- deemed to be financial and is converted at ment or its agencies or by another OECD 100 percent, while a letter of credit that guaran- central government. To qualify as an eligible tees a contractor will pave a street according to ABCP liquidity facility, if the assets covered by certain specifications is deemed to be perfor- the liquidity facility are initially externally rated mance related and is converted at 50 percent. (at the time the facility is provided), the facil- Financial standby letters of credit have a higher ity can be used to fund only those assets that are conversion factor in large part because, unlike externally rated investment grade at the time of performance standby letters of credit, they tend funding. to be drawn down only when the account party’s The practice of purchasing assets that are financial condition has deteriorated. externally rated below investment grade out of an ABCP program is considered the equivalent of providing credit protection to the commercial Participations of Off-Balance-Sheet paper investors. Thus, liquidity facilities permit- Transactions ting purchases of below-investment-grade securities will be considered either recourse obliga- If a standby letter of credit or commitment has tions or direct-credit substitutes. However, the been participated to other institutions in the ‘‘investment-grade’’ limitation is not applied in form of a syndication, as defined in the instruc- the asset-quality test with respect to assets that tions to the Call Report, that is, if each bank is are conditionally or unconditionally guaranteed by the U.S. government or its agencies or by another OECD central government. If the asset- quality tests are not met (that is, if a bank actually funds through the liquidity facility assets that do not satisfy the facility’s asset-quality tests), the liquidity facility will be considered a

41. See 65 Fed. Reg. 36904 (June 12, 2000).

April 2011 Commercial Bank Examination Manual Page 38 Assessment of Capital Adequacy 3020.1 responsible only for its pro rata share of loss and other form of consideration. Commitments are there is no recourse to the originating bank, each included in weighted-risk assets regardless of bank includes only its pro rata share of the whether they contain ‘‘material adverse change’’ standby or commitment in its risk-based capital clauses or other provisions that are intended to calculation. relieve the issuer of its funding obligation under The treatment differs, however, if the partici- certain conditions. In the case of commitments pation takes the form of a conveyance of a risk structured as syndications, where the bank is participation. In such a participation, the origi- obligated solely for its pro rata share, only the nating bank remains liable to the beneficiary for bank’s proportional share of the syndicated the full amount of the standby or commitment if commitment is taken into account in calculating the institution that has acquired the participation the risk-based capital ratio. fails to pay when the instrument is drawn. Under this arrangement, the originating bank is exposed Commitments to make off-balance-sheet trans- to the credit risk of the institution that has actions. As specified in the instructions to the acquired the conveyance rather than that of the Call Report, a commitment to make a standby account party. Accordingly, for risk-based capi- letter of credit is considered to be a standby tal purposes, the originating bank should con- letter of credit. Accordingly, such a commitment vert the full amount of the standby or commit- should be converted to an on-balance-sheet ment to an on-balance-sheet credit-equivalent credit-equivalent amount at 100 percent if it is amount. The credit-equivalent amount of the a commitment to make a financial standby let- portion of the credit that has not been conveyed ter of credit or at 50 percent if it is a commit- is assigned to the risk category appropriate to ment to make a performance standby letter of the obligor, after giving effect to any collateral credit. or guarantees. The portion that has been con- A commitment to make a commitment is veyed is assigned either to the same risk cate- treated as a single commitment whose maturity gory as the obligor or to the risk category is the combined maturity of the two commit- appropriate to the institution acquiring the par- ments. For example, a 6-month commitment to ticipation, whichever category carries the lower make a 1-year commitment is considered to be a risk weight. Any remainder is assigned to the single 18-month commitment. Since the matu- risk category appropriate to the obligor, guaran- rity is over one year, such a commitment would tor, or collateral. For example, the pro rata share receive the 50 percent conversion factor appro- of the full amount of the assets supported, in priate to long-term commitments, rather than the whole or in part, by a direct-credit substitute zero percent conversion factor that would be conveyed as a risk participation to a U.S. domes- accorded to separate unrelated short-term com- tic depository institution or foreign bank is mitments of six months and one year. assigned to the 20 percent risk category. Risk A commitment to make a commercial letter of participations with a remaining maturity of over credit may be treated either as a commitment or one year that are conveyed to non-OECD banks as a commercial letter of credit, whichever are to be assigned to the 100 percent risk results in the lower conversion factor. Normally, category, unless a lower risk category is appro- this would mean that a commitment under one priate to the obligor, guarantor, or collateral. year to make a commercial letter of credit would be treated as a commitment and converted at zero percent, while a similar commitment of Commitments over one year would be treated as a commercial letter of credit and converted at 20 percent. Commitments are defined as any legally binding If a commitment facility is structured so that arrangements that obligate a bank to extend it can be drawn down in several forms, such as credit in the form of loans or leases; to purchase a standby letter of credit, a loan, or a commer- loans, securities, or other assets; or to participate cial letter of credit, the entire facility should be in loans and leases. Commitments also include treated as a commitment to extend credit in the overdraft facilities, revolving credit, home equity form that incurs the highest capital charge. and mortgage lines of credit, eligible ABCP Thus, if a facility could be drawn down in any of liquidity facilities, and similar transactions. Nor- the three forms just cited, the entire facility mally, commitments involve a written contract would be treated as a commitment to issue a or agreement and a commitment fee, or some standby letter of credit and would be converted

Commercial Bank Examination Manual November 2004 Page 39 3020.1 Assessment of Capital Adequacy at 100 percent, rather than treated as a commit- advance notice of cancellation to the obligor or ment to make a loan or commercial letter of which permit the commitment to roll over auto- credit, which would have a lower conversion matically (that is, on the same terms and without factor. a thorough credit review) unless the bank gives notice otherwise, are not unconditionally can- Unused commitments. Except for eligible ABCP celable. Thus, any such commitment whose liquidity facilities,42 unused portions of commit- term from date of issuance could exceed one ments, including underwriting commitments, and year is subject to the 50 percent conversion commercial and consumer credit commitments factor. that have an original maturity of one year or less A bank may issue a commitment that expires are converted at zero percent. within one year, with the understanding that the Unused commitments that have an original commitment will be renewed upon expiration maturity of over one year are converted at subject to a thorough credit review of the 50 percent. For this purpose, original maturity is obligor. Such a commitment may be converted defined as the length of time between the date at zero percent only if (1) the renegotiation the commitment is issued and the earliest date process is carried out in good faith, involves a on which (1) the bank has the permanent ability full credit assessment of the obligor, and allows to, at its option, unconditionally cancel43 (with- the bank flexibility to alter the terms and con- out cause) the commitment44 and (2) the bank is ditions of the new commitment; (2) the bank has scheduled to (and as a normal practice actually absolute discretion to decline renewal or exten- does) review the facility to determine whether sion of the commitment; and (3) the renegoti- the unused commitment should be extended. (It ated commitment expires within 12 months should be noted that the term of any loan from the time it is made. Some commitments advances that can be made under a commitment contain unusual renegotiation arrangements that is not taken into account in determining the would give the borrower a considerable amount commitment’s maturity.) Under this definition of advance notice that a commitment would not of original maturity, commitments with a nomi- be renewed. Provisions of this kind can have the nal original maturity of more than one year can effect of creating a rolling commitment arrange- be treated as having a maturity of one year or ment that should be treated for risk-based capital less for risk-based capital purposes only if the purposes as a long-term commitment and should issuing bank (1) has full and unconditional therefore be converted to a credit-equivalent discretion to cancel the commitment without amount at 50 percent. Normally, the renegotia- cause and without notice on each and every day tion process should take no more than six to after the first year and (2) conducts at least eight weeks, and in many cases it should take a annually a formal credit review of the commit- shorter period of time. The renegotiation period ment, including an assessment of the credit should immediately precede the expiration date quality of the obligor. of the commitment and should be reasonably It should be noted that a bank is not deemed short and appropriate to the complexity of the able to unconditionally cancel a commitment transaction. The reasons for provisions in a if it is required to give, or is presumed to be commitment arrangement that would appear to required to give, any advance notice of cancel- allow for a protracted renegotiation period should lation. Accordingly, so-called evergreen com- be thoroughly documented by the bank and mitments, which require the bank to give reviewed by the examiner. As mentioned above, a commitment to make a commitment is treated as a single commitment 42. Unused portions of eligible ABCP liquidity facilities with an original maturity of one year of less are converted at whose maturity is the combined maturity of the 10 percent. two commitments. Although such commitments 43. A bank’s option to cancel a commitment under a whose combined maturity is in excess of one material adverse change clause is not considered to be an year are generally considered long-term, if the option to unconditionally cancel a commitment. 44. In the case of consumer home equity or mortgage lines customer has a bona fide business reason for of credit secured by liens on one- to four-family residential requesting a new commitment to supersede the properties, the bank is deemed able to unconditionally cancel unexpired one, such as an unanticipated increase the commitment for the purpose of this criterion if, at its in the volume of business or a change in the option, it can prohibit additional extensions of credit, reduce the credit lines, and terminate the commitment to the full customer’s cash flow and credit needs, then the extent permitted by relevant federal law. commitment would not automatically be consid-

November 2004 Commercial Bank Examination Manual Page 40 Assessment of Capital Adequacy 3020.1 ered long-term. However, if the bank exhibits a following off-balance-sheet contracts: pattern and practice of extending short-term commitments before their expiration—either for • interest-rate contracts one customer or more broadly within the bank— — single-currency interest-rate swaps then such extended commitments would be — basis swaps viewed as long-term. This treatment generally — forward rate agreements would apply to all commitments, including tra- — interest-rate options purchased (includ- ditional commercial paper liquidity lines. ing caps, collars, and ﬂoors purchased) Other criteria for determining whether a — any other instrument linked to interest facility is short- or long-term include the actual rates that gives rise to similar credit risks level of risk associated with the transaction and (including when-issued securities and for- whether that level of risk is more characteristic ward deposits accepted) of a long-term (as opposed to a short-term) • exchange-rate contracts commitment. Liquidity facilities issued in con- — cross-currency interest-rate swaps nection with asset-backed commercial paper — forward foreign-exchange-rate contracts programs, when judged by these criteria, seem — currency options purchased to possess risk characteristics that are less than — any other instrument linked to exchange those associated with typical short-term com- rates that gives rise to similar credit risks mercial loan commitments. One of these char- • equity derivative contracts acteristics is the short-term nature of the secu- — equity-linked swaps ritized receivables. The receivables that are — equity-linked options purchased securitized in asset-backed commercial paper — forward equity-linked contracts programs tend to be of very short average — any other instrument linked to equities maturity—often in the range of 30 to 60 days. that gives rise to similar credit risks Advances under asset-backed commercial paper • commodity (including precious metal) deriva- liquidity facilities generally are very rare, and tive contracts when such advances are made, it is against pools — commodity-linked swaps of very high-quality performing receivables that — commodity-linked options purchased would generally liquidate very quickly. These — forward commodity-linked contracts facilities are further protected against credit risk — any other instrument linked to commodi- by signiﬁcant amounts of overcollateralization, ties that gives rise to similar credit risks as well as other credit enhancements. • credit derivatives A series of short-term commitments would — credit-default swaps generally be treated as a single commitment — total-rate-of-return swaps whose original maturity is the combined matu- — other types of credit derivatives rities of the individual commitments in the series. Also, a commitment may be structured to Exceptions. Exchange-rate contracts with an be drawn down in a number of tranches, some original maturity of 14 or fewer calendar days exercisable in one year or less and others exer- and derivative contracts traded on exchanges cisable in over one year. The full amount of such that require daily receipt and payment of cash- a commitment is deemed to be over one year variation margin may be excluded from the and converted at 50 percent. Some long-term risk-based ratio calculation. Gold contracts are commitments may permit the customer to draw accorded the same treatment as exchange-rate down varying amounts at different times to contracts, except that gold contracts with an accommodate, for example, seasonal borrowing original maturity of 14 or fewer calendar days needs. The 50 percent conversion factor should are included in the risk-based ratio calculation. be applied to the maximum amount that could Over-the-counter options purchased are included be drawn down under such commitments. and treated in the same way as other derivative contracts.

Credit-Equivalent Computations for Calculation of credit-equivalent amounts. The Derivative Contracts credit-equivalent amount of a derivative contract (excluding credit derivatives) that is not Applicable derivative contracts. Credit- subject to a qualifying bilateral netting contract equivalent amounts are computed for each of the is equal to the sum of—

Commercial Bank Examination Manual November 2004 Page 41 3020.1 Assessment of Capital Adequacy

Table 5—Conversion-Factor Matrix

Other Foreign- Precious commodity exchange- metals (excluding Interest- rate (excluding precious Remaining maturity rate and gold Equity gold) metals)

One year or less 0.0 1.0 6.0 7.0 10.0 Over one to ﬁve years 0.5 5.0 8.0 7.0 12.0 Over ﬁve years 1.5 7.5 10.0 8.0 15.0

• the current exposure (sometimes referred to as tract. A derivative contract not included in the the replacement cost) of the contract, and definitions of interest-rate, exchange-rate, equity, • an estimate of the potential future credit or commodity contracts is included in the risk- exposure of the contract. based capital calculation and is subject to the same conversion factors as a commodity, exclud- The current exposure is determined by the ing precious metals. mark-to-market value of the contract. If the No potential future credit exposure is calcu- mark-to-market value is positive, then the cur- lated for a single-currency interest-rate swap in rent exposure is equal to that mark-to-market which payments are made based on two floating- value. If the mark-to-market value is zero or rate indexes, so-called floating/floating or basis negative, then the current exposure is zero. swaps. The credit exposure on these contracts is Mark-to-market values are measured in dollars, evaluated solely on the basis of their mark-to- regardless of the currency or currencies speci- market values. fied in the contract, and should reflect changes in the underlying rates, prices, and indexes, as well Avoidance of double-counting. In certain cases, as in counterparty credit quality. credit exposures arising from derivative con- The potential future credit exposure of a tracts may be reflected, in part, on the balance contract, including a contract with a negative sheet. To avoid double counting these exposures mark-to-market value, is estimated by multiply- in the assessment of capital adequacy and, ing the notional principal amount of the contract perhaps, assigning inappropriate risk weights, by a credit-conversion factor. Banks should use, examiners may need to exclude counterparty subject to examiner review, the effective rather credit exposures arising from the derivative than the apparent or stated notional amount in instruments covered by the guidelines from this calculation. The conversion factors (in per- balance-sheet assets when calculating a bank’s cent) are in table 5. The Board has noted that risk-based capital ratios. This exclusion will these conversion factors, which are based on eliminate the possibility that an organization observed volatilities of the particular types of could be required to hold capital against both an instruments, are subject to review and modifi- off-balance-sheet and on-balance-sheet amount cation in light of changing volatilities or market for the same item. This treatment is not accorded conditions. to margin accounts and accrued receivables For a contract that is structured such that related to interest-rate and exchange-rate on specified dates any outstanding exposure is contracts. settled and the terms are reset so that the mar- The aggregate on-balance-sheet amount ket value of the contract is zero, the remaining excluded from the risk-based capital calculation maturity is equal to the time until the next reset is equal to the lower of— date. Such resetting interest-rate contracts must have a minimum conversion factor of • each contract’s positive on-balance-sheet 0.5 percent. amount, or For a contract with multiple exchanges of • its positive market value included in principal, the conversion factor is multiplied by the off-balance-sheet risk-based capital the number of remaining payments in the con- calculation.

November 2004 Commercial Bank Examination Manual Page 42 Assessment of Capital Adequacy 3020.1

For example, a forward contract that is marked lent location in the case of noncorporate to market will have the same market value on entities, and if a branch of the counter- the balance sheet as is used in calculating the party is involved, then also under the law credit-equivalent amount for off-balance-sheet of the jurisdiction in which the branch is exposures under the guidelines. Therefore, the located; on-balance-sheet amount is not included in the — the law that governs the individual con- risk-based capital calculation. When either the tracts covered by the netting contract; contract’s on-balance-sheet amount or its mar- and ket value is negative or zero, no deduction from — the law that governs the netting contract; on-balance-sheet items is necessary for that • the bank establishes and maintains procedures contract. to ensure that the legal characteristics of If the positive on-balance-sheet asset amount netting contracts are kept under review in light exceeds the contract’s market value, the excess of possible changes in relevant law; and (up to the amount of the on-balance-sheet asset) • the bank maintains documentation in its files should be included in the appropriate risk- that is adequate to support the netting of rate weight category. For example, a purchased contracts, including a copy of the bilateral option will often have an on-balance-sheet netting contract and necessary legal opinions. amount equal to the fee paid until the option expires. If that amount exceeds market value, A contract containing a walkaway clause is not the excess of carrying value over market value eligible for netting for purposes of calculating would be included in the appropriate risk-weight the credit-equivalent amount. category for purposes of the on-balance-sheet By netting individual contracts for the pur- portion of the calculation. pose of calculating credit-equivalent amounts of derivative contracts, a bank represents that it has Netting of swaps and similar contracts. Netting met the requirements of the risk-based measure refers to the offsetting of positive and negative of the capital adequacy guidelines for bank mark-to-market values in the determination of a holding companies and that all the appropriate current exposure to be used in the calculation of documents are in the organization’s files and a credit-equivalent amount. Any legally enforce- available for inspection by the Federal Reserve. able form of bilateral netting (that is, netting The Federal Reserve may determine that a with a single counterparty) of derivative con- bank’s files are inadequate or that a netting tracts is recognized for purposes of calculating contract, or any of its underlying individual the credit-equivalent amount provided that— contracts, may not be legally enforceable. If such a determination is made, the netting con- • the netting is accomplished under a written tract may be disqualified from recognition for netting contract that creates a single legal risk-based capital purposes, or underlying indi- obligation, covering all included individual vidual contracts may be treated as though they contracts, with the effect that the organization are not subject to the netting contract. would have a claim to receive, or an obliga- The credit-equivalent amount of contracts tion to receive or pay, only the net amount of that are subject to a qualifying bilateral netting the sum of the positive and negative mark-to- contract is calculated by adding— market values on included individual contracts if a counterparty, or a counterparty to • the current exposure of the netting contract whom the contract has been validly assigned, (net current exposure), and fails to perform due to default, insolvency, • the sum of the estimates of the potential future liquidation, or similar circumstances; credit exposures on all individual contracts • the bank obtains written and reasoned legal subject to the netting contract (gross potential opinions that in the event of a legal challenge— future exposure), adjusted to reflect the effects including one resulting from default, insol- of the netting contract. vency, liquidation, or similar circumstances— the relevant court and administrative authorities The net current exposure of the netting con- would find the bank’s exposure to be such a tract is determined by summing all positive and net amount under— negative mark-to-market values of the indi- — the law of the jurisdiction in which the vidual contracts included in the netting contract. counterparty is chartered or the equiva- If the net sum of the mark-to-market values is

Commercial Bank Examination Manual November 2004 Page 43 3020.1 Assessment of Capital Adequacy positive, then the current exposure of the netting ing bilateral netting contract to determine the contract is equal to that sum. If the net sum of adjusted add-on for that netting contract. the mark-to-market values is zero or negative, In the event a netting contract covers con- then the current exposure of the netting contract tracts that are normally excluded from the risk- is zero. The Federal Reserve may determine that based ratio calculation—for example, exchange- a netting contract qualiﬁes for risk-based capital rate contracts with an original maturity of 14 or netting treatment even though certain individual fewer calendar days or instruments traded on contracts may not qualify. In these instances, the exchanges that require daily payment and receipt nonqualifying contracts should be treated as of cash-variation margin—an institution may individual contracts that are not subject to the elect to either include or exclude all mark-to- netting contract. market values of such contracts when determin- Gross potential future exposure (Agross)is ing net current exposure, provided the method calculated by summing the estimates of poten- chosen is applied consistently. tial future exposure for each individual contract Examiners should review the netting of off- subject to the qualifying bilateral netting con- balance-sheet derivative contracts used by banks tract. The effects of the bilateral netting contract when calculating or verifying risk-based capital on the gross potential future exposure are rec- ratios to ensure that the positions of such con- ognized through the application of a formula tracts are reported gross, unless the net positions that results in an adjusted add-on amount (Anet). of those contracts reﬂect netting arrangements The formula, which employs the ratio of net that comply with the netting requirements listed current exposure to gross current exposure previously. (NGR), is expressed as— Credit Derivatives Anet = (0.4 × Agross) + 0.6(NGR × Agross)

The NGR may be calculated in accordance with Credit derivatives are off-balance-sheet arrange- either the counterparty-by-counterparty approach ments that allow one party (the beneﬁciary) to or the aggregate approach. Under the transfer credit risk of a reference asset—which counterparty-by-counterparty approach, the NGR the beneﬁciary may or may not own—to another is the ratio of the net current exposure for a party (the guarantor).45 Many banks increas- netting contract to the gross current exposure of ingly use these instruments to manage their the netting contract. The gross current exposure overall credit-risk exposure. In general, credit is the sum of the current exposures of all derivatives have three distinguishing features: individual contracts subject to the netting contract. Net negative mark-to-market values for • the transfer of the credit risk associated with a individual netting contracts with the same coun- reference asset through contingent payments terparty may not be used to offset net positive based on events of default and, usually, the mark-to-market values for other netting con- prices of instruments before, at, and shortly tracts with the same counterparty. after default (reference assets most often take Under the aggregate approach, the NGR is the the form of traded sovereign and corporate ratio of the sum of all the net current exposures debt instruments or syndicated bank loans) for qualifying bilateral netting contracts to the • the periodic exchange of payments or the sum of all the gross current exposures for those payment of a premium rather than the pay- netting contracts (each gross current exposure is ment of fees customary with other off-balance- calculated in the same manner as in the sheet credit products, such as letters of credit counterparty-by-counterparty approach). Net • the use of an International Swap Derivatives negative mark-to-market values for individual Association (ISDA) master agreement and the counterparties may not be used to offset legal format of a derivatives contract net positive current exposures for other counterparties. A bank must consistently use either the 45. Credit derivatives generally fall into three basic trans- counterparty-by-counterparty approach or the action types: total-rate-of-return swaps, credit-default swaps, aggregate approach to calculate the NGR. and credit-default or credit-linked notes. For a more in-depth description of these types of credit derivatives, see the Federal Regardless of the approach used, the NGR Reserve’s Trading and Capital-Markets Activities Manual, should be applied individually to each qualify- section 4350.1, ‘‘Credit Derivatives,’’ as well as SR-96-17.

November 2004 Commercial Bank Examination Manual Page 44 Assessment of Capital Adequacy 3020.1

For risk-based capital purposes, total-rate-of- A bank providing a guarantee through a credit return swaps and credit-default swaps generally derivative may mitigate the credit risk associ- should be treated as off-balance-sheet direct- ated with the transaction by entering into an credit substitutes.46 The notional amount of a offsetting credit derivative with another contract should be converted at 100 percent to counterparty—a so-called back-to-back posi- determine the credit-equivalent amount to be tion. A bank that has entered into such a position included in the risk-weighted assets of a guar- may treat the first credit derivative as being antor.47 A bank that provides a guarantee through guaranteed by the offsetting transaction for risk- a credit derivative transaction should assign its based capital purposes. Accordingly, the notional credit exposure to the risk category appropriate amount of the first credit derivative may be to the obligor of the reference asset or any assigned to the risk category appropriate to the collateral. On the other hand, a bank that owns counterparty providing credit protection through the underlying asset upon which effective credit the offsetting credit derivative arrangement (for protection has been acquired through a credit example, the 20 percent risk category if the derivative may, under certain circumstances, counterparty is an OECD bank). assign the unamortized portion of the underlying In some instances, the reference asset in the asset to the risk category appropriate to the credit derivative transaction may not be identi- guarantor (for example, the 20 percent risk cal to the underlying asset for which the bene- category if the guarantor is an OECD bank). ficiary has acquired credit protection. For exam- Whether the credit derivative is considered an ple, a credit derivative used to offset the credit eligible guarantee for purposes of risk-based exposure of a loan to a corporate customer may capital depends on the actual degree of credit use as the reference asset a publicly traded protection. The amount of credit protection corporate bond of that customer, with the credit actually provided by a credit derivative may be quality of the bond serving as a proxy for the limited depending on the terms of the arrange- on-balance-sheet loan. In such a case, the under- ment. In this regard, for example, a relatively lying asset would still generally be considered restrictive definition of a default event or a guaranteed for capital purposes, as long as both materiality threshold that requires a comparably the underlying asset and the reference asset are high percentage of loss to occur before the obligations of the same legal entity and have the guarantor is obliged to pay could effectively same level of seniority in bankruptcy. In addi- limit the amount of credit risk actually trans- tion, a bank offsetting credit exposure in this ferred in the transaction. If the terms of the manner would be obligated to demonstrate to credit derivative arrangement significantly limit examiners that (1) there is a high degree of the degree of risk transference, then the benefi- correlation between the two instruments; (2) the ciary bank cannot reduce the risk weight of the reference instrument is a reasonable and suffi- ‘‘protected’’ asset to that of the guarantor bank. ciently liquid proxy for the underlying asset so On the other hand, even if the transfer of credit that the instruments can be reasonably expected risk is limited, a bank providing limited credit to behave in a similar manner in the event of protection through a credit derivative should default; and (3) at a minimum, the reference hold appropriate capital against the underlying asset and underlying asset are subject to mutual exposure while it is exposed to the credit risk of cross-default provisions. A bank that uses a the reference asset. credit derivative that is based on a reference asset that differs from the protected underlying asset must document the credit derivative being used to offset credit risk, and must link it 46. Unlike total-rate-of-return swaps and credit-default directly to the asset or assets whose credit risk swaps, credit-linked notes are on-balance-sheet assets or the transaction is designed to offset. The docu- liabilities. A guarantor bank should assign the on-balance- mentation and the effectiveness of the credit sheet amount of the credit-linked note to the risk category derivative transaction are subject to examiner appropriate to either the issuer or the reference asset, whichever is higher. For a beneficiary bank, cash consideration review. A bank providing credit protection received in the sale of the note may be considered as collateral through such an arrangement must hold capital for risk-based capital purposes. against the risk exposures that are assumed. 47. A guarantor bank that has made cash payments repre- Some credit derivative transactions provide senting depreciation on reference assets may deduct such payments from the notional amount when computing credit- credit protection for a group or basket of refer- equivalent amounts for capital purposes. ence assets and call for the guarantor to absorb

Commercial Bank Examination Manual November 2004 Page 45 3020.1 Assessment of Capital Adequacy losses on only the first asset in the group that facilities, letters of credit, banker’s acceptances, defaults. Once the first asset in the group defaults, or other asset-backed securities. In a typical the credit protection for the remaining assets CLO transaction, the sponsoring banking orga- covered by the credit derivative ceases. If nization (SBO) transfers the loans and other examiners determine that the credit risk for the assets to a bankruptcy-remote special-purpose basket of assets has effectively been transferred vehicle (SPV), which then issues asset-backed to the guarantor and the beneficiary banking securities consisting of one or more classes of organization owns all of the reference assets debt. This type of transaction represents a included in the basket, then the beneficiary may so-called cash-flow CLO. It enables the spon- assign the asset with the smallest dollar amount soring institution (SI) to reduce its leverage and in the group—if less than or equal to the risk-based capital requirements, improve its notional amount of the credit derivative—to the liquidity, and manage credit concentrations. risk category appropriate to the guarantor. Con- The first synthetic CLO (issued in 1997) used versely, a bank extending credit protection credit-linked notes (CLNs).49 Rather than trans- through a credit derivative on a basket of assets ferring assets to the SPV, the sponsoring bank must assign the contract’s notional amount of issued CLNs to the SPV, individually referenc- credit exposure to the highest risk category ing the payment obligation of a particular com- appropriate to the assets in the basket. pany, or ‘‘reference obligor.’’ The notional In addition to holding capital against credit amount of the CLNs issued equaled the dollar risk, a bank that is subject to the market-risk rule amount of the reference assets the sponsor was (see ‘‘Market-Risk Measure’’ earlier in this hedging on its balance sheet. Other structures section) must hold capital against market risk have evolved that use credit-default swaps to for credit derivatives held in its trading account. transfer credit risk and create different levels of (For a description of market-risk capital require- risk exposure, but that hedge only a portion of ments for credit derivatives, see SR-97-18.) the notional amount of the overall reference portfolio.50 Traditional CLO structures usually transfer Using Credit Derivatives assets into the SPV. In synthetic securitizations, to Synthetically Replicate Collateralized the underlying exposures that make up the Loan Obligations reference portfolio remain in the institution’s banking book.51 The credit risk is transferred Credit derivatives can be used to synthetically into the SPV through credit-default swaps or replicate collateralized loan obligations (CLOs). CLNs. The institution is thus able to maintain Banking organizations (BOs) can use CLOs and client confidentiality and avoid sensitive their synthetic variants to manage their balance client-relationship issues that arise from loan- sheets and, in some instances, transfer credit risk transfer-notification requirements, loan- to the capital markets. Such transactions allow assignment provisions, and loan-participation economic capital to be more efficiently allo- restrictions. cated, resulting in, among other things, improved Corporate credits are assigned to the 100 per- shareholders’ returns. cent risk-weighted asset category. In the case of The issue for BOs is how synthetic CLOs high-quality investment-grade corporate expo- should be treated under the risk-based and sures, the associated 8 percent capital require- leverage capital guidelines.48 Supervisors and ment may exceed the economic capital that the examiners need to fully understand these com- sponsoring bank sets aside to cover the credit plex structures and identify the relative degree of transference and retention of the securitized 49. CLNs are obligations whose principal repayment is portfolio’s credit risk. They must determine conditioned upon the performance of a referenced asset or whether the institution’s regulatory capital is portfolio. The assets’ performance may be based on a variety adequate given the retained credit exposures. of measures, such as movements in price or credit spread, or the occurrence of default. A CLO is an asset-backed security that is 50. A credit-default swap is similar to a financial standby usually supported by a variety of assets, includ- letter of credit in that the institution writing the swap provides, ing whole commercial loans, revolving-credit for a fee, credit protection against credit losses associated with a default on a specified reference asset or pool of assets. 51. ‘‘Banking book’’ refers to nontrading accounts. See the 48. See SR-99-32 and its November 15, 1999, attachment, definition of ‘‘trading accounts’’ in the glossary for the an FRB-OCC capital interpretation on synthetic CLOs. instructions to the bank Call Report.

November 2004 Commercial Bank Examination Manual Page 46 Assessment of Capital Adequacy 3020.1

Figure 1—Transaction 1

Bank SPV $1.5 billion $1.5 billion cash cash proceeds $1.5 billionproceeds Holds portfolio credit portfolio of CLNs $1.5 billion of CLNs issued by bank

$1.5 billion of notes

X-year Y-year notes notes

risk of the transaction. Therefore, one of the In the example shown in figure 1, this amount is apparent motivations behind CLOs and other $1.5 billion. securitizations is to more closely align the SI’s If any obligor linked to a CLN in the SPV regulatory capital requirements with the eco- defaults, the SI will call the individual CLN and nomic capital required by the market. redeem it based on the repayment terms speci- Synthetic CLOs can raise questions about fied in the note agreement. The term of each their capital treatment when calculating the CLN is set so that the credit exposure (to which risk-based and leverage capital ratios. Capital it is linked) matures before the maturity of the treatments for three synthetic CLO transactions CLN, which ensures that the CLN will be in follow. They are discussed from the perspective place for the full term of the exposure to which of the investors and the SBOs. it is linked. An investor in the notes issued by the SPV is Transaction 1—Entire notional amount of the exposed to the risk of default of the underlying reference portfolio is hedged. In the first type of reference assets, as well as to the risk that the SI synthetic securitization, the SBO, through a will not repay principal at the maturity of the synthetic CLO, hedges the entire notional amount notes. Because of the linkage between the credit of a reference-asset portfolio. An SPV acquires quality of the SI and the issued notes, a down- the credit risk on a reference portfolio by pur- grade of the sponsor’s credit rating most likely chasing CLNs issued by the SBO. The SPV will result in the notes also being downgraded. funds the purchase of the CLNs by issuing a Thus, a BO investing in this type of synthetic series of notes in several tranches to third-party CLO should assign the notes to the higher of the investors. The investor notes are in effect col- risk categories appropriate to the underlying lateralized by the CLNs. Each CLN represents reference assets or the issuing entity. one obligor and the bank’s credit-risk exposure For purposes of risk-based capital, the SBOs to that obligor, which could take the form of may treat the cash proceeds from the sale of bonds, commitments, loans, and counterparty CLNs that provide protection against underlying exposures. Since the noteholders are exposed to reference assets as cash collateralizing these the full amount of credit risk associated with the assets.52 This treatment would permit the refer- individual reference obligors, all of the credit risk of the reference portfolio is shifted from the sponsoring bank to the capital markets. The 52. The CLNs should not contain terms that would significantly limit the credit protection provided against the under- dollar amount of notes issued to investors equals lying reference assets, for example, a materiality threshold the notional amount of the reference portfolio. that requires a relatively high percentage of loss to occur

Commercial Bank Examination Manual November 2004 Page 47 3020.1 Assessment of Capital Adequacy ence assets, if carried on the SI’s books, to be In the structure illustrated in figure 2, the assigned to the zero percent risk category to the SBO purchases default protection from an SPV extent that their notional amount is fully collat- for a specifically identified portfolio of banking- eralized by cash. This treatment may be applied book credit exposures, which may include let- even if the cash collateral is transferred directly ters of credit and loan commitments. The credit into the general operating funds of the institu- risk on the identified reference portfolio (which tion and is not deposited in a segregated account. continues to remain in the sponsor’s banking The synthetic CLO would not confer any bene- book) is transferred to the SPV through the use fits to the SBO for purposes of calculating its of credit-default swaps. In exchange tier 1 leverage ratio because the reference assets for the credit protection, the SI pays the SPV remain on the organization’s balance sheet. an annual fee. The default swaps on each of the obligors in the reference portfolio are struc- Transaction 2—High-quality, senior risk posi- tured to pay the average default losses on all tion in the reference portfolio is retained. In the senior unsecured obligations of defaulted second type of synthetic CLO transaction, the borrowers. SBO hedges a portion of the reference portfolio To support its guarantee, the SPV sells CLNs and retains a high-quality, senior risk position to investors and uses the cash proceeds to that absorbs only those credit losses in excess of purchase U.S. government Treasury notes. The the junior-loss positions. In some recent syn- SPV then pledges the Treasuries to the SBO to thetic CLOs, the SBO has used a combination of cover any default losses.53 The CLNs are often credit-default swaps and CLNs to essentially issued in multiple tranches of differing seniority transfer to the capital markets the credit risk of and in an aggregate amount that is significantly a designated portfolio of the organization’s credit less than the notional amount of the reference exposures. Such a transaction allows the SI to portfolio. The amount of notes issued typically allocate economic capital more efficiently and to is set at a level sufficient to cover some multiple significantly reduce its regulatory capital of expected losses, but well below the notional requirements. amount of the reference portfolio being hedged. before CLN payments are adversely affected, or a structuring 53. The names of corporate obligors included in the refer- of CLN post-default payments that does not adequately pass ence portfolio may be disclosed to investors in the CLNs. through credit-related losses on the reference assets to investors in the CLNs.

Figure 2—Transaction 2

Default payment and pledge of Treasuries Bank SPV

$5 billion Holds $400 million credit portfolio $5 billion of credit-default swaps of pledged Treasuries and annual fee

$400 million $400 million of CLNs of cash

Senior notes

Junior notes

November 2004 Commercial Bank Examination Manual Page 48 Assessment of Capital Adequacy 3020.1

There may be several levels of loss in this tion of its retained senior position in the refer- type of synthetic securitization. The first-loss ence portfolio to the 20 percent risk weight. position may consist of a small cash reserve, However, to the extent that the reference port- sufficient to cover expected losses. The cash folio includes loans and other on-balance-sheet reserve accumulates over a period of years and assets, an SBO involved in such a synthetic is funded from the excess of the SPV’s income securitization would not realize any benefits in (that is, the yield on the Treasury securities plus the determination of its leverage ratio. the credit-default-swap fee) over the interest In addition to the three stringent minimum paid to investors on the notes. The investors in conditions, the Federal Reserve may impose the SPV assume a second-loss position through other requirements as it deems necessary to their investment in the SPV’s senior and junior ensure that the SI has virtually eliminated all of notes, which tend to be rated AAA and BB, its credit exposure. Furthermore, the Federal respectively. Finally, the SBO retains a high- Reserve retains the discretion to increase the quality, senior risk position that would absorb risk-based capital requirement assessed against any credit losses in the reference portfolio that the retained senior exposure in these structures, exceed the first- and second-loss positions. if the underlying asset pool deteriorates Typically, no default payments are made until significantly. the maturity of the overall transaction, regard- Federal Reserve staff will make a case-by- less of when a reference obligor defaults. While case determination, based on a qualitative review, operationally important to the SBO, this feature as to whether the senior retained portion of an has the effect of ignoring the time value of SBO’s synthetic securitization qualifies for the money. Thus, the Federal Reserve expects that 20 percent risk weight. The SI must be able to when the reference obligor defaults under the demonstrate that virtually all the credit risk of terms of the credit derivative and when the the reference portfolio has been transferred from reference asset falls significantly in value, the the banking book to the capital markets. As they SBO should, in accordance with GAAP, make do when BOs are engaging in more traditional appropriate adjustments in its regulatory reports securitization activities, examiners must care- to reflect the estimated loss that takes into fully evaluate whether the institution is fully account the time value of money. capable of assessing the credit risk it retains in For risk-based capital purposes, BOs invest- its banking book and whether it is adequately ing in the notes must assign them to the risk capitalized given its residual risk exposure. The weight appropriate to the underlying reference Federal Reserve will require the SBO to main- assets.54 The SBO for such transactions must tain higher levels of capital if it is not deemed to include in its risk-weighted assets its retained be adequately capitalized given the retained senior exposure in the reference portfolio, to the residual risks. In addition, an SI involved in extent these underlying assets are held in its synthetic securitizations must adequately dis- banking book. The portion of the reference close to the marketplace the effect of the trans- portfolio that is collateralized by the pledged action on its risk profile and capital adequacy. Treasury securities may be assigned a zero The Federal Reserve may consider an SBO’s percent risk weight. Unless the SBO meets the failure to require the investors in the CLNs to stringent minimum conditions for transaction 2 absorb the credit losses that they contractually that are outlined in the minimum conditions agreed to assume to be an unsafe and unsound explanation below, the remainder of the port- banking practice. In addition, such a failure folio should be risk-weighted according to the generally would constitute ‘‘implicit recourse’’ obligor of the exposures. or support to the transaction, which would result When the SI has virtually eliminated its in the SBO’s losing preferential capital treat- credit-risk exposure to the reference portfolio ment on its retained senior position. through the issuance of CLNs, and when the If an SBO of a synthetic securitization does other stringent minimum conditions are met, the not meet the stringent minimum conditions, it institution may assign the uncollateralized por- may still reduce the risk-based capital requirement on the senior risk position retained in the 54. Under this type of transaction, if a structure exposes banking book by transferring the remaining investing BOs to the creditworthiness of a substantive issuer, credit risk to a third-party OECD bank through for example, the SI, then the investing institutions should assign the notes to the higher of the risk categories appropriate the use of a credit derivative. Provided the credit to the underlying reference assets or the SI. derivative transaction qualifies as a guarantee

Commercial Bank Examination Manual November 2004 Page 49 3020.1 Assessment of Capital Adequacy under the risk-based capital guidelines, the risk other credit enhancements—which effec- weight on the senior position may be reduced tively must be deducted from capital—is from 100 percent to 20 percent. Institutions may no greater than a reasonable estimate of not enter into nonsubstantive transactions that expected losses on the reference portfolio; transfer banking-book items into the trading and account to obtain lower regulatory capital — ensure that the SI does not reassume any requirements.55 credit risk beyond the first-loss position through another credit derivative or any Minimum conditions. The following stringent other means. minimum conditions are those that SIs must • Condition 2—Demonstration of ability to meet to use the synthetic securitization capital evaluate remaining banking-book risk expo- treatment for transaction 2. The Federal Reserve sures and provide adequate capital support. may impose additional requirements or condi- To ensure that the SI has adequate capital for tions as deemed necessary to ascertain that the the credit risk of its unhedged exposures, an SBO has sufficiently isolated itself from the institution is expected to have adequate sys- credit-risk exposure of the hedged reference tems that fully account for the effect of those portfolio. transactions on its risk profiles and capital adequacy. In particular, its systems should be • Condition 1—Demonstration of transfer of capable of fully differentiating the nature and virtually all of the risk to third parties. Not all quality of the risk exposures an institution transactions structured as synthetic securitiza- transfers from the nature and quality of the tions transfer the level of credit risk needed to risk exposures it retains. Specifically, to gain receive the 20 percent risk weight on the capital relief institutions are expected to— retained senior position. To demonstrate that a — have a credible internal process for grad- transfer of virtually all of the risk has been ing credit-risk exposures, including achieved, institutions must— (1) adequate differentiation of risk among — produce credible analyses indicating a risk grades, (2) adequate controls to transfer of virtually all of the credit risk to ensure the objectivity and consistency of substantive third parties; the rating process, and (3) analysis or — ensure the absence of any early- evidence supporting the accuracy or amortization or other credit performance– appropriateness of the risk-grading system; contingent clauses;56 — have a credible internal economic capital- — subject the transaction to market discipline assessment process that defines the insti- through the issuance of a substantive tution to be adequately capitalized at an amount of notes or securities to the capital appropriate insolvency probability and that markets; readjusts, as necessary, its internal eco- — have notes or securities rated by a nation- nomic capital requirements to take into ally recognized credit rating agency; account the effect of the synthetic- — structure a senior class of notes that securitization transaction. In addition, the receives the highest possible investment- process should employ a sufficiently long grade rating, for example, AAA, from a time horizon to allow necessary adjust- nationally recognized credit rating agency; ments in the event of significant losses. — ensure that any first-loss position retained The results of an exercise demonstrating by the SI in the form of fees, reserves, or that the organization is adequately capitalized after the securitization transaction 55. For instance, a lower risk weight would not be applied must be presented for examiner review; to a nonsubstantive transaction in which the SI (1) enters into — evaluate the effect of the transaction on the a credit derivative transaction to pass the credit risk of the nature and distribution of the nontrans- senior retained portion held in its banking book to an OECD ferred banking-book exposures. This analy- bank and then (2) enters into a second credit derivative transaction with the same OECD bank, in which it reassumes sis should include a comparison of the into its trading account the credit risk initially transferred. banking book’s risk profile and economic 56. Early-amortization clauses may generally be defined as capital requirements before and after the features that are designed to force a wind-down of a securi- transaction, including the mix of expo- tization program and rapid repayment of principal to asset- backed securities investors if the credit quality of the under- sures by risk grade and business or eco- lying asset pool deteriorates significantly. nomic sector. The analysis should also

November 2004 Commercial Bank Examination Manual Page 50 Assessment of Capital Adequacy 3020.1

identify any concentrations of credit risk 10-K and annual reports, SIs must adequately and maturity mismatches. Additionally, disclose to the marketplace the accounting, the bank must adequately manage and economic, and regulatory consequences of control the forward credit exposure that synthetic CLO transactions. In particular, arises from any maturity mismatch. The institutions are expected to disclose— Federal Reserve retains the flexibility to — the notional amount of loans and commit- require additional regulatory capital if the ments involved in the transaction; maturity mismatches are substantive — the amount of economic capital shed enough to raise a supervisory concern. through the transaction; Moreover, as stated above, the SBO must — the amount of reduction in risk-weighted demonstrate that it meets its internal eco- assets and regulatory capital resulting from nomic capital requirement subsequent to the transaction, both in dollar terms and in the completion of the synthetic securitiza- terms of the effect in basis points on the tion; and risk-based capital ratios; and — perform rigorous and robust forward- — the effect of the transaction on the distri- looking stress testing on nontransferred bution and concentration of risk in the exposures (remaining banking-book loans retained portfolio by risk grade and sector. and commitments), transferred exposures, and exposures retained to facilitate trans- Transaction 3—Retention of a first-loss position. fers (credit enhancements). The stress tests In the third type of synthetic transaction, the must demonstrate that the level of credit SBO may retain a subordinated position that enhancement is sufficient to protect the absorbs first losses in a reference portfolio. The sponsoring bank from losses under SBO retains the credit risk associated with a scenarios appropriate to the specific first-loss position and, through the use of credit- transaction. default swaps, passes the second- and senior- • Condition 3—Provide adequate public disclo- loss positions to a third-party entity, most often sures of synthetic CLO transactions regarding an OECD bank. The third-party entity, acting as their risk profile and capital adequacy. In their an intermediary, enters into offsetting credit-

Figure 3—Transaction 3

Credit-default-swap fee (basis points per year) SPV Intermediary OECD Bank Holds $400 million Default payment and of pledged Treasuries pledge of Treasuries

Default payment $400 million $400 million and pledge of of cash Treasuries equal of CLNs Credit-default- to $400 million to swap fee cover losses above 1% of the Senior reference assets notes

Sponsoring Bank Junior $5 billion credit notes portfolio

Commercial Bank Examination Manual November 2004 Page 51 3020.1 Assessment of Capital Adequacy default swaps with an SPV, thus transferring its It is possible that the second approach may credit risk associated with the second-loss posi- result in a higher risk-based capital requirement tion to the SPV.57 The SPV then issues CLNs to than the dollar-for-dollar capital charge imposed the capital markets for a portion of the reference by the first approach. This depends on whether portfolio and purchases Treasury collateral to the reference portfolio consists primarily of cover some multiple of expected losses on the loans to private obligors or of undrawn long- underlying exposures. (See figure 3.) term commitments, which generally have an Two alternative approaches could be used to effective risk-based capital requirement that is determine how the SBO should treat the overall one-half of the requirement for loans, since such transaction for risk-based capital purposes. The commitments are converted to an on-balance- first approach employs an analogy to the low- sheet credit-equivalent amount using the 50 per- level capital rule for assets sold with recourse. cent conversion factor. If the reference pool Under this rule, a transfer of assets with recourse consists primarily of drawn loans to private that contractually is limited to an amount less obligors, then the capital requirement on the than the effective risk-based capital require- senior loss position would be significantly higher ments for the transferred assets is assessed a than if the reference portfolio contained only total capital charge equal to the maximum undrawn long-term commitments. As a result, amount of loss possible under the recourse the capital charge for the overall transaction obligation. If this rule was applied to an SBO could be greater than the dollar-for-dollar capi- retaining a 1 percent first-loss position on a tal requirement set forth in the first approach. synthetically securitized portfolio that would SIs will be required to hold capital against a otherwise be assessed 8 percent capital, the SBO retained first-loss position in a synthetic securi- would be required to hold dollar-for-dollar capi- tization equal to the higher of the two capital tal against the 1 percent first-loss risk position. charges resulting from application of the first The SI would not be assessed a capital charge and second approaches, as discussed above. against the second and senior risk positions.58 Further, although the SBO retains only the credit The second approach employs a literal read- risk associated with the first-loss position, it still ing of the capital guidelines to determine the should continue to monitor all the underlying SBO’s risk-based capital charge. In this instance, credit exposures of the reference portfolio to the one percent first-loss position retained by the detect any changes in the credit-risk profile of SI would be treated as a guarantee, that is, a the counterparties. This is important to ensure direct-credit substitute, which would be assessed that the institution has adequate capital to pro- an 8 percent capital charge against its face value tect against unexpected losses. Examiners should of one percent. The second-loss position, which determine whether the sponsoring bank has the is collateralized by Treasury securities, would capability to assess and manage the retained risk be viewed as fully collateralized and subject to a in its credit portfolio after the synthetic securi- zero percent capital charge. The senior-loss tization is completed. For risk-based capital position guaranteed by the intermediary bank purposes, BOs investing in the notes must assign would be assigned to the 20 percent risk cate- them to the risk weight appropriate to the gory appropriate to claims guaranteed by OECD underlying reference assets.60 banks.59

Reservation of Authority 57. Because the credit risk of the senior position is not transferred to the capital markets but remains with the intermediary bank, the SBO should ensure that its counter- The Federal Reserve reserves its authority to party is of high credit quality, for example, at least investment determine, on a case-by-case basis, the appro- grade. priate risk weight for assets and credit-equivalent 58. A BO that sponsors this type of synthetic securitization would not realize any benefits with respect to the determination of its leverage ratio since the reference assets remain on the SI’s balance sheet. would be subject to the standardized specific-risk capital 59. If the intermediary is a BO, then it could place both sets charge. of credit-default swaps in its trading account and, if subject to 60. Under this type of transaction, if a structure exposes the Federal Reserve’s market-risk capital rules, use its general- investing BOs to the creditworthiness of a substantive issuer, market-risk model and, if approved, specific-risk model to for example, the SI, then the investing institutions should calculate the appropriate risk-based capital requirement. If the assign the notes to the higher of the risk categories appropriate specific-risk model has not been approved, then the SBO to the underlying reference assets or the SI.

November 2004 Commercial Bank Examination Manual Page 52 Assessment of Capital Adequacy 3020.1 amounts and the appropriate credit-conversion Certain agency securities-lending arrangements factor for off-balance-sheet items. The Federal (May 2003 exception for ‘‘cash-collateral trans- Reserve’s exercise of this authority may result actions’’). In response to a bank’s inquiry, the in a higher or lower risk weight for an asset Board issued a May 14, 2003, interpretation for or credit-equivalent amount, or in a higher or the risk-based capital treatment of certain Euro- lower credit-conversion factor for an off- pean agency securities’ lending arrangements in balance-sheet item. This reservation of authority which the bank, acting as agent, lends securities explicitly recognizes that the Federal Reserve of a client and receives cash collateral from the retains sufficient discretion to ensure that banks, borrower. The transaction is marked-to-market as they develop novel financial assets, will daily and a positive margin of cash collateral be treated appropriately under the regulatory relative to the market value of the securities lent capital standards. Under this authority, the Fed- is maintained at all times. If the borrowing eral Reserve reserves its right to assign risk counterparty defaults on the securities loaned positions in securitizations to appropriate risk through, for example, failure to post margin categories on a case-by-case basis, if the credit when required, the transaction is immediately rating of the risk position is determined to be terminated and the cash collateral is used by the inappropriate. bank to repurchase in the market the securities lent in order to restore them to the client. The bank indemnifies its client against the risk that, in the event of counterparty default, the amount Board Approved Exceptions to Risk-Based of cash collateral may be insufficient to repur- Capital Guidelines (Reservation of chase the amount of securities lent. Thus, the Authority) Involving Securities Lending indemnification is limited to the difference between the value of the cash collateral and the Securities lent by a bank are treated in one of repurchase price of the replacement securities. two ways, depending upon whether the lender In addition, the bank, again acting as agent, is at risk of loss. If a bank, as agent for a cus- reinvests, on the client’s behalf, the cash collat- tomer, lends the customer’s securities and does eral received from the borrower. The reinvest- not indemnify the customer against loss, then ment transaction takes the form of a cash loan to the transaction is excluded from the risk-based a counterparty that is fully collateralized by capital calculation. Alternatively, if a bank government or corporate securities (through, for lends its own securities or, acting as agent for a example, a reverse repurchase agreement). Like customer, lends the customer’s securities and the first transaction, the reinvestment transaction indemnifies the customer against loss, the is subject to daily marking-to-market and remar- transaction is converted at 100 percent and gining and is immediately terminable in the assigned to the risk-weight category appropri- event of counterparty default. The bank issues ate to the obligor, or, if applicable, to any col- an indemnification to the client against the lateral delivered to the lending bank or the reinvestment risk, which is similar to the indem- independent custodian acting on the lending nification the bank gives on the original bank’s behalf. When a bank is acting as agent securities-lending transaction. for a customer in a transaction involving the The Federal Reserve Board’s current risk- lending or sale of securities that is collateral- based capital guidelines treat indemnifications ized by cash delivered to the bank, the transac- issued in connection with agency securities- tion is deemed to be collateralized by cash on lending activities as off-balance-sheet guaran- deposit for purposes of determining the appro- tees that are subject to capital charges. Under the priate risk-weight category, provided that guidelines, the bank’s first indemnification would (1) any indemnification is limited to no more receive the risk weight of the securities- than the difference between the market value of borrowing counterparty because of the bank’s the securities and the cash collateral received indemnification of the client’s reinvestment risk and (2) any reinvestment risk associated with on the cash collateral. (See 12 CFR 208, appen- that cash collateral is borne by the customer. dix A, section III.D.1.c.) The bank’s second See the ‘‘Risk-Weighting Process’’ discussion indemnification would receive the lower of the in this section and also the discussion in sec- risk weight of the reverse repurchase counter- tion 2030.1 on bank dealer securities-lending or party or the collateral, unless it was fully collat- -borrowing transactions. eralized with margin by OECD government

Commercial Bank Examination Manual November 2006 Page 53 3020.1 Assessment of Capital Adequacy securities, which would qualify for a zero per- unsecured loan equivalent amount will be cent risk weight. (See 12 CFR 208, appendix A, assigned the risk weight appropriate to the sections III.D.1.a. and b.) counterparty. The bank inquired about the possibility of To determine the unsecured loan equivalent assigning a zero percent risk weight for both amount, the bank must add together its current indemnifications, given the low risk they pose to exposure to the counterparty and a measure for the bank. The Board approved an exception to potential future exposure (PFE) to the counter- its risk-based capital guidelines for the bank’s party. The current exposure is the sum of the agency securities-lending transactions. The Board market value of all securities and cash lent to the approved this exception under the reservation of counterparty under the bank’s indemnified authority provision contained in the guidelines. arrangements, less the sum of all securities and This provision permits the Board, on a case-by- cash received from the counterparty as collateral case basis, to determine the appropriate risk under the indemnified arrangements. The PFE weight for any asset or off-balance-sheet item calculation is to be based on the market volatili- that imposes risks on a bank that are incommen- ties of the securities lent and the securities surate with the risk weight otherwise specified received, as well as any foreign exchange rate in the guidelines. (See 12 CFR 208, appendix A, volatilities associated with any cash or securities section III.A.) lent or received. This exception applies to the bank’s agency The Board considered two methods for incor- securities-lending transactions collateralized by porating market volatilities into the PFE calcu- cash where the bank indemnifies its client lation: (1) the bank’s own estimates of those against (1) the risk that, in the event of default volatilities based on a year’s historical observa- by the securities borrower, the amount of cash tion of market prices with no recognition of collateral may be insufficient to repurchase the correlation effects or (2) a value-at-risk (VaR) amount of securities lent and (2) the reinvest- type model. The bank was calculating daily, ment risk associated with lending the cash counterparty VAR estimates for its agency lend- collateral in a transaction fully collateralized by ing transactions and it had a VaR model that had securities (for example, in a reverse repur- been approved for purposes of the Board’s chase transaction). market risk rule. The Board determined that the The capital treatment the Board approved for bankt could use a VaR model to calculate the these transactions relies upon an economic mea- PFE for each of its counterparties. surement of the amount of risk exposure the The bank must calculate the VaR using a bank has to each of its counterparties. Under this five-day holding period and a 99th percentile approved approach, the bank does not use the one-tailed confidence interval based on market notional amount of underlying transactions that price data over a one-year historical observa- are subject to client indemnifications as the tion period. The data set used should be updated exposure amount for risk-based capital pur- no less frequently than once every three months poses. Rather, the bank must use an economic and should be reassessed whenever market exposure amount that takes into account the prices are subject to material changes. For each market value of collateral and the market price counterparty, the bank is required to calculate volatilities of (1) the instruments delivered by daily an unsecured loan equivalent amount, the bank to the counterparty and (2) the instru- including the VaR PFE component. These ments received by the bank from the counter- calculations will be subject to supervisory party. This approach builds on best practices of review to ensure they are in line with the banks for measuring their credit exposure quarter-end calculations used to determine amounts for purposes of managing internal regulatory capital requirements. single-borrower exposure limits, as well as upon To qualify for the capital treatment outlined existing concepts incorporated in the Basel above, the securities-lending and cash loan trans- Accord and the Board’s risk-based capital and actions covered by the bank’s indemnification market risk rules. The bank, under this excep- must meet the following conditions: tion, is required to determine an unsecured loan equivalent amount for each of the counterparties • the transactions are fully collateralized to which, as agent, the bank lends securities • any securities lent or taken as collateral are collateralized by cash or lends cash collateral- eligible for inclusion in the trading book and ized by securities. As described below, the are liquid and readily marketable

November 2006 Commercial Bank Examination Manual Page 54 Assessment of Capital Adequacy 3020.1

• any securities lent or taken as collateral are request and receive Board approval for such marked-to-market daily treatment. • the transactions are subject to a daily margin maintenance requirement Certain agency securities-lending arrangements (August 2006 exception for ‘‘securities-collateral Further, the transactions must be executed transactions’’). In response to an inquiry made under a bilateral netting agreement or an equiva- by a bank, a Board interpretation was issued on lent arrangement. These arrangements must August 15, 2006, which discussed the regulatory (1) provide the non-defaulting party the right to capital treatment of certain securities-lending promptly terminate and close out all transactions transactions. In these transactions, the bank, under the agreement upon an event of default, acting as agent for its clients, lends its clients’ including insolvency or bankruptcy of the coun- securities and receives liquid securities collat- terparty; (2) provide for the netting of gains and eral in return (the securities-collateral transac- losses on transactions (including the value of tions).61 Each securities loan is marked-to- any collateral) terminated and closed out under market daily, and the bank calls for additional the agreement so that a single net amount is margin as needed to maintain a positive margin owed by one party to the other; (3) allow for the of collateral relative to the market value of the prompt liquidation or setoff of collateral upon securities lent at all times. The bank also agrees the occurrence of an event of default; (4) be to indemnify its clients against the risk that, in conducted, together with the rights arising from the event of borrower default, the market value the conditions required in provisions 1 and 3 of the securities collateral is insufficient to above, under documentation that is legally bind- repurchase the amount of securities lent. ing on all parties and legally enforceable in each If the borrower were to default, the bank relevant jurisdiction upon the occurrence of an would be in a position to terminate a securities- event of default and regardless of the counter- collateral transaction and sell the collateral in party’s insolvency or bankruptcy; and (5) be order to purchase securities to replace the secu- conducted under documentation for which the rities that were originally lent. The bank’s expo- bank has completed sufficient legal review to sure under a securities-collateral transaction verify it meets provision 4 above and for which would be limited to the difference between the the bank has a well-founded legal basis for purchase price of the replacement securities and reaching this conclusion. the market value of the securities collateral. With regard to the counterparty VaR model The bank requested that the Federal Reserve that the bank uses, the bank is required to Board approve another exception to the capital conduct regular and rigorous backtesting proce- guidelines that would permit the bank to mea- dures, subject to supervisory review, to ensure sure its exposure amounts for risk-based capital the validity of the correlation factors used by the purposes with respect to the securities-collateral bank and the stability of these factors over time. transactions under the methodology of the bank’s The bank was not subject to a formal backtest- prior May 14, 2003, approval (the prior approval). ing procedure requirement at the time the letter The Board, again, determined that, under its was issued. However, if supervisory review current risk-based capital guidelines, the capital determines that the bank’s counterparty VaR charges for these securities-lending arrange- model or its backtesting procedures have mate- ments would exceed the amount of economic rial deficiencies and the bank does not take risk posed to the bank, which would result in appropriate and expeditious steps to rectify those capital charges that would be significantly out of deficiencies, supervisors may take action to proportion to the risk posed. The Board there- adjust the bank’s capital calculations. Such action fore approved an August 15, 2006, exception to could range from imposing a multiplier on the its risk-based capital guidelines according to the VaR estimates of PFE calculated by the bank to prior approval, allowing the bank to compute its disallowing the use of its counterparty VaR regulatory capital for these transactions using a model and requiring use of the own estimates loan-equivalent methodology. In so doing, the approach to determine the PFE component of bank would assign the risk weight of the coun- the unsecured loan equivalent amounts. terparty to the exposure amount of all such The capital treatment that the Board approved in the letter has been and will be made 61. The liquid securities collateral includes government available to similarly situated institutions that agency, government-sponsored entity, corporate debt or equity, or asset-backed or mortgage-backed securities. Commercial Bank Examination Manual November 2006 Page 55 3020.1 Assessment of Capital Adequacy transactions with the counterparty. Specifically, ment, funding sources, capital formation, man- the Board granted the bank its request to use an agement, marketing, operations, and informa- unsecured loan equivalent amount (calculated as tion systems to achieve success. Strategic current exposure plus a VaR-modeled PFE) for planning helps the organization more effectively the securities-collateral transactions for risk- anticipate and adapt to change. Management based capital purposes. The Board approved the must also ensure that planning information as exception under the reservation authority provi- well as corporate goals and objectives are effec- sion contained in its capital guidelines. tively communicated throughout the organization. Effective strategic planning allows the institution to be more proactive than reactive in shaping its own future. The strategic plan should Overall Assessment of Capital clearly outline the bank’s capital base, antici- Adequacy pated capital expenditures, desirable capital level, and external capital sources. Each of these areas The following factors should be taken into should be evaluated in consideration of the account in assessing the overall capital ade- degree and type of risk that management and the quacy of a bank. board of directors are willing to accept.

Capital Ratios Growth. Capital is necessary to support a bank’s growth; however, it is the imposition of required Capital ratios should be compared with regula- capital ratios that controls growth. Because a tory minimums and with peer-group averages. bank has to maintain a minimum ratio of capital Banks are expected to have a minimum total to assets, it will only be able to grow so fast. For risk-based capital ratio of 8 percent. However, example, a rapid growth in a bank’s loan port- because risk-based capital does not take explicit folio may be a cause of concern, for it could account of the quality of individual asset port- indicate that a bank is altering its risk profile by folios or the range of other types of risks to reducing its underwriting standards. which banks may be exposed, such as interest- rate, liquidity, market, or operational risks, banks Dividends. Examiners should review historical are generally expected to operate with capital and planned cash-dividend payout ratios to deter- positions above the minimum ratios. Institutions mine whether dividend payments are impairing with high or inordinate levels of risk are also capital adequacy.62 Excessive dividend payouts expected to maintain capital well above the may result from several sources: minimum levels. The minimum tier 1 leverage ratio is 3 per- • If the bank is owned by a holding company, cent. However, an institution operating at or the holding company may be requiring exces- near these levels is expected to have well- sive dividend payments from the bank to fund diversified risk, including no undue interest-rate the holding company’s debt-repayment pro- risk exposure, excellent asset quality, high gram, expansion goals, or other cash needs. liquidity, and good earnings, and to generally be • The bank’s board of directors may be under considered a strong banking organization, rated pressure from individual shareholders to pro- composite 1 under the CAMELS rating system vide funds to repay bank stock debt or to use of banks. For all but the most highly rated banks for other purposes. meeting the above conditions, the minimum • Dividends may be paid or promised to support tier 1 leverage ratio is 3 percent plus an addi- a proposed equity offering. tional cushion of at least 100 to 200 basis points. Access to additional capital. Banks that do not generate sufficient capital internally may require Impact of Management external sources of capital. Large, independent institutions may solicit additional funding from Strategic planning. One of management’s most the capital markets. Smaller institutions may important functions is to lead the organization rely on a bank holding company or a principal by designing, implementing, and supporting an shareholder or control group to provide addi- effective strategic plan. Strategic planning is a long-term approach to integrating asset deploy- 62. See also ‘‘Dividends,’’ section 4070.1.

November 2006 Commercial Bank Examination Manual Page 56 Assessment of Capital Adequacy 3020.1 tional funds, or on the issuance of new capital a bank generating losses is incapable of replen- instruments to existing or new investors. Cur- ishing its capital accounts internally. rent shareholders may resist efforts to obtain additional capital by issuing new capital instru- Funds management. A bank with undue levels ments because of the diluting effect of the new of interest-rate risk should be required to capital. In deciding whether to approve obtain- strengthen its capital positions, even though it ing additional capital in this manner, sharehold- may meet the minimum risk-based capital stan- ers must weigh the dilution against the possibil- dards. Assessments of capital adequacy should ity that, without the additional funds, the reflect banks’ appropriate use of hedging instru- institution may fail. ments. Other things being equal, banks that have Under Federal Reserve policy, a bank holding appropriately hedged their interest-rate exposure company is expected to serve as a source of will be permitted to operate with lower levels of strength to its subsidiary banks. A bank holding capital than those banks that are vulnerable to company can fulfill this obligation by having interest-rate changes. While the Federal Reserve enough liquidity to inject funds into the bank or does not want to discourage the use of legitimate by having access to the same sources of addi- hedging vehicles, some instruments, in particu- tional capital, that is, current or existing share- lar interest-only strips (IOs) and principal-only holders, as outlined above. strips (POs), raise concerns. IOs and POs have highly volatile price characteristics as interest rates change, and they are generally not consid- Financial Considerations ered appropriate investments for most banks. However, some sophisticated banks may have Capital levels and ratios should be evaluated in the expertise and systems to appropriately use view of the bank’s overall financial condition, IOs and POs as hedging vehicles. including the following areas. Off-balance-sheet items and activities. Once Asset quality. The final supervisory judgment on funded, off-balance-sheet items become subject a bank’s capital adequacy may differ signifi- to the same capital requirements as on-balance- cantly from conclusions that may be drawn sheet items. A bank’s capital levels should be solely from the level of a bank’s risk-based sufficient to support the quality and quantity of capital ratio. Generally, the main reason for this assets that would result from a significant por- difference is the evaluation of asset quality. tion of these items being funded within a short Final supervisory judgment of a bank’s capital time. adequacy should take into account examination findings, particularly those on the severity of problem and classified assets and investment or Adequacy of and Compliance with loan portfolio concentrations, as well as on the Capital-Improvement Plans adequacy of the bank’s allowance for loan and lease losses. Capital-improvement plans are required for banks operating with capital ratios below regu- Balance-sheet composition. A bank whose earn- latory minimums as required by the prompt- ing assets are not diversified or whose credit corrective-action part of the Federal Deposit culture is more risk-tolerant is generally expected Insurance Act, as well as for some banks oper- to operate with higher capital levels than a ating under supervisory actions. Examiners similar-sized institution with well-diversified, should review any such plans and determine less-risky investments. their adequacy and reasonableness, keeping in mind that banks may meet required capital-to- Earnings. An adequately capitalized, growing asset ratios in three ways: bank should have a consistent pattern of capital augmentation by earnings retention. Poor earn- • They may issue more capital. In doing so, ings can have a negative effect on capital banks must weigh the need for additional adequacy in two ways. First, any losses absorbed capital against the dilution of market value by capital reduce the ability of the remaining that will result. capital to fulfill that function. Second, the impact • They may retain earnings rather than paying of losses on capital is magnified by the fact that them out as dividends.

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• They may sell assets. By reducing the amount included in tier 2 capital is limited to 50 percent of total assets, a bank reduces the amount of of tier 1 capital. Amounts issued or outstanding capital necessary to meet the required ratios. in excess of this limit are not included in the risk-based capital calculation but should be taken into consideration when assessing the Inadequate Allowance for Loan and bank’s funding and ﬁnancial condition. Lease Losses Unrealized Asset Values An inadequate allowance for loan and lease losses (ALLL) will require an additional charge Banks often have assets on their books that are to current income. Any charge to current income carried at signiﬁcant discounts below current will reduce the amount of earnings available to market values. The excess of the market value supplement tier 1 capital. Because the amount of over the book value (historical cost or acquisi- the ALLL that can be included in tier 2 capital is tion value) of assets such as investment securi- limited to 1.25 percent of gross risk-weighted ties or banking premises may represent capital assets, an additional provision may increase the to the bank. These unrealized asset values are ALLL level above this limit, thereby resulting in not included in the risk-based capital calculation the excess portion being excluded from tier 2 but should be taken into consideration when capital. assessing capital adequacy. Particular attention should be given to the nature of the asset, the reasonableness of its valuation, its marketability, Ineligible Collateral and Guarantees and the likelihood of its sale.

The risk-based capital guidelines recognize only limited types of collateral and guarantees. Other Accounting for Defined Benefit Pension types of collateral and guarantees may support and Other Postretirement Plans the asset mix of the bank, particularly within its loan portfolio. Such collateral or guarantees In September 2006, the Financial Accounting may serve to substantially improve the overall Standards Board adopted the Statement of Finan- quality of a loan portfolio and other credit cial Accounting Standard No. 158, ‘‘Employers exposures, and should be considered in the Accounting for Defined Benefit Pension and overall assessment of capital adequacy. Other Postretirement Plans’’ (FAS 158). The standard requires, as early as December 31, 2006, that a bank, bank holding company, or Market Value of Bank Stock other banking or thrift organization that sponsors a single-employer defined benefit postre- Examiners should review trends in the market tirement plan—such as a pension plan or health price of the bank’s stock and whether stock is care plan—to recognize the overfunded or under- trading at a reasonable multiple of earnings or a funded status of each such plan as an asset or reasonable percentage (or multiple) of book liability on its balance sheet with corresponding value. A bank’s low stock price may merely be adjustments recognized in accumulated other an indication that it is undervalued, or it may be comprehensive income (AOCI), a component of indicative of regional or industry-wide prob- equity capital. After a banking organization lems. However, a low-valued stock may also initially applies FAS 158, changes in the benefit indicate that investors lack confidence in the plan asset or liability reported on the organiza- institution; such lack of support could impair the tion’s balance sheet will be recognized in the bank’s ability to raise additional capital in the year in which the changes occur and will result capital markets. in an increase or decrease in AOCI. Postretire- ment plan amounts carried in AOCI are adjusted as they are subsequently recognized in earnings Subordinated Debt in Excess of Limits as components of the plans’ net periodic benefit cost. The total of term subordinated debt and The Federal Reserve Board, along with other intermediate-term preferred stock that may be federal bank and thrift regulatory agencies (the

May 2007 Commercial Bank Examination Manual Page 58 Assessment of Capital Adequacy 3020.1

Agencies63), issued a joint press release on will; amounts of mortgage-servicing assets, December 14, 2006, in which they announced nonmortgage-servicing assets, and purchased that FAS 158 will not affect a banking organi- credit-card relationships that, in the aggregate, zations’ regulatory capital. The agencies decided, are in excess of 100 percent of tier 1 capital; until they can determine otherwise through a amounts of nonmortgage-servicing assets and rulemaking, that banks should exclude from purchased credit-card relationships that, in the regulatory capital any amounts recorded in AOCI aggregate, are in excess of 25 percent of tier 1 resulting from the adoption and application of capital; amounts of credit-enhancing interest- FAS 158. The purpose of this exclusion is to only strips that are in excess of 25 percent of tier neutralize the effect of the application of FAS 1 capital; all other identifiable intangible assets; 158 on regulatory capital, including the report- any investments in subsidiaries or associated ing of the risk-based and leverage capital companies that the Federal Reserve determines measures. should be deducted from tier 1 capital; deferred tax assets that are dependent on future taxable income, net of their valuation allowance, in TIER 1 LEVERAGE RATIO FOR excess of the limitations set forth in section II.B. STATE MEMBER BANKS of appendix A of Regulation H; and the amount of the total adjusted carrying value of nonfinan- The Federal Reserve has adopted a minimum cial equity investments that is subject to a ratio of tier 1 capital to average total assets to deduction from tier 1 capital. assist in the assessment of the capital adequacy Under the tier 1 leverage ratio guidelines, the of state member banks. The principal objective minimum level of tier 1 capital to total assets for of this measure (which is intended to be used as strong state member banks is 4 percent, unless a supplement to the risk-based capital measure) they are rated composite 1 under the UFIRS is to place a constraint on the maximum degree (CAMELS) rating system of banks. Institutions to which a state member bank can leverage its not meeting these characteristics, as well as equity capital base. institutions with supervisory, financial, or opera- The guidelines implementing the tier 1 lever- tional weaknesses, are expected to operate well age ratio are found in Regulation H (12 CFR above minimum capital standards. Institutions 208), appendix B, and apply to all state member experiencing or anticipating significant growth banks on a consolidated basis. The ratio is to be are also expected to maintain capital ratios, used in the examination and supervisory pro- including tangible capital positions, well above cess, as well as in the analysis of applications the minimum levels. Moreover, higher capital acted on by the Federal Reserve. ratios may be required for any banking institu- A bank’s tier 1 leverage ratio is calculated by tion if warranted by its particular circumstances dividing its tier 1 capital (the numerator of the or risk profile. In all cases, institutions should ratio) by its average total consolidated assets hold capital commensurate with the level and (the denominator of the ratio). For purposes of nature of the risks, including the volume and calculating this ratio during an examination, severity of problem loans, to which they are examiners may use the bank’s average total exposed. assets as of the last Call Report date. The ratio A bank that does not have a 4 percent will be calculated using period-end assets when- leverage ratio (3 percent if it is rated a compos- ever necessary, on a case-by-case basis. For the ite CAMELS 1) is considered undercapitalized purpose of this leverage ratio, the definition of under the prompt-corrective-action framework tier 1 capital as set forth in the risk-based capital and must file a capital-restoration plan that guidelines in appendix A of the Federal Reserve’s meets certain requirements. Regulation H is used. Average total consolidated assets are defined as the quarterly average total assets (defined net of the allowance for loan and De Novo Banks lease losses) reported on the bank’s Reports of Condition and Income (Call Reports), less good- Initial capital in a de novo state member bank should be reasonable in relation to the bank’s 63. The Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Office of location, business plan, competitive environ- Thrift Supervision. ment, and state law. At a minimum, however, a

Commercial Bank Examination Manual May 2007 Page 59 3020.1 Assessment of Capital Adequacy de novo bank must maintain a tangible tier 1 reliance on additional capital injections. Even leverage ratio (core capital elements minus all though a 9 percent tangible leverage ratio is not intangible assets divided by average total assets required after the third year, de novo banks are minus all intangible assets) of 9 percent for the expected to maintain capital ratios that are ﬁrst three years of operations. The applicant commensurate with ongoing safety-and- must provide projections of asset growth and soundness concerns and that are generally well earnings performance that reasonably support in excess of regulatory minimums. (See SR- the bank’s ability to maintain this ratio without 91-17.)

May 2007 Commercial Bank Examination Manual Page 60 Assessment of Capital Adequacy Examination Objectives Effective date May 2000 Section 3020.2

1. To determine the adequacy of capital. leverage capital guidelines, as well as exist- 2. To determine compliance with the risk- ing conditions and future plans. based and tier 1 leverage capital adequacy 6. To initiate corrective action when policies, guidelines. procedures, or capital are deﬁcient. 3. To determine if the policies, practices, and 7. To evaluate whether— procedures with regard to the capital ade- a. the institution is fully capable of assessing quacy guidelines are adequate. the credit risk associated with the collat- 4. To determine if the bank’s ofﬁcers and eralized loan obligations (CLOs) it retains employees are operating in conformity with in its banking book (nontrading accounts); the Board’s established capital adequacy and guidelines. b. the institution is adequately capitalized 5. To evaluate the propriety and consistency of given its residual risk exposure involving the bank’s present and planned level of CLOs. capitalization in light of the risk-based and

Commercial Bank Examination Manual May 2000 Page 1 Assessment of Capital Adequacy Examination Procedures Effective date November 2004 Section 3020.3

VERIFICATION OF THE — any issuer-redemption feature must RISK-BASED CAPITAL RATIO be subject to prior Federal Reserve approval Examiners should verify that the bank has — noncumulative adequate systems in place to compute and docu- — fixed rate or traditional floating or ment its risk-based capital ratios. Small banks adjustable rate with capital ratios well in excess of established — must not contain features that would minimums may not have a system explicitly require or create an incentive for designed to capture risk-based capital informa- the issuer to redeem or repurchase tion. In addition, depending on a bank’s current the instrument, such as an ‘‘explod- capital structure and ratios, all procedures may ing rate,’’ an auction-rate pricing not apply. mechanism, or a feature that allows the stock to be converted into 1. Verify that the bank is correctly reporting increasing numbers of common the risk-based capital information requested shares on the Reports of Condition and Income. • Perpetual preferred stock, includable within tier 2 capital without a sublimit, For the qualifying components of capital (the must have the characteristics listed ratio’s numerator): above for tier 1 perpetual preferred stock, but perpetual preferred stock 2. Determine if management is adhering to the does not otherwise qualify for inclu- underlying terms of any currently outstand- sion in tier 1 capital. For example, ing stock issues. cumulative or auction-rate perpetual 3. Review common stock to ensure that the preferred stock, which does not qualify bank is in compliance with the terms of any for tier 1 capital, may be includable in underlying agreements and to determine if tier 2 capital. more than one class exists. When more than 5. Verify that minority interest in equity one class exists, review the terms for any accounts of consolidated subsidiaries preference or nonvoting features. If the included in tier 1 capital consists only of terms include such features, determine qualifying tier 1 capital elements. Deter- whether the class of common stock qualifies mine whether any perpetual preferred stock for inclusion in tier 1 capital. of a subsidiary that is included in minority 4. Review any perpetual and long-term pre- interest is secured by the subsidiary’s assets; ferred stock for the following: if so, that stock may not be included in a. Compliance with terms of the underlying capital. agreements carefully noting— 6. Review the intermediate-term preferred • adherence to the cumulative or non- stock and subordinated debt instruments cumulative nature of the stock and included in capital for the following: • adherence to any conversion rights. a. Compliance with terms of the underlying b. Proper categorization as tier 1 or tier 2 agreements, noting that subordinated debt for capital adequacy purposes, noting the containing the following terms may not following requirements: be included in capital: • Tier 1 perpetual preferred stock must • interest payments tied to the bank’s have the following characteristics: financial condition — no maturity date • acceleration clauses or broad condi- — cannot be redeemed at the option tions of events of default that are of the holder inconsistent with safe and sound bank- — unsecured ing practices — ability to absorb losses b. Compliance with restrictions on the — ability and legal right for issuer to inclusion of such instruments in capital defer or eliminate dividends by verifying that the aggregate amount

Commercial Bank Examination Manual November 2004 Page 1 3020.3 Assessment of Capital Adequacy: Examination Procedures

of both types of instruments does not 9. Verify that the amount of the allowance for exceed 50 percent of tier 1 capital (net of loan and lease losses included in tier 2 goodwill) and that the portions includ- capital has been properly calculated and able in tier 2 capital possess the follow- disclosed, and verify that the supporting ing characteristics: computations of that amount have been • unsecured adequately documented. • minimum five-year original weighted average maturity For the calculation of risk-weighted assets • in the case of subordinated debt, con- (the ratio’s denominator): tains terms stating that the debt (1) is not a deposit, (2) is not insured by 10. Determine whether the bank consolidates, a federal agency, (3) cannot be in accordance with the Financial Account- redeemed without prior approval from ing Standards Board’s FIN 46-R, the assets the Federal Reserve, and (4) is sub- of any asset-backed commercial paper ordinated to depositors and general (ABCP) program that it sponsors. creditors a. Determine whether the bank’s ABCP c. Appropriate amortization, if the instru- program meets the definition of a spon- ments have a remaining maturity of less sored ABCP program under the Federal than five years. Reserve’s risk-based capital guidelines. 7. Determine, through review of minutes of If the bank does consolidate the assets of board of directors meetings, if a stock an ABCP program, review the documen- offering or subordinated debt issue is being tation of its risk-based capital ratio cal- considered. If so, determine that manage- culations, and determine whether the ment is aware of the risk-based capital associated ABCP program’s assets and requirements for inclusion in capital. minority interests were excluded from 8. Review any mandatory convertible debt the bank’s risk-weighted asset base (and securities for the following: also if they were excluded from tier 1 a. Compliance of the terms with the criteria capital—the ratio’s numerator). See sec- set forth in 12 CFR 225 (Regulation Y), tion III.B.6. of the risk-based capital appendix B. guidelines (12 CFR 208, appendix A). b. Notification in the terms of agreement b. Determine whether any of the bank’s that the redemption or repurchase of liquidity facilities meet the definition and such securities before maturity is subject requirements of an eligible ABCP liquid- to prior approval from the Federal ity facility under the Federal Reserve’s Reserve. risk-based capital guidelines. See section c. The treatment of the portions of such III.B.3.a.iv. of the risk-based capital securities covered by the issuance of guidelines (12 CFR 208, appendix A). common or perpetual preferred stock c. Determine from the bank’s supporting dedicated to the repayment of the secu- documentation of its risk-based capital rities, bearing in mind the following: ratios whether the bank held risk-based • The amount of the security covered by capital against its eligible ABCP liquid- dedicated stock should be treated as ity facilities. subordinated debt and is subject, d. Determine whether the bank applied the together with other subordinated debt correct conversion factors to the eligible and intermediate-term preferred stock, ABCP liquidity facilities when it deter- to a sublimit within tier 2 capital of mined the amount of risk-weighted assets 50 percent of tier 1 capital, as well as for its risk-based capital ratios. See sec- to amortization in the last five years of tion III.D. of the risk-based capital guide- life. lines (12 CFR 208, appendix A). • The portion of a mandatory convert- • For those eligible ABCP liquidity ible security that is not covered by facilities having an original maturity of dedication qualifies for inclusion in one year or less, determine if a 10 per- tier 2 capital without any sublimit and cent credit-conversion factor was used. without being subject to amortization • For those eligible ABCP liquidity in the last five years of life. facilities having an original maturity

November 2004 Commercial Bank Examination Manual Page 2 Assessment of Capital Adequacy: Examination Procedures 3020.3

exceeding one year, determine if a or that are otherwise considered to lack 50 percent credit-conversion factor sufficient capital to support their activities, should have been used. examine the bank’s capital plans for achiev- e. Determine if ineligible ABCP liquidity ing adequate levels of capital. In conjunc- facilities were treated as direct-credit tion with management of the appropriate substitutes or as recourse obligations, as Reserve Bank, determine whether the plans required by the risk-based capital guide- are acceptable to the Federal Reserve. lines. Review and comment on these plans and 11. Verify that each on- and off-balance-sheet any progress achieved in meeting the item has been assigned to the appropriate requirements. risk category in accordance with the risk- 2. The review processes discussed in ‘‘Overall based capital guidelines. Close attention Conclusions Regarding Condition of the should be paid to the underlying obligor, Bank,’’ section 5020.1, require an evalua- collateral, and guarantees, and to assign- tion of the propriety and consistency of the ment to a risk category based on the terms bank’s present and planned level of capitali- of a claim. The claim should be assigned to zation in light of existing conditions and the risk category appropriate to the highest future plans. In this regard, the examiner risk option available under the terms of the assigned to assessing capital adequacy transaction. Verify that the bank’s documen- should do the following: tation supports the assignment of preferen- a. Using the latest Uniform Bank Perfor- tial risk weights. If necessary, recalculate mance Report (UBPR), analyze applica- the value of risk-weighted assets. ble ratios involving capital funds, com- 12. Verify that all off-balance-sheet items have paring these ratios with those of the been converted properly to credit-equivalent bank’s peer group and investigating amounts based on the risk-based capital trends or significant variations from peer- guidelines. Close attention should be paid to group averages. the proper reporting of assets sold with b. Determine, with regard to the bank’s recourse, financial and performance standby overall financial condition, that the bank’s letters of credit, participations of off-balance- capital is sufficient to compensate for sheet transactions, and commitments. any instabilities or deficiencies in the asset and liability mix and in quality, as described in the ‘‘Funds Management’’ VERIFICATION OF THE TIER 1 paragraph (‘‘Financial Considerations’’ subsection of section 3020.1). LEVERAGE RATIO c. Determine if the bank’s earnings performance enables it to fund its expansion 1. Verify that the bank has correctly calculated adequately, to remain competitive in the tier 1 capital in accordance with the defini- market, and to replenish or increase its tion of tier 1 capital, as set forth in the capital funds as needed. risk-based capital guidelines. d. Analyze trends in the bank’s deposit and 2. Verify that the bank has properly calculated borrowed funds structure to determine average total consolidated assets, which are whether capital is maintained at a level defined as the quarterly average total assets sufficient to sustain depositor and lender as reported on the Call Report, less good- confidence. will and any other intangible assets and any e. If the allowance for loan and lease losses investments in subsidiaries that the Federal is determined to be inadequate, analyze Reserve determines should be deducted from the impact of current and potential losses tier 1 capital. on the bank’s capital structure. See ‘‘Ana- lytical Review and Income and Expense,’’ section 4010.1. OVERALL ASSESSMENT OF f. Consider the impact of any management CAPITAL ADEQUACY deficiencies on present and projected capital. 1. For banks that do not meet the minimum g. Determine if there are any assets or risk-based tier 1 leverage capital standards contingent accounts whose quality rep-

Commercial Bank Examination Manual November 2004 Page 3 3020.3 Assessment of Capital Adequacy: Examination Procedures

resents an actual or potential serious minimum conditions have been met for weakening of capital. that treatment. h. Consider the potential impact of any 3. Review capital adjustments such as good- proposed changes in controlling owner- will and intangible assets by performing the ship (if approved) on the projected capi- following procedures: tal position. a. Verify the existence of adequate docu- i. Analyze assets that are considered mentation concerning book and fair undervalued on the balance sheet and values and the amortization method. carried at below-market values. The b. Verify that intangibles are being reduced excess of fair value over cost may rep- in accordance with the amortization resent an additional cushion to the bank. method. If the book carrying amount j. Consider the cushion for absorbing losses exceeds the fair value, the intangible that may be provided by any subordi- should be written down or off. nated debt or intermediate-term pre- c. Determine if the bank is performing a ferred stock not included in tier 2 capital quarterly review of the book and fair because of the 50 percent of tier 2 capital values and the quality of all intangibles. limitation, or that is not included in d. Verify that goodwill and other nonquali- capital for tier 1 leverage ratio purposes. fying identifiable intangibles are deducted k. Analyze any collateral and guarantees from tier 1 capital. supporting assets that may not be taken e. Determine the proper inclusion of other into account for risk-based or tier 1 identifiable intangibles included in tier 1 leverage capital purposes, and consider capital by verifying that the criteria and these collateral and guarantees in the limitations outlined in the risk-based capi- overall assessment of capital adequacy. tal guidelines are met. l. Evaluate the bank’s overall asset quality, 4. In light of the analysis conducted in step 2 and determine whether the bank needs to (under ‘‘Overall Assessment of Capital strengthen its capital position based on Adequacy’’), and in accordance with the the following: Federal Reserve’s capital adequacy guide- • the severity of problem and classified lines, determine any appropriate supervi- assets sory action with regard to the bank’s capital • investment or loan- portfolio con- adequacy. centrations 5. Review the following items with the • the adequacy of loan-loss reserves examiner-in-charge in preparation for dis- m. Analyze the bank’s interest-rate risk and cussion with appropriate management: use of hedging instruments. Determine if a. all deficiencies noted with respect to the the bank should strengthen its capital capital accounts position because of undue levels of risk. b. the adequacy of present and projected Review hedging instruments for the use capital of interest-only strips (IOs) and principal- 6. Ascertain through minutes, reports, etc., or only strips (POs) (which raise concerns), through discussions with management, how and review management’s expertise in the future plans of the bank (for example, using hedging instruments. growth through commercial lending, retail n. Determine whether the sponsoring bank operations, etc.) will affect the bank’s asset is able to assess and manage the retained quality, capital position, and other areas of risk in its credit portfolio after the issu- its balance sheet. ance of synthetic collateralized loan 7. Prepare comments for the examination report obligations (CLOs). on the bank’s capital position, including any o. If the bank has used the special risk- deficiencies noted. based regulatory capital treatment for 8. Update the workpapers with any informa- synthetic CLOs, verify that the stringent tion that will facilitate future examinations.

November 2004 Commercial Bank Examination Manual Page 4 Assessment of Capital Adequacy Internal Control Questionnaire Effective date November 1993 Section 3020.4

Review the bank’s internal controls, policies, *4. Are capital transactions verified by more practices, and procedures concerning capital. than one person before stock certificates The bank’s system should be documented in a are issued? complete and concise manner and should include, *5. Are stock certificates and debentures han- where appropriate, narrative descriptions, flow- dled by persons who do not also record charts, copies of forms used, and other pertinent those transactions? information. Items marked with an asterisk *6. Does the bank maintain a stock certificate require substantiation by observation or testing. book with certificates serially numbered by the printer? *7. Is the stock certificate book maintained GENERAL under dual control? *8. Does the bank’s policy prohibit the sign- 1. Has the bank established procedures to ing of blank stock certificates? ensure that— *9. Does the bank maintain a shareholders’ a. all components of capital are accurately ledger that shows the total number of categorized and reported for purposes shares owned by each stockholder? of the risk-based and leverage capital *10. Does the bank maintain a stock transfer measures? journal disclosing names, dates, and b. all on-and off-balance-sheet items are amounts of transactions? accurately risk-weighted and reported *11. Does the bank cancel surrendered stock for purposes of the risk-based capital certificates? measures? *12. Are inventories of unissued notes or c. categorization of on- and off-balance- debentures— sheet items and capital for purposes of a. maintained under dual control? the risk-based capital measures is ade- b. counted periodically by someone other quately documented? than the person responsible for their d. the bank is in compliance with the custody? terms of any contractual agreements *13. When transfers are made— underlying capital instruments? a. are notes or debentures surrendered and e. management and the board of directors promptly cancelled? consider the requirements of the risk- b. are surrendered notes or debentures based capital guidelines for inclusion inspected to determine that proper in capital of stock or debt prior to assignment has been made and that new issuance? notes or debentures agree in amount? 2. Does the bank prepare a periodic analysis of its risk-based and leverage capital positions to assess capital adequacy for both CONCLUSION current and anticipated needs? *3. Has the board of directors authorized spe- 14. Indicate additional procedures used in cific bank officers to— arriving at conclusions. a. sign stock certificates? 15. Are internal controls of capital adequate b. maintain custody of unissued stock based on a composite evaluation, as certificates? evidenced by answers to the foregoing c. maintain stock journals and records? questions?

Commercial Bank Examination Manual March 1994 Page 1 Assessing Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs Effective date October 2007 Section 3030.1

The Federal Reserve Board and the other federal internal-ratings approach to their unrated direct- banking agencies (the agencies)1 amended their credit substitutes extended to ABCP programs4 risk-based capital standards on November 29, that they sponsor by mapping internal risk 2001, to adopt a new capital framework for ratings to external rating equivalents. These banking organizations (includes bank holding external credit rating equivalents are organized companies) engaged in securitization activities into three ratings categories: investment-grade (the securitization capital rule).2 In March 2005, (BBB and above) credit risk, high non- the agencies issued interagency guidance that investment-grade (BB+ through BB-) credit risk, clariﬁes how banking organizations are to use and low non-investment-grade (below BB-) internal ratings that they assign to asset pools credit risk. These rating categories can then be purchased by their asset-backed commercial used to determine whether a direct-credit sub- paper (ABCP) programs in order to appropri- stitute provided to an ABCP program should be ately risk-weight any direct-credit substitutes (1) assigned to a risk weight of 100 percent or (for example, guarantees) extended to such pro- 200 percent or (2) subject to the ‘‘gross-up’’ grams. For state member bank examination treatment, as summarized in the table on the purposes, the interagency guidance has been next page.5 (See appendix A for a more detailed reformatted for examiner use as examination description of ABCP programs.) objectives, examination procedures, and an inter- As the table indicates, the minimum risk nal control questionnaire. The guidance uses the weight available under the internal risk-ratings term ‘‘banking organization.’’ In this section, the approach is 100 percent, regardless of the inter- guidance should be interpreted to mean the nal rating.6 Conversely, positions rated below application of the risk-based capital guidelines BB- receive the gross-up treatment. That is, the to all state member banks on a consolidated banking organization holding the position must basis. maintain capital against the amount of the posi- The guidance sets forth an analytical frame- tion plus all more senior positions.7 Application work for assessing the broad risk characteristics of gross-up treatment, in many cases, will result of direct-credit substitutes3 that a banking orga- in a full dollar-for-dollar capital charge (the nization provides to an ABCP program it spon- equivalent of a 1,250 percent risk weight) on sors. The guidance provides speciﬁc informa- direct-credit substitutes that fall into the low tion on evaluating direct-credit substitutes issued non-investment-grade category. In addition, the in the form of program-wide credit enhance- risk-based capital requirement applied to a direct- ments, as well as an approach to determine the credit substitute is subject to the low-level- risk-based capital charge for these enhance- exposure rule. Under the rule, the amount of ments. (See SR-05-6 and its attachment. Also, required risk-based capital would be limited to see sections 3020.1, ‘‘Assessment of Capital the lower of a full dollar-for-dollar capital charge Adequacy,’’ and 4030.1, ‘‘Asset Securitization.’’) against the direct-credit substitute or the effec- The securitization capital rule permits bank- tive risk-based capital charge (for example, ing organizations with qualifying internal risk- 8 percent) for the entire amount of assets in the rating systems to use those systems to apply the

4. ABCP programs include multiseller ABCP conduits, 1. The Ofﬁce of the Comptroller of the Currency, the credit arbitrage ABCP conduits, and structured investment Federal Deposit Insurance Corporation, and the Ofﬁce of vehicles. Thrift Supervision. 5. The rating designations (for example, ‘‘BBB-’’ and 2. See 66 Fed. Reg. 59614 (November 29, 2001). See also ‘‘BB+’’) used in the table are illustrative only and do not 12 C.F.R. 208, appendix A, section III.B.3. indicate any preference for, or endorsement of, any particular 3. Direct-credit substitute means an arrangement in which rating designation system. a banking organization assumes, in form or in substance, 6. Exposures externally rated by a nationally recognized credit risk associated with an on- or off-balance-sheet credit statistical rating organization (NRSRO) above BBB+ are exposure that it did not previously own (that is, a third-party eligible for lower risk weights (that is, 20 percent for AAA asset) and the risk it assumes exceeds the pro rata share of its and AA, 50 percent for A). interest in the third-party asset. If the banking organization has 7. Gross-up treatment means that a position is combined no claim on the third-party asset, then the organization’s with all more senior positions in the transaction. The resulting assumption of any credit risk with respect to the third-party amount is then risk-weighted based on the obligor or, if asset is a direct-credit substitute. relevant, the guarantor or the nature of the collateral.

Commercial Bank Examination Manual October 2007 Page 1 3030.1 Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs

Internal risk-rating equivalent Ratings category Risk weighting BBB- or better Investment grade 100% BB+ to BB- High non-investment 200% grade Below BB- Low non-investment Gross-up treatment grade

ABCP program.8 A process is provided that is designed to aid The use of internal risk rattings under the in determining the regulatory capital treatment securitization capital rule is limited to determin- for program-wide credit enhancements, pro- ing the risk-based capital charge for unrated vided to an ABCP program. The key underlying direct-credit substitutes that banking organiza- principles are as follows: tions provide to ABCP programs. Thus, banking organizations may not use the internal-ratings 1. The determination of the credit quality of the approach to derive the risk-based capital require- program-wide credit enhancement shall be ment for unrated direct-credit substitutes ex- based on the risk of draw and subsequent tended to other transactions. Approved use of loss, which depends directly on the quality of the internal rating-based approach for ABCP the credit-enhanced assets funded through programs under the securitization capital rule the ABCP program. will have no bearing on the overall appropriate- 2. An estimate of the risk of draw for the ness of a banking organization’s internal risk- program-wide credit enhancement is derived rating system for other purposes. from the quality (rating) of the riskiest cred- Most rated commercial paper issued out of an it(s) within the ABCP program, which is ABCP program is supported by program-wide often indicated by the internal rating a bank- credit enhancement, which is a direct-credit ing organization assigns to a transaction’s substitute. Often the sponsoring banking orga- pool-specific liquidity facility. Other credit nization provides, in whole or in part, program- risks (for example, seller/servicer risk) to the wide credit enhancement to the ABCP program. program-wide credit enhancement may also Program-wide credit enhancement may take a be considered. number of different forms, including an irrevo- 3. The weakest-link approach assigns risk- cable loan facility, a standby letter of credit, a based capital against the program-wide credit financial guarantee, or a subordinated debt. enhancement in rank order of the internal The interagency guidance also discusses the ratings starting with the lowest-rated posi- weakest-link approach. This approach is used tions supported by the program-wide credit for calculating the risk-based capital require- enhancement. Therefore, if all of the posi- ment and assumes that the risk of the program- tions supported by the program-wide credit wide credit enhancement is directly dependent enhancement are internally rated investment on the quality (that is, internal rating) of the grade, the banking organization would risk- riskiest transaction(s) within the ABCP weight the notional amount of the program- program. (See step 9 of the examination wide credit enhancement at 100 percent and procedures, section 3030.3.) More specifically, there would be no need to proceed further. the weakest-link concept presupposes the prob- However, for positions supported by the ability that the program-wide credit enhance- program-wide credit enhancement that are ment that will be drawn is equal to the prob- non-investment grade, banking organizations ability of default of the transaction(s) with the can use the formula-driven weakest-link weakest transaction risk rating. approach illustrated in step 9 of the examination procedures to generate the appropriate amount of risk-based capital to be assessed 8. The low-level-exposure rule provides that the dollar against an unrated position. amount of risk-based capital required for a recourse obligation or direct-credit substitute should not exceed the maximum dollar amount for which a banking organization is contractually liable. (See 12 C.F.R 208, appendix A, section III.B.3.g.i.)

October 2007 Commercial Bank Examination Manual Page 2 Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs 3030.1

Asset Pools Pool-Specific Credit Pool-Specific Enhancement Liquidity Facility

ABCP Conduit

Program Manager/ Program-Wide Sponsor Liquidity Facility

Commercial Program-Wide Paper Investors Credit Enhancement

ASSESSMENT OF INTERNAL APPENDIX A—OVERVIEW OF RATING SYSTEMS ABCP PROGRAMS

The guidance is organized in the form of a ABCP programs provide a means for corpora- decision tree that (1) provides an outline of the tions to obtain relatively low-cost funding by key decisions that examiners and sponsoring selling or securitizing pools of homogenous banking organizations should consider when assets (for example, trade receivables) to reviewing internal risk-rating systems for ABCP special-purpose entities (SPEs/ABCP programs and (2) provides supervisors with programs). The ABCP program raises funds for more-specific information on how to assess the purchase of these assets by issuing commercial adequacy of these systems. Many of the quali- paper into the marketplace. The commercial tative and quantitative factors used to evaluate paper investors are protected by structural risk in this guidance are comparable with rating enhancements provided by the seller (for agency criteria (for example, criteria from S&P, example, overcollateralization, spread ac- Moody’s, and Fitch) because the ABCP pro- counts, early-amortization triggers, etc.) and by gram sponsors generally use the rating method- credit enhancements (for example, subordinated ologies of nationally recognized statistical rating loans or guarantees) provided by banking organizations (NRSROs) when assessing the organization sponsors of the ABCP program credit quality of their risk exposures to ABCP and by other third parties. In addition, liquid- programs. The guidance has two primary goals: ity facilities are also present to ensure the rapid and orderly repayment of commercial paper • provide information to banking organizations should cash-flow difficulties emerge. ABCP to ensure the accuracy and consistency of the programs are nominally capitalized SPEs that ratings assigned to transactions in an ABCP program issue commercial paper. A sponsoring banking • assist supervisors in assessing the adequacy of organization establishes the ABCP program but a banking organization’s internal risk-rating usually does not own the conduit’s equity, system based on the nine key criteria set forth which is often held by unaffiliated third-party in the securitization capital rule9 management companies that specialize in owning such entities, and are structured to be bankruptcy remote. 9. 12 C.F.R. 208, appendix A, III.B.3.f.i.

Commercial Bank Examination Manual October 2007 Page 3 3030.1 Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs

Typical Structure or higher. SIVs operate on a market-value basis similar to market value CDOs in that they must ABCP programs are funding vehicles that bank- maintain a dynamic overcollateralization ratio ing organizations and other intermediaries estab- determined by analysis of the potential price lish to provide an alternative source of funding volatility on securities held in the portfolio. to themselves or their customers. In contrast to SIVs are monitored daily and must meet strict term securitizations, which tend to be amortiz- liquidity, capitalization, leverage, and concentra- ing, ABCP programs are ongoing entities that tion guidelines established by the rating agencies. usually issue new commercial paper to repay maturing commercial paper. The majority of ABCP programs in the capital markets are Key Parties and Roles established and managed by major international commercial banking organizations. As with tra- Key parties for an ABCP program include the ditional commercial paper, which has a maxi- following: mum maturity of 270 days, ABCP is short-term debt that may either pay interest or be issued at • program management/administrators a discount. • credit-enhancement providers • liquidity-facility providers • seller/servicers Types of ABCP Programs • commercial paper investors

Multiseller programs generally provide working Program Management capital financing by purchasing or advancing against receivables generated by multiple cor- The sponsor of an ABCP program initiates the porate clients of the sponsoring banking organi- creation of the program but typically does not zations. These programs are generally well diver- own the equity of the ABCP program, which is sified across both sellers and asset types. provided by unaffiliated third-party investors. Despite not owning the equity of the ABCP Single-seller programs are generally established program, sponsors usually retain a financial to fund one or more types of assets originated by stake in the program by providing credit a single seller. The lack of diversification is enhancement, liquidity support, or both, and generally compensated for by increased program- they play an active role in managing the pro- wide credit enhancement. gram. Sponsors typically earn fees—such as credit-enhancement, liquidity-facility, and Loan-backed programs fund direct loans to program-management fees—for services pro- corporate customers of the ABCP program’s vided to their ABCP programs. sponsoring banking organization. These loans Typically, an ABCP program makes arrange- are generally closely managed by the banking ments with various agents/servicers to conduct organization and have a variety of covenants the administration and daily operation of the designed to reduce credit risk. ABCP program. This includes such activities as purchasing and selling assets, maintaining oper- Securities-arbitrage programs invest in securi- ating accounts, and monitoring the ongoing ties that generally are rated AA- or higher. They performance of each transaction. The sponsor is generally have no additional credit enhancement also actively engaged in the management of the at the seller/transaction level because the secu- ABCP program, including underwriting the rities are highly rated. These programs are assets purchased by the ABCP program and the typically well diversified across security types. type/level of credit enhancements provided to The arbitrage is mainly due to the difference the ABCP program. between the yield on the securities and the funding cost of the commercial paper. Credit-Enhancement Providers Structured investment vehicles (SIVs) are a form of a securities-arbitrage program. These ABCP The sponsoring banking organization typically programs invest in securities typically rated AA- provides pool-specific and program-wide backup

October 2007 Commercial Bank Examination Manual Page 4 Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs 3030.1 liquidity facilities, and program-wide credit can purchase the ABCP from the conduit if the enhancements, all of which are usually unrated commercial paper cannot be issued. Pool- (pool-specific credit enhancement, such as over- specific and program-wide credit enhance- collateralization, is provided by the seller of the ments also protect commercial paper investors assets). These enhancements are fundamental from deterioration of the underlying asset pools. for obtaining high investment-grade ratings on the commercial paper issued to the market by the ABCP program. Seller-provided credit The Loss Waterfall enhancement may exist in various forms and is generally sized based on the type and credit The loss waterfall diagram (on the next page) quality of the underlying assets as well as the for the exposures of a typical ABCP program quality and financial strength of seller/servicers. generally has four legally distinct layers. Higher-quality assets may only need partial However, most legal documents do not specify support to achieve a satisfactory rating for the which form of credit or liquidity enhancement is commercial paper. Lower-quality assets may in a priority position after pool-specific credit need full support. enhancement is exhausted due to defaults. For example, after becoming aware of weakness in the seller/servicer or in asset performance, an Liquidity-Facility Providers ABCP program sponsor may purchase assets out of the conduit using pool-specific liquidity. The sponsoring banking organization and in Liquidity agreements must be subject to a valid some cases, unaffiliated third parties, provide asset-quality test that prevents the purchase of pool-specific or program-wide liquidity facili- defaulted or highly delinquent assets. Liquidity ties. These backup liquidity facilities ensure the facilities that are not limited by such an asset- timely repayment of commercial paper under quality test are to be viewed as credit enhance- certain conditions, such as financial market ment and are subject to the risk-based capital disruptions or if cash-flow timing mismatches requirements applicable to direct-credit occur, but generally not under conditions associ- substitutes. ated with the credit deterioration of the underlying assets or the seller/servicer to the extent that such deterioration is beyond what is permitted Pool-Specific Credit Enhancement under the related asset-quality test. The form and size of credit enhancement for each particular asset pool is dependent upon the Commercial Paper Investors nature and quality of the asset pool and the seller/servicer’s risk profile. In determining the Commercial paper investors are typically level of credit enhancement, consideration is institutional investors, such as pension funds, given to the seller/servicer’s financial strength, money market mutual funds, bank trust depart- quality as a servicer, obligor concentrations, and ments, foreign banks, and investment obligor credit quality, as well as the historic companies. Commercial paper maturities range performance of the asset pool. Credit enhance- from 1 day to 270 days, but most frequently are ment is generally sized to cover a multiple level issued for 30 days or less. There is a limited of historical losses and dilution for the particular secondary market for commercial paper since asset pool. Pool-specific credit enhancement can issuers can closely match the maturity of the take several forms, including overcollateraliza- paper to the investors’ needs. Commercial paper tion, cash reserves, seller/servicer guarantees investors are generally repaid from the reissu- (for only highly rated seller/servicers), and sub- ance of new commercial paper or from cash ordination. Credit enhancement can either be flows stemming from the underlying asset pools dynamic (that is, increases as the asset pool’s purchased by the program. In addition, to ensure performance deteriorates) or static (that is, fixed timely repayment in the event that new com- percentage). Pool-specific credit enhancement is mercial paper cannot be issued or if anticipated generally provided by the seller/servicer (or cash flows from the underlying assets do not oc- carved out of the asset pool in the case of cur, ABCP programs utilize backup liquidity overcollateralization) but may be provided by facilities. In addition, the banking organization other third parties.

Commercial Bank Examination Manual October 2007 Page 5 3030.1 Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs

The Loss Waterfall

Last Loss

Program- Wide Liquidity

Pool-Specific Liquidity

Program-Wide Credit Enhancement

Pool-Specific Credit Enhancement First Loss

The ABCP program sponsor or administrator specific credit enhancement and other structur- will generally set strict eligibility requirements ing protections. for the receivables to be included in the purchased asset pool. For example, receivable eligibility requirements will establish minimum Program-Wide Credit Enhancement credit ratings or credit scores for the obligors and the maximum number of days the receivable The second level of contractual credit protection can be past due. is the program-wide credit enhancement, which Usually the purchased asset pools are struc- may take the form of an irrevocable loan facility, tured (credit-enhanced) to achieve a credit- a standby letter of credit, a surety bond from a quality equivalent of investment grade (that is, monoline insurer, or an issuance of subordinated BBB or higher). The sponsoring banking orga- debt. Program-wide credit enhancement protects nization will typically utilize established rating commercial paper investors if one or more of the agency criteria and structuring methodologies to underlying transactions exhaust the pool-specific achieve the desired internal rating level. In credit enhancement and other structural protec- certain instances, such as when ABCP programs tions. The sponsoring banking organization or purchase ABS, the pool-specific credit enhance- third-party guarantors are providers of this type ment is already built into the purchased ABS of credit protection. The program-wide credit and is reflected in the security’s credit rating. enhancement is generally sized by the rating The internal rating on the pool-specific liquidity agencies to cover the potential of multiple facility provided to support the purchased asset defaults in the underlying portfolio of transac- pool will reflect the inclusion of the pool- tions within ABCP conduits and takes into

October 2007 Commercial Bank Examination Manual Page 6 Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs 3030.1 account concentration risk among seller/servicers defaults that would require a draw against the and industry sectors. program-wide credit enhancement.11 While the liquidity banking organization is exposed to the credit risk of the underlying asset pool, the risk Pool-Specific Liquidity is mitigated by the seller-provided credit enhancement and the asset-quality test.12 At the Pool-specific liquidity facilities are an important time that the asset pool is put to the liquidity structural feature in ABCP programs because banking organization, the facility is usually fully they ensure investors of timely payments on the drawn because the entire amount of the pool that issued commercial paper by smoothing timing qualifies under the asset-quality test is pur- differences in the payment of interest and prin- chased by the banking organization. However, cipal on the pooled assets and ensuring pay- with respect to revolving transactions (such as ments in the event of market disruptions. The credit card securitizations) it is possible to types of liquidity facilities may differ among average less than 100 percent of the commitment. various ABCP programs and may even differ among asset pools purchased by a single ABCP program. For instance, liquidity facilities may Program-Wide Liquidity be structured either in the form of (1) an asset-purchase agreement, which provides liquid- The senior-most position in the waterfall, ity to the ABCP program by purchasing nonde- program-wide liquidity, is provided in an amount faulted assets from a specific asset pool, or (2) a sufficient to support that portion of the face loan to the ABCP program, which is repaid amount of all the commercial paper that is solely by the cash flows from the underlying issued by the ABCP program that is necessary to assets.10 Some older ABCP programs may have achieve the desired external rating on the issued both pool-specific liquidity and program-wide paper. Progam-wide liquidity also provides liquidity coverage, while more-recent ABCP liquidity in the event of a short-term disruption programs tend to utilize only pool-specific facili- in the commercial paper market. In some cases, ties. Typically, the seller-provided credit enhance- a liquidity banking organization that extends a ment continues to provide credit protection on direct liquidity loan to an ABCP program may an asset pool that is purchased by a liquidity be able to access the program-wide credit banking organization so that the institution is enhancement to cover losses while funding the protected against credit losses that may arise due underlying asset pool. to subsequent deterioration of the pool. Pool-specific liquidity, when drawn prior to the ABCP program’s credit enhancements, is APPENDIX B—CREDIT- subject to the credit risk of the underlying asset APPROVAL MEMORANDUM pool. However, the liquidity facility does not provide direct-credit enhancement to the com- The credit-approval memorandum typically mercial paper holders. Thus, the pool-specific should include a description of the following: liquidity facility generally is in an economic second-loss position after the seller-provided 1. Transaction structure. In the beginning of the credit enhancements and prior to the program- credit-approval memorandum, the sponsor- wide credit enhancement even when the legal ing banking organization will outline the documents state that the program-wide credit structure of the transaction, which includes a enhancement would absorb losses prior to the pool-specific liquidity facilities. This is because 11. In fact, according to the contractual provisions of some the sponsor of the ABCP program would most conduits, a certain level of draws on the program-wide credit likely manage the asset pools in such a way that enhancement is a condition for unwinding the conduit pro- deteriorating portfolios or assets would be put to gram, which means that this enhancement is never meant to be used. the liquidity banking organizations prior to any 12. An asset-quality test or liquidity-funding formula determines how much funding the liquidity banking organization 10. Direct-liquidity loans to an ABCP program may be will extend to the conduit based on the quality of the termed a commissioning agreement (most likely in a foreign underlying asset pool at the time of the draw. Typically, bank program) and may share in the security interest in the liquidity banking organizations will fund against the conduit’s underlying assets when commercial paper ceases to be issued purchase price of the asset pool less the amount of defaulted due to deterioration of the asset pool. assets in the pool.

Commercial Bank Examination Manual October 2007 Page 7 3030.1 Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs

discussion of the asset type that would be tion summary. For certain types of assets, purchased by the ABCP program and the such as auto loans, the sponsoring banking liquidity facilities (and possibly credit organization should consider the seller’s use enhancements) that the sponsoring banking of credit scoring and the minimum accept- organization is providing to the transaction. able loan score that may be included in the Generally, the sponsoring banking organiza- asset pool. In addition, the credit-approval tion indicates the type and dollar volume of memorandum may include an indication of the liquidity facility that the institution is whether the underwriting standards have seeking to extend to the transaction, such as remained relatively constant over time or a $250 million short-term pool-specific liquid- whether there has been a recent tightening or ity facility, as well as the type of first-loss loosening. credit enhancement that is provided by the 4. Asset-eligibility criteria. In order to reduce seller, such as overcollateralization. The asset the ABCP program’s exposure to higher- purchase by the ABCP conduit from the risk assets, an ABCP program generally seller may be described as a two-step sale specifies minimum asset-eligibility criteria. that first involves the sale of the assets (for This is particularly true for revolving example, trade receivables) to an SPV on a transactions since the seller’s underwriting true-sale basis and then involves the sale of standards may change so that the credit qual- the assets by the SPV to the ABCP program. ity of the assets purchased by the ABCP Other features of the structure should be program can be adversely affected. While described, such as if the transaction is a eligibility criteria may be designed for revolving transaction with a one-year revolv- specific transactions, there is a common set ing period. of criteria that are generally applicable, In addition, the sponsoring banking orga- including those that exclude the purchase of nization typically obtains true-sale and non- defaulted assets or assets past due more than consolidation opinions from the seller’s a specified number of days appropriate for external legal counsel. The opinions should the specific transaction; limiting excess identify the various participants in the concentration to an individual obligor; transaction—including the seller, servicer, excluding the purchase of assets of obligors and trustee—as appropriate. For instance, the that are affiliates of the seller; or limiting the seller of the assets is identified as the party tenor of the assets to be purchased. Other that would act as the servicer of the assets and criteria also may require that the obligor be a who is responsible for all the representa- resident of a certain country and that the tions and warranties associated with the sold asset is payable in a particular currency. All assets. of these criteria are intended to reduce the 2. Asset seller’s risk profile. The assessment of credit risk inherent in the asset pool to be the asset seller’s risk profile should consider purchased by the ABCP program. A strong its past and expected future financial perfor- set of eligibility criteria may reduce the mance, its current market position and necessary credit enhancement provided by expected competitiveness going forward, as the selling organization. well as its current debt ratings. For example, 5. Collection process. Often, if the seller/ the sponsor may review the seller’s leverage, servicer has a senior unsecured debt rating of generation of cash flow, and interest cover- at least BBB-, cash collections may be com- age ratios, and whether the seller is at least mingled with the seller/servicer’s cash until investment grade. Also, the sponsoring bank- such time as periodic payments are required ing organization may attempt to anticipate to be made to the ABCP program. Documen- the seller’s ability to continue to perform tation should provide an ABCP program with under more-adverse economic conditions. In the ability to take steps to control the cash addition, some sponsors may take other infor- flows when necessary and include covenants mation into account, such as KMV ratings, to to redirect cash flows or cause the segrega- confirm their internal view of the seller’s tion of funds into a bankruptcy-remote SPE financial strength. upon the occurrence of certain triggers. A 3. Underwriting standards. A discussion of the description of how checks, cash, and debit seller’s current and historical underwriting payments are to be handled may be dis- standards should be included in the transac- cussed. For instance, documentation may

October 2007 Commercial Bank Examination Manual Page 8 Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs 3030.1

state that payments by check must be pro- ABCP program. cessed on the same day they are received by 8. Historical performance. As a prelude to siz- the lockbox and that after the checks clear, ing the pool-specific credit enhancement pro- the cash is deposited in a segregated collec- vided by the seller, the sponsoring banking tion account at the sponsoring banking orga- organization will review the historical per- nization. Also, the documents may describe formance of the seller’s portfolio, including the types of eligible investments in which the consideration of losses (that is, loss rate and cash may be invested, which are usually loss severity), delinquencies, dilutions, and highly rated, liquid investments such as gov- the turnover rate.13 An indication of the ernment securities and A1/P1+ commercial direction of losses and delinquencies, and the paper. reasons behind any increase or decrease are 6. Assets’ characteristics. Usually, a transaction often articulated. For instance, an increase in summary will provide a description of the losses may reflect losses due to specific assets that will be sold into the program and industry-related problems and general eco- outline relevant pool statistics. For instance, nomic downturns. Typically, the rating agen- there likely will be a discussion of the cies prefer at least three years’ worth of weighted average loan balance, weighted historical information on the performance of average credit score (if appropriate), weighted the seller’s asset pools, although the rating average original term, and weighted average agencies periodically permit transactions to coupon, as well as the ranges of each char- have less information. As a result, a sponsor- acteristic. In addition, the portfolio may be ing banking organization likely will require segmented by the sponsoring banking orga- the same degree of information as a rating nization’s internal-rating grades to give an agency whether this is a full three-year his- indication of each segment’s average credit tory or a lesser amount, as appropriate, when quality (as evidenced by an average credit assessing the credit quality of its liquidity score) and share of the portfolio’s balances. and credit-enhancement exposures. Many times, the sponsor will identify con- 9. Termination events. ABCP programs usually centrations to individual obligors or geo- incorporate commercial paper stop-issuance graphic areas, such as states. or wind-down triggers to mitigate losses that 7. Dilution. Certain asset types (for example, may result from a deteriorating asset pool or trade receivables) purchased by ABCP pro- some event that may hinder the ABCP programs may be subject to dilution, which is grams’ ability to repay maturing commercial the evaporation of the asset due to customer paper. Such triggers may be established at returns of sold goods, warranty claims, dis- either the pool level or program-wide level, putes between the seller and its customers, as and may, if hit, require the ABCP program to well as other factors. For instance, the seller immediately stop issuing commercial paper of the assets to the ABCP program may to fund (1) new purchases from a particular permit its customers to return goods, at seller or (2) any new purchases regardless of which point the receivables cease to exist. the seller. In addition, such triggers may The likelihood of this risk varies by asset require the ABCP program to begin liquidat- type and is typically addressed in the trans- ing specific asset pools or its entire portfolio. action summary. For instance, in sales of The rating agencies consider these struc- credit card receivables to an ABCP program, tural safeguards, which are designed to pro- the risk of dilution is small due to the tect the ABCP program from credit deterio- underlying diversity of the obligors and mer- ration over time, in determining the rating on chants. While the pool-specific liquidity an ABCP program’s commercial paper. In facilities often absorb dilution initially, the many ABCP programs, there may be a pro- seller generally is required to establish a vision that requires the program to wind reserve to cover a multiple of expected dilu- down if a certain percentage of the program- tion, which is based on historical informa- wide credit enhancement has been used to tion. The adequacy of the dilution reserve is reviewed at the inception of the transaction 13. The turnover rate of a receivables portfolio is a and may or may not be incorporated in the measure of how fast the outstanding assets are paid off. For example, if a seller had sales of $4,000 in the prior year and seller-provided credit enhancement that is an average portfolio balance of $1,000, then the turnover rate provided on the pool of assets sold to the of the portfolio is four.

Commercial Bank Examination Manual October 2007 Page 9 3030.1 Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs

cover losses (for example, 25 percent). above predetermined levels. Program-wide Examples of pool-speciﬁc triggers include triggers may include (1) the ABCP pro- the insolvency or bankruptcy of the seller/ gram’s failure to repay maturing commercial servicer; downgrade of the seller’s credit paper or (2) when draws reduce the program- rating below a speciﬁc rating grade; or dete- wide credit enhancement below a stated rioration of the asset pool to the point where threshold. charge-offs, delinquencies, or dilution rises

October 2007 Commercial Bank Examination Manual Page 10 Assessing Risk-Based Capital (RBC)—Direct-Credit Substitutes Extended to ABCP Programs Examination Objectives Effective date October 2007 Section 3030.2

Unless otherwise specified, examiners should by the ABCP programs is rated by one or weigh the importance and significance of the more nationally recognized statistical rating objectives being assessed when he or she deter- organizations (NRSROs). mines a final conclusion. 2. To verify that NRSROs are monitoring the ABCP programs in order to ensure the maintenance of minimum standards for the respec- INTERNAL RISK-RATING tive ABCP program’s rating. SYSTEM

1. To determine if the banking organization has UNDERWRITING STANDARDS a robust internal risk-rating system. AND MANAGEMENT OVERSIGHT 2. To determine if the banking organization generally has sound risk-management prac- 1. To assess the quality and robustness of the tices and principles. underwriting process.

INTERNAL RISK-RATING SYSTEM FOR ABCP INTERNAL-RATING SECURITIZATION EXPOSURES CONSISTENCY WITH RATINGS ISSUED BY THE 1. To determine the extent to which the banking RATING AGENCIES organization integrates its ABCP internal risk-rating process with its credit-risk man- 1. To conﬁrm that whenever ABCP program agement framework. transactions are externally rated, internal rat- 2. To qualitatively assess the suitability of the ings are consistent with, or more conserva- banking organization’s risk-rating process tive than, those issued by NRSROs. relative to the transactions and type of assets securitized. 3. To assess the adequacy of the credit-approval FIRST-LOSS POSITION FOR process. PROGRAM-WIDE CREDIT ENHANCEMENT

INTERNALLY RATED 1. To assertain the rank order, if possible, of the EXPOSURES risk assumed by the various direct-credit substitutes and liquidity facilities in the ABCP 1. To determine whether the banking organiza- program—determining the order in which tion applies its internal risk-rating system to various exposures would absorb losses. liquidity facilities and credit enhancements 2. To determine if third-party investors provide extended to ABCP programs. program-wide credit enhancement to the 2. To determine whether the assigned internal ABCP conduit. ratings incorporate all of the risks associated 3. To determine if the spread that third-party with rated exposures extended to ABCP investors or the banking organization charges programs. for taking program-wide credit-enhancement risk is generally within the market’s investment-grade pricing range. MONITORING OF ABCP PROGRAMS BY RATING AGENCIES

1. To conﬁrm that the commercial paper issued

Commercial Bank Examination Manual October 2007 Page 1 3030.2 RBC—Direct-Credit Substitutions Extended to ABCP Programs: Examination Objectives

CONCENTRATIONS OF mine the banking organization’s assessment NON-INVESTMENT GRADE of the credit quality of the risk exposure. SELLER/SERVICERS 2. To rank-order the underlying transactions in the ABCP program on the basis of internal 1. To determine if the sponsoring banking orga- risk ratings in order to determine the notional nization is exposed to an inordinate amount amount of transactions falling in each of the of seller/servicer risk. three ratings categories: investment grade (BBB- or better), high non-investment grade (BB+ to BB-), and low non-investment grade UNDERLYING ASSETS OF THE (below BB-). ABCP PROGRAM STRUCTURED 3. To determine a risk-based capital require- TO INVESTMENT-GRADE RISK ment for the program-wide credit enhancement. 1. To obtain the internal rating for the program- wide credit enhancement in order to deter-

October 2007 Commercial Bank Examination Manual Page 2 Assessing Risk-Based Capital (RBC)—Direct-Credit Substitutes Extended to ABCP Programs Examination Procedures Effective date October 2007 Section 3030.3

DECISION TREE the internal-ratings approach for exposures to ABCP programs is inappropriate for purposes of The decision tree is intended to assist examiners the respective provisions of the risk-based capi- in determining the adequacy of the internal tal rule. rating systems used for rating direct-credit sub- While this guidance has been designed to stitutes extended to asset-backed commercial address common industry underwriting and risk- paper (ABCP) programs. If examiners consider management practices, it may not sufficiently a banking organization’s internal rating system address all circumstances. For unique cases not adequate, then the institution may use the inter- adequately addressed by the guidance, examin- nal ratings assigned to calculate the risk-based ers should review the specific facts and circum- capital charge for unrated direct-credit substi- stances with the responsible Reserve Bank man- tutes, including program-wide credit enhance- agement in conjunction with the Board’s Banking ments. The determination process can essen- Supervision and Regulation staff before render- tially be broken down into individual steps that ing a final conclusion. start by answering broad fundamental risk questions and end with examining more-detailed ABCP program-specific characteristics. Organizing the Examination Process The first six steps (1–6) of the process focus When organizing the examination, examiners on evaluating the banking organization’s risk- should note if the banking organization operates rating system, while the final three steps (7–9) multiple ABCP conduits. In some cases, a bank- are used to determine the amount of risk-based ing organization may manage individual ABCP capital to be assessed against program-wide conduits out of different legal entities or lines of credit enhancements. business, and each conduit may focus on different business strategies.

PERFORMING THE 1. Before initiating the examination process, EXAMINATION PROCEDURES determine— a. the number of ABCP conduits sponsored Examiners should be mindful that evaluating the by the banking organization, adequacy of internal risk-rating systems gener- b. which ABCP conduits have direct-credit ally depends on both subjective judgments and substitutes provided by the banking orga- objective information generated in each step of nization, and the process. When performing the examination c. from what areas within the organization procedures, the examiner may determine that these activities are conducted. certain observed weaknesses in meeting speciﬁc 2. When multiple ABCP conduits exist, assess supervisory expectations may not necessarily be whether the banking organization applies the severe enough to conclude that the internal internal risk-rating system consistently to risk-rating system is inadequate. In some cases, each program with identical policies, proce- compensating strengths in components of the dures, and controls. risk-rating system may offset observed weak- 3. If the banking organization operates ABCP nesses. However, examiners should take such program activities out of different legal enti- weaknesses into consideration in formulating ties or lines of business, or if the application their overall conclusion and consider them when of an internal rating system varies from developing recommendations to improve the program to program, evaluate the adequacy internal risk-rating process. Failure to meet the of each unique application. regulatory requirements and follow the supervi- 4. Consider limiting any Federal Reserve sory guidance typically is an indication of unsafe approval of the use of internal ratings to and unsound banking practices in the risk man- those programs that have been examined and agement of ABCP programs. Where failures are determined to meet the requirements outlined observed, examiners should conclude that use of in this guidance.

Commercial Bank Examination Manual October 2007 Page 1 3030.3 RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures

Assessment of Internal Risk-Rating System Assessment of Program-wide Credit Enhancement

Begin

Step 1 Step 7 Program-wide Exposure Is Acceptable Credit No in the First Ye s Risk-Rating May Require Loss System? Use of Internal Gross-Up Position? Risk-Rating Treatment System Should Not be Approved

Ye s No

Step 2 Step 8

Established Is Seller/ No Ye s Rating System Service for ABCP Risk High? Exposure?

Ye s No

Step 3 Step 9 Are All Risk-weight Relevant Underlying Ye s Program-wide Exposures No Exposures Credit Internally Investment Enhancement Rated? Grade? at 100%

Ye s No

Step 4 Determine Exposures Risk-Based Capital Monitored by No Requirement Using Rating Weakest-Link Agencies? Formula

Ye s

Step 5 Sufficient Underwriting No Standards & Oversight?

Ye s

Step 6 Internal & External No Ratings are Consistent?

Ye s

Use of Internal Risk- Rating System is Approved

October 2007 Commercial Bank Examination Manual Page 2 RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures 3030.3

Banking organizations may have estab- enhancement to maintain an internal risk lished ABCP lines of business from which rating. they coordinate client relationships, 6. The transactional due-diligence, approval, transaction-origination activities, funding or execution documentation is poorly activities, and ABCP conduit management. prepared. An inspection of such ‘‘front-office’’ opera- 7. A significant number of problem transactions can provide important insight into the tions are taken out of the ABCP program unique characteristics of the banking organi- through liquidity draws. zation’s ABCP program. Examiners should 8. There is no independent review or oversight focus the examination’s review on the areas of the internal rating system or the assigned of the organization where credit decisions transaction ratings. A review conducted by and credit-risk management are housed and internal parties within the sponsoring/ where oversight of the internal risk-rating administrating banking organization may system is maintained. still be considered independent so long as 5. Consider the factors listed below while con- the business unit conducting the review ducting the banking organization’s examina- does not report to the unit that is responsible tion. When any of these factors are observed, for the ABCP program’s transactions. perform a more thorough review of its inter- 9. The transaction-underwriting and risk- nal controls, risk management, and potential management functions of an ABCP pro- weaknesses before approving the banking gram sponsor/administrator, other than rou- organization’s internal risk-rating system. tine outside audit reviews, are delegated to Although observation of a single factor unaffiliated third parties. may not be compelling enough for withhold- 10. The ABCP conduit commercial paper is not ing approval, the examiner’s observation of rated lower than A-2/P2 on an ongoing one or more of these factors should result in basis by the rating agencies. the adoption of a more conservative bias as the examination procedures are performed. If examiners observe either of the following two factors, the banking organization should If a combination of the risk factors identified not receive Federal Reserve approval to use below is observed during the examination the internal-ratings approach. (See the process, the examiner may determine that the examination procedures for more detail.) internal risk-rating system should not be relied upon for assessing the risk-based capi- 11. The banking organization does not have, in tal treatment for direct-credit substitutes pro- the examiner’s view, an established or vided to ABCP programs. acceptable internal risk-rating system to assess the credit quality of its exposures to The following factors should be considered: its ABCP programs. 12. Relevant direct-credit substitutes or liquid- 1. The sponsoring banking organization has a ity facilities are not internally risk rated. short track record and is inexperienced in the management of an ABCP program. 2. The transaction-specific credit enhancement is solely in the form of excess spread. Step 1—Acceptable Internal 3. Significantly higher ABCP program costs Risk-Rating Systems exist for program-wide credit enhancement as compared with the internal and external 1. Determine if the banking organization is able benchmarks for investment-grade risk. to satisfactorily demonstrate how its internal 4. The sponsoring banking organization fails risk-rating system corresponds to the rating to maintain historical ratings-migration data agencies’ standards used as the framework or the migration data of required credit- for complying with the securitization require- enhancement levels. ments in the risk-based capital rule. Ascer- 5. There is an excessive number of transaction- tain whether the credit ratings map to the rating migrations (both internal and exter- risk-weight categories in the ratings-based nal), or excessive collateral calls are neces- approach so they can be applied to internal sary to enhance transaction-level credit ratings.

Commercial Bank Examination Manual October 2007 Page 3 3030.3 RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures

2. If a separate supervisory team has conducted credit-risk management or loan-review a detailed evaluation of the robustness and personnel assigning or reviewing the effectiveness of the banking organization’s credit-risk ratings. overall internal ratings system, use the inspec- g. The banking organization has an internal tion work to assess the application of internal audit procedure that periodically verifies ratings specific to the banking organization’s that internal risk ratings are assigned in ABCP programs. Consider reducing the pro- accordance with the organization’s estab- cedures to a quick review of the previous lished criteria. examination’s findings. h. The banking organization (1) monitors the 3. If there was no previous evaluation of the performance of the internal credit-risk banking organization’s risk-rating system or ratings assigned to nonrated, nontraded if documentation of the evaluation findings is direct-credit substitutes over time to deter- unavailable, perform a full review of the mine the appropriateness of the initial organization’s risk-rating system. credit-risk rating assignment and (2) adjusts 4. Ascertain whether the banking organiza- individual credit-risk ratings, or the over- tion’s overall risk-rating process is generally all internal credit-risk ratings system, as consistent with the fundamental elements of needed. sound risk management and with the rating i. The internal credit-risk system makes assumptions and methodologies of the rating credit-risk rating assumptions that are con- agencies. sistent with, or more conservative than, a. Determine if the internal ratings are incor- the credit-risk rating assumptions and porated into the credit-approval process methodologies of the nationally recog- and are considered in the pricing of credit. nized statistical rating organizations b. Find out if the internal lending and expo- (NRSROs). sure limits are linked to internal ratings. 5. Verify that the internal risk-rating system for If all of the above supervisory guidance is ABCP programs contains the following nine not adhered to, the use of internal ratings criteria: under the risk-based capital rule should not a. The internal credit-risk system is an inte- be approved. gral part of the banking organization’s risk-management system, which explicitly incorporates the full range of risks arising Step 2—Use of an Established from its participation in securitization Internal Risk-Rating System Tailored activities. to ABCP Securitization Exposures b. Internal credit ratings are linked to measurable outcomes, such as the probability 1. Determine if an internal rating system exists that the position will experience any loss, that assesses exposures (for example, liquid- the position’s expected loss given default, ity facilities) provided to ABCP programs. and the degree of variance in losses given 2. Ascertain whether there is evidence that the default on that position. ABCP internal risk-rating process is an inte- c. The banking organization’s internal credit- grated component of the enterprise-wide risk system separately considers (1) the credit-risk management process. This risk associated with the underlying loans includes— or borrowers and (2) the risk associated a. risk ratings that are a fundamental portfo- with the structure of a particular securiti- lio management tool and zation transaction. b. internal ratings that are considered in d. The banking organization’s internal credit- credit and pricing decisions. risk system identifies gradations of risk 3. Evaluate whether the management team and among ‘‘pass’’ assets and other risk staff are experienced with the types of assets positions. and facilities internally rated for the ABCP e. The banking organization has clear, explicit program. criteria, including subjective factors, that 4. Determine if there is meaningful differentia- are used to classify assets into each inter- tion of risk. Verify that— nal risk grade. a. separate ratings are applied to borrowers f. The banking organization has independent and facilities that separately consider the

October 2007 Commercial Bank Examination Manual Page 4 RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures 3030.3

risk associated with the underlying loans the ABCP program has been rated in the and borrowers, as well as the risk associ- second-highest short-term rating category ated with the specific positions in a secu- (A2, P2, or F2) or higher. ritization transaction, and 2. Confirm that there is evidence that rating b. a distinct set of rating criteria exists for agencies are actively monitoring the structur- each grade. The banking organization ing methodologies and credit quality of the should have classified its assets into each transactions purchased by the ABCP conduit. risk grade using clear, explicit criteria, a. Prescreened programs. Confirm that even for subjective factors. NRSROs are prescreening each new trans- 5. Verify that the risk-ratings criteria for ABCP action placed in the ABCP program. transactions are documented with specific b. Post-review programs. Find out if ABCP methodologies detailed for different asset program transactions are monitored by the types. NRSROs via monthly or quarterly reports. 6. Find out if the banking organization includes Determine if the banking organization is a transaction summary1 as part of its credit- promptly forwarding information on new approval process. The transaction summary transactions and transactions experiencing should include a description of the following: deterioration to the NRSROs (for example, transaction structure, seller/servicer’s risk pro- through monthly reports). file,2 relevant underwriting criteria, asset- eligibility criteria, collection process, asset characteristics, dilution and historical loss rates, and trigger and termination events. Step 5—Sufficient Underwriting (See appendix B of section 3030.1 for a more Standards and Management Oversight detailed description of the above transaction- summary categories.) 1. Determine if the banking organization has 7. Before reaching a final assessment, consult internal policies addressing underwriting with the other examiners who have con- standards that are applicable to ABCP ducted reviews of the banking organization’s programs. other risk-rating systems, including the cor- 2. For each ABCP transaction, ascertain porate risk-rating system. whether the institution applies the following factors in its underwriting process:

Step 3—Relevant Internally Rated a. General Portfolio Characteristics: Exposures • an understanding of the operations of 1. Verify that the banking organization inter- the businesses that originates the nally rates all relevant exposures to ABCP assets being securitized programs, such as pool-speciﬁc liquidity • a review of the general terms offered facilities. to the customer 2. Ascertain if the banking organization maps • a determination of the quality of assets its internal ratings to the full scale of external and from which legal entity assets are ratings provided by the NRSROs. originated • a determination of customer, indus- Step 4—ABCP Program Monitored try, and geographic concentrations • an understanding of the recent trends by Rating Agencies in the business that may affect any historical information about the assets 1. Verify that the commercial paper issued by

1. The transaction summary may not be specifically iden- b. Legal Structure of the tified, but its elements would be part of the credit-approval Transaction: process. 2. The seller/servicer’s risk profile may be developed by a • A general structuring of transactions group within the banking organization other than the ABCP program group and incorporated into the transaction summary as ‘‘bankruptcy-remote’’ via a legal by reference. ‘‘true sale’’ of assets rather than as

Commercial Bank Examination Manual October 2007 Page 5 3030.3 RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures

secured loans. (This reduces the like- Reserves may take a number of differ- lihood that a creditor of the seller can ent forms, including recourse to the successfully challenge the security seller (if the seller is of high credit interest in the asset pool in the event quality), funded cash reserves, and over- of seller insolvency.) Determine if the collateralization. banking organization maintains cop- (1) Determine if the credit-approval ies of true-sale opinions in the facility chain carefully scrutinizes transac- file or as a part of the facility’s legal tions in which reserves are in the documents. form of recourse to a seller with • An appropriate management level in weak credit quality. the credit-approval hierarchy that is (2) Ascertain if the banking organiza- responsible for reviewing transaction’s criteria for structuring the tions that do not have a bankruptcy- appropriate reserve levels are gen- remote ‘‘true-sale’’ structure. erally consistent with rating agency • Uniform commercial code (UCC) fil- criteria for a particular asset class. ings and searches on securitized (3) Review and consider the relevant assets. (UCC filings are often needed rating agency methodology when to ensure that asset transfers resist evaluating reserves for any particu- third-party attack [that is, are ‘‘per- lar transaction. fected’’]). UCC searches often ensure that asset transfers are not subject to a d. Eligibility Criteria higher-priority security interest (that is, that the banking organization’s Eligibility criteria are structured into interests are ‘‘first priority’’). If such securitization transactions to restrict (or filings and searches have not been limit) the inclusion of certain categories performed, examiners should make of receivables as appropriate to the further inquiry. There may be a satis- particular transaction. Examples of such factory reason for not using the UCC restricted categories may include: filing system. • delinquent receivables (based on a • Transactions that include a contrac- stated aging policy, such as 30 days tual representation or a legal opinion past due) ensuring that there are no provisions, • receivables of bankrupt obligors such as negative pledges or limita- • foreign receivables tions on the sale of assets, that would • affiliate receivables prohibit the securitization transaction. • receivables of obligors with delinquent balances above a certain amount c. Transaction-Specific Credit • bill and hold receivables Enhancements • unearned receivables • non-U.S.-dollar-denominated receiv- Transaction-specific credit enhance- ables ment takes a variety of forms depend- • receivables subject to offset ing upon the asset type. For instance, • disputed receivables credit enhancement relating to trade • receivables with a payment date receivables may consist of the follow- beyond a specified time horizon ing types of reserves: • post-petition receivables • loss reserve—reserves related to obligor default risk The above list is illustrative and should • dilution reserve—reserves related to not be considered comprehensive. non-cash reductions of balances • servicing reserve—reserves related to (1) Conduct further analysis when there fees for servicing and trustees is a lack of any specific eligibility criteria (for example, those listed The loss and dilution reserves typically above) that warrants a further deter- account for most of the reserves. mination as to whether the banking

October 2007 Commercial Bank Examination Manual Page 6 RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures 3030.3

organization has taken appropriate g. Due-Diligence Reviews measures to alleviate any particular risk arising from the lack of a (1) Ascertain if the banking organiza- specific feature. tion conducts due-diligence reviews prior to closing its ABCP transactions. Determine if such reviews e. Concentrations were tailored to the asset type being securitized and the availability of (1) Analyze obligor, industry, and geo- audit information. A frequent pub- graphic concentrations. lic asset-backed securities (ABS) (2) Ascertain if the appropriate concen- issuer that accesses conduit funding tration limits have been established or a seller that has strong credit within transaction documents, often quality may be eligible for a post- within the eligibility criteria. closing review, provided recent audit results are obtained. If not, it should be subject to pre-closing f. Trigger Events and Termination review. For example, a review tai- Events lored to trade receivables should focus on most of the following: The inclusion of trigger and termination • Confirming the receivable infor- events plays a critical role in securiti- mation (balances, sales, dilution, zation structures. It is standard practice write-offs, etc.) previously pro- to have trigger or termination events vided by the seller, with the sell- related to the performance of the assets er’s books and records over at and, depending upon the asset type, to least two reporting periods. Such the seller/servicer. Trigger events are a review might be performed by a comparable to performance covenants third-party auditor. in corporate debt and provide a lender • Sampling invoices against the with the ability to accelerate a transac- seller’s aged trial balance to test tion, when appropriate. In addition, such the accuracy of agings. triggers create incentives that allow the • Sampling past invoices to deter- seller and the banking organization to mine ultimate resolution (paid, negotiate higher levels of credit enhance- credited, written-off, etc.) ment or add further restrictions to eli- • Sampling credits against their gibility criteria when the receivables’ respective invoices to test the performance metrics indicate deteriora- dilution horizon. tion beyond an established trigger level. • Sampling write-offs to determine In a similar way, termination events are timing and reasons for write-offs. established to begin the early termina- • Reviewing significant customer tion of the transaction when the receiv- concentrations, including delin- able performance deteriorates. Typical quent balances. trigger events are based on one or more • Determining systems capability of the following performance metrics: with respect to transaction report- • asset coverage ratio ing and compliance. • Reviewing credit files for com- • delinquencies pleteness and conformity with • losses credit policies. • dilution • Reviewing collection systems and determining the portion of cash Termination events may include these going into segregated lockboxes same metrics but may also include the or bank accounts. bankruptcy, insolvency, change of con- • Reviewing internal and external trol of the seller/servicer, or the failure auditor reports to the extent that of the servicer to perform its responsi- such documents are available for bilities in full. review.

Commercial Bank Examination Manual October 2007 Page 7 3030.3 RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures

• Noting any unusual items that should be required in the monthly report. may complicate the receivable transaction. (1) Determine if quarterly, or more fre- (2) Determine if ABCP transactions are quent, reports for a trade receivable reviewed at least annually. transaction include the following: • Confirm that the banking organi- • beginning balances zation verifies the accuracy of the • sales monthly servicer’s transaction • cash collections reports, including compliance • dilution or credits with sale and servicing require- • write-offs ments. • ending balances • Determine if an increased review • delinquencies by aging bucket frequency is needed for any issues • ineligible assets raised in prior reviews, transac- • total eligible receivables tions with higher-risk sellers, and • excess concentrations transactions serviced out of mul- • net receivable balance tiple locations. • conduit investment • conduit’s purchased interest • calculation of receivable perfor- h. Cash Management mance termination events • top 10 obligor concentrations (1) Assess a seller’s cash-management (2) Ascertain if the banking organiza- practices. Commingling of cash col- tion has established other special lections can cause a loss in the reporting requirements based on the perfected security interest of cash particular pool of receivables being flows, particularly in the event of securitized. seller insolvency. • Determine if, preferably, the banking organization requires that all j. Receivable Systems payment collections flow into a single, segregated lockbox (1) Because of the significant reporting account to minimize cash- requirements in a securitization commingling risk. transaction, verify that the banking • For trade receivables, find out if organization assesses— the banking organization requires • the seller’s receivable systems to that the cash collections be rein- determine if they will be suffi- vested in new receivables to cient to provide the required eliminate cash-commingling risk. information and (2) For higher-risk sellers, determine if • the seller’s data backup and disas- the banking organization— ter recovery systems. • establishes an account in the name of the trust or special-purpose vehicle (SPV) into which collec- k. Quality of Seller/Servicer tions could be swept on a daily (1) Verify that the banking organiza- basis or tion performs an assessment of the • requires that settlement be done creditworthiness of the seller that is weekly, or daily, ensuring that conducted from the relationship there are always sufficient receiv- side. ables to cover investments and (2) Determine if the banking organiza- reserves. tion conducts a more focused assessment on the seller/servicer’s i. Reporting management team that is involved in the day-to-day receivables opera- When underwriting a portfolio, it is tion (that is, credit, accounting, important to decide what information sales, servicing, etc.).

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l. Performance Monitoring (2) Evaluate the robustness of the underwriting process and deter- (1) Find out whether the banking orga- mine if it is comparable to stated nization has developed and uses a rating agency criteria. If weak- performance-monitoring plan that nesses in the underwriting process periodically monitors the portfolio. are found, determine if there are • Determine if there is appropriate any existing compensating strengths monitoring that allows the desig- and any other relevant factors to be nated administrator to review rel- considered when determining its evant pool performance to evalu- overall assessment. ate the level of available funding (3) If the examiner determines that the under the asset-quality tests in supervisory expectations generally the related liquidity facility. are not met, he or she should not • Determine if the banking organi- recommend to the appropriate zation tests these conditions when Reserve Bank supervisory ofﬁcial the seller reports performance that the use of internal ratings, data relating to an underlying under the securitization capital rule, transaction (usually monthly or be approved. quarterly).

Typically, a liquidity facility has a fund- Step 6—Consistency of Internal ing condition based on asset quality Ratings of ABCP Program’s whereby the liquidity provider will not Exposures with Ratings Issued advance against any receivable that is considered defaulted. A performance- by the Rating Agencies monitoring plan may entail monitoring the run rate of defaulted assets so that the 1. Find out if any underlying transactions funded potential losses do not exceed the loss through ABCP programs are externally rated protection. by one or more rating agencies. 2. Conﬁrm if the mapping of the internal ratings assigned to these transactions is consistent m. Post-Closing Monitoring with, or more conservative than, those issued by NRSROs. (1) Determine if the banking organiza- 3. When the underlying transactions are split- tion’s underwriting team assists the rated by two or more rating agencies, deter- portfolio management team in mine if the internal ratings are consistent developing all of the items that with the most conservative (lowest) external should be tracked on the transac- rating. tion, including the development of 4. Ascertain that the above exceptions do not a spreadsheet that ensures the cap- represent more than a small fraction of the ture and calculation of the appro- total number of transactions that are exter- priate information. nally rated. If such exceptions exist, determine if there are generally an equal or larger n. Underwriting Exceptions percentage of externally rated transactions where internal ratings are more conservative (1) If a banking organization approves than the external rating. a transaction after it has agreed to an exception from standard under- If supervisory expectations are not met, then writing procedures, ﬁnd out if the the internal risk-rating system may not be banking organization closely moni- appropriately mapped to the external ratings tors and periodically evaluates the of an NRSRO. In such cases, further review policy exception. of the adequacy of the banking organization’s risk-rating system must be undertaken Banking organizations may utilize variations of before the use of internal ratings under the the above-listed underwriting standards. securitization capital rule can be approved.

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Determine Adequacy of Internal Ratings ranges of non-investment-grade and Systems investment-grade exposures of the sponsoring banking organization, the loan syn- If, through the examination process, the internal dication market, and the bond market. risk-rating system utilized for ABCP exposures This may be a gauge as to whether a third is found to be inadequate, then the banking party considers the risk as investment organization may not apply the internal risk- grade or non-investment grade. ratings approach to ABCP exposures for risk- b. Reference such sources for reviewing mar- based capital purposes until the organization has ket pricing as Loan Pricing Corporation’s remedied the deficiencies. Banking organiza- Gold Sheets and Bloomberg (for bond tions that have adequate risk-rating systems that spreads). A range or average pricing for are well integrated into risk-management pro- both investment-grade and non-investment- cesses applied to ABCP programs may be grade syndicated loans can be found in the approved for use of the internal risk-ratings Gold Sheets. approach. c. Similarly, review also the price the sponsor/ Once a banking organization’s internal rating banking organization is charging for its system is deemed adequate, the organization respective portion of the program-wide may use its internal ratings to slot ABCP expo- credit enhancement. sures, including pool-specific liquidity facilities, into the appropriate rating category (investment grade, high non-investment grade, and low non- Step 8—Risk Levels investment grade), and apply the corresponding risk weights. However, due to the unique nature Posed by Concentrations of of program-wide credit enhancements, further Non-Investment-Grade guidance is provided in steps 7 through 9 to help Seller/Servicers establish the appropriate capital requirement. 1. Confirm that the banking organization’s internal risk-rating systems properly account for the existence of seller/servicer risk. Step 7—Determination of Whether An asset originator (that is, the entity Program-Wide Credit Enhancements selling the assets to the ABCP program) Are in the First-Loss Position typically is the servicer and essentially acts as the portfolio manager for the ABCP pro- 1. Determine if the ABCP program documenta- gram’s investment. The servicer identifies tion confirms that the program-wide credit receivables eligible for the ABCP program enhancement is not the first-loss credit and manages to preserve the investment on enhancement for any transaction in the ABCP behalf of the banking organization sponsor- program and is, at worst, in the second- ing the ABCP program. As previously dis- economic-loss position, usually after cussed, servicer risk can be partially miti- transaction-specific credit enhancements. gated through seller allocation and structuring 2. Verify if the spread charged for the program- payments to protect against commingling of wide credit enhancement is the spread range cash. of investment-grade exposures of a term 2. Determine if the banking organization has securitization. Consider other factors that specific transaction structures, such as a may influence pricing, such as availability of backup servicer, in place to mitigate servicer the credit enhancement. risk. 3. Find out if the financial guarantee providers, 3. Ascertain if exposure to an excessive number such as AMBAC, FSA, and FGIC, partici- of non-investment-grade servicers adversely pate in a program-wide credit-enhancement affects the overall credit quality of the ABCP tranche either on a senior position or on a program, exposing the conduit to the higher pari-passu position with other providers. The bankruptcy risk that inherently exists with risk taken by these institutions is usually non-investment-grade obligors. investment grade. 4. Use the benchmarks below to assess the a. Compare the price of the guarantee banking organization’s potential exposures charged by these institutions to the pricing to non-investment-grade seller/servicer con-

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centrations in its ABCP program. Depending tions are internally rated below invest- on the circumstances, concentrations exceed- ment grade, then consider using the fol- ing these benchmarks may be considered as lowing weakest-link approach to calculate unsafe and unsound banking practices. an appropriate risk-based capital charge a. Determine, based on the grid below, the for the program-wide credit enhancement. percentage of securitized assets from non- The approach takes into account the investment-grade servicers to the total internal ratings assigned to each underly- outstandings of an ABCP program that ing transaction in an ABCP program. has a lower weighted average rating of all These transaction-level ratings are typi- the transactions in the program. For cally based on the internal assessment of a example, if the ABCP program transac- transaction’s pool-speciﬁc liquidity facil- tions have a weighted average rating ity and the likelihood of its being drawn. equivalent to ‘‘BBB,’’ no more than 30 per- The transactions are rank-ordered by their cent of the total outstandings of the ABCP internal rating and then bucketed into the program should be represented by non- three ratings categories: investment grade, investment-grade seller/servicers. How- high non-investment grade, and low non- ever, an ABCP program that has transac- investment grade. The program-wide credit tions structured to a higher weighted enhancement is then assigned an appropri- average rating, such as a single ‘‘A’’ ate risk weight based upon the notional equivalent, could have up to 60 percent of amount of transactions in each ratings the outstandings originated by non- bucket. investment-grade seller/servicers without Under the weakest-link approach, the causing undue concerns. risk of loss corresponds ﬁrst to the weakest transactions to which the program- Weighted Servicer wide credit enhancement is exposed. Bank- average rating percentage ing organizations should begin with the lowest bucket (low non-investment grade) equivalent below and then move to the next-highest rating of transactions investment grade bucket until the entire amount of the AA 90% program-wide credit enhancement has AA– 80% been assigned. The assigned risk weights A+ 70% and their associated capital charges are A 60% then aggregated. However, if the risk- A– 50% based capital charge for the non- BBB+ 40% investment-grade asset pools equals or BBB 30% exceeds the 8 percent charge against the BBB– 20% entire amount of assets in the ABCP BB+ 10% program, then the risk-based capital charge is limited to the 8 percent against the program’s assets. Banking organizations that sponsor Step 9—The Portion of Underlying ABCP programs may have other method- Assets of the ABCP Program ologies to quantify risk across multiple Structured to Investment-Grade Risk exposures. For example, collateralized debt obligation (CDO) ratings methodology 1. Determine the appropriate amount of risk- takes into account both the probability of based capital that should be assessed against loss on each underlying transaction and the program-wide credit enhancement based correlations between the underlying trans- on the internal risk ratings of the underlying actions. This and other methods may gen- transactions in the ABCP program. erate capital requirements equal to or a. If all underlying transactions are rated more conservative than those arrived at investment grade, risk-weight the notional via the weakest-link method. Regardless amount of the program-wide credit of the approach used, well-managed insti- enhancement at 100 percent. tutions should be able to support their b. If one or more of the underlying transac- risk-based capital calculations.

Commercial Bank Examination Manual October 2007 Page 11 3030.3 RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures

Weakest-Link Formula

IF [(0.16 * NI1) + NI2**] ≥ (0.08 * PROG), THEN RBC = (0.08 x PROG) Else Capital = [0.08 * (PWC Ø (NI1 + NI2))] + 0.16 * NI1] + [NI2**]

**Although the term NI2 should reﬂect a gross-up charge under the securitization capital rule (that is, an effective 1,250 percent risk weight), for the sake of simplicity a dollar-for-dollar charge is used here. The reason for using dollar-for-dollar is based on the assumption that the NI2 portion of an ABCP pool is typically smaller than the gross-up charge would be on the entire pool. Thus, instead of grossing-up the NI2 portion and then applying the low-level- exposure rule (which, if NI2 is less than the gross-up charge, will yield a dollar-for-dollar capital charge), the term just assumes the dollar-for-dollar amount.

In any event, the risk-based capital charge on the program-wide credit enhancement will never exceed the maximum contractual amount of that program-wide credit enhancement (that is, the low-level-exposure rule).

RBC = Risk-based capital PROG = Notional amount of all underlying exposures in the program PWC = Notional amount of program-wide credit enhancement IG = Notional amount of exposures rated BBB- or better NI1 = Notional amount of exposures rated between BB+ and BB- NI2 = Notional amount of exposures rated below BB-

Example 1 Example 2

ABCP program size (PROG) = $1,000 MM ABCP program size (PROG) = $1,000 MM Program-wide credit enhancement (PWC) = Program-wide credit enhancement (PWC) = $100 MM $150 MM Total amount of investment grade (IG) = Total amount of investment grade (IG) = $995 MM $940 MM Total amount of high non-investment grade Total amount of high non-investment grade (NI1) = $4 MM (NI1) = $50 MM Total amount of low non-investment grade Total amount of low non-investment grade (NI2) = $1 MM (NI2) = $10 MM

Weakest Link Weakest Link

RBC = IF [(0.16 * 4) + 1] ≥ (0.08 * 1,000), then RBC = IF [(0.16 * 50) + 10] ≥ (0.08 * 1,000), RBC = (0.08 * 1,000) then RBC = (0.08 * 1,000) = $18 MM = $1.64 MM < $80 MM < $80 MM

Else Else

RBC = [(0.08 * (100 Ø (4 + 1))] + (0.16 * 4) + RBC = [(0.08 * (150 Ø (50+10))] + (0.16 * 50) (1) + (10) RBC = (7.60) + (0.64) + (1) RBC = (7.20) + (8.00) + (10) = $ 9.24 MM = $25.2MM

October 2007 Commercial Bank Examination Manual Page 12 RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures 3030.3

Example 3 too much risk-based capital being assessed. If this situation arises, banking organizations ABCP program size (PROG) = $1,000 MM should ﬁrst apply the gross-up treatment to the Program-wide credit enhancement (PWC) = NI2 asset pools and then assess 16 percent $150 MM risk-based capital against an amount of the NI1 Total amount of investment grade (IG) = asset pools that, when added with the NI2 asset $0 MM pools, would equal the amount of the program- Total amount of high non-investment grade wide credit enhancement. For example, if the (NI1) = $500 MM program-wide credit enhancement is $100 on Total amount of low non-investment grade underlying transactions totaling $1,000, and the (NI2) = $500 MM underlying exposures are $10 low non- investment grade, $100 high non-investment grade, and $890 investment grade, then risk Weakest Link weighting will be based on the gross-up approach for $10 and assigning the remaining $90 to the RBC = IF [(0.16 * 500) + 500] ≥ (0.08 * 1,000), > 200 percent risk-weight category, as shown THEN RBC = (0.08 * 1,000) = $580 MM below: $80 MM Therefore, $10 * 1,250% * 8% = $10.00 $90 * 200% * 8% = $14.40 RBC = (0.08 * 1,000) = $80 MM Total $24.40 Because $580 MM is greater than the $80 MM capital charge that would apply if all of the Finally, the aggregate capital charge, $24.40 assets supported by the PWC were on-balance- in this case, is then compared to the capital sheet, the maximum risk-based capital charge is charge imposed on the underlying transactions if $80 MM. all the program assets were on the banking When the sum of all non-investment-grade organization’s balance sheet (that is, 0.08 * asset pools (that is, NI1 + NI2) exceeds the $1,000 = $80); the lower amount prevails. This amount of the program-wide credit enhance- establishes the capital charge for the program- ment, the weakest-link formula would result in wide credit enhancement.

Commercial Bank Examination Manual October 2007 Page 13 Assessing Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs Internal Control Questionnaire Effective date October 2007 Section 3030.4

1. Does the banking organization have an sures consistent with ratings issued by the acceptable risk-rating system? rating agencies? 2. Does the banking organization use an estab- 7. Is program-wide credit enhancement in the lished internal risk-rating system tailored to ﬁrst-loss position? ABCP securitization exposures? 3. Are the relevant exposures internally rated? 8. Do concentrations of non-investment-grade 4. Are the ABCP programs monitored by rating seller/services pose an excessive level of agencies? risk? 5. Are there sufﬁcient underwriting standards 9. What portion of the underlying assets of the and management oversight? ABCP programs is structured to investment- 6. Are internal ratings of ABCP program expo- grade risk?

Commercial Bank Examination Manual October 2007 Page 1 Dodd-Frank Act Company-Run Stress Testing for Banking Organizations with Total Consolidated Assets $10−50 Billion Effective date April 2015 Section 3050.1

The federal banking agencies1 issued Supervi- annual Comprehensive Capital Analysis and sory Guidance on Implementing Dodd-Frank Review (CCAR), supervisory stress tests for Act2 Company-Run Stress Tests for Banking capital adequacy, or the related data collections Organizations with Total Consolidated Assets of supporting the supervisory stress test. Refer to More Than $10 Billion but Less than $50 Billion SR-14-3 and its attachments 1 and 2. (see 79 Fed. Reg. 14153, March 13, 2014) ($10–50 billion companies). The guidance offers additional details about methodologies that EXPECTATIONS FOR should be employed by these companies. The DODD-FRANK ACT STRESS term “company” refers to state member banks, TESTS bank holding companies, and savings and loan holding companies. This guidance builds upon The supervisory expectations contained in the the interagency stress testing guidance that was guidance follow the specific rule requirements issued in May 2012 for companies with more contained in the final Dodd-Frank Act stress test than $10 billion in total consolidated assets that rules for $10–50 billion companies and are set forth general principles for a satisfactory organized in a similar manner. The guidance stress testing framework.3 The guidance dis- covers several categories, outlined below. cusses supervisory expectations for the Dodd- Frank Wall Street Reform and Consumer Pro- tection Act (Dodd-Frank Act) stress test practices Dodd-Frank Act Stress Test Timelines for companies. The agencies determined that providing the supervisory guidance would be Under the Dodd-Frank Act stress test rules, helpful to the $10–50 billion companies in stress test projections are based on exposures carrying out their tests that are appropriate for with the as-of date of September 30 and extend their risk profile, size, complexity, business mix, over a nine-quarter planning horizon that begins and market footprint.4 in the quarter ending December 31 of the same The Dodd-Frank Act stress tests may not year and ends December 31 two years later. necessarily capture a company’s full range of risks, exposures, activities, and vulnerabilities Scenarios for Dodd-Frank Act Stress that have a potential effect on capital adequacy. Additionally, the Dodd-Frank Act stress tests Tests assess the impact of stressful outcomes on Under the stress test rules implementing the capital adequacy and are not intended to mea- Dodd-Frank Act requirements, $10–50 billion sure the adequacy of a company’s liquidity in companies must assess the potential impact on the stress scenarios. Companies to which this capital of a minimum of three macroeconomic guidance applies are not subject to the Federal scenarios (that is, baseline, adverse, and severely Reserve’s capital plan rule, the Federal Reserve’s adverse scenarios) provided by their primary supervisor on their consolidated losses, rev- 1. The Federal Reserve Board, the Office of the Comptrol- enues, balance sheet (including risk-weighted ler of the Currency, and Federal Deposit Insurance Corpora- assets), and capital. A company is not required tion (the agencies). 2. Pub. L. 111–203, 124 Stat. 1376 (2010). to use all of the variables provided in the 3. See 77 Fed. Reg. 29458, “Supervisory Guidance on scenario, if those variables are not relevant or Stress Testing for Banking Organizations With More Than appropriate to the company’s line of business. In $10 Billion in Total Consolidated Assets,” (May 17, 2012). addition, a company may, but is not required to, The Federal Reserve’s rule for “Annual Company-Run Stress Test Requirements for Banking Organizations with Total use additional variables beyond those provided Consolidated Assets over $10 Billion Other than Covered by the agencies. When using additional vari- Companies” was issued by the Board on October 12, 2012 (77 ables, companies should ensure that the paths of Fed. Reg. 62396). such variables (including their timing) are con- 4. The Dodd-Frank Act stress tests produce projections of hypothetical results and are not intended to be forecasts of sistent with the general economic environment expected or most likely outcomes. assumed in the supervisory scenarios.

Commercial Bank Examination Manual April 2015 Page 1 3050.1 Dodd-Frank Act Company-Run Stress Testing

Dodd-Frank Act Stress Test • Model risk management. Companies should Methodologies and Practices have in place effective model risk-management practices, including validation, for all models The agencies expect that the specific method- used in Dodd-Frank Act stress tests, consis- ological practices used by companies to produce tent with existing supervisory guidance.7 Com- the estimates of the impact on capital and that panies should ensure an effective challenge other measures may vary across organizations.5 process by unbiased, competent, and qualified In addition, Dodd-Frank Act stress testing prac- parties is in place for all models. There should tices for $10–50 billon companies should be also be sufficient documentation of all models, commensurate with each company’s size, com- including model assumptions, limitations, and plexity, and sophistication. This means that, uncertainties. Companies should ensure that generally, larger or more sophisticated compa- their model risk-management policies and nies should consider employing not just the practices generally apply to the use of vendor minimum expectations, but the more advanced and third-party products as well. Qualitative practices described in the supervisory guidance. elements of models should also be subject to In addition, $10–50 billion companies should model risk management. consider using more than just the minimum • Loss estimation. For their Dodd-Frank Act expectations for the exposures and activities of stress tests, companies are expected to have highest impact and that present the highest risk. credible loss estimation practices that capture the risks associated with their portfolios, busi- • Data sources. Companies are expected to ness lines, and activities. Credit losses associ- have appropriate management information sys- ated with loan portfolios and securities hold- tems and data processes that enable them to ings should be estimated directly and separately, collect, sort, aggregate, and update data and whereas other types of losses should be incor- other information efficiently and reliably porated into estimated pre-provision net rev- within business lines and across the company enue (PPNR).8 Each company’s loss estima- for use in Dodd-Frank Act stress tests. In tion practices should be commensurate with some cases, proxy data may be used. Compa- the materiality of the risks measured and well nies should challenge conventional assump- supported by sound, empirical analysis. Loss tions to ensure that a company’s stress test is estimates should include projections of other- not constrained by its own past experience. than-temporary impairments (OTTI) for secu- • Data segmentation. To account for differences rities both held for sale and held to maturity. in risk profiles across various exposures and • Pre-provision net revenue estimation. For the activities, companies should segment their Dodd-Frank Act stress test, companies are portfolios and business activities into catego- required to project PPNR over the planning ries based on common or related risk charac- horizon for each supervisory scenario. Com- teristics. The company should select the appro- panies should estimate PPNR at a level at least priate level of segmentation based on the size, as granular as the components outlined in the materiality, and risk of a given portfolio, $10–50 billion reporting form. Companies provided there are sufficiently granular histori- should ensure that PPNR projections are gen- cal data available to allow for the desired erally consistent with projections of losses, segmentation. The minimum expectation is the balance sheet, and risk-weighted assets. A that companies will segment their portfolios company may estimate the stressed compo- and business activities using the categories nents of PPNR based on its own or industry- listed in the $10–50 billion reporting form.6 “$10–50 billion reporting form” generally refers to the Annual Company-Run Stress Test Report (FR Y-16). However, for 5. In making projections, companies should make conser- subsidiary banks and thrifts of $10–50 billion holding com- vative assumptions about management responses in the stress panies, it could be the relevant reporting form the subsidiary tests and should include only those responses for which there will use to report the results of its Dodd-Frank Act stress tests is substantial support. For example, companies may account to its primary federal financial regulatory agency. for hedges that are already in place as potential mitigating 7. Refer to SR-11-7, “Guidance on Model Risk factors against losses but should be conservative in making Management.” assumptions about potential future hedging activities and not 8. The Dodd-Frank Act stress test rules define PPNR as net necessarily anticipate that actions taken in the past could be interest income plus non-interest income less non-interest taken under the supervisory scenarios. expense. Non-operational or non-recurring income and expense 6. For purposes of the supervisory guidance, the term items should be excluded.

April 2015 Commercial Bank Examination Manual Page 2 Dodd-Frank Act Company-Run Stress Testing 3050.1

wide historical income and expense experi- and a general assumption of no redemptions, ence. Other types of losses that could arise repurchases, or issuances of capital instruments. under the supervisory scenarios should be There are no specified capital actions for state included in projections of PPNR to the extent member banks. they would arise under the specified scenario conditions. • Balance sheet and risk-weighted asset projec- Controls, Oversight, and tions. A company is expected to project its Documentation balance sheet and risk-weighted assets for each of the supervisory scenarios. In doing so, A company must establish and maintain a sys- these projections should be consistent with tem of controls, oversight, and documentation, scenario conditions and the company’s prior including policies and procedures that apply to history of managing through the different all of its Dodd-Frank Act stress test compo- business environments, especially stressful nents. Senior management and the board of ones. The projections of the balance sheet and directors have specific responsibilities relating risk-weighted assets should be consistent with to Dodd-Frank Act stress testing. The board of other aspects of stress test projections, such as directors should ensure it remains informed losses and PPNR. about critical reviews of elements of the Dodd- • Projections for quarterly provisions and allow- Frank Act stress tests, especially regarding key ance for loan and lease losses (ALLL). The assumptions, uncertainties, and limitations. In Dodd-Frank Act stress test rules require com- addition, the board of directors and senior man- panies to project quarterly provisions for loan agement of a $10–50 billion company must and lease losses (PLLL). Companies are consider the role of stress testing results in expected to project PLLL for each scenario normal business, including the company’s capi- based on projections of quarterly loan and tal planning, assessment of capital adequacy, lease losses and while maintaining an appro- and risk-management practices. A company priate ALLL balance at the end of each should appropriately document the manner in quarter of the planning horizon, including the which Dodd-Frank Act stress tests are used for last quarter. key decisions about capital adequacy, including • Projections for quarterly net income. Under capital actions and capital contingency plans. the Dodd-Frank Act stress test rules, compa- The company should indicate the extent to nies must estimate projected quarterly net which Dodd-Frank Act stress tests are used in income for each scenario. Net income projec- conjunction with other capital assessment tools. tions should be based on loss, revenue, and expense projections. Report to Supervisors

Estimating the Potential Impact on A $10–50 billion company must report the Regulatory Capital Levels and Capital results of its Dodd-Frank Act company-run stress tests on the $10–50 billion annual report- Ratios ing form (FR Y-16). This report will include a company’s quantitative projections of losses, Companies must estimate projected quarterly PPNR, balance sheet, risk-weighted assets, regulatory capital levels and regulatory capital ALLL, and capital on a quarterly basis over the ratios for each scenario. Any rare cases in which duration of the scenario and planning horizon. In ratios are higher under the adverse and severely addition to the quantitative projections, compa- adverse scenarios should be very well supported nies are required to submit qualitative informa- by analysis and documentation. Projected capi- tion supporting their projections.9 tal levels and ratios should reﬂect applicable regulations and accounting standards for each quarter of the planning horizon. In their Dodd- 9. These companies should look to the $10–50 billion Frank Act stress tests, bank holding companies consolidated assets reporting instructions for the supervisory and savings and loan holding companies are expectations as to what information should be included in the required to calculate pro forma capital ratios report on the company’s Dodd-Frank Act stress test. See the FR Y-16 instructions: using a set of capital action assumptions based http://www.federalreserve.gov/apps/reportforms/ on historical distributions, contracted payments, reportdetail.aspx?sOoYJ+5BzDbzK2O0R3zNJw==

Commercial Bank Examination Manual April 2015 Page 3 3050.1 Dodd-Frank Act Company-Run Stress Testing

Public Disclosure of Dodd-Frank Act The summary of the results of the stress test, Test Results including both quantitative and qualitative information, should be included in a single release on Under the Dodd-Frank Act stress test rules, a a company’s website or in any other forum that $10–50 billion company must publicly disclose is reasonably accessible to the public. A com- Dodd-Frank Act stress test results between June pany is required to publish results for the severely 15 and June 30, with the ﬁrst disclosure in 2015. adverse scenario only.

April 2015 Commercial Bank Examination Manual Page 4