Examination Manual for US Branches and Agencies Of

Home , Initiation (The Office), Regulatory agency

Examination Manual for U.S. Branches and Agencies of Foreign Banking Organizations Second Printing, September 1997 Inquiries or comments relating to the contents of this manual should be addressed to: Director, Division of Banking Supervision and Regulation Board of Governors of the Federal Reserve System Washington, D.C. 20551

Copies of this manual may be obtained from: Publications Services Mail Stop 127 Board of Governors of the Federal Reserve System Washington, D.C. 20551

The price is $40.00 per copy. Remittance should be made payable to the Board of Governors of the Federal Reserve System by check or money order, drawn on a U.S. bank; or by VISA or Master Charge. Updates are available at an additional charge. For information about updates or to order by credit card, call 202-452-3244. Table of Contents

Section Section

1000 INTRODUCTION 3230 Deposit Accounts 3240 Due From/Due to Related Ofﬁces 1000 Acknowledgements 1010 General Introduction OFF-BALANCE SHEET 1020 Format and Use of Manual ACTIVITIES 3300 Off-Balance-Sheet Activities 3310 Guarantees Issued 2000 GENERAL 3320 Letters of Credit 3330 Trading Activities 2000 Enhanced Framework for Supervising the U.S. Operations of Foreign OTHER Banking Organizations 3400 Income and Expenses 2001 Strength-of-Support Assessment for 3410 Management Information Systems Foreign Banking Organizations 3420 Other Assets and Other Liabilities with U.S. Operations 3430 Private Banking 2002 Examination Planning and the Assessment of the U.S. Operations of Foreign Banking Organizations 2003 Rating System for U.S. Branches 4000 OPERATIONAL CONTROLS and Agencies of Foreign Banking Organizations 4000 Introduction 2010 Risk-Focused Approach to 4010 Internal and External Audits Pre-Examination Planning 4020 Internal Control 2020 Loan Sampling 4030 Emergency Preparedness Measures 2030 Workpapers 4040 Cash Accounts 2040 Supervisory Follow-up Actions 4050 Consigned Items and Other Nonledger Control Accounts 4060 Payment System Risk and Electronic 3000 RISK MANAGEMENT Funds Transfer Activities

3000 Introduction 3010 Credit Risk Management 5000 COMPLIANCE 3020 Asset-Based Lending 3030 Asset Securitization 5000 Introduction 3040 Bankers’ Acceptances 5010 Financial Recordkeeping and 3050 Commercial Loans Reporting Regulations 3060 Corporate Restructurings 5020 Asset Maintenance 3070 Due From Nonrelated Banks 5030 Asset Pledge and Capital Equivalency 3080 Financing Foreign Receivables Deposit 3090 Other Real Estate Owned 5040 Suspicious Activities 3100 Real Estate Loans 5050 International Banking Facilities 3110 Real Estate Construction Loans 5060 Review of Regulatory Reports 3120 Securities and Broker Dealer Loans 5070 Other Compliance Matters 3130 Securities Activities

ASSET AND LIABILITY 6000 ASSET QUALITY MANAGEMENT 3200 Funds Management and Liquidity 6000 Introduction 3210 Interest Rate Risk Management 6010 Classiﬁcation of Credits 3220 Borrowed Funds 6020 Transfer Risk

Branch and Agency Examination Manual September 1997 Page 1 Table of Contents

Section Section

7000 APPENDICES 7030 Survey of Foreign Regulation in Selected States 7010 Federal Deposit Insurance—Uninsured & Insured Branches 7020 Subsequent Events, Litigation, and 8000 SUBJECT INDEX Other Legal Matters

September 1997 Branch and Agency Examination Manual Page 2 Acknowledgements Effective date July 1997 Section 1000.1

The Examination Manual for U.S. Branches and opment of the manual. Accordingly, this manual Agencies of Foreign Banking Organizations was reflects general policies and procedures to be prepared under the direction of the Federal used in conducting examinations of individual Reserve Board and Reserve Bank supervision branches and agencies of foreign banking personnel. Federal Reserve staff acknowledge organizations. and thank the staff of the New York State The manual will be updated periodically to Banking Department, the Federal Deposit Insur- reflect changes in examination policies and pro- ance Corporation, the Office of the Comptroller cedures. We solicit the input and contribution of of the Currency, and the Conference of State all supervisory staff and others in the refining Bank Supervisors for contributing to the devel- and modification of its contents.

Branch and Agency Examination Manual September 1997 Page 1 General Introduction Effective date July 1997 Section 1010.1

Foreign banking organizations have had a long- International Banking Act of 1978 instructed the standing presence in the United States. Their Federal Reserve to use, to the extent possible, operations encompass a wide variety of banking the examination reports of other state and fed- and nonbanking activities, through subsidiaries, eral regulators in carrying out its responsibility branches, agencies, and representative offices. for overseeing the U.S. operations of foreign These activities are located primarily in the banking organizations. Enactment of FBSEA major U.S. cities where finance and international was intended to fill gaps in the supervision and trade are most actively conducted. regulation of the U.S. operations of foreign Branches of foreign banking organizations banks and to ensure that the banking policies are licensed by the state banking authorities or established by Congress are implemented in a the Office of the Comptroller of the Currency. In fair and consistent manner with respect to all addition, certain grandfathered branches may be entities (domestic and foreign) conducting a insured by the Federal Deposit Insurance Cor- banking business in the United States. FBSEA poration. Agencies are licensed by the state established uniform federal standards for entry banking authorities. The Federal Reserve, there- and expansion of foreign banks in the United fore, shares its regulatory responsibility with States and substantially increased the role of the other state and federal supervisory authorities. Federal Reserve in the supervision and regula- Separately, the Board of Governors delegates tion of their U.S. activities. Under FBSEA, the certain of its supervisory and regulatory func- Federal Reserve may examine any office or tions to the Reserve Banks and directs, coordi- affiliate of a foreign bank in the United States nates, and reviews actions taken by the Reserve and is to coordinate such examinations with the Banks. OCC, FDIC, and appropriate state banking Prior to the December 1991 passage of the supervisors to the extent possible. A comprehen- Foreign Bank Supervision Enhancement Act sive set of procedures has been developed to (FBSEA), the examination of federal and state provide a uniform framework to be used in branches and agencies of foreign banks was examining branches and agencies of foreign largely the responsibility of the respective licens- banking organizations. ing authorities (the states and the OCC). The

Branch and Agency Examination Manual September 1997 Page 1 Format and Use of Manual Effective date July 1997 Section 1020.1

FORMAT In general, key examination objectives are designed to determine how well risk is managed This manual is divided into sections dealing by: (1) determining the adequacy of the system with particular banking activities that relate of internal control and of policies, practices, and specifically to the examination and evaluation of procedures; (2) evaluating the scope and adequacy U.S. branches and agencies1 of foreign banking of the internal control environment and audit organizations (FBOs). Each section, in turn, function; (3) determining compliance with laws, may be divided into up to five subsections, regulations, and rulings; and (4) evaluating depending upon the topic of discussion. These adherence with internal policies and procedures. subsections are: These objectives all relate to the overall assessment of the branch as described in the ROCA • Overview. rating system and ultimately could result in • Examination Objectives. the implementation of corrective action, if • Examination Procedures. appropriate. • Internal Control Questionnaire. • Audit Guidelines. Examination Procedures The manual is intended to provide a comprehensive overview of banking activities that may These subsections include procedures to be be conducted in a wide variety of branches. Not performed during a comprehensive examination all activities will be conducted by every branch. of the particular area of examination interest. Accordingly, the examiner-in-charge should plan There may be instances where the procedures the examination, particularly as it relates to will not apply in their entirety to a particular examination procedures and internal control branch; thus, the examiner-in-charge should questionnaires, based on the range of activities exercise judgement as to which procedures will of the particular branch under examination. be conducted during the on-site examination. (This point is discussed in greater detail below.) The procedures to be addressed should be based upon the particular characteristics of the branch under examination, such as size, range, and Overview complexity of activities and condition. The materiality and significance of a given area of a The Overview section presents background branch’s operations are primary considerations information on the respective topics. This infor- in determining the scope of the examination and mation will be supplemented and reinforced the procedures to be performed. Examiner flex- through the supervisory agencies’ educational ibility in this respect will result in examinations programs, updates to existing supervisory poli- that are tailored to fit the condition, nature, and cies, and the examiner’s growing on-the-job scope of operations, i.e., a risk focus approach. experience. If, for example, serious deficiencies surface or issues are raised during an examination, all relevant examination procedures set forth in the Examination Objectives manual are generally expected to be followed. Additional procedures may also be required The subsections in the Examination Objectives from other supervisory manuals and materials. section list the goals that should be of primary When modifying the procedures, the examiner- interest to the examiner. Examination objectives in-charge is responsible for determining that the are broadly stated and are thus similar for most examination objectives are met and that the manual sections. The objectives directly relate scope of the examination is consistent with to procedures that will be performed at the the condition of the individual branch. examination and thus will influence the scope of the examination for the specific focus of examination interest. Internal Control Questionnaire

1. Collectively referred to as ‘‘branches’’ throughout this The evaluation of a branch’s internal control manual, unless otherwise indicated. environment should encompass a review of the

Branch and Agency Examination Manual September 1997 Page 1 1020.1 Format and Use of Manual internal audit activities and the implementation The manual was initially published in January of selected Internal Control Questionnaires 1995, and subsequently revised July 1997. Since (ICQs), which set forth standards for operational the entire manual was updated and reprinted at control. Due to the inherent differences between that time, all pages are dated as of the July 1997 an examination and an audit, it is not contem- revision date. Supplemental pages will be peri- plated that all ICQs will necessarily be imple- odically published and distributed by the Fed- mented on every examination. The ICQs eral Reserve Board and appropriately dated. employed during the course of the examination should include: (1) those selected by the examiner-in-charge based upon his/her experience, knowledge of problems within the branch, and perception of risk; and (2) those that focus USE OF MANUAL on areas where on-site evaluation of operational The manual should serve as a working tool as control seems warranted in light of the results of well as a reference manual. It is organized to the examination of internal audit activities. In provide flexibility to the examiner in planning addition to serving as a guide for on-site evalu- and conducting a branch examination and iden- ations, the ICQs can be used in the appraisal of tifying the key areas of concern as presented in operational audit techniques. the ROCA rating system. As discussed earlier, examination procedures may be modified, depending upon the size, Audit Guidelines range of activities, and condition of the branch. State laws and local characteristics may also The Audit Guidelines under selected sections necessitate a review of additional factors and are included as an additional source of informa- supplemental procedures. For example, specific tion relative to special situations where serious procedures relating to highly sophisticated trad- issues are raised with respect to the internal ing activities have not been included in this audit program or the general internal control manual. Examination procedures for those environment. Audit Guidelines set forth tradi- activities may be found in the Trading Activities tional audit techniques that ideally should be Manual of the Board of Governors of the employed by the local staff, head office, internal Federal Reserve System. Similarly, applicable or external auditors, or a combination thereof. State, FDIC, and OCC banking rules and regu- Audit guidelines should not be routinely included lations must be considered in various areas, such in the scope of every examination. as those relating to asset maintenance requirements or asset pledge/capital equivalency deposits. NUMBERING SYSTEM Although the manual discusses selected branch activities in general terms, it is primarily ori- The manual is arranged using a numbering ented toward describing examination procedures system based on the manual’s sections and covering those activities. Therefore, the manual subsections. For example, the Overview subsec- should not be viewed as a comprehensive train- tion of the Credit Risk Management section is ing guide or a legal reference. Separate training numbered 3010.1., 3010 is the section number programs will provide more detailed instruc- for Credit Risk Management, and .1 is the tions to assist the examiner in better understand- subsection number for the Overview. The ing branch activities and applying examination Examination Objectives subsection for that sec- procedures. In addition, questions concerning tion is numbered 3010.2, and so on. Subsections applicability and compliance with federal and are always numbered consecutively regardless state laws and regulations should be referred to of the number of subsections within a particular the legal staff of the appropriate regulatory section. agency.

September 1997 Branch and Agency Examination Manual Page 2 Enhanced Framework for Supervising the U.S. Operations of Foreign Banking Organizations Effective date July 1997 Section 2000.1

Foreign banking organizations (‘‘FBOs’’) con- Banking Act. In addition, the Federal Reserve duct an extensive and diverse business in the shares supervisory responsibility with other United States. Consistent with economic efﬁ- regulatory agencies for FBOs with respect to the ciency and national treatment, FBOs are free to business they conduct within the United States, conduct their U.S. activities through a variety of including representative ofﬁces. As a result, legal entities. Banking activities are conducted FBOs are subject to a number of state and primarily through branches or agencies licensed federal statutes, and various aspects of their by the individual states or by the Comptroller of operations are supervised and regulated by the Currency and, to a lesser extent, through both state and federal banking supervisory banks chartered by those banking supervisory authorities. authorities and through special-purpose banking In order to better coordinate and further corporations chartered by the states and the enhance the supervision of the U.S. activities of Federal Reserve. Some of these banking entities FBOs, the banking supervisory authorities that also are insured and therefore subject to the have supervisory and examination powers over oversight of the Federal Deposit Insurance Cor- the U.S. operations of FBOs have developed a poration. Non-banking activities are authorized program encompassing the supervisory prin- by the Federal Reserve pursuant to the Bank ciples and processes relating to FBOs, which is Holding Company Act and the International summarized in the following sections.

Branch and Agency Examination Manual September 1997 Page 1 Strength-of-Support Assessment for Foreign Banking Organizations with U.S. Operations Effective date July 1997 Section 2001.1

OVERVIEW recent merger, significant other expansion or changes in operations, or reported control prob- The strength-of-support assessment (SOSA) pro- lems at non-U.S. operations pose a potential risk vides a general framework for evaluating and to the U.S. operations. The factors considered assimilating significant financial and managerial for this component also are discussed below. information related to individual foreign bank- Specific standards or criteria for the second ing organizations (FBOs) in order to assign a component of the SOSA are not discussed two-component SOSA. The FBO assessment because the purpose of this component is to provides information to the supervisory agen- indicate whether any such concerns exist, a cies that is taken into account in reaching determination that is largely judgmental in nature decisions regarding the scope and frequency of and not readily quantified. For this reason, the examinations and other appropriate supervisory asterisk is used rather than an alpha or numeric initiatives. The assessment also provides a basis symbol which would incorrectly imply differing for the more efficient utilization of supervisory degrees of such concerns. resources. All SOSAs are for internal supervisory use The first component of the SOSA addresses only and are not disclosed to the general public whether any factors relating to the ability of the or to FBO’s management, either in the United FBO to meet its U.S. obligations warrant special States or at the head office or to the home monitoring of the FBO’s U.S. operations. This country supervisor(s). If deemed appropriate, component is a reflection of the overall financial any specific concerns raised through the assess- viability of the FBO as well as several external ment process, rather than the assessment itself, factors such as the degree of supervision the will be communicated directly to the FBO’s FBO receives from its home country supervisor. management and home country supervisor(s), This component is based on a scale of ‘‘A’’ particularly if those concerns lead to supervisory through ‘‘E’’ with ‘‘A’’ representing the lowest follow-up action with regard to the FBO’s U.S. level of supervisory concern and ‘‘E’’ represent- operations. ing the highest. Factors considered in assigning the first component include a review of the FBO’s financial condition and prospects, the system of supervi- SOSA INDICATORS sion in the FBO’s home country, the record of home country government support of the bank- There are five possible indicators for the first ing system or other sources of support of the component of the SOSA: FBO, and any transfer risk concerns. In assigning this component, all relevant factors are Assessment of A—The FBO has a financial weighed and evaluated. Standards and criteria profile that is regarded as strong by both home for this component, including the five possible country peer and international standards. It has strength-of-support indicators, are discussed in superior risk-based capital ratios,1 more than greater detail below. ample access to U.S. dollar funding, and, if rated The second component of the SOSA, which is by any of the ratings agencies, is accorded one utilized on an as-needed basis, identifies whether of the two highest market or investment rating there are any factors that raise questions about categories. Supervision by the home country the ability of the FBO to maintain adequate supervisory agency or agencies is conducted on internal controls and compliance procedures at a comprehensive basis, covering the worldwide its U.S. offices, irrespective of the overall financial condition of the FBO. If any such control risks are apparent, an asterisk is placed next to the letter component of the SOSA. Factors considered in assigning the asterisk 1. Risk-based capital ratios based on Basle or EC criteria are available for most banks. For those banks not providing include the FBO’s managerial and operational such ratios, judgments related to the adequacy of capital are record and whether current activities such as a based on the ratio of equity capital to total assets.

Branch and Agency Examination Manual September 1997 Page 1 2001.1 Strength-of-Support Assessment for Foreign Banking Organizations with U.S. Operations operations of the FBO and its affiliates.2 The Assessment of D—Significant financial or super- home country has a good record of supervising visory weaknesses are apparent such that impo- financial institutions and dealing with problem sition of asset maintenance requirements on the institutions, and transfer risk is not an issue of U.S. branches and agencies should be consid- concern. The FBO is an unquestioned source of ered. The FBO may be expected to continue as strength to its U.S. operations. a going concern due primarily to government support, ownership, or other significant factors, Assessment of B—The financial profile and out- although resource constraints, transfer risk con- look pose a low risk that the FBO will be unable siderations, operating structure, or other factors to support its U.S. operations. The FBO is may place important limitations on that support. viewed as investment grade or equivalent, capi- Conversely, the financial profile, based on avail- tal ratios are above internationally accepted able information, may imply a higher assess- minima, and access to U.S. dollar funding is ment, but home country supervision is deemed readily available; however, financial factors are to be substantially or wholly deficient, or there not as strong as those of institutions with an are significant transfer risk concerns. assessment of A. The FBO is subject to a significant degree of supervision of its overall Assessment of E—Due to a seriously deficient operations by the home country supervisor(s) financial profile and/or poor operating practices and the country has a good record for dealing and the absence of any sufficient supervisory with problems in the local financial system. oversight and support, there is a strong possibil- Transfer risk factors are generally consistent ity that the FBO will be unable to honor its U.S. with those of FBOs with an assessment of A. An obligations in the near future or is otherwise FBO whose financial profile is consistent with a considered to present a hazard to U.S. financial B assessment could be assigned an assessment markets. of C or lower if its home country has a supervisory system that is lacking in significant respects or significant transfer risk consider- SOSA FACTORS ations exist. Determining whether an individual FBO has the Assessment of C—The current operating perfor- internal or external resources to provide the mance of the FBO and its immediate financial necessary financial or managerial support to its outlook, although not posing significant con- U.S. operations depends to a great extent upon cerns about the ability of the organization to its financial condition, operating record, and honor its U.S. liabilities, may warrant more than general outlook. A good financial condition normal review based on such factors as the lack combined with capable management is gener- of an investment grade rating, capital ratios ally sufficient to ensure that support. However, below internationally accepted minima, or other the degree of certainty about the ability of an factors that are considered less than adequate by FBO to provide any necessary financial support international standards. While the FBO cur- may be limited by weaknesses in its home rently may not meet all international financial country supervisory system or a significant standards, the home country has demonstrated degree of transfer risk associated with its major an ability and willingness to support the FBO or operations. These two factors also may influ- similar financial institutions. ence the home country’s record of support for its Conversely, the financial profile of the FBO financial institutions. may appear to warrant a stronger rating; how- Accordingly, the first component of the SOSA ever, supervision by the home country regula- considers four major factors: (a) the financial tors is lacking in significant respects or signifi- profile of the FBO based on its present financial cant transfer risk considerations exist. condition and outlook, including capital ratios and access to U.S. dollar liquidity; (b) the FBO’s home country banking supervision system; 2. This covers instances in which a determination regard- (c) the demonstrated capabilities of the home ing comprehensive, consolidated supervision has already been country in dealing with banking problems; and made by the Federal Reserve Board or where Board staff, based on available information, are prepared to make a (d) the degree of transfer risk associated with the positive recommendation to the Board with regard to com- FBO’s home country and any other countries in prehensive, consolidated supervision. which the FBO has major operations.

September 1997 Branch and Agency Examination Manual Page 2 Strength-of-Support Assessment for Foreign Banking Organizations with U.S. Operations 2001.1

All assessment factors are considered as a System of Home Country Supervision whole in assigning the first component of the SOSA. None of the four principal factors are A review of the home country supervisory assigned a separate ‘‘rating’’ or are considered a system is essential to ensure that the FBO is discrete component of the final assessment. subject to an appropriate level of supervision of its global operations. In assigning an FBO’S SOSA, the review of the system of home coun- Financial Profile try supervision should concentrate on its general policies and how the supervisory framework applies in practice to the individual FBO. In this The financial profile of the FBO is based on the context, the mere presence of a home country institution’s current condition and future pros- supervisor is not considered sufficient. pects. A review of financial condition is based The FBO’s home country supervisory system on the level and trend in financial performance should be evaluated based on those general indicators relating to the FBO’s capital, profit- principles and practices that ensure regulatory ability and asset quality. These indicators should monitoring over the FBO’s principal operations be evaluated in the context of peer performance and activities, including those outside the home and knowledge of the FBO’s home country country. These general supervisory principles financial system and accounting policies and and practices usually include some level of practices.3 The financial outlook should con- periodic reporting, on-site and/or off-site review, sider a broad range of external and internal prudential guidelines (including capital adequacy factors, such as the home country banking requirements), and supervisory enforcement system, the FBO’s political and economic envi- powers. Effective regulatory systems may take ronment, its market position, risk profile, own- many forms; however, the system of any coun- ership, and management. try should ensure that the internationally active Generally, the FBO’s short-term and long- banks operating under that system are subject to term market ratings are good indicators of its a sufficient level of supervision. financial outlook. An FBO with the highest Supervisory systems may also vary with market ratings should be able to demonstrate a respect to the type of institution. Therefore, the strong financial condition and outlook. The FBO analysis of the supervisory system should evalu- would likely be assigned an A assessment if ate actual regulatory practices for the individual other factors are consistent with the assessment. FBO. This assessment will be based largely on Notwithstanding the significance of market rat- the information that has been accumulated over ings, the FBO’s financial profile and resultant time by the U.S. banking supervisory agencies. assessment should not be based on market It is expected that this assessment will be ratings alone. Rather the ratings should serve as enhanced as additional information on other a reference point for the independent assessment supervisory systems is obtained through improved of the institution, because market ratings may contacts and informational exchange. not always reflect the most current view of the FBO or the supervisory authorities may have information not directly or indirectly available to the market. For example, examination find- Record of Home Country Support ings of the U.S. operations could raise questions about the FBO’s overall operations and manage- Related to home country supervision is the ment that could lead to a SOSA lower than that matter of the home country’s record of ensuring indicated by the FBO’s market ratings. How- the solvency of its financial institutions, particu- ever, any significant difference between the larly those that operate internationally. The assessment and market ratings should be fully record of support varies by country with respect analyzed and justified. to structure, coverage of banks, and resources. Such support may be either direct or indirect in nature and may be widespread or only applica- 3. While recognizing that in many cases knowledge of this ble to banking institutions with specific nature will take time to develop, it is particularly important characteristics. because financial disclosure varies among countries. For this reason, meetings with head office management and the home Some countries are able to take whatever country supervisors of FBOs are useful sources of information. steps are necessary to support their banks

Branch and Agency Examination Manual September 1997 Page 3 2001.1 Strength-of-Support Assessment for Foreign Banking Organizations with U.S. Operations unequivocally while others will have a more experiencing certain operational problems, not limited degree of support for their banks due to necessarily in the United States. The FBO may legal restrictions or financial constraints. These be undergoing extensive expansion into new factors should be reviewed, giving particular markets or products that over time could pose a emphasis to past performance and an assessment strain on its financial and managerial resources. of the country’s resources. The FBO also could be experiencing well- publicized internal control problems at offices outside the United States. Although these con- Level of Transfer Risk trol problems would not necessarily affect the ability of the FBO to pay its obligations, they may be symptomatic of larger control problems Transfer risk, which relates to the FBO’s ability that also might exist in the U.S. offices. Any to access U.S. dollars, is an essential factor in such concerns should be explored to the extent determining whether the FBO can support its possible, particularly as they may influence the U.S. operations. For some FBOs, transfer risk is examination plan for the FBO’s U.S. operations. increased due to heavy debt servicing or other financial restraints relating to the home country, which often leads to exchange controls and hard currency restrictions. As a result, these FBOs GENERAL SUPERVISORY may be limited in providing necessary support IMPLICATIONS to their U.S. operations. The assessment of transfer risk for individual As discussed earlier, one of the principal goals countries is uniformly handled by U.S. regula- of the SOSA is to identify those FBOs that may tors through the Interagency Country Exposure pose risks to their U.S. operations or to U.S. Review Committee (ICERC). These ICERC financial markets due to financial, operational, assessments can therefore be used in determin- or other concerns at the FBO as a whole. The ing the SOSAs. For those countries not evalu- SOSA serves to categorize all FBOs conducting ated by ICERC, the assessments of transfer risk banking operations in the United States and to will made in the same manner as conducted by highlight those FBOs warranting higher levels ICERC. of supervisory attention with respect to their Generally, FBOs from countries rated substan- U.S. operations. This assessment may influence dard or worse would be accorded an assessment the examination plan and potential supervisory of no better than C. However, a high level of follow-up actions for the FBO’s U.S. operations. transfer risk associated with the FBO’s home An FBO’s SOSA is taken into consideration country could be mitigated by other consider- in setting the examination plan for the FBO’s ations that clearly indicate that the FBO has U.S. operations. The examination plan considers broad access to U.S. dollars. any issues raised in the assessment process and addresses them accordingly. For example, the U.S. operations of FBOs whose assessments are Other Factors marked by an asterisk may have examinations that specially target operational or management Determining whether an FBO poses any mana- areas. The FBO’s SOSA is also a factor in gerial or operational control risks to its U.S. determining whether the FBO will be subject to operations can be influenced by a broad range of a simultaneous examination. factors that are generally more subjective than The FBO’s SOSA also is considered in imple- those discussed under the first component of the menting supervisory follow-up action for the SOSA. Any such risks, both actual and poten- U.S. operations. Generally, an assessment of C tial, which do not directly relate to the ability of or worse would imply a level of concern that an FBO to meet its obligations as discussed would subject the FBO’s U.S. offices to at least earlier, should be denoted by placing an asterisk periodic monitoring of their due to/due from beside the FBO’s letter assessment. The nature positions. Any additional supervisory steps, such of these risks should be discussed separately in as imposing an asset pledge or asset main- the FBO evaluation. tenance requirement, would be implemented One example of such control risks is an FBO largely based on the condition and nature of the that otherwise has a SOSA of A or B but may be U.S. operations. An FBO accorded an assess-

September 1997 Branch and Agency Examination Manual Page 4 Strength-of-Support Assessment for Foreign Banking Organizations with U.S. Operations 2001.1 ment of D or worse indicates a higher level of E Assessment— The FBO will be placed under concern with some presumption of asset main- continuous surveillance and reporting as war- tenance regardless of the condition of its U.S. ranted. Termination proceedings for the U.S. operations. operations of such an FBO will be considered As with all such supervisory follow-up actions, under applicable regulatory guidelines. these steps are considered and implemented based on the general criteria for applying supervisory follow-up actions in the context of the DEVELOPING THE SOSA FBO’s SOSA. Supervisory follow-up action can be modified based upon a number of criteria. It The FBO’s SOSA is developed annually through is stressed that no automatic supervisory pro- a process that involves all U.S. supervisors that gram is mandated as part of the FBO SOSA. have licensing, chartering, or examining respon- Furthermore, an assessment of A or B generally sibilities over the FBO’s U.S. operations. The would imply little if any concern relating to the process includes an analysis of available infor- ability of the FBO to meet its obligations. If an mation on the financial condition of the FBO FBO does raise liquidity or solvency concerns, within the context of the home country financial the FBO should not be accorded an assessment system, the banking supervisory system, the ofAorB. record of the authorities in preventing or suc- Suggested guidelines for supervisory follow-up cessfully dealing with banking system prob- action for each assessment category are as lems, and transfer risk considerations. The FBO follows: evaluations are based on information compiled by all of the relevant U.S. banking supervisory A or B Assessment—Normally, any supervisory agencies. follow-up action for FBOs with a SOSA of A or Information obtained by any of the banking B is applied only if warranted by the condition supervisory agencies relating to individual FBOs, of the U.S. operations. Supervisory measures their home country financial systems, supervi- generally would not relate to liquidation con- sory systems and accounting policies should be cerns. As such, asset maintenance usually would transmitted to the Federal Reserve, which will not be required for branches and agencies of assume responsibility for organizing and main- these FBOs; however, supervisory actions would taining a database for this information. This be undertaken, if necessary, to resolve any database is available to all of the relevant U.S. significant deficiencies in risk management, banking supervisory agencies. operations and internal controls, or compliance All of the relevant state and federal banking at any of the U.S. offices. supervisory agencies, whenever possible, will obtain information for the database, especially as it relates to the individual FBOs, the financial C Assessment—The FBO’s SOSA is reviewed systems within which they primarily operate and at least annually. The due to/due from position is the supervisory systems in the different coun- closely monitored and any substantial due from tries. This information will help to keep the position is fully analyzed for risk implications. database as current as possible and is developed If warranted by the condition of the combined primarily through discussions with the U.S. and U.S. operations or the asset quality at the U.S. head office managements of the FBOs as well as offices of such an FBO, asset maintenance the home country supervisor(s). would be considered for branches and agencies, and U.S. subsidiary banks could be required to operate at capital levels above the minima. PRIMARY PRODUCTS

D Assessment—There is a strong presumption The information in the database is used to of asset maintenance for branches and agencies develop three primary products, each of which of an FBO in this category, and U.S. bank summarizes information in the database and subsidiaries should operate at strong capital provides the supporting data for the SOSA. levels. The FBO is more closely monitored and These three products are: (1) an evaluation of its assessment may be subject to review at least the ﬁnancial condition of the FBO, (2) a review semi-annually. of the home country ﬁnancial system, and (3) a

Branch and Agency Examination Manual September 1997 Page 5 2001.1 Strength-of-Support Assessment for Foreign Banking Organizations with U.S. Operations review of significant home country accounting of the U.S. operations of the FBO. The evalua- policies and practices. tions and assessments normally are reviewed annually. The evaluations will be revised in the interim only if information is obtained by any of the U.S. supervisory agencies that is significant Evaluation of the Financial Condition enough to change the SOSA, either positively or of the FBO negatively. These evaluations are kept strictly confiden- Normally, the FBO evaluation is drafted by the tial by each of the agencies, in part to ensure that Federal Reserve each year. The initial source of the sharing of information between the agencies information for the evaluation is the FR Y7 for purposes of analyzing the condition of the report as well as any external sources that are FBO and assigning its SOSA does not violate readily available (e.g. periodicals and services). state or federal regulations. Over time, as the database becomes more developed, many additional sources of information will be utilized. The individual Reserve Banks responsible for Review of Home Country Financial drafting FBO evaluations produce a schedule at System the beginning of each year showing the approximate date that the draft evaluation and recom- As mentioned above, a database containing mended SOSA for each FBO will be circulated information on the financial system of each for comments. This schedule is based primarily country with bank representation in the United on the fiscal year-end of the FBO (and conse- States is maintained by the Federal Reserve, quently the date the FR Y7 report is received), using its own sources and information submitted the extent and overall condition of the FBO’s by the other supervisory agencies. This informa- combined U.S. operations, and the prior SOSA tion is made available to all of the agencies. In of the FBO. This schedule is distributed to all of addition, the Federal Reserve provides, in a the state and federal agencies participating in uniform format, reviews summarizing informa- this joint program along with the name of a tion on the home country financial system, the contact person at each Reserve Bank. The other nature of banking supervision and the country’s agencies, as well as the other Reserve Banks, record in dealing with banking problems.4 These may request, through the assigned contact per- reviews are updated whenever any of the super- son, that an FBO evaluation in any given year be visory agencies obtain significant information given a higher priority than the schedule regarding the financial system of the particular indicates. country. The database includes all such reviews The draft evaluation and the proposed SOSA prepared by the Federal Reserve and any pro- is circulated for comments within the Federal vided by the other supervisory agencies. Reserve System and to all federal and state supervisory agencies involved in supervising the FBO. Each party reviews the draft and com- Review of Home Country Accounting ments, if necessary. In addition, the analyst who Practices prepared the draft will be available to answer questions regarding the draft. If the initial review The database also contains information on sig- of the draft indicates differences in view regard- nificant accounting policies and practices in ing the proposed assessment that can not be other countries and is utilized to develop reviews resolved informally, a meeting of the relevant of such practices. These reviews are developed banking supervisory agencies could be called by by the Federal Reserve utilizing information any supervisory agency to discuss the SOSA of the FBO. While it is expected that a consensus assessment will result from this process, indi- 4. These reviews are produced based on a schedule pro- vidual agencies retain the right to exercise all vided by the Reserve Banks. The schedules give priority to statutory authorities available to them to meet those countries that have a major banking presence in the their supervisory concerns. United States or are experiencing significant problems within the home country financial system. The draft is provided to the The finalized evaluation is sent to all of the other agencies for their comments. The analyst who prepared supervisory agencies involved in the supervision the draft is available to answer questions regarding the draft.

September 1997 Branch and Agency Examination Manual Page 6 Strength-of-Support Assessment for Foreign Banking Organizations with U.S. Operations 2001.1 derived from the same sources as used for the provided in the FR Y7 report. These reviews are review of the home country ﬁnancial system as updated whenever any signiﬁcant changes occur well as from general accounting information in accounting policies or practices.

Branch and Agency Examination Manual September 1997 Page 7 Examination Planning and the Assessment of the U.S. Operations of Foreign Banking Organizations Effective date July 1997 Section 2002.1

OVERVIEW scheduling meeting takes place each year to determine the scope and timing of examinations This segment of the program is designed to of FBOs that are to be conducted on a more provide a more efficient, rational, and uniform coordinated basis. The Federal Reserve finalizes approach to supervising the U.S. operations of the comprehensive examination schedule and foreign banking organizations (FBOs), particu- provides it to all of the supervisory agencies. larly those that operate in the United States For FBOs that conduct all or substantially all through numerous entities and across multiple of their U.S. operations through entities licensed jurisdictions. In order to ensure coordination of or chartered by one banking supervisory agency, supervisory efforts and avoid duplication, the the timing of the annual examination is estab- U.S. banking supervisory agencies communicate lished by the licensing authority. In agreement with each other to a greater extent regarding with the individual states, the Federal Reserve their examination plans, examination results, and, for insured branches, the FDIC, share the and, where applicable, their proposed supervi- burden of conducting the annual examinations sory follow-up actions. In addition, the Federal of state-licensed branches and agencies. In those Reserve assesses annually the combined U.S. years that the Federal Reserve or FDIC conduct operations of each FBO, based largely on input the examination, the timing will be established from and discussions with the examining by that agency. agencies. FBOs which operate in the United States through multiple offices often will have all offices examined using the same ‘‘as of’’ finan- EXAMINATION SCHEDULING cial statement date. This provides the supervi- AND DEVELOPMENT OF sory agencies with increased information on the EXAMINATION PLANS interrelationships among the various offices and can enhance the examination of individual offices FBSEA requires that each U.S. branch and and the FBO’s overall U.S. operations. These agency of an FBO be subject to one safety and examinations are conducted by the various soundness examination in each twelve month agencies. period. More frequent examination may be war- Sometimes, certain activities of a branch are ranted in certain situations.1 functionally managed or operationally per- To ensure coordination, the licensing and formed at the branch being examined, but are insuring agencies provide the local Federal booked at another office of the FBO, either in Reserve Bank with a copy of their preliminary the U.S. or offshore. It is not uncommon for one examination schedule for the coming year for all branch to generate, or be responsible for loans, U.S. offices of an FBO for which the agency trading assets, or deposits that are ultimately anticipates conducting an examination. The Fed- booked at another office. Similarly, it also is not eral Reserve uses these schedules, along with uncommon for a branch to perform certain the preliminary examination schedules of the operations such as electronic data processing, various Reserve Banks, to derive a draft com- accounting, financial reporting, or credit admin- prehensive examination schedule for all U.S. istration on behalf of another office of the FBO. operations of individual FBOs. Even when a U.S. branch performs limited The draft schedule is provided to each operational functions for a related office, exam- involved agency in order to permit all of the iners should evaluate whether the branch has examining agencies to review their own sched- sufficient records and controls in place to execute ules in conjunction with those of the other the delegated responsibilities. If there is insuffi- agencies. In addition, where necessary, an inter- cient information to evaluate the nature of and agency the performance of the U.S. branch with respect to the business relationship with another office 1. Under legislation passed in 1996, branches and agencies of the FBO, examiners should cite this defi- that meet certain size and other criteria may be examined once in every 18 month period. Those criteria currently are under ciency in the report of examination as a matter development and further guidance will be issued. that requires immediate attention.

Branch and Agency Examination Manual September 1997 Page 1 2002.1 Examination Planning and the Assessment of the U.S. Operations of Foreign Banking Organizations

SR 96-36 provides detailed guidance on how supervisory agency and/or with significant U.S. to review duties performed by one branch on the non-banking activities. The Federal Reserve behalf of another. Essentially, a branch perform- drafts the comprehensive Exam Plan based on ing duties on behalf of another office of the FBO the individual examination plans prepared by should have adequate policies, procedures, and the different state and federal supervisory agen- documentation to clearly delineate the over- cies for each office to be examined. These sight, operational, and control responsibilities of examination plans should be developed after the the branch. There should be adequate risk man- regulatory agency has completed its most recent agement processes, operational controls, and examination of the FBO entity subject to its compliance programs covering all activities for supervision. The plan should be incorporated which the branch has responsibility. The exami- into the confidential section of the examination nation treatment under the ROCA rating system report. After conferring with other participating for activities conducted by a U.S. branch on banking supervisory agencies, the scope or time- behalf of another office of the FBO should be table of an examination, as set out in the annual the same as for activities conducted by the comprehensive Exam Plan, may be altered in the branch for its own book, except for the evalua- event there are impediments to completing an tion of asset quality. In rating asset quality, the examination as originally planned. examiner should only evaluate assets that are on the books of the U.S. branch. However, examiners should be mindful of the general quality of assets being generated by the U.S. branch and IMPLEMENTING THE ANNUAL booked elsewhere so as to be alert to any pattern EXAMINATION PLAN of booking low quality assets outside the U.S. or any other situations that might indicate prob- The Federal Reserve coordinates the sharing of lems in risk management or operational controls. information throughout the examinations of FBOs with multi-state operations. Because of the differing starting dates and lengths of individual examinations, most examinations are com- EXAMINATION PLAN pleted by participating banking supervisory agencies at different times. Consequently, an important Subsequent to the examination scheduling pro- part of this program is the sharing of critical cess, detailed examination plans are developed, examination findings throughout the process. exchanged and coordinated among the examin- The U.S. supervisory agencies have committed ing agencies. Each state and federal supervisory to advising those agencies responsible for exam- agency participating in this program is commit- ining other U.S. offices of the FBO of any ted to developing, to the extent possible, exami- critical examination findings prior to the exit nation plans for individual offices of FBOs that meeting for that examination. they plan to examine based primarily on the The Federal Reserve, in its statutory role as following: umbrella authority with responsibility for overall U.S. operations, confers with the examining • findings and scope of previous examinations; agencies to determine if its participation in any • the results of any off-site surveillance; of the examiner closeout meetings is warranted. • the latest assessment of the combined U.S. Such participation typically is appropriate in the operations of the FBO and the role of the event there are systemic weaknesses detected in office in the context of the FBO’s overall U.S. the U.S. operations or problems exist that are so business activities; significant as to affect the rating of the overall • results of meetings with both U.S. and head U.S. operations. In those instances where a office management of the FBO, and the home Federal Reserve Bank has conducted the exami- country supervisor(s); and, nation, that Reserve Bank confers with the • the evaluation of the FBO and the SOSA licensing agency to determine if the participa- assigned. tion of that agency is warranted. However, the normal presumption is that the banking super- A comprehensive examination plan (‘‘Exam visory agency that conducted the examination Plan’’) is developed annually for each FBO with also will conduct the closeout meeting without banking offices licensed by more than one participation by non-examining agencies.

September 1997 Branch and Agency Examination Manual Page 2 Examination Planning and the Assessment of the U.S. Operations of Foreign Banking Organizations 2002.1

The agency responsible for the examination combined U.S. operations. of any office in a given year is also responsible The Summary of Condition is drafted by the for completion of the examination and prepara- Federal Reserve which provides a copy of the tion of the examination report for that entity. In draft and proposed rating to each supervisory the case of joint examinations, the examining agency with examination authority over an office agencies strive to issue only one report of of the FBO in order to make certain that examination for that office of the FBO. The information obtained from these agencies was supervisory agency that conducted the examina- correctly interpreted. tion of an individual office of an FBO also is Once the Summary of Condition is finalized, responsible for the distribution of the transmittal the Federal Reserve provides a copy, including letter and examination report. the rating, to the Chief Executive Officer at the Supervisory actions that affect only one office head office of the FBO. The Summary of Con- of an FBO also normally are entered into solely dition and the rating serve as a starting point in by the licensing authority, unless the action drafting the Exam Plan for the next year. resulted from an examination conducted by the In arriving at the rating for the combined U.S. FDIC or the Federal Reserve. In these cases the operations of the FBO, all of the FBO’s U.S. action is undertaken by the examining agency vehicles are considered; however, this rating is or, at the option of the licensing authority, on a not based merely on an arithmetic average of the joint basis with that authority. Actions that apply examination ratings of the vehicles examined. to the overall operations of an FBO are entered The strengths or weaknesses exhibited within into by the Federal Reserve and those licensing individual entities are evaluated based on the or insuring agencies that have offices affected by size and importance of the entity relative to the the supervisory action and wish to enter into FBO’s entire U.S. operations, and the material- such an action with the office they license. ity and extent of the weaknesses. The five ratings are defined as follows:

Combined Rating of 1—The overall operations ASSESSMENT OF COMBINED U.S. are fundamentally sound in every respect. They OPERATIONS AND ASSIGNMENT cause no supervisory concern and require only OF A RATING normal supervisory attention.

An important component of this program is the Combined Rating of 2—The combined U.S. integration of individual examination findings operations operate in a basically sound manner, into an assessment of an FBO’s entire U.S. but may have modest weaknesses that can be operations. This assessment provides the FBO corrected by management in the normal course and the U.S. supervisory agencies with a view of of business. They do not require more than the overall condition of the U.S. operations, and normal supervisory attention. helps put into context the strengths and weaknesses of individual offices. It also highlights Combined Rating of 3—Overall U.S. operations supervisory concerns regarding any problems are weak in risk management, operational con- that are pervasive in the U.S. operations of the trols, and compliance, or have numerous asset FBO. quality problems that in combination with the The Federal Reserve conducts an annual condition of the FBO cause supervisory con- assessment of the combined U.S. operations and cern. U.S. and/or head office management may prepares a "Summary of Condition" for all not be taking the necessary corrective actions to FBOs with U.S. offices supervised by more than address weaknesses. This rating may also be one agency. The summary includes an assess- assigned when either risk management, opera- ment of all risk factors, including (1) all ele- tional controls, or compliance is individually ments of the ROCA rating system, (2) quality of viewed as unsatisfactory. Generally, these opera- risk management oversight employed by all tions raise supervisory concern and require more levels of management in the FBO’s U.S. opera- than normal supervision to address their tions, and (3) the examinations of all vehicles of weaknesses. the FBO conducted during the year. The Sum- mary of Condition leads to the assignment of a Combined Rating of 4—The combined U.S. single-component rating between 1 and 5 for the operations have a significant volume of serious

Branch and Agency Examination Manual September 1997 Page 3 2002.1 Examination Planning and the Assessment of the U.S. Operations of Foreign Banking Organizations weaknesses. Serious problems or unsafe and unsafe and unsound conditions that they require unsound banking practices or operations exist, urgent restructuring by head office management. which have not been satisfactorily addressed or resolved by U.S. or head office management. This composite assessment serves to apprise These operations require close supervisory the various U.S. supervisory authorities of the attention and surveillance monitoring and a condition of all the U.S. entities of individual definitive plan for corrective action by head FBOs. These agencies can then factor the infor- office management. mation that they obtain from the Summary of Condition and the composite assessment into Combined Rating of 5—The combined U.S. their supervision of the U.S. entities under their operations have so many severe weaknesses or jurisdiction.

September 1997 Branch and Agency Examination Manual Page 4 Rating System for U.S. Branches and Agencies of Foreign Banking Organizations Effective date July 1997 Section 2003.1

The rating system for U.S. branches of FBOs is The composite rating is based on a scale of a management information and supervisory tool one through five in ascending order of supervi- designed to assess the condition of a branch and sory concern. Thus, one represents the lowest to identify significant supervisory concerns at a level of supervisory concern while five repre- branch in a systematic and consistent fashion. sents the highest level. The five composite The rating system (ROCA) has been revised ratings are defined as follows. from the previous rating system of asset quality, internal controls, and management (AIM), to better assess the condition of a branch within the Composite Rating 1 context of the FBO, of which it is an integral part, and to pinpoint the key areas of concern in Branches in this group are strong in every a branch office. respect. These branches require only normal For evaluation purposes, the rating system supervisory attention. divides a branch’s overall activities into three individual components: risk management, operational controls, and compliance. These components represent the major activities or processes Composite Rating 2 of the branch that may raise supervisory concern. The rating system also provides for a Branches in this group are in satisfactory con- specific rating of the quality of the branch’s dition, but may have modest weaknesses that stock of assets as of the examination date. can be corrected by branch management in the normal course of business. Generally, they do not require additional or more than normal supervisory attention. COMPOSITE RATING

The overall or composite rating indicates whether, in the aggregate, the operations of the branch Composite Rating 3 may present supervisory concerns and the extent of any concerns. While the individual compo- Branches in this group are viewed as fair due to nent ratings are taken into consideration in a combination of weaknesses in risk manage- arriving at the branch’s overall assessment, the ment, operational controls, and compliance, or composite rating should not be merely an arith- asset quality problems that, in combination with metic average of the individual components. the condition of the FBO or other factors, cause The examiner should assign and justify in the supervisory concern. In addition, branch and/or report a composite rating using definitions pro- head office management may not be taking the vided below as a guide.1 necessary corrective actions to address substantive weaknesses. This rating may also be assigned when risk management, operational 1. Assessment of asset quality is an integral part of any controls, or compliance is individually viewed examination; however, under certain circumstances, it may be appropriate to give the individual asset quality rating component greater or lesser weight in arriving at an overall compos- loans, but is otherwise poorly managed should not be given ite rating. In ensuring the protection of branch creditors, an undue credit for having good asset quality. Alternatively, a important factor is the strength of the FBO. As the financial branch that is designated to hold problem assets generated by strength of the FBO weakens, it becomes increasingly impor- other offices of the FBO, in order to better manage the tant to look to the quality of the assets booked in the United workout process, should not be penalized, so long as the FBO States as the source of protection for local creditors, and, at a has the ability to support the level of problem assets. certain point, asset maintenance should be imposed. Similarly, Finally, it should be recognized that asset quality tends where the FBO is strong, and the need to look to local assets to be a ‘‘trailing’’ indicator of branch performance. In instances for protection of creditors seems remote, the relative weighing where risk management systems are weak, but problem assets of the asset quality component in the overall evaluation are currently nominal, it is realistic to assume there will be diminishes. future deterioration in asset quality. By the same measure, It also should be recognized that different offices of the management should be given credit in the overall evaluation FBO can be assigned widely different roles in the FBO’s where the causes of past asset quality problems have been overall strategy. Thus, an individual office that books very few corrected.

Branch and Agency Examination Manual September 1997 Page 1 2003.1 Rating System for U.S. Branches and Agencies of Foreign Banking Organizations as unsatisfactory. Generally, these branches raise one to five, where one represents the lowest supervisory concern and require more than level of supervisory concern and five represents normal supervisory attention to address their the highest. Each component is discussed below weaknesses. followed by a description of the individual performance ratings. Composite Rating 4 Risk Management Branches in this group are in marginal condition due to serious weaknesses as reflected in the Risk is an inevitable component of any financial assessments of the individual components. institution. Risk management, or the process of Serious problems or unsafe and unsound bank- identifying, measuring, and controlling risk, is ing practices or operations exist, which have not therefore an important responsibility of any been satisfactorily addressed or resolved by financial institution. In a branch, which is typi- branch and/or head office management. Branches cally removed from its head office by location in this category require close supervisory atten- and time zone, an effective risk management tion and surveillance monitoring and a definitive system is critical not only to manage the scope plan for corrective action by branch and head of its activities but to achieve comprehensive, office management. ongoing oversight by branch and head office management. In the examination process, examiners will therefore determine the extent to Composite Rating 5 which risk management techniques are adequate (i) to control risk exposures that result from the Branches in this group are in unsatisfactory branch’s activities and (ii) to ensure adequate condition due to a high level of severe weak- oversight by branch and head office manage- nesses or unsafe and unsound conditions and ment and thereby promote a safe and sound consequently require urgent restructuring banking environment. of operations by branch and head office The primary components of a sound risk management. management system are a comprehensive risk assessment approach; a detailed structure of limits, guidelines, and other parameters used to DISCLOSURE govern risk taking; and a strong management information system for monitoring and reporting Following approval of the rating by appropriate risks. senior supervisory officials at the examining The process of risk assessment includes the agency, the numeric ratings for all components identification of all the risks associated with the as well as the overall composite rating should be branch’s balance sheet and off-balance-sheet disclosed in the open, summary section of the activities and grouping them into appropriate examination report. This also applies when con- risk categories. These categories broadly relate ducting meetings with senior management. In to credit, market, liquidity, operational, and disclosing the rating, its meaning should be legal risks.2 All major risks should be measured explained clearly using the appropriate compos- explicitly and consistently by branch manage- ite rating definition. The report should also ment; risks should also be reevaluated on an make it clear that the rating is part of the overall ongoing basis as underlying risk assumptions findings of the examination and is thus confi- relating to economic and market conditions vary dential. Any rating disclosed or discussed at an and as the branch’s activities change. The examination closeout meeting should be held branch’s expansion into new products or busi- out by the examiner-in-charge to be tentative. ness lines should not outpace proper risk management or supervision by head office. Where risks cannot be explicitly measured, manage- COMPONENT EVALUATIONS 2. While operational risks are identified as part of the branch’s overall risk assessment process, the effectiveness of Similar to the composite rating, the individual the branch’s operational controls is separately evaluated under rating components are evaluated on a scale of ROCA.

September 1997 Branch and Agency Examination Manual Page 2 Rating System for U.S. Branches and Agencies of Foreign Banking Organizations 2003.1 ment should demonstrate knowledge of their • Whether risk policies, guidelines, and limits at potential impact and a sense of how to manage the branch are consistent with its lending, such risks. trading, and other activities; management’s Risk identification and measurement are fol- experience level; and the overall financial lowed by an evaluation of the tradeoff between strength of the branch and/or the FBO. risks and returns to establish acceptable risk • Whether the management information system exposure levels, which are stated primarily in and other forms of communication are consis- the branch’s lending and trading policies subject tent with the level of business activity at the to the approval of head office management. branch and sufficient to accurately monitor These policies should give standards for evalu- risk exposure, compliance with established ating and undertaking risk exposure in indi- limits, and sufficient to enable the head office vidual branch activities as well as procedures for to monitor the real performance and risks of tracking and reporting risk exposure to monitor the branch. compliance with established policy limits or guidelines. • Management’s ability to recognize and accom- Head office management has a role in devel- modate new risks that may arise from the oping and approving the branch’s risk manage- changing environment, and to identify and ment system as part of its responsibility to address risks not readily quantified in a risk provide a comprehensive system of oversight management system. for the branch. Generally, the branch’s risk management system, including risk identifica- For example, in the lending area, a branch is tion, measurement, limits or guidelines, and expected to have (1) experienced lending offi- monitoring should be modeled on that of the cers, an effective credit approval and review FBO as a whole to provide for a fully-integrated function, and, where appropriate, credit work- risk management system.3 out personnel; (2) a credit risk evaluation system In assigning the risk management rating, that is adequate in assessing relative credit risks; examiners should evaluate the current, ongoing (3) branch officer lending limits, lending guide- situation and concentrate on developments since lines, and portfolio policies consistent with the the previous examination. The rating should not abilities of branch personnel and the financial concentrate on past problems, such as those expertise and resources of the FBO; (4) a system relating to the current quality of the branch’s that identifies existing and potential problem stock of assets, if risk management techniques credits, a method for assessing the likely impact have improved significantly since those prob- of those credits on existing and future profits, lems developed.4 and procedures for accurately informing head More specifically, in rating the branch’s risk office of the credit quality of the portfolio and management procedures, examiners should con- possible credit losses; and (5) procedures for sider the following. assessing the impact on the portfolio of specific or general changes in the business climate. • The extent to which the branch is able to manage the risks inherent in its lending, trad- A rating of 1 indicates that management has a ing, and other activities, specifically its ability fully-integrated risk management system that to identify, measure, and control these risks. effectively identifies and controls all major types • The soundness of the qualitative and quanti- of risk at the branch, including those from new tative assumptions implicit in the risk man- products and the changing environment. This agement system. assessment, in most cases, will be supported by a superior level of financial performance and 3. For a more detailed overview of the risk management asset quality at the branch. No supervisory process in trading operations, refer to the Federal Reserve’s concerns are evident. Trading Activities Manual. 4. Thus, for example, the change in the level of problem assets since the previous examination is normally more A rating of 2 indicates that the risk manage- important than the absolute level of problem assets. At the ment system is fully effective with respect to same time, a loan portfolio that has few borrowers experienc- almost all major risk factors. It reflects a respon- ing debt service problems does not necessarily indicate a siveness and ability to cope successfully with sound risk management system because weak underwriting standards may make the branch vulnerable to credit problems existing and foreseeable exposures that may during a future economic downturn. arise in carrying out the branch’s business plan.

Branch and Agency Examination Manual September 1997 Page 3 2003.1 Rating System for U.S. Branches and Agencies of Foreign Banking Organizations

While the branch may have residual risk-related based on the expectation that branches should weaknesses, these problems have been recog- have an independent internal audit function nized and are being addressed by the branch and/or an adequate system of head office or and/or head office. Any such weaknesses will external audits as well as a system of internal not have a material adverse affect on the branch. controls consistent with the size and complexity Generally, risks are being controlled in a manner of their operations. In this regard, internal audit that does not require additional or more than and control procedures should ensure that normal supervisory attention. operations are conducted in accordance with internal guidelines and regulatory policies and A rating of 3 signifies a risk management that all reports and analyses provided to the head system that is lacking in some important mea- office and branch senior management are timely sures. Its effectiveness in dealing with the and accurate. branch’s level of risk exposures is cause for The rating of operational controls should more than normal supervisory attention, and include the following. deterioration in financial performance indicators is probable. Current risk-related procedures are • The adequacy of controls and the level of considered fair, existing problems are not being adherence to existing procedures and systems. satisfactorily addressed, or risks are not being (These are separate but related factors.) adequately identified and controlled. While these • The frequency, scope, and adequacy of the deficiencies may not have caused significant branch’s internal and external audit function, problems yet, there are clear indications that the relative to the size and risk profile of the branch is vulnerable to risk-related deterioration. branch, and the independence of the internal audit function from line management. A rating of 4 represents a marginal risk • The number and severity of internal control management system that generally fails to iden- and audit exceptions. tify and control significant risk exposures in • Whether internal control and audit exceptions many important respects. Generally, such a situ- are effectively tracked and resolved in a timely ation reflects a lack of adequate guidance and manner. supervision by head office management. As a • The adequacy and accuracy of management result, deterioration in overall performance is information reports. This assessment should imminent or is already evident in the branch’s be based primarily on whether reports and overall performance since the previous exami- analyses are sufficient to properly inform head nation. Failure of management to correct risk office management of the branch’s condition management deficiencies that have created sig- on a timely basis, and whether there are nificant problems in the past warrants close sufficient procedures to ensure the accuracy of supervisory attention. those reports. • Whether the system of controls is regularly A branch rated 5 has critical performance reviewed to keep pace with changes in problems that are due to the absence of an the branch’s business plan and laws and effective risk management system in almost regulations. every respect. Not only are there a large volume of problem risk exposures, the problems are also A branch that is rated 1 has a fully compre- intensifying. Management has not demonstrated hensive system of operational controls that pro- the capability to stabilize the branch’s situation. tects against losses from transactional and If corrective actions are not taken immediately, operational risks and ensures accurate financial the operations of the branch are severely reporting. Branch operations are fully consistent endangered. with sound market practices. The branch also has a well-defined and independent audit function that is appropriate to the size and risk profile of the branch. No supervisory concerns Operational Controls are evident.

This component assesses the effectiveness of the A rating of 2 may indicate some minor branch’s operational controls, including account- weaknesses, such as the presence of new busi- ing and ﬁnancial controls. The assessment is ness activities where some modest control deﬁ-

September 1997 Branch and Agency Examination Manual Page 4 Rating System for U.S. Branches and Agencies of Foreign Banking Organizations 2003.1 ciencies exist, but which management is address- to other U.S. offices of the FBO. SR 96-27 ing. Some recommendations may be noted. provides additional guidance regarding these Overall, the system of controls, including the special audits. audit function, is considered satisfactory and effective in maintaining a safe and sound branch operation. Only routine supervisory attention is Compliance required. In addition to maintaining an effective system of A rating of 3 indicates that the branch’s operational controls, branches should also dem- system of controls, including the quality of the onstrate compliance with all applicable state and audit function, is lacking in some important federal laws and regulations, including reporting respects, particularly as indicated by continued and special supervisory requirements. To the control exceptions and/or substantial deficien- extent possible given the size, risk profile and cies in or failure to adhere to written policies organizational structure of the branch, these and procedures. As a result, more than normal responsibilities should be vested in a branch supervisory attention is required. official or compliance officer whose function is separate from line management. Branch man- A branch that is rated 4 signifies that the agement should also ensure that all appropriate system of operational controls has serious defi- personnel are properly trained in meeting regu- ciencies that require substantial improvement. latory requirements on an ongoing basis. The In such a case, the branch may lack control scope of the branch’s audit function also should functions, including those related to the audit ensure that the branch is meeting all applicable function, that meet minimal expectations; there- regulatory requirements. fore, adherence to bank and regulatory policy is Accordingly, the branch’s level of compli- questionable. Head office management has failed ance should be rated based on the following to give the branch proper support to maintain factors. operations in accordance with U.S. norms. Close supervisory attention is required. • The level of adherence to applicable state and federal laws and regulations and any supervi- A branch that is rated 5 lacks a system of sory follow-up actions. operational controls to such a degree that its • The effectiveness of (i) written compliance operations are in serious jeopardy. The branch procedures and (ii) training of line personnel either lacks or has a wholly deficient audit charged with maintaining compliance with function. Immediate substantial improvement is regulatory requirements. required by branch and head office management, • Management’s ability to submit required regu- along with strong supervisory attention. latory reports in a timely and accurate manner. • Management’s ability to identify and correct Special audit procedures are required when compliance issues. both the O component and the composite rating • Whether the internal audit function checks for are 3 or worse. If both the O component and the compliance with applicable state and federal composite rating are 3, the special audit proce- laws and regulations. dures may be performed by the internal audit function if, and only if, the audit function is A branch accorded a rating of 1 demonstrates considered satisfactory. If the internal audit an outstanding level of compliance with appli- function is less than satisfactory, or if both the O cable laws, regulations, and reporting require- component and composite rating are 4 or worse, ments. No supervisory concerns are evident. then an external audit is required. An external audit also is required if the internal auditors had A rating of 2 indicates that compliance is performed the special audit procedures follow- generally effective with respect to most factors. ing the previous examination, and the O and Compliance monitoring and related training pro- composite ratings are again assigned a 3 rating. grams are sufficient to prevent significant prob- As significant internal control weaknesses in the lems. Minor reporting errors may be present, but operations of one office may be an indication of they are being adequately addressed by branch systemic weaknesses in other branches as well, management. Only normal supervisory attention the special audit procedures may be applied is warranted.

Branch and Agency Examination Manual September 1997 Page 5 2003.1 Rating System for U.S. Branches and Agencies of Foreign Banking Organizations

A branch that is rated 3 has deficiencies in ability of a branch to honor its liabilities ulti- management and training systems that result in mately is based upon the condition and level of an atmosphere where significant compliance support from the FBO, a concept that is integral problems could and do occur. Such deficiencies to the FBO supervision program. could include a lack of written compliance This concept states that if the condition of the procedures, no system for identifying possible FBO is satisfactory, the FBO is presumed to be compliance issues, or a substantial number of able to support the branch with sufficient minor or repeat violations or deficiencies. More resources on a consolidated basis. As a result, than normal supervisory attention is warranted. the assessment of asset quality in such circumstances would not in and of itself be a predomi- A rating of 4 indicates that compliance mat- nant factor in the branch’s overall assessment, if ters are not given proper attention by branch and existing risk management techniques are satis- head office management and close supervisory factory. If, however, support from the FBO is attention is warranted. The lack of an effective questionable, the evaluation of asset quality compliance program, including an ongoing train- should be carefully considered in determining ing program, may be evident along with a failure whether supervisory actions are needed to to meet significant regulatory requirements improve the branch’s ability to meet its obliga- and/or significant, widespread inaccuracies in tions on a stand-alone basis. In cases where a regulatory reports. branch is subject to asset maintenance, it is expected that asset quality issues will be A rating of 5 would signal that attention to addressed by disqualifying classified assets as compliance matters is wholly lacking at the eligible assets. branch to the extent that immediate supervisory The quality of the branch’s stock of assets is attention is warranted. evaluated based on the following factors. Gen- erally, credit administration concerns should be addressed in rating risk management. Asset Quality • The level, distribution, and severity of asset Generally, asset quality is evaluated to deter- and off-balance-sheet exposures classified for mine whether a financial entity has sufficient credit and transfer risk.5 capital to absorb prospective losses and, ulti- • The level and composition of nonaccrual and mately, whether it can maintain its viability as reduced rate assets. an ongoing entity. The evaluation of asset quality in a branch does not have the same result A branch rated 1 has strong asset quality. because a branch is not a separately capitalized A branch rated 2 has satisfactory asset quality. entity. Instead, a branch relies on the financial A branch rated 3 has fair asset quality. and managerial support of the FBO as a whole. A branch rated 4 has marginal asset quality. Nonetheless, the evaluation of asset quality is important both in assessing the effectiveness of A branch rated 5 has unsatisfactory asset quality. credit risk management and in the event of a possible liquidation of a branch. However, as indicated above, a branch is not strictly limited 5. The various state and federal agencies may differ in terms of specific practices and methodologies used to imple- by its own internal and external funding sources ment the above guidelines. For further guidance in this area, in meeting solvency and liquidity needs. The examiners should consult with their respective agencies.

September 1997 Branch and Agency Examination Manual Page 6 Risk-Focused Approach to Pre-Examination Planning Effective date July 1997 Section 2010.1

Risk-focused examinations emphasize effective RISK ASSESSMENT planning and scoping in order to customize examinations to the size and activities of the In order to focus procedures on the areas of institution and to concentrate examiner resources greatest risk to the branch, a risk assessment on areas that expose the institution to the great- should be performed in advance of the on-site est degree of risk. In addition, under a risk- work. The risk assessment process highlights focused approach, the resources directed to both the strengths and the vulnerabilities of the assessing an organization’s management are institution and provides a foundation from which generally increased, while the degree of trans- to determine the procedures to be conducted action testing may be reduced in order to mini- during an examination. Risk assessments entail mize the regulatory burden. the identification of the financial activities in Transaction testing includes the reconciliation which a banking organization has chosen to of internal accounting records to financial reports engage, the determination of the types and (in order to evaluate the accuracy of account quantities of risk, and the consideration of the balances), the comparison of day-to-day prac- quality of the management and control of these tices to the office’s policies and procedures (in risks. At the conclusion of the risk assessment order to assess compliance with internal sys- process, a preliminary supervisory strategy for tems), and all other supervisory testing proce- the institution and each of its major activities dures, such as the review of the quality of can be formulated. Those activities that are most individual loans and investments. Risk-focused significant to the organization’s risk profile or examinations still require an appropriate level of that have inadequate risk management processes transaction testing to verify (1) the adequacy of, or rudimentary internal controls represent the and adherence to, internal policies, procedures, highest risks to the institution and should undergo and limits; (2) the accuracy and completeness of the most rigorous scrutiny and testing. management reports and financial records; and (3) the adequacy and reliability of internal Identifying the significant activities of an control systems. However, under a risk-focused institution is the first step in the risk assessment examination approach, the degree of transaction process. These activities may be identified testing should be reduced when internal risk through the review of prior examination and management processes are determined to be inspection reports and workpapers, surveillance adequate or risks considered minimal. and monitoring reports generated by the Board Generally, advance notification of an exami- and Reserve Bank staff, regulatory reports, and nation is given to enable branch management to other relevant supervisory material. Once sig- have the necessary information available for nificant activities have been identified, the types examiners when they arrive on-site. This prac- and quantities of risks to which these activities tice results in significant savings in time and expose the institution should be determined. personnel resources. However, surprise or non- This allows identification of the high risk areas routine examinations may be conducted at any that should be emphasized during the examina- time at the examining agency’s discretion. tion. The types of risk which may be encountered individually or in various combinations are credit, market, liquidity, operational, legal, or reputational. These risk types are discussed PURPOSE OF PRE-EXAMINATION further in Section 3000.1 of this manual. PREPARATION The quantity of risk can be determined by a number of factors. For example, in order to Pre-examination planning results in more effec- assess the quantity of credit risk in loans and tive examinations that are focused on risks commitments, the level of past due loans, inter- particular to the specific institution and thus nally classified or watch list loans, nonperform- minimizes regulatory burden. Further, such plan- ing loans, and concentrations of credit to par- ning facilitates close coordination with other ticular industries or regions should be considered. state and Federal banking agencies and allows In addition, the examiner should consider the information requests to be better tailored to the trends in special mention and classified loans specific institutions. and historic chargeoff levels.

Branch and Agency Examination Manual September 1997 Page 1 2010.1 Risk-Focused Approach to Pre-Examination Planning

Once the types and quantities of risk in each GENERAL GUIDELINES FOR activity have been identified, a preliminary PRE-EXAMINATION assessment of the process in place to identify, PREPARATION measure, monitor, and control these risks should be completed. Sound risk management will vary Because the primary purpose of the pre- from branch to branch, but generally include examination preparation is to determine exami- four basic elements. These are: (1) active senior nation objectives and scope, only general guide- management oversight, (2) adequate policies, lines for the procedures to be performed can be procedures, and limits, (3) adequate risk mea- given. Accordingly, the procedures that follow surement, monitoring, and management infor- may be modified to fit the specific circumstances mation systems, and (4) comprehensive internal encountered. General guidelines for pre- audits and controls. examination preparation include: Ordinarily the pre-examination preparation is performed by the examiner-in-charge or desig- • Reviewing the examination strategy/annual nee and one or more assistants. Time require- examination plan developed by the appropri- ments for this preparation may vary consider- ate supervisory authorities. ably depending upon the size, complexity, and • Reviewing examination manuals, programs, condition of the branch being examined. The and regulatory letters applicable to the exami- timing should allow overall scheduling effi- nation. ciency and should consider such factors as the • Reviewing all other available analyses pre- number and experience of participating person- pared by the coordinating Reserve Bank and nel, geographic location of the branch, and the other supervisory agencies. results of previous examinations. Scheduling • Reviewing all available regulatory reports, factors may result in the pre-examination prepa- including the Report of Assets and Liabilities ration being performed from many weeks before of U.S. Branches and Agencies of Foreign the start of the examination to the week imme- Banks (FFIEC 002) and the Country Exposure diately preceding the examination. Report (FFIEC 019). • Reviewing the branch’s strategic or business plan, if available. This plan, provided by the ASSIGNMENT AND SUPERVISION branch, can be useful in examination plan- OF PERSONNEL ning, as it may indicate new or discontinued services that could affect the scope and direc- Early review allows the examiner-in-charge the tion of the examination. The plan can also greatest flexibility in determining the number of serve as a reference between examinations. examining personnel needed and any special The plan usually contains goals and prospects expertise required. for the branch over the next business period, The examiner-in-charge must be able to pri- indicating target markets and the expected oritize critical categories of the examination and level of profitability and other performance determine the optimum timing of simultaneous standards to be achieved. activities. Budgeting and allocating human • Reviewing the following list of branch ser- resources should include the following vices and products to determine their impor- considerations: tance to the examination: — Deposit services: checking, automatic • Assignment of examiners based on their skills/ funds transfer, telephone transfer; expertise and examination objectives. — Credit services: commercial loans, over- • Assignment of priorities to avoid duplication draft banking, installment loans, mortgage of effort and ensure timely completion of the lending, letters of credit, bills discounted; examination. — EDP services; • Coordination with other regulatory agencies — Securities trading and off-balance sheet that may be conducting a joint, concurrent, or activities, including foreign exchange; related office examination. — Fiduciary activities; and • Assignment of examining personnel in a man- — Private banking. ner to maintain an even workload throughout • Reviewing all related examination and visita- the examination. tion reports, correspondence, enforcement

September 1997 Branch and Agency Examination Manual Page 2 Risk-Focused Approach to Pre-Examination Planning 2010.1

actions, minutes, and memoranda of in the near-term. Arrangements should be made significance. with branch personnel as to the level of their • Coordinating with other pertinent regulatory assistance required during the examination. agencies or units, particularly in the case of Discussions should be held with any examin- special examinations resulting from novel or ers offering specialized assistance during the unusual situations. Determining which related examination, for example, consumer affairs, organizations are to be examined and the EDP, or audit, to determine the scope of their extent of the procedures to be performed. review and the inclusion of those results within • Completing personnel assignments and coor- the context of the overall examination report, if dinating with assisting personnel regarding so planned. any preliminary procedures that are to be At this point in time, the scope of the exami- performed. nation should be developed so as to facilitate the • Determining the cut-off line or the appropriate development of a First Day Letter applicable to statistical sampling technique to be used for the branch being examined. performing risk asset review. Note any unusual considerations that may affect the establishment of the factors. • Reviewing and customizing the First Day Letter before presentation to branch manage- PREPARATION OF A SCOPE ment; early presentation permits timely comple- MEMORANDUM tion of bank-prepared information. Once the examination planning and risk assess- Upon completion of the pre-examination ment processes are completed, a scope memo- preparation, the scope of the examination should randum should be prepared. A scope memoran- be established and a planning memorandum dum provides a detailed summary of the should be developed. Accomplishing the fore- supervisory strategy for an institution and assigns going tasks before starting the examination will specific responsibilities to examination team provide for an efficient examination, consistent members. A scope memorandum should be with established objectives. tailored to the size and complexity of the institution, should define the objectives of each examination, and generally should include:

DETERMINING THE SCOPE OF • Name and location of entity to be examined. THE EXAMINATION • Results of previous examination. • Objectives of the examination. Full-scope examinations under a risk-focused • Identification of the risks to be assessed. approach are not comprised of a fixed set of • Scope of the examination/nature and depth of routine procedures. Rather, the procedures that coverage. must be performed to fulfill the objectives of a • An overview of the branch’s management full-scope examination must be adjusted depend- structure. ing on the circumstances of the institution being evaluated. At a minimum, however, full-scope • Summary of the branch’s activities. examinations should include sufficient proce- • Summary of earnings and other performance dures to reach an informed judgement on the information to date. risk management, operational, and compliance • Summary of the structure and business factors rated under ROCA. strategy/plan of the branch. If necessary, the examiner-in-charge should • Balance sheet and contingency/memoranda meet with the principal branch officers before items. the start of the examination to determine the • Administrative issues. breadth of their individual responsibilities. The examiner-in-charge should determine at this • Allocation of assigned personnel resources. meeting whether any important developments • Business components and support functions. have occurred since the previous examination or • Workpaper and report of examination if any planned or probable events are expected requirements.

Branch and Agency Examination Manual September 1997 Page 3 2010.1 Risk-Focused Approach to Pre-Examination Planning

DEVELOPING THE FIRST DAY requested and how to avoid duplication of effort LETTER through the use of information that may already be generated by the branch’s own management Once the scope memorandum is completed, the information systems. examiner-in-charge can develop the First Day The examiner-in-charge must ensure that Letter, which should be delivered to branch branch personnel are fully aware of how the management in a timely manner, before the start information is to be prepared, when the infor- of the examination. Upon presentation of the mation is required, and the need for accuracy First Day Letter, the examiner should ensure and completeness. that management understands what is being

September 1997 Branch and Agency Examination Manual Page 4 Loan Sampling Effective date July 1997 Section 2020.1

A risk-focused review of a loan portfolio is one and evaluation of samples by employing the of the most important elements of an examina- concepts of probability. Use of these concepts tion. Credit reviews are an examiner’s primary eliminates (or at least minimizes) biases by means for evaluating the effectiveness of inter- satisfying a condition that each item in the nal loan review and credit-grading systems, population must have an equal or otherwise determining that credit is being extended in determinable probability of being included in compliance with internal policies and credit the examined portion. By satisfying that condi- standards, ascertaining a branch’s compliance tion, statistical sampling provides the examiner with applicable laws and regulations, and judg- with a quantitative measure of risk that can be ing the safety and soundness of the branch’s controlled at a level that is tolerable to the lending and credit administration functions. examiner. Statistical sampling techniques may Examiners must select for review a sample of be implemented only in those branches that loans1 that is sufficient in size and scope to were found to be in financially sound condition enable them to reach reliable conclusions about at the latest examination and only in those the branch’s overall lending function. The spe- branches where it is determined that the systems cific details of selecting the sample is subject to and controls are appropriate for implementing the examiners’s discretion, based on the level of such techniques. Moreover, if during the exami- risk perceived at the institution. nation where statistical sampling is being used, Sampling enables the examiner to draw con- the examiner determines that the sample results clusions regarding the condition of the entire are unsatisfactory or the condition of the branch loan portfolio and selected off-balance-sheet has deteriorated since the previous examination, items by reviewing only a selected portion of the traditional judgmental sampling technique outstanding credit facilities. Thus, such tech- must be implemented. niques economize on the use of examination The following is a description of the two resources and allow examiners to devote more recommended statistical sampling techniques: of their time and efforts to other areas of examination interest. Generally, a judgmental sampling technique is used for reviewing credit facilities. This ATTRIBUTE SAMPLING technique enables examiners to evaluate the portfolio by reviewing a desired percentage of The objective of attribute sampling is to use a all loans and appropriate off-balance-sheet items sample, within specified reliability limits, to over preselected cut-off amounts. In addition to determine the validity of the branch’s internal the judgmental sampling approach, statistical credit review program. The reliability limits are sampling techniques can also be valid methods determined by the examiner who formulates a for evaluating credit portfolios. Two statistical hypothesis about the branch’s credit review sampling techniques that may be selectively program when evaluating its policies, practices, implemented during on-site examinations are and procedures with regard to extensions of attribute sampling and proportional sampling. credit. The sample population consists of all Attribute sampling is used in certain branches loans and appropriate off-balance-sheet items that have formal loan review programs; propor- between certain dollar parameters, except for tional sampling is used in branches without such credit facilities reviewed under the Shared internal credit review programs. National Credit Program and facilities to iden- In statistical sampling, the examiner applies tified problem industries, which are reviewed sampling techniques to the design, selection, separately during the examination. The lower dollar parameter is an amount that the examiner deems sufficient to achieve the desired coverage 1. For the purposes of this section, the term "loans" includes all sources of credit exposure arising from loans and of the portfolio and is selected in much the same leases including interbank placements, investment securities, manner as a cut-off line is chosen in judgmental and banker’s acceptances. This exposure also includes credit- sampling. The upper dollar parameter is an related off-balance-sheet items such as standby letters of amount over which all credit facilities must be credit, loan commitments, and risk participations in acceptances. Credit exposures arising from trading and derivatives reviewed because of the significant effect each activities are not generally included. could have on the branch’s condition. Credit

Branch and Agency Examination Manual September 1997 Page 1 2020.1 Loan Sampling facilities are selected from the sample popula- technique is to determine whether management tion by using a random digit table. can identify all the criticizable credit facilities in When the selected credit facilities are reviewed, its portfolio. In proportional sampling, every the examiner compares the findings with those credit in the sample population is given an equal of the branch’s credit review program. An error chance of selection proportionate to its size; exists if the examiner’s criticism of a particular therefore, the larger the credit, the more likely it credit is significantly more severe than the will be selected for review. branch’s findings. If the error rate in the sample As in attribute sampling, the examiner speci- is beyond the reliability limits that the examiner fies the desired precision of the sample, i.e., that is willing to accept, all credit facilities over the the true error rate in the branch’s problem credit appropriate cut-off line will be reviewed. If the list should be contained within a certain range of examiner is satisfied with the sample results, the values. As a control measure, sample precision branch’s internal classifications may be accepted is set to represent a specified percentage of the for all criticized loans within the sample popu- branch’s net assets. A statistical error occurs lation. Even when the branch’s classifications whenever the examiner criticizes a credit not are deemed acceptable by the examiner, any previously identified by the branch. If the error loans reviewed and found to be in error will be rate is higher than expected, the examiner may appropriately classified in the report. review all credit facilities over selected cut-off lines, which are determined by using the same criteria used for line selection in judgmental PROPORTIONAL SAMPLING sampling. If the sample results indicate an error rate within expectations, then the examiner may Generally speaking, the procedures for propor- accept the branch’s problem credit list as being tional sampling are similar to those followed for representative of the quality of the population of attribute sampling. The examiner formulates a credits from which the sample was taken. The hypothesis about the quality of the examined examiner will then review each credit on the branch’s credit administration based upon an problem list over the selected cut-off lines to analysis of its loan policies, practices, and pro- determine the amounts that should be classified. cedures with regard to extensions of credit. For detailed procedures on how to implement Additionally, the branch is asked to provide a both attribute and proportional sampling tech- problem credit list, without grading the credit niques, examiners should contact appropriate facilities. The examiner’s findings are compared regulatory agency staff. to that list. The objective of this sampling

September 1997 Branch and Agency Examination Manual Page 2 Workpapers Effective date July 1997 Section 2030.1

The primary goal of workpapers is to strengthen WORKPAPER DOCUMENTATION the examination process by providing a clear recounting of the many tasks performed during an examination. Workpapers, their purpose, their Each individual workpaper should include a quality, and organization are important to the workpaper coversheet, scope, and conclusion. supervisory process because the workpapers support the information and conclusions contained in the related report of examination. Workpaper Coversheet—A workpaper cover- Accordingly, they could include, but are not sheet should provide the following information: necessarily limited to: risk-focused scope memorandum (as discussed in section 2010), exami- • Office name and location; nation procedures and verifications, memo- • Workpaper title; randa, schedules, questionnaires, checklists, • Examination date and work performance date; abstracts of branch documents, analyses prepared or obtained by examiners, and a summary • Initials of preparer and initials of the assigned memorandum for each component. To this end, reviewer; the workpapers should achieve the following • Name and title of person or description of objectives: records that provided the information for the workpaper; and • Organize the material assembled during an • An index number identifying the workpaper examination to facilitate review and future and facilitating organization of the workpaper reference; files. • Aid the examiner in efficiently conducting the examination; • Document the policies, practices, procedures, Scope—This should address the activities per- and internal controls of the branch; formed in order to examine the particular area, including the nature, timing, and extent of test- • Provide written support of the examination ing in the application of examination and audit procedures performed during the examination; procedures as well as the examiner’s evaluation • Indicate why certain steps or procedures were of and reliance on internal and external audit eliminated or deemed unnecessary; procedures and compliance testing of internal • Document the results of testing and formalize controls. To the extent that this information is the examiner’s conclusions; and, contained in other workpapers, such as the risk-focused scope memorandum, a reference to • Substantiate the assertions of fact or opinion the appropriate workpaper will be sufficient. contained in the report of examination. Because of the risk-focused nature of examinations, an explanation should be provided in the They also are useful as: scope section of the workpapers explaining why the particular scope was chosen for a specific • A tool for the examiner-in-charge to use in area or function. The workpapers also should planning, directing, and coordinating the work contain an explanation as to why certain steps or of the other examiners; examination procedures were eliminated or • A means of evaluating the quality of the work deemed unnecessary. This information is neces- performed; sary in order to ensure that an effective audit • A confirmation that the work recommended trail is documented in the workpapers detailing by the annual examination plan was per- the reasons for the scope chosen. formed as specified; • A guide in estimating future personnel and Conclusion—This summarizes the findings both time requirements; and positive and negative, and lists any recommen- • A record of the procedures used by the branch dations made by examiners. Each workpaper to assemble data for reports to supervisory summary is consolidated into the applicable authorities. component(s) rating conclusion memorandum.

Branch and Agency Examination Manual September 1997 Page 1 2030.1 Workpapers

ORGANIZATION OF reached, and explanations of symbols used WORKPAPERS should be free from ambiguity or obscurity. In addition, examining personnel should be To promote efficiency and help ensure that all instructed on workpaper standards and content applicable areas of an examination have been to ensure that they will meet the quality stan- considered and documented, examiners should dards of the regulatory agencies. When workpa- use an indexing system to organize workpaper pers have the necessary qualities of complete- files. A general outline or index of all examina- ness, clarity, conciseness, and neatness, a tion areas provides a basis for organization to qualified reviewer may easily determine their which a numbering or other sequential system relative value in support of conclusions and can be assigned and applied to each workpaper objectives reached. Incomplete, unclear, or vague file. workpapers may lead a reviewer to the conclu- When all workpapers pertinent to a specific sion that the examination has not been adequately area of the examination have been completed, performed. the workpapers should be indexed and filed by each rating component. A component rating conclusion memorandum is then prepared for each of the ROCA components. This memoran- REVIEW PROCEDURES dum should include a list of workpapers com- Experienced personnel must review all workpa- pleted, a summary of findings and conclusions, a pers prepared during an examination. Usually, recommended rating for the component, and any that review is performed by the examiner-in- required corrective action to be recommended in charge, although in some cases, the examiner- the report. in-charge may designate other experienced personnel to perform the review. The primary purposes of a review of workpapers by senior CONTROL AND REVIEW personnel are to determine that the work is adequate, given the circumstances, and to ensure All examiners assigned to an examination should that the record is sufficient to support the con- ensure that workpapers are controlled at all clusions reached in the report of examination. times while the examination is in progress. For The timely review and discussion of workpapers example, when in the branch’s offices, the work- with the individual who prepared them is one papers should be secured at night and safe- of the more effective on-the-job training guarded during the lunch hour or at other times procedures. when no examining personnel are present in the Normally, the review should be performed as immediate vicinity. It is essential to completely soon as practicable after the completion of each control confidential information provided by the assignment. This review ideally occurs at the branch. In addition, information relating to the branch’s office, so that, if additional information extent of tests and similar details of examination or work is required, the matter can be promptly procedures should not be made available to attended to with a minimum loss of efficiency. branch employees. When the review of workpapers is completed, In cases where customary workpaper proce- the reviewer should sign or initial the applicable dures are not practical, alternative procedures documents. Although all workpapers should be and the extent to which they are applied should reviewed, the depth and degree of review be documented. The need for completeness depends on factors such as: requires that there be no open items, unfinished operations, or unanswered questions in the work- • The nature of the work and its relative impor- papers at the conclusion of the examination. tance to the overall examination objectives. The clarity of workpapers should be such that • The extent to which the reviewer has been an examiner or examining official unfamiliar associated with the area during the examination. with the work could readily understand them. • The experience of the examiners who have Commentaries should be legible, concise, and carried out the various operations. support the examiner’s conclusions. Descrip- tions of work completed, notations of confer- Examiner judgment must be exercised through- ences with branch management, conclusions out the review process.

September 1997 Branch and Agency Examination Manual Page 2 Workpapers 2030.1

WORKPAPER RETENTION

Examiners should consult with their respective agency for further guidance on workpaper retention guidelines.

Branch and Agency Examination Manual September 1997 Page 3 Supervisory Follow-up Actions Effective date July 1997 Section 2040.1

Supervisory follow-up actions are implemented nature, do warrant some type of remedial action to ensure that appropriate corrective actions are undertaking with the foreign banking organiza- taken in a timely manner to resolve any super- tion. Such concerns may be isolated in one visory concerns that exist with respect to a branch or may be evident in other branches of branch. Generally, supervisory action is initiated the foreign banking organization. In either case, based upon the results of an on-site examina- the action is entered into with the foreign tion. Action may be initiated, however, in banking organization and the affected U.S. response to concerns developed through various branch or branches; it involves a mutually agreed supervisory monitoring programs or through the upon understanding between the foreign bank- review of other available information. ing organization and the supervisory agency or Because branches are subject to supervision agencies. The action generally lists and describes by their federal or state licensing authority, how specific objectives are to be achieved, branches may be subject to supervisory follow-up including timeframes for achieving those actions by all of these supervisory authorities. In objectives. most cases, however, if concerns are limited to Informal enforcement actions that may be one branch of the foreign banking organization, utilized for branches include the Commitment supervisory follow-up action will be the respon- Letter and the Memorandum of Understanding. sibility of the examining agency or agencies. If A Commitment Letter is a document that problems are apparent in other branches of the contains specific written commitments to take foreign banking organization, the various super- corrective action in response to problems or visory authorities will coordinate the develop- concerns identified by the supervisory agency or ment of the supervisory action plan for the agencies. A Commitment Letter is not a binding institution. legal document; however, failure to meet the commitments in the letter will provide strong evidence of the need for more formal supervisory action. INFORMAL AND FORMAL A Memorandum of Understanding is a more SUPERVISORY ACTIONS formally designed action, though still not a binding legal document, that incorporates even As a general rule, informal and formal supervi- greater specificity concerning the measures being sory action should be considered when normal taken to resolve problems than found in a follow-up procedures and other more routine Commitment Letter. A Memorandum of Under- measures, such as formal discussions with a standing suggests a higher level of supervisory branch’s local or head office management, have concern over that of a Commitment Letter. It failed to resolve supervisory concerns. This generally must be signed by senior officials from practice is consistent with the treatment of the head office. domestic banking organizations and is based on Formal supervisory actions are appropriate in the expectation that all banking institutions instances where supervisory concerns have risen operating in the United States are expected to to a level where stronger or more immediate operate in a safe and sound manner and in action is necessary to ensure that corrective compliance with applicable U.S. laws and regu- actions are taken and fully implemented. These lations. Accordingly, when supervisory con- actions are authorized by statute and noncom- cerns are identified, corrective action should be pliance has a legal liability, i.e. violators can be initiated by branch or head office management subject to additional enforcement actions, such as soon as possible. In this regard, examiners as the assessment of civil money penalties. should communicate to the management of the Formal enforcement actions include the Cease branch throughout the course of the examination and Desist Order, including a Temporary (Emer- and at its close, both the problems identified and gency) Cease and Desist Order, and the Written the actions recommended to correct those Agreement. Cease and desist action may be problems. initiated when there is a finding that an offender Generally, an informal supervisory action is is engaging, has engaged, or may engage in an appropriate when supervisory concerns have unsafe or unsound practice in conducting the been identified that, while not overly serious in business of the institution. An action may also

Branch and Agency Examination Manual September 1997 Page 1 2040.1 Supervisory Follow-up Actions be deemed necessary due to a finding that the In determining the appropriateness of initiat- offender is violating, has violated, or may vio- ing a civil money penalty assessment proceed- late a law, rule, or regulation, or any condition ing, the federal banking agencies may use a imposed in writing, for example, by the Board variety of relevant factors. For example, in of Governors in connection with the granting of assessing a civil money penalty, the Board of any application or written agreement. Governors is required to consider the size of the In the event that a violation of law, rule, or financial resources and good faith of the respon- regulation, or the undertaking of an unsafe or dent, the gravity of the violation, the history of unsound practice meets certain criteria, a tem- previous violations and such other matters as porary (emergency) cease and desist order may justice may require. (See FRRS, Section 3-1605.) be issued. This order may also be issued if it is Other regulatory agencies have their own guide- determined that the institution’s books and lines. (See, for example, OCC Policy and Pro- records are incomplete or that the institution’s cedures Manual.) financial condition or the details or purpose of Depending upon the regulatory agency in- any transaction cannot be determined through volved, examiners may be responsible for the the normal supervisory process. The temporary initial analyses of potential civil money penal- order may require the same corrections as an ties. Civil money penalties may be proposed for order issued either on consent or after the full serious violations and for violations that, because administrative process. Its advantage is that it is of their frequency or recurring nature, show a effective immediately upon service on the entity general disregard for the law. After the examiner or individual. A hearing must be held within has reviewed the facts and decided to recom- 30–60 days, during which time the temporary mend a civil money penalty, he or she should order stays in effect. Within 5–10 days of the contact the appropriate federal regulatory agency service of the temporary order, the subject may for advice on proper documentation and any appeal to a U.S. District Court for relief from the other assistance. order. When circumstances warrant a less severe form of formal supervisory action, a formal ASSET MAINTENANCE written agreement may be used. Other enforcement tools that are applicable to branches include In cases where there is doubt concerning the the imposition of civil money penalties, prohi- ability of a foreign banking organization to bition orders, and possibly termination. continue to serve as a source of strength to its U.S. branch(es), supervisory action may have to be taken to safeguard the U.S. branch(es) and ensure that it can honor its liabilities to third parties. Under these circumstances, an asset CIVIL MONEY PENALTIES maintenance requirement1 of at least 105 percent material may be imposed on the individual Under provisions of the Financial Institutions branch. Regulatory and Interest Rate Control Act of Other actions that may be taken to address 1978 (FICA) (Pub. L. 95-630), the appropriate concerns of this nature regarding the foreign federal banking agency is authorized to assess banking organization include: asset pledge civil money penalties for violations of any law requirements, increased capital equivalency or regulation or for violation of the terms of any deposits, restrictions on transactions with related written agreement, any final or temporary cease and desist order or any condition imposed in writing by a federal banking agency in connec- 1. Asset maintenance means the maintenance of eligible tion with the granting of any application by the assets in the United States covering a specified percentage of foreign banking organization. Civil money pen- third party liabilities of a branch. In general, eligible assets are those for which there is a reasonable expectation of liquida- alties may also be imposed, in certain cases, for tion on a timely basis. When under an asset maintenance engaging in unsafe and unsound practices (12 requirement, a branch must maintain a net due to related USC Section 1818). In addition, civil money parties position at all times. Thus, the branch is prevented penalties may be assessed against officers, from providing net funding to other branches or the head office. For more specific information on the examination directors, and other institution-affiliated parties objectives and procedures relating to asset maintenance, refer for violations of any of the above situations. to that section of the manual.

September 1997 Branch and Agency Examination Manual Page 2 Supervisory Follow-up Actions 2040.1 parties, funding limitations, growth limitations, bination of informal or formal supervisory action and voluntary or involuntary termination of the and asset maintenance requirement. branch. When an asset maintenance requirement is In some cases, because of concerns about the deemed necessary, the preferred way to imple- financial condition of the foreign banking orga- ment such a requirement is by action of the nization or circumstances in the home country appropriate licensing agency and the insurer that may adversely affect the foreign banking through any means available, including mutual organization’s U.S. operations, asset mainte- agreement, authorization under state law, or nance may be necessary even when the U.S. formal supervisory action. Asset maintenance operations are in satisfactory condition. When may therefore be imposed regardless of whether the U.S. operations, of a foreign banking orga- it is a specific regulatory tool of the licensing nization are in less than satisfactory condition, authority. When multiple branches are involved, the severity of the problems in those operations, as a general principle, asset maintenance require- combined with the degree of concern over the ments will be defined to be applied in a consis- solvency of the foreign banking organization, tent manner to all of the operations of the will be used to determine the appropriate com- foreign banking organization.

Branch and Agency Examination Manual September 1997 Page 3 Risk Management Introduction Effective date July 1997 Section 3000.1

Taking and managing risks are fundamental to • Operational risk1 which arises from the the business of banking. The U.S. banking potential that inadequate information systems, supervisory agencies place significant emphasis operational problems, breaches in internal con- on the adequacy of an institution’s management trols, fraud, or unforeseen catastrophes will of risk, including the establishment of a man- result in unexpected losses. agement structure that adequately identifies, mea- • Legal risk which arises from the potential that sures, monitors, and controls the risks involved unenforceable contracts, lawsuits, or adverse in its various products and lines of business. In judgments can disrupt or otherwise negatively a branch, which is typically removed from its affect the operations or condition of the branch. head office by location and time zone, an effec- • Reputational risk which is the potential that tive risk management system is critical not only negative publicity regarding a branch or its to manage the scope of its activities but to parent bank will cause a decline in the cus- achieve comprehensive, ongoing oversight by tomer base, costly litigation, or revenue branch and head office management. In the reductions. examination process, examiners will therefore determine the extent to which risk management techniques are adequate (1) to control risk ELEMENTS OF RISK exposures that result from the branch’s activities MANAGEMENT and (2) to ensure adequate oversight by branch and head office management and thereby pro- When rating the quality of risk management at mote a safe and sound banking environment. branches, examiners should place primary con- Principles of sound management should apply sideration on findings relating to the following to the entire spectrum of risks facing a branch elements of a sound risk management system: including, but not limited to, the following: • active senior management oversight at the • Credit risk which arises from the potential that head office, regional management office (if a borrower or counterparty will fail to perform applicable) and local branch levels; on an obligation. • adequate policies, procedures, and limits; and • a strong management information system for • Country/transfer risk which encompasses the measuring, monitoring and reporting risks. entire spectrum of risks arising from the economic, social and political environments Each of these elements is described further of a foreign country which may have potential below, along with a list of considerations rel- consequences for foreigners’ debt and equity evant to assessing the adequacy of each element. investments in that country. More specifically, Examiners should recognize that the consid- transfer risk focuses on a borrower’s capacity erations specified in these guidelines are intended to obtain the foreign exchange required to only to assist in the evaluation of risk manage- service its cross-border debt. ment practices and not as a checklist of require- • Market risk which is the risk to a financial ments for each branch. institution resulting from adverse movements Adequate risk management programs can vary in market rates or prices, such as interest rates, considerably in sophistication, depending on the foreign exchange rates, or equity prices. size and complexity of the FBO and its branch • Liquidity risk which is the potential that a network and the level of risk that it accepts. branch will be unable to meet its obligations Examiners need to ensure that senior managers as they come due because of an inability to liquidate assets or obtain adequate funding 1. While operational, legal and reputational risks are iden- (referred to as ‘‘funding liquidity risk’’) or that tified as part of the branch’s overall risk assessment process, it cannot easily unwind or offset specific the effectiveness of the branch’s operational controls are exposures without significantly lowering mar- included in the ‘‘O’’ component of the ROCA rating system assessment. Further, when legal and reputational risks poten- ket prices because of inadequate market depth tially result in violations of law or regulation, the ‘‘C’’ or market disruptions (‘‘market liquidity risk’’). component would also be impacted.

Branch and Agency Examination Manual September 1997 Page 1 3000.1 Risk Management Introduction at the head office and/or at the regional manage- follows policies and practices such as the ment office are provided with the information following: they need to monitor and direct day-to-day activities of the branch. • Management has identified and clearly The risk management processes of branches understands the types of risks inherent in the would typically contain detailed guidelines that activities of the branch and makes appropriate set specific prudential limits on the principal efforts to remain informed about these risks as types of risks relevant to the FBO’s activities financial markets, risk management practices, worldwide. Reporting systems should comprise and the branch’s activities evolve. Manage- an adequate array of reports that provide the ment periodically reviews risk exposure limits levels of detail about risk exposures that are to ensure they are appropriate considering relevant to the duties and responsibilities of changing circumstances. senior management at the head office and, where • Management has reviewed and approved applicable, the regional management office. appropriate policies to limit risks inherent in The risk management systems will naturally all significant activities of the branch, includ- require independent monitoring and testing in ing lending, investing, trading, private bank- addition to review by internal or external audi- ing, and trust. tors to ensure the integrity of the information • Management is sufficiently familiar with and used by senior officials in overseeing compli- is using adequate recordkeeping and reporting ance with policies and limits. The risk manage- systems to measure and monitor the major ment systems or units of FBOs must also be sources of risk to the branch. sufficiently independent of the business lines in • Management ensures that the branch’s areas order to ensure an adequate separation of duties of activities are managed and staffed by per- and the avoidance of conflicts of interest. sonnel with knowledge and experience consistent with the nature and scope of these activities. • Management ensures that the depth of staff resources is sufficient to operate and manage ACTIVE HEAD OFFICE SENIOR the activities of the branch and that branch MANAGEMENT OVERSIGHT employees have the necessary integrity, ethical values, and competence. As part of its responsibility to provide a com- • Management at all levels provides adequate prehensive system of oversight for the branch, supervision of the day-to-day activities of all the head office has a role in developing and employees, including senior officers. approving a risk management system for the • Management is able to respond to risks that branch. Senior management at the head office, may arise from changes in the competitive regional management office and local branch environment or from innovations in markets levels are responsible for implementing strate- in which the branch is active. gies in a manner that limits risks associated with • Management identifies and reviews all risks each strategy, and that ensures compliance with associated with new activities or products and laws and regulations on both a long-term and ensures that the branch infrastructure and day-to-day basis. Accordingly, branch manage- internal controls in place are adequate to ment should be fully involved in the activities of manage related risks prior to commencing the branch and possess sufficient knowledge of new activities or offering new products. all major business lines to ensure that appropriate policies, controls, and risk monitoring systems are in place and that accountability and lines of authority are clearly delineated. Man- ADEQUATE POLICIES, agement is also responsible for establishing and PROCEDURES AND LIMITS communicating a strong awareness of and need for effective internal controls and high ethical Head office management should tailor risk man- standards. agement policies and procedures to the types of In assessing the quality of the oversight by risks that arise from the activities the branch head office, regional and branch management, conducts. Once the risks are properly identified, examiners should consider whether the branch the branch’s policies and procedures provide

September 1997 Branch and Agency Examination Manual Page 2 Risk Management Introduction 3000.1 detailed guidance for the day-to-day implemen- branch with timely reports on the financial tation of broad business strategies, and generally condition, operating performance, and risk include limits designed to shield the branch exposure of the consolidated organization, as from excessive or imprudent risks. While all well as with regular and sufficiently detailed branches should have policies and procedures reports for line managers to engage in the that address significant activities and risks, the day-to-day management of the branch’s activities. coverage and level of detail in these policies and The sophistication of the risk monitoring and procedures will vary among branches. A smaller, management information systems should be con- less complex branch that has effective manage- sistent with the complexity and diversity of the ment that is actively involved in day-to-day branch’s operations. Accordingly, smaller and operations generally would be expected to have less complicated branches may require only a only basic policies addressing the significant limited set of management reports to support areas of operations and setting forth a limited set risk monitoring activities. These reports include, of requirements and procedures. In a larger for example, daily or weekly balance sheets and branch, where senior management must rely on income statements, a watch list for potentially widely-dispersed staff to implement strategies in troubled loans, a report for past due loans, a an extended range of potentially complex busi- simple interest rate risk report, and similar nesses, far more detailed policies and related items. Larger, more complex branches, however, procedures would generally be expected. In would be expected to have much more compre- either case, management is expected to ensure hensive reporting and monitoring systems that that policies and procedures address the material allow, for example, for more frequent reporting, areas of risk to the FBO and the branch and that tighter monitoring of complex trading activities, they are modified when necessary to respond to and the aggregation of risks on a fully consoli- significant changes in the branch’s activities or dated basis across all business lines and activi- business conditions. ties. Branches of all sizes are expected to have In evaluating the adequacy of a branch’s risk monitoring and management information policies, procedures and limits, examiners should systems in place that provide senior manage- consider whether: ment with a clear understanding of the branch’s positions and risk exposures. • The branch’s policies, procedures and limits In assessing the adequacy of the measurement provide for adequate identification, measure- and monitoring of risk as well as management ment, monitoring and control of the risks reports and information systems at a branch, posed by lending, investing, trading, private examiners should consider whether: banking, trust and other significant activities. • The branch’s policies, procedures and limits • The branch’s risk monitoring practices and are consistent with the experience level, stated reports address all risks. goals and objectives, and overall financial strength of the organization. • Key assumptions, data sources, and proce- • Policies clearly delineate accountability and dures used to measure and monitor risk are lines of authority across the branch’s activities. appropriate, adequately documented and periodically tested. • Reports and other forms of communication are consistent with the activities of the branch, EFFECTIVE RISK MONITORING are structured to monitor exposures and com- AND MANAGEMENT pliance with established limits, goals and INFORMATION SYSTEMS objectives, and, as appropriate, compare expected to actual performance. Effective risk monitoring requires branches to • Reports to head office are accurate and timely identify and measure all risk exposures. Conse- and contain sufficient information for senior quently, risk monitoring activities must be sup- management to identify any adverse trends ported by information systems that provide senior and to evaluate the level of risk assumed by managers at the head office, regional office, and the branch.

Branch and Agency Examination Manual September 1997 Page 3 Credit Risk Management Effective date July 1997 Section 3010.1

CREDIT RISK management. Throughout this manual there is considerable emphasis on the establishment of This section is devoted to credit risks associated formal written policies to guide and manage the with direct lending arrangements. The compre- scope of the branch’s activities within accept- hensiveness of a credit risk management system able risk parameters, and to achieve comprehen- will depend upon the sophistication and types sive, ongoing oversight by branch and head of credit-related activities being conducted by office management. This is perhaps the most the branch. In some circumstances, a branch important element in the branch lending func- may have no independent lending authority and tion. The banking organization, in discharging may simply serve as a booking office for loans its duty to both the depositors and shareholders, approved by the head office. A more active must ensure that loans in the branch portfolio branch may, however, have an independent credit are made in accordance with the following two review department and established lending objectives: authorities. Therefore, credit policies, procedures, and documentation may vary significantly. • To grant loans to creditworthy borrowers for This section will assist the examiner in constructive purposes. performing two separate, but interrelated, • To grant loans that generate income for the procedures: benefit of shareholders and the protection of depositors, and in the case of branches, the • The evaluation of the depth and scope of protection of third parties. formalized policies and procedures used by the branch to manage and control its credit A loan policy will differ from loan proce- risks. dures. Branches need both to adequately address • An overview of the performance of the all areas of lending and loan administration. The branch’s entire lending operations by evaluat- lending policy should contain a general outline ing the results of all lending departments. of the scope of the branch’s credit facilities and the manner in which loans are made, serviced, and collected. The policy should be broad in Branch Credit Administration Policies nature and not overly restrictive. The formula- tion and enforcement of inflexible rules not only stifles initiative but also may hamper profitabil- As part of the analysis of a branch’s loan ity and prevent the branch from serving custom- portfolio, examiners review credit policies, credit ers’ changing needs. A lending policy should administration procedures, and credit risk con- provide for the presentation to the head office or trol procedures. The maintenance of prudent a committee thereof, of loans that credit officers written lending policies, effective internal sys- believe are fundamentally sound and worthy of tems and controls, and thorough loan documen- consideration, even though they may not con- tation is essential to the institution’s manage- form with certain aspects of the branch’s written ment of the lending function. lending policy. Any exceptions to the lending The policies and procedures governing a policy should be approved, documented, moni- branch’s lending activities must be clearly com- tored and reported to head office. Flexibility municated to management and lending staff. must exist to allow for fast reaction and early These policies and procedures must define pru- adaptation to changing conditions in the branch’s dent underwriting standards, credit risk controls, earning assets mix and within its service area. prudent internal limits, and an effective credit review and risk identification process. The com- The written loan policy is the cornerstone for plexity and scope of these policies and proce- sound lending and loan administration. An dures should be appropriate to the size and adequate loan policy serves to promote: nature of the branch’s activities, and should be consistent with prudent banking practices and • Consistency in business and lending philoso- applicable federal and state laws and regulations. phy, despite changes in management. The establishment of a written lending policy • Stability as it provides a reference for lending provides the foundation for sound loan portfolio authorities.

Branch and Agency Examination Manual September 1997 Page 1 3010.1 Credit Risk Management

• Clarity to minimize confusion concerning lend- limit, borrower or industry concentration, the ing guidelines. volatility of funding and the credit risks involved • Objectivity as it provides sound guidelines for must be considered. Additionally, limits on evaluating new business opportunities. aggregate percentages of total loans in commercial, real estate, consumer, or other categories In developing the lending policy, consider- are common. Such policies are beneficial but ation must be given to the branch’s business should allow for deviations with the approval by plan, financial resources, and personnel. Typi- the head office. This allows credit to be distrib- cally, a branch’s lending policy will be used to uted in relation to the changing needs of the describe the branch’s mission statement, e.g., target markets. facilitating trade transactions with the home country and lending to U.S. subsidiaries of home Geographic Limits—A branch’s trade area country corporations. should be clearly delineated and loan officers A lending policy should prohibit discrimina- and senior management should be fully aware of tory practices. However, a policy should identify specific geographic limitations for lending pur- acceptable and unacceptable types of credit and poses. Although many branches will define their establish prudent underwriting standards, includ- trade areas to include a number of states, fre- ing pricing standards. Other internal factors quently, the primary calling efforts are focused addressed include granting credit authority, on a narrower area. Certain types of lending, establishing lending limits, and defining organi- which require significant knowledge of local zational structure. As authority is spread through- market conditions or intensive monitoring of out its offices, the organization must have an branch personnel, should be carefully consid- effective method for monitoring adherence to ered. Examples include commercial loans to established policy. The testing of credit quality large regional companies, loans to finance com- standards can best be accomplished by an inter- mercial real estate projects, or asset based lend- nal loan review and reporting function to the ing that requires regular monitoring of accounts head office, which allows senior head office receivables. In addition, the branch’s defined management to monitor adherence to policies trade area should not be so large that, given its and provides information sufficient to evaluate resources, proper and adequate monitoring and the performance of branch officers and the administration of the branch’s credits cannot be condition of the loan portfolio. The audit func- reasonably determined. tion can also serve to enforce compliance with policies, guidelines, and approved credit administration practices. Concentrations of Credit—The loan policy should recognize the need for diversification of risk and establish some parameters on concentrations of loans to industries, related groups of Components for a Sound Lending borrowers, loans collateralized by a single secu- Policy rity or securities with common characteristics, and loans to borrowers with common character- The lending policy should require diversifica- istics within an industry. tion within the portfolio and provide prudent Examiners should recognize that as a part of a underwriting standards. There are certain com- larger banking entity, individual branches may ponents that form the basis for a sound loan have concentrations that are well within proper policy and should be addressed by every lending diversification in the context of the overall institution. organization. Many branches specialize in terms of the kind of business transacted and the types Aggregate Limits and Distributions by of credits extended. Many credits are trade- Category—In order to limit the total amount of related and often reflect the economic makeup loans outstanding, relationships with other bal- of the branch’s home country. In addition, cred- ance sheet accounts should be established. its at the branch are often booked at the direction Branches usually express controls over the loan of the head office and can reveal concentration portfolio relative to their total claims on nonre- by industry, country, or borrower. Nonetheless, lated parties. In setting such limits, various branches, as part of a sound risk management factors, such as credit demand, legal lending system, must establish procedures for identify-

September 1997 Branch and Agency Examination Manual Page 2 Credit Risk Management 3010.1 ing and monitoring inherent risk resulting from relevant factors, such as commitment fees, are concentrations of credit. also germane to pricing policy. Institutions that have effective controls in place to manage and reduce undue concentra- Documentation and Collateral—Trade financ- tions need not refuse credit to sound borrowers ing often represents a significant amount of the simply because of the borrower’s industry or branch’s lending activity. In such financing, the geographic location. It is important to empha- branch deals only in documents while its cus- size that this principle applies to loan renewals, tomer is responsible for the merchandise under rollovers, and new extensions of credit. the terms of the contract. The branch’s control of documents, especially title documents, is Types of Loans—The lending policy should crucial. There are significant differences between state the types of loans that the branch will make domestic loan agreements and foreign ones. and should set forth guidelines to follow in Nevertheless, the branch must ensure that it is making specific loans. The decision about the adequately protected through loan agreements types of loans to be granted should be based on with foreign borrowers. The loan agreement a consideration of the business plan, expertise of should also protect against adverse changes in the lending officers and support personnel, the foreign tax rules, loan funding problems, and funding structure of the branch, and anticipated additional withholding and other types of taxes. credit demands of the target markets. Credits The branch should have policies for taking involving complex structures or repayment foreign collateral as security for a loan to assure arrangements or loans secured by collateral that adherence with the local required procedures. require more than normal policing should be For example, liens on fixed assets in many avoided unless or until the branch obtains the countries must be registered with the local necessary personnel, policies, controls, and sys- government. tems to properly administer such loans. Types of credits that have resulted in an abnormal loss to Maximum Ratio of Loan Amount to Collateral the branch should be identified, scrutinized, and Value or Acquisition Costs—The branch’s lend- controlled within the framework of stated policy. ing policy should identify where the responsibility for appraisals or internal evaluations lies Repayment Terms and Maximum Maturities— and should define formal, standard appraisal, Loans should be granted with realistic repay- and evaluation procedures, and procedures for ment plans. Maturity scheduling should be possible reappraisals or reevaluations in the case related to the anticipated source of repayment, of renewals or extensions. Acceptable types of the purpose of the loan, and the useful life of the appraisals or evaluations should be listed. The collateral. For term loans, a lending policy policy should also include the limits on the should state the maximum number of months dollar amount and type of real or personal over which loans may be amortized. Specific property that branch personnel are authorized to procedures should be developed for situations appraise. Circumstances regarding the use of requiring balloon payments and modification of in-house appraisers versus a fee appraiser should the original terms of a loan. If the branch be identified. The ratio of loan amount to the requires a cleanup (out-of-debt) period for lines value of the collateral, the method of valuation, of credit, the period should be explicitly stated. and the differences for various types of property should be detailed. Loan Pricing—Rates on various loan types established by the loan policy must be sufficient Financial Information—Extending credit on to cover the costs of the funds loaned, of a safe and sound basis depends on complete and servicing the loan, including general overhead accurate information regarding the borrower’s and of probable losses while providing for a credit standing. One exception is when the loan reasonable margin of profit. Policy makers must is predicated on readily marketable collateral, know those costs before establishing rates that the disposition of which was originally desig- arise out of an effective risk management pro- nated as the source of repayment for the advance. cess. Periodic review allows the rates to be Current and complete financial information is adjusted to reflect changes in costs, competitive necessary not only at the inception of the credit factors, or the risks associated with the type of but also throughout the term of the credit. The extension of credit. Specific guidelines for other lending policy should define the requirements of

Branch and Agency Examination Manual September 1997 Page 3 3010.1 Credit Risk Management

financial statement information for various types from another bank. Direct lending promotes of credit extended by the branch. In addition, the customer relationships, serves the credit needs lending policy should define the requirements of customers, and develops additional business. for financial statements and operating data for In some instances, however, a branch may not businesses and individuals at various borrowing be able to make a loan to a customer for the full levels and should include requirements for amount requested because of prudential lending audited, non-audited, annual, interim, income, limitations or other reasons. In such situations, cash flow and other financial statements, tax the branch may extend credit to its customer for returns, changes in owner’s equity and other the full amount needed and sell or participate supporting notes, schedules, and management out that portion that exceeds the branch’s lend- analyses. Financial statement requirements should ing limit or the amount it wishes to extend on its include external credit checks required at the own. Generally, such sales arrangements are time of periodic updates. The policy should established before the credit is ultimately define the financial requirements in such a approved. These sales should be on a nonre- manner that any credit data exception in an course basis to the branch and the originating examination report should be a clear contraven- and purchasing institutions should share in the tion of the branch’s lending policy. risks and contractual payments on a pro rata Financial statements for foreign borrowers or basis. Selling or participating out portions of guarantors may present additional risks or prob- loans to accommodate the credit needs of cus- lems not associated with domestic borrowers. tomers promotes goodwill and enables a branch Foreign customers’ financial statements may be to retain customers who might otherwise seek prepared in either U.S. dollar equivalents or in credit elsewhere. the borrower’s local currency. Most branches Conversely, many branches purchase loans or analyze the latter statements, particularly if that participations in loans originated by other orga- currency is unstable, therefore figures stated in nizations. The policy should require that loans U.S. dollar equivalent amounts would be dis- purchased from another source be evaluated in torted by the conversion rates used at various the same manner as loans originated by the times. Sometimes, the branch may need to branch itself. Generally, the branch should avoid reconstruct a borrower’s financial statement in concentrations in purchasing loans from any one U.S. dollar equivalents to reflect the borrower’s outside source or concentrations in purchases of financial strength and weaknesses more accu- loans to any one industry. rately. Since the financial information may not Purchasing and selling loans can have a be reliable, the branch’s policies should enable it legitimate role in a branch’s asset and liability to determine by other means the capacity, integ- management and can contribute to the efficient rity, experience and reputation of the foreign functioning of the financial system. In addition, borrower. While analyzing foreign borrowers’ these activities can assist a branch in diversify- financial statements, examiners should take into ing its risks and improving its liquidity. consideration the differences in foreign account- The policy should state the limits for the ing practices from the generally accepted aggregate amount of loans purchased from and accounting principles (GAAP) in the United sold to any one outside source and for all loans States. purchased and sold. Limits should also be established for the aggregate amount of loans to Limits on Country Exposures—The loan pol- particular types of industries that may be pur- icy should define maximum exposures to coun- chased. Guidelines should be established for the tries other than the United States. All sizeable type and frequency of credit and other informa- exposures should be supported by country analy- tion that should be obtained from the lead ses and other supporting information. Country institution in order to keep the branch continu- limits should be consistent with the creditwor- ally updated on the financial condition of the thiness of the respective countries. borrower and the status of the credit. Because of the inherent reliance on the lead institution to Limits and Guidelines for Purchasing and administer and collect participated loans, the Selling Loans Either Directly or Through Par- purchasing branch should evaluate the lead ticipations or Swaps—If sufficient loan demand institution’s ability to properly carry out these exists, lending within the branch’s trade area is responsibilities. Conversely, guidelines should safer and less expensive than purchasing paper also be established for supplying complete and

September 1997 Branch and Agency Examination Manual Page 4 Credit Risk Management 3010.1 regularly updated credit information to the pur- departments of the branch. Written policies and chasers of loans originated and sold by the procedures approved and enforced in various branch. departments should be referenced in the general lending policy of the branch. Loan Authority—The lending policy should Management should establish appropriate poli- establish limits for all lending officers. In many cies, procedures, and information systems to branches of FBOs, most lending authority ensure that the impact of the branch’s lending remains with the head office. If lending policies activities on its interest rate exposure is care- are clearly established and enforced, individual fully analyzed, monitored, and managed. In this officer limitations may be somewhat higher, regard, consideration should also be given to the based on the officer’s experience and tenure risks associated with off-balance sheet instru- with the branch. Frequently, group lending lim- ments related to lending arrangements, such as its are set, allowing a combination of officers or loan commitments and swaps. a committee to approve larger loans than the members would be permitted to approve individually. The reporting procedures and the fre- Approval Process quency of committee meetings should be defined. In addition to the components that form the Collections, Charge-Offs, and Specific basis for a sound lending policy, there should be Reserves—The lending policy should define a documented approval process for exceptions delinquent obligations and contain guidelines to that policy, including the need for approval of for placing loans on nonaccrual status and initi- exceptions by the head office. Management ating foreclosure proceedings. Delinquency sta- information systems should report and highlight tus is determined by the contractual terms and loan exceptions to branch management and the defined as when the principal or interest on an head office. asset becomes due and unpaid for 30 days or Before a branch extends credit, its objectives, more. For regulatory reports, branches must policies, and practices must be clearly estab- comply with the reporting requirements for past lished. Before examining a loan department, due and nonaccrual loans. Additionally, the those objectives, policies, and practices should policy should dictate the appropriate reports to be reviewed by the examiner to determine if be submitted to the head office concerning those they are reasonable and adequate to properly obligations. The reports should include suffi- supervise the portfolio. The absence of written cient detail to allow for the determination of the guidelines is a major deficiency in the lending loss potential and alternative courses of action. area and may indicate that the branch is not The policy should require a follow-up collection being properly supervised by its head office. The notice procedure that is systematic and progres- various credit extending areas should be exam- sively stronger. Guidelines should be estab- ined to determine compliance with objectives, lished to ensure that all accounts are presented policies, and practices, which is a prime exami- to and reviewed by the head office for charge- nation objective. offs or specific reserves in accordance with applicable regulatory policy.

Legal Lending Limits—The lending policy Loan Information Systems may describe limitations on loans to one borrower, as are consistent with head office and/or The loan information system should include the federal requirements. The Foreign Bank Super- loan policy and loan administration procedures, vision Enhancement Act of 1991 superseded loan documentation maintained for borrowers, state legal lending limits to the extent that reports prepared for the benefit of senior man- exposures to a single borrower by all state and agement at the branch or at the head office, the federal branches of the same FBO must be loan grading and loan review system, and the aggregated and applied against the capital of the system to manage problem loans. FBO (12 USC 84.) Loan information and documentation should demonstrate that the borrower has the ability Other—The lending policy should be supple- and willingness to repay the loan. These documented with other written guidelines for specific ments should also indicate that the lending

Branch and Agency Examination Manual September 1997 Page 5 3010.1 Credit Risk Management officer has adhered to sound lending practices, periodically and any exceptions are addressed acted prudently to safeguard the branch’s funds, promptly. and ensured repayment of the loan by all reasonable means. Loan information and other documentation supporting an extension of credit INTERNAL LOAN REVIEW should be in English to enable the examiner to properly evaluate the quality of the credit. Key Loan Review Objectives In general, loan documents should provide answers to the following questions: Depending on the branch’s size, its lending activities, and management philosophy, loan • Who is the borrower, including ownership and review may be handled by a part-time person, affiliations? one person, an independent contractor, or a • How did the borrower come to the branch? separate department staffed by a number of • What is the borrower’s business? employees at the branch, at a regional U.S. • What is the purpose of the credit? office, or at the head office. An important • What are the primary and secondary sources ingredient of loan review is that it must be of repayment? independent from the approval process. Regard- • What is the borrower’s financial condition? less of how loan review is structured, a satisfac- • What are projections for the borrower’s future tory loan review system should have the follow- financial performance? ing objectives: • How has the borrower performed on other credit obligations? • Provide an objective grading system for loans. • What is the collateral for the loan, its location, • Provide current information regarding port- value, and condition? folio risk to branch management and the head office on a timely basis. If guarantees are involved, the branch must • Identify problem credits and place them under have sufficient information on the guarantor’s additional scrutiny. financial condition. Income, liquidity, cash flows, • Assist in the evaluation of the adequacy of contingent liabilities, and other relevant factors specific and general reserves in accordance should be evaluated, including credit ratings, with applicable regulatory policy.1 when available, to demonstrate the guarantor’s • Evaluate trends in the loan portfolio. financial capacity to fulfill the obligation. Gen- • Cite loan policy exceptions and noncompli- erally, however, loan quality should be evalu- ance with procedures. ated based on the primary source of payment not • Cite documentation exceptions. secondary sources, such as guarantees. In this • Cite violations of laws and regulations. respect, guarantees from head office are not • Assist in the development and revision of viewed as providing support to a loan. policy and procedures. An effective system to obtain and maintain • Act as an information source concerning complete and current loan information and docu- emerging trends in the portfolio and the mentation is a necessary component of sound branch’s lending areas. lending. Failure to establish and enforce this system will increase credit risk and cause the branch to suffer losses that could have been Loan Review Reporting avoided. Before the loan is funded, the branch must Loan review reporting must be thorough, accu- ensure that all the required documentation is rate, and timely to provide sufficient information current. It is generally easier to ensure complete to allow management and the head office to both and current documentation before the loan is funded, as the borrower will be cooperative and the loan has the lending officer’s full attention. 1. Branches are not required to maintain an allowance for To ensure on-going attention to documenta- loan losses for Federal Reserve supervisory purposes. How- tion, the loan policy should require the branch to ever, it is recognized that the licensing and insuring authorities obtain and maintain current documentation on may require U.S. branches to maintain such reserves under their respective jurisdictions to fulfill the requirements of their borrowers and collateral. The loan policy should individual licensing or insurance statutes, or to satisfy other also ensure that loan documentation is reviewed specific concerns of the authority.

September 1997 Branch and Agency Examination Manual Page 6 Credit Risk Management 3010.1 identify and control risk. At a minimum, there Loan Problems should be three types of reporting required from loan review: file memoranda, head office reports, The failure of branch and head office manage- and an annual schedule or loan review plan. ment to establish a sound lending policy, to File memoranda are completed after each establish adequate written procedures, and to loan is reviewed and are placed in the credit file monitor and administer the lending function to document the reviewer’s conclusions. Loan within established guidelines may result in sub- grades and supporting facts should be included, stantial problems for the branch. Loan problems along with any instances of noncompliance with may be caused by a number of factors affecting the branch’s policy, procedures and applicable the branch or its borrowers, such as the regulations. Documentation exceptions should following: also be indicated. If the process is conducted by the lending Anxiety for Income—The loan portfolio is officers themselves, then compliance with poli- usually the branch’s most important revenue cies and procedures is best determined by another producing asset. However, the pursuit of earn- branch department, such as internal audit. ings must never be permitted to override sound Head office/management reports are summa- underwriting principles by extending credit that ries of the loan reviewer’s conclusions regarding carries undue risks or unsatisfactory repayment the quality of the portfolio or segment of the terms. Over the long term, unsound loans usu- portfolio. These reports should state the scope of ally cost far more than the revenue they produce. the review; the distribution of loan grades for the portfolio or segment of the portfolio; the Compromise of Credit Principles—Branch percentage of both collateral and financial docu- management, for various reasons, may know- mentation exceptions; all instances of noncom- ingly grant loans carrying undue risks or unsat- pliance with policies, procedures, or regulations; isfactory terms in violation of its own underwrit- an assessment of the overall quality of the ing standards. These reasons may include head portfolio; and the resulting impact on the allow- office relationships with associated companies ance for loan losses, where applicable, and any of the branch’s customer. Self-dealing, anxiety other factors that might have an adverse effect for income, inappropriate salary incentives, on the portfolio. bonuses based on loan portfolio growth, and These reports should go to head office man- competitive pressures may also lead to a com- agement. If applicable, a copy of these reports promise of sound credit principles. can also be given to U.S. regional management, the manager of the loan department, and the Incomplete Credit Information—Character and branch’s executive management; however, man- capability may be determined by many means agement should not be allowed to influence the but complete credit information is the only content of the report. The head office should be acceptable and reasonably accurate method for given this report on a timely basis and require determining a borrower’s financial condition. lending officers to correct and respond to all The lack of sufficient financial information is an significant problems and exceptions within a important cause of problem credits. Current and specified time frame. complete comparative financial statements, Although a good loan review system is operating reports, and other pertinent statistical important to ensure sound lending and strong support should be available. Other essential loan administration, excessive reliance should information, such as the purpose of the borrow- not be placed on this system. It is always the ing, the intended plan and source of repayment, lending officers’ responsibility to maintain sound progress reports, inspections, and memoranda underwriting standards and loan quality. It is of outside information and loan conferences, also their responsibility to monitor the portfolio should be contained in the branch’s credit files. on an ongoing basis and to initially identify Proper credit administration and accurate credit problem credits. Loan review should not be the appraisals are not possible without such first line of defense to identify emerging prob- information. lems. Its primary responsibility is to identify The Interagency Policy on Documentation of weaknesses in lending and loan administration Loans by U.S. Branches and Agencies of For- and their underlying causes. eign Banks, which was issued on May 14, 1993,

Branch and Agency Examination Manual September 1997 Page 7 3010.1 Credit Risk Management exempts these branches from certain docu- management may restructure loans or take other mentation requirements for credits to small and measures in recognition of borrowers’ condition medium-sized businesses and farm loans. (Refer and repayment prospects. Such actions, if done to the policy statement for specific limitations.) in a way that is consistent with prudent lending principles and supervisory practices, can improve Failure To Obtain or Enforce Repayment a branch’s prospects for collection. Generally Agreements—Loans granted without a clear writ- accepted accounting principles (GAAP) and ten agreement governing repayment violate a regulatory reporting requirements provide a fundamental banking principle that frequently is framework for working in a constructive fashion a major cause of problem loans. Another com- with borrowers experiencing financial difficul- mon cause of problem loans is when scheduled ties. payments or reductions are not collected in The Interagency Policy Statement on Credit accordance with the terms of the loan agreement. Availability, issued on March 1, 1991, presented clarifications of a number of supervisory poli- Inadequate supervision of familiar borrowers. cies regarding issues relating to nonaccrual assets and restructured loans. These clarifications indi- Over-reliance on verbal information fur- cated that when certain criteria are met: (a) inter- nished by borrowers in lieu of reliable financial est payments on nonaccrual assets can be rec- data. ognized as income on a cash basis, without first recovering any previous partial charge-offs; Downplaying of known credit weaknesses (b) nonaccrual assets can be restored to accrual because of the borrower’s past history of over- status when subject to formal restructuring in coming recurrent hazards and distress. accordance with Financial Accounting Stan- dards Board (FASB) Statement No. 15; and Ignoring warning signs pertaining to the (c) restructuring that yields a market rate of borrower, economy, region, industry, or other interest would not have to be included in restruc- related factors. tured loan amounts reported in the years subsequent to the year of the restructuring. Lack of Supervision—Many loans that are sound at inception have developed into problems and losses because of lack of effective on-going supervision. Nonaccrual of Interest

Technical Incompetence—Able and experi- Loans and lease financing receivables are to be enced bankers should possess the technical abil- placed in nonaccrual status if: ity to analyze financial statements and to obtain and evaluate other credit information. Technical • They are maintained on a cash basis because incompetence often results in unexpected losses. of deterioration in the financial condition of the borrower. Overlending—Loans granted beyond the bor- • Payment in full of principal or interest is not rower’s reasonable capacity to repay are inher- expected; or ently unsound. Technical competence and sound • Principal or interest has been in default for a credit judgment are necessary in determining a period of 90 days or more, unless the loan is sound borrower’s safe, maximum loan level. both well secured and in the process of collection. Competition—Competition among branches for size and market share may result in the A debt is well secured if it is secured (a) by compromise of credit principles and the funding collateral in the form of liens on or pledges of of unsound loans. real or personal property, including securities, that have a realizable value sufficient to discharge the debt, including accrued interest, in Nonaccrual and Restructured Loans full, or (b) by the guarantee of a financially responsible party. A debt is in the process of Working in a prudent manner with borrowers collection if collection of the asset is proceeding that are experiencing financial difficulties, branch in due course either through legal action, includ-

September 1997 Branch and Agency Examination Manual Page 8 Credit Risk Management 3010.1 ing judgment enforcement procedures or, in accordance with the contractual terms, involv- appropriate circumstances, through collection ing payments of cash or cash equivalents. How- efforts not involving legal action, which are ever, loans that meet these criteria would con- reasonably expected to result in repayment of tinue to be disclosed as past due and still the debt or in its restoration to a current status in accruing for purposes of the Report of Assets the near future. and Liabilities (call report), until they have been brought fully current. Treatment of Cash Payments and Criteria for For purposes of meeting the first test, the the Cash Basis Recognition of Income—When branch must have received repayment of the doubt exists as to the collectibility of the remain- past due principal and interest unless, as dis- ing book balance of a loan in nonaccrual status, cussed below, the loan has been formally any payments received must be applied to reduce restructured and qualifies for accrual status or principal to the extent necessary to eliminate the asset has been acquired at a discount (because such doubt. Placing an asset in nonaccrual status there is uncertainty as to the amounts or timing does not, in and of itself, require a charge-off, in of future cash flows) from an unaffiliated third whole or in part, of the asset’s principal. How- party and meets the criteria for amortization, ever, identified losses must be charged-off. When i.e., accretion of discount, specified in AICPA a loan is in nonaccrual status, some or all of the Practice Bulletin No. 6. cash interest payments received may be treated Until the loan is restored to accrual status, as interest income on a cash basis if the remain- cash payments received must be treated in ing book balance of the asset, after a charge-off, accordance with the criteria stated above. In if any, is deemed to be fully collectible. A addition, after a formal restructuring, if a restruc- branch’s determination as to the ultimate col- tured loan that has been returned to accrual lectibility of the asset’s remaining book balance status later meets the criteria for placement in must be supported by a current, well-documented nonaccrual status as a result of past due status credit evaluation of the borrower’s financial based on its modified terms or for any other condition and prospects for repayment, includ- reasons, the asset must be placed in nonaccrual ing consideration of the borrower’s historical status. Under GAAP, when a charge-off was repayment performance and other relevant taken before the date of the restructuring, the factors. charge-off does not have to be recovered before When recognition of interest income on a the restructured loan can be restored to accrual cash basis is appropriate, the amount of income status. When a charge-off occurs after the date that is recognized should be limited to that of the restructuring, the considerations and treat- which would have been accrued on the loan’s ments discussed in the previous paragraphs in remaining book balance at the contractual rate. this section are applicable. For a formally restructured loan, the effective interest rate should be used. Any cash interest Treatment of Multiple Extensions of Credit to payments received in excess of this limit, and One Borrower—As a general principle, nonac- not applied to reduce the loan’s remaining book crual status for an asset should be determined balance, should be recorded as recoveries of based on an assessment of the individual asset’s previous charge-offs, until these charge-offs have collectibility and payment ability and perfor- been fully recovered. mance. Thus, when one loan to a borrower is placed in nonaccrual status, a branch does not Restoration to Accrual Status—According to have to place all other extensions of credit to the Revised Interagency Guidance on Returning that borrower in nonaccrual status. When a Certain Nonaccrual Loans to Accrual Status branch has multiple loans or other extensions of issued June 10, 1993, nonaccrual loans may be credit outstanding to a single borrower, and one returned to accrual status, even though the loans loan meets the criteria for nonaccrual status, the have not been brought fully current, provided branch should evaluate its other extensions of two criteria are met: (1) all principal and interest credit to that borrower to determine whether one amounts contractually due, including arrearages, or more of these other assets should also be are reasonably certain of repayment within a placed in nonaccrual status. reasonable period and (2) there is a sustained period of repayment performance (generally a Examiner Review—Some states have promul- minimum of six months) by the borrower, in gated regulations or adopted policies for nonac-

Branch and Agency Examination Manual September 1997 Page 9 3010.1 Credit Risk Management crual of interest on delinquent loans, which may nonaccrual status include the requirement that differ from the above procedures. In such cases, loans or other assets be placed in nonaccrual the branch should comply with the more restric- status when repayment in full of principal or tive policy. The examiner should ensure that the interest is not expected, such nonaccrual loans branch is complying with such guidelines. In all should not be restored to accrual status. instances, whether or not there is a formal It is imperative that the reasons for the resto- policy, each branch should formulate its own ration of a partially charged-off loan to accrual policies to ensure that income is not being status be documented. Such actions should be overstated. The examiner should review the supported by a current, well-documented credit branch’s specific policy to ensure that it is evaluation of the borrower’s financial condition prudent. and prospects for full repayment of contractual When a branch places a loan in nonaccrual principal, including any amounts charged-off, status, it must determine an appropriate treat- and interest. This documentation will be subject ment for previously accrued but uncollected to review by examiners. interest and subsequent payments. One acceptable method is to reverse all previously accrued but uncollected interest against appropriate income and balance sheet accounts. For interest Renegotiated Troubled Debt accrued in the current accounting period, the entry is made directly against the interest income Renegotiated troubled debt includes those loans account. For prior accounting periods, all inter- and lease financing receivables that have been est previously recognized, if accrued interest restructured or renegotiated to provide conces- provisions had not been provided, would be sions to the borrower, e.g., a reduction of inter- reversed (expensed) against current earnings. est or principal payments because of a deterio- Generally accepted accounting principles do ration in the financial position of the borrower. not require the write-off of previously accrued A loan extended or renewed at a stated rate interest if principal and interest are ultimately equal to the current interest rate for new debt protected by sound collateral values. A branch is with similar risk is not considered renegotiated expected to have a well-defined policy govern- debt. For further information, see Financial ing the write-off of accrued interest receivable. Accounting Standards Board Statement No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructuring, (FASB Statement No. 15). Treatment of Nonaccrual Loans with Branches should develop a policy relative to Partial Charge-offs renegotiated troubled debt to ensure that such items are identified, monitored, and properly Questions have been raised regarding whether handled from an accounting and control stand- partial charge-offs associated with a nonaccrual point. Such items should be relatively infrequent loan (that has not been formally restructured) in occurrence. If not, the branch is probably must first be fully recovered before a loan can be experiencing significant problems. Before such restored to accrual status. GAAP and regulatory concessions are made to a borrower, it is good reporting requirements do not explicitly address practice to have the transactions receive prior this issue. approval of the head office. All such transac- When a loan has been brought fully current tions should be reported to the head office upon with respect to contractual principal and interest enactment. and the borrower’s financial condition and prospects for repayment have improved so that the full amount of contractual principal, including any amounts charged-off, and interest is expected Nonaccrual Assets Subject to FASB to be repaid, the loan may be restored to accrual Statement No. 15 Restructuring status without having to first recover the charge- off. On the other hand, this treatment would not The Policy Statement on Credit Availability be appropriate when the charge-off is indicative Issues indicated that a loan or other debt instru- of continuing doubt regarding the collectibility ment that has been formally restructured, so as of principal or interest. Because the criteria for to be reasonably certain of repayment and per-

September 1997 Branch and Agency Examination Manual Page 10 Credit Risk Management 3010.1 formance according to its modified terms in The formal restructuring of a loan or other accordance with a reasonable repayment sched- debt instrument should be undertaken in ways ule, need not be maintained in nonaccrual status. that improve the likelihood that the credit will Furthermore, the policy statement indicated that, be repaid in full under the modified terms in in returning the asset to accrual status, sustained accordance with a reasonable repayment sched- historical payment performance for a reasonable ule. When a restructured loan is not reasonably time before the restructuring may be taken into certain of repayment and performance under its account. modified terms in accordance with a reasonable For example, a loan may have been restruc- repayment schedule, the loan may not be restored tured, in part, to reduce the amount of the to accrual status. borrower’s contractual payments. In so doing, When restructuring loans, regulatory report- the borrower’s restructured terms may require ing requirements and GAAP do not require payments that do not exceed the amount and banking organizations to grant excessive con- frequency that have been demonstrated by the cessions, forgive principal, or take other steps sustained historical payment performance of the not commensurate with the borrower’s ability to borrower for a reasonable time before the loan repay in order to use the reporting treatment was restructured. In this situation, assuming that specified in FASB Statement No.15. Further- the restructured loan is reasonably certain of more, regulatory reporting requirements and repayment and performance according to its GAAP do not preclude institutions from includ- modified terms, the loan can be immediately ing prudent contingent payment provisions in restored to accrual status. the restructured terms that permit an institution Clearly, a period of sustained performance, to obtain appropriate recovery of concessions whether before or after the date of the restruc- involved in the restructuring, should the borrow- turing, is an important factor in determining er’s condition substantially improve. whether there is reasonable assurance of repay- A nonaccrual loan or debt instrument may ment and performance according to the loan’s have been formally restructured in accordance modified terms. In certain circumstances, evi- with FASB Statement No. 15 so that it meets the dence may exist regarding other characteristics criteria for restoration to accrual status pre- of the borrower that may be sufficient to dem- sented in the previous section that addresses onstrate a relative improvement in the borrow- restructured loans. Under GAAP, when a charge- er’s condition and debt service capacity, thereby off was taken before the date of the restructur- reducing the degree of reliance on the borrowing, the charge-off does not have to be recovered er’s performance to date in assessing prospects before the restructured loan can be restored to for future performance and collectibility under accrual status. When a charge-off occurs after the modified terms. For example, substantial and the date of the restructuring, the considerations reliable sales, lease, or rental contracts obtained and treatments discussed in the previous para- by the borrower, or other important develop- graphs in this section are applicable. ments that are expected to significantly increase the borrower’s cash flow and debt service capacity and strengthen the borrower’s commitment to repay, may be sufficient to provide this Reporting of Loan Fees and Interest assurance. In certain circumstances, a prepon- derance of such evidence, in and of itself, may The accounting standards for nonrefundable fees be sufficient to warrant returning a restructured and costs associated with lending, commitments loan to accrual status, provided the loan under to lend, and purchasing a loan or group of loans, its restructured terms is reasonably certain of are set forth in FASB Statement No. 91, Account- performance and full collectibility. ing for Nonrefundable Fees and Costs Associ- It is imperative that the reasons for the resto- ated with Originating or Acquiring Loans and ration of restructured debt to accrual status be Initial Direct Costs of Leases. The statement fully documented. Such actions should be sup- applies to all types of loans and to debt securi- ported by a current, well-documented credit ties but not to loans or securities carried at evaluation of the borrower’s financial condition market value and to all types of lenders. It must and prospects for repayment under the modified be applied to all lending and leasing transactions terms. This documentation will be subject to in fiscal years beginning after December 15, review by examiners. 1987, but retroactive application is permitted.

Branch and Agency Examination Manual September 1997 Page 11 3010.1 Credit Risk Management

For further information, see FASB Statement assets for the purpose of avoiding examination No. 91. scrutiny and possible classification. All other lending-related costs, whether or not During branch examinations, examiners should incremental, should be charged to expense as identify situations where low quality assets have incurred, including costs related to activities been transferred between the branch being performed by the lender or by independent third examined and another U.S. branch of a foreign parties for the lender, for advertising, identifying bank or other depository institution. Low quality potential borrowers, soliciting potential borrow- loans, broadly defined, include loans that are ers, servicing existing loans, and other ancillary classified or specially mentioned or if subjected activities related to establishing and monitoring to review would most likely be classified or credit policies, supervision, and administration. specially mentioned, past due loans, nonaccrual Employees’ compensation and fringe benefits loans, loans on which the terms have been related to these activities, unsuccessful loan renegotiated because of a borrower’s poor finan- origination efforts, and idle time should be cial condition, and any other loans that the charged to expense as incurred. Administrative examiner believes are of questionable quality. costs, rent, depreciation, and all other occupancy and equipment costs are considered indirect costs and should be charged to expense as Examining the Lending Function incurred. Net unamortized loan fees represent an adjust- The results of the loan examination should ment of the loan yield and shall be reported in provide the examiner with a method of arriving the same manner as unearned income on loans, at an overall evaluation for the entire branch i.e., deducted from the related loan balances, to loan portfolio. Historically, examination results the extent possible, or deducted from total loans have identified problems in the loan area through in any unearned income on loans in the call a detailed review of credits and credit documen- report, which provides a breakdown of various tation. The examiner should also correlate the types of loans. Net unamortized direct loan following items with the overall system of origination costs shall be added to the related policies, practices, procedures, and controls loan balances. Amounts of loan origination, instituted by the branch to prevent such problems: commitment, and other fees and costs recognized as an adjustment of yield should be • Identified problem credits. reported under the appropriate Interest income • Unsafe or unsound lending procedures. item in the income statement. Other fees, such • Past due loans. as fees that are recognized during the commit- • Credit documentary exceptions. ment period or included in income when the • Violations of laws and regulations. commitment expires, i.e., fees, retrospectively • Concentrations of credit. determined, and fees for commitments, where • Evidence of self-dealing loan transactions. exercise is remote, and (b) syndication fees that are not deferred, should be reported as other • Collateral documentary exceptions. noninterest income. The purpose of this correlation is to determine causes of existing problems and weak situations, which represent a potential weakness in the branch’s risk management process. Other Lending Concerns The examiner performing the procedures in this section should make the final decision as to The transfer of low quality loans from one the quality of the entire portfolio, the quality of depository institution to another may be made to management review and controls, and the scope avoid detection and classification during regula- and adequacy of internal guidelines. A great tory examinations. Transfer may be accom- deal of judgment is necessary in making those plished through participations, purchases/sales, decisions because they significantly affect the and asset swaps with other affiliated or nonaf- overall conclusions reached by the examiner-in- filiated financial institutions. Examiners should charge. The process of compiling information be alert to situations where a branch’s intention generated, analyzing it, and formulating conclu- seems to be the concealment of low quality sions about the causes of existing deficiencies,

September 1997 Branch and Agency Examination Manual Page 12 Credit Risk Management 3010.1 requires considerable thought and judgement on erential treatment should be given to loans to the part of the examiner. The ultimate conclu- insiders of correspondent banks nor should there sions concern the risk management of the lend- be the appearance of a conflict of interest. The ing function, as it now exists, and as it is branch should comply with Title VIII of the projected for the future. Furthermore, the exam- Financial Institutions Regulatory and Interest iner is expected to discern causes of existing and Rate Control Act of 1978 (FIRA) (12 USC potential problems, to capsulize the causes and 1972(2)). effects, and to present the problems to branch management in such a manner as to obtain Appraisals and Evaluations. Federally-insured positive corrective action. branches should obtain an appraisal or evaluation for all real estate-related financial transactions prior to making the final credit decision in Regulatory Compliance conformance with Title XI of the Financial Institutions Reform, Recovery and Enforcement Branches are expected to comply with laws, Act of 1989 (FIRREA) (12 USC 3310, 3331- regulations, and applicable regulatory policy in 3351). Appraisal and evaluation requirements all aspects of their lending programs. Moreover, are separately discussed in the Real Estate branches should establish adequate internal con- Appraisals and Evaluations part of this section. trols to detect deficiencies or exceptions to their lending policy that result in unsafe and unsound Consumer Compliance. The residential lend- lending practices. In regard to applicable lending program at a federally-insured branch should ing limits, the examiner should review the ensure that the loan applicant is adequately branch’s lending practices in accordance with informed of the annual interest rate, finance the applicable state laws in the following areas charges, amount financed, total payments, and that prescribe limits on aggregate advances to a repayment schedule, as mandated in the Federal single borrower and related borrowers. Reserve’s Regulation Z, Truth in Lending (12 CFR 226). The federally insured branch’s Commissions or Gifts for Procuring Loans.A process for taking, evaluating, and accepting or branch officer, employee, agent, or attorney rejecting a credit application is subject to the should not receive anything of value for procur- Federal Reserve’s Regulation B, Equal Credit ing or endeavoring to procure a loan, which is Opportunity (12 CFR 202). prohibited under 18 USC 215. Credit Life Insurance Income. The branch’s Political Contributions. Loans made in con- sale of mortgage life insurance in connection nection with any election to any political office with its real estate lending activity should com- should comply with applicable state banking ply with the sales practices, sales commission laws and regulations and with the Foreign Cor- limits, and disclosure requirements as defined in rupt Practices Act of 1977 (Pub. L. 95-213, the Federal Reserve’s policy statement on the 91 Stat. 1494 (1977), 15 USC 78dd-1 and 2, disposition of credit life insurance income 78m, 78o, and 78ff) and the Federal Election (67 Federal Reserve Bulletin 431 (1981), Campaign Act (2 USC 441b). FRRS 3–1556).

Loans to Executives, Ofﬁcers, and Principal Shareholders of Correspondent Banks. No pref-

Branch and Agency Examination Manual September 1997 Page 13 Credit Risk Management Examination Objectives Effective date July 1997 Section 3010.2

1. To determine if policies, practices, proce- 5. To prepare information regarding the branch’s dures, and internal controls regarding credit lending function in concise reportable format. risk management are adequate. 6. To determine compliance with applicable 2. To determine if branch ofﬁcers are operating laws and regulations. in conformance with the established 7. To recommend corrective action when poli- guidelines. cies, practices, procedures, or internal con- 3. To determine the scope and adequacy of the trols are deﬁcient or when violations of audit and loan review functions. applicable law or regulations have been noted. 4. To determine the overall quality of the loan portfolio and how that quality relates to the risk management function of the branch.

Branch and Agency Examination Manual September 1997 Page 1 Credit Risk Management Examination Procedures Effective date July 1997 Section 3010.3

The following procedures are intended to deter- LOAN REVIEW mine that the branch under examination has established satisfactory procedures to ensure In general, a loan review program should pro- that controls regarding credit risk management vide an independent means to identify credit and are adequate. Examiner discretion is required in loan administration weaknesses, provide accu- applying these procedures. Before beginning the rate and timely reports to management detailing assignment, the examiner should review the weaknesses discovered, and provide a means for scope memorandum and consult with the recognizing potential problems. examiner-in-charge or other designated individual to determine the scope of the review. 7. Determine if the loan review program Some of the procedures may not be necessary, ensures independence from the lending func- based on the quality of the branch’s internal tion including whether: controls or the nature and level of activity in the a. Policies specifically address the separa- area. tion of loan review from the lending and credit approval functions. 1. If selected for implementation, complete, or b. The loan review function reports directly update the Internal Control Questionnaire to the head office, a regional office, or a for this section. senior branch officer not involved in the 2. Determine if deficiencies noted at previous lending function. If not, determine if the examinations and internal/external audits branch has adequate controls to ensure have been adequately addressed by independence from the lending function. management. 8. Determine if the frequency of loan review is 3. Reconcile the customer central liability led- adequate, and if the program includes: ger or subsidiary loan ledgers to the general a. A minimum frequency of reviews. ledger. b. A frequency which is sufficient to provide timely information concerning 4. Obtain the branch’s internal listing of Shared emerging trends in the portfolio and National Credits and verify ratings with general economic conditions. regulatory records. c. Increased frequency for identified prob- 5. Review the branch’s lending policies to lem credits. determine: 9. Evaluate the adequacy of the scope of the a. If the policies are adequate for the size, loan review, including: nature, and business of the bank. a. Method of loan selection. b. If the branch is in compliance with its b. Manner in which loans are reviewed, policies. including: • an analysis of the current financial c. If the policies are reviewed and updated condition of the borrower which periodically to ensure they are relevant addresses repayment ability, and with changing market conditions and new business lines of the bank. • tests for documentation exceptions, policy exceptions, noncompliance with d. If policies have been approved by the internal procedures, and violations of head office. laws and regulations. 6. If applicable, review minutes of the branch’s 10. Assess the qualifications of the personnel loan committee meetings to determine: involved in the credit review function. a. Current members and their attendance 11. Evaluate the loan review reporting system record. including credit file memoranda, head office reports, and an annual schedule or loan b. Scope of work performed. review plan, to ensure it is thorough, accu- c. Any information deemed useful in the rate and timely and will provide sufficient examination of specific loan categories information to allow management and the or other areas of the branch. head office to both identify and control risk.

Branch and Agency Examination Manual September 1997 Page 1 3010.3 Credit Risk Management Examination Procedures

Determine if the reports include: h. The accuracy and completeness of reports a. Identification of problem credits. submitted to the head office or regional b. Current information regarding portfolio office. risk. i. Competency of senior management, loan c. Information concerning emerging trends officers and credit administration in the portfolio and the branch’s lending personnel. areas. 15. Determine, through information previously generated, the causes of existing problems or weaknesses within the system, which CREDIT GRADING SYSTEM present potential for future problems. 12. Assess the adequacy of the credit grading system and determine if it: PROBLEM LOAN a. Includes an objective grading system for ADMINISTRATION loans. b. Contains explicit definitions of the 16. Determine if the branch has adequate poli- branch’s internal grading system, and cies and procedures for problem and work- that it is easily understood by all lenders out loans, including: and loan review staff. a. A periodic review of individual problem c. Designates who has ultimate authority to credits. assign and change credit grades. b. Guidelines for collecting or strengthen- 13. Evaluate the accuracy of the branch’s credit ing the loan, including requirements for grading system by comparing the credit updating collateral values and lien posi- grade assigned by the branch with those tions, documentation review, officer call assigned by examiners. Determine the extent reports. of management’s knowledge of its own c. Volume and trend of past due or nonac- loan problems. crual credits. d. Qualified officers handling problem loans. e. Guidelines on proper accounting for prob- GENERAL CREDIT RISK lem loans, e.g., non-accrual policy; spe- ADMINISTRATION cific reserve policy.

14. Assess the effectiveness of the branch’s credit administration and portfolio manage- COMPLIANCE ment by evaluating: a. Management’s general lending philoso- 17. Assess the branch’s compliance with laws phy in such a manner as to elicit man- and regulations, by determining whether: agement responses. a. The branch has loans to affiliates (Sec- b. The volume and magnitude of differ- tion 23A of the Federal Reserve Act). ences in grades assigned by the branch b. A bank officer or employee received and by the examiners. anything of value for procuring or c. The impact of credits not supported by endeavoring to procure any extension of current and complete financial informa- credit (18 USC 215 for Commission or tion and analysis of repayment ability. Gift for Procuring a Loan). d. The impact of credits for which loan and c. The branch has a stated purpose for each collateral documentation are deficient. loan over $10 thousand, except those e. The volume of loans improperly struc- secured by real estate (31 CFR 103.33(a) tured, e.g., repayment schedule does not of the Bank Secrecy Act). match loan purpose. d. The branch is in compliance with state f. The volume and nature of concentrations and federal lending limits, as described of credit, including concentrations of in Regulation K, or specific statutes. classified and criticized credits. e. The branch is in compliance with Regu- g. The appropriateness of transfers of low lation O regarding loans to insiders. quality credits to or from another affili- (applicable to FDIC-insured branches ated office. only).

September 1997 Branch and Agency Examination Manual Page 2 Credit Risk Management Examination Procedures 3010.3

18. Forward any violations of law to the exam- e. Compile a listing of all loans not iner in charge of compliance, and include a supported by current and complete credit cross reference here. information and collateral documentation. f. Compile a listing of low quality loans transferred to or from another lending SPECIFIC RESERVES institution through purchases/sales, participations, or swaps. 19. Ensure that any specific reserves reported 23. Discuss results of the examination of the by the branch are appropriate, i.e., based on lending function with senior management, a specific loss amount that has been identi- structuring inquiries in such a manner as to: fied for an individual credit. a. Elicit management responses for correc- 20. Determine if the branch accounts for spe- tion of deficiencies. cific reserves appropriately when the under- 24. Write, in appropriate report format, general lying asset has been transferred, sold, or remarks including: paid off. a. The scope of the examination of the 21. Review the management reports submitted lending function. to the head office, to determine that reports b. The quality of internal policies, prac- are sufficiently detailed to evaluate risk tices, procedures, and controls over the factors. lending function. 22. Summarize your findings being sure to c. The general level of adherence to inter- consider the following: nal policies, practices, procedures, and a. Check for noncompliance with internal controls. policies, practices, procedures, and con- d. The scope and adequacy of the internal trols. Determine if instances of noncom- loan review system. pliance are system-wide or limited to a e. The quality of the entire loan portfolio. specific area. f. The competency of management with b. Organize exceptions in order of relative respect to the lending function. importance. g. Causes of existing problems. c. Organize and prepare a listing of viola- h. Expectations for continued sound lend- tions of laws and regulations. ing or correction of existing deficiencies. d. Determine the aggregate amount of loans 25. Prepare a complete set of workpapers to criticized in each of the four levels of support conclusions, and discuss all mate- criticism. rial findings with management.

Branch and Agency Examination Manual September 1997 Page 3 Credit Risk Management Internal Control Questionnaire Effective date July 1997 Section 3010.4

Review the branch’s internal controls, policies, 5. Do credit files contain the following practices, and procedures for managing the loan information: portfolio. The system should be documented in a complete and concise manner and should include, where appropriate, narrative descrip- GENERAL INFORMATION tions, flowcharts, copies of forms used, and other pertinent information. • The borrower’s name, address, ownership, and affiliations? 1. Has a policy for credit risk management • A description of the borrower’s business? been adopted that specifically: • Amount, rate and maturity of the loan; type of a. Establishes suggested guidelines for dis- loan; appropriate approvals? tribution of loans in the commercial, real • The purpose of the loan? estate, and other categories? • The primary and secondary sources of b. Establishes geographic limits, including repayment? country limits,for loans? • The planned repayment schedule? c. Establishes suggested guidelines for • The disposition of the loan proceeds? aggregate outstanding loans in relation to other balance sheet categories? d. Establishes loan authorities of committees and individual lending officers? FINANCIAL INFORMATION e. Defines acceptable types of loans? • Current financial information on the borrower f. Establishes maximum maturities for vari- and guarantor (if applicable)? ous types of loans? • Three years of previous financial statements? g. Establishes loan pricing? • An analysis of the borrower’s and guarantor’s h. Establishes appraisal policy? (if applicable) financial condition? i. Establishes minimum financial informa- • Projections for the borrower’s future financial tion required at the inception of the performance? credit? • A description of the collateral, its location, j. Establishes limits and guidelines for pur- value, and condition? chasing loans? • Covenant compliance checksheet, if applicable. k. Establishes collection procedures? l. Defines the duties and responsibilities of 6. Does the branch perform a credit investiga- loan officers and loan committees? tion on proposed and existing borrowers for m. Outlines loan portfolio management new loan applications? objectives that acknowledge the need to 7. Is it required that all loan commitments be employ personnel with specialized knowl- in writing? edge and experience? 8. Are lines of credit reviewed and updated at 2. Are the following reported to the head least annually? office at least monthly: 9. Are borrowers’ outstanding liabilities checked to appropriate lines of credit before a. Past due loans? additional advances are granted? b. Loans on nonaccrual? 10. Does the branch employ a procedure for c. Classified loans? disclosure of a loan or combination of loans d. Loans requiring special attention? that are or will be secured by 25 percent of e. New loans, loan renewals, and restruc- another insured financial institution’s stock? tured loans? 11. Is there an internal review system that: 3. Are reports checked by a designated indi- a. Rechecks interest, discount, and maturity vidual for possible omissions before they date computations? are submitted to the head office? b. Reexamines notes for proper execution, 4. Are written applications required for all receipt of all required supporting papers, loans? and proper disclosure forms?

Branch and Agency Examination Manual September 1997 Page 1 3010.4 Credit Risk Management Internal Control Questionnaire

c. Determines that loan approvals are within nation, or were considered to be of the limits of the branch’s lending authori- questionable quality for any other reason. ties? g. Review the branch’s policies and proce- d. Determines that notes bear the initial of dures to determine whether or not assets the loan officer? or participations purchased by the branch e. Ascertains that new loans are within the are given an independent, complete, and limitations set for the borrower by cor- adequate credit evaluation. porate resolution? h. Determine that assets purchased by the f. Rechecks the liability ledger to deter- branch are properly reflected on its books mine that new loans have been accu- at fair market value. rately posted? While fair market value may be difficult to Loan transfers, purchases and sales involving determine, it should, at a minimum, reflect both other U.S. branches and affiliates of the FBO are the rate of return being earned on such assets evaluated to determine whether branch manage- and an appropriate risk premium. Determine ment retains responsibility for the loan. In such that appropriate write-offs are taken on any a case, the management of the transferred loans assets sold by the branch at less than book value. will be considered in assessing risk management at the branch. Loan transfers are also evaluated 13. Is a systematic and progressively stronger to determine whether they were transferred to follow-up notice procedure utilized for avoid classification and to determine any effect delinquent loans? of the transfer on the institution’s condition. In 14. Has the branch conducted industry studies cases where the transfer is suspected of being for those industries in which it is a substan- improper, the appropriate regulatory authorities tial lender? for the other financial institution involved in the 15. Are loan proceeds ever disbursed in cash? If transfer should be notified. so, notify BSA examiner. 16. Are loans ever paid off by liquidating cash 12. Review loan transfers for the following: collateral? If so, notify BSA examiner. a. Determine that the branch does not buy 17. Are adequate accounting and control proce- back or pay interest on defaulted loans in dures in effect with respect to recoveries? contravention of the underlying loan 18. Are adequate procedures in effect to moni- agreement. tor compliance with the lending limits? b. Compare the volume of loans purchased 19. Are original loan documents safeguarded and sold to the total portfolio. properly? c. Determine that the branch has sufficient 20. Are notes and collateral periodically veri- expertise to properly evaluate the vol- fied by an independent party? ume of loans purchased and sold. d. Determine if loans are sold primarily to accommodate overline needs of customers or to generate fee income. CONCLUSION e. Investigate any situations where assets were transferred before the date of the 21. Is the information covered by this ICQ examination to determine if any were adequate for evaluating internal controls in transferred to avoid possible criticism this area? If not, indicate any additional during the examination. examination procedures deemed necessary. f. Determine whether any of the loans trans- 22. Based on the information gathered, evaluate ferred were nonperforming at the time of the internal controls in this area (i.e. strong, transfer, classified at the previous exami- satisfactory, fair, marginal, unsatisfactory).

September 1997 Branch and Agency Examination Manual Page 2 Credit Risk Management Audit Guidelines Effective date July 1997 Section 3010.5

1. Test the additions of the trial balances and the p. For banker’s acceptances, compare collat- reconciliation of the trial balances to the eral (e.g. trust receipts and warehouse general ledger. Include loan commitments receipts) with the description on the col- and other contingent liabilities. lateral records. Check to be sure that 2. Using an appropriate sampling technique, procedures are in effect to preclude a select loans from the trial balance and per- customer from obtaining additional credit form the following: extensions on the same merchandise. a. Prepare and mail confirmation forms to q. Review escrow account provisions to borrowers. Loans serviced by other insti- determine if undisbursed amounts are at tutions, either whole loans or participa- least equal to the provisions in the escrow tions, should be confirmed only with the agreements. Determine if debit entries to servicing institution. Confirmation forms escrow accounts are authorized according should include borrower’s name, loan to the terms of the loan agreement and if number, the original amount, interest rate, they are supported by individual bills or current loan balance, contingency and other evidence. escrow account balance, and a brief r. List all discrepancies and investigate. description of the collateral. s. Determine that each file has documenta- b. After a reasonable time, mail second tion supporting guarantees and subordina- requests. tion agreements, where appropriate. c. Follow up on any no-replies or excep- t. Determine that any necessary insurance tions, and resolve differences. coverage is adequate and that the branch d. Examine notes for completeness and verify is named as loss payee. date, amount, and terms to trial balance. u. Review participation agreements, making e. In the event any notes are not held at the excerpts where necessary for such items branch, request confirmation by the holder. as rate of service fee, interest rate, reten- f. Check to see that the note is signed, tion of late charges, and remittance appears to be genuine, and is negotiable. requirements, and determine whether par- g. Check to see that the required initials of ticipant has complied. the approving officer are on the note. v. Review disbursement ledgers and autho- h. Determine that the amount is within the rizations and determine if authorizations officer’s lending limit. are signed in accordance with the terms of i. Compare collateral held in files with the the loan agreement. description on the collateral register. 3. Review the accrued interest accounts by: j. Determine that the proper assignments, a. Reviewing and testing procedures for stock powers, hypothecation agreements, accounting for accrued interest and for statements of purpose, etc., are on file. handling of adjustments. k. Test the pricing of the negotiable collateral. b. Scanning accrued interest for any unusual l. Determine that margins are reasonable entries and following up on any unusual and are in line with branch policy and items by tracing to initial and supporting legal requirements. records. m. Determine if any collateral is held by an c. For those loans selected in step 2, inde- outside custodian or has been temporarily pendently calculate the amount of accrued removed for any reason. interest and verify the amount to the detail n. Forward a confirmation request on any of accrued interest receivable for that collateral held outside the branch. loan. o. For accounts receivable financing, recon- 4. Using a list of nonaccruing loans, check loan cile accounts receivable invoices to col- accrual records to determine if interest income lateral records. is not being recorded.

Branch and Agency Examination Manual September 1997 Page 1 3010.5 Credit Risk Management Audit Guidelines

5. Obtain or prepare a schedule showing the b. Investigate signiﬁcant ﬂuctuations and/or monthly interest income amounts and the trends. accounts receivable loan balance at each 6. Test accuracy and completeness of all man- month-end since the last audit and: agement reports. a. Calculate yield.

September 1997 Branch and Agency Examination Manual Page 2 Asset-Based Lending Effective date July 1997 Section 3020.1

Asset-based lending is a specialized area of • Provides an efficient way to finance an expand- commercial lending in which borrowers assign ing operation because borrowing capacity their interests in certain accounts receivable and expands as sales increase; inventory, and in selected cases, fixed assets, to • Permits the borrower to take advantage of the lender as collateral. In asset-based lending, purchase discounts because the company the primary repayment source is the conversion receives immediate cash on its sales and is of the pledged assets into cash. Asset-based able to pay trade creditors on a satisfactory lending differs from a commercial loan in which basis, thereby earning a good reputation and the bank takes a security interest in all accounts reducing the cost of goods sold; receivable and inventory owned or acquired by • Ensures a revolving, expanding line of credit the borrower. This section will discuss asset- for which the actual interest paid may be less based lending in relation to the characteristics of than that for a fixed amount unsecured loan. the borrower, its advantages to the borrower and the branch, credit and collateral analysis, docu- From the branch’s viewpoint, asset-based mentation, and safeguards to ensure the authen- lending: ticity and collectibility of the assigned receivables. The examiner must judge the quality of the • Generates a relatively high yield loan com- credit by evaluating the financial condition and mensurate with the perceived credit risk of the debt-servicing ability of the borrower and the borrower; quality of the collateral. In addition, the exam- • Generates a depository relationship which iner must evaluate the branch’s internal con- provides income and enhances the branch’s trols, policies, practices, and procedures. ability to monitor changes in the borrower’s cash flow and overall financial condition; CHARACTERISTICS OF THE • Permits a continuing branch relationship with longstanding customers whose financial con- BORROWER dition no longer warrant unsecured credit or traditional commercial lines of credit; and, Many borrowers whose financial condition is not strong enough to allow them to qualify for • Minimizes potential loss when the loan is regular, secured commercial loans may use asset- collateralized by a percentage of the accounts based loans to meet their financial needs. Typi- receivable and inventory. cal characteristics of asset-based borrowers are those which: However, as discussed further, this type of lending requires close and periodic supervision • Are growing rapidly and need year-round of the borrower’s financial condition and regular financing in amounts too large to justify monitoring of the borrower’s accounts receiv- unsecured credit or commercial lines of credit ables to ensure compliance with the financing secured by blanket liens on accounts receiv- agreement. able and inventory; • Are nonseasonal and need year-round financing because working capital and profits are insufficient to permit periodic clean-ups; CREDIT AND COLLATERAL • Have inadequate working capital for the vol- ANALYSIS ume of sales and type of operation; and, • Cannot obtain regular commercial loan terms Although asset-based loans are collateralized because of deteriorating credit factors. and closely monitored, it is important to analyze the borrower’s financial statements. Even if the collateral is of good quality and supports the ADVANTAGES TO THE loan, the borrower must demonstrate financial BORROWER AND THE BRANCH progress. Full repayment through collateral liquidation is normally a solution of last resort. The From the borrower’s viewpoint, asset-based borrower’s financial statements should be ana- lending: lyzed with particular emphasis on working capi-

Branch and Agency Examination Manual September 1997 Page 1 3020.1 Asset-Based Lending tal and its trends. Trade reports should be decreasing, the quality of receivables may be reviewed, the agings of receivables and payables deteriorating. should be scrutinized, and inventory turnover should be analyzed. Furthermore, the prompt Aging of accounts receivable. The branch payment of taxes, especially payroll taxes, should should obtain a monthly aging of the accounts be verified. A primary reason for a company to receivable pledged. The examiner should note obtain asset-based financing is to maximize the percentage of accounts delinquent in relation discounts offered by suppliers; therefore, it to the total accounts pledged, and those accounts should pay creditors promptly upon receiving having past due balances, which also have the financing. If it is not doing so, it may be current amounts due. diverting the funds out of the business and/or the company’s financial condition may not warrant Concentration of debtor accounts. A lender this type of financing. may be vulnerable to loss if a large percentage of the dollar amount of receivables assigned is Branch management’s ability to recognize a concentrated in a few accounts. A list of con- customer’s financial problems as they develop centrations should be prepared periodically and to initiate orderly liquidation, if necessary, showing the largest accounts. is important in the supervision of asset-based financing. The line theoretically could be fully liquidated by discontinuing further advances, Ineligible receivables. The examiner should collecting the assigned receivables and liquidat- be aware of receivables that, by their nature, ing pledged inventory. However, such drastic should be excluded from the lending formula. action could cause the borrower’s business to The following are examples of receivables that close resulting in a probable deterioration of the may be considered ineligible: receivables from new disputes and in returns and offsets. So that the branch’s loan may be • Due from affiliated companies. Although such liquidated in an orderly manner without losses receivables might be valid, the temptation for or other adverse effects, the branch usually the borrower to create fraudulent invoices notifies its borrower of a contemplated liquida- would be great. tion, allowing the borrower time to seek other • Receivables subject to a purchase money inter- means of continuing the business. Asset-based est, such as floor plan arrangements. The lines where the financial position has declined manufacturer will frequently file financing so that refinancing is prevented should be criti- statements when merchandise is delivered to cized, unless the branch has initiated an orderly the borrower. That filing usually gives the liquidation. When such a liquidation is occur- manufacturer a superior lien on the receivable. ring, the examiner may not see the need for An alternative would be to enter into an classification if the borrower’s business is con- agreement with the manufacturer where rights tinuing, the existing collateral is of good quality, to the receivables are subordinated to the and no collateral deterioration is anticipated. branch.

In asset-based lending, branch management Financial strength of debtor accounts. The should continually evaluate the realizable value branch should maintain credit information and of assets pledged. To do so, management should trade reports on large debtor accounts as part of review the loan agreement and compliance there- the borrower’s credit file. The examiner should with; the quality of the assets pledged, including determine whether the debtor accounts are sig- documentation; and the safeguards to ensure the nificant to the borrower’s business and are well authenticity and collectibility of the pledged rated and financially strong. assets. The information obtained is sometimes difficult to interpret unless it is related to other Disputes, returns, and offsets. The borrower periods, comparable businesses, or industry sta- should furnish promptly to the branch copies of tistics. The following factors should be consid- all significant credit memoranda issued. An ered in evaluating the quality of assets pledged: analysis of those memoranda must be made. A large or increasing volume of such transactions The turnover of the receivables pledged and could adversely affect the branch’s collateral the borrower’s credit limit. If the turnover is position.

September 1997 Branch and Agency Examination Manual Page 2 Asset-Based Lending 3020.1

DOCUMENTATION the agreed percentage of the outstanding receivables. The receivables are usually pledged on a Loan Agreement—An asset-based loan agree- notification basis. Under this method, the branch ment is a contract between a borrower and the maintains complete control of all funds paid on branch that sets forth conditions governing the all accounts pledged by requiring the borrower’s handling of the account and the remedies avail- customer(s) to remit directly to the branch. The able in the event of default. Among the major same application of payments is then used as provisions, might be: under the blanket assignment method. Regard- less of the methods used, the branch should • A percentage advance against acceptable ensure its collateral through a program of regu- receivables. The advance may depend on the lar audit and direct confirmation. gross profit margin from the sale of merchandise and the credit quality of the borrower’s Security Agreement and Financing customers. For example, if a borrower has a Statement—Article 9 of the Uniform Commer- gross profit margin of 30 percent, the maxi- cial Code (UCC) applies to any transaction that mum advance might be 70 percent, with a is intended to create a security interest in reduced percentage if the borrower’s custom- accounts receivable. Under the UCC, the branch ers do not have top credit ratings. must create a valid and enforceable security interest and perfect that interest. Once an • Use of only acceptable receivables. This term enforceable security interest is created, the refers to a branch’s outlining qualifications for secured party can always enforce it, on default, acceptance. For example, acceptable receiv- against the debtor, provided there is no superior ables may include only those accounts that are third-party interest. If the holder of a valid and current or not more than a given number of enforceable Article 9 interest takes the addi- days past due. The entire amount of receiv- tional steps required to perfect under Article 9, it ables may be unacceptable if a certain per- will defeat most such third parties. centage, e.g., 10 percent, is 90 days or more delinquent. Under the provisions of the UCC, a branch should request from the Secretary of State, or • A maximum dollar amount due from any one other filing office, a listing of any open liens on account debtor. Because there is always the the customer’s receivables or inventory. Provid- possibility of unforeseen and undisclosed ing no such liens are outstanding, the branch credit failure or a return of merchandise, a should then obtain a Security Agreement, common benchmark is that no more than Accounts Receivable and a Financing Statement 20 percent of the receivables assigned are and file promptly. The security agreement and from one customer. financing statement should cover current and future accounts and advances for all proceeds Documentation of Advances—There are two thereof (a ‘‘blanket assignment’’), or detail the dominant methods by which advances are made. specific item(s) being taken as collateral (a Under the blanket assignment method, the bor- ‘‘specific assignment’’). To protect its rights to rower periodically supplies the branch with the receivables, the lending branch should con- documentation of the amount of receivables sider taking a lien on the borrower’s current and outstanding on its books. Based upon this infor- future inventory and all proceeds thereof. mation, the branch advances the agreed percent- Sections 9-203 and 9-204 of the UCC require age of the outstanding receivables. The receiv- that the parties take four steps to create a valid ables are usually pledged on a non-notification and enforceable security interest. They must: basis and payments on receivables are made directly to the borrower, who then remits them • Enter into a security agreement. to the branch. The branch applies all or a portion of such funds to the borrower’s loan and/or the • Reduce as much of that agreement to writing cash collateral account, which is under the as is necessary to satisfy Section 9-203, which branch’s control. Under the ledgering of accounts also requires that the debtor sign this writing method, the lender receives duplicate copies of or give possession of the collateral to the the invoices together with the shipping docu- creditor. ments and/or delivery receipts. Upon receipt of • Have the debtor acquire rights in the collateral. satisfactory information, the branch advances • Have the secured party give value.

Branch and Agency Examination Manual September 1997 Page 3 3020.1 Asset-Based Lending

Section 9-302(10) provides for automatic per- ENSURING AUTHENTICITY AND fection, without filing a financing statement, COLLECTIBILITY when any or all assignments to the branch do not transfer a significant part of the outstanding Regardless of the advance methods used, the accounts of the borrower. However, in all other following safeguards, which branch manage- accounts receivable security interests, the branch ment should consider and the examiner should must file a financing statement to perfect its evaluate, ensure the authenticity and collectibil- security interest. The law of the jurisdiction in ity of the pledged assets: which the debtor is located provides where the financing statement must be filed. Filing loca- Audits. To verify the information supplied by tion is determined by place of business, execu- the borrower to the branch, the branch sends its tive office, or residence if the debtor has no staff member(s) to the borrower’s place of place of business in the state. Refer to the business to audit its books. The audit should appropriate State jurisdiction for filing occur several times a year, usually on a quarterly instructions. basis. The scope of such audit should include The financing statement, which is the docu- preparation of balance sheets, profit and loss ment filed for public notice, must: statements, working capital analysis, agings of payables and receivables, an inspection of inven- • Give the names and mailing addresses of the tory and related records, and a determination debtor and secured party. that the debtor accounts are properly marked on • Be signed by the debtor. the books as assigned to the branch. The audit • Give an address of the secured party from also should include procedures to determine which information concerning the security whether all significant credit memoranda have interest may be obtained. been properly issued and reported by the bor- • Give the mailing addresses of the debtor and rower to the branch. the secured party. • Contain a statement indicating the types of Confirmations. To verify the authenticity of collateral or describing the items or collateral. the pledged collateral, the branch should insti- • Be renewed every five years. tute a program of direct confirmation. This procedure is particularly important if the accounts A copy of the security agreement is sufficient receivable are pledged on a non-notification as a financing statement if it meets the preceding basis because the branch does not have the same requirements. control of the debtor accounts as it does when Although effective compliance with the UCC the receivables are pledged on a notification creates, in most instances, a valid and enforce- basis. Direct confirmations should be made able first lien, it does not insulate the branch before the initial lending arrangement and, there- from the need to police its collateral. By filing, after, at least semiannually. Confirmations should the branch establishes the right to collect on be on a positive basis. The branch should obtain only those receivables assigned to it, provided: written approval from the borrower before confirming accounts receivable on a non-notification • The sales are legitimate. basis. Further, the branch should consider using • The merchandise has been delivered. the name of a phantom company as sender of the • The merchandise is as ordered. confirmations and having the confirmations • Sales were made without warranties (almost returned to a post office box to ensure that all sales are covered by warranties). account debtors do not know that their receiv- • The merchandise was not shipped on ables are being pledged. consignment. • The merchandise is not subject to offset, i.e., contra accounts or liens. • The receivable has not already been paid to the borrower.

September 1997 Branch and Agency Examination Manual Page 4 Asset-Based Lending Examination Objectives Effective date July 1997 Section 3020.2

1. To determine if the policies, practices, pro- 3. To evaluate the portfolio for collateral suffi- cedures, and internal controls regarding asset- ciency, credit quality, and collectibility. based lending are adequate. 4. To recommend corrective action when poli- 2. To determine if branch officers are operating cies, practices, procedures, or internal con- in conformance with the established trols are deficient or when violations of laws guidelines. or regulations have been noted.

Branch and Agency Examination Manual September 1997 Page 1 Asset-Based Lending Examination Procedures Effective date July 1997 Section 3020.3

Refer to the Credit Risk Management examina- 4. Analyze secondary support offered by guar- tion procedures for general procedures to assess antors and endorsers. the risk of asset-based lending activities. How- 5. Ascertain compliance with established branch ever, if the branch engages in significant asset- policy. based lending activities, and additional informa- 6. Discuss with appropriate officer(s) and pre- tion is needed, the examiner should perform the pare a summary of the branch’s asset-based following examination procedures. lending activities. 7. Evaluate the function with respect to: 1. If selected for implementation, complete or a. The adequacy of written policies relating update the Internal Control Questionnaire for to asset-based lending. this area. b. The manner in which branch officers are 2. Determine if deficiencies noted at previous conforming with established policy. examinations and internal/external audits c. Adverse trends within the asset-based lend- have been adequately addressed by ing department. management. d. Accuracy and completeness of the man- 3. Review the following information for selected agement reports relating to asset-based asset-based loans: lending obtained from the branch. a. Relationship between amount collected in a month on the receivables pledged as e. Internal control deficiencies or exceptions. collateral and the borrower’s credit limit. f. Recommended corrective action when b. Aging of accounts receivable. policies, practices, or procedures are c. Ineligible receivables. deficient. d. Concentration of debtor accounts. g. The competency of departmental e. Financial strength of debtor accounts. management. f. Disputes, returns, and offsets. h. Other matters of significance. g. Management’s safeguards to ensure the 8. Update the workpapers with any information authenticity and collectibility of the that will facilitate future examinations. assigned receivables.

Branch and Agency Examination Manual September 1997 Page 1 Asset-Based Lending Internal Control Questionnaire Effective date July 1997 Section 3020.4

Refer to the Credit Risk Management internal 3. Does the branch record on a timely basis a control questionnaire for a general review of the first lien on the assigned receivables for each branch’s internal controls, policies, practices, borrower? and procedures. If the branch engages in signifi- 4. Do all loans granted on the security of the cant asset-based lending activities, and addi- receivables also have an assignment of the tional information is needed, the examiner should inventory? complete the following internal control questionnaire. For audit procedures, refer to the Credit 5. Does the branch verify the borrower’s Risk Management section 3010.5. accounts receivable or require independent verification on a periodic basis? 1. Does the branch have policies specifically 6. Does the branch require the borrower to relating to asset-based lending that: provide aged accounts receivable schedules a. Establish procedures for reviewing asset- on a periodic basis? based lending applications? b. Establish standards for determining credit lines? c. Establish standards for determining the percentage advance to be made against CONCLUSION acceptable receivables? d. Define acceptable receivables? 7. Is the information covered by this ICQ ad- e. Establish minimum requirements for veri- equate for evaluating internal controls in this fication of borrower’s pledged assets? area? If not, indicate any additional exami- f. Establish minimum standards for nation procedures deemed necessary. documentation? 8. Based on the information gathered, evaluate 2. Are policies reviewed at least annually to internal controls in this area (i.e. strong, determine if they are compatible with chang- satisfactory, fair, marginal, unsatisfactory). ing market conditions?

Branch and Agency Examination Manual September 1997 Page 1 Asset Securitization Effective date July 1997 Section 3030.1

Banking organizations, including branches, have mercial real estate loans, home equity loans, long been involved with asset-backed securities student loans, nonperforming loans, and lease (ABS), both as investors in such securities and receivables. as major participants in the securitization process. In recent years, they have stepped up their involvement by increasing their participation in the long-established market for securities backed BENEFITS AND RISKS OF ASSET by residential mortgage loans. Banking organi- SECURITIZATION zations have also expanded their securitization activities to include other types of assets, such as While the objectives of securitization may vary credit card receivables, automobile loans, boat from organization to organization, there are loans, commercial real estate loans, student essentially five benefits that can be derived from loans, nonperforming loans, and lease receivables. securitized transactions. First, the sale of assets may reduce regulatory costs. The removal of an asset from an FBO’s books generally reduces capital requirements and reserve requirements AN OVERVIEW OF ASSET on the deposits funding the asset. Second, asset SECURITIZATION securitization provides originators with an additional source of funding or liquidity or both. The In recent years, the number of banking organi- process of securitization basically converts an zations that have issued securities backed by illiquid asset into a security with greater mar- their own assets and that have acquired ABS as ketability. Securitized issues often require a investments has increased markedly. This increase credit enhancement, which results in a higher has resulted because securitization activities can credit rating than what would normally be yield significant financial and operational benefits. obtainable by the institution itself. Conse- In its simplest form, asset securitization quently, these issues may provide a cheaper involves the selling of assets. The process first form of funding to the banking organization. segregates generally illiquid assets into pools Third, securitization may be used to reduce and transforms them into capital market instru- interest-rate risk by improving the organiza- ments. The payment of principal and interest on tion’s asset-liability mix. Such a benefit is more these instruments depends on the cash flows likely if the organization has a large investment from the assets in the pool underlying the new in fixed-rate, low-yield assets. Fourth, by securities. The new securities may have denomi- removing assets, the organization enhances its nations, cash flows, and other features that differ return on equity and assets. Finally, the ability to from the pooled assets making the securities in sell these securities worldwide diversifies the them more attractive to investors. organization’s funding base which reduces the The federal government encourages the secu- dependence of the branch on local economies. ritization of residential mortgages. In 1970, the It may be appropriate for a banking organiza- Government National Mortgage Association tion, including a branch, to engage in securiti- (GNMA) created the first publicly traded zation activities and to invest in ABS, if it does mortgage-backed security. Soon, the Federal so in a prudent manner. Nonetheless, these National Mortgage Association (FNMA) and activities can significantly affect a branch’s the Federal Home Loan Mortgage Corporation overall risk exposure. It is of great importance, (FHLMC), both government-sponsored agen- particularly given the growth and expansion of cies, also developed mortgage-backed securi- such activities, that examiners be fully informed ties. The guarantees provided by these govern- of the fundamentals of the securitization pro- ment or government-sponsored entities assure cess, including knowledge of the various risks investors of the payment of principal and inter- that securitization and investing in ABS create est and have thus greatly facilitated the securi- for branches. Additionally, examiners need to be tization of mortgage assets. As previously men- aware of the pertinent examination procedures tioned, securities have also been issued that are in order to effectively assess the branch’s expo- backed by other assets such as: credit card sure to risk and its ability to manage that receivables, automobile loans, boat loans, com- exposure.

Branch and Agency Examination Manual September 1997 Page 1 3030.1 Asset Securitization

The following instructions were developed sponsored agencies that are perceived by the for Federal Reserve System use in order to credit markets to have the implicit support of the provide examiners with the information and federal government. Privately issued, mortgage- guidance they need on asset securitization. These backed securities and other types of asset- instructions discuss the mechanics of securitiza- backed securities generally depend on some tion and related accounting issues while also form of credit enhancement provided by the providing a set of examination guidelines, originator or third party to insulate the investor objectives, and procedures.1 The various state from a portion of or all credit losses. Usually, and federal agencies may differ in terms of the amount of the credit enhancement is based speciﬁc practices and methodologies used to upon several multiples of the historical losses implement these guidelines. For further guid- experienced on the particular asset backing the ance in this area, examiners should consult with security. their respective agencies.

Credit Enhancement THE SECURITIZATION PROCESS One form of credit enhancement is the recourse The asset securitization process begins with the provision, or guarantee, that requires the origi- segregation of loans or leases into pools that are nator to cover any losses up to an amount relatively homogeneous with respect to credit, contractually agreed upon. Some asset-backed maturity, and interest-rate risks. These pools of securities, such as those backed by credit card assets are then transferred to a trust or other receivables, typically use a spread account. This entity known as an issuer, because it issues the account is actually an escrow account. The securities or ownership interests that are acquired funds in this account are derived from a portion by investors. These asset-backed securities may of the spread between the interest earned on the take the form of debt, certificates of beneficial assets in the underlying pool and the lower ownership, or other instruments. The issuer is interest paid on securities issued by the trust. typically protected from bankruptcy by various The amounts that accumulate in the account are structural and legal arrangements. A sponsor used to cover credit losses in the underlying that provides the assets to be securitized owns or asset pool up to several multiples of historical otherwise establishes the issuer. losses on the particular asset collateralizing the Each issue of ABS has a servicer that is securities. responsible for collecting interest and principal payments on the loans or leases in the under- Overcollateralization, another form of credit lying pool of assets and for transmitting these enhancement covering a predetermined amount funds to investors (or a trustee representing of potential credit losses, occurs when the value them). A trustee is responsible for monitoring of the underlying assets exceeds the face value the activities of the servicer to ensure that it of the securities. A third form of credit enhance- properly fulfills its role. ment involves the use of the senior-subordinated A guarantor may also be involved to ensure security structure. Under such a structure, at that principal and interest payments will be least two classes of asset-backed securities are received by investors on a timely basis, even if issued, with the senior class having a priority the servicer does not collect these payments claim on the cash flows from the underlying from the obligors. Many issues of mortgage- pool of assets. Therefore, the subordinated class backed securities are guaranteed directly by must absorb credit losses before they can be GNMA, a government agency backed by the charged to the senior portion. Because the senior full faith and credit of the U.S. government, or class has this priority claim, cash flows from the by FNMA or FHLMC, both government- underlying pool of assets must first satisfy the requirements of the senior class. Only after these 1. The Federal Reserve System has developed a three- requirements have been met will the cash flows volume set that contains educational material concerning the be directed to service the subordinated class. process of asset securitization and examination guidelines. A more recent form of credit enhancement is The volumes are as follows: (a) An Introduction to Asset the cash collateral account, which is established Securitization, (b) Accounting Issues Relating to Asset Secu- ritization, and (c) Examination Guidelines for Asset when a third party deposits cash into a pledged Securitization. account. The use of cash collateral accounts

September 1997 Branch and Agency Examination Manual Page 2 Asset Securitization 3030.1 grew as the number of highly rated banks and The pay-through structure with multiple other credit enhancers declined in the early classes combines the cash flows from the under- 1990s. Other forms of credit enhancement lying pool of assets and reallocates them to two include standby letters of credit, pool insurance, or more issues of securities that have different or surety bonds from third parties. cash flow characteristics and maturities. An An investment banking firm or other organi- example is the collateralized mortgage obliga- zation generally serves as an underwriter for tion (CMO), which has a series of bond classes, ABS. In addition, for asset-backed issues that each with its own specified coupon and stated are publicly offered, a credit rating agency will maturity. In most cases, the assets that make up analyze the policies and operations of the origi- the CMO collateral pools are pass-through nator and servicer as well as the structure, securities. Scheduled principal payments, and underlying pool of assets, expected cash flows, any prepayments, from the underlying collateral and other attributes of such securities. Before go first to the earliest maturing class of bonds. assigning a rating to the issue, the rating agency This first class of bonds must be retired before will also assess the extent of loss protection the principal cash flows are used to retire the provided to investors by the credit enhance- later bond classes. The development of the ments associated with the issue. pay-through structure resulted from the desire to Traditional lending activities are generally broaden the marketability of these securities to funded by deposits or other liabilities with both investors who were interested in maturities other the assets and related liabilities reflected on the than those generally associated with pass- balance sheet. Liabilities must generally increase through securities. in order to fund additional loans. In contrast, the Multiple-class, ABS may also be issued as securitization process generally does not increase derivative instruments, such as stripped securi- on-balance-sheet liabilities in proportion to the ties. Investors in each class of a stripped security volume of loans or other assets securitized. As will receive a different portion of the principal discussed more fully below, when banking and interest cash flows from the underlying pool organizations securitize their assets and these of assets. In their purest form, stripped securities transactions are treated as sales, both the assets may be issued as interest-only (IO) strips, for and the related ABS (i.e., liabilities) are removed which the investor receives 100 percent of the from the balance sheet. The cash proceeds from interest from the underlying pool of assets and the securitization transactions are generally used as principal-only (PO) strips, for which the to originate or acquire additional loans or other investor receives all of the principal. assets for securitization and the process is In addition to these securities, other types of repeated. Thus, for the same volume of loan financial instruments may arise as a result of originations, securitization results in lower assets asset securitization, as follows: and liabilities in comparison to traditional lending activities. • Loan servicing rights—these instruments are created when organizations purchase or originate loans, sell or securitize the loans, and The Structure Of Different Types retain the right to act as servicers for pools of Of ABS loans. The cost of these purchased servicing rights may be recorded as an intangible asset Asset securitization involves different types of when certain criteria are met. In addition, capital market instruments. These instruments servicing rights are created when organiza- may be structured as pass-throughs or pay- throughs. Under a pass-through structure, the cash flows from the underlying pool of assets (CMOs), or multiple class securities, were introduced to help minimize the reinvestment and interest rate risks inherent in are passed through to investors on a pro rata the traditional fixed rate mortgage-backed security. As a result basis. This type of security may be a single-class of the Tax Reform Act of 1986, REMIC was created. The instrument such as a GNMA pass-through or a REMIC is a more flexible mortgage security, which expanded multi-class instrument such as a real estate the appeal of the CMO structure to a wider investor base and offered preferred tax status to both investors and issuers. 2 mortgage investment conduit (REMIC). Today, almost all CMOs are issued in REMIC form. (From The ABCs of CMOs, REMICs and IO/POs: Rocket Science Comes to Mortgage Finance, Journal of Accountancy, April 2. In the early 1980s, collateralized mortgage obligations 1991, p. 41.)

Branch and Agency Examination Manual September 1997 Page 3 3030.1 Asset Securitization

tions purchase the right to act as servicers for secondary markets for certain ABS are thin, loan pools. investors may encounter greater than anticipated • Excess servicing fee receivables —These difficulties when seeking to sell their securities. instruments generally arise when the present Furthermore, certain derivative instruments, such value of any additional cash flows from the as stripped ABS and residuals, may be extremely underlying assets that a servicer expects to sensitive to interest rates and exhibit a high receive exceeds standard servicing fees. degree of price volatility, and, therefore, may • ABS residuals (sometimes referred to as dramatically affect the risk exposure of inves- residuals or residual interests)—They repre- tors, unless used in a properly structured hedg- sent claims on any cash flows that remain after ing strategy. all obligations to investors and any related expenses have been met. Such excess cash flows may arise as a result of overcollateralization or from reinvestment income. Residu- Issuer als can be retained by sponsors or purchased by investors in the form of securities. Banking organizations that issue ABS may be subject to pressures to sell only their best assets, thus reducing the quality of their own loan portfolios. On the other hand, some organiza- SUPERVISORY CONSIDERATIONS tions may feel pressures to relax their credit standards because they can sell assets with Clear benefits can accrue to banking organiza- higher risk than they would normally want to tions that engage in securitization activities and retain for their own portfolios. invest in ABS. Nonetheless, securitization To protect their names in the market, issuers activities can increase the overall risk profile of may feel pressures to provide moral recourse by the banking organization if the activities are not repurchasing securities backed by loans or leases carried out in a prudent manner. For the most that they originated and which have since dete- part, the types of risks that financial institutions riorated and become nonperforming. Funding encounter in the securitization process are iden- risk may also be a problem for issuers when tical to those that they face in traditional lending market aberrations do not permit the issuance of transactions. These involve credit risk, concen- ABS that are in the securitization pipeline. tration risk, interest-rate risk, including prepayment risk, operational risk, liquidity risk, moral recourse risk, and funding risk. However, because the securitization process separates the Servicer traditional lending function into several limited roles such as originator, servicer, credit enhancer, Banking organizations that service securitiza- trustee, and investor, the types of risks that a tion issues must ensure that their policies, branch will encounter will differ depending on operations, and systems will not permit break- the role it assumes. downs that may lead to defaults. Substantial fee As with direct investments in the underlying income can be realized by acting as servicer. An assets, investors in ABS will be exposed to institution already has a fixed investment in its credit risk, that is, the risk that obligors will servicing systems, and achieving economies of default on principal and interest payments. scale relating to that investment is in its best Investors are also subject to the risk that the interest. The danger, though, lies in overloading various parties, for example, the servicer or the systems’ capacity, thereby creating enor- trustee, in the securitization structure will be mous out-of-balance positions and cost over- unable to fulfill their contractual obligations. runs. Servicing problems may potentially pre- Moreover, investors may be susceptible to con- cipitate a technical default, which, in turn, could centrations of risks across various ABS issues lead to the premature redemption of the security. through over-exposure to an organization per- In addition, expected collection costs could forming various roles in the securitization pro- exceed fee income. (For further guidance, refer cess, or as a result of geographic concentrations to the Federal Reserve’s Commercial Bank within the pool of assets providing the cash Examination Manual, Loan Portfolio Manage- flows for an individual issue. Also, because the ment section.)

September 1997 Branch and Agency Examination Manual Page 4 Asset Securitization 3030.1

Accounting Issues Securitization Of Commercial Paper

Asset securitization transactions are frequently Over time, banking institutions have increas- structured to obtain certain accounting treat- ingly been involved in the securitization of ments, which, in turn, affect reported measures commercial paper. It is important to note, how- of profitability and capital adequacy. In transfer- ever, that asset-backed commercial paper pro- ring assets into a pool to serve as collateral for grams differ from other methods of securitiza- ABS, a key question is whether the transfer tion. One difference is that more than one type should be treated as a sale of the assets or as a of asset may be included in the receivables pool. collateralized borrowing, that is, a financing Moreover, in certain cases, the cash flow from transaction secured by assets. Sales treatment the receivables pool may not necessarily match results in the assets being removed from the the payments to investors because the maturity branch’s balance sheet, thus reducing total assets of the underlying asset pool does not always relative to earnings and capital and, thereby, parallel the maturity of the structure of the producing higher performance and capital ratios. commercial paper. Consequently, when the paper Treatment of these transactions as financings, matures, it is usually rolled over or funded by however, means that the assets in the pool another issue. In certain circumstances, a matur- remain on the balance sheet and the related ing issue of commercial paper cannot be rolled liabilities are subject to reserve requirements.3 over. To address this problem, many banking institutions have established back-up liquidity facilities. Certain banking institutions have classified these back-up facilities as pure liquidity facilities despite the credit-enhancement element present in such facilities and, as a result, 3. Note, however, that it is the Federal Reserve’s Regula- have incorrectly assessed the risks associated tion D that defines what constitutes a reservable liability of a with such back-up liquidity facilities. In these depository institution. Thus, although a given transaction may cases, the back-up liquidity facilities have been qualify as an asset sale for regulatory reporting purposes, it nevertheless could result in a reservable liability under more similar to direct credit substitutes than to Regulation D. loan commitments.

Branch and Agency Examination Manual September 1997 Page 5 Asset Securitization Examination Objectives Effective date July 1997 Section 3030.2

1. To determine if the branch is in compliance 10. To determine that liquidity and market risks with laws, regulations and policy statements. are recognized and the branch is not exces- 2. To determine if the branch is involved in sively dependent on securitization as a sub- originating, servicing, providing credit stitute for funding or as a source of income. enhancements, serving as a trustee for, or 11. To determine that steps have been taken to investing in securitized assets. minimize the potential for conflicts of inter- 3. To determine that securitization activities est due to securitization. are properly managed within the context of the branch’s overall risk management 12. To determine that possible sources of struc- techniques. tural failure in securitization transactions 4. To determine that management has an are recognized, and that branch and head appropriate level of experience in securiti- office management has adopted measures to zation activities. minimize the impact of such failures should 5. To ensure that the branch does not hold any they occur. asset-backed securities that are inappropri- 13. To determine that branch and head office ate, given the size of the branch and the management is aware of the legal risks and sophistication of its operations, e.g., IOs uncertainty regarding various aspects of and POs. securitization. 6. To ensure that all asset-backed securities 14. To determine that concentrations of expo- owned and any assets sold with recourse are sure in the underlying asset pools, in the properly accounted for on the branch’s asset-backed securities portfolio, or in the books and in the branch’s regulatory reports. structural elements of securitization trans- 7. To determine that sources of credit risk are actions are avoided. understood and properly analyzed and managed without excessive reliance on credit 15. To determine that all sources of risk are ratings by outside agencies. evaluated at the inception of each securiti- 8. To determine that credit, operational, and zation activity and are monitored on an other risks are recognized and are addressed ongoing basis. through appropriate policies, procedures, 16. To recommend corrective action when poli- management reports, and other controls. cies, practices, procedures, or internal con- 9. To determine if officers are operating in trols are deficient or when violations of conformance with established branch poli- laws, regulations or policy statements have cies and procedures. been noted.

Branch and Agency Examination Manual September 1997 Page 1 Asset Securitization Examination Procedures Effective date July 1997 Section 3030.3

These procedures represent a comprehensive list 6. Determine whether adequate procedures for of processes and activities to be reviewed during evaluating the branch’s internal control pro- a full scope examination. The examiner-in- cedures and financial strength of the other charge will establish the general scope of the institutions involved in the securitization examination and work with the examination process are in place. staff to tailor specific areas for review as cir- 7. Obtain the documentation outlining any cumstances warrant. The procedures selected credit enhancements and the remedies avail- will be based on internal audit comments, pre- able in the event of a default. In addition, vious examination workpapers, a general review both originators and purchasers of securi- of the activity to be examined, and the judge- tized assets should have a prospectus on the ment of the examiner and examiner-in-charge. issue. Obtaining a copy of the prospectus can be an invaluable source of information; 1. Request a schedule of all asset-backed a prospectus generally should contain infor- securities owned by the branch. Reconcile mation on credit enhancement, default pro- to subsidiary ledgers of the balance sheet visions, subordination agreements, etc. In and review credit ratings assigned to these addition to the prospectus, obtain the docu- securities by independent rating agencies. mentation confirming the purchase or sale Determine that the accounting methods and of a security. procedures used for these assets, at inception and throughout the carrying life, are 8. Ensure that, regardless of the role a branch appropriate. plays in the securitization process, the documentation for an asset-backed security 2. Request and review information on the clearly specifies the limitations of the types and amount of assets that have been branch’s legal responsibility to assume securitized by the branch. In addition, losses. request information concerning potential contractual or contingent liability from guar- 9. Verify whether the branch, acting as origi- antees, underwriting, and servicing of secu- nator, packager, or underwriter, has written ritized assets, whether originally securitized policies addressing the repurchase of assets by the branch or not. and other reimbursement to investors in the 3. Review the branch’s policies and proce- event that a defaulted package results in dures to ensure that it follows prudent losses exceeding any contractual credit standards of credit assessment and approval enhancement. The repurchase of defaulted for all securitization exposure. Procedures assets or pools, although not required by the should include thorough and independent underlying agreement, in effect sets a stan- credit assessment of each loan or pool for dard by which a branch could potentially be which it has assumed credit risk followed found legally liable for all sold assets. by periodic credit reviews to monitor per- Review and report any situations in which formance throughout the life of the expo- the branch has repurchased or otherwise sure. If a branch invests in asset-backed reimbursed investors for poor quality assets. securities, determine whether there is sole 10. Evaluate credit risk of asset-backed securi- reliance upon the conclusions of external ties and classify any adverse credit risk. List rating services when evaluating the securities. classified assets and evaluate the impact of 4. Determine that rigorous credit standards are the classifications on the overall evaluation applied regardless of the role the branch of the branch. plays in the securitization process, for exam- 11. Aggregate securitization exposures with all ple, servicer, credit enhancer, or investor. loans, extensions of credit, debt and equity 5. Determine that major policies and proce- securities, legally binding financial guaran- dures, including internal credit review and tees and commitments, and any other invest- approval procedures and in-house exposure ments involving the same obligor when limits, are reviewed periodically and determining compliance with internal credit approved by head office management. exposure limits.

Branch and Agency Examination Manual September 1997 Page 1 3030.3 Asset Securitization Examination Procedures

12. Review the branch’s valuation methodol- 18. Check whether internal auditors review all ogy for asset-backed securities to determine facets of securitization on a regularly basis. if it is appropriate. 19. Review policies and procedures for compli- 13. Review securitized assets for industrial or ance with applicable state and federal lend- geographic concentrations. Excessive expo- ing limits. These requirements must be sures to an industry or region among the analyzed to determine whether a particular underlying assets should be noted in the asset-backed security issue is considered a review of the loan portfolio and evaluated in single investment or a loan to each of the the context of the risk management creditors underlying the pool. Collateralized assessment. mortgage obligations may be exempt from 14. Ensure that, in addition to policies limiting this limitation, if they are issued or guaran- direct credit exposure, a branch has devel- teed by an agency or instrumentality of the oped exposure limits with respect to par- U.S. government. ticular originators, credit enhancers, trust- 20. Determine whether the underwriting of ees, and servicers. asset-backed securities of affiliates are: 15. Review the policies of a branch engaged in underwriting with regard to situations in a. Rated by an unaffiliated, nationally rec- which it cannot sell underwritten asset- ognized statistical rating organization. backed securities. Credit review, funding b. Issued or guaranteed by FNMA, FHLMC, capabilities, and approval limits should or GNMA, or represent interests in such allow the branch to purchase and hold obligations. unsold securities. All potential credit expo- 21. Determine if purchases of high-risk sure should be within prudential lending mortgage-backed securities were made to limits. reduce the overall interest rate risk of the 16. Ensure that internal systems and controls branch. Determine if the branch evaluates adequately track the performance and con- and documents at least quarterly whether dition of internal exposures and monitor the these securities have reduced its interest rate branch’s compliance with internal proce- risk. dures and limits. In addition, verify that adequate audit trails and internal audit cov- 22. Review and discuss any documentation erage are in place. Ensure that the internal exceptions, violations, internal control reports are adequate in scope and frequency. exceptions, and classifications with manage- 17. Determine that management information ment and obtain and document manage- systems provide: ment’s response. a. A listing of all securitizations in which 23. Review the branch’s liquidity agreements the branch is involved. with any asset-backed commercial paper b. A listing of industry and geographic programs and determine whether the agree- concentrations. ments have any credit related components. c. Information on total exposure to specific Is the branch required to purchase the assets? originators, servicers, credit enhancers, Are these assets repurchased from the trustees, or underwriters. branch? If the facility is determined to be a d. Information regarding portfolio aging and commitment, determine whether its matu- performance relative to expectations. rity is short-term or long-term. Do any of e. Periodic and timely information to head the liquidity agreements contain a material office management on the branch’s adverse clause or any other credit contin- involvement in, and credit exposure aris- gency provision? ing from, securitization.

September 1997 Branch and Agency Examination Manual Page 2 Asset Securitization Internal Controls Questionnaire Effective date July 1997 Section 3030.4

Review the branch’s internal controls, policies, f. Hedge the branch’s exposure to adverse practices, and procedures for all aspects of asset price movements when engaged in under- securitization. The branch’s system should be writing or market-making activities? documented in a complete and concise manner 3. Are securitization policies reviewed and and should include, where appropriate, narra- reafﬁrmed at least annually to determine if tive descriptions, ﬂowcharts, copies of forms they are compatible with changing market used, and other pertinent information. conditions?

INTERNAL POLICIES CONTROL/MANAGEMENT INFORMATION SYSTEMS 1. Does the branch employ the services of a securities dealer? If so, does the branch rely 4. Do the branch’s internal systems and con- solely on the advice of such a dealer when trols adequately track the performance and purchasing asset-backed securities for the condition of internal exposures, and do the branch’s investment portfolio? Does the systems monitor the branch’s compliance branch have staff responsible for reviewing with internal procedures and limits? Are and approving the investment manager’s adequate audit trails and internal and external acquisitions? Have minimum criteria been audit coverage provided? established for selecting a securities dealer? 5. Do the branch’s cost accounting systems 2. To ensure a proper level of supervision over provide a reliable determination of the prof- branch activities, has head office manage- itability and volatility of asset securitization ment reviewed and ratified asset securitiza- activities? tion policies, practices, and procedures that: 6. Are management information systems and a. Require an initial thorough and indepen- reporting procedures adequate, in that they: dent credit assessment of each asset pool a. Provide a listing of all securitizations for for which the branch has assumed credit which the branch is originator, servicer, risk as either a participant in the securiti- credit enhancer, underwriter, or trustee? zation process or as an investor? b. Provide a listing of industry and geographic concentrations? b. Address the repurchase of assets and other c. Provide information on total exposure to forms of reimbursement to investors by specific originators, servicers, credit the branch when it is serving as the enhancers, trustees, or underwriters? originator, packager, or underwriter in d. Provide information regarding portfolio the event that a default results in losses aging and performance relative to expec- exceeding any contractual credit tations? enhancement? e. Provide periodic and timely information c. Ensure that the credit, pricing, and servic- to head office management on the branch’s ing standards for securitized assets are involvement in, and credit exposure aris- equivalent to standards for assets that ing from, securitization? remain on the branch’s books? f. Provide credit ratings assigned by inde- d. Ensure that the credit, pricing, and servic- pendent rating agencies to all asset- ing standards and compliance with any backed securities held by the branch? provisions relating to government guarantees are reviewed periodically by head office management? CONCLUSION e. Establish in-house diversification requirements, within proper risk management 7. Is the information covered by this ICQ techniques, regarding aggregate outstand- adequate for evaluating internal controls in ing exposures to a particular institution, this area? If not, indicate any additional industry, or geographic area? examination procedures deemed necessary.

Branch and Agency Examination Manual September 1997 Page 1 3030.4 Asset Securitization Internal Controls Questionnaire

8. Based on the information gathered, evaluate the internal controls in this area (i.e. strong, satisfactory, fair, marginal, unsatisfactory).

September 1997 Branch and Agency Examination Manual Page 2 Banker’s Acceptances Effective date July 1997 Section 3040.1

One method of financing international trade is on Acceptances (liability) accounts are reduced by the use of a banker’s acceptance. Such an and the discounted acceptance is recorded with instrument may be used to finance all of the other loans and discounts. If the accepting bank successive stages of the movement of goods subsequently rediscounts (sells) the acceptance through the channels of trade from the point of in the market, that acceptance is rebooked as origin to the final destination. Customers’ Liability on Acceptances and Bank’s A banker’s acceptance is an order in the form Liability on Acceptances outstanding and the of a time draft (also referred to as a bill of loan and discount account is reduced. Redis- exchange or a usance draft) drawn by one party counted acceptances are not considered borrow- (the drawer) in favor of itself or another party ings. The customer’s liability on acceptances is (the payee), addressed to (drawn on) a bank (the reduced by a customer’s prepayment or antici- drawee) and accepted by that bank to pay the pation, of an acceptance outstanding. However, holder a certain sum on or before a specified the bank’s liability is not similarly reduced by date. The bank’s acceptance of this order from an anticipation. the drawer, by stamping across the face of the The established market for banker’s accep- draft ACCEPTED and dating and signing the tances in the United States is regulated by the stamp, is a formal acknowledgement of the Federal Reserve System. Federal Reserve Banks obligation and constitutes an unconditional are authorized to discount or purchase eligible promise by that bank to honor the time draft at banker’s acceptances subject to qualitative and maturity. The drawee bank creating the accep- quantitative limits, thus providing a source of tance is primarily liable for the instrument, liquidity to the selling banks. The creation of while the payee, as first endorser, is secondarily banker’s acceptances is governed by Section 13 liable for paying the holder in due course. If the of the Federal Reserve Act (12 USC 372), which drawee (acceptor) is other than a bank, the establishes criteria that must be met in order for instrument is a trade acceptance, not a banker’s the instrument to be eligible for either discount acceptance. or purchase by the Federal Reserve Banks. In Most banker’s acceptances are used to finance addition, for federally-licensed branches, the trade transactions. Accordingly, acceptances are eligible banker’s acceptance limit is in addition often created in connection with a letter of to the loan and investment securities limits. The credit, although they may arise in connection rules governing whether an acceptance meets with collection or open account transactions. the eligibility requirements for discount or pur- Refer to the manual section entitled Letters of chase are important for two major reasons. First, Credit. In general, acceptance credit is consid- acceptances meeting the conditions of eligibility ered self-liquidating in that it provides the means are more readily salable in the market than are for its own payment at maturity. Self-liquidation acceptances that do not satisfy these conditions is accomplished because the acceptance must be and, as such, provide a greater degree of liquid- based on a specific trade transaction in which ity for the accepting bank. Second, unlike eli- goods are being shipped prior to entering the gible acceptances, ineligible acceptances are channels of trade. Therefore, satisfactory evi- subject to reserve maintenance requirements, dence should be available indicating that the thus raising the cost to the borrower over that of draft, when created, is based on an actual an eligible acceptance. For federally-licensed shipment or storage. Furthermore, at maturity of branches, ineligible banker’s acceptances are the draft, the proceeds from the sale of the goods subject to the limits specified in 12 USC 84 and will be used to settle the draft. To a lesser extent, are combined with loans. The examiner must be acceptances also finance the domestic shipment familiar with the criteria used for determining of goods and domestic or foreign storage of eligibility for discount or purchase by the Fed- readily marketable staples. eral Reserve Banks. The payee of the acceptance may hold an Branches that are subject to reserve require- acceptance until maturity, discount it with his or ments (i.e. controlled by an entity with $1 bil- her bank, or sell it in the acceptance market. lion in total worldwide consolidated assets) When a bank discounts (purchases) its own under Section 7 of the International Banking Act acceptance for the payee, its Customers’ Liabil- of 1978 (12 USC 3105(a)) are subject to the ity on Acceptances (asset) and Bank’s Liability limitations described in Section 13 of the Fed-

Branch and Agency Examination Manual September 1997 Page 1 3040.1 Banker’s Acceptances eral Reserve Act (12 USC 372). These regula- cent of the aggregate of all eligible acceptances tions limit the amount of eligible banker’s accep- authorized for a branch. tances that may be created to 150 percent (or Banker’s acceptances, as a source of finance 200 percent with the permission of the Board) of and investment, offer significant advantages to the paid up and unimpaired capital stock and borrowers, accepting banks, and investors alike. surplus of the foreign banking organization Over the years, a banker’s acceptance has often (FBO). In addition, all U.S. branches of an FBO been a cheaper financing vehicle than a loan, are prohibited from creating eligible banker’s because it is readily marketable, is considered an acceptances for any one person in the aggregate important secondary reserve for the accepting in excess of 10 percent of the FBO’s capital. bank, and is a relatively secure investment to the Eligible banker’s acceptances growing out of investor because of its two-name backing. domestic transactions are not to exceed 50 per-

September 1997 Branch and Agency Examination Manual Page 2 Banker’s Acceptances Examination Objectives Effective date July 1997 Section 3040.2

1. To determine if objectives, policies, prac- 4. To evaluate the portfolio for documentation tices, procedures, and internal controls and collateral sufficiency, credit quality, and regarding banker’s acceptances are adequate. collectibility. 2. To determine if branch officers are operating 5. To determine compliance with applicable in conformance with the established federal and state laws and regulations. guidelines. 6. To recommend corrective action when poli- 3. To determine the scope and adequacy of the cies, practices, procedures, or internal con- audit function as it applies to banker’s trols are deficient or when violations of law acceptances. or regulations have been noted.

Branch and Agency Examination Manual September 1997 Page 1 Banker’s Acceptances Examination Procedures Effective date July 1997 Section 3040.3

1. If selected for implementation, complete or eligibility according to established criteria. update the Internal Control Questionnaire Details provided should cover: for this section. 2. Determine if deficiencies noted at previous • Value of merchandise. examinations and internal/external audits • Description of merchandise. have been adequately addressed by manage- • Origin and destination of shipment. ment. • Date of shipment. 3. Review the bankers acceptance section of • Certification that the merchandise is not being the lending policy for adequacy. financed elsewhere. 4. Check scope of internal audit to ensure that it covers a review of bankers acceptances. 12. Review procedures for financing clean 5. Reconcile balances to departmental controls acceptances (i.e. when the title and shipping and the general ledger. documentation is not processed by the office) 6. Verify that appropriate accounting methods to ensure they include: are used and that regulatory reports are a. Details of the shipment such as invoice accurately prepared. amount, type of commodity or merchan- 7. Determine that there is appropriate segrega- dise, ports of embarkation and debarka- tion of duties in that: tion, and the bill of lading date. a. Individuals who prepare and post BA b. Certification that duplicate financing does records also do not issue official checks not exist. or handle cash, c. An agreement by the customer to pro- b. Individuals who perform reconciliations vide copies of invoices and bills of and certifications also do not process lading to the branch upon request. acceptances, and 13. Review procedures for monitoring the stipu- c. Persons who investigate exceptions and lated aggregate liability limitations on out- respond to inquiries do not normally standing acceptances. Systems should be in process acceptances. place to monitor the global customer expo- 8. Ensure the branch has an adequate system sure on the aggregate outstanding amount to track outstanding exceptions and on a consolidated basis which cannot exceed delinquencies. 150% of parent bank capital. 9. Ensure that acceptances are registered in 14. Select a sample of bankers acceptances some manner (manual log book or com- created for specific borrowers and review puter system), consecutively numbered, and credit files for credit risk. Forward findings identified by type of transaction so as to to examiner in charge of loan review. leave an audit trail. 15. Ensure the branch has procedures in place 10. Review procedures for safeguarding blank, to comply with OFAC and Anti-Boycott accepted, and pre-signed documents and provisions. drafts. 16. Prepare, in appropriate format, the findings 11. Review procedures for determining BA eli- and conclusions regarding: gibility. Ensure that ineligible acceptances a. The adequacy of policies relating to are appropriately segregated from the elibible banker’s acceptances. acceptances. Ineligible acceptances cannot b. Whether branch officers are operating in be discounted at the Federal Reserve and conformance with established policy. are treated as reservable liabilities. c. Adverse trends within the banker’s acceptance department. Eligibility can be determined by reviewing d. The accuracy and completeness of the documentary evidence detailing the nature of schedules obtained. the transaction underlying the credit extended. e. Internal control deficiencies or exceptions. This evidence may be in the form of correspon- f. Recommended corrective action when dence, title documents, or document transmittal policies, practices, or procedures are letters that provide sufficient detail to judge deficient.

Branch and Agency Examination Manual September 1997 Page 1 3040.3 Banker’s Acceptances Examination Procedures

g. Other matters of signiﬁcance. 17. Update the workpapers with any information that will facilitate future examinations.

September 1997 Branch and Agency Examination Manual Page 2 Banker’s Acceptances Internal Control Questionnaire Effective date July 1997 Section 3040.4

POLICIES be shown as a liability under Bank’s Liabil- ity on Acceptances Outstanding? 1. Have policies been adopted that: 11. Are banker’s acceptance record copies and a. Establish procedures for reviewing bank- liability ledger trial balances prepared and er’s acceptance applications? reconciled monthly with control accounts b. Define qualified customers? by employees who do not process or record c. Establish minimum standards for docu- acceptance transactions? mentation in accordance with the Uni- form Commercial Code? 2. Are policies reviewed at least annually to FEES determine if they are compatible with changing market conditions? 12. Is the preparation and posting of fees and discounts performed or reviewed by persons who do not also handle cash or issue official checks or drafts? RECORDS 13. Are any independent fee and discount computations made and compared or adequately 3. Is the preparation and posting of subsidiary tested to initial fee and discount records by banker’s acceptance records performed or persons who do not also handle cash or reviewed by persons who do not also handle issue official checks or drafts? cash or issue official checks or drafts? 4. Are the subsidiary banker’s acceptance records balanced daily with the appropriate OTHER general ledger accounts and are reconciling items adequately investigated by persons 14. Are acceptance record copies, own accep- who do not normally handle acceptances tances discounted (purchased) and accep- and post records? tances of other banks purchased safe- 5. Are acceptance delinquencies prepared for guarded during banking hours, locked in and reviewed by management on a timely the vault overnight, and periodically basis? inventoried? 6. Are inquiries about acceptance balances 15. Are blank (pre-signed) customer drafts main- received and investigated by persons who tained under dual control in the vault, num- do not normally handle settlements or post bered, inventoried monthly, and verified records? with the customer on a monthly basis? 7. Are bookkeeping adjustments checked and 16. Are any acceptance fee rebates approved by approved by an appropriate officer? an officer? 8. Is a daily record maintained, summarizing 17. Does the branch have an internal review acceptance transactions details, i.e., bank- system that: er’s acceptances created, payments received, a. Reviews collateral and supporting docu- and fees collected, to support applicable mentation held for negotiability and general ledger account entries? proper assignment? 9. Are acceptances of other banks that have b. Test checks the values assigned to col- been purchased in the open market segre- lateral at frequent intervals? gated on the branch’s records from the c. Determines that lending officers are peri- branch’s own acceptances purchased? odically advised of maturing banker’s 10. Are prepayments on banker’s acceptances acceptances or acceptance lines. netted against the appropriate asset account d. Determines that the individuals to whom Customer Liability for Acceptances Out- funds are being disbursed are authorized standing (or loans and discounts, depending by the beneficiary to receive the funds? upon whether the branch has discounted its e. Addresses funding procedures for redis- own acceptance), and do they continue to counted acceptances?

Branch and Agency Examination Manual September 1997 Page 1 3040.4 Banker’s Acceptances Internal Control Questionnaire

f. Tests for compliance with IBF ing internal controls in this area? If not, restrictions? indicate any additional examination proce- 18. Does the branch’s acceptance ﬁling system dures deemed necessary. provide for the identiﬁcation of each accep- 20. Based on the information gathered, evaluate tance, e.g., by consecutive numbering and internal controls in this area (i.e. strong, applicable letter of credit, to provide a satisfactory, fair, marginal, unsatisfactory). proper audit trail?

CONCLUSION

19. Is the information covered by this internal control questionnaire adequate for evaluat-

September 1997 Branch and Agency Examination Manual Page 2 Commercial Loans Effective date July 1997 Section 3050.1

Generally, commercial loans comprise the larg- of credit are generally reviewed annually by the est asset concentration of a branch, offer the branch, do not have a fixed repayment schedule, most complexity, and require the greatest com- and may not require fees or compensating bal- mitment from branch management to monitor ances. In the case of unadvised lines of credit, and control risks. Proper management of these the branch has more control over advances and assets requires a clearly articulated credit policy may terminate the facility at any time, depend- that imposes discipline and sound loan admin- ing on state law or legal precedents. A revolving istration. Since lenders are subject to pressures line of credit is valid for a stated period of time related to productivity and competition, they and does not have a fixed repayment schedule, may be tempted to relax prudent credit under- but usually has a required fee. The lender has writing standards to remain competitive in the less control over a revolving credit since there is marketplace, thus increasing the potential for an embedded guarantee (i.e. firm commitment) risk. Examiners need to understand the unique to make advances within the prescribed limits of characteristics of the varying types of commer- the loan agreement. The borrower may receive cial and industrial loans, as well as how to periodic advances under the line of credit or the properly analyze their quality. revolving credit up to the agreed limit. Repay- Commercial loans are extended on a secured ment is generally accomplished through the or unsecured basis with a wide range of pur- conversion or turnover of short-term assets, poses, terms, and maturities. While the types of such as inventory or accounts receivable. Inter- commercial and industrial loans can vary widely est payments on working capital loans are usu- depending on the purpose of loans made and ally paid throughout the term of the loan, such as market characteristics where the branch oper- monthly or quarterly. ates, most commercial and industrial loans will Working-capital loans are intended to be primarily be made in the form of a working- repaid through the cash flow derived from con- capital loan, term loan, or loan to an individual verting the financed assets to cash. The structure for a business purpose. This section will provide of the loans can vary, but they should be closely examiners with a fundamental understanding of tied to the timing of the conversion of the secured and unsecured transactions, the key financed assets. In most cases, working-capital principles for assessing credit quality, and basic facilities are renewable at maturity, are for a bankruptcy law. Other sections of this manual one-year term, and include a clean-up require- discuss more specific types of lending. ment for a period sometime during the low point or contraction phase of the business cycle. The clean-up period is a specified period (usually 30 days) during the term of the loan in which the TYPES OF COMMERCIAL LOANS borrower is required to pay off the loan. While this requirement is becoming less common, it Working Capital or Seasonal Loans provides the branch with proof that the borrower is not dependent on the lender for permanent Working capital or seasonal loans provide a financing. It is important to note, however, that business with short-term financing for inven- an expanding business may not be able to clean tory, receivables, the purchase of supplies, or up its facility since it may be increasing its other operating needs during the business cycle. current assets. These types of loans are often appropriate for businesses that experience seasonal or short- term peaks in current assets and current liabilities, such as a retailer who relies heavily on a Analysis of Working-Capital Loans holiday season for sales or a manufacturing company that specializes in summer clothing. The analysis of a working-capital loan is best These types of loans are often structured in the accomplished by a monthly or quarterly review form of an advised line of credit or a revolving of a company’s balance sheet and income state- credit. An advised line of credit is a revocable ments to identify the peak and contraction phases commitment by the branch to lend funds up to a of the business cycle. The lender should know specified period of time, usually one year. Lines when the peak and contraction phases are, and

Branch and Agency Examination Manual September 1997 Page 1 3050.1 Commercial Loans the loan should be structured accordingly. The The following are potential problems associ- lender’s primary objective is to determine ated with working-capital loans: whether the advances are being used for the intended purposes (inventories or payables) and • Working-capital advances used for funding not for the acquisition of fixed assets or pay- losses. A business uses advances from a ments on other debts. Repayments on the facil- revolving line of credit to fund business losses, ity should also be consistent with the conversion including the funding of wages, business of assets. If the borrower has other loan facilities expenses, debt service, or any other cost not at the branch, all credit facilities should be specifically associated with the intended pur- reviewed at the same time to ensure that the pose of the facility. activity with the working-capital facility is not • Working-capital advances funding long-term used to pay interest on other loans in the branch. assets. A business will use working-capital Projections of sources and uses of funds are also funds to purchase capital assets that are nor- a valuable tool for reviewing a working-capital mally acquired with term business loans. line of credit and determining the sales cycle. • Trade creditors not paid out at end of business Quarterly balance-sheet and income state- cycle. While the branch may be paid out, ments are very helpful when a comparison is some trade creditors may not get full repay- made with the original projections. Other help- ment. This can cause a strained relationship as ful information can be obtained from a review of unpaid trade creditors may be less willing to an aging of accounts receivable for delinquen- provide financing or offer favorable credit cies and concentrations, a current list of inven- terms in the future. In turn, the business will tory, an accounts-payable aging, and accruals become more reliant on the branch to support made during the quarter. This information can funding needs that were previously financed be compared with the outstanding balance of the by trade creditors. facility to ensure that the loan is not overex- • Overextension of collateral. The business does tended and that the collateral margins are con- not have the collateral to support the extension sistent with borrowing-base parameters. of credit, causing an out-of-borrowing-base A borrowing base is the amount the lender is situation. Examiners should review borrowing- willing to advance against a dollar value of base certificates to verify that coverage meets pledged collateral; for example, a branch will the prescribed limitations established by the only lend up to a predetermined specified per- branch’s credit policy for the specific assets centage of total outstanding receivables less all being financed. accounts more than a certain number of days delinquent. A borrowing-base certificate should • Value of inventory declines. When a business be compiled at least monthly or more often does not pay back the branch after inventory is during peak activity in the facility. When review- converted to cash or accounts receivable, the ing working-capital loans, examiners should value of the inventory declines. Other causes remember that a branch relies heavily on inven- of inventory devaluation include obsoles- tory as collateral in the beginning of a compa- cence, a general economic downturn, or in the ny’s business cycle and on receivables toward case of a commodity, market volatility. the end of the business cycle. However, in Declines in inventory value will commonly traditional working-capital loans, greater empha- put a working-capital facility in an out-of- sis is usually placed on accounts receivable as borrowing-base situation and require the collateral throughout the loan’s tenure. excess debt to be amortized and repaid through Normally, a branch is secured by a perfected future profits of the business. blanket security interest on accounts receivable, • Collectibility of accounts receivable declines. inventory, and equipment, and on the proceeds The increasingly past-due status of accounts from the turnover of these assets. Well- receivable or deteriorating credit quality of capitalized companies with a good history of account customers both result in the noncol- payout or cleanup may be exceptions and qualify lection of receivables. This can also cause an for unsecured lending. An annual lien search, out-of-borrowing-base situation for the lend- however, would be prudent under this type of ing institution. lending relationship to detect any purchase • Working-capital advances used to fund long- money security interest that may have occurred term capital. Funds may be inappropriately during the business cycle. used to repurchase company stock, pay off

September 1997 Branch and Agency Examination Manual Page 2 Commercial Loans 3050.1

subordinated debt holders, or even pay divi- rower pledges to fulfill certain requirements, dends on capital stock. such as maintain adequate insurance coverage, make timely loan repayments, or ensure the These situations may cause a loan balance to financial stability of the business. Negative or be remaining at the end of the business cycle. If restrictive covenants prohibit or require the this should occur, the branch generally has one borrower to refrain from certain practices, such of three options: (1) Require the unpaid balance as selling or transferring assets, defaulting, fall- to be amortized; This option is, however, depen- ing below a minimum debt coverage ratio, dent on the ability of the business to repay the exceeding a maximum debt-to-equity ratio, or debt through future profits; (2) Request the taking any action that may diminish the value of borrower to find another lender or require an collateral or impair the collectibility of the loan. infusion of capital by the borrower. This is not Covenants should not be written so restrictively always a feasible option because of the probable that the borrower is constantly in default over weakened financial condition of the business trivial issues; however, violations should be and ownership under these circumstances; or dealt with immediately to give credibility to the (3) Liquidate the collateral. Foreclosing on the agreement. Violations of these covenants can collateral should only be executed when it often result in acceleration of the debt maturity becomes obvious that the business can no longer and payments. A formal loan agreement is most function as a going concern. The problem with often associated with longer-term loans. If a this option is that once the branch discovers that formal agreement does not exist, the term loans the business is no longer a viable concern, should be written with shorter maturities and realizing the full value of the collateral is in balloon payments to allow more frequent review jeopardy. The need to resort to any of these by branch management. options will usually prompt criticism of the credit. Analysis of Term Loans

Term Loans While a working-capital loan analysis emphasizes the balance sheet, the analysis of term Term loans are generally granted at a fixed or loans will focus on both the balance sheet and variable rate of interest, have a maturity in the income statement. Because a term loan is excess of one year, and are intended to provide repaid from excess cash flow, the long-term an organization with the funds needed to acquire viability of the business is critical in determin- long-term assets, such as physical plants and ing the overall quality of the credit. In evaluat- equipment, or finance the residual balance on ing long-term earnings, the examiner must lines of credit or long-term working capital. develop a fundamental understanding of the Term loans are repaid through the business’s company’s industry and competitive position in cash flow, according to a fixed-amortization the marketplace. Most of the analysis will be schedule, which can vary based on the cash-flow conducted based on the historical performance expectations of the underlying asset financed or of the business and its history of making pay- the anticipated profitability or cash flow of the ments on its debt. Any historical record of business. Term loans involve greater risk than inconsistencies or inability to perform on exist- short-term advances because of the length of ing debt should prompt an in-depth review to time the credit is extended. As a result of this determine the ability of the borrower to meet the greater risk, term loans are usually secured. loan’s contractual agreements. One of the most Loan interest may be payable monthly, quar- critical determinations that should be made when terly, semiannually, or annually. Loan principal evaluating term debt is whether the term of the should amortize with the same frequency in debt exceeds the useful life of the underlying order to fully pay off the loan at maturity. asset being financed. In most cases, the terms of these loans are While cash flow of the business is the primary detailed in formal loan agreements with affirma- source of repayment for a term loan, a secondary tive and negative covenants that place certain source would be the sale of the underlying conditions on the borrower throughout the term collateral. Often, if circumstances warrant a of the loan. In affirmative covenants, the bor- collateral sale, the branch may face steep dis-

Branch and Agency Examination Manual September 1997 Page 3 3050.1 Commercial Loans counts and significant expenses related to the institutions with the purchasing entity assum- sale. Examiners should carefully consider these ing its pro rata share of the credit risk. issues when evaluating the underlying value of collateral under a liquidation scenario. A single facility with different terms and/or The following are potential problems associ- participants for tranches should be reported as ated with term loans: separate credits. Loans sold to affiliate banks of the same holding company are not part of the • The term of the loan is not consistent with the SNC program. useful life of collateral. If the outstanding balance or commitment of a • Cash flow from operations does not allow for SNC falls below $20 million after its inception, adequate debt amortization, a fundamental and it is not criticized, the credit will not be problem that can be solved only by improved reviewed at the next review date. Therefore, the performance. examiner should conduct an individual review • The gross margin of the business is narrow- of the credit at the branch under examination. ing, which requires the business to sell more However, if the former SNC facility fell below product to produce the same gross profit. the threshold through a charge-off, and was Higher sales volume could require more cash classified or specially mentioned at the most for expansion of current assets, leaving less recent SNC review, the credit relationship would cash for debt amortization. This situation is a continue to be reviewed under the SNC program common by-product of increased competition. until such time that the balance falls below • Sales are lower than expected. In the face of $10 million. The Federal Deposit Insurance lower sales, management is unable or unwill- Corporation (FDIC), the state agencies, and the ing to cut overhead expenses, straining cash Office of the Comptroller of the Currency (OCC) flow and resulting in diminished debt servic- also participate in this program. The Federal ing ability. Reserve carries out the examination of SNCs at • Fixed assets that are financed by term loans the lead or agent banks that are state-member become obsolete before the loans are retired, banks, state-chartered foreign branches, and likely causing the value of underlying collat- credit-extending nonbank subsidiaries of domes- eral to deteriorate. tic and foreign organizations. The FDIC is • The business’s excess cash is spent on higher primarily responsible for any SNC credits at salaries or other unnecessary expenses. state non-member banks, and the OCC super- • The payments on term debt have put a strain vises the review of those SNCs in which the lead on cash flow, and the business is unable to bank is a national bank or an OCC-chartered adequately operate or allow natural expan- foreign branch. sion. SNCs should not be analyzed or reviewed • The balance sheet of the business is weaken- during the examination of the individual partici- ing. The overall financial condition of the pating branch. If the examiner is uncertain business is deteriorating because of poor per- whether the credit was reviewed under the SNC formance or unforeseen occurrences in the program, the respective Reserve Bank coordina- industry. tor should be contacted. If credits eligible for the program are found but have not been reviewed (other than new SNCs since the time of the last SNC program review), the examiner should Shared National Credits submit a memorandum detailing those credits to the respective Reserve Bank coordinator to be Regulatory agencies participate in a program for forwarded to the SNC coordinator at the Federal the uniform review of shared national credits Reserve Bank of New York. (SNC). A SNC is defined as any loan, commit- The SNC program does not track subpartici- ment, or group of loans or commitments aggre- pations. A subparticipant is a banking organiza- gating $20 million or more at origination that is: tion that has purchased a share from either a bank in the original syndicate or from a bank • Committed under a formal lending considered a first-tier participant. Therefore, if arrangement. the bank is a subparticipant in a credit, it will not • Shared at its inception by two or more super- appear in the ‘‘Report of Lenders and their vised institutions or sold to one or more Borrowers’’. However, the credit may have been

September 1997 Branch and Agency Examination Manual Page 4 Commercial Loans 3050.1 reviewed by the SNC Program and examiners which the security interest is created and can obtain the results of such a review by calling becomes enforceable against the debtor. Perfec- the SNC coordinator for their agency. tion refers to the steps that must be taken in order for the security interest to be enforceable against third parties who have claims against collateral. SECURED AND UNSECURED TRANSACTIONS Attachment of Security Interest This subsection is intended to be a general reference for an examiner’s review of a credit file to determine whether the branch’s collateral The three requirements for the creation of a position is properly documented. Examiners security interest are stated in UCC section should be aware that secured transactions 9-203(1). Once the following requirements are encompass an extensive body of law that is met, the security interest is attached. rather technical in nature. The following discussion contains general information for examiners • The collateral is in the possession of the on the basic laws that govern a branch’s security secured party pursuant to agreement, or the interest in property and on the documentation debtor has signed a security agreement that that needs to be in a loan file to properly contains a description of the collateral and, document a perfected security interest in a when the security interest covers crops now borrower’s assets. growing or to be grown or timber to be cut, a description of the land concerned. • Value has been given to the debtor. Secured Transactions • The debtor has rights in the collateral. Most secured transactions in personal property and fixtures are governed by article 9 of the Thus, unless the collateral is in the possession Uniform Commercial Code (UCC). The UCC of the secured party, there must be a written has been adopted by all 50 states, the District of security agreement that describes the collateral. Columbia, and the Virgin Islands. Timing dif- The description does not have to be very specific ferences as well as filing locations differ from or detailed— ‘‘any description of personal prop- state to state. Failure to file a financing statement erty... is sufficient whether or not it is specific if in a timely manner or in the proper location will it reasonably identifies what is described’’ (see compromise a lender’s security interest in the UCC section 9-110). The agreement must also collateral. be signed by the debtor. The creditor may sign Article 9 of the UCC applies to any transac- it, but its failure to do so does not affect the tion that is intended to create a security interest agreement’s enforceability against the debtor. in personal property. Mortgage transactions are Giving value is any consideration that sup- not covered, marine mortgages are filed with the ports a contract. Value can be given by a direct Coast Guard, and aircraft liens are filed with the loan, a commitment to grant a loan in the future, Federal Aviation Administration. A security the release of an existing security interest, or the interest is defined in the UCC as ‘‘an interest in sale of goods on contract. personal property or fixtures which secures pay- While the debtor must have rights in the ment or performance of an obligation.’’ A collateral, he or she does not necessarily have to secured transaction requires that there be an have title to the property. For example, the agreement between the parties indicating the debtor may be the beneficiary of a trust (the parties’ intention to create a security interest for trustee has title of trust assets) or may lease the the benefit of the creditor or secured party. This collateral. The debtor, in such cases, has rights agreement is commonly referred to as a security in the collateral, but does not hold the title to the agreement. collateral. The secured party, however, only Article 9 of the UCC refers to two different obtains the debtor’s limited interest in the col- concepts related to security interests: attachment lateral on default if the debtor does not have full and perfection. Attachment is the point in time at title to the collateral.

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Perfection of Security Interest in county where the collateral is located if it is Property owned by a nonresident. • Alternative System Three. In a few states, Perfection represents the legal process by which filings made with the secretary of state must a creditor secures an interest in property. Per- also be filed in the county of the borrower’s fection provides the branch assurance that it has business (or residence if there is no place of a legal interest in the collateral. The category of business in that state). Otherwise, the require- collateral will dictate the method of perfection ment in these states is the same as system two. to be used. The most common methods of perfection are: (1) automatic perfection when As each state may select any of the above the security interest is attached (such as in the three alternatives or a modified version of them, case of purchase-money security interests appli- it is important that the examiner ascertain the cable to consumer goods other than vehicles); filing requirements of the state(s) where the (2) perfection by possession; (3) the filing of a branch’s customer operates. Most importantly, it financing statement in one or more public filing is the location of the borrower, not the branch, offices,1 and (4) compliance with a state certifi- that determines where the financing statement cate of title law or central filing under a state must be filed. statute other than the UCC, such as registration of vehicles. The most common method of perfecting a Evaluation of Security Interest in security interest is public filing. Public filing Property serves as a constructive notice to the rest of the world that the branch claims a security interest Key items to look for in evaluating a security in certain property of the debtor described in interest in property include the following: both the security agreement and the financing statement. Public filing is accomplished by fil- • Security agreement. There should be a proper ing a financing statement (UCC-1) in a public security agreement, signed and dated by the office, usually the county recorder or secretary borrower, that identifies the appropriate col- of state. The system of filing required by the lateral to be secured. It should include a UCC provides for a notice filing whereby description of the collateral and its location in potential creditors can determine the existence sufficient detail so the lender can identify it, of any outstanding liens against the debtor’s and should assign to the lender the right to sell property. or dispose of the collateral if the borrower is The form of the financing statement and unable to pay the obligation. where to file it varies from state to state. While • Collateral possession. If the institution has the filing of a nonstandard form will generally taken possession of the collateral to perfect its be accepted, the failure to file in the proper security interest, management of the institu- public office can jeopardize the priority of the tion should have an adequate record-keeping lender’s security interest. The UCC provides system and proper dual control over the three alternative filing systems: property. • Financing statement. If the institution has • Alternative System One. Liens on minerals, filed a financing statement with the state or timber to be cut, and fixtures are filed in the local authority to perfect its security interest in county land records. All other liens are filed in the collateral, in general, it should contain the the office of the secretary of state. following information: • Alternative System Two. The majority of states — names of the secured party and debtor have adopted this version. It is the same as — the debtor’s signature system one, except liens on consumer goods, — the debtor’s mailing address farm equipment, and farm products are filed in — the address of the secured party from the county where the debtor resides, or in the which information about the security interest may be obtained — the types of the collateral and description 1. The financing statement is good for five years, and the of the collateral2 lender must file for a continuation within the six-month period before expiration of the original statement. 2. Substantial compliance with the requirements of UCC

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• Amendments. Not all amendments require the judicial foreclosure, whereas, in some states, a borrower’s signature, and branches may file foreclosure on a deed of trust may not. Nearly an amendment for the following reasons: all matters affecting the title to the real estate, — borrower’s change of address including the ownership thereof, are recorded in — creditor’s change of address the recorder’s office. — borrower’s name change When determining the enforceability of a real — creditor’s name change estate mortgage or deed of trust, the examiner — correction of an inaccurate collateral should be aware of the following requirements: description — addition of a trade name for the borrower • The mortgage must be in writing. that was subsequently adopted • To be recordable, the mortgage must be • Where to file a financing statement. In general, acknowledged. There are different forms of financing statements filed in good faith or acknowledgments for various situations financing statements not filed in all of the depending on whether individuals, corpora- required places are still effective. If a local tions, partnerships, or other entities are execut- filing is required, the office of the recorder in ing the mortgage. Make sure that the form of the county of the debtor’s residence is the the acknowledgment used is in accordance place to file. If state filing is required, the with the type of individual or entity executing office of the secretary of state is the place to the mortgage. file. • If a corporation is the mortgagor, its articles of • Duration of effectiveness of a financing state- incorporation or bylaws often will specifically ment. Generally, effectiveness lapses five years state which officers have authority to sign an after filing date. If a continuation statement is instrument affecting real estate. In these filed within six months before the lapse, instances, the designated officer should be effectiveness is extended five years after the required to sign. If the corporation has a seal, last date on which the filing was effective. that also must be affixed. If the corporation Succeeding continuation statements may be does not have a seal, this fact must be shown filed to further extend the period of in the acknowledgment. effectiveness. • As soon as possible after the mortgage is executed, it should be recorded in the office of the recorder for each county in which the property described in the mortgage is located. Perfection of Security Interest in Real In most cases, the borrower signs an affidavit Estate that indicates, in part, that he or she will not attempt to encumber the property while the As previously mentioned, real estate is expressly lender is waiting for the mortgage to be excluded from coverage under the UCC. A recorded. In any event, the lender should separate body of state law covers such interests. conduct a title search after the mortgage is However, for a real estate mortgage to be recorded to ensure that his position has not enforceable, the mortgage must be recorded in been compromised. the county where the real estate covered by the • If the mortgagor is married, the spouse must mortgage is located. join in the execution of the mortgage to subject his or her interest to the lien of the Real estate mortgage/deed of trust. When mortgage. If the mortgagor is single, the obtaining a valid lien on real estate, only one mortgage should indicate that no spouse exists document is used, the mortgage or deed of trust. who might have a dower interest or homestead The difference between a mortgage and a deed interest in the property. of trust varies from state to state; however, the primary difference relates to the process of • If the mortgagor is a partnership, it must be foreclosure. A mortgage generally requires a determined whether the title is in the name of the partnership or in the names of the individual partners. If the title is in the names of the individual partners, their spouses should section 9-402 is sufficient if errors are only minor and not seriously misleading. Some states require the debtor’s tax ID join in executing the mortgage. If the title is in number on the financing statement. the name of the partnership, those partners

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who are required to sign under the partnership REVIEWING CREDIT QUALITY agreement should sign. Importance of Cash Flow

Unsecured Transactions Evaluating cash flow is the single most important element in determining whether a business Unsecured transactions are granted based on the has the ability to repay debt. Two principal borrower’s financial capacity, credit history, methods of calculating the cash flow available in earnings potential, and/or liquidity. Assignment a business to service debt are presented in this of the borrower’s collateral is not required, and subsection. The results of these methods should repayment is based on the terms and conditions be used to determine the adequacy of cash flow of the loan agreement. While unsecured loans in each credit evaluated at an institution. The often represent the branch’s strongest borrow- accrual conversion method is the preferred ers, the unsecured loan portfolio can represent method because it is the most reliable. The its most significant risk. One of the primary second and less reliable method is the supple- concerns related to unsecured credit is that if the mental or traditional cash-flow analysis; how- borrower’s financial condition deteriorates, the ever, the information needed for this analysis is lender’s options to work out of the lending usually more obtainable and easier to calculate. relationship deteriorate as well. In general, if a The traditional method can be used when cir- credit is unsecured, the file should contain cumstances warrant, for example, when the reliable and current financial information that is borrower’s financial statements are not suffi- sufficient to indicate that the borrower has the ciently detailed for the information requested in capacity and can be reasonably expected to the accrual conversion analysis or when histori- repay the debt. cal information is inadequate.

Emerging Problem Loans Analysis and Limitations of Cash The following are key signals of an emerging Flow problem loan: Cash-flow analysis uses the income statement • Outdated or inaccurate financial information. and balance sheet to determine a borrower’s The borrower is unwilling to provide the operational cash flow. Careful analysis of all financial institution with a current, complete, investment and financing (borrowing) activities and accurate financial statement at least annu- must be made for an accurate assessment of cash ally. Management also should request a per- flow. In reality, examiners face time constraints sonal tax return (and all related schedules) on that often prevent them from performing the the borrower. While borrowers will usually complex mathematical calculations involved in present their personal financial statements in sophisticated cash-flow analysis. Therefore, the the most favorable light, their income tax cash-flow methods presented below were return provides a more conservative picture. designed to be reasonable and practical for • The crisis borrower. The borrower needed the examiner use. However, examiners should be money yesterday, so the branch advanced careful of conclusions reached using the tradi- unsecured credit. tional cash-flow analysis, without consideration • No specific terms for repayment. The unse- of balance-sheet changes or other activities that cured loan has no structure for repayment, and affect cash flow. The traditional cash-flow analy- it is commonly renewed or extended at sis does not recognize growth in accounts maturity. receivable or inventory, a slow-down in accounts • Undefined source of repayment. Repayment payable, capital expenditures, or additional bor- sources are often not identified and are unpre- rowings. If the credit file contains a CPA- dictable. These types of loans are often repaid prepared statement of cash flow or a statement through excess cash flow of the borrower, sale prepared using the accrual conversion method, of an asset(s), or loan proceeds from another the examiner should concentrate efforts on financial institution. reviewing and analyzing these statements rather

September 1997 Branch and Agency Examination Manual Page 8 Commercial Loans 3050.1 than on preparing a traditional cash-flow Excess (Deficit) statement. Cash Flow: Represents cash available before One critical issue to remember is that deficit debt service. cash flow does not always mean that the borrower is encountering serious financial difficulties. In some cases, deficit cash flow is caused by a business’s experiencing significant growth, and there is a pronounced need for external Calculation of financing to accommodate this growth and elimi- Supplemental/Traditional Cash Flow nate the deficit cash-flow position. In this case, an adequate working-capital facility may not be in place to accommodate the need for additional Net Income: Amount of net income reported inventory. A comprehensive analysis of changes on most recent annual income in the balance sheet from period to period statement before taxes. should be made before the loan is criticized. Interest Expense: Add the total amount of interest expense for the period. Components of the Accrual Depreciation/ Conversion Method of Cash Flow Amortization: Add all noncash depreciation and principal amortization on outstanding debt. Category Basis for Amount Cash Flow before Sales: Dollar amount of sales in period Debt Service: Indicates net Earnings Before Interest, Taxes, Depreciation, +/−change in and Amortization (EBITDA). A/R, INV., Amortization should include A/P: Represents the absolute differ- both principal and interest pay- ence of the current period from ments required on debt. the corresponding period of the previous year in accounts Debt Service: Subtract scheduled principal receivable, inventory, and and interest payments. accounts payable. Capital Formula: a) An increase in any current Expenditures: Subtract all capital expendi- asset is a use of cash and is tures for the period. subtracted from the calculation. EQUALS— Conversely, a decrease in any Excess (Deficit) current asset is a source of cash Cash Flow: Total amount of excess or defi- and is added to the calculation. cit cash flow for the period after b) An increase in any current debt service. liability is a source of cash and Coverage is added to the calculation. Con- Ratio: Cash flow before debt service versely, a decrease in any cur- divided by debt service (princi- rent liability is a use of cash pal and interest). and is subtracted from the calculation. SGA: Subtract selling, general, and administrative expenses. Importance of Financial Analysis Interest Expense: Add interest expense to the cal- While cash-flow analysis is critical in reviewing culation if SGA ‘‘expense’’ whether a borrower has the ability to repay includes interest expense. individual debt, a review of the borrower’s other

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

September 1997 Branch and Agency Examination Manual Page 10 Commercial Loans 3050.1

• Existence of heavy liens on assets. Evidence of law; it would be difficult in this manual to of second and third mortgage holders is a sign discuss all the issues necessary for comprehen- of greater-than-average risk. The cost of junior sive understanding of the code. This subsection money is high. Most borrowers are reluctant will focus on basic issues that an examiner to use this source of funds unless conventional needs to be familiar with relative to three sources are unavailable. principal sections of the code, chapters 7, 11, • Concentrations of noncurrent assets other and 13. than fixed assets. A company may put funds into affiliates or subsidiaries for which the branch may not have a ready source of information on operations. Creditors of a Bankrupt Business • High levels of intangible assets. Intangible assets, which shrink or vanish much more A creditor in bankruptcy is anyone with a claim quickly than hard assets, usually have very against a bankrupt business, even if a formal uncertain values in the marketplace. In some claim is not filed in the bankruptcy case. In cases, however, intangible assets such as pat- bankruptcy court, a claim is defined very broadly. ents or trademarks have significant value and A claim may include a right to payment from a should be given considerable credit. bankrupt business, a promise to perform work, or a right to a disputed payment from the debtor • Substantial increases in long-term debt. This that is contingent on some other event. The two symptom causes increasing dependence on basic types of creditors are secured and unse- cash flow and long-term profits to support cured. Secured creditors are those with perfected debt repayment. security interest in specific property, such as • A major gap between gross and net sales. This equipment, accounts receivable, or any other gap represents a rising level of returns and asset pledged as collateral on a loan. Unsecured allowances, which could indicate lower qual- creditors are generally trade creditors and others ity or inferior product lines. Customer dissat- who have not taken a specific interest in prop- isfaction can seriously affect future profitability. erty supplied to the bankrupt debtor. • Rising cost percentages. These percentages can indicate the business’s inability or unwill- ingness to pass higher costs to the customer or its inability to control overhead expenses. Voluntary Versus Involuntary • A rising level of total assets in relation to Bankruptcy sales. If a company does more business, it will take more current assets in the form of inven- When a debtor files a bankruptcy petition, it is tory, receivables, and fixed assets. Examiners described as a voluntary bankruptcy filing. The should be concerned when assets are increas- individual or organization does not have to be ing faster than sales growth. insolvent to file a voluntary case. Creditors may • Significant changes in the balance-sheet struc- also file a bankruptcy petition, in which case the ture. These changes may not be the customary proceeding is known as an involuntary bank- changes mentioned previously, but they are ruptcy. This form of petition can occur in represented by marked changes spread across chapters 7 and 11 bankruptcy cases, and the many balance-sheet items and may not be debtor generally must be insolvent. To be deemed consistent with changes in the marketplace, insolvent, the debtor must be unable to pay debts profits or sales, product lines, or the general as they mature. However, the code does limit nature of the business. who an involuntary action can be sought against.

BANKRUPTCY LAW AND Chapter 7—Liquidation Bankruptcy COMMERCIAL LOANS A chapter 7 action may be filed by virtually any This section provides examiners with an over- person or business organization that is eligible view of the United States Bankruptcy Code to file bankruptcy. Chapter 7 bankruptcy can be (code) chapters that affect commercial and indus- filed by a sole proprietorship, partnership, cor- trial loans. Bankruptcy law is a significant body poration, joint stock company, or any other

Branch and Agency Examination Manual September 1997 Page 11 3050.1 Commercial Loans business organization. Restrictions apply to only Chapter 11—Reorganization a few highly regulated businesses, such as railroads, insurance companies, banks, munici- Most major or large businesses filing bank- palities, and other financial institutions. This ruptcy file a chapter 11 reorganization. As in chapter is often referred to as ‘‘straight liquida- chapter 7, virtually any business can file bank- tion’’ or the orderly liquidation of all assets of ruptcy under chapter 11. There are specialized the entity. Generally, a debtor in a chapter 7 chapter 11 reorganization procedures for certain bankruptcy case is released from obligations to businesses such as railroads, and chapter 11 is pay all dischargeable pre-bankruptcy debts in not available to stockbrokers, commodity bro- exchange for surrendering all nonexempt assets kers, or a municipality. The basic concept behind to a bankruptcy trustee. The trustee liquidates all chapter 11 is that a business gets temporary assets and distributes the net proceeds on a pro relief or a reprieve from paying all debts owed rata basis against the allowed claims of unse- to creditors. This temporary relief gives the cured creditors. Secured creditor claims are business time to reorganize, reschedule its debts generally satisfied by possession or sale of the (at least partially), and successfully emerge from debtor’s assets. Depending on the circum- bankruptcy as a viable business. The basic stances, a secured creditor may receive the assumption underlying a chapter 11 bankruptcy collateral, the proceeds from the sale of the is that the value of the enterprise as a going collateral, or a reaffirmation of the debt from the concern will usually exceed the liquidation value debtor. The reaffirmed debts are generally of its assets. secured by property that the debtor can exempt from the bankruptcy estate, such as a home or vehicle. The amount of the reaffirmation is limited to the value of the asset at the time of the Reorganization Plan bankruptcy filing. Some characteristics of a chapter 7 bank- Generally, the debtor has an exclusive 120-day ruptcy are described below: period to prepare and file a reorganization plan. If the debtor’s plan has not been confirmed within 180 days of the bankruptcy filing, a • A trustee is appointed in all chapter 7 bank- creditor may file a plan. A plan can provide for ruptcies and acts as an administrator of the any treatment of creditor claims and equity bankruptcy estate. The bankruptcy estate that interest, as long as it meets the requirements set is established when the petition is filed out in the code. For example, a plan must becomes the legal owner of the property. The designate substantially similar creditor claims trustee acts to protect the interest of all parties and equity interest into classes and provide for affected by the bankruptcy. equal treatment of such class members. A plan must also identify those classes with impaired • The trustee has control of all nonexempt claims and their proposed treatment. Finally, a assets of the bankrupt debtor. method of implementation must be provided. • The trustee is required to liquidate the estate Although plans do not have to be filed by a quickly without jeopardizing the interests of deadline, the bankruptcy judge will generally the affected parties. place a deadline on the debtor or creditor authorized to prepare the plan. • The proceeds from the sale pay trustee’s fees and other creditors. Trustee fees are deter- Some characteristics of a chapter 11 bank- mined according to the amount disbursed to ruptcy are described below. the creditors and are a priority claim. • The bankrupt debtor usually controls the busi- • A chapter 7 bankruptcy is typically completed ness during the bankruptcy proceedings. This in 90 days, depending on the time needed to arrangement is referred to as ‘‘debtor in pos- liquidate collateral. In rare situations, other session.’’ chapter 7 bankruptcies may take years to • The business continues to operate while in complete. bankruptcy. • The court may allow the trustee to continue to • The debtor is charged with the duty of devel- operate a business, if this is consistent with oping a reorganization plan within the first the orderly liquidation of the estate. 120 days of the filing. After this period

September 1997 Branch and Agency Examination Manual Page 12 Commercial Loans 3050.1

expires, the court may grant this authority to a amount that the creditor would get in a liquida- creditors’ committee. tion or chapter 7 bankruptcy. Chapter 13 may be • Once the plan is approved by the bankruptcy used for a business bankruptcy, but only if the court, the debtor’s payment of debts is gener- business is a proprietorship. In most cases, the ally limited to the schedule and amounts that business needs to be fairly small to qualify. are detailed in the reorganization plan. Some characteristics of a chapter 13 bank- • A chapter 11 proceeding can be complex and ruptcy are described below: lengthy, depending on the number of creditors, amount of the debts, amount of the • In most cases, only an individual can ﬁle a assets, and other factors that complicate the chapter 13 bankruptcy. proceedings. • Secured debt may not exceed $350,000. • Unsecured debt may not exceed $100,000. • The debtor must propose a good-faith plan to Chapter 13—Wage-Earner Bankruptcy repay as many debts as possible from available income. A chapter 13 bankruptcy is available to any • A debtor makes regular payments to a trustee, individual whose income is sufﬁciently stable who disburses the funds to creditors under the and regular to enable him or her to make terms of the plan. payments under the plan. As long as the indi- • The trustee does not control the debtor’s vidual has regular wages or takes a regular draw assets. from his or her business, the individual may • A chapter 13 bankruptcy may include the qualify under chapter 13 of the code. Under debts of a sole proprietorship. The business chapter 13, an individual or married couple can may continue to operate during the bank- pay their debts over time without selling their ruptcy. property. As a protection to creditors, the money • After all payments are made under the plan, paid to a creditor must equal or exceed the general discharge is granted.

Branch and Agency Examination Manual September 1997 Page 13 Commercial Loans Examination Objectives Effective date July 1997 Section 3050.2

1. To determine if lending policies, practices, 4. To recommend corrective action when poli- procedures, and internal controls regarding cies, practices, procedures, or internal con- commercial loans are adequate. trols are deficient or when violations of law 2. To determine if branch officers are operating or regulations have been noted. in conformance with the established guidelines. 3. To evaluate the portfolio for credit quality, performance, collectibility, and collateral sufficiency.

Branch and Agency Examination Manual September 1997 Page 1 Commercial Loans Examination Procedures Effective date July 1997 Section 3050.3

Refer to the Credit Risk Management examina- 3. If the branch has any credits that should be tion procedures for general procedures to assess reviewed under the Shared National Credit the risk of commercial lending activities. How- program but were omitted (other than new ever, if the branch conducts significant commer- credits that originated since the previous cial lending activities, and additional informa- review) submit a memorandum to the SNC tion is needed, the examiner should perform the coordinator detailing those credits to the following procedures. respective Federal Reserve District. Do not include subparticipations, where the branch 1. If selected for implementation, complete or purchased its share from either a bank in the update the Internal Control Questionnaire for original syndicate, or from a bank considered this area. a first-tier participant. Subparticipations should 2. Determine if deficiencies noted at previous only be tracked internally by the branch. examinations and internal/external audits have been addressed by management.

Branch and Agency Examination Manual September 1997 Page 1 Commercial Loans Internal Control Questionnaire Effective date July 1997 Section 3050.4

Refer to the Credit Risk Management internal b. Checks collateral values when the loan is control questionnaire for a general review of the made and at reasonable intervals branch’s internal controls, policies, practices, thereafter? and procedures. If additional information is c. Ensures that cash flow analyses are per- needed, complete the following internal control formed on appropriate borrowers in a questionnaire. For audit procedures, refer to the timely manner? Credit Risk Management section 3010.5. d. Determines that loan payments are promptly posted? 6. Do working capital loans require clean-up POLICIES periods? 7. Who is responsible for monitoring the 1. Has the head office adopted written com- clean-up period, the account officer or an mercial loan policies for the branch that: independent source? a. Establish procedures for reviewing com- 8. What are the consequences if the borrower mercial loan applications? cannot clean-up the line? b. Define qualified borrowers? 9. Are different criteria used for loans to c. Establish minimum standards for borrowers on an unsecured basis versus a documentation? secured basis (e.g. more stringent documen- 2. Are policies reviewed, at least annually, to tation requirements, more frequent credit determine if they are compatible with chang- reviews, or cashflow analyses)? ing market conditions? 10. Is there any evidence that the branch is 3. Do loan records provide satisfactory audit extending working capital loans to finance trails that permit the tracing of transactions the acquisition of long-term assets or capital? from initiation to final disposition? 11. Do all term loans require meaningful prin- 4. Has the branch instituted a system that cipal amortization (at least quarterly)? ensures: 12. Does the term of the loan correspond to the a. Security agreements are filed? useful life of the underlying asset being b. Collateral mortgages are properly financed? recorded? c. Title searches and property appraisals are performed in connection with collat- CONCLUSION eral mortgages? d. Insurance coverage, including loss payee 13. Is the information covered by this internal clause, is in effect on property covered control questionnaire adequate for evaluat- by collateral mortgages? ing internal controls in this area? If not, e. The borrower is in compliance with all indicate any additional examination proce- the covenants of the loan agreement? dures deemed necessary. 5. Does the branch have an internal review 14. Based on the information gathered, evaluate system that: internal controls in this area (i.e. strong, a. Ensures liens are perfected? satisfactory, fair, marginal, unsatisfactory).

Branch and Agency Examination Manual September 1997 Page 1 Financing Corporate Restructurings Effective date July 1997 Section 3060.1

Corporate restructurings have become a tech- cise caution and apply especially rigorous lend- nique for financing acquisitions through lever- ing and investing standards in participating in aged buyouts, resisting takeovers, and restruc- these transactions. turing corporate balance sheets. They encompass traditional leveraged buyouts, management buyouts, corporate mergers and acquisitions, and WAYS TO FINANCE CORPORATE significant stock buybacks. Leveraged Employee RESTRUCTURINGS Stock Option Plans (ESOPs) may also be considered as corporate restructurings if they are Corporate restructurings are typically financed used to acquire or recapitalize an existing through a complex combination of debt and business. equity instruments. A general overview of the It is not considered inappropriate for branches types of financings is provided as follows: to lead and/or participate in loans to finance corporate restructurings so long as they are conducted in a sound and prudent manner. However, booking of such credits could affect Senior Debt asset quality and increase overall levels of risk This term refers to all loans and debt securities exposure. secured by first liens on assets or the stock of the Corporate restructurings involve many of the borrower’s operating entities; and, any unse- same characteristics and risks that have tradi- cured loans and debt securities, which have tionally been evaluated during on-site examina- priority in repayment over all other creditors and tions. These relate to the borrower’s income, equity investors in the event of liquidation. The cash flow, and general ability to pay interest and majority of senior debt generally consists of principal on outstanding debt; economic condi- secured term loans; however, other types of tions and trends; the borrower’s management; debt, including revolving working capital loans, and the borrower’s ability to realize value bridge loans, and debt securities may be consid- through the sale or liquidation of assets. What ered senior debt. To be considered as senior usually distinguishes corporate restructurings debt, the loans must not be subordinated to any from typical bank loans is the level of debt the other obligations in the event of liquidation. borrower assumes in relation to standard measures of financial capacity or ability to repay. Clearly, a high level of debt in relation to net worth or total assets can place heavy demands Mezzanine Financing on a borrower’s cash flow and reduce the borrower’s ability to absorb the effects of unan- Mezzanine financing consists of all layers of ticipated financial shocks or economic adversity. financing between senior debt and equity invest- Branches may be involved in corporate ments. These include all unsecured loans and restructurings at a number of levels. First, they, debt securities where payment is subordinated, together with other institutional lenders, may loans or debt securities secured by liens inferior provide senior secured financing that typically to those of senior debt, fully subordinated debt, represents the largest portion of a corporate and any limited-life preferred stock with signifi- restructuring. In addition, branches may extend cant debt characteristics. credit on a subordinated basis. Bridge loans also represent another type of financing, which may be considered as senior debt or mezzanine Bridge Loans financing, depending on its characteristics. Because corporate restructurings traditionally Bridge loans have varying characteristics and entail high leverage, they often increase the are considered as either senior debt or mezza- vulnerability of borrowers to adverse market nine financing based upon the definitions above. and financial developments and have the poten- Repayment of bridge loans is dependent on the tial to raise the level of risk in bank loan successful marketing of longer term securities or portfolios. For these reasons, bank supervisors the sale of assets for repayment. Bridge loans have actively urged bank management to exer- that would be subordinated to other obligations

Branch and Agency Examination Manual September 1997 Page 1 3060.1 Financing Corporate Restructurings in the event of liquidation are considered mez- restructurings (commonly referred to as junk zanine ﬁnancing. bonds). This includes various types of high yield issues, which have attributes of debt, such as zero-coupon or zero-slash bonds and pay-in- Noninvestment Grade Bonds kind (PIK) bonds. Pay-in-kind preferred stock and other issues with signiﬁcant equity attributes These bonds consist of all noninvestment-grade, are considered equity investments. high-yield debt securities involved in corporate

September 1997 Branch and Agency Examination Manual Page 2 Financing Corporate Restructurings Examination Objectives Effective date July 1997 Section 3060.2

1. To determine if policies, practices, proce- 3. To determine compliance with applicable dures, and internal controls regarding corpo- laws and regulations. rate restructurings are adequate. 4. To recommend corrective action when poli- 2. To determine if branch ofﬁcers are oper- cies, practices, procedures, or internal con- ating in conformance with the established trols are deﬁcient or when violations of law guidelines. or regulations have been noted.

Branch and Agency Examination Manual September 1997 Page 1 Financing Corporate Restructurings Examination Procedures Effective date July 1997 Section 3060.3

Determine if management performs the 4. Maintains internal systems, controls, and following: reporting procedures that track the performance and condition of individual exposures, 1. Evaluates the adequacy and stability of the monitor the organization’s compliance with borrower’s current and prospective cash ﬂow internal procedures and limits and keep head under varying economic scenarios, including ofﬁce management adequately informed on a the possibility of an economic decline. timely basis of the organization’s involve- 2. Sets reasonable in-house limits regarding ment in corporate restructurings. exposure to individual borrowers, total expo- 5. Establishes pricing policies and practices that sure to all corporate restructured borrowers, take into account a prudent manner of the and industry concentrations resulting from trade-off between risk and return. corporate restructurings. 6. Avoids compromising sound banking prac- 3. Establishes credit analysis, approval, and tices in an effort to broaden market share or review procedures that take account of the realize substantial fees. high levels of debt involved in these transactions.

Branch and Agency Examination Manual September 1997 Page 1 Due From Nonrelated Banks Effective date July 1997 Section 3070.1

This section refers to deposit accounts with TIME DEPOSITS nonrelated banking organizations. These deposit accounts can be either noninterest-bearing settle- Branches also maintain interest-bearing time ment accounts (demand) or interest-bearing deposits, known as due from banks-time, with deposits and placements (time). For information other banks. Those assets may also be referred on accounts with related banking offices and to as placements, placings, interbank placements affiliates see the Due From/Due To Related (deposits), redeposits or even Federal funds, in Offices section of this manual. In addition, the instances where their maturities are similar to instructions for the FFIEC 002, Report of Assets Federal funds. These placements represent a and Liabilities of U.S. Branches and Agencies of source of primary liquidity to many branches. Foreign Banks, are an important source of All banks with which the branch has demand information on accounts with nonrelated and and time accounts shown on its books should be related offices and institutions. subject to an appropriate level of scrutiny for creditworthiness, which should be documented in the branch’s on-site credit files. In cases, where these credit evaluations are conducted by the head office or another related office, branch DEMAND DEPOSITS management should obtain copies of these evaluations for its files. Due from banks-time deposit activities became Banks maintain deposits in other banks to facili- important with the growth of the Eurodollar tate the transfer of funds. Those assets, known market. The bulk of due from banks-time depos- as due from banks-demand, correspondent bank its now consist of Eurodollars, with smaller balances, or settlement accounts, are a part of amounts in other Eurocurrencies. Other foreign the primary, uninvested funds of every bank. A currency time deposits are placed in substan- transfer of funds between banks may result, in tially the same manner as Eurodollar deposits, part, from the collection of cash items, the subject to differing exchange control regulations transfer and settlement of securities transac- or local customs. tions, the transfer of participating loan funds, Eurodollar (interbank) deposits are some- and the purchase or sale of Federal funds. times linked with foreign exchange transactions. Banks also utilize other banks to provide As a result, the branch’s foreign exchange or certain services that can be performed more Eurocurrency deposit traders frequently work economically or efficiently by the other banks closely with the trader responsible for placing because of their size or geographic location. due from banks-time deposits. Foreign exchange Such services include processing of cash letters, brokers also may act as intermediaries if war- packaging loan agreements, funding overline ranted by market conditions, local customers, loan requests of customers, performing EDP the size of the branch, or other factors. services, collecting out-of-area items, exchang- The practice of placing interbank deposits ing foreign currency, and providing financial (and takings on the liability side) originated in advice in specialized loan areas. When the London because, under U.K. regulations, banks service is one-way, the bank receiving that were entitled to ‘‘accept’’ interbank deposits service usually maintains a minimum balance whereas interbank borrowings (i.e. loans) required that acts as a compensating balance in full or authorization by the Bank of England. There- partial payment for the services received. fore, due from banks-time deposits are ‘‘accepted’’ even though the receiving bank may Some banks, particularly branches, must be have instructed its foreign exchange trader, prepared to make and receive payments in directly or through brokers, to find a bank foreign currencies to meet the needs of their willing to offer it such deposits. international customers. This can be accom- Due from banks-time deposits contain the plished by maintaining foreign currency due same credit and country risks as any extension from banks-demand accounts with affiliates (nos- of credit to a bank. Consequently, a prudently tro balances) or with other banks in foreign managed bank should place deposits with (i.e. countries. lend to) only well-managed banks. The traders

Branch and Agency Examination Manual September 1997 Page 1 3070.1 Due From Nonrelated Banks should be provided with a list of approved banks its are placed for longer periods. Furthermore, with which funds can be deposited up to pre- the credit risks for specialized or smaller banks scribed limits for each bank. Due from bank- that have recently entered the interbank deposit time deposits differ from other types of credit market can be far greater than that for larger, extensions because they often represent deposits long-established banks. Banks which tradition- of relatively short maturity which normally ally utilized only regular lines of credit or receive first priority in case of insolvency. Nev- special facilities also have entered the due from ertheless, the credit and country exposure exists, banks-time deposit market to meet their external and customer limits must be established by needs. Those banks could be the first to be credit officers and not by foreign exchange caught in a market crunch. traders. Such limits must be reviewed regularly Incoming confirmations from banks must be by credit officers, particularly during periods of meticulously checked by the bank to record money market uncertainty or rapidly changing copies in each instances to protect against fraud economic and political conditions. and errors. Similarly, a systematic follow-up on The examiner also must recognize that credit non-receipt of incoming confirmations should risks intensify when due from bank-time depos- be carefully monitored by the bank.

September 1997 Branch and Agency Examination Manual Page 2 Due From Nonrelated Banks Examination Objectives Effective date July 1997 Section 3070.2

1. To determine if the policies, practices, pro- 4. To determine whether the branch evaluates cedures, and internal controls regarding bal- the credit quality of banks with which demand ances due from banks, both demand and and time accounts are maintained. time, are adequate. 5. To determine the scope and adequacy of the 2. To determine if branch ofﬁcers and employ- internal and external audit coverage as it ees are operating in conformance with estab- applies to this area. lished guidelines. 6. To recommend corrective action when poli- 3. To determine that all due from accounts are cies, practices, procedures, or internal con- reasonably stated and represent funds on trols are deﬁcient or when violations of law, deposit with other banks. rulings, or regulations have been noted.

Branch and Agency Examination Manual September 1997 Page 1 Due From Nonrelated Banks Examination Procedures Effective date July 1997 Section 3070.3

1. If included in the scope of the examination, are not confirmed as of the date of exami- complete or update the Internal Control nation, determine why incoming confirma- Questionnaire. tion is missing. 2. Test for compliance with policies, practices, 8. The credit quality of placements is included procedures, and internal controls within the in the scope of the asset quality review. parameters of the established scope. Using appropriate sampling techniques, 3. Scan the most recent bank-prepared recon- select deposit customers for examination cilements for any unusual items and deter- and review the credit file maintained on mine that closing balances listed on recon- each bank. Ensure the bank has performed a cilements agree with the general ledger and credit analysis on all approved due from with the balance shown on the cut-off state- bank counterparties. If the credit analysis ment if one has been obtained. has been prepared by the head office, shadow 4. If the bank’s policy for charge-off of old files need to be maintained at the institution. open items provides for exceptions in 9. Check back office procedures, adequacy of extenuating circumstances, review excepted separation of duties, and who monitors items and determine if charge-off is limits. appropriate. 10. If problems are detected concerning the 5. If the bank has no policy for charge-off of institution’s policies or lack thereof, the old open items, review any items which are deficiencies should be discussed under Risk large or unusual or which have been out- Management. If the institution is deficient standing for over two months, along with in its operations and is not following its related correspondence, and determine if policies, the exception should be discussed charge-off is appropriate. under Operational Controls. 6. Obtain a trial balance of the due from banks 11. Prepare comments on deficiencies or viola- —time balances. Reconcile balances to tions of law noted above for inclusion in the department controls and general ledger. examination report. 7. Check a sample of confirmations. This will 12. Assemble workpapers to support conclu- ensure that the balances are indeed due from sions reached. Include any information that bank balances and not loans to banks (for will facilitate future examinations. Call Report purposes). If any transactions

Branch and Agency Examination Manual September 1997 Page 1 Due From Nonrelated Banks Internal Control Questionnaire Effective date July 1997 Section 3070.4

AUDIT COVERAGE POLICIES FOR DUE FROM BANKS 1. Does the scope of the branch’s internal audit program include procedures covering: 3. Do current written policies and procedures a. Due from banks-demand accounts? exist for due from banks-demand accounts b. Due from banks-time accounts? that: 2. Do audit procedures include all of the a. Provide for periodic review and approval following to ascertain the effectiveness of of balances maintained in each such internal controls: account? b. Indicate person(s) responsible for moni- a. Ensure that procedural manuals or toring balances and the application of instructions covering the reconcilement approved procedures? function exist? c. Establish levels of check-signing author- b. Ascertain if statements are not recon- ity? ciled by an individual, who also: d. Indicate officers responsible for approval • Has signing authority on the account? of transfers between correspondent banks • Approves entries? and procedures for documenting such • Posts the general ledger? approval? • Effects money transfers? e. Indicate the supervisor responsible for c. Ensure that statements are reconciled regular review of reconciliations and rec- promptly when received? onciling items? d. Check to see that reconcilements are f. Indicate that all entries to the accounts prepared on preprinted forms? are to be approved by an officer or appropriate supervisor and that such e. Ensure that completed reconcilements approval will be documented? are properly stored to satisfy record- g. Establish time guidelines for charge off retention requirements? of old open items? f. Ensure that open items are promptly 4. Do current written policies and procedures referred to and followed up by the exist for due from banks-time account that: appropriate operating department or a. Establish maximum limits of the aggre- responsible officer? gate amount of due from banks-time g. Test that open entries outstanding beyond deposits for each: a reasonable length of time are: • Bank? • Referred to appropriate senior branch • Currency of deposit? management in writing? • Country of deposit? • Charged off to profit/loss accounts? b. Restrict due from banks-time deposits to • Transferred to special suspense only those customers for whom lines accounts, pending additional follow-up have been established? action? c. Establish definite procedures for: h. Ensure that reconciliation personnel are • Balancing of accounts? prohibited from preparing adjusting • Holdover deals? entries? • Rendering of reports to management, i. Spot check selected general ledger tick- external auditors, and regulating ets and supporting documentation for: agencies? • Adequate details of the transaction? • Accounting cut-off deadlines? • Proper officer approvals? • Handling of interest? j. Test check on selected transactions that 5. Are the policies and procedures for due include open, reconciled, adjusted, and from bank accounts reviewed at least annu- charged-off items to ascertain propriety ally to determine their adequacy in light of of disposition? changing conditions?

Branch and Agency Examination Manual September 1997 Page 1 3070.4 Due From Nonrelated Banks: Internal Control Questionnaire

BANK RECONCILEMENTS 11. Are overdrafts in due from bank accounts properly recorded on the branch’s records 6. Are branch reconcilements prepared and promptly reported to the responsible promptly upon receipt of the statements? officer? 7. Are statements examined for any sign of 12. Are individual interest computations checked alteration and are payments or paid drafts or adequately tested by persons independent compared with such statements by the per- of those functions? sons who prepare branch reconcilements? If 13. Are accrual balances for due from banks- yes, skip question 8. time verified periodically by an authorized 8. If the answer to question 7 is no, are official? If so, indicate frequency. statements and paid drafts or payments 14. Do all internal entries require the approval handled before reconcilement only by per- of appropriate officials? sons who do not also: a. Issue drafts or official checks and prepare, add, or post the general or subsid- CONCLUSION iary ledgers? b. Handle cash and prepare, add, or post the 15. Is the information covered by this ICQ general ledger or subsidiary ledgers? adequate for evaluating internal controls in 9. Are branch reconcilements prepared by per- this area? If not, indicate any additional sons who do not also: examination procedures deemed necessary. a. Issue drafts or official checks? 16. Based on the information gathered, evaluate b. Handle cash? the internal controls in this area (i.e., strong, c. Prepare general ledger entries? satisfactory, fair, marginal, unsatisfactory).

OTHER

10. Is a separate general ledger account or individual subsidiary account maintained for each due from bank account?

September 1997 Branch and Agency Examination Manual Page 2 Due From Nonrelated Banks Audit Guidelines Effective date July 1997 Section 3070.5

1. Determine the number of the last unissued d. Determine that the closing balance and draft of each due from bank account and date listed on the statement used in the record for comparison when performing branch’s last reconcilement agrees to the reconcilements. opening balance and date listed on the 2. Prepare a listing of all due from bank cut-off statement as of the examination accounts, together with their balances from date. the branch’s daily statement as of the exami- e. Determine that any open items from pre- nation date. Compare each balance or total vious reconcilements have cleared. balances to the appropriate subtotal in the f. If any items on a previous reconcilement general ledger as of the examination date. do not clear, list on the reconcilement 3. Request a cut-off statement as of the exami- form being prepared. nation date and for a subsequent date, not g. Determine that each debit and credit entry less than ﬁve days later for each due from shown on the general ledger since the date account. Include instructions that the state- of the last reconcilement is offset by a ments be addressed to the examiner-in- corresponding credit or debit on the cor- charge and be delivered unopened. respondent bank’s cut-off statement. 4. In preparing or reviewing reconcilements: h. Any items on the general ledger, except a. Review reconciling items carefully to outstanding drafts, that are not offset by determine that the time period between an appropriate debit or credit on the cor- debit or credit entries and the offsetting respondent bank’s cut-off statement are credit or debit by the correspondent bank considered open and should be transferred is comparable for similar types of items. If to the reconcilement form under the any differences in timing occur, ascertain appropriate we debit or we credit caption the reason. along with the date and a brief description. b. Determine that wire transfers appear on i. Any items on the correspondent bank’s the correspondent statement the same day cut-off statement that are not offset by an as entered on the branch’s books. Deter- appropriate debit or credit on the branch mine the reason for any exception. general ledger are considered open and c. Test all drafts included in the cut-off should be transferred to the reconcilement statement for authorized signature, proper form under the appropriate they debit or endorsement, dates of drafts, payee, and they credit caption along with the date and amounts and determine that: a brief description. • Dates drawn are not subsequent to dates j. ‘‘We credit’’ items that represent drafts paid by the correspondent bank. outstanding should not be listed on the • Drafts issued to transfer funds from the ‘‘we credit’’ section of the reconcilement branch’s account to the correspondent’s form. Each outstanding draft should be account are not outstanding more than listed by number on the reverse side of the the normal transit time. reconcilement form and the total should • Drafts are numbered. be carried forward opposite the caption • Drafts are issued sequentially. drafts outstanding. The listing should 5. Reconcile due from bank accounts on a include any drafts still outstanding from reconcilement form using the following steps: the previous reconcilement. a. Prove the mathematical accuracy of the k. Prove the reconcilement. prior reconcilement by a machine run of 6. Determine clearance of ‘‘we debit’’ and ‘‘we the ﬁgures. credit’’ items using later cut-off statements, b. Determine that our balance to their debit when available, and: agrees to general ledger as of their prior a. If an item is cleared by reversing the entry, reconcilement date. that is, by a subsequent offsetting debit or c. Determine that their balance to our credit credit entry on the ledger of the branch agrees to each correspondent bank state- under examination, check the entry through ment as of the prior reconcilement date. to its source.

Branch and Agency Examination Manual September 1997 Page 1 3070.5 Due From Nonrelated Banks: Audit Guidelines

b. All material ‘‘we debit’’ and ‘‘we credit’’ a. Reviewing and testing procedures for items that do not clear on the later cut-off accounting for accrued interest and for statements received should be confirmed, handling adjustments. with a copy of the confirmation tracer b. Scanning accrued interest for any unusual retained for comparison to the original entries and following up on any unusual after it is returned. items by tracing them to initial and sup- 7. Utilizing the general ledger or appropriate porting records. subsidiary ledger, determine clearance of 9. Obtain or prepare a schedule showing the ‘‘they debit’’ and ‘‘they credit’’ items. The accrued interest balances and the deposit reason for nonclearance should be deter- balances for selected time periods since the mined for all ‘‘they debit’’ and ‘‘they credit’’ previous examination. items that do not clear in a reasonable amount a. Calculate ratios. of time. b. Investigate significant fluctuations and/or 8. Review the accrued interest accounts by: trends.

September 1997 Branch and Agency Examination Manual Page 2 Financing Foreign Receivables Effective date July 1997 Section 3080.1

Financing foreign receivables includes open considerable. As with open account sales, there account financing, sales on consignment, is a lack of standard trade financing documen- advances against collections, banker’s accep- tation on which to base legal action if the tances, factoring, and forfaiting. Certain foreign consignee defaults. The exporter should thor- receivables are guaranteed or insured for credit oughly understand the inherent credit risks, and political risk by the Export-Import Bank of especially when goods are consigned to an the United States, the Foreign Credit Insurance agent, representative, or import house abroad. Association, or other American and foreign In countries with free ports or free trade organizations. zones, consigned goods may be placed in a bonded warehouse in the name of a foreign bank or branch of the bank. Arrangements may then OPEN ACCOUNT FINANCING be made to release the consigned merchandise at the time it is sold. Merchandise is cleared through customs after the sale has been com- The simplest method of financing foreign receiv- pleted. However, that type of consignment should ables is on open account. In such a sale, the not be made and will not usually be accepted by buyer and seller agree on payment at a specified many foreign banks until all pertinent condi- date without any negotiable instruments, such as tions, regulations, and storage facilities are veri- a draft or acceptance, evidencing the obligation. fied. The exporter’s bank also should verify that In most instances, the shipping documents are goods not sold may be returned to the country of sent directly to the buyer rather than through a origin. Bank financed consignment shipments bank. The exporter may request the buyer to should be limited to those countries that do not make payment to the bank in which the exporter have burdensome foreign exchange restrictions maintains an account. The advantages of an and have sufficient foreign exchange available open account sale are its simplicity and the lack to pay for imports. of bank charges and stamp duties applied to drafts by certain countries. To overcome the disadvantages of financing The financing of open account sales contains shipments on an open account or consignment certain risks. The lending bank and exporter basis, exporters frequently ship goods against have no control over the documents and the documentary collections. That practice means buyer (importer) may take possession of the that the exporter, in the case of a time or arrival goods without the bank’s or the exporter’s draft, and the exporter and the importer, jointly, consent. In addition, if the importer does not in the case of a sight draft, finance(s) the register the goods with the proper authorities, shipment. The exporter and the importer may the dollar or other exchange may not be avail- have unused credit lines with their banks and be able at the time of payment. Probably the able to borrow the needed money without tying greatest risk in open account financing is the the financing to the trade transaction. Often, lack of standard trade financing documentation however, the exporter’s or the importer’s regular on which to base legal action against the importer bank lines are used up for other transactions. in the event of default. Therefore, open account Consequently, they may ask their bankers to sales are most appropriate when the buyer provide financing through advances against out- (importer) is a subsidiary of a related company ward collections, discounting trade acceptances, or is well-known to the seller. bankers’ acceptances, factoring, or forfaiting.

SALES ON CONSIGNMENT ADVANCES AGAINST FOREIGN COLLECTIONS Under a consignment arrangement, goods are consigned to the importer (consignee) abroad A manufacturer or merchant conducting a strictly and the exporter (consignor) retains title to them domestic business often gets a loan from a bank, until they are sold to a third party. However, ﬁnance company, factor, or forfaiter by using unless the shipment is made to an exporter’s accounts receivable as security. Because out- overseas branch or subsidiary, the credit risk is ward collections are the same as foreign receiv-

Branch and Agency Examination Manual September 1997 Page 1 3080.1 Financing Foreign Receivables ables, the same general type of financing vehicle ing documents. Because the branch wishes to is available to exporters. maintain control of the merchandise, the bill of A common method of financing foreign lading should be either to the order of the shipper receivables is for the exporter to pledge all and blank endorsed or to the order of the branch. outward collections to its bank. The exporter The bill of lading must not be consigned to the may then borrow from the bank up to a stated buyer (importer); otherwise, the buyer has con- maximum percentage of the total amount of trol over the goods. In addition, shipments receivables pledged at any one time. When financed should be covered by adequate notes, rather than drafts, are used to finance insurance. foreign collections, they are usually paid on demand enabling the exporter to increase or decrease the loan depending on need and the DISCOUNTING TRADE current amount of collections outstanding. Pref- ACCEPTANCES erably, all of the collections lodged with the exporter’s bank should be pledged to the bank. A draft accepted by the foreign buyer becomes a When a particular collection is paid, it is remit- trade acceptance, carrying the full credit obligated by the foreign collecting bank to the domes- tion of the importer. Such trade acceptances are tic bank that has advanced the funds. The latter also frequently called trade bills or trade paper. uses the proceeds of the collection to reduce the The acceptance is returned to, and becomes the exporter’s loan. Some exporters have no need property of, the exporter, who will ask the for a continuous financing arrangement but collecting bank to present it to the acceptor for occasionally may wish to obtain financing on payment at maturity. The exporter is, therefore, only one large foreign collection. In such providing the financing or carrying its own instances, the branch may be willing to advance foreign receivables. However, if the exporter money with only that one receivable as security. needs the funds before maturity of the trade Again, the branch establishes a maximum per- acceptance, the exporter may ask the branch to centage of the amount of the draft that it is discount the draft with or without recourse. If willing to advance. When payment for the the primary obligor (acceptor) is a well-known receivable is obtained, the branch uses the company of good credit standing, the branch proceeds to liquidate the loan, crediting any may be willing to discount the draft without excess to the exporter. Bank financing in the recourse to the exporter. More commonly, how- form of advances against export collections is an ever, the lending bank looks to the exporter for accepted practice in international trade and is recourse, should the primary obligor fail to pay not considered factoring. the amount when due. Besides having a pledge on the exporter’s When discounting a trade acceptance, the outward collections, the branch usually retains branch advances the face amount of the draft to recourse to the exporter whose financial condi- the exporter, minus discount charges, until the tion and reputation are of prime importance. maturity date. In that case, the branch is buying Other factors, however, are also significant. If the trade acceptance for value and is entitled to the foreign importers are prime companies with any benefits due it from the primary obligor as a undoubted reputation and financial strength, the holder in due course of a negotiable instrument. branch will probably advance a larger percent- That is also the case whenever the branch makes age on collections directed to them. The branch advances against a single collection or a pool of will also advance a larger percentage of funds to collections. Any intermediary collecting bank importers in those countries that promptly pay also has a financial interest in the collection and drafts drawn on them. In other countries, where has all the rights of a holder in due course under payment is generally slow, perhaps because the Uniform Commercial Code. importers are financially weak or because U.S. dollar or other foreign currency exchange is hard to obtain, the branch will advance a lower BANKER’S ACCEPTANCES percentage on collections. Certain collections to CREATED AGAINST FOREIGN habitually slow paying importers or countries COLLECTIONS may be entirely ineligible for financing. When a branch advances against foreign col- During periods of tight money, branches may lections, it must carefully scrutinize the support- choose to finance foreign collections by using

September 1997 Branch and Agency Examination Manual Page 2 Financing Foreign Receivables 3080.1 banker’s acceptances. Banker’s acceptances are maintain bookkeeping or accounting records discussed separately in this manual, so the pertaining to the status of receivables. These following comments relate only to the financing responsibilities have been assumed by the fac- of foreign collections. tor. In addition, under the terms of an advance As with all acceptance financing, the exporter factoring arrangement, the client receives pay- first submits a signed acceptance agreement to ment for its receivables before the time agreed its bank. To obtain acceptance financing for upon under the normal terms of the invoice. foreign receivables, the exporter draws two Maturity factoring and advance factoring are drafts. The first is a time draft drawn on the two basic types of service offered by the indus- foreign buyer (importer) that, along with the try. In maturity factoring, an average maturity necessary documents, is sent for collection in due date is computed for the receivables pur- the usual manner. The other draft, for the same chased during a period and the client receives or smaller amount as agreed on by the branch payment on that date. Advance factoring uses and exporter, is drawn by the latter on the branch the same computations; however, the client has and has the same tenor as the draft drawn on the the option of taking advance payments equal to importer. The branch accepts the latter draft and a percentage of the balance due at any time prior discounts it, crediting the net amount to the to the computed average maturity due date. The exporter’s account. The branch has now created unadvanced balance, sometimes called the cli- a banker’s acceptance that can be sold in the ent’s equity, is payable on demand at the due highly liquid acceptance market, provided the date. branch’s reputation is fully established. When The typical factoring agreement stipulates payment is received from the importer, the that all accounts receivable of a client are branch applies the proceeds to pay its own assigned to the factor but not all are purchased acceptance, which will be presented for payment without recourse. The agreement between the if sold in the market. Should the importer factor and the client will usually state that default, the branch has recourse on the drawer receivables subject to shipping disputes, errors, and can demand payment from that source. returns, and adjustments are chargeable back to the client because they do not represent bona fide sales. In addition, sales made by the client FACTORING without the factor’s approval are considered client risk receivables, with full recourse to the A factor buys accounts receivable with or with- client if the customer fails to pay. The usual out recourse. In the past, factoring was used approval process requires the client to contact primarily in domestic trade in certain industries, the factor’s credit department before filling a such as textiles. In recent years, however, sev- sales order on credit terms. The credit depart- eral domestic factors have established foreign ment will conduct a credit review, determine the affiliates or invested in foreign finance compa- creditworthiness of the customer and approve or nies and several banks have purchased or estab- reject the sale. If the credit department rejects lished factoring firms to finance foreign trade. the sale, the client may complete the sale but at Branches are also financing foreign trade by the client’s own risk. The most commonly factoring. rejected sales are those to affiliates, to known Factoring is the purchase, on a without bad risks, to customers whose credit cannot be recourse basis, of the accounts receivable of a verified, and to those customers whose outstand- client. Factoring differs from asset-based lending payables exceed the factor’s credit line to ing financing, in that the factor assumes the those customers. credit and collection risk associated with the Once a sale has been made and the receivable, receivables. In asset-based lending these risks whether or not approved, is assigned to the remain with the client. Among the principal factor, the client’s account will be credited for advantages of factoring to the client, is that the the net invoice amount of the sale. Trade or client is certain of the collection of the proceeds volume discounts, early payment terms, and of its sales, regardless of whether or not the other adjustments are deducted from the invoice factor is paid. Other advantages of factoring are amount. The receivable then becomes part of the that the client does not have to maintain a credit client’s availability to be paid in advance or at department to evaluate the creditworthiness of the computed date, depending upon the basis of customers and collect past due accounts or the factoring arrangement.

Branch and Agency Examination Manual September 1997 Page 3 3080.1 Financing Foreign Receivables

Factoring Foreign Receivables payment to the factor when due. Frequently, instead of making immediate pay- A factor who purchases a foreign receivable ment under a sight letter of credit, the factor will must approve the credit standing of a specified utilize its credit line with the bank. This option foreign obligor before the sales contract is may be taken by either asking the bank to create concluded. If the foreign buyer’s credit is not a banker’s acceptance or by charging the fac- approved, the exporter may still make the ship- tor’s loan account. In both instances, the factor ment but at its own risk. If shipments to approved must pay the bank at maturity of the acceptance importers are made on a documentary collection or loan. Such maturities should coincide as basis, the drafts and documents are submitted to closely as possible with the expected payment of the factor who purchases them without recourse. the accounts receivable by the ultimate customer. The factor pays the money to the exporter either A factor buying foreign accounts receivables at the average maturity date, when actually created through open account shipments follows received or, if financing is also required, imme- the same basic procedures as in purchasing diately. Thereafter, the drafts and documents are domestic receivables. As discussed heretofore, routed through commercial banks for collection. the exporter and financing institution could lose Because the factor owns the drafts and docu- control over the goods because the shipping ments, the collection process is undertaken for documents are consigned directly to the its account. Occasionally, a factor will make use importer. Consequently, open account shipments of its own credit line with a commercial bank to should be conducted only with prime foreign carry receivables purchased from the exporter buyers. until payment is received from the ultimate buyer. When financing imports, the factor may Client Records arrange for the opening of a letter of credit through its bank in favor of an overseas supplier. A client’s balance sheet will have a due from The factor becomes an intermediary between its factor account instead of accounts receivable. customer and the bank, substituting its own The account balance may be somewhat lower credit for that of the client. Because the factor is than a normal receivables balance, thus affecting guaranteeing the letter of credit, the bank is turnover ratios and other short-term ratios. The willing to open the credit, which it might not difference relates to the client’s ability to con- have done for the importer directly. vert sales to cash faster with a factor than if the When the goods are shipped, the title docu- receivables were to be collected by the client. ments are either consigned or endorsed over to Each month, the client receives an accounts the factor. The factor, in turn, releases the current statement from the factor, detailing trans- documents to the importer against either a trust actions on a daily basis. This statement reflects receipt or warehouse receipt. All proceeds from the daily assignments of receivables, remit- subsequent sales are turned over to the factor. tances made (including overadvances and Once the final sale has been made to a customer amounts advanced at the client’s risk), deduc- approved by the factor, an account receivable is tions for term loans, interest charges, and fac- created. The factor, according to its agreement toring commissions. Credit memos, client risk with the customer, buys that receivable without charge-backs, and other adjustments also will be recourse. shown. Client risk charge-backs are the amounts When the bank turns over the shipping docu- deducted from the balance due to the client upon ments to the factor, arrangements must be made the failure of customers to pay receivables to pay under the sight letter of credit. The factor factored at client risk. The accounts current may pay the bank from its own funds. The goods statement and the availability sheets are neces- are cleared through customs and the factor is sary for asset analysis. The accounting system paid on the average or final maturity date of the that develops this data probably will be auto- accounts receivable, which the factor has bought mated, allowing the factor to compare and from its customer without recourse. monitor data on the client. Examiners should Time letters of credit are paid to the bank by use the data provided, within client records, the factor at maturity and the resulting accep- toenhance the asset analysis process for these tances are charged to the customer’s account for types of credits.

September 1997 Branch and Agency Examination Manual Page 4 Financing Foreign Receivables 3080.1

Factor Records ity and collection. The other major portion of the assets will be the client loans and credit accom- The factor’s balance sheet reflects the purchased modations, such as overadvances and amounts accounts receivable as factored receivables on advanced at the client’s risk, for which the the asset side and due to clients as the corre- account officers are responsible. sponding liability. Usually, the due to clients Any factor’s ability to buy receivables with- balance will be less than the factored receivables out recourse is predicated on its ability to make balance because of payments and advances to sound credit judgments regarding buyers. The the clients. If, however, the factor makes factor, therefore, replaces the credit and, in part, advances to the client for greater amounts than the receivables bookkeeping departments of sell- are due to the client, these amounts will be ers. The credit department maintains a credit file reflected on the asset side of the balance sheet as for each of its client’s customers, which are overadvances. Overadvances are tantamount to continually updated as purchases are made and unsecured loans. A limit on the amount of paid for by the customers. These files include overadvances available at any one time to the financial statements, credit bureau reports, and client should be included in the factoring agree- details of purchasing volume and paying habits. ment. Such limitation is generally based upon, Credit information on domestic buyers is easier but not necessarily secured by, the amount of the to obtain than on buyers located overseas. How- client’s inventory. This relationship is used ever, by establishing foreign affiliates, factors because, theoretically, the inventory will be sold have improved their ability to determine the to generate receivables that the factor has con- credit standing of foreign importers. tracted to purchase. The proceeds from the factored receivables will then be used to repay the overadvance. The factor’s income statement Systems and Controls will show factoring commissions that represent the discount on the receivables purchased as Considering the large volume of daily transac- income. Interest income for advances on the due tions that flows through a factor, any internal to client balances may or may not be a separate control that can be easily negated represents a line item. potential problem. The review of the factoring An analysis of the changes in the relative department’s internal systems and controls proportions of the due to clients account should should be continuous during the examination. provide valuable input into the analysis of the This review should include the credit controls earnings of a branch’s factoring operation. for both clients and customers. Credit controls Because factoring is a highly competitive indus- and systems must be responsive to the identifi- try, price cutting has reduced factoring commis- cation of these problems because problems can sions to a point where they provide minimal develop rapidly in factoring. Earnings are evalu- support to earnings; therefore, the interest mar- ated in terms of the department’s own perfor- gins on factoring advances have a significant mance. The factoring department’s earnings impact on net income. The implication of the trends may be evaluated by using a comparative analysis of proportional changes is that as more yield on assets approach. By analyzing yields on clients take advances (reducing due to clients), asset categories from period to period, the profit margins should widen. Conversely, as the examiner will be able to make a judgment as to due to clients proportion of total liabilities rises, the efficiency of the systems. Factors are subject profit margins may be expected to narrow. to the same price competition in the commercial finance market as accounts receivable finan- ciers. Declining portfolio yields may reflect the Evaluating the Factoring Operation inroads made by competition and may indicate a decline in future profitability. The evaluation of a branch’s factoring operation includes: (a) a review of its systems and controls, and (b) an analysis of the quality of its Asset Evaluation assets. A major portion of a factor’s assets will be factored receivables, for which the credit The asset evaluation involves an evaluation of department has the responsibility for credit qual- (1) credit accommodations to each client and

Branch and Agency Examination Manual September 1997 Page 5 3080.1 Financing Foreign Receivables

(2) customer receivables purchased by the factor An analysis of the client’s balance sheet at its own risk. For the first part of the evalua- should incorporate an assessment of the client’s tion, generate a list of each client’s aggregate ability to absorb normal dilution and the poten- credit exposure to the factor, both direct and tial losses associated with client risk receiv- indirect, including overadvances and receivables, particularly when these elements are ables purchased at the client’s risk. For the higher than usual for the portfolio. The analysis second part of the evaluation, use the aging also should consider the client’s ability to repay schedule of factored receivables aggregated by any advances received from the factor in the customer but net of client risk receivables. form of overadvances, term loans, or other Select clients and customers for review based credit accommodations. upon the same selection methods used for the When classifying the credit exposure to a commercial loan review. Clients with high dilu- client, the client risk receivables portion of tion of receivables (i.e., customer nonpayment factored volume is the only amount appropriate due to returns, shipping disputes, and errors and for use in the classification. Because of the the like) and those with client risk receivables recourse aspect, the balance is considered as an equal to 20 percent or more of factored volume indirect obligation rather than a direct obliga- may also be included. tion. Any other credit accommodations to a client that are not reflected in factored receivables, such as overadvances, term loans, etc., are Credit Accommodations to Each also appropriate for classification. Asset quality, as measured by classifications, may be influ- Client enced by seasonal aspects of clients’ businesses and should be carefully analyzed allowing for In order to evaluate credit accommodations to such influences. each client, generate a list of each client’s aggregate credit exposure to the factor, both direct and indirect, including overadvances and receivables purchased at the client’s risk. Customer Receivables Purchased by Although past due status is an essential element the Factor at its Own Risk in evaluating customer accounts, it should be noted that for its clients, a factor usually collects To evaluate receivables purchased by the factor principal and interest payments directly from the at its own risk, use the aging schedule of client’s availability. This practice means that the factored receivables aggregated by customer but expected delinquency rate is minimal. Past due net of client risk receivables. Select customers volume is not an effective measure of client for review based upon the same selections quality. methods used for the commercial loan review. A client’s availability is the sum of all fac- Past due volume is an essential element in tored receivables, less trade and other discounts, evaluating customer accounts. In addition, cus- factoring commissions, client risk charge-backs, tomer files maintained by the factor should and other miscellaneous charges to the client’s include financial statements and an analysis of account. There may also be other deductions for the customers’ financial condition. letters of credit and other credit accommodations. An advance client’s availability would be When classifying credit exposure to a cus- further reduced by advances on the factored tomer, factored receivables are appropriate for receivables, interest charges, and the reciprocal classification. Care should be taken not to clas- of the contractually agreed upon advance per- sify any receivables that have already been centage. This reciprocal, 20 percent in the case classified under client risk exposure. of an 80 percent advance client, is sometimes referred to as the client’s equity in the factored receivables. Availability may be increased by liens on additional collateral, such as inventory, FORFAITING machinery and equipment, real estate, and other marketable assets. Loans against this type of A number of financial institutions are financing collateral may be handled in the commercial receivables from Eastern European and devel- finance section of a factoring department. oping countries by a method called forfaiting.

September 1997 Branch and Agency Examination Manual Page 6 Financing Foreign Receivables 3080.1

Forfaiting is nonrecourse financing of receiv- THE EXPORT-IMPORT BANK OF ables similar to factoring. However, while a THE UNITED STATES factor normally purchases a company’s short- term receivables, a forfait bank purchases notes The Export-Import Bank of the United States that are long-term receivables with maximum (Eximbank) issues to commercial banks, for a maturities of eight years. The forfaiting bank has fee, guarantees of payment for foreign receiv- no recourse to the seller of the goods but gets the ables that the branch purchases from exporters, notes at a substantial discount for cash. generally without recourse to the latter. The The centers of forfaiting are Zurich and maturities of the receivables range from 181 Vienna, where many large banks, including days to over five years. Generally, the foreign American institutions, provide forfaiting through buyer must make a cash payment, either before either their branches or specialized subsidiaries. or upon delivery, of at least 10 percent of the Forfaiting is used when government export invoice value and the amount of receivables credits or credit guarantees are not available or purchased by the branch without recourse to the when a seller does not extend long-term credits exporter normally cannot exceed 90 percent of to areas, such as Eastern Europe. Forfaiting is the financed portion of the sale (invoice amount also an important method of financing for small less cash payment). That guarantee covers and medium-sized companies because it enables political risks, such as inconvertibility of foreign them to negotiate transactions that would nor- currencies into U.S. dollars, governmental actions mally exceed their financial capabilities. By preventing importation of goods, war, civil strife, using forfaiting, small and medium-sized con- expropriation, and confiscation by government cerns can immediately sell their long-term action. Commercial risks, basically the credit receivables without recourse. risk of the foreign purchaser, usually are covered The examiner should review the branch’s from six months to five years. forfaiting activities carefully to determine whether long-term receivables have been purchased from countries prone to frequent political changes and fluctuations in exchange rates. In addition, the THE FOREIGN CREDIT other risks peculiar to factoring are present in INSURANCE ASSOCIATION forfaiting, along with the risks associated with the long-term nature of receivables purchased. The Foreign Credit Insurance Association (FCIA) is an association of leading marine, property, and casualty insurance companies. In coopera- tion with Eximbank, FCIA offers a comprehensive selection of credit insurance policies, which U.S. AND FOREIGN protect policyholders against loss from failure to RECEIVABLES GUARANTEE AND receive payment from foreign buyers. INSURANCE PLANS FCIA coverage protects the exporter against the failure of the buyer to pay dollar obligations To reduce credit, political, and other risks asso- for commercial or political reasons; enables the ciated with foreign receivables financing, exporter to offer foreign buyers competitive branches may avail themselves of a variety of terms of payment; supports the exporter’s pru- guarantee and insurance plans, both public and dent penetration of higher risk foreign markets; private, that are available in many countries. and, gives the exporter greater financial liquidity Because of the complexity of the numerous and flexibility in administering a foreign receiv- plans available, an examiner must frequently ables portfolio. rely on the technical knowledge of the staff of The FCIA does not itself finance export sales; the branch. Nevertheless, the examiner should however, the exporter who insures account know the risk coverage and claim adjustment receivables against commercial and political provisions of the major plans. Often a branch’s risks is usually able to obtain financing from experience with its receivables insurance and commercial banks and other lending institutions guarantee plans indicates its effectiveness and at lower rates and on more liberal terms than whether the branch has properly met its respon- would otherwise be possible by assigning the sibilities under the programs. proceeds of the FCIA insurance to the lenders.

Branch and Agency Examination Manual September 1997 Page 7 3080.1 Financing Foreign Receivables

Comprehensive FCIA policies protect insur- 3. Combined short-term/medium-term policies ers against nonpayment of receivables due to for sales that pass through distributors before unforeseeable commercial and political occur- reaching final buyers. rences. Commercial risks that are covered 4. Master policies that include the basic insur- include insolvency or protracted default, which ance features of the previous policies, plus may be caused by economic deterioration in the discretionary and deductible provisions. Under buyer’s market area, shifts in demand, unantici- a master policy, usually only for short-term pated competition, tariffs, or technical changes. and seldom for medium-term transactions, Political risk coverage applies to defaults due to exporters may obtain FCIA authority to grant government action, such as currency inconvert- insured credit up to a certain amount without ibility, expropriation, and cancellation of import seeking prior approval. The deductible pro- license and to political disturbances such as war, vision, used only for commercial risks and revolution, and insurrection. not political risks, requires the exporter to FCIA generally offers four basic types of assume a fixed amount of the first loss on insurance policies covering political and com- total debts. mercial risks (Source: Washington Agencies that Help to Finance Foreign Trade, Seventh Edition, Bankers Trust Company, N.Y.C.): OTHER INSURERS 1. Short-term policies covering shipments normally sold on terms up to 180 days. The There are numerous other private and govern- usual policy covers 100 percent of political mental institutions, both in the U.S. and over- risk and 90 percent of any losses from seas, that guarantee or insure risks assumed by commercial risk. banks financing foreign receivables. Some for- 2. Minimum-term policies insuring transactions eign examples are the Export Credits Guarantee from six months to five years. FCIA covers Department (ECGD) in the United Kingdom, up to 90 percent of commercial risks and up COFACE in France, and HERMES in West to 100 percent of political risks, with the Germany. remainder retained by the exporter.

September 1997 Branch and Agency Examination Manual Page 8 Financing Foreign Receivables Examination Objectives Effective date July 1997 Section 3080.2

1. To determine if the policies, practices, pro- 4. To determine the scope and adequacy of the cedures, and internal controls regarding the audit function as it relates to the financing of financing of foreign receivables are adequate. foreign receivables. 2. To determine if branch officers are operating 5. To recommend corrective action when poli- in conformance with established branch cies, practices, procedures, or internal con- guidelines. trols are deficient. 3. To evaluate the portfolio for credit quality, collectibility, and collateral sufficiency.

Branch and Agency Examination Manual September 1997 Page 1 Financing Foreign Receivables Examination Procedures Effective date July 1997 Section 3080.3

1. If selected for implementation, complete or • The regulations in the country of des- update the Internal Control Questionnaire. tination regarding the return of unsold 2. Determine the scope of the examination consigned goods to the country of based on the evaluation of internal controls origin. and the work performed by internal and • The branch’s past experience in deal- external auditors. ing with the borrower who sells on 3. Test for compliance with policies, practices, consignment. procedures, and internal controls in conjunc- c. Advances Against Collections: tion with performing the remaining exami- • The relationship between the amount nation procedures. Obtain a listing of any collected in a month on the collections deficiencies noted in the latest reviews by pledged as collateral and the borrow- internal and external auditors from the er’s credit limit. examiner performing the audit assignment, • The tenor of sight drafts stated number and determine if appropriate corrections of days after sight or a stated number have been made. of days after the date of the draft. 4. Obtain the following information for: • Instructions regarding delivery of documents against payment (D/P) or docu- a. Open Account Financing: ments against acceptance (D/A). • Whether the shipment is directed to • Whether amounts advanced against col- third parties or branches and subsidi- lections are within the percentage of aries of the borrower. advance limitation established. • The financial strength and trustworthi- • Aging of drafts (collections). ness of the overseas buyer. • Ineligible drawees, including house • The extent of foreign exchange control bills. and the availability of exchange for the • Concentrations of drawees. importer to effect payment. • Financial strength of drawees. • The branch’s past experience in deal- • Unusual situations such as disputes, ing with the borrower who sells on nonacceptance of goods, and posses- open account. sion of goods without payment. b. Sales on Consignment: • Dishonor and protest instructions. • Whether the shipment is directed to • Any special instructions. third parties or branches and subsidi- • The extent of foreign exchange con- aries of the obligor. trols and the availability of exchange • The financial strength and trustworthi- for that type of transaction in the ness of the foreign consignee. country of destination. • The branch’s experience in dealing • The responsibilities of the foreign sales with the borrower who receives agent, overseas representative, or import advances against collections. house under contract. d. Discounted Trade Acceptances: • The extent of foreign exchange control • The relationship between the amount and the availability of exchange for collected in a month on the trade that type of transaction in the country acceptances discounted and the bor- of destination. rower’s credit limit. • Whether the borrower’s goods without • Whether the branch discounted the a definite buyer are consigned abroad trade acceptance with or without in the name of the borrower’s bank or recourse. a foreign bank. • Whether the borrower retains a per- • Whether the goods being shipped are centage of the trade acceptance assigned to a responsible warehouse. endorsed to the branch. • Any arrangements that have been made • Aging of trade acceptances. whereby the selling agent negotiates • Ineligible drawees, including house for the sale of the goods. bills.

Branch and Agency Examination Manual September 1997 Page 1 3080.3 Financing Foreign Receivables: Examination Procedures

• Concentrations of drawees. • Whether the imported goods held under • Financial strength of the drawees. warehouse receipt are stored in an • Unusual situations, such as disputes, independent warehouse for the account nonacceptance of goods, and posses- of the factor. sion of goods without payment. • Whether banker’s acceptances are • Dishonor and protest instructions. charged to the branch customer’s • Any special instructions. account for payment to the factor when • The extent of foreign exchange con- due. trols and the availability of exchange • Whether the factor creates a banker’s for that type of transaction in the acceptance pending payment of country of destination. accounts receivable resulting from the • The branch’s experience in dealing sale of goods imported under letters of with the borrower for whom its trade credit. acceptances are discounted by the • The financial strength of the importer branch. for whom the branch opened the letter e. Banker’s Acceptance Financing: of credit. • The relationship between the amount • Any disputes, nonacceptance of goods, collected from the foreign buyer in a and possession of goods without month and the borrower’s credit limit. payment. • Whether the discounted draft drawn by • The branch’s experience in dealing the exporter (customer) on the export- with the factor. er’s bank has the same tenor as the g. Forfaiting: draft addressed to the foreign buyer. • Agings of debtor accounts purchased. • The procedures for applying payment • Ineligible debtor accounts purchased, received from the foreign buyer to pay including affiliate receivables, if any. the branch’s own acceptance. • Concentration of debtor accounts • Aging of time drafts drawn on the purchased. importer (drawee). • The adequacy of the branch’s credit • Ineligible foreign buyers (drawees), investigation before approving the sale including house bills. (or signing of a sales contract) creating • Concentrations of foreign buyers a receivable. (drawees). • The financial strength of the debtor • Financial strength of the foreign buy- accounts purchased. ers (drawees). • The capability of the exporter from • Disputes, nonacceptance of goods, and whom receivables were purchased to possession of goods without payment. provide any required after-sales ser- • Dishonor and protest instructions. vice and to honor warranties. • Any special instructions. • Disputes and returns. • The extent of foreign exchange control • The extent of foreign exchange restric- and the availability of exchange for tions, availability of exchange, and that type of transaction in the country country risk involved that could jeop- of destination. ardize collection of receivables • The branch’s experience in dealing purchased. with the borrower. • The branch’s experience in dealing f. Factoring: with both the debtors and the exporter. • The extent of factor guarantees (letters h. U.S. and foreign receivables guarantee of credit opened by the branch in favor and insurance plans: of overseas suppliers). • Whether foreign receivables coverage • Whether the title documents on import by FCIA, Eximbank, or other insur- transactions are consigned to or ance or guarantee programs is suffi- endorsed over to the factor. cient, adequately identifies risks, and is • Whether the importer who receives consistent with established limits. goods under trust receipt agrees to 5. Analyze secondary support offered by guar- hold them in trust for the factor. antors and endorsers.

September 1997 Branch and Agency Examination Manual Page 2 Financing Foreign Receivables: Examination Procedures 3080.3

6. Determine compliance with the branch’s g. Concentrations of credit. established loan policy. h. Other matters regarding the condition of 7. At this point, the examiner needs to decide the department. whether further examination and testing is 9. Evaluate the branch with respect to: needed. If further work is warranted, refer a. The adequacy of written policies relating to the audit guidelines. After reviewing the to financing foreign receivables. audit guidelines, proceed to step 8. b. The manner in which branch officers are 8. Discuss with appropriate officers and pre- operating in conformance with estab- pare summaries in appropriate report form lished policy. of: c. Adverse trends in those sections con- a. Delinquent loans. cerned with financing foreign receivables. b. Loans not supported by current and com- d. Recommended corrective action when plete financial information. policies, practices, or procedures are c. Loans on which documentation is deficient. deficient. e. The competency of departmental d. Loans with credit weaknesses. management, e. Inadequately collateralized loans. f. Other matters of significance. f. Criticized loans, including supporting 10. Update the workpapers with any informa- commentaries. tion that will facilitate future examinations.

Branch and Agency Examination Manual September 1997 Page 3 Financing Foreign Receivables Internal Control Questionnaire Effective date July 1997 Section 3080.4

POLICIES 8. Are frequent debt instrument and liability ledger trial balances prepared and recon- 1. Has the head office adopted policies that: ciled monthly with control accounts by a. Establish procedures for reviewing financ- employees who do not process or record ing applications? loan transactions? b. Establish standards for determining credit lines? c. Establish standards for determining the DOCUMENTATION percentage of advances made against acceptable collections (receivables)? 9. Are terms, dates, weights, description of the d. Define acceptable receivables merchandise, etc., shown on invoices, ship- (collections)? ping documents, trust receipts, and bills of e. Establish minimum requirements for veri- lading scrutinized for differences? fication of borrower’s receivables 10. Are procedures in effect to determine if the (collections)? signatures shown on the above documents f. Establish minimum standards for docu- are authentic? mentation in accordance with the Uni- 11. Are payments received from customers scru- form Commercial Code? tinized for differences in invoice dates, 2. Are policies reviewed at least annually to numbers, terms, etc.? determine if they are compatible with changing market conditions? LOAN INTEREST ACCOUNTING RECORDS If the following questions have been answered in the Credit Risk section (3010), skip to ques- If the following questions have been answered in tion 14. the Credit Risk section (3010), skip to question 9. 12. Is the preparation and posting of loan interest records performed or adequately reviewed 3. Is the preparation and posting of subsidiary by persons who do not also: records performed or adequately reviewed a. Issue official checks or drafts? by persons who do not also: b. Handle cash? a. Issue official checks or drafts? 13. Are independent interest computations made b. Handle cash? and compared or adequately tested to initial 4. Are subsidiary records reconciled, at least loan interest records by persons who do not monthly, with the appropriate general led- also: ger accounts, and are reconciling items a. Issue official checks or drafts? adequately investigated by persons who do b. Handle cash? not normally handle foreign receivables financing? 5. Are inquiries regarding loan balances for COLLATERAL foreign receivables financing received and investigated by persons who do not nor- 14. Does the branch record a first lien on mally process documents, handle settle- assigned foreign receivables for each bor- ments, or post records? rower on a timely basis? 6. Are bookkeeping adjustments checked and 15. Do loans granted on the security of the approved by an appropriate officer? foreign receivables also have an assignment 7. Is a daily record maintained summarizing of the inventory? transaction details, i.e., loans made, pay- 16. Does the branch verify the borrower’s ments received, and interest collected to receivables or require independent verifica- support applicable general ledger entries? tion on a periodic basis?

Branch and Agency Examination Manual September 1997 Page 1 3080.4 Financing Foreign Receivables: Internal Control Questionnaire

17. Does the branch require the borrower to 32. Is the employee handling collection pro- provide aged receivables schedules on a ceeds required to apply them to the borrow- periodic basis? er’s advance on the same business day that 18. Are underlying bills of lading covering payment is received? shipments either to the order of the shipper 33. Is the disposition of each collection noted or blank endorsed to the order of the branch on the register so that verification of dispo- rather than the foreign buyer? sition can be made? 19. Are the shipments being financed covered 34. Has a regular policy of follow-up proce- by adequate insurance? dures been established for sending tracers and inquiries on unpaid collections in the hands of correspondents? ADVANCES AGAINST 35. Should the foreign drawee refuse to honor COLLECTIONS AND the draft, are instructions clear as to what DISCOUNTED TRADE actions should be taken by the collecting ACCEPTANCES bank? 36. In the event of nonpayment of the collec- 20. Are permanent registers kept for foreign tion, is the borrower promptly notified by collections against which advances were the branch? made or trade acceptances were discounted? 37. Are collections against which advances have 21. Are all collections indexed in a collection been made or trade acceptances discounted register? distinctly segregated from ordinary collec- 22. Do these registers furnish a complete his- tion items? tory of the origin and final disposition of 38. Are financed collections maintained under each collection against which advances were memorandum control and is the control made or trade acceptances were discounted? balanced regularly? 23. Are receipts issued to loan customers for all 39. Are collections against which advances have collections received from them? been made or trade acceptances discounted 24. Are serial numbers or prenumbered forms booked by persons other than employees assigned to each collection item and all handling those items? related papers? 40. Are collections carried over to the next 25. Are all incoming tracers and inquiries business day adequately secured? handled by an officer or employee not 41. Does the customer for whom trade accep- connected with the processing of collections? tances were discounted know whether they 26. Is a daily record maintained showing the were purchased with or without recourse to various collections that have been paid and that customer? credited to the borrower’s advance? 42. Do all parties, i.e., the seller (exporter), 27. Are proceeds of paid collections credited to importer (buyer), and banks, clearly under- the correct customer’s advance? stand whether interest, discount, and collec- 28. Is an itemized daily summary made of all tion charges are to be absorbed by the seller interest charged and received from the or paid by the importer? exporter or importer (drawee) indicating underlying collection numbers and amounts? 29. Are payments collected from importers (drawees) by foreign banks or branches of U.S. banks forwarded directly to the branch FACTORING and not through the exporter? 30. If the exporter accepts importer (drawee) 43. Has the branch properly surrendered the payments directly, are controls established shipping documents to the factor either or audits of exporter’s books conducted? If through endorsement or consignment? so, explain briefly. 44. Do advances or banker’s acceptances coin- 31. Are employees handling collections periodi- cide with the expected payment of the cally rotated, without advance notification, accounts receivable by the ultimate to other banking duties? customer?

September 1997 Branch and Agency Examination Manual Page 2 Financing Foreign Receivables: Internal Control Questionnaire 3080.4

FOREIGN CREDIT INSURANCE 53. If the branch has discretionary authority ASSOCIATION INSURANCE from Eximbank, does it nevertheless inform Eximbank of each transaction thereunder? 45. Is the branch aware of risks not covered 54. If the branch has been issued an equipment under its assigned FCIA insurance? political risk guarantee by Eximbank, does 46. Does the branch monitor whether the bor- it have a written statement from the govern- rower exceeded its FCIA established credit ment of the country in which the equipment limits? will be used indicating that it will permit the 47. Does the branch monitor whether the bor- importation, use, and any subsequent expor- rower properly assigned the proceeds of its tation of the equipment? FCIA insurance to the branch? 55. Does the branch monitor whether loan agree- 48. Is the branch aware of whether the FCIA ments between applicable borrowers and insurance is on either simple notice or a the branch are acceptable to Eximbank? special assignment basis? 56. Does the branch report delinquencies to 49. Does the branch retain recourse to the Eximbank in a timely manner, as specified exporter under its FCIA arrangement? in its agreement with that agency? 50. Has the branch reported delinquencies to 57. If default occurs, does the branch file a FCIA in accordance with its agreement with proper claim with Eximbank? the Association? 51. If default occurs, does the branch file a proper claim with FCIA? CONCLUSION EXPORT-IMPORT BANK OF THE 58. Is the information covered by this ICQ UNITED STATES adequate for evaluating internal controls in this area? If not, indicate any additional 52. Does the branch, financing under Eximbank examination procedures deemed necessary. arrangements, have properly executed 59. Based on the information gathered, evaluate Eximbank guarantees or commitments cov- the internal controls in this area (i.e. strong, ering transactions? satisfactory, fair, marginal, unsatisfactory).

Branch and Agency Examination Manual September 1997 Page 3 Financing Foreign Receivables Audit Guidelines Effective date July 1997 Section 3080.5

1. Test the addition of trial balances and their j. Determine that records are posted promptly reconciliation to the general ledger. Include on collections settled, preferably on the loan commitments and other contingent same day they are received. liabilities. 3. Review the applicable accrued interest 2. If memoranda controls are maintained, pre- accounts by: pare a trial balance of each account so a. Reviewing and testing procedures of controlled. Using an appropriate sampling accounting for accrued interest and for technique, select representative items and: handling adjustments. a. Review all supporting documents. b. Scanning accrued interest for any unusual b. Verify the authenticity of each item entries and following up on any unusual selected and trace and clear each item items by tracing them to initial and sup- through final payment, including appropri- porting records. ate credit to the customer’s account. c. Independently calculating for those credit c. In the case of unusual, altered, or long- extensions selected in step 2, the amount standing items, prepare and mail confir- of accrued interest and confirming the mation requests to customers. amount to the detail of accrued interest d. Examine financing instruments for com- receivable for that loan. pleteness and verify dates, amounts, and 4. Using a list of nonaccruing loans, check items to the trial balance. accrual records to determine that interest e. Check to see that financing instruments income is not being recorded. are signed, appear to be genuine, and are negotiable. 5. Test appropriate records to determine that f. Check to see that required initials of an discount, commissions, fees, and collection approved lending officer are on the financ- charges are in accordance with established ing instrument. amounts and that the income accounts are g. Determine that the amount is within the properly credited. officer’s lending limit. 6. Obtain or prepare a schedule showing the h. Determine that any necessary insurance monthly interest income amounts and appli- coverage is adequate and that the branch cable loan balances at each month-end since is named as loss payee. the last audit and: i. Review disbursement ledgers and autho- a. Calculate yield. rizations to determine if: b. Investigate significant fluctuations and • Authorizations are signed in accordance trends. with the terms of the loan agreement. • Collection funds received are credits in accordance with provisions of the borrower’s loan agreement.

Branch and Agency Examination Manual September 1997 Page 1 Other Real Estate Owned Effective date July 1997 Section 3090.1

A branch’s authority to hold real estate rests ENVIRONMENTAL LIABILITY with the laws of its respective state (if state licensed) or the National Banking Act (if feder- Under federal and state environmental liability ally licensed). State and federal laws and regu- statutes, a branch may be liable for cleaning up lations may dictate accounting procedures, maxi- hazardous substance contamination of other real mum holding periods, and other details relating estate owned. In some cases, the liability may to other real estate owned. Examiners should arise before the branch takes title to a borrow- follow the most recent interagency guidelines er’s collateral real estate. A property’s transition when verifying the proper identification, report- from collateral to branch ownership may take an ing, valuation, and accounting for disposal of extended period of time. As the financial prob- other real estate owned (OREO). lems facing a borrower worsen, a branch may Relevant interagency joint statements include become more involved in managing a company ‘‘Interagency Guidance on Accounting for or property. Such involvement may become Dispositions of Other Real Estate Owned,’’ extensive enough that the branch is deemed to dated July 16, 1993, and ‘‘Interagency Guidance have met substantially all ownership criteria, the on Reporting of In-Substance Foreclosures,’’ absence of a clear title in the branch’s name dated June 10, 1993. In addition, refer to the notwithstanding. Generally, the more involved final rule entitled ‘‘Real Estate Lending Stan- branch management is in such activity, the dards,’’ promulgated by the Federal Reserve greater the branch’s exposure to any future Board, FDIC, OTS, and OCC in December clean-up costs assessed in connection with the 1992. See Final Rule, 57 Fed. Reg. 62890 property. A more thorough discussion of envi- (December 31, 1992). The various state and ronmental liability can be found in the Real federal agencies may differ in terms of specific Estate Loans section of this manual. practices and methodologies used to implement the above guidelines. For further guidance in this area, examiners should consult with their respective agencies. TRANSFER OF ASSETS TO Real property becomes other real estate owned OTHER REAL ESTATE OWNED through: Real estate assets transferred to OREO should • Conveyance in satisfaction of debts previ- be accounted for individually on the date of ously contracted; transfer, at the lower of the recorded investment in the loan or fair value. The recorded invest- • Exchange for future advances to an existing ment in a loan is the unpaid balance, increased borrower to fully or partially satisfy debts by accrued and uncollected interest, unamor- previously contracted; tized premium, finance charges, and loan- acquisition costs, if any, and decreased by pre- • Purchase to secure debts previously contracted; vious write-downs and unamortized discount, if • Relocation of branch premises; or any. Any excess of the recorded investment in the loan over the property’s fair value must be • Abandonment of plans to use real estate charged against the allowance for loan and lease acquired for future expansion for banking losses immediately upon the property’s transfer premises. to OREO. Legal fees should generally be charged to expenses unless payment of the fees is for the Although the borrower may still retain pos- purpose of enhancing the property’s value (for session and legal title to the property, certain example, obtaining a zoning variance). troubled loans secured by real estate are consid- Establishing a valuation allowance for esti- ered to be ‘‘insubstance foreclosures’’ and are mated selling expenses may also be necessary also treated as other real estate owned. An upon transferring each property to OREO to insubstance foreclosure situation is generally comply with AICPA Statement of Position 92-3, characterized by a borrower with little or no Accounting for Foreclosed Assets. According to equity and the sale of the property is the only this pronouncement, the value of OREO prop- source of repayment. erties must be reported at the lesser of the fair

Branch and Agency Examination Manual September 1997 Page 1 3090.1 Other Real Estate Owned value minus estimated selling expenses or the OREO, it is common practice to use the terms recorded investment in the loan. For example, if ‘‘fair value’’ and ‘‘market value’’ interchange- the recorded investment of the property is $125, ably. When no active market exists for a prop- the fair value is $100, and the estimated selling erty, the accounting industry’s definition of fair expenses are $6, the carrying value for this value applies because the appraiser cannot deter- property would be $94. The difference between mine a market value. The accounting industry the recorded investment and the fair value ($25) definition requires the appraisal or evaluation to would be charged to the allowance for loan and contain an estimate of the property’s fair value lease losses at the time the property was trans- based on a forecast of expected cash flows, ferred to OREO. In addition, since the branch discounted at a rate commensurate with the risks estimated it would incur selling expenses of $6, involved. The cash flow estimate should include a valuation reserve for this amount must be projected revenues and the costs of ownership, established. The net of the fair value and this development, operation, marketing, and sale. In valuation reserve for selling expenses is called such situations, the appraiser or evaluator should the ‘‘net realizable value,’’ and in this example fully describe the definition of value and the would be $94. Changes to this valuation reserve market conditions that have been considered in should be handled as outlined in the subsection estimating the property’s value. ‘‘Accounting for Subsequent Changes in Market When a branch acquires a property through Value.’’ foreclosure as a junior lienholder, whether or not On the other hand, if the recorded investment the first lien has been assumed, the fair value of in the property is $250, the fair value is $300, the property should be recorded as an asset and and the estimated selling expenses are $18, the the senior debt as a liability. The senior debt carrying value of this property would be $250 should not be netted against the assets. Any (the lesser of the recorded investment or the fair excess of the recorded investment of the prop- value). In this example, a valuation reserve for erty over the fair value should be charged off, as estimated selling expenses is unnecessary, as the recorded investment may not exceed the sum netting the estimated selling expenses ($18) of the junior and senior debt. Payments made on from the fair value ($300) would yield a net senior debt should be accounted for by reducing realizable value of $282. both the asset and the liability, and interest that accrues on the senior debt after foreclosure The transfer of a loan to OREO is considered should be recognized as interest expense. to be a ‘‘transaction involving an existing exten- For regulatory reporting purposes, a collateral- sion of credit’’ under 12 CFR 225.63(a)(7) and dependent real estate loan should be transferred is exempt from Regulation Y’s appraisal require- to OREO only when the lender has taken pos- ment. However, under 12 CFR 225.63(b), the session (title) of the collateral. Nevertheless, to branch must obtain an ‘‘appropriate evaluation’’ facilitate administration and tracking, branches of the real estate that is ‘‘consistent with safe may choose to include a collateral-dependent and sound banking practices’’ to establish the real estate loan in the OREO portfolio as poten- carrying value of the OREO. A branch may tial or probable OREO. Examiners should review elect, but is not required, to obtain an appraisal these loans using the same criteria applied to to serve as the ‘‘appropriate evaluation.’’ Until OREO. the evaluation is available, a branch should rely on its best estimate of the property’s value to establish the carrying value. The federal banking agencies have issued appraisal and evaluation guidelines to provide guidance to examin- CARRYING VALUE OF OTHER ing personnel and federally regulated institutions REAL ESTATE OWNED regarding prudent appraisal and evaluation policies, procedures, practices, and standards. A branch should have a policy for periodically The appraisal or evaluation should provide an determining the fair value of its OREO property estimate of the parcel’s market value. Refer to by obtaining an appraisal or an evaluation, as Real Estate Loans section of this manual for a appropriate. While the Federal Reserve has no definition of market value. Generally, market prescribed time frame for when a branch should value and fair value are equivalent when an reappraise or reevaluate its OREO property, the active market exists for a property. In discussing branch’s policy should conform to state or

September 1997 Branch and Agency Examination Manual Page 2 Other Real Estate Owned 3090.1 federal law, if applicable, and address the vola- Depreciation in OREO Property Value tility of the local real estate market. Specifically, a branch should determine if there have been Assume a branch has written down its initial material changes to the underlying assumptions recorded investment in an OREO property from in the appraisal or valuation that have affected $125 to its fair value of $100. Since the fair the original estimate of value. If material changes value of the property was less than the initial have occurred, the branch should obtain a new recorded investment, a valuation reserve for appraisal or evaluation based on assumptions estimated selling expenses was established. In that reflect the changed conditions. this example, assume these to be $6. Accord- ingly, the net realizable value was $94 ($100 minus $6). Next, assume a new appraisal indicates a fair value of $90, reducing the estimated ACCOUNTING FOR SUBSEQUENT selling expenses to $5. Although the branch must expense the depreciation in the fair value CHANGES IN MARKET VALUE ($10), the valuation reserve for selling expenses would be reduced by the difference in the Charges for subsequent declines in the fair value estimate of the selling expenses ($1). Given this of OREO property should never be posted to the scenario, the ‘‘adjusted’’ net realizable value allowance for loan and lease losses. If an would be $85 ($90 minus $5). appraisal or evaluation indicates a subsequent decline in the fair value of an OREO property, the loss in value should be recognized by a charge to earnings. Branches should attempt to Appreciation in OREO Property Value determine whether a property’s decline in value is temporary or permanent, taking into consid- Assume a branch has written down its recorded eration each property’s characteristics and exist- investment in an OREO property to its fair value ing market dynamics. The preferred treatment of $100. Since the fair value of the property was for permanent losses in value is the direct less than the original recorded investment, an write-down method, in which the charge to estimated valuation reserve for selling expenses expenses is offset by a reduction in the OREO of $6 was established. Accordingly, the net property’s carrying value. If the reduction in realizable value was $94. A new appraisal value is deemed temporary, the charge to earn- indicates an increase in the fair value of the ings may be offset by establishing a valuation property to $110, with selling expenses now allowance specifically for that property. In the estimated at $7. As a result, the net realizable event of subsequent appreciation in the value of value is now $103. Given that the new net an OREO property, the increase can only be realizable value is greater than the recorded reflected by reducing this valuation allowance or investment of $100, the selling expense valua- recognizing a gain upon disposition, but never tion reserve is no longer necessary and the $6 by a direct write-up of the property’s value. A can be reversed to income. Notwithstanding the change to the valuation allowance should be property’s increased fair value, the recorded offset with a debit or credit to expense in the investment value cannot be increased above period in which it occurs. $100. The valuation reserve for selling expenses In addition to the preceding treatment of the can never be less than zero, thus prohibiting an write-down in the OREO value, the previous increase in the value of the property above the subsection ‘‘Transfer of Assets to Other Real recorded investment. Estate Owned’’ discusses setting up a valuation allowance for estimated selling expenses associated with the sale of the other real estate. The balance of this valuation reserve can fluctuate ACCOUNTING FOR INCOME AND based on changes in the fair value of the EXPENSE property held, but it can never be less than zero. The following examples are presented to illus- Gross revenue from other real estate owned trate the treatment that subsequent depreciation should be recognized in the period in which it is and appreciation would have on OREO earned. Direct costs incurred in connection with properties. holding an OREO property, including legal fees,

Branch and Agency Examination Manual September 1997 Page 3 3090.1 Other Real Estate Owned real estate taxes, depreciation, and direct write- OREO property begins on the day that plans for downs, should be charged to expense when future use are formally terminated. Some states incurred. require OREO property to be written off or A branch can expend funds to develop and depreciated on a scheduled basis, or to be improve OREO when it appears reasonable to written off at the end of a specified time period. expect that any shortfall between the property’s The branch should determine whether such fair value and the branch’s recorded book value requirements exist and comply with them. will be reduced by an amount equal to or greater than the expenditure. Such expenditures should not be used for speculation in real estate. The economic assumptions relating to the branch’s ACCOUNTING FOR THE SALE OF decision to improve a particular OREO property OTHER REAL ESTATE OWNED should be well documented. Any payments for developing or improving OREO property are Gains and losses resulting from a sale of OREO treated as capital expenditures and should be properties for cash must be recognized imme- reflected by increasing the property’s carrying diately. A gain resulting from a sale in which value. the branch provides financing should be accounted for under the standards described in Statement of Financial Accounting Standards 66 DISPOSITION OF OTHER REAL (SFAS 66). ESTATE OWNED SFAS 66 recognizes that differences in terms of the sale and in selling procedures lead to OREO property must be disposed of within any different profit recognition criteria and methods. holding period established by state law and, in Branches may facilitate the sale of foreclosed any case, as soon as it is prudent and reasonable. real estate by requiring little or no down pay- Branches should maintain documentation reflect- ment, or by offering loans with favorable terms. ing their efforts to dispose of OREO property, Profit shall only be recognized in full when the which should include a record of inquiries and collectibility of the sales price is reasonably offers made by potential buyers, methods used ensured and when the seller is not obligated to in advertising the property for sale whether by perform significant activities after the sale to the branch or its agent, and other information earn the profit. Unless both conditions exist, reflecting sales efforts. recognition of all or part of the profit shall be The sale or disposition of OREO property is deferred. Collectibility of the sale price of OREO considered a real estate-related financial trans- property is demonstrated when the buyer’s action under the Board’s appraisal regulation. A investment is sufficient to assure that the buyer sale or disposition of an OREO property that will be motivated to honor his or her obligation qualifies as a federally related transaction under to the seller rather than lose the investment. the regulation requires an appraisal conforming Collectibility shall also be assessed by consid- to the regulation. A sale or disposition that does ering factors such as the credit standing of the not qualify as a federally-related transaction buyer, age and location of the property, and nonetheless must comply with the regulation by adequacy of cash flow from the property. having an appropriate evaluation of the real The practice of recognizing all profit from the estate, that is consistent with safe and sound sale of branch-financed OREO at the time of the banking practices. sale is referred to as the full-accrual method. A The branch should promptly dispose of OREO branch shall not recognize profit using this if it can recover the amount of its original loan method until all of the following general criteria plus additional advances and other costs related are met: to the loan or the OREO property before the end of the legal holding period. The holding period • A sale is consummated. generally begins on the date that legal title to the • The buyer’s initial and continuing investments property is transferred to the branch, except for adequately demonstrate a commitment to pay real estate that has become OREO because the for the property. branch no longer contemplates using it as its • The branch’s loan is not subject to future premises. The holding period for this type of subordination.

September 1997 Branch and Agency Examination Manual Page 4 Other Real Estate Owned 3090.1

• The branch has transferred to the buyer the The Installment Method usual risks and rewards of ownership in a transaction that is in substance a sale, and it This method is used when the buyer’s down has no substantial continuing involvement in payment is insufficient to allow the full-accrual the property. method, but when recovery of the cost of the property is reasonably assured if the buyer A sale will not be considered consummated defaults. The installment method recognizes the until the parties are bound by the terms of the sale of the property and the booking of the contract, all consideration has been exchanged, corresponding loan, although profits from the and all conditions precedent to closing have sale are recognized only as the branch receives been performed. payments from the buyer. Under this method, Initial investment, as defined by SFAS 66, interest income is recognized on an accrual includes only cash down payments, notes sup- basis, when appropriate. ported by irrevocable letters of credit from an Since default on the loan usually results in the independent lending institution, payments by seller (the branch) reacquiring the real estate, the the buyer to third parties to reduce existing debt branch is reasonably assured that it will be able on the property, and other amounts paid by the to recover its costs with a relatively small down buyer that are part of the sale price. In these payment. Cost recovery is especially likely when situations, SFAS 66 requires that profit on the loans are made to buyers who have verifiable net sale be deferred until a minimum down payment worth, liquid assets, and income levels adequate has been received and annual payments equal to service the loan. Reasonable assurance of cost those for a loan for a similar type of property recovery also may be achieved when the buyer with a customary amortization period. The pledges adequate additional collateral. amount of down payment required varies by category of property: land, 20–25 percent; commercial and industrial, 10–25 percent; multifam- The Cost-Recovery Method ily residential, 10–25 percent; and single-family residential, 5–10 percent. Ranges within these Dispositions of OREO that do not qualify for categories are defined further in the statement. either the full-accrual or installment methods are Continuing investment requires the buyer to sometimes accounted for using the cost-recovery be contractually obligated to make level annual method. This method recognizes the sale of the payments on his or her total debt for the pur- property and the booking of the corresponding chase price of the property. This level annual loan, but all income recognition is deferred. payment must be able to service principal and Principal payments are applied by reducing the interest payments amortized for no more than 20 loan balance, and interest payments are accounted years for raw land, and for no more than the for by increasing the unrecognized gross profit. customary amortization term for a first-mortgage No profit or interest income is recognized until loan by an independent lending institution for either the buyer’s aggregate payments exceed other types of real estate. the recorded amount of the loan or a change to If a branch finances the sale of foreclosed another accounting method (for example, the property it owns with a loan at less than current installment method) is appropriate. Conse- market interest rates or noncustomary amortiza- quently, the loan is maintained on nonaccrual tion terms, generally accepted accounting prin- status while this method is being used. ciples require that the loan be discounted to bring its yield to a market rate, using a customary amortization schedule. This discount will The Reduced Profit Method either increase the loss or reduce the gain resulting from the transaction. Interest income is This method is used in certain situations when then generally recognized at a constant yield the branch receives an adequate down payment, over the life of the loan. but the loan amortization schedule does not If a transaction does not qualify for the meet the requirements for use of the full-accrual full-accrual accounting method, SFAS 66 iden- method. The branch again recognizes the sale of tifies alternative methods of accounting for sales the property and the booking of the correspond- of OREO property as described below. ing loan but, as under the installment method,

Branch and Agency Examination Manual September 1997 Page 5 3090.1 Other Real Estate Owned profits from the sale are recognized only as the When evaluating the OREO property for branch receives payments from the buyer. Since classification purposes, the examiner must con- sales with adequate down payments generally sider the property’s market value, whether it is are not structured with inadequate loan- being held in conformance with state law, and amortization schedules, this method is seldom whether it is being disposed of according to the used. branch’s plan. The amount of an OREO property subject to classification is the carrying value of the property, net of any specific valuation The Deposit Method allowance. The existence of a specific valuation allowance does not preclude adverse classifica- This method is used when a sale of OREO has tion of OREO. The examiner should review all not been consummated. It also may be used for types of OREO for classification purposes, dispositions that could be accounted for under including sales that fail to meet the standards the cost-recovery method. Under this method, a required for the full-accrual method of account- sale is not recorded, so the asset continues to be ing. When the branch provides financing, the reported as OREO. Further, no profit or interest examiner should determine whether it is pru- income is recognized. Payments received from dently underwritten. the buyer are reported as a liability until the use The examiner should review all relevant fac- of one of the other methods is appropriate. tors to determine the quality and risk of the Branches may promote the sale of foreclosed OREO property and the degree of probability real estate by offering nonrecourse financing to that its carrying value will be realized. Some buyers. These loans should be made under the factors the examiner should consider include : same credit terms and underwriting standards the branch employs for its regular lending • The property’s carrying value relative to its activity. Financing arrangements associated with market value (including the date of any this type of transaction are subject to the account- appraisal or evaluation relative to changes in ing treatment discussed above. market conditions), the branch’s asking price, Branch records should (1) indicate the account- and offers received; ing method used for each sale of OREO, (2) sup- • The source and quality of the appraisal or port the choice of the method selected, and evaluation, including the reasonableness of (3) sufficiently document that the institution is assumptions, such as projected cash flow for correctly reporting associated notes receivable, commercial properties; as either loans or OREO property, with valua- • The length of time a property has been on the tion allowances as appropriate. market and local market conditions for the type of property involved, such as history and trend of recent sales for comparable properties; CLASSIFICATION OF OTHER • Branch management’s ability and track record REAL ESTATE OWNED in liquidating other real estate and assets acquired in satisfaction of debts previously The examiner should generally evaluate the contracted; quality of each OREO property to determine if • Income and expenses generated by the prop- classification is appropriate. OREO usually erty and other economic factors affecting the should be considered a problem asset, even probability of loss exposure; when it is carried at or below its appraised value. • The manner in which the branch intends to Despite the apparent adequacy of the fair or dispose of the property; and market value, the branch’s acquisition of OREO • Other pertinent factors, including property- through foreclosure usually indicates a lack of title problems, statutory redemption privi- demand. As time passes, the lack of demand can leges, pending changes in the property’s zon- become more apparent, and the value of the real ing, environmental hazards, other liens, tax estate can become increasingly questionable. status, and insurance.

September 1997 Branch and Agency Examination Manual Page 6 Other Real Estate Owned Examination Objectives Effective date July 1997 Section 3090.2

1. To determine if the policies, practices, pro- 4. To determine the scope and adequacy of the cedures, and internal controls regarding other internal/external audit function. real estate owned are adequate. 5. To determine compliance with applicable 2. To determine that branch ofﬁcers and laws and regulations. employees are operating in conformance with 6. To recommend corrective action when poli- the established guidelines. cies, practices, procedures, or internal con- 3. To verify the carrying value of all other real trols are deﬁcient or when violations of law estate owned. or regulations have been noted.

Branch and Agency Examination Manual September 1997 Page 1 Other Real Estate Owned Examination Procedures Effective date July 1997 Section 3090.3

1. If included in the scope of the examination, d. Review the details of all other real estate complete or update the Internal Control owned transactions to determine that: Questionnaire. • The property has been booked at its fair 2. Test for compliance with policies, practices, value. procedures, and internal controls in conjunc- • The documentation reflects the branch’s tion with performing the remaining examina- persistent and diligent effort to dispose tion procedures. Obtain a listing of any audit of the property. deficiencies noted in the latest review by • If the branch has made expenditures to internal/external auditors, and determine if improve and develop other real estate appropriate corrections have been made. owned, proper documentation is in the 3. Obtain a list of other real estate owned and file. reconcile the total to the general ledger. • Real estate that is former banking prem- 4. Review the other real estate owned account ises has been accounted for as other real to determine if any property has been dis- estate owned since the date of its aban- posed of since the prior examination and: donment. a. If so, determine that: • Such property is disposed of in accor- • The branch accepted written bids for the dance with state or federal laws and property. regulations, including Regulation Y. • The bids are maintained on file. • The valuation is not affected by an • There is justification for accepting a Environmental Protection Agency issue. lower bid if the branch did not accept 6. Review parcels of other real estate owned the highest one. with appropriate management personnel and, b. Investigate any insider transactions. if justified, assign appropriate classification. 5. Test compliance with applicable laws and Classification comments should include: regulations: a. Description of property. a. Determine that other real estate owned is b. How and when real estate was acquired. held in accordance with the provisions of c. Amount and date of appraisal. applicable state or federal laws and d. Amount of any offers and branch’s asking regulations. price. b. Determine if other real estate is being e. Other circumstances pertinent to the clas- amortized or written off in compliance sification. with applicable state or federal laws and 7. Review the following with appropriate man- regulations. agement personnel or prepare a memo to c. Consult with the examiners assigned to other examiners for their use in reviewing ‘‘Loan Portfolio Management,’’ ‘‘Other with management: Assets (and Other Liabilities),’’ and ‘‘Bank a. Internal control exceptions and deficiencies Premises and Equipment’’ to determine: in, or noncompliance with, written poli- • If the branch holds real estate acquired cies, practices, and procedures. as salvage on uncollectible loans, aban- b. Uncorrected audit deficiencies. doned bank premises, or property origi- c. Violations of law. nally purchased for future expansion but 8. Prepare comments in appropriate report form which is no longer intended for such for all: usage. a. Criticized other real estate owned. • If troubled real estate loans meeting the b. Deficiencies noted. criteria for in-substance foreclosures and c. Violations of law. covered transactions are identified. 9. Update the workpapers with any information • If covered transactions and in-substance that will facilitate future examinations. foreclosures are being properly accounted for and reported as other real estate owned.

Branch and Agency Examination Manual September 1997 Page 1 Other Real Estate Owned Internal Control Questionnaire Effective date July 1997 Section 3090.4

OTHER REAL ESTATE OWNED e. Anticipated methods for disposal of RECORDS property? f. Changes in tax status, zoning restric- 1. Are postings to the general ledger account tions, other liens, etc.? for other real estate owned approved and/or tested, prior to posting, by persons who do not have direct, physical, or accounting, OTHER PROCEDURES control of those assets? 2. Are the subsidiary records for other real 7. Does the branch have written policies and estate owned balanced at least quarterly to procedures relating to other real estate the appropriate general ledger accounts by owned? persons who do not have direct, physical, or 8. Does the branch factor in Environmental accounting control of those assets? Protection Agency issues and their impact 3. Are supporting documents maintained for on valuation into its policies? all entries to other real estate owned accounts? 4. Are acquisitions and disposals of other real estate owned reported to senior manage- CONCLUSION ment at the head ofﬁce? 5. Does the branch maintain insurance cover- 9. Is the information covered by this ICQ age on other real estate owned, including adequate for evaluating internal controls in liability coverage where necessary? this area? If not, indicate any additional 6. Are all parcels of other real estate owned examination procedures deemed necessary. reviewed at least annually for: 10. Based on the information gathered, evaluate a. Current appraisal or certiﬁcation? the internal controls in this area (i.e. strong, b. Documentation inquiries and offers? satisfactory, fair, marginal, unsatisfactory). c. Documented sales efforts? d. Evidence of the prudence of additional advances?

Branch and Agency Examination Manual September 1997 Page 1 Other Real Estate Owned Audit Guidelines Effective date July 1997 Section 3090.5

1. Test the additions of the subsidiary ledgers 3. Using appropriate sampling techniques, and reconcile the total to the general ledger. select specific properties, and for expenses Include insubstance foreclosures and prop- incurred in maintaining the properties or erty sold in ‘‘covered transactions.’’ capitalized costs of improvement and 2. Using appropriate sampling techniques, select development: specific properties and determine that: a. Trace the transaction to any previous a. Legal title to the property is obtained records and to postings in the general when the asset is recorded as other real ledger. estate owned. b. Examine documentation supporting the b. Legal fees and direct costs of acquiring transaction and prove any computations title, including payment of existing liens, reflected on the supporting document. taxes, and recording fees are expensed when incurred and are not capitalized. c. Insurance, including liability coverage, is adequate and the branch is named as loss payee.

Branch and Agency Examination Manual September 1997 Page 1 Real Estate Loans Effective date July 1997 Section 3100.1

Real estate lending is a major function of some istration procedures, and credit risk control pro- branches. However, the composition of real cedures as well as the branch’s compliance with estate loan portfolios will vary from branch to its policy. branch because of differences in strategic direc- On March 19, 1993, a uniform rule on real tion, asset size, lending experience, market con- estate lending by insured depository institutions ditions, and location. This section of the manual promulgated by the federal banking agencies deals with the permanent financing of residential became effective. Although the rule does not and commercial real estate. Also included in this directly apply to uninsured branches, it should section are discussions on real estate appraisals be used as a general supervisory guide when and environmental liability. Real estate construc- reviewing loan portfolios, procedures, and prac- tion lending is discussed separately in the fol- tices at all branches. The rule requires each lowing section of this manual. insured depository institution to adopt and main- Due to the differences in individual state tain comprehensive written real estate lending banking laws, this section of the manual pro- policies that are consistent with safe and sound vides a general overview of the supervisory and banking practices, are appropriate to the size of regulatory requirements for a safe and sound the institution, and the nature and scope of its real estate lending program. For information on operations. The policies must establish loan-to- lending limitations and restrictions, refer to the value limits; loan administration procedures; applicable banking laws and regulations that portfolio diversification standards; and documen- govern federally-insured and state-licensed tation, approval, and reporting requirements. branches. The policies adopted by the branch should reflect consideration of the Interagency Guide- lines for Real Estate Lending Policies established by the federal banking agencies. In addi- REAL ESTATE LENDING POLICY tion to the requirements of the uniform rule, a branch’s real estate lending policy should include The branch’s real estate lending policy is a principal amortization terms acceptable for each broad statement of the standards, guidelines, and type of real estate loan that the branch under- limitations that senior branch management and writes. Branch management should also ensure lending officers are expected to adhere to in the that loans are granted with the reasonable process of making a real estate loan. The main- expectation that the borrowers will be able and tenance of prudent written lending policies, willing to meet the repayment terms. Any loan effective internal systems and controls, and that does not follow this principle should be thorough loan documentation is essential to the regarded as an unsound banking practice, regard- branch’s management of the real estate lending less of the collateral value and favorable ratio of function. collateral value to the outstanding loan. While The policies governing a branch’s real estate there is no single lending policy appropriate for lending activities must include prudent under- all branches, there are basic elements that a writing standards that are periodically reviewed branch should consider in formulating its policy, by head office management and clearly commu- including: nicated to the branch’s management and lending staff. The branch should also have credit risk • Allocation of funds (i.e., maximum exposure) control procedures that include, for example, for real estate lending; prudent internal limits on exposure and an • Definition of acceptable loans that the branch effective credit review and problem loan identi- would consider making and the minimum fication process. The complexity and scope of terms that are acceptable to the branch (i.e., these policies and procedures should be appro- amortization rates and cash flow coverage priate to the size of the branch and the nature of ratio by loan type); the branch’s activities, and should be consistent • Geographic area in which the branch will with prudent banking practices and relevant consider lending; regulatory requirements. As part of the analysis • Minimum standards for credit analysis and of a branch’s real estate loan portfolio, examin- loan documentation, including real estate ers should review lending policies, loan admin- appraisal and evaluation policies;

Branch and Agency Examination Manual September 1997 Page 1 3100.1 Real Estate Loans

• Minimum credit criteria that a borrower must this task is even more evident in real estate meet for the credit to be considered by the lending activity. Many institutions reduce their branch; funding risk by entering into loan participations • Maximum loan amounts and loan maturities and sales with other institutions and asset secu- that can be extended on a given property type; ritization transactions.1 • Maximum aggregate loan amounts that may For a detailed discussion on short-term financ- be extended for a given category of real estate ing, see the manual section on Real Estate loans and for all other real estate loans; Construction Loans. • Required pricing structure for each type of loan; • Definition of lending authorities and loan UNSOUND LENDING PRACTICES approval process; • Structure and procedures for administrating Some institutions have adversely affected their the disbursement and servicing of the branch’s financial condition and performance by granting real estate loan portfolio; loans based on ill-conceived real estate projects. • System for monitoring troubled loans; Apart from losses due to unforeseen economic • Regular review of procedures and practices to downturns, these losses have generally been the ensure compliance with the branch’s lending result of poor or lax underwriting standards and policy and safe and sound lending practices; improper management of the institution’s over- and all real estate loan portfolio. • Procedures for originating and purchasing A principal indication of an unsound lending loans with loan-to-value ratios in excess of practice is an improper relationship between the those limits discussed in the Interagency loan amount and the market value of the prop- Guidelines for Real Estate Lending Policies, erty; for example, a high loan-to-value ratio in based on the support provided by other credit relation to normal lending practice for a similar factors. type of property. Other unsafe and unsound lending practices include the failure of the institution to examine the borrower’s debt service ability, or inappropriate loan structure such REAL ESTATE LENDING as capitalizing interest on a term loan, not ACTIVITY AND RISKS requiring principal amortization, or ‘‘evergreen’’ lending—i.e. extending a short-term loan Real estate lending falls into two broad catego- for long-term purposes. For a commercial real ries: short-term financing (i.e., construction estate loan, sound underwriting practices are loans) and permanent financing (e.g., a 30-year critical to the detection of problems in the residential mortgage or 10-year balloon mort- project’s plans, such as unrealistic income gage on an existing commercial office building). assumptions, substandard project design, poten- Each type of lending carries with it unique tial construction problems, and a poor marketing underwriting risks and common risks associated plan that will affect the feasibility of the project. with any type of lending. In all cases, the branch should understand the credit risks and structure of the proposed transaction, even if it is not the originating lender. This policy includes, at a REAL ESTATE LOAN PORTFOLIO minimum, evaluating the financial strength of CONCENTRATION RISK the borrower to repay the debt and the value of the underlying real estate collateral. A branch should have in place effective internal Permanent financing, as the name implies, is policies, systems, and controls to monitor and long-term in nature and presents a funding risk manage its real estate loan portfolio risk. An because a branch’s source of funds is generally indication of improper management of a branch’s of a shorter maturity. Accordingly, branch man- portfolio is an excessive concentration in loans agement should be aware of the source for funding this lending activity. While matching the maturity structures of assets to liabilities is 1. See the section on Asset Securitization for additional information, including information on mortgage-backed secu- particularly important for a branch’s overall rities (MBSs), collateralized mortgage obligations (CMOs), loan portfolio management, the importance of and real estate mortgage investment conduits (REMICS).

September 1997 Branch and Agency Examination Manual Page 2 Real Estate Loans 3100.1 to one borrower or related borrowers, in one and remitting the funds to the insurance com- type of real estate loan, or in a geographic pany and taxing authority. location outside the branch’s designated trade area. In the case of a branch, examiners should Collateral administration—maintaining docu- base their initial review of asset concentrations ments to reflect the status of the branch’s lien on on the total assets of the branch. (See the Credit the collateral (i.e., mortgage/deed of trust and Risk Management section for further informa- title policy/attorney’s opinion), the value of the tion on branch concentrations.) collateral (i.e., real estate appraisal or evaluation In identifying loan concentrations, commer- and verification of senior lien, if in existence), cial real estate loans and residential real estate and the protection of the collateral (i.e., hazard/ loans should be viewed separately when their liability insurance and tax payments). performance is not subject to similar economic or financial risks. However, groups or classes of Loan pay-offs—determining the pay-off amount, real estate loans should be viewed as concentra- preparing the borrower release or assumption tions when there are significant common char- documents, confirming the receipt of funds, and acteristics and the loans are affected by similar recording the appropriate lien-release docu- adverse economic, financial, or business devel- ments in the public land records. opments. Institutions with asset concentrations should have effective internal policies, systems, Collections and foreclosure—monitoring the pay- and controls in place to monitor and manage this ment performance of the borrower and pursuing risk. collection of past-due amounts in accordance Concentrations that involve excessive or with branch policy on delinquencies. undue risks require close scrutiny by the branch and head office management, and should be Claims processing—seeking recoveries on reduced over a reasonable period of time. To defaulted loans that are covered by a govern- reduce this risk, the branch should develop a ment guarantee or insurance program or a pri- prudent plan and institute strong underwriting vate mortgage insurance company. standards and loan administration to control the risks associated with new loans. The branch should have adequate procedures to ensure segregation of duties for disbursal and receipt of funds control purposes. Additionally, the procedures should address the need for LOAN ADMINISTRATION AND document control because of the importance of SERVICING the timely recording of the branch’s security interests in the public land records. Real estate loan administration is responsible for Some institutions provide various levels of certain aspects of loan monitoring. While the loan services for other institutions, which may administration may be segregated by property range from the distribution of payments received type, such as residential or commercial real to the ultimate collection of the debt through estate loans, the functions of the servicing foreclosure. In such cases, the branch will have department may be divided into the following the additional responsibility of remitting funds categories (although the organization will vary on a timely basis to the other institutions, in among institutions): accordance with a servicing agreement. The servicing agreement sets forth the servicer’s Loan closing and disbursement—preparing the duties, reporting requirements, time frame for legal documents verifying the transaction, remitting funds, and fee structure. If one insti- recording the appropriate documents in the pub- tution relies upon another institution for servic- lic land records, and disbursing funds in accor- ing, the branch should have adequate control dance with the loan agreement. and audit procedures to verify the performance of the servicer (also see the manual section on Payment processing—collecting and applying Asset Securitization). For residential loans sold the loan payments. into the secondary mortgage market for which the branch has retained servicing, the Federal Escrow administration—collecting insurance National Mortgage Association (FNMA), the premiums and property taxes from the borrower Federal Home Loan Mortgage Corporation

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(FHLMC), and the Government National Mort- If a branch delegates the loan origination gage Corporation (GNMA) have specific stan- function to a third party, the branch should have dards to which the branch (i.e., seller/servicer) adequate controls to ensure that its loan policies must adhere. Failure to meet these standards can and procedures are being followed. The controls result in the termination of the servicing should include a review of the third party’s agreement. qualifications; a written agreement between the branch and the third-party originator to set forth the responsibilities of the third party as an agent ASSESSMENT OF THE for the branch; a periodic review of the third BORROWER party’s operations to ensure that the branch’s policies and procedures are being followed; and While the value of the real estate collateral is an development of quality controls to ensure that important component of the loan approval pro- loans originated by the third party meet the cess, the branch should not place undue reliance branch’s lending standards and those of the upon the collateral value in lieu of an adequate secondary mortgage market, if the branch expects assessment of the borrower’s ability to repay the to sell the mortgages. loan. These assessment factors will differ depending upon the purpose of the loan, such as single family residential loans compared to Secondary Residential Mortgage income producing commercial property loans Market and commercial or residential development loans (referred to as ‘‘commercial real estate lend- In the secondary market, a branch (the primary ing’’). The loan documentation must adequately mortgage originator) sells all or a portion of its support the branch’s assessment of the borrower interest in residential mortgages to other finan- and contain the appropriate legal documentation cial institutions (investors). Thus, the secondary to protect the branch’s interests. mortgage market provides an avenue for a branch to liquidate a long-term asset, as the need for funds arises. The majority of the secondary Single Family Residential Loans mortgage market activity is supported by three government-related or controlled institutions: Some branches make single family residential FNMA,3 FHLMC,4 and GNMA 5. These entities loans, typically to branch employees. As with were created or sponsored by the federal gov- other such loans, the branch should evaluate the ernment to encourage the financing and construc- applicant’s creditworthiness and determine tion of residential housing. FNMA, FHLMC, whether the individual has the ability to meet and GNMA have specific underwriting stan- monthly mortgage payments and meet all other dards and loan documentation requirements for obligations and expenses associated with home mortgages, which they purchase or guarantee. ownership. This process includes an assessment of the applicant’s income, liquid assets, employment history, credit history, and existing obliga- 3. Although FNMA was originally created in 1938 as an tions.2 The branch should also consider the organization within the federal government, it became a federally chartered, stockholder corporation in 1968, when availability of private mortgage insurance, a some of its functions were placed under the newly created government guarantee, or a government insur- GNMA. Financial institutions can either sell mortgages ance program, such as loans through the FHA- directly to FNMA or pool mortgages for placement in a insured or VA-guaranteed programs, in assess- FNMA-guaranteed mortgage-backed security. 4. FHLMC was sponsored by the Federal Home Loan ing the credit risk of a loan applicant. Bank Board and its members in 1970. Its primary purpose is to provide a secondary market for conventional mortgages originated by thrifts. 2. There are restrictions on the information that federally- 5. GNMA, a government agency under the Department of insured branches can request. The Federal Reserve’s Regula- Housing and Urban Development (HUD), was created in 1968 tion B, Equal Credit Opportunity (12 CFR 202), details the when FNMA became a private corporation. It has several information that may and may not be requested on a loan functions to assist in government housing programs, such as application and provides a model form for a residential managing and liquidating loans acquired by the government. mortgage transaction; and Regulation Z, Truth in Lending (12 In the secondary market, GNMA acts as a guarantor of CFR 226), describes the disclosure requirements to the poten- mortgage-backed securities for pools of loans originated and tial borrower on the cost of financing. securitized by financial institutions.

September 1997 Branch and Agency Examination Manual Page 4 Real Estate Loans 3100.1

Generally, financial institutions enter into either ASSESSMENT OF THE REAL a mandatory or a standby commitment agree- ESTATE COLLATERAL ment with these entities, wherein the financial institution agrees to sell loans according to Branches should obtain an appraisal or evalua- certain delivery schedules, terms, and perfor- tion, as required by any applicable federal or mance penalties. state laws or regulations, for all real estate- related financial transactions, before making the final credit or other decision. (Refer to the Real Estate Appraisals and Evaluations part of this Commercial Real Estate Loans section for additional information.) The appraisal section explains the standards for appraisals, As with other types of lending activities, the indicates which transactions should have an extent of commercial real estate lending activity appraisal or an evaluation, provides guidelines should be contingent upon the lender’s expertise on qualifications for an appraiser and evaluator, and the branch’s experience. In considering an provides guidance on evaluations, and describes application for a commercial real estate loan, a the three appraisal approaches for a Complete branch should understand the relationship of the Appraisal. actual borrower to the project being financed. Management is responsible for determining The form of business ownership varies for whether the assumptions and conclusions of the commercial real estate projects and can affect appraisal or evaluation are reasonable. In addi- the financial resources available for the completion, management’s rationale for accepting and tion of the project and the management and relying upon the appraisal or evaluation should repayment of the loan. be documented in writing. In assessing the Information on past and current projects con- underwriting risks, management should recon- structed, rented, or managed by the potential sider any assumptions used by an appraiser that borrower can help the branch assess the borrow- reflect overly optimistic or pessimistic values. If er’s experience and the likelihood of the pro- management, after its review of the appraisal or posed project’s success. For development and evaluation, determines that there are unsubstan- construction projects, the branch should closely tiated assumptions, the branch may request the review the project’s feasibility study. The study appraiser or evaluator to provide a more detailed should provide sensitivity and risk analyses of justification of the assumptions or obtain a new the potential impact of changes in key economic appraisal or evaluation. variables, such as interest rates, vacancy rates, or operating expenses. The branch should also conduct credit checks of the borrower and of all Single Family Residential Loans principals involved in the transaction to verify relationships with contractors, suppliers, and The assessment of the residential property’s business associates. market value is critical to the branch’s estimate Finally, the branch should assess the borrow- of loan-to-value ratio. This assessment provides er’s financial strength to determine if the prin- the branch with an estimate of the borrower’s cipals of the project have the necessary working equity in the property and the branch’s potential capital and financial resources to support the credit risk, if the borrower should default on the project until it reaches stabilization. As with any loan. While transactions under $250,000 may type of lending on income-producing proper- not require an appraisal, a branch is expected to ties,6 the branch should quantify the degree of perform an appropriate evaluation of the under- protection from the borrower’s (or collateral’s) lying real estate collateral. Additionally, state cash flow, the value of the underlying collateral, laws for appraisals may differ from federal and any guarantees or other collateral that may regulatory or internal requirements. be available as a source of loan repayment.

Commercial Real Estate Loans 6. Income-producing commercial properties include rental apartments, retail properties, ofﬁce buildings, warehouses, and Due to the variety of uses and the complexity of hotels. most commercial projects, there is no uniformly

Branch and Agency Examination Manual September 1997 Page 5 3100.1 Real Estate Loans accepted format for valuing commercial proper- of commercial real estate, the branch should ties as there is for valuing one-to-four family consider: residential properties. A branch relies upon outside appraisers or, in some instances, in-house • Current and projected vacancy and absorption expertise to prepare appraisals. For the most rates; part, appraisals on commercial real estate • Lease renewal trends and anticipated rents; projects are presented in a narrative format with • Volume and trends in past due leases; supporting schedules. As the complexity of a • The project’s feasibility study and market commercial project increases, the detail of the survey to determine support for the assump- appraisal report or evaluation should also tions concerning future supply and demand increase to fully support the analysis. factors; When estimating the value of income- • Effective rental rates or sale prices (taking into producing real estate, the appraiser generally account all concessions); relies on the income approach to valuation to a • Net operating income of the property com- greater degree than on the comparable sales pared to budget projections; and, approach or the cost approach. The income • Discount rates and direct capitalization rates. approach converts all expected future net operating income into present value terms using Because the income approach is generally different analytical methods. One method, known relied upon to a greater degree than the other as the direct capitalization method, estimates the methods, with specific emphasis on arriving at present value of a property by discounting its stabilized values, the branch must use judgment stabilized net operating income at an appropriate in determining the time it will take for a prop- capitalization rate (commonly referred to as a erty to achieve stabilized occupancy and rental cap rate). Stabilized net operating income is the rates. The analysis of collateral values should net cash flow derived from a property when not be based on a simple projection of current market conditions are stable and no unusual levels of net operating income if markets are patterns of future rents and occupancy are depressed or reflect speculative pressures but expected. To approximate stabilized net operat- can be expected over a reasonable period of time ing income, the appraiser or branch may need to to return to normal (stabilized) conditions. adjust the current net operating income of a The capacity of a property to generate cash property either up or down to reflect current flow to service a loan is evaluated on the basis of market conditions. The direct capitalization rents (or sales), expenses, and rates of occu- method is appropriate only for use in valuing pancy that are reasonably estimated to be stabilized properties. achieved over time. The determination of the Another method, known as the discounted level of stabilized occupancy, rental rates, and cash flow method, requires the discounting of net operating income should be based on an expected future cash flows, at an appropriate analysis of current and reasonably expected discount rate, to determine the net present value market conditions, taking into consideration his- of a property. This method is appropriate for use torical levels, when appropriate. in estimating the values of new properties that have not yet stabilized or for troubled properties that are experiencing fluctuations in income. The discount rates and cap rates, used in EARLY INDICATIONS OF estimating property values, should reflect rea- TROUBLED COMMERCIAL REAL sonable expectations about the rate of return that ESTATE LOANS investors and lenders require under normal, orderly, and sustainable market conditions. The Market Related appraiser’s analysis and assumptions should support the discount and cap rates used in the To evaluate the collectibility of their commer- appraisal. The appraiser should not use exagger- cial real estate portfolio, branches should be ated, imprudent, or unsustainably high or alert for economic indicators of weakness in low discount rates, cap rates, or income their real estate markets and for indicators of projections. actual or potential problems in the individual In assessing the reasonableness of the facts commercial real estate projects. Available indi- and assumptions associated with the valuation cators, which may be useful in evaluating the

September 1997 Branch and Agency Examination Manual Page 6 Real Estate Loans 3100.1 condition of the local real estate market, include • Loans on speculative, undeveloped property permits for and the value of new construction, where the borrower’s only source of repay- absorption rates, employment trends, vacancy ment is the sale of the developed property; rates, and tenant lease incentives. Weaknesses • Loans based on land values that have been disclosed by these types of statistics may signify driven up by rapid turnover of ownership but that a real estate market is experiencing difficul- without any corresponding improvements to ties that may cause cash flow problems for the property or supportable income projec- individual real estate projects, declining real tions to justify an increase in value; estate values and ultimately, troubled real estate • Additional advances to service an existing loans. loan without evidence that the loan will be repaid in full; • Loans to borrowers with no development Project Related plans or noncurrent development plans; • Renewals, extensions, and refinancings that Characteristics of potential or actual difficulties lack credible support for full repayment from in commercial real estate projects may include: reliable sources and that do not have a reasonable repayment schedule7; • An excess supply of similar projects under • Evergreen loans—short-term, interest-only construction in the same trade area; loans that are renewed annually with no pro- • The lack of a sound feasibility study or vision for repayment. Although structured as a analysis that reflects current and reasonably short-term loan, these loans are intended for anticipated market conditions; long-term purposes such as for the acquisition • Changes in concept or plan (for example, a or development of real estate; condominium project converted to an apart- • Loans that continue to capitalize interest after ment project because of unfavorable market construction is completed because of slower conditions); than anticipated lease-up; • Rent concessions or sales discounts, resulting • Loans with no meaningful principal amortiza- in cash flow below the level projected in the tion, instead relying on price appreciation and original feasibility study, appraisal or the sale of property for repayment; and, evaluation; • Loans that are funded before zoning is • Concessions on finishing tenant space, mov- obtained, water rights acquired, or an environ- ing expenses, and lease buyouts; mental study is performed. • Slow leasing or lack of sustained sales activity and increasing sales cancellations that may reduce the project’s income potential, result- EXAMINER REVIEW OF ing in protracted repayment or default on the loan; COLLATERAL VALUE • Delinquent lease payments from major tenants; The focus of an examiner’s review of a real • Land values that assume future rezoning; estate loan is on the ability of the loan to be • Tax arrearages; and, repaid. The principal factors that bear on this • Environmental hazards and liability for cleanup. review are the income-producing potential of the underlying collateral and the borrower’s As the problems associated with a commer- willingness and ability to repay the loan from cial real estate loan become more pronounced, other resources, if necessary, and according to the borrower/guarantor may experience a reduc- existing loan terms. In evaluating the overall tion in cash flow to service related debts, which risk associated with a real estate loan, examiners could result in delinquent interest and principal should consider a number of factors, including payments. While some real estate loans become troubled 7. As discussed more fully in the section on Asset Quality because of a general downturn in the market, Classifications, the refinancing or renewing of loans to sound others become troubled because the loans were borrowers would not result in a supervisory classification or originated on an unsound or a liberal basis. criticism unless well-defined weaknesses exist that jeopardize Common examples of unsound loans include: repayment of the loans. Consistent with sound banking practices, institutions should work in an appropriate and constructive manner with borrowers who may be experiencing • Loans with little or no borrower equity; temporary difficulties.

Branch and Agency Examination Manual September 1997 Page 7 3100.1 Real Estate Loans the borrower’s character, overall financial con- credit analysis purposes when the examiner can dition and resources, and payment history; the establish that underlying facts or assumptionsare prospects for support from any financially inappropriate and can support alternative responsible guarantors; and the nature and degree assumptions. of protection provided by the cash flow and value of the underlying collateral.8 As the borrower’s and guarantor’s ability to repay a CLASSIFICATION GUIDELINES troubled real estate loan decreases, the importance of the collateral value of the loan increases As with other types of loans, real estate loans commensurately. that are adequately protected by the current An examiner’s analysis of the collateral value sound worth and debt service capacity of the is based on the branch’s most recent appraisal or borrower, guarantor, or the underlying collateral evaluation and includes a review of the major generally are not classified. In analyzing loans, facts, assumptions and approaches used by the the examiner should focus on the ability of the appraiser (including any comments made by borrower, guarantor, or the collateral to provide management on the value rendered by the the necessary cash flow to adequately service appraiser). This review and any resulting adjust- the loan. However, the fact that the underlying ments to value are solely for purposes of an collateral value equals or exceeds the current examiner’s analysis and classification of a credit loan balance, does not preclude the loan from and do not involve actual adjustments to an classification if other factors jeopardize the appraisal or evaluation. repayment ability of the borrower, such as the Examiners should not make adjustments to lack of credible financial support for full repay- appraisal or evaluation assumptions for credit ment from reliable sources. analysis purposes based on worst-case scenarios Similarly, loans to sound borrowers that are that are unlikely to occur. For example, exam- refinanced or renewed according to prudent iners should not necessarily assume that a build- underwriting standards, including loans to cred- ing will become vacant just because an existing itworthy commercial or residential real estate tenant, who is renting at a rate above today’s developers, should not be classified or catego- market rate, may vacate the property when the rized as special mention, unless well-defined current lease expires. On the other hand, an weaknesses exist that jeopardize repayment. A adjustment to value may be appropriate for branch should not be criticized for working with credit analysis purposes when the valuation borrowers whose loans are classified or catego- assumes renewal at the above-market rate, unless rized as special mention, as long as the branch that rate is a reasonable estimate of the expected has a well-conceived and effective workout plan market rate at the time of renewal. for such borrowers and effective internal con- Assumptions should be given a reasonable trols to manage the level of these loans. amount of deference when recently made by In evaluating real estate credits for possible qualified appraisers or qualified evaluators and classification, examiners should apply the stan- when consistent with the discussion above. dard classification definitions as set forth in the Examiners should not challenge the underlying Classification of Credits section of the manual. assumptions, including discount rates and cap In determining the appropriate classification, rates used in appraisals or evaluations, that examiners should consider all important infor- differ only in a limited way from norms that mation regarding repayment prospects, includ- would generally be associated with the property ing information on the borrower’s creditworthi- under review. However, the estimated value of ness, the value of and cash flow provided by all the underlying collateral may be adjusted for collateral supporting the loan, and any support provided by financially responsible guarantors. The loan’s performance history to date is 8. The primary basis for the review and classification of the important and must be considered by the exam- loan should be the original source of repayment and the borrower’s intent and ability to fulfill the obligation without iner. As a general principle, a performing real relying on third-party guarantees. However, examiners should estate loan should not be automatically classi- also consider the support provided by any guarantees when fied or charged off solely because the value of determining the appropriate classification treatment for a the underlying collateral has declined to an troubled loan. The treatment of guarantees in the classification process is discussed in the Asset Quality Classifications amount that is less than the loan balance. How- section of this manual. ever, it would be appropriate to classify a

September 1997 Branch and Agency Examination Manual Page 8 Real Estate Loans 3100.1 performing loan when well-defined weaknesses Partially Charged-Off Loans exist that jeopardize repayment, such as the lack of credible support for full repayment from An evaluation based upon consideration of all reliable sources.9 relevant factors may indicate that a credit has These classification guidelines apply to indi- well-defined weaknesses that jeopardize collec- vidual credits, even if portions or segments of tion in full, although a portion of the loan may the industry to which the borrower belongs are be reasonably certain of collection. When a experiencing financial difficulties. The evalua- charge-off has been taken in an amount suffi- tion of each credit should be based upon the cient to ensure that the remaining recorded fundamental characteristics affecting the collect- balance of the loan (1) is being serviced (based ibility of the particular credit. The problems upon reliable sources) and (2) is reasonably broadly associated with some sectors or seg- assured of collection, classification of the remain- ments of an industry, such as certain commercial ing recorded balance may not be appropriate. real estate markets, should not lead to overly Classification would be appropriate when well- pessimistic assessments of particular credits in defined weaknesses continue to be present in the the same industry that are not affected by the remaining recorded balance. In such cases, the problems of the troubled sectors. remaining recorded balance would generally be classified no more severely than substandard. A more severe classification than substandard Troubled Project-Dependent for the remaining recorded balance would be Commercial Real Estate Loans appropriate, however, if the loss exposure cannot be reasonably determined; for example, The following guidelines for classifying a where significant risk exposures are perceived, troubled commercial real estate loan apply when such as in the case of bankruptcy situations or the repayment of the debt will be provided loans collateralized by properties subject to solely by the underlying real estate collateral environmental hazards. In addition, classifica- and there are no other available and reliable tion of the remaining recorded balance more sources of repayment. As a general principle, for severely than substandard would be appropriate a troubled project-dependent commercial real when sources of repayment are considered estate loan, any portion of the loan balance that unreliable. exceeds the amount that is adequately secured by the value of the collateral and that can be clearly identified as uncollectible, should be Formally Restructured Loans classified ‘‘loss.’’ The portion of the loan balance that is adequately secured by the value of The classification treatment previously dis- the collateral should generally be classified no cussed for a partially charged-off loan would worse than substandard. The amount of the loan also generally be appropriate for a formally balance in excess of the value of the collateral, restructured loan, when partial charge-offs have or portions thereof, should be classified doubtful been taken. For a formally restructured loan, the when the potential for full loss may be mitigated focus of the examiner’s analysis is on the ability by the outcome of certain pending events or of the borrower to repay the loan in accordance when loss is expected, but the amount of the loss with its modified terms. Classification of a cannot be reasonably determined. If warranted formally restructured loan would be appropriate by the underlying circumstances, an examiner if, after the restructuring, well-defined weak- may use a doubtful classification on the entire nesses exist that jeopardize the orderly repay- loan balance. However, this methodology would ment of the loan in accordance with reasonable occur infrequently. modified terms.10 Troubled commercial real estate loans, whose terms have been restructured, should be identified in the institution’s 9. Another issue that arises in the review of commercial real estate loans is its accrual or nonaccrual treatment for reporting purposes. The federal banking agencies, under the auspices of the FFIEC, have provided guidance on nonaccrual 10. An example of a restructured commercial real estate status in the instructions for the Report of Assets and loan that does not have reasonable modified terms would be a Liabilities (call report) and in related supervisory guidance of ‘‘cash flow’’ mortgage, which requires interest payments only the banking regulatory agencies. This guidance is summarized when the underlying collateral generates cash flow but pro- in the Credit Risk Management section of this manual. vides no substantive benefits to the lending institution.

Branch and Agency Examination Manual September 1997 Page 9 3100.1 Real Estate Loans internal credit review system and closely moni- pursuant to Title XI of FIRREA are discussed in tored by management. the remainder of this section. The appraisal regulations are directly applicable only to FDIC- insured branches. In uninsured branches, examiners may use the regulations as general super- REAL ESTATE APPRAISALS AND visory guidance when reviewing appraisal EVALUATIONS practices. As such, while an examiner in an uninsured branch may not cite the branch as Bank regulators have a long-standing policy on being in violation of law or regulation for real estate appraisals that emphasizes the impor- appraisal practices not consistent with the stan- tance of sound appraisal policies and proce- dards set forth in Title XI and the implementing dures. In December 1987, the federal banking appraisal regulations, the examiner may criticize agencies jointly adopted supervisory guidelines such practices in the report of examination if for real estate appraisal policies and review considered appropriate from a risk management procedures (which were revised in September basis. 1992). With the passage of Title XI of the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989, in August 1990, the federal banking agencies adopted Effective Date regulations regarding the performance and utilization of appraisals by federally regulated finan- Appraisals performed in connection with cial institutions. federally-related transactions after the effective The intent of Title XI of FIRREA is to protect date of August 9, 1990, are to comply with the federal financial and public policy interests in regulations. Appraisals for real estate-related real estate-related financial transactions requir- financial transactions entered into before August ing the services of an appraiser. Title XI requires 9, 1990, do not have to comply with the regu- that real estate appraisals be performed in writ- lations. However, the branch would have had to ing in accordance with uniform standards and by adhere to the Federal Reserve Board’s supervi- individuals with demonstrated competency and sory guidelines, issued in 1987, for such real whose professional conduct is subject to effec- estate appraisals. Transactions are deemed to tive supervision. In this regard, Title XI required have been entered into and a loan is deemed to each state to establish a program for certifying have been originated if there was a binding and licensing real estate appraisers, who are commitment to perform, before the effective qualified to perform appraisals in connection date. with federally-related transactions (which are The requirement to use a state-certified or defined later in this section). Additionally, Title -licensed appraiser had a separate effective date XI designated the Appraisal Foundation, a non- of no later than December 31, 1992. However, profit appraisal industry group, as the authority states had the flexibility to adopt an earlier for establishing qualifications criteria for implementation date regarding state require- appraiser certification and standards for the ments that an appraiser be certified or licensed performance of an appraisal. However, Title XI to perform an appraisal within their state. Finan- left to the states the authority to establish quali- cial institutions doing business in a state that had fication standards for licensing. Title XI estab- an effective date for mandatory use of certified lished the Appraisal Subcommittee of the Fed- or licensed appraiser earlier than the federally- eral Financial Institutions Examination Council mandated effective date would have had to abide to monitor the requirements established to meet by any state laws in this regard. the intent of Title XI.

Applicability of Title XI of FIRREA Branch Appraisal and Evaluation to Branches Policy

The requirements of the appraisal regulations Branch and head ofﬁce management is respon- adopted by each of the federal banking agencies sible for adopting policies and procedures that

September 1997 Branch and Agency Examination Manual Page 10 Real Estate Loans 3100.1 establish effective real estate appraisal and evalu- ses, opinions, and conclusions. The branch ation programs for the branch. Analyzing real should maintain formal documentation or evi- estate collateral at a loan’s inception and over its dence of the critique to support the compliance life requires a sufficient understanding of review. An individual performing critiques, appraisals and evaluations to fully assess credit either an employee of the branch or an outside risk. While the appraisal plays an important role consultant, should have real estate-related train- in the loan approval process, undue reliance ing or experience and be independent of the should not be placed upon the collateral value in transaction. The individual may not change the lieu of an adequate assessment of the borrower’s estimate of value of the appraisal or evaluation repayment ability. However, when a credit as a result of a critique. becomes troubled, the primary source of repayment often shifts from the borrower’s capacity to repay to the value of the collateral. For these Reappraisals and Reevaluations reasons, it is important that branches have sound appraisal policies and procedures as a method of The program should also include a process for controlling risk. determining when a reappraisal and reevaluation is required on a prior transaction. In these situations, the original appraisal or evaluation will have become unreliable, e.g., the useful life Appraisal and Evaluation Programs of the appraisal or evaluation has ended and further circumstances dictate that the collateral The appraisal and evaluation programs of a should be reappraised or reevaluated. The indi- branch should be tailored to the branch’s size, vidual who makes this determination should location, and the nature of its real estate market have real estate-related training or experience. and attendant real estate-related activity. Such The decision to obtain a reappraisal or programs should establish prudent standards and reevaluation will depend upon the condition and procedures that ensure written appraisals or quality of a credit or investment and the sound- evaluations are obtained and analyzed for real ness of the underlying collateral. The volatility estate-related financial transactions before the of the local real estate market should also be branch makes its final credit decision. considered in determining the need for a reap- The branch’s appraisal and evaluation pro- praisal or reevaluation. In certain situations, grams should also establish the manner in which such as loan workouts, loan renewals, loan it selects, evaluates, and monitors individuals restructurings, or problem credits or invest- who perform real estate appraisals or evalua- ments, the need for a reappraisal or reevaluation tions. The key elements of the branch’s pro- should receive particularly close attention. In all grams should ensure that individuals possess the cases, the information sources and analyses requisite expertise to satisfactorily complete the relied upon must sufficiently support a branch’s assignment, hold the proper state certification or determination of whether a reappraisal or license, if applicable, and are capable of render- reevaluation is required. Reappraisals should ing a high quality, written appraisal or evaluation. conform with appraisal regulations, and reevaluations should conform with applicable supervisory guidelines. A reappraisal would not be required when an Compliance Procedures institution advances funds to protect its interest in a property, such as to repair damaged prop- To ensure the branch’s compliance with appli- erty, because these funds should be used to cable supervisory guidelines, the branch should restore the damaged property to its original have established regulatory compliance proce- condition. If a loan workout involves modifica- dures for all appraisals and evaluations. Addi- tion of the terms and conditions of an existing tionally, a branch should critique selected credit, including acceptances of new or addi- appraisals and evaluations for adequacy and tional real estate collateral, which facilitates the relevance of the data before making final credit orderly collection of the credit or reduces the decisions. The critique should consider the institution’s risk of loss, a reappraisal or reevalu- appropriateness of the methods and approaches ation may be prudent, even if it is obtained after used, and assess the reasonableness of the analy- the modification occurs.

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FEDERALLY-RELATED collateral, solely through an abundance of FINANCIAL TRANSACTIONS caution and, as a consequence, the terms of the transaction have not been made more A federally-related transaction is defined in favorable than the terms would have been in Title XI as a real estate-related financial trans- the absence of a lien; action that a federal financial institution’s regu- • The transaction is not secured by real estate; latory agency engages in, contracts for, or regu- • A lien on real estate has been taken for lates and that requires the services of an purposes other than the real estate’s value; appraiser. Title XI further defines a real estate- • The transaction is a business loan that has a related financial transaction as any transaction transaction value of $1 million or less and is involving the sale, lease, purchase, investmen- not dependent on the sale of, or rental income tin, or exchange of real property, including derived from, real estate as the primary source interests in property or the financing thereof; the of repayment; refinancing of real property or interests in real • A lease of real estate is entered into, unless the property; or the use of real property or interests lease is the economic equivalent of a purchase in property as security for a loan or investment, or sale of the leased real estate; including mortgage-backed securities. • The transaction involves the purchase, sale, The federal banking agencies recognize that investment in, exchange of, or extension of not all real estate-related financial transactions credit secured by a loan or interest in a loan, require the services of a certified or licensed pooled loans, or interests in real property, appraiser and, therefore, would not be consid- including mortgage-backed securities, and ered federally-related transactions. While these each loan or interest in a loan, pooled loan, or transactions do not require a certified or licensed real property interest met the Board’s regula- appraisal, an evaluation of the underlying col- tory requirements for appraisals at the time of lateral is required under existing supervisory origination; guidelines. • The transaction is wholly or partially insured or guaranteed by a U.S. government agency or U.S. government- sponsored agency; • The transaction either qualifies for sale to a Transaction Value U.S. government agency or U.S. government- sponsored agency, or involves a residential The transaction value is defined as the amount real estate transaction in which the appraisal of the loan or extension of credit under consid- conforms to the Federal National Mortgage eration. For a pool of loans or a mortgage- Association or Federal Home Loan Mortgage backed security, the transaction value is the Corporation appraisal standards applicable to amount of each individual loan. In determining that category of real estate; or transaction value, the senior and junior debt are • There is a subsequent transaction resulting considered separate transactions under the from a maturing extension of credit, provided appraisal rule. However, a series of related that: transactions will be considered one transaction — The borrower has performed satisfactorily, if it seems that an institution is attempting to according to the original terms; avoid the appraisal requirement by structuring — No new monies have been advanced, other the transactions below the appraisal threshold. than as previously agreed; — The credit standing of the borrower has not deteriorated; and Transactions Not Requiring the — There has been no obvious and material Services of a Licensed or Certified deterioration in market conditions or physi- Appraiser cal aspects of the property, which would threaten the branch’s collateral protection; Currently, the categories of transactions not or requiring the services of an appraiser include — A branch purchases a loan or interest in a transactions where: loan, pooled loans, or interests in real property, including mortgage-backed secu- • The transaction value is $250,000 or less; rities, provided that the appraisal prepared • A lien on real property has been taken as for each pooled loan or real property

September 1997 Branch and Agency Examination Manual Page 12 Real Estate Loans 3100.1

interest met the requirements of the is still valid at the time the branch extends the appraisal regulation. additional credit for the new phase.

When a real estate-related financial transac- Cross-Collateralization—In cases where mul- tion does not require a certified or licensed tiple loans are secured by separate parcels of appraiser, the U.S. regulator may still require an real estate and are collateralized by the real appropriate evaluation of the real property that estate pledged to other loans, the branch would is consistent with the guidelines for real estate not necessarily be required to reappraise all real appraisal and evaluation programs. estate collateral if an extension or renewal is granted on one of the loans. However, if the branch is relying on the excess collateral of the Obtaining an Appraisal other loans to support the loan in question, the branch would have to have a valid appraisal on all real estate collateral. The branch or its agent is responsible for engaging the appraiser and must have sufficient time Loan Assumptions—If a new borrower is substi- to analyze the appraisal as part of the decision tuted for the original borrower and the original process to enter into the transaction. A branch borrower is released from any future obligation may not accept an appraisal prepared for a on the loan, the branch would be required to potential borrower as the appraisal for a feder- have a valid appraisal. ally related transaction. However, an appraisal prepared for one federally-regulated financial Loan Restructuring and Workouts—A branch institution may be used by the branch, so long as would have to have a valid appraisal if the the branch has established procedures for review- transaction is a refinancing. ing appraisals, the review indicates that the appraisal meets the regulation, and the review is Foreclosures—At the time title to foreclosed documented in writing. real estate passes to the branch, a branch needs to have a valid appraisal. It is recommended that the individual who performed the appraisal for When to Obtain an Appraisal the original credit decision should normally not perform the appraisal for this subsequent The branch should obtain the appraisal in suffi- transaction. cient time to be analyzed before the branch makes its final credit or other decision. In certain Sale of Other Real Estate Owned (OREO)—A circumstances, when a branch acts to prudently branch is required to have a valid appraisal protect its interest by modifying the terms and when the sale occurs. The appraisal prepared for conditions of an existing extension of credit to the foreclosure may be used, if that appraisal facilitate orderly collection and thereby reduce remains valid. its risk of loss, an appraisal or evaluation may be obtained after the branch makes its decision concerning the extension of credit. The determination of when a federally-related Useful Life of Appraisals or transaction has occurred may be difficult to Evaluations define in existing credits or in established lending arrangements. A new federally-related trans- The useful life of an appraisal or evaluation will action is generally considered to have occurred vary depending upon the circumstances sur- when there is a potential change in the branch’s rounding the property and the marketplace. exposure to risk. This includes, but is not limited When deciding if an appraisal or evaluation may to the following situations. be used for a subsequent transaction, a branch should determine if there has been any material Phased Developments—The appraisal of an ear- change to the underlying assumptions, which lier phase cannot be used for a new phase. would affect the original estimate of value. However, if the original appraisal was prepared Examples of factors that could cause material for all phases of the project, the branch may use changes to reported values include the passage the project appraisal, provided that the appraisal of time; the volatility of the local market; the

Branch and Agency Examination Manual September 1997 Page 13 3100.1 Real Estate Loans availability of financing; the inventory of com- Departure Provision which allows the appraiser peting properties; new improvements to, or lack to depart, under limited conditions, from stan- of maintenance of, the subject or competing, dards identified as specific guidelines. For exam- surrounding properties; change in zoning; or ple, in a Limited Appraisal, the appraiser might environmental contamination. The branch should not utilize all three approaches to value. Depar- document its information sources and analyses ture from standards designed as binding require- used to determine that an existing appraisal or ments is not permitted. evaluation remains valid and that the branch will A branch and appraiser must concur that use use that appraisal or evaluation in a subsequent of the Departure Provision is appropriate for the transaction. transaction before the appraiser commences the appraisal assignment. The appraiser must ensure that the resulting appraisal report will not mis- Updated Appraisal lead the branch or agency or other intended users of the appraisal report. The banking regulators do not prohibit the use of a Limited An updated appraisal is currently not acceptable Appraisal for a federally related transaction, but as an appraisal under the Board of Governors’ the bank regulators believe that branches should regulation. However, a branch may use an be cautious in their use of a Limited Appraisal updated appraisal in the following cases: because it will be less thorough than a Complete Appraisal. • To evaluate real estate when a federally- Complete and Limited Appraisal assignments related transaction has not occurred; or may be reported in three different report for- • To assess the useful life of an appraisal. mats: a Self-Contained Report, a Summary Report, or a Restricted Report. The major difference among these three reports relates to the degree of detail presented in the report by the APPRAISAL REQUIREMENTS appraiser. The Self-Contained Appraisal Report provides the most detail, while the Summary The objective of an appraisal is to communicate Appraisal Report presents the information in a the appraiser’s reasoning and conclusions in a condensed manner. The Restricted Report pro- logical manner so that the reader is led to the vides a capsulized report with the supporting appraiser’s estimation of market value. The details maintained in the appraiser’s files. contents of appraisals should conform to the The banking agencies believe that the standards of the Board’s appraisal regulation, if Restricted Report format will not be appropriate applicable, and the Uniform Standards of Pro- to underwrite a significant number of federally fessional Appraisal Practice (USPAP), promul- related transactions due to the lack of sufficient gated by the Appraisal Standards Board of the supporting information and analysis in the Appraisal Foundation. The actual form, length, appraisal report. However, it might be appropri- and content of appraisal reports may vary, ate to use this type of appraisal report for depending on the type of property being ongoing collateral monitoring of a branch’s real appraised and the nature of the assignment. estate transactions and under other circum- Standard forms completed in compliance with stances when a branch’s program requires an the rule and USPAP are also acceptable. evaluation. Moreover, since a branch is responsible for selecting the appropriate appraisal report to Appraisal Options support its underwriting decisions, its program should identify the type of appraisal report that A branch may engage an appraiser to perform will be appropriate for various lending transac- either a Complete or Limited Appraisal. When tions. The branch’s program should consider the performing a Complete Appraisal assignment, risk, size, and complexity of the individual loan an appraisal must comply with all USPAP stan- and the supporting collateral when determining dards without departing from any binding the level of appraisal development and the type requirements and specific guidelines when esti- of report format that will be ordered. When mating market value. When performing a Lim- ordering an appraisal report, institutions may ited Appraisal, the appraiser elects to invoke the want to consider the benefits of a written

September 1997 Branch and Agency Examination Manual Page 14 Real Estate Loans 3100.1 engagement letter that outlines the branch’s • Render the ‘‘as is’’ value, which reflects the expectations and delineated each party’s respon- value of the property in its current physical sibilities, especially for large, complex, or out- condition and subject to the zoning in effect as of-area properties. of the appraisal date. Appropriate deductions and discounts should be made for proposed development projects to reflect holding costs, marketing expenses, and entrepreneurial profit, Appraisal Standards which are based on stabilized occupancy for commercial projects or a retail sales program Title XI mandated that the minimum standards for residential projects; for Complete appraisals performed in connec- • Report the sales history on the appraised tion with federally-related transactions are stan- property for one year for 1–to–4 family resi- dards set forth in USPAP together with any other dential properties and three years for all other standards that the federal banking agencies deem types of properties; necessary. In summary, an appraisal must: • Address a proposed project’s marketability and feasibility prospects. Studies prepared by • Be performed by a qualified, independent staff a party other than the appraiser must be or fee-paid appraiser, selected by the branch, verified to the extent assumptions are utilized. who is competent and knowledgeable of rel- The appraiser’s acceptance or rejection of the evant markets. The appraiser must also hold third party study and its impact on value must the proper state certification or license as be fully explained; required under the appraisal regulations. An • State the marketing period for the appraised independent appraisal is one in which the property, the effective date of the appraisal, appraiser is not participating in the adminis- and the date the appraisal was rendered; tration of the credit or in the approval of the • Include a legal description of the subject transaction and has no interest, financial or property; otherwise, in the property; • Identify and separately value any personal • Result in a market value that is defined as the property, fixtures, and intangible items that are most probable price that a property should not real property but are included in the bring in a competitive and open market under appraisal, and discuss the impact of their all conditions requisite to a fair sale, assuming inclusion or exclusion on the estimate of the buyer and seller are both acting prudently market value of the real property; and knowledgeably and the price is not affected • Contain an appraiser’s certification statement by any undue stimulus; in which the appraiser attests to the accuracy • State the market value in terms of the cash of the data, the disclosure of assumptions, and equivalent value, which reflects the value of independence from the transaction; states the property without the influence of special whether an inspection of the property was or creative financing or seller concessions; made; discloses any professional assistance • Follow a reasonable valuation method, which received from another appraiser; and certifies addresses cost, income, and direct sales com- that a fee, contingent on the value rendered, parison approaches to determine market value, was not received; and unless the appraiser fully explains and docu- • The appraisal regulations and USPAP provide ments the elimination of an approach; a complete listing of the appraisal standards. • Support the current valuation of the real estate. All assumptions and projections should be supportable by current market conditions Appraisal Valuation Approaches and expectations of current market trends. In the case of income property, the capitalization There are three basic approaches used in apprais- rate, discount rate, net income and/or loss ing the market value of real estate in a Complete projections, cash flow, financing terms, and Appraisal: absorption rate should be reasonable and supportable by current market conditions; • Cost Approach; • Document and explain how the discount and • Market Data or Direct Comparable Sales capitalization rates used in generating present Approach; and value estimates were derived; • Capitalization of Income Approach.

Branch and Agency Examination Manual September 1997 Page 15 3100.1 Real Estate Loans

All three approaches have particular merits though vacant; (2) estimate the current cost of depending upon the type of real estate being reproducing the existing improvements; appraised. For single family residential property, (3) estimate depreciation and deduct from the the cost and comparable sales approaches are reproduction cost estimate; and (4) add the most frequently used because the common use estimate of land value and the depreciated of the property is the personal residence of the reproduction cost of improvements to determine owner. However, if a single family residential the value estimate. property is intended to be used as a rental property, the appraiser would have to consider the income approach and the cost and comparable sales approaches. For special use commer- Market Data or Direct Sales cial properties, the appraiser may have difficulty in obtaining sales data on comparable properties Comparison Approach and may have to base the value estimate on the cost and capitalization of income approach. If an The essence of this approach is to determine the approach is not used in the appraisal, the price at which similar properties have sold for appraiser should disclose the reason the approach recently on the local market. Through an appro- was not used and whether this affects the value priate adjustment for differences in the subject estimate. property and the selected comparable properties, the appraiser estimates the market value of the subject property based on the sales price of the Value Correlation comparable properties. The market approach to value estimation is essential in nearly every The three value estimates—cost, market, and appraisal of real property and is based on the income—must be evaluated by the appraiser and following assumptions: correlated into a final value estimate based on the appraiser’s judgment. Correlation does not • Market value is the highest price for which a imply averaging the value estimates obtained by property is deemed most likely to sell in a using the three different approaches. Where competitive market; these value estimates are relatively close together, • A reasonable time is allowed for exposure of correlating them and setting the final market the property in the open market; value estimate presents no special problem. It is • Payment is to be made in cash or on terms in situations where widely divergent values are reasonably equivalent to cash or on typical obtained by using the three appraisal approaches financing terms available at the time of the that judgment must be exercised in analyzing appraisal; the results and determining the estimate of market value. • Both the buyer and seller are typically motivated and the price is not affected by undue stimulus; and Cost Approach • Both buyer and seller act prudently and knowledgeably and have reasonable knowledge of In the cost approach to value estimation, the the various uses to which the property may be appraiser obtains a preliminary indication of put. value by adding the estimated depreciated reproduction cost of the improvements to the The application of this approach produces an estimated land value. This approach is based on estimate of value of a property by comparing it the assumption that the reproduction cost is the with similar properties that have been sold upper limit of value and that a newly con- recently. The process used in determining the structed building would have functional and degree of comparability of two or more proper- mechanical advantages over an existing build- ties involves judgment as to their similarity with ing. The appraiser would evaluate any deprecia- respect to age, location, condition, construction, tion, i.e., disadvantages or deficiencies of the layout, and equipment. The sales price or list existing building in relation to a new structure. price of those properties deemed most compa- The cost approach consists of four basic rable tend to set the range in which the value of steps: (1) estimate the value of the land as the subject property lies.

September 1997 Branch and Agency Examination Manual Page 16 Real Estate Loans 3100.1

Capitalization of Income Approach ties. This method calculates the value of a property by dividing an estimate of its ‘‘stabi- The income approach estimates the project’s lized’’ annual income by a factor called a ‘‘cap’’ expected income over time converted to an rate. Stabilized income generally is defined as estimate of its present value. The income the yearly net operating income produced by the approach typically is used to determine the property at normal occupancy and rental rates; it market value of income producing properties, may be adjusted upward or downward from such as office buildings, apartment complexes, today’s actual market conditions. The ‘‘cap’’ hotels, and shopping centers. In the income rate—usually defined for each property type in a approach, the appraiser can use several different market area—is viewed by some analysts as the capitalization or discounted cash flow tech- required rate of return stated in terms of current niques to arrive at a market value. These tech- income. niques include band-of-investments method, The use of this technique assumes that either mortgage equity method, annuity method, and the stabilized income or the ‘‘cap’’ rate used land residual technique. The use of a particular accurately captures all relevant characteristics of technique will depend upon whether there is the property relating to its risk and income project financing, whether there are long-term potential. If the same risk factors, required rate leases with fixed level payments and whether of return, financing arrangements, and income the value is being rendered for a component of projections are used, explicit discounting and the project, such as land or buildings. direct capitalization will yield the same results. The accuracy of this method depends on the For special use properties, new projects, or appraiser’s skill in estimating the anticipated troubled properties, the discounted cash flow future net income of the property and in select- (net present value) method is the more typical ing the appropriate capitalization rate and approach to analyzing a property’s value. In this method. The following data are assembled and method, a time frame for achieving a ‘‘stabi- analyzed to determine potential net income and lized,’’ or normal occupancy and rent level, is value: projected. Each year’s net operating income during that period is discounted to arrive at the • Rent schedules and the percentage of occu- present value of expected future cash flows. The pancy for the subject property and for compa- property’s anticipated sales value at the end of rable properties for the current year and sev- the period until stabilization (its terminal or eral preceding years. This information provides reversion value) is then estimated. The reversion gross rental data and the trend of rentals and value represents the capitalization of all future occupancy, which are then analyzed by the income streams of the property after the pro- appraiser to estimate the gross income the jected occupancy level is achieved. The terminal property should produce; or reversion value is then discounted to its present value and added to the discounted income • Expense data, such as taxes, insurance, and stream to arrive at the total present market value operating costs being paid from revenues of the property. derived from the subject property and by comparable properties. Historical trends in Most importantly, the analysis should be based these expense items are also determined; on the ability of the project to generate income over time based upon reasonable and support- • Time frame for achieving a ‘‘stabilized’’ or able assumptions. Additionally, the discount rate normal occupancy and rent levels (also referred should reflect reasonable expectations about the to as holding period); and rate of return that investors require under nor- • An appropriate capitalization rate and valua- mal, orderly, and sustainable market conditions. tion technique are selected and applied to net For further discussion, refer to the section of this income to establish a value estimate. manual on Real Estate Loans. Basically, the income approach converts all expected future net operating income into present value terms. When market conditions are stable Other Definitions of Value and no unusual patterns of future rents and occupancy rates are expected, the direct capitali- An appraisal for a federally-related transaction zation method is used to value income proper- must reflect a market value as defined in the

Branch and Agency Examination Manual September 1997 Page 17 3100.1 Real Estate Loans regulations. The regulations also require that, ciples (GAAP) as ‘‘the estimated selling price in for development projects, the appraisal contain the ordinary course of business less estimated the ‘‘as is’’ value as of the date of the appraisal. costs of completion (to the stage of completion However, there are other definitions of value assumed in determining the selling price), hold- that are encountered in appraising and evaluating, and disposal.’’ The NRV is generally used ing real estate transactions. These include: to evaluate the carrying amount of assets being held for disposition and properties representing Fair Value. This term is an accounting term that collateral. While the market value or future is generally defined as the amount, in cash or selling price are generally used as the basis for cash equivalent value or other consideration, the NRV calculation, the NRV also reflects the that a real estate parcel would yield in a current current owner’s costs to complete the project sale between a willing buyer and a willing seller and to hold and dispose of the property. For this (i.e., selling price), that is, other than in a forced reason, the NRV will generally be less than the or liquidation sale. According to accounting market value. literature, fair value is generally used in valuing The appraiser should state the definition of assets in troubled debt restructuring, quasi- value reported in the appraisal, and, for federally- reorganizations, nonmonetary transactions, and related transactions, the value must meet the business combinations accounted for by the market value definition as defined in the regu- purchase method. An accountant generally lations. This value is the most probable price defines fair value as market value; however, that a property should bring in a competitive and depending on the circumstances, these values open market under all conditions requisite to a may not be the same for a particular property. fair sale, assuming the buyer and seller are both acting prudently and knowledgeably and the Investment Value. This term is based on the data price is not affected by undue stimulus. Other and assumptions that meet the criteria and presentations of value, in addition to market objectives of a particular investor for a specific value, are allowed and may be included in the property or project. The investor’s criteria and appraisal at the request of the branch. objectives are often substantially different than participants in a broader market. Thus, investment value can be significantly higher than market value in certain circumstances and should EVALUATION REQUIREMENTS not be used in credit analysis decisions. The appraisal regulations identify certain real Liquidation Value. This term assumes that there estate-related financial transactions that do not is little or no current demand for the property require the services of an appraiser (i.e., do not and that the property needs to be disposed of need an appraisal). In the context of Title XI of quickly, resulting in the owner sacrificing poten- FIRREA, an appraisal means the kind of spe- tial property appreciation for an immediate sale. cialized opinion as to the value of real estate containing certain formal elements recognized Going-Concern Value. This term is based on the by appraisal industry practices and standards. value of a business entity rather than the value For transactions that do not require an appraisal of just the real estate. The valuation is based on by a licensed or certified appraiser under the the existing operations of the business that has a appraisal regulations, the branch should estab- proven operating record with the assumption lish an evaluation program and perform an that the business will continue to operate. appropriate evaluation of the real estate for these transactions as a prudent banking practice. The Assessed Value. This term represents the value evaluation should result in a determination of on which a taxing authority bases its assess- value that will assist the branch in assessing the ment. The assessed value and market value may soundness of the transaction and that will pro- differ considerably due to tax assessment laws, tect the branch’s interest in the transaction. timing of reassessments, and tax exemptions Further, the evaluation need not meet all of the allowed on properties or portions of a property. detailed requirements of an appraisal as set forth in the appraisal regulations. Net Realizable Value (NRV). This term is recog- Bank regulators’ appraisal regulations allow nized under generally accepted accounting prin- an institution to use an appropriate evaluation of

September 1997 Branch and Agency Examination Manual Page 18 Real Estate Loans 3100.1 real estate rather than an appraisal when the rience relevant to the type of property but does transaction: not have to be a state-licensed or -certified appraiser. Prudent practices generally require • Has a value of $250,000 or less; that, as the branch’s exposure in a real estate- • Is a business loan of $1,000,000 or less, and related financial transaction increases, a more the transaction is not dependent on the sale of, detailed evaluation should be performed, whe- or rental income derived from, real estate as ther or not specifically subject to appraisal the primary source of repayment; or regulations. • Involves an existing extension of credit at the An evaluation for a transaction that needs a lending branch, provided that: (i) there has more detailed analysis should fully describe the been no obvious and material change in the property and discuss its use, especially for market conditions or physical aspects of the nonresidential property. An evaluation report property that threaten the adequacy of the should include calculations, supporting assump- branch’s real estate collateral protection after tions, and, if utilized, a discussion of compa- the transaction, even with the advancement of rable sales. Documentation should be sufficient new monies; or (ii) there is no advancement of to allow an institution to understand the analy- new monies other than funds necessary to sis, assumptions, and conclusions. An institu- cover reasonable closing costs. tion’s own real estate loan portfolio experience and value estimates prepared for recent loans on The branch is not precluded from obtaining comparable properties might provide a basis for an appraisal that conforms to the regulation for evaluations. any real estate-related financial transaction. If a An evaluation for a transaction that requires a branch makes loans that may be sold into the less detailed analysis may be based upon infor- secondary market at a later date, the branch may mation, such as comparable property sales need to ensure that they meet the secondary information from sales data services, for exam- mortgage market requirements. ple, the multiple listing service or current tax assessed value in appropriate situations. Further, the branch’s own real estate loan portfolio Form and Content of Evaluations experience and value estimates, which were prepared for recent loans on comparable prop- The documentation for evaluations should fully erties where appraisals meeting the requirements support the estimate of value and include suffi- of the regulation were obtained, may be used. cient information to understand the evaluator’s Regardless of the method, the branch must docu- analysis and assumptions. There is no requirement its analysis and findings in the loan file. ment that the evaluator use a particular form or valuation approach but the analysis should be applicable to the type of property and fully Letter Updates explain the value rendered. An evaluation, at a minimum, should: A branch may use letter updates to an appraisal as an evaluation even though such updates do • Be written; not conform to the appraisal regulations and • Include the preparer’s name, address, and would not be acceptable for the initial credit signature, and the effective date of the decision for federally-related transactions. For evaluation; example, an existing appraisal for a first mort- • Describe the real estate collateral, its condi- gage might be updated for a subsequent home tion, its current and projected use; equity line of credit where the extension of • Describe the source(s) of information used in credit is below the threshold amount. the analysis; • Describe the analysis and supporting information; and • Provide an estimate of the real estate’s market QUALIFICATIONS CRITERIA FOR value, with any limiting conditions. APPRAISERS AND EVALUATORS

An individual who conducts an evaluation The accuracy of an appraisal or evaluation should have real estate-related training or expe- depends on the competence and integrity of the

Branch and Agency Examination Manual September 1997 Page 19 3100.1 Real Estate Loans individual performing the appraisal or evalua- ticular designation from an appraisal association and the expertise of the appraiser or evalu- tion, organization, or society. ator at developing and interpreting pertinent In that regard, branches should treat all data for the subject property. Appraisers and appraisers fairly and equitably in determining evaluators should have adequate training, expe- whether to use the services of a particular rience, and knowledge of the local real estate appraiser. Generally, financial institutions have market to make sound judgments concerning the established procedures for selecting appraisers value of a particular property. The level of and maintaining an approved appraiser list. The training, experience, and knowledge should be practice of pre-approving appraisers for on-going commensurate with the type and complexity of appraisal work and maintaining an approved the property to be valued. Additionally, apprais- appraiser list is acceptable as long as all appraisers and evaluators should be independent of the ers are required to follow the same approval credit decision, have no interest in the property process. However, a branch that requires apprais- being appraised, and have no affiliations or ers who are not members of a particular appraisal associations with the potential borrower. organization to formally apply, pay an application fee, and submit samples of previous appraisal reports for review—but does not have Appraiser Qualifications identical requirements for appraisers who are members of certain appraisal organizations— Under Title XI of FIRREA, two classifications would be viewed as having a questionable of appraisers were identified to be used in selection process. federally-related transactions: ‘‘state-certified appraiser’’ and ‘‘state-licensed appraiser.’’ For a certified appraiser, Title XI contemplated that APPRAISALS PERFORMED BY the states would adopt similar standards for CERTIFIED OR LICENSED certification based on the qualification criteria of APPRAISERS the Appraiser Qualifications Board of the Appraisal Foundation. These standards set forth In summary, a federally-insured branch is minimum educational, testing, experience, and required to use a Certified Appraiser for: continuing education requirements. For a licensed appraiser, the states have some latitude in estab- • All federally-related transactions over lishing qualification standards provided that the $1 million; criteria are adequate to protect federal financial • Nonresidential federally-related transactions and public policy interests. of $250,000 or more; and The Appraisal Subcommittee of the FFIEC is • Complex residential federally-related transac- responsible for monitoring the states for com- tions of $250,000 or more. pliance with Title XI. The federal banking agencies also have the authority to impose A federally-insured branch is required to use additional certification and licensing require- a Licensed Appraiser for: ments to those adopted by a given state. • All other federally-related transactions over the $250,000 transaction value not requiring Selection of an Appraiser the services of a certified appraiser. These also may be performed by a certified appraiser. In selecting an appraiser for an appraisal assignment, a branch is expected to consider whether Some of the states have adopted other the individual holds the proper state certification appraiser designations, which may cause confu- or license and has the appropriate experience sion on whether a particular appraiser holds the and educational background to complete the appropriate designation for a given appraisal assignment. Financial institutions may not assignment. Additionally, some states have used exclude a qualified appraiser from consideration designations such as ‘‘certified residential’’ for an appraisal assignment solely because the appraiser and ‘‘certified general’’ appraiser, appraiser lacks membership in a particular which leads to further confusion. Other states appraisal organization or does not hold a par- have no specified license designation but have

September 1997 Branch and Agency Examination Manual Page 20 Real Estate Loans 3100.1 used the term ‘‘certified residential’’ based on activities, including but not limited to apprais- the standards for licensing. For this reason, the als, real estate lending experience, real estate branch needs to understand (1) the qualifications consulting, and real estate sales. An individual criteria set forth by the state appraiser regulatory performing an evaluation need not be licensed body and (2) whether these standards are equiva- or certified. The branch’s evaluation procedures lent to the federal designations as accepted by should have established standards for selecting the Appraisal Subcommittee. qualified individuals to perform evaluations and confirming their qualifications and independence to perform an evaluation for a particular transaction. Other Appraiser Designations

The Appraisal Subcommittee recognized two Supervisory Policy and Evaluations other appraiser designations: certified residential appraiser and transitional license. For the certi- A branch’s appraisal and evaluation policies and fied residential appraiser, the minimum qualifi- procedures should be reviewed as part of the cation standards are those established by the examination of its overall real estate-related Appraiser Qualifications Board for ‘‘certified activities to ensure compliance with regulations, residential real estate appraiser.’’ Under the if a federally-insured branch, and to evaluate appraisal regulations, a certified residential risk management techniques as appropriate. This appraiser would be permitted to appraise real process would include a review of the proce- estate in connection with a federally-related dures for selecting an appraiser for a particular transaction designated for a ‘‘certified’’ appraiser appraisal assignment and confirming that the as long as the individual is competent for the appraiser is qualified, independent, and licensed/ particular appraisal assignment. certified to undertake the assignment. If a branch The Appraisal Subcommittee and the federal maintains a list of qualified real estate appraisers banking agencies also recognized a transitional acceptable for the branch’s use, the examiner license, which allowed a state to issue a license should ascertain whether senior management of to an appraiser provided that the individual had the branch has periodically reviewed and passed an examination and had satisfied either approved the list. the education or experience requirement. A When analyzing individual credits, examiners transitional licensed appraiser was permitted to should analyze appraisals or evaluations to deter- appraise real estate collateral in connection with mine that the methods, assumptions, findings, a federally-related transaction as if licensed. The and conclusions are reasonable and in compli- transitionally-licensed appraiser was expected ance with any applicable appraisal regulations to complete the missing requirement within a and supervisory guidelines. Examiners should set time frame or the license would expire. not challenge the underlying assumptions, includ- The recognition of a transitional license was ing discount rates and capitalization rates used believed to be necessary to ease the initial in appraisals, that differ only in a limited way problems and inefficiencies resulting from the from norms that would generally be associated establishment of a new regulatory program. The with the property under review. Additionally, an Appraisal Subcommittee advised the states that examiner is not bound to accept the results of the use of the transitional license should be the appraisal or evaluation, regardless of whether phased out over time once the appraiser regula- a new appraisal or evaluation was requested tory program is fully established. As a result, the during the examination. If an examiner con- use of the transitional license and the applicable cludes that an appraisal or evaluation is deficient time frame varies from state to state. for any reason, that fact will be taken into account in reaching a judgment on the quality of the credit. Qualifications of Individuals Who When the examiner can establish that the Can Perform Evaluations underlying facts or assumptions are inappropriate and can support alternative assumptions, the Evaluations can be performed by a competent examiner may adjust the estimated value of the person who has experience in real estate-related property for credit analysis purposes. It is

Branch and Agency Examination Manual September 1997 Page 21 3100.1 Real Estate Loans important to emphasize that an examiner’s over- and state statutes that establish environmental all analysis and classification of a credit may be liability that could place banking organiza- based upon other credit or underwriting stan- tions at risk. For example, underground storage dards, even if the loan is secured by real tanks are also covered by separate federal property whose value is supported by an legislation.11 appraisal or evaluation. Further discussion on While the superfund statute was enacted in the examiner’s assessment of value for loan 1980, it has been only since the mid-1980s that classification can be found in sections in this court actions have resulted in some banking manual on Classification of Credits. organizations being held liable for the clean-up Significant failures to meet applicable stan- of hazardous substance contamination. These dards and procedures as outlined previously early court decisions had a wide array of inter- should be criticized and corrective action should pretations as to whether banking organizations be required. Furthermore, inadequate appraisal are owners or operators of contaminated facili- and evaluation procedures may be considered an ties and thereby liable under the superfund unsafe and unsound banking practice if the statute for clean-up costs. These decisions led to failure to accurately reflect the value of assets on uncertainty on the part of banking organizations a timely basis misrepresents the branch’s finan- as to how best to protect themselves from cial condition. In this situation, formal correc- environmental liability. tive measures will be pursued as appropriate. The relevant provisions of CERCLA, the The appraisal regulation and guidelines require so-called ‘‘superfund’’ statute as it pertains to that federally-insured financial institutions use banking organizations indicate which persons or the services of qualified, independent, certified entities are subject to liability for clean-up costs or licensed appraisers to perform appraisals. A of hazardous substance contamination. These branch that knowingly uses the services of an include ‘‘the owner and operator of a vessel or a individual to perform an appraisal in connection facility, (or) any person who at the time of with a federally-related transaction who is not disposal of any hazardous substance owned or properly certified or licensed is in violation of operated any facility at which such hazardous Section 1120(a)(1) of Title XI of FIRREA. Any substances were disposed.’’12 A person or entity action of a state-certified or -licensed appraiser that transports or arranges to transport hazard- that is contrary to the purpose of Title XI should ous substances can also be held liable for be reported to the branch’s appropriate federal cleaning up contamination under the superfund and/or state regulators for referral to the state statute. appraiser regulatory agency for investigation. The liability imposed by the superfund statute is strict liability, which means the government does not have to prove that the owners or operators had knowledge of or caused the haz- ENVIRONMENTAL LIABILITY ardous substance contamination. Moreover, liability is joint and several, which allows the In connection with any real estate lending activ- government to seek recovery of the entire cost ity, a branch and its legal entity, the foreign of the clean up from any individual party that is banking organization, may be subject to liability liable for those clean-up costs under CERCLA. associated with the clean-up of hazardous sub- In this connection, CERCLA does not limit the stance contamination pursuant to the Compre- bringing of such actions to the EPA but permits hensive Environmental Response, Compensa- such actions to be brought by third parties. tion and Liability Act (CERCLA), the federal CERCLA provides a secured creditor exemp- superfund statute. CERCLA was enacted in tion in the definition of ‘‘owner and operator’’ response to the growing problem of improper by stating that these terms do not include ‘‘a handling and disposal of hazardous substances. person, who, without participating in the man- CERCLA authorizes the Environmental Protec- agement of a vessel or facility, holds indicia of tion Agency (EPA) to clean up hazardous waste ownership primarily to protect his security inter- sites and to recover costs associated with the clean up from entities specified in the statute. The superfund statute is the primary federal law 11. Resource Conservation and Recovery Act of 1987 dealing with hazardous substance contamina- (RCRA). tion. However, there are numerous other federal 12. CERCLA, Section 107(a).

September 1997 Branch and Agency Examination Manual Page 22 Real Estate Loans 3100.1 est in the vessel or facility.’’13 However, this • Dry cleaners (various cleaning solvents). exception has not provided banking organiza- • Service station and convenience store operations with an effective ‘‘safe harbor’’ because tors (underground storage tanks). early court decisions worked to limit the appli- • Fertilizer and chemical dealers and applicators cation of this exemption. Specifically, courts (storage and transportation of chemicals). held that actions by lenders to protect their • Lawn care businesses (application of lawn security interests may result in the banking chemicals). organization ‘‘participating in the management’’ • Trucking firms (local and long haul transport- of a vessel or facility, thereby voiding the ers of hazardous substances, such as fuel or exemption. Additionally, once the title to a chemicals). foreclosed property passes to the banking orga- • The real estate industry has taken the brunt of nization, courts held that the exemption no the adverse affects of hazardous waste con- longer applies and that the banking organization tamination. In addition to having land con- is liable under the superfund statute as an taminated with toxic substances, construction ‘‘owner’’ of the property. Under some circum- methods for major construction projects, such stances, CERCLA may exempt landowners who as commercial buildings, have utilized mate- acquire property without the knowledge of pre- rials that have been subsequently determined existing conditions (the so-called ‘‘innocent land- to be hazardous resulting in significant declines owner defense’’). However, the courts applied a in their value. For example, asbestos was stringent standard to qualify for this defense. commonly used in commercial construction Because little guidance is provided by the stat- from the 1950s to the late 1970s. Asbestos ute as to what constitutes the appropriate timing was found to be a health hazard and now must and degree of ‘‘due diligence’’ to successfully meet certain federal and, in many instances, employ this defense, banking organizations state requirements for costly removal or abate- should exercise caution before relying on it. ment (enclosing or otherwise sealing off). • Another common source of hazardous substance contamination is underground storage Overview of Environmental Hazards tanks. Leaks in these tanks not only contami- nate the surrounding ground but often flow Environmental risk can be characterized as into ground water and travel far away from the adverse consequences resulting from having original contamination site. As contamination generated or handled hazardous substances or spreads to other sites, clean-up costs escalate. otherwise having been associated with the after- math of subsequent contamination. The following discussion highlights some common environmental hazards but by no means covers all Impact on Banking Organization environmental hazards. Hazardous substance contamination is most Banking organizations may encounter losses often associated with industrial or manufactur- arising from environmental liability in several ing processes that involve chemicals or solvents ways. The greatest risk to banks resulting from in the manufacturing process or as waste prod- the superfund statute and other environmental ucts. For years, these types of hazardous sub- liability statutes is the possibility of being held stances were disposed of in land fills or just solely liable for costly environmental clean ups, dumped on industrial sites. Hazardous sub- such as hazardous substance contamination. If a stances are also found in many other lines of bank is found to be a responsible party under business. The following examples demonstrate CERCLA, it may find itself responsible for the diverse sources of potential hazardous sub- cleaning up a contaminated site at a cost that far stance contamination, which should be of con- exceeds any outstanding loan balance. This risk cern to banking organizations. of loss results from an interpretation of the superfund statute as providing for joint and • Farmers and ranchers (use of fuel, fertilizers, several liability. Any responsible party, includ- herbicides, insecticides, and feedlot runoff). ing a branch and the foreign banking organization or FBO, as the branch’s legal entity, could be forced to pay the full cost of any clean up. Of 13. CERCLA, Section 101(20)(A). course, the branch or FBO may attempt to

Branch and Agency Examination Manual September 1997 Page 23 3100.1 Real Estate Loans recover such costs from the borrower, or from Risk of credit losses can also arise where the the owner, if different than the borrower, pro- credit quality of individual borrowers (opera- vided that the borrower or owner continues in tors, generators, or transporters of hazardous existence and is solvent. Banking organizations substances) deteriorates markedly as a result of may be held liable for the clean up of hazardous being required to clean up hazardous substance substance contaminations in situations where it: contamination. Banking organizations must be aware that significant clean-up costs borne by • Takes title to property pursuant to foreclosure; the borrower could threaten the borrower’s sol- • Involves the banking organization’s personnel vency and jeopardize the lender’s ultimate col- or contractors engaged by the bank in day-to- lection of outstanding loans to that borrower day management of the facility; regardless of the fact that no real property • Takes actions designed to make the contami- collateral is involved. Therefore, ultimate col- nated property salable, possibly resulting in lection of loans to fund operations or to acquire further contamination; manufacturing or transportation equipment • Acts in a fiduciary capacity, including man- can be jeopardized by the borrower’s generating agement involvement in the day-to-day opera- or handling of hazardous substances in an tions of industrial or commercial concerns and improper manner. Further, some bankruptcy purchasing or selling contaminated property; courts have required clean up of hazardous • Owns or acquires (by merger or acquisition), substance contamination before distribution of a subsidiaries involved in activities that might debtor’s estate to secured creditors. result in a finding of environmental liability; Borrowers may have existing subsidiaries or or may be involved in merger and acquisition • Owns or acquires, for future expansion, prem- activity that may place the borrower at risk for ises that have been previously contaminated the activities of others that result in environmen- by hazardous substances. For example, site tal liability. Some courts have held that for the contamination at a branch office where a purposes of determining liability under the service station with underground storage tanks superfund statute, the corporate veil may not once operated. Premises or other real estate protect parent companies that participate in the owned could also be contaminated by asbestos day-to-day operations of their subsidiaries from requiring costly clean up or abatement. environmental liability and court imposed clean-up costs. Additionally, borrowers can be A more common situation encountered by held liable for contamination that occurred before banking organizations has been where real prop- they owned or used real estate. erty collateral is found to be contaminated by hazardous substances. The value of contaminated real property collateral can decline dramatically depending on the degree of contamination. As the projected clean-up costs increase, Protection Against Environmental the borrower may not be able to provide the Liability necessary funds to remove contaminated materials. In making its determination whether to Lenders have numerous ways to identify and foreclose, the lender must estimate the potential minimize their exposure to environmental liabil- clean-up costs. In many cases, this estimated ity. Because environmental liability is relatively cost has been found to be well in excess of the recent, procedures used to safeguard against outstanding loan balance and the lender has such liability are evolving. Generally, however, elected to abandon its security interest in the banking organizations should have in place property and write-off the loan. This situation adequate safeguards and controls to limit their occurs, regardless of the fact that the superfund exposure to potential environmental liability. statute provides a secured creditor exemption. Loan policies and procedures should address Some courts have not extended this exemption methods for identifying potential environmental to situations where lenders have taken title to a problems relating to credit requests and existing property pursuant to foreclosure. These rulings loans. The loan policy should describe an have been based on a strict reading of the statute appropriate degree of due diligence investiga- that provides the exemption to ‘‘security inter- tion required for credit requests. Borrowers in ests’’ only. high-risk industries or localities should be held

September 1997 Branch and Agency Examination Manual Page 24 Real Estate Loans 3100.1 to a more stringent due diligence investigation investigate, in greater detail, those factors listed than borrowers in low-risk industries or localities. previously and actually test for hazardous sub- In addition to establishing procedures for stance contamination. Such testing might require granting credit, procedures should be developed collecting and analyzing air samples, surface and applied to portfolio analysis, credit moni- soil samples, and subsurface soil samples and toring, loan workout situations, and—before drilling wells to sample ground water. taking title to real property—foreclosures. Banks Other measures used by some banking orga- may avoid or mitigate potential environmental nizations to assist in identifying and minimizing liability by having sound policies and proce- environmental liability include obtaining indem- dures designed to identify, assess, and control nities from borrowers for any clean-up costs environmental liability. incurred by the bank and including afﬁrmative At the same time, banking organizations must covenants in loan agreements (and attendant be careful that any lending policies and proce- default provisions) requiring the borrower to dures, especially those undertaken to assess and comply with all applicable environmental regu- control environmental liability, cannot be con- lations. Although these measures may provide strued as taking an active role in participating in some aid in identifying and minimizing poten- the management or day-to-day operations of the tial environmental liability, they are not a sub- borrower’s business. Activities that could be stitute for environmental reviews, assessments, considered active participation in the manage- and audits because their effectiveness is depen- ment of the borrower’s business and therefore dent upon the ﬁnancial strength of the borrower. subject the banking organization to potential The foregoing discussion provides general liability, include but are not limited to: guidance on environmental liability. Because of continuing legal and regulatory changes and • Having branch or FBO employees serve as court decisions in this area, all policies, prac- members of the borrower’s board of directors tices, and procedures should be periodically or actively participating in board decisions; reviewed by legal counsel to ensure that they are • Assisting in day-to-day management and adequate and up-to-date. operating decisions; or • Actively determining management changes.

These considerations are especially important Conclusion when the banking organization is actively involved in loan workouts or debt restructuring. Potential environmental liability can touch on a The first step in identifying and minimizing great number of loans to borrowers in many environmental risk is for banks to perform industries or localities. Moreover, nonlending environmental reviews. Such reviews may be activities and affiliations can lead to environ- performed by loan officers or others and typi- mental liability depending upon the nature of cally identify past practices and uses of the these activities and the degree of participation facility and property, evaluate regulatory com- that the banking organization, whether domestic pliance, if applicable, and identify potential or foreign, exercises in its U.S. operations. future problems. This review is accomplished Such liability can result in losses arising from by interviewing persons familiar with past and hazardous substance contamination because present uses of the facility and property, review- banking organizations are held directly liable for ing relevant records and documents, and visiting costly court ordered clean ups. Additionally, the and inspecting the site. banking organization’s ability to collect the Where the environmental review reveals pos- loans it makes may be hampered by significant sible hazardous substance contamination, an declines in collateral value or the inability of a environmental assessment or audit may be borrower to meet debt payments, after paying required. Environmental assessments are made for costly clean-ups of hazardous substance by personnel trained in identifying potential contamination. environmental hazards and provide a more thor- Banking organizations must understand the ough review and inspection of the facility and nature of environmental liability arising from property. Environmental audits differ markedly hazardous substance contamination. Addition- from environmental assessments in that indepen- ally, they should take prudential steps to identify dent environmental engineers are employed to and minimize their potential environmental lia-

Branch and Agency Examination Manual September 1997 Page 25 3100.1 Real Estate Loans bility. Indeed, the common thread to environ- substances, not types of borrowers, lines of mental liability is the existence of hazardous business, or real property.

September 1997 Branch and Agency Examination Manual Page 26 Real Estate Loans Examination Objectives Effective date July 1997 Section 3100.2

1. To determine if policies, practices, proce- the appraisal regulations and the Uniform dures, and internal controls regarding real Standards of Professional Appraisal Practice. estate lending activities and appraisals are 5. To determine whether adequate safeguards adequate. and controls have been established to limit 2. To determine if branch officers are operating exposure to potential environmental liability. in conformance with established guidelines. 6. To determine compliance with applicable 3. To evaluate the portfolio for collateral suffi- laws and regulations. ciency, performance, credit quality, and 7. To recommend corrective action when poli- collectibility. cies, practices, procedures, or internal con- 4. To determine that appraisals performed in trols are deficient or when violations of laws connection with federally-related transac- or regulations have been noted. tions comply with the minimum standards of

Branch and Agency Examination Manual September 1997 Page 1 Real Estate Loans Examination Procedures Effective date July 1997 Section 3100.3

Refer to the Credit Risk Management examina- a. The adequacy of the policies, proce- tion procedures for general procedures to assess dures, and internal controls. the risk of real estate lending activities. How- b. The adherence to policies and proce- ever, if the branch engages in significant real dures, and accuracy and completeness of estate lending activities, and additional informa- the branch’s records. tion is needed, the examiner should perform the c. The competency of management and following examination procedures. loan officers. d. The adequacy of systems to monitor both 1. If selected for implementation, complete or favorable and adverse trends in the over- update the Internal Control Questionnaire. all real estate industry. 2. Determine if deficiencies noted at previous e. The quality of the real estate loan port- examinations and internal/external audits folio, including the level and trends of have been adequately addressed by classified and criticized loans, and delin- management. quent and nonaccrual loans. Ascertain if 3. Review the following information for management is aware of the causes of selected real estate loans: existing problems. a. Determine the primary source of repay- f. Loans lacking current and complete ment and evaluate its adequacy. financial information or documentation. b. Assess the quality of any secondary col- Address deficiencies related to items such lateral afforded by the loan guarantors or as appraisals, feasibility studies, the partners. environmental impact study, takeout c. Compare collateral values to outstanding commitment, title policy, deeds of trust, debt and determine whether the loan’s and mortgage notes. LTV ratio is in excess of the suggested g. Compliance with laws, regulations, and supervisory LTV limits. applicable regulatory policy. d. Assess the adequacy of the appraisal or h. Independent verification of collateral evaluation. values. e. Determine if the loan complies with branch policy. f. Identify deficiencies in the loan’s credit files or the collateral records. APPRAISALS g. Review the borrower’s compliance with loan covenants, and payment 5. Review the branch’s appraisal and evalua- performance. tion program, making sure it includes guide- h. Determine if any problems exist that lines for obtaining appraisals from third may jeopardize the repayment of the party appraisers and evaluating appraisals loan. in-house. i. If the loan was classified during the 6. Evaluate the adequacy and integrity of preceding examination and has subse- the appraisal and evaluation process, quently been paid off, determine the considering: source of funds for repayment (e.g. a. The appropriateness of the methods, another loan, a sale to another institution, assumptions, and techniques used, and or repossession of the property.) compliance with interagency real estate j. If the loan is to a firm or to individuals appraisal and evaluation guidelines. who provided professional services to b. Other appraisal deficiencies such as: the branch, such as attorneys, accoun- • Misrepresentation of data, tants, or appraisers, determine if the • Inadequate analysis, borrower received preferential treatment. • Use of dissimilar comparables, 4. Evaluate the branch’s real estate lending • Underestimation of factors, such as activities, taking into account the following construction cost, construction period, items: lease-up period, and rent concessions,

Branch and Agency Examination Manual September 1997 Page 1 3100.3 Real Estate Loans: Examination Procedures

• Use of best case assumptions for the 9. Review loan agreements to determine if income approach, or warranties, representations, and indemniﬁ- • Overly optimistic assumptions, such as cations have been included in loan agree- a high absorption rate in an overbuilt ments designed to protect the branch from market. losses stemming from hazardous substance contamination. (Although such provisions provide some protection for the lender, ENVIRONMENTAL LIABILITY these agreements are not binding against the government or third parties. Such contrac- 7. Determine if policies, procedures, and other tual protections are only as secure as the safeguards and controls have been estab- borrower’s ﬁnancial strength.) lished to avoid or mitigate potential envi- 10. Update workpapers with any information ronmental liability. that will facilitate future examinations. 8. Determine whether appropriate periodic analysis of potential environmental liability is conducted.

September 1997 Branch and Agency Examination Manual Page 2 Real Estate Loans Internal Control Questionnaire Effective date July 1997 Section 3100.4

Refer to the Credit Risk Management Internal drawn, executed, recorded, and filed within Control Questionnaire, section 3010.4, for a the loan files? general review of the branch’s internal controls, 7. Is there a procedure for monitoring escrow policies, practices, and procedures. If the branch accounts to determine that private mortgage engages in significant real estate lending activi- insurance premiums and hazard insurance ties, and additional information is needed, the premiums are current? examiner should complete the following ICQ. 8. Do hazard insurance policies include a loss For audit procedures, refer to the Credit Risk payable clause to the branch? Management section 3010.5. 9. Are escrow accounts reviewed at least annually to determine if monthly deposits will 1. Has branch and head office management cover anticipated disbursements? adopted written real estate lending policies 10. Are disbursements for taxes and insurance that define: supported by records showing the nature a. Target market? and purpose of the disbursement? b. Acceptable collateral? 11. Does the branch have adequate collection c. Prudent, clear, and measurable underwrit- procedures to monitor delinquencies and ing standards for each type of property pursue foreclosure? such as: 12. Are ‘‘in-substance foreclosure’’ properties • Maximum loan amount and maturity? appropriately identified? • Repayment terms? 13. Are properties to which the branch has • Pricing structure? obtained title appropriately transferred to • Loan-to-value (LTV) limits? other real estate owned (OREO)? Refer to d. Approval procedures and authority limits? the Other Real Estate Owned section in this e. Loan administration procedures that manual for requirements. include documentation, disbursement, collateral inspection, collection, and loan review? f. Minimum loan documentation standards, such as minimum frequency and type of APPRAISALS AND EVALUATIONS financial information required for each category of real estate loan? 14. Do appraisal policies include: g. Appraisals and evaluations? a. Guidelines for selecting, evaluating, and h. Reporting requirements to the head office monitoring the individuals performing relative to loan portfolio monitoring, appraisals or evaluations, whether third including items such as compliance with party or in-house? lending policies and procedures, delin- b. Procedures for when to obtain appraisals quency trends, and problem loans? and evaluations on new loans, as well as 2. Are policies and procedures appropriate to reappraisals or reevaluations on existing the size and sophistication of the branch, loans? and are they reviewed annually to ensure c. Review procedures to determine that they are compatible with changing market appraisals and evaluations comply with conditions? supervisory guidelines? 3. Has someone been assigned the responsibil- 15. If appropriate, does the appraisal meet the ity for maintaining the document files? minimum standards of the appraisal regula- 4. Are notes and other original documents tions and the Uniform Standards of Profes- properly safeguarded? sional Appraisal Practice, including: 5. Is a tickler system or a check sheet used to a. Purpose? ensure that required documents are received b. Market value? and on file? c. Effective date? 6. Are loan files reviewed after closing to d. Marketing period? determine if all documents are properly e. Sales history of subject property?

Branch and Agency Examination Manual September 1997 Page 1 3100.4 Real Estate Loans: Internal Control Questionnaire

f. Reflect the valuation using the cost, adequate due diligence regarding environ- income, and comparable sales mental risk matters has been performed by approaches? the lead lender? g. Evaluate and correlate the three 22. Do loans receive a Phase I Environmental approaches into a final value estimate, Risk Report if the collateral is deemed to based on the appraiser’s judgment? have a higher environmental risk potential h. Explain why an approach is inappropri- than other types of real property? ate and not used in the appraisal? 23. Has senior management designated a spe- i. Fully support the assumptions and the cific ‘‘environmental risk analyst’’ who value rendered through adequate receives special training on environmental documentation? risk? 16. Are staff appraisers independent of the lend- 24. Are potential environmental problems noted ing, investment, and collection functions? in an environmental risk report considered 17. Are fee appraisers engaged directly by the by senior management prior to loan approval? branch and do they have no direct or indi- 25. Are procedures established for reviewing rect interest, financial or otherwise, in the collateral prior to foreclosure to ensure property or transaction? environmental risk has been addressed? 18. Are fee appraisers paid the same fee whether 26. Are training programs conducted so that or not the loan is granted? lending personnel are aware of environmen- 19. If the transaction is outside the local geo- tal liability issues and are able to identify graphic market of the branch, does the borrowers with potential problems? branch engage an appraiser with knowledge of the market where the real estate collateral is located? CONCLUSION

27. Is the information covered by this ICQ ENVIRONMENTAL LIABILITY adequate for evaluating internal controls in this area? If not, indicate any additional 20. Do loan applicants provide information on examination procedures deemed necessary. environmental matters pertaining to their 28. Based on the information gathered, evaluate business facilities? the internal controls in this area (i.e. strong, 21. If the branch acquires a loan, either by satisfactory, fair, marginal, unsatisfactory). purchase or participation, does it ensure that

September 1997 Branch and Agency Examination Manual Page 2 Real Estate Construction Loans Effective date July 1997 Section 3110.1

INTRODUCTION Lending Limits

A construction loan is used to finance the A branch should establish well-controlled con- construction of a particular project within a struction lending limits that are within the specified period of time and is funded by super- acceptable standards of state banking regula- vised disbursements of a predetermined amount tions. State banking statutes governing construc- over the construction period. When properly tion lending may contain minimum standards of controlled, a branch can promote commercial or prudence without specifying actual loan terms. residential development through its construction The branch’s internal limits should not exceed lending as well as receive significant profits over the supervisory loan-to-value (LTV) limits set a relatively short time frame. forth in the Interagency Guidelines for Real Inasmuch as construction lending is a form of Estate Lending Policies, as required by section interim financing, loan repayment is contingent 304 of the Federal Deposit Insurance Corpora- upon the borrower either obtaining permanent tion Improvement Act of 1991 and included as financing or finding a buyer with sufficient funds appendix C of the Federal Reserve’s Regula- to purchase the completed project. Because tion H. These guidelines, and the accompanying many borrowers anticipate retaining ownership LTV limits, are discussed in the Real Estate after construction, the cost and availability of Loans section of this manual. Generally, the funds from permanent financing is a primary LTV ratio should not exceed the following factor to be considered by the branch in assess- supervisory guidance limits: ing the risk of a construction loan. A construction loan is generally secured by a • 65 percent for raw land loans; first mortgage or deed of trust on the land and • 75 percent for land development and improved improvements, which is often backed by a land loans; purchase agreement from a financially sound • 80 percent for commercial, multifamily, and investor or by a takeout financing agreement other nonresidential construction loans; and from a responsible permanent lender. A long- • 85 percent for one- to four-family residential term mortgage loan (permanent financing) is construction loans. typically obtained prior to or simultaneous with the construction loan and is made to refinance The foregoing limits apply only to domestic the short-term construction loan. Additionally, banks, not to FBOs; however, these guidelines the bank may require a borrower to provide are provided for reference. secondary collateral in the form of a junior For loans that fund multiple phases of the interest in another real estate project or a per- same real estate project, the appropriate LTV sonal guarantee. limit is the supervisory LTV limit applicable to the final phase of the project.

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

Branch and Agency Examination Manual September 1997 Page 1 3110.1 Real Estate Construction Loans

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

Land Development Loans Residential Construction Loans

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

September 1997 Branch and Agency Examination Manual Page 2 Real Estate Construction Loans 3110.1 be sold later in the general market, or for a Commercial Construction Loans specific buyer with prearranged permanent financing. Loans financing residential projects that do not have prearranged home buyer financ- A branch’s commercial construction lending ing are usually limited to a predetermined num- activity can encompass a wide range of ber of speculative homes, which are permitted to projects—apartments, condominiums, office get the project started. It is important to ensure buildings, shopping centers, and hotels—with that the home buyer has arranged permanent each requiring a special set of skills and exper- financing before the branch finances the con- tise to successfully manage, construct, and struction; otherwise, the branch may find itself market. without a source of repayment. Construction Commercial construction loan agreements loans without permanent takeout commitments should normally require the borrower to have a generally should be aggregated to determine precommitted extended-term loan to ‘‘takeout’’ whether a concentration of credit exists, that is, the construction lender. Takeout financing agree- in those situations when the amount exceeds the ments, however, are usually voidable if construc- designated percentage of total assets. For further tion is not completed by the final funding date, guidance in this area, examiners should consult if the project does not receive occupancy per- with their respective agencies. mits, or if the preleasing or occupancy rate does Proposals to finance speculative construction not meet an agreed-upon level. A branch can projects should be evaluated according to pre- also enter into an ‘‘open-end’’ construction loan determined policies that are compatible with the where there is no precommitted source to repay institution’s size, the technical competence of its the construction loan. Such loans pose an added management, and the housing needs of its ser- risk because the branch may be forced into vice area. The prospective borrower’s reputa- providing permanent financing, oftentimes in tion, experience, and financial condition should distressed situations. In evaluating this risk, the also be reviewed to assess the likelihood of branch should consider whether the completed completing the proposed project. Until the project will be able to attract extended-term project is completed, the actual value of the real financing, supported by the projected net oper- estate is questionable. Thus, the marketability of ating income. the project should be substantiated in a feasibility study, reflecting a realistic assessment of The risk of commercial construction requires current favorable and unfavorable local housing a complete assessment of the real estate collat- market conditions. As in any real estate loan, the eral, borrower’s financial resources, source of branch must also obtain an appraisal or evalua- the extended-term financing, and construction tion for the project. The appraisal or evaluation plans. As in any real estate loan, the branch must and the feasibility study are important tools to obtain an appraisal or evaluation of the real be used by lenders in evaluating project risks. estate in accordance with the Federal Reserve’s For projects located out of area, the lender may Regulation H. Additionally, the borrower should lack market expertise, which makes evaluating provide a feasibility study for the project that the reasonableness of the marketing plan and details the project’s marketing plan, as well as feasibility study more difficult, and therefore an analysis of the supply-and-demand factors makes the loan inherently riskier. affecting the projected absorption rate. For an open-end construction loan, the feasibility study A branch dealing with speculative builders is particularly important to the branch’s assess- should have control procedures tailored to the ment of the credit because the repayment of the individual project. A predetermined limit on the loan becomes increasingly dependent on the number of unsold units to be financed at any one sales program or leasing of the project. time should be included in the loan agreement to avoid overextending the builder’s capacity. The The branch also needs to assess the borrow- construction lender should receive current er’s development expertise, that is, whether the inspection reports indicating the project’s borrower can complete the project within budget progress. In some instances, the construction and according to the construction plans. The lender is also the permanent mortgagor. Loans financial risk of the project is contingent on the on larger residential construction projects are borrower’s development expertise because the usually negotiated with prearranged permanent source of the extended-term loan may be predi- financing as part of the construction loan. cated upon a set date for project completion.

Branch and Agency Examination Manual September 1997 Page 3 3110.1 Real Estate Construction Loans

Until the project is completed, the actual value analyzed to ensure that the loan can be repaid in of the real estate is questionable. the event that a takeout does not occur. A branch may reduce its financial risk by The degree of analysis depends on whether funding the construction loan after the borrower the borrower is a single-asset entity or a multi- has funded its share of the project equity (for asset entity. A loan to a single-asset entity is example, by paying for the feasibility study and often predicated upon the strength of the partners/ land acquisition and development costs). An guarantors. Accordingly, understanding their alternative approach would require the borrower financial strength, which frequently is made up to inject its own funds into the project at of various partnership interests, is key to assess- agreed-upon intervals during the project’s man- ing the project’s strength. In this example, it agement, construction, and marketing phases to would be necessary to obtain financial informa- coincide with the construction lender’s contri- tion on the partner’s/guarantor’s other projects, butions. In larger projects, equity injections can even those not financed by the branch, to under- be provided by equity partners or joint ventures. stand their overall financial condition. This is These can take the form of equity syndications, necessary because other unsuccessful projects with contributions injected in the project in may cause financial trouble for the partner/ phases. A branch should assess the likelihood of guarantor, despite a successful sales program by the syndication being able to raise the necessary the branch’s borrower. Issues to be considered, equity. in addition to those raised in the preceding paragraph, include the vacancy rates of the various projects, break-even points, and rent rolls. BRANCH ASSESSMENT OF THE A loan to a multi-asset entity has similar BORROWER characteristics to those found in the single-asset entity, in that it is necessary to evaluate all of the The term ‘‘borrower’’ can refer to different types assets contained therein to ascertain the actual of entities. These forms can range from an entity financial strength. In both cases, assessment of whose sole asset is the project being financed to the project under construction would include an entity that has other assets available to preleasing requirements. For a loan with a support the debt in addition to the project being takeout commitment, the financial strength and financed (a multi-asset entity). reputation of the permanent lender should be Although the value of the real estate collateral analyzed. For a loan without a takeout commit- is an important component of the loan approval ment, or one where the construction lender process, the branch should not place undue provides the permanent financing for its con- reliance on the collateral value in lieu of an struction loan, the long-term risks also need to adequate analysis of the borrower’s ability to be evaluated. Refer to the Real Estate Loans repay the loan. The analytical factors differ section in this manual, on the branch’s assess- depending on the purpose of the loan, such as ment of the borrower, for additional factors to be residential construction versus the various types considered. of commercial construction loans. In instances where approval for the loan is The branch’s analysis is contained in its predicated upon the strength of entities other documentation files, which should include back- than the borrower (partner/guarantor), the branch ground information on the borrower and partner/ should obtain information on their financial guarantor concerning their character and credit condition, income, liquidity, cash flow, contin- history, expertise, and financial statements (pref- gent liabilities, and any other relevant factors erably audited) for the most recent fiscal years. that exist to demonstrate their financial capacity Background information regarding a borrower’s to fulfill the obligation in the event that the and partner’s/guarantor’s character and credit borrower defaults. history is based upon their work experience and Partners/guarantors generally have invest- previous repayment practices, both relative to ments in other projects included as assets on trade creditors and financial institutions. The their financial statements. The value of these documentation files should indicate whether the investments frequently represents the partner’s/ borrower has demonstrated the ability to suc- guarantor’s own estimate of the investment’s cessfully complete the type of project to be worth, as opposed to a value based upon the undertaken. The financial statements should be investment’s financial statements. As a result, it

September 1997 Branch and Agency Examination Manual Page 4 Real Estate Construction Loans 3110.1 is necessary to obtain detailed financial state- the appraiser’s acceptance or rejection of the ments for each investment to understand the study and its effect on the value should be fully partner’s/guarantor’s complete financial picture explained in the appraisal. and capacity to support the loan. The statements Management is responsible for reviewing the should include detailed current and accurate reasonableness of the appraisal’s or evaluation’s cash flow information since cash flow is often assumptions and conclusions. Also, manage- the source of repayment. ment’s rationale in accepting and relying upon It is also important to consider the number the appraisal or evaluation should be docu- and amount of the guarantees currently extended mented in writing and made a part of loan by a partner/guarantor to determine if they have documentation. In assessing the underwriting the financial capacity to fulfill the contingent risks, management should reconsider any claims that exist. Furthermore, the branch should assumptions used by an appraiser that reflect review the prior performance of the partner/ overly optimistic or pessimistic values. If man- guarantor to voluntarily honor the guarantee as agement, after its review of the appraisal or well as the marketability of the assets collater- evaluation, determines that there are unsubstan- alizing the guarantee. Since the guarantee can be tiated assumptions, the branch may request the limited to development and construction phases appraiser or evaluator to provide a more detailed of a project, the branch should closely monitor justification of the assumptions or obtain a new the project before issuing a release to the partner/ appraisal or evaluation. Since the approval of guarantor. the loan is based upon the value of the project after the construction is completed, insofar as the value component of the loan-to-value ratio is concerned, it is important for the branch to BRANCH ASSESSMENT OF REAL closely monitor the project’s progress and value ESTATE COLLATERAL during the construction period. Refer to the Real Estate Loans section of the manual for addi- Branches should obtain an appraisal or evalua- tional information relative to the real estate tion, as appropriate, for all real estate-related collateral assessment. financial transactions prior to making the final credit or other decision. Refer to the Real Estate Appraisals and Evaluations section of this manual for a description of the related require- LOAN DOCUMENTATION ments a branch must satisfy for real estate- related financial transactions. The appraisal sec- The loan documentation should provide infor- tion explains the standards for appraisals, mation on the essential details of the loan indicates which transactions require an appraisal transaction, the security interest in the real estate or an evaluation, states qualifications necessary collateral, and the takeout loan commitment, if for an appraiser and evaluator, provides guid- any. The necessary documentation before the ance on evaluations, and describes the three start of construction generally includes: appraisal methods. The appraisal or evaluation techniques used • Financial and background information on the to value a proposed construction project are borrower to substantiate the borrower’s exper- essentially the same as those used for other tise and financial strength to complete the types of real estate. The aggregate principal project. amount of the loan should be based on an • The construction loan agreement, which sets appraisal or evaluation that provides, at a mini- forth the rights and obligations of the lender mum, the ‘‘as is’’ market value of the property. and borrower, conditions for advancing funds, Additionally, the branch will normally request and events of default. In some states, the the appraiser to report the ‘‘as completed’’ agreement must be cited in either the deed of value. Projections should be accompanied by a trust or the mortgage. feasibility study explaining the effect of pro- • A recorded mortgage or deed of trust, which jected property improvements on the market can be used to foreclose and to obtain title to value of the land. The feasibility study may be a the collateral. separate report or incorporated into the appraisal • A title insurance binder or policy, usually report. If the appraiser uses the feasibility study, issued by a recognized title insurance com-

Branch and Agency Examination Manual September 1997 Page 5 3110.1 Real Estate Construction Loans

pany or, in some states, an attorney’s opinion. essary for processing and servicing the loan and The title should be updated with each advance protect the branch in the event of default. of funds to provide additional collateral protection. • Insurance policies and proof of payment as Documentation for Residential evidence that the builder has adequate and Construction Loans on Subdivisions enforceable coverage for liability, fire and other hazards, and vandalism and malicious The documents mentioned above are usually mischief losses. available for residential construction loans on • An appropriate appraisal or evaluation show- subdivisions (tracts). Documentation of tract ing the value of the land and improvements to loans frequently includes a master note in the date or, possibly, a master appraisal based on gross amount of the entire project, and a master specifications for a multi-phase development. deed of trust covering all of the land involved in • Project plans, a feasibility study, and a con- the project. In addition to an appraisal or evalu- struction budget showing the development ation for each type of house to be constructed, plans, project costs, marketing plans, and the branch should also obtain a master appraisal equity contributions. A detailed cost break- including a feasibility study for the entire devel- down of land and ‘‘hard’’ construction costs, opment. The feasibility study compares the as well as indirect or ‘‘soft’’ costs for con- projected demand for housing against the antici- struction loan interest, organizational and pated supply of housing in the market area of the administrative cost, and architectural, engi- proposed tract development. This analysis should neering, and legal fees should be included. indicate whether there will be sufficient demand • Property surveys, easements, an environmen- for the developer’s homes given the project’s tal impact report, and soil reports that indicate location, type of homes, and unit sales price. construction is feasible on the selected development site. The branch should also obtain the architect’s certification of the plan’s compli- Documentation for Takeout ance with all applicable building codes and Commitment zoning, environmental protection, and other government regulations, as well as the engi- Most construction lenders require the developer neer’s report on compliance with building to have an arrangement for permanent financing codes and standards. If internal expertise is for each house to be constructed. Exceptions not available, a branch may need to retain an include model homes, typically one for each independent construction expert to review style of home offered, and a limited number of these documents to assess the reasonableness housing starts ahead of sales (speculative build- and appropriateness of the construction plans ing). The starts ahead of sales, however, contain and costs. additional risk. If the branch finances too many • The takeout commitment from the permanent houses without purchase contracts, and housing lender, if applicable, and the terms of the loan. sales decline rapidly, it may have to foreclose on The branch should verify the financial strength the unsold houses and sell them for less than of the permanent lender to fund the takeout their loan value. A takeout of this type is usually commitment. an arrangement between the developer and a • A completion or performance bond signed by permanent mortgage lender, but construction the borrower that guarantees that the borrower lenders may also finance the permanent will apply the loan proceeds to the project mortgages. being financed. The essential information required for a com- • An owners’ affidavit or a borrowing resolution mercial real estate takeout to proceed includes empowering the borrower or its representative the floor and ceiling rental rates and minimum to enter into the loan agreement. occupancy requirements; details of the project • Evidence that property taxes have been paid to being financed; expiration date; standby fee date. requirement; assignment of rents; and, generally, a requirement that the construction loan be These documents furnish evidence that the fully disbursed and not in any way be in default lending officer is obtaining the information nec- at the time settlement occurs.

September 1997 Branch and Agency Examination Manual Page 6 Real Estate Construction Loans 3110.1

The commitment agreement, referred to as a Stage Payment Plan buy/sell contract or a tri-party agreement, is signed by the borrower, the construction lender, The stage payment plan, which is normally and the permanent lender. The purpose of this applied to residential and smaller commercial agreement is to permit the permanent lender to construction loans, uses a pre-established sched- buy the loan directly from the construction ule for fixed disbursements to the borrower at lender upon completion of the construction, the end of each specified stage of construction. with the stipulation that all contingencies have The amount of the draw is usually based upon been satisfied. Examples of contingencies include the stage of development because residential project completion by the required date, clear housing projects normally consist of houses in title to the property, and minimum lease-up various stages of construction. Nevertheless, requirements. A commitment agreement also loan agreements involving tract financing typi- protects the construction lender against unfore- cally restrict further advances in the event of an seen possibilities, such as the death of a princi- accumulation of completed and unsold houses. pal, before the permanent loan documents are Disbursements are made when construction has signed. reached the agreed-upon stages, verified by an actual inspection of the property. These typically include advances at the conclusion of various stages of construction, such as the foun- LOAN ADMINISTRATION dation, exterior framing, the roof, interior finishing, and completion of the house. The final The branch and the borrower must effectively payment is made after the legally stipulated lien cooperate as partners if controls relative to period for mechanic’s liens has lapsed. construction progress are to be maintained. The Disbursement programs of this type are usu- loan agreement specifies the performance of ally required for each house constructed within a each party during the entire course of construc- tract development. As each house is completed tion. Any changes in construction plans should and sold, the branch makes a partial release be approved by both the construction lender and relative to that particular house covered by its the takeout lender. Construction changes can master deed of trust. The amount of the release result in increased costs, which may not neces- is set forth in the loan agreement, which speci- sarily increase the market value of the com- fies the agreed-upon release price for each house pleted project. On the other hand, a decrease in sold with any excess over the net sales proceeds costs may not indicate a savings but may sug- remitted to the borrower. gest the use of lesser quality materials or work- manship, which could affect the marketability of the project. Progress Payment Plan

The progress payment plan is normally used for Disbursement of Loan Funds commercial projects. Under a progress payment system, funds are released as the borrower Loan funds are generally disbursed through completes certain phases of construction as either a stage payment plan or a progress pay- agreed upon in the loan agreement. Normally, ment plan. Regardless of the method of dis- the branch retains a percentage of the funds as a bursement, the amount of each construction hold-back (or retainage) to cover project cost draw should be commensurate with the improve- overruns or outstanding bills from suppliers or ments made to date. Funds should not be subcontractors. Hold-backs occur when a advanced unless they are used in the project developer/contractor uses a number of subcon- being financed and as stipulated in the draw tractors and maintains possession of a portion of request. Therefore, the construction lender must the amounts owed to the subcontractors during monitor the funds being disbursed and must be the construction period. This is done to ensure assured, at every stage of construction, that that the subcontractors finish their work before sufficient funds are available to complete the receiving the final amount owed. Accordingly, project. the construction lender holds back the same

Branch and Agency Examination Manual September 1997 Page 7 3110.1 Real Estate Construction Loans funds from the developer/contractor to avert the Before any draw amount is disbursed, however, risk of their misapplication or misappropriation. the branch must obtain verification of continued The borrower presents a request for payment title insurance. Generally, this means verifying from the branch in the form of a ‘‘construction that no liens have been filed against the title of draw’’ request or ‘‘certification for payment,’’ the project since the previous draw. The title which sets forth the funding request by construc- insurance insuring the construction lender’s tion phase and cost category for work that has mortgage or lien is then increased to include the been completed. This request should be accom- new draw, which results in an increase in the panied by receipts for the completed work title insurance commensurate with the disburse- (material and labor) for which payment is being ment of funds. The lender frequently examines requested. The borrower also certifies that the title to the property securing the construction conditions of the loan agreement have been loan to also be certain that the borrower is not met—that all requested funds have been used in pledging it for other borrowings and to be sure the subject project and that suppliers and sub- that mechanic’s liens are not being filed for contractors have been paid. Additionally, the unpaid bills. When the project is not proceeding subcontractors and suppliers should provide the as anticipated, that fact should be reflected in the branch with lien waivers covering the work inspection reports. completed for which payment has been received. Another important component in the process Upon review of the draw request and indepen- is the ongoing monitoring of general economic dent confirmation on the progress of work, the factors that will affect the marketing and selling branch will disburse funds for construction costs of the residential or commercial properties and incurred, less the hold-back. The percentage of affect their success upon completion of the the loan funds retained are released when a project. notice of the project’s completion has been filed, and after the stipulated period has elapsed under which subcontractors or suppliers can file a lien. Monitoring Residential Projects

An inventory list is maintained for each tract or Monitoring Progress of Construction phase of the project. The inventory list should and Loan Draws show each lot number, the style of house, the release price, the sale price, and the loan balance. The list should be posted daily with It is critical that a branch has appropriate pro- advances and payments indicating the balance cedures and an adequate tracking system to advanced for each house, date completed, date monitor payments to ensure that the funds sold, and date paid, and should age the builder’s requested are appropriate for the given stage of inventory by listing the older houses completed development. The monitoring occurs through and unsold. physical inspections of the project once it has started. The results of the inspections are then Inspections (usually monthly) during the documented in the inspection reports, which are course of construction of each house should be kept in the appropriate file. Depending on the documented in progress reports. The progress complexity of the project, the inspection reports report should indicate the project’s activity dur- can be completed either by the lender or by an ing the previous month, reflecting the number of independent construction consulting firm, the homes under construction, the number com- latter generally staffed by architects and engi- pleted, and the number sold. The monthly report neers. The reports address both the quantity and should indicate whether advances are being the quality of the work for which funds are made in compliance with the loan agreement. being requested. They also verify that the plans are being followed and that the construction is proceeding on schedule and within budget. Monitoring Commercial Projects The branch must be accurately informed of the progress to date in order to monitor the loan. To have an effective control over its commercial It is also important that the branch ascertain construction loan program, the branch must whether draws are being taken in accordance have an established loan administration process with the predetermined disbursement schedule. that continually monitors each project. The pro-

September 1997 Branch and Agency Examination Manual Page 8 Real Estate Construction Loans 3110.1 cess should include monthly reporting on the lord’s position by the branch in the event the work completed, the cost to date, the cost to borrower declares bankruptcy. Furthermore, to complete, construction deadlines, and loan funds ensure that the branch has full knowledge of all remaining. Any changes in construction plans provisions of the lease agreements, tenants should be documented and reviewed by the should be required to sign an estoppel certifica- construction consulting firm and should be tion. approved by the branch and takeout lender. A In some cases, the takeout lender may only significant number of change orders may indi- pay off a portion of the construction loan because cate poor planning or project design, or prob- a conditional requirement for full funding has lems in construction, and should be tracked and not been met, such as the project not attaining a reflected in the project’s budget. Soft costs such certain level of occupancy. The construction as advertising and promotional expenses nor- lender would then have a second mortgage on mally are not funded until the marketing of the the remaining balance of the construction loan. project has started. When the conditions of the takeout loan are met, the construction lender is repaid in full and the lien is released. Final Repayment Interest Reserves Before the final draw is made, the construction loan should be in a condition to be converted to A construction loan is generally an interest-only a permanent loan. Usually the final draw includes loan because of the fact that cash flow is not payment of the hold-back stipulated in the loan available from most projects until they are agreement and is used to pay all remaining bills. completed. The borrower’s interest expense is The branch should obtain full waivers of liens therefore borrowed from the construction lender (releases) from all contractors, subcontractors, as part of the construction loan for the purpose and suppliers before the loan is released and the of ‘‘paying’’ the lender interest on the ‘‘portion’’ hold-back is disbursed. The branch should also of the loan used for actual construction. The obtain a final inspection report to confirm the funds advanced to pay the interest are included project is completed and meets the building as part of the typical monthly draw. As a result, specifications, including confirmation of the cer- the balance due to the lender increases with each tificate of occupancy from the governing build- draw by the full amount of construction costs, ing authority. plus the interest that is borrowed. Sources of permanent funding for commercial The borrower’s interest cost is determined by projects vary greatly, depending upon the type the amount of credit extended and the length of of project. For condominium projects, the con- time needed to complete the project. This inter- struction lender may also be providing the est cost is referred to as an interest reserve. This funding for marketing the individual units and period of time should be evaluated for reason- would be releasing the loan on a unit-by-unit ableness relative to the project being financed. basis similar to a residential development con- In larger projects, cash flow may be generated struction loan. If there is a pre-committed take- prior to the project’s completion. In such cases, out lender, the new lender could purchase the any income from the project should be applied construction loan documents and assume the to debt service before there is a draw on the security interest from the construction lender. If interest reserve. The lender should closely moni- the project is being purchased for cash, the tor the lease-up of the project to ensure that the branch would release its lien and cancel the project’s net income is being applied to debt note. service and not diverted to the borrower as a Additionally, as the commercial project is return of the developer’s capital or for use in the leased, the lender should ensure that the branch’s developer’s other projects. position is protected in the event that extended- term funding is not obtained. The branch may require tenants to enter into subordination, Loan Default attornment, and nondisturbance agreements, which protect the branch’s interests in the lease The inherent exposure in construction financing by providing for the assumption of the land- is that the full value of the collateral is not

Branch and Agency Examination Manual September 1997 Page 9 3110.1 Real Estate Construction Loans realized until the project is completed. In default greater number of assets (projects/properties) situations the branch must consider the alterna- that make up the borrower. As a result, it is tives available to recover its advances. For necessary to obtain detailed financial statements incomplete projects, the branch must decide of each of the assets (projects/properties) and whether it is more advantageous to complete the the consolidating financial statements, as well as project or to sell on an ‘‘as is’’ basis. The various the consolidated financial statements. This is mechanic’s and materialmen’s liens, tax liens, important because each kind of statement can and other judgments that arise in such cases are provide significant insight into problems that distressing to even the most seasoned lender. could adversely affect the borrower’s overall Due to these factors, the construction lender financial condition. may not be in the preferred position indicated by Assessing the financial condition of the multi- documents in the file. Therefore, the lender asset entity includes evaluating the major sources should take every precaution to minimize any of cash and determining whether cash flow is third-party claim on the collateral. Because laws dependent on income generated from completed regarding the priority of certain liens may vary projects, the sale of real estate, or infusion of among states, the branch should take the neces- outside capital. Additionally, the branch should sary steps to ensure that its lien is recorded prior also review the borrower’s account receivables to the commencement of work or the delivery of for the appropriateness of intercompany trans- materials and supplies. actions and to guard against diversion of funds. Depending upon the structure of the loan, it may also be desirable to obtain a partner’s/ guarantor’s financial statements on a periodic Signs of Problems basis. In such cases it is important to obtain detailed current and accurate financial state- To detect signs of a borrower’s financial prob- ments that include cash flow information on a lems, the branch should review the borrower’s project-by-project basis. financial statements on a periodic (quarterly) Slow unit sales, or excessive inventory rela- basis, assessing the liquidity, debt level, and tive to sales, indicate the borrower may have cash flow. The degree of information the finan- difficulty repaying the loan. Although some- cial statements provide the branch, insofar as times there are mitigating factors beyond the understanding the borrower’s financial condi- control of the borrower, such as delays in tion is concerned, depends primarily on whether obtaining materials and supplies, adverse weather the borrower is a single-asset entity or a multi- conditions, or unanticipated site work, the bor- asset entity. rower may be unable to overcome these prob- The financial statements of a single-asset lems. Such delays usually increase project costs entity only reflect the project being constructed; and could hamper the loan’s repayment. therefore, they are of a more limited use than The construction lender should be aware of statements of multi-asset entities. Nevertheless, funds being misused—for example, rebuilding one issue that is of importance to financial to meet specification changes not previously statements of both entities relates to monitoring disclosed, starting a new project, or possibly changes in accounts and trade payables. Moni- paying subcontractors for work performed else- toring these payables in a detailed manner helps where. The practice of ‘‘front loading,’’ whereby the branch to determine if trade payables are a builder deliberately overstates the cost of the paid late or if there are any unpaid bills. In the work to be completed in the early stages of event of problems, a branch might choose to construction, is not uncommon and, if not either contact the payables directly or request an detected early on, will almost certainly result in additional credit check on the borrower. Another insufficient loan funds available to complete source of information indicating borrower prob- construction in the event of a default. lems is local publications that list lawsuits or judgments that have been filed or entered against the borrower. Additionally, the branch should also verify that the borrower is making its tax Loan Workouts payments on time. In a multi-asset entity, on the other hand, Sound workout programs begin with a full more potential problems could arise due to the disclosure of all relevant information based on a

September 1997 Branch and Agency Examination Manual Page 10 Real Estate Construction Loans 3110.1 realistic evaluation of the borrower’s ability to which led to declining rental income caused by manage the business entity (business, technical, the ever greater need for rent concessions. This and financial capabilities), and the branch’s decline in cash flow from income-producing ability to assist the borrower in developing and properties, and the uncertainty regarding future monitoring a feasible workout/repayment plan. income, reduced the market value of many Management should then decide on a course of properties to levels considered undesirable by action to resolve the problems, with the terms of permanent mortgage lenders. As a result of the the workout documented in writing and formally subsequent void created by the permanent lend- agreed to by the borrower. If additional collat- ers, banks in the mid- and late-1980s began to eral is accepted or substituted, the branch should extend medium-term loans with maturities of up ensure that the necessary legal documents are to seven years (also referred to as mini-perms). filed to protect the branch’s collateral position. These mini-perms were granted with the expec- In those cases where the borrower is permit- tation by banks that as the excess supply of ted to finish the project, additional extensions of space declined, the return on investment would credit for completing the project, due to cost improve, and permanent lenders would return. overruns or an insufficient interest reserve, may As these loans mature in the 1990s, borrowers represent the best alternative for a workout plan. may continue to find it difficult to obtain At the same time, the branch should evaluate the adequate sources of long-term credit. In some cause of the problem(s), such as mismanage- cases, banks may determine that the most desir- ment, and determine whether it is in its best able and prudent course is to roll over or renew interest to allow the borrower to complete the loans to those borrowers who have demon- project. strated an ability to pay interest on their debts, but who presently may not be in a position to obtain long-term financing for the loan balance. SUPERVISORY POLICY The act of refinancing or renewing loans to sound borrowers, including creditworthy com- As a result of competitive pressures, many mercial or residential real estate developers, branches in the early 1980s made construction generally should not be subject to supervisory loans on an open-end basis, wherein the bor- criticism in the absence of well-defined weak- rower did not have a commitment for longer- nesses that jeopardize repayment of the loans. term or takeout financing before construction Refinancings or renewals should be structured in was started. Although there was sufficient such a manner that is consistent with sound demand for commercial real estate space when banking principles, supervisory guidelines, and this practice commenced, the supply of space accounting practices, which would protect the began to exceed demand. One symptom of the branch and improve its prospects for collecting excess supply was an increase in vacancy rates, or recovering on the asset.

Branch and Agency Examination Manual September 1997 Page 11 Real Estate Construction Loans Examination Objectives Effective date July 1997 Section 3110.2

1. To determine if policies, practices, proce- 4. To determine compliance with applicable dures, and internal controls regarding real laws and regulations. estate construction loans are adequate. 5. To initiate corrective action when policies, 2. To determine if branch officers are operating practices, procedures, or internal controls are in conformance with the branch’s established deficient or when violations of law or regu- guidelines. lations have been noted. 3. To evaluate the portfolio for collateral sufficiency, performance, credit quality, and collectibility.

Branch and Agency Examination Manual September 1997 Page 1 Real Estate Construction Loans Examination Procedures Effective date July 1997 Section 3110.3

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

Branch and Agency Examination Manual September 1997 Page 1 3110.3 Real Estate Construction Loans: Examination Procedures

• the permanent lender has the financial j. Determine whether the loan was classified resources to meet its commitment. during the preceding examination, and, if • the amount of the construction loan and the loan has been paid off, whether all or its estimated completion date corre- part of the funds for repayment came from spond to the amount and expiration date another loan at the bank or from the of the takeout commitment and/or repossession of the property. completion bond. 7. In connection with the examination of other • the permanent lender and/or the bond- lending activity in the branch, the examiner ing company have approved any modi- should check the central liability file on the fications to the original agreement. borrower(s) and determine whether the total • properties securing construction loans construction lending activity exceeds the lend- that are not supported by a takeout ing limit to a single borrower. commitment will be marketable upon 8. Summarize the findings of the construction completion. loan portfolio review and address: b. Analyze secondary support afforded by a. the scope of the examination. guarantors and partners. b. the quality of the policies, procedures, and c. Relate collateral values to outstanding controls. debt by: c. the general level of adherence to policies • assessing the adequacy of the appraisal and procedures. and evaluation. d. the competency of management. • ascertaining whether inspection reports e. the quality of the loan portfolio. support disbursements to date. f. loans not supported by current and com- • determining whether the amount of plete financial information. undisbursed loan funds is sufficient to g. loans with incomplete documentation, complete the project. addressing deficiencies related to items • establishing whether title records assure such as appraisals or evaluations, feasibil- the primacy of the branch’s liens. ity studies, the environmental impact study, • determining if adequate hazard, build- takeout commitment, title policy, construc- er’s risks, and worker’s compensation tion plans, inspection reports, change insurance is maintained. orders, proof of payment for insurance d. Determine whether the loan-to-value (LTV) and taxes, deeds of trust, and mortgage ratio is in excess of the supervisory LTV notes. limits. If so, ascertain whether the loan h. the adequacy of control over construction has been properly reported as a noncon- draws and advances. forming loan. i. loans to officers, directors, shareholders, e. Ascertain whether the loan complies with or their interests. established branch policy. f. Identify any deficiencies in the loan’s j. causes of existing problems. documentation in both the credit files and k. delinquent loans and the aggregate amount the collateral records. of statutory bad debts. Refer to the manual g. Identify whether the loan is to an officer or section on classification of credits for a director of the branch or to a correspon- discussion on statutory bad debts or ‘‘A’’ dent bank, and whether an officer, direc- paper. tor, or shareholder of the bank is a guar- l. concentrations of credit. antor on the loan. m. classified loans. h. Review the borrower’s compliance with n. violations of laws or regulations, and non- the provisions of the loan agreement, compliance with regulatory requirements. indicating whether the loan is in default or o. action taken by management to correct in past-due status. previously noted deficiencies and correc- i. Determine if there are any problems that tive actions recommended to management may jeopardize the repayment of the con- at this examination, with the branch’s struction loan. response to such recommendations.

September 1997 Branch and Agency Examination Manual Page 2 Real Estate Construction Loans Internal Control Questionnaire Effective date July 1997 Section 3110.4

POLICIES AND OBJECTIVES • public liability insurance? • completion insurance? 1. Has the head office and branch management b. the property owner’s payment of real adopted and written construction lending estate taxes? policies that: 4. Does the branch require that files include: a. outline construction lending objectives a. loan applications? regarding: b. financial statements for the: • the aggregate limit for construction • borrower? loans? • builder? • concentrations of credit in particular • proposed prime tenant? types of construction projects? • takeout lender? b. establish minimum standards for • guarantors/partners? documentation? c. credit and trade checks on the: c. define qualified collateral and minimum • borrower? margin requirements? • builder? d. define the minimum equity requirement • major subcontractor? for a project? • proposed tenants? e. define loan-to-value (LTV) limits that are d. a copy of plans and specifications? consistent with supervisory LTV limits? e. a copy of the building permit? f. require an appraisal or evaluation that f. a survey of the property? complies with the Federal Reserve real g. the construction loan agreement? estate appraisal regulation and guidelines? h. an appraisal or evaluation and feasibility g. delineate standards for takeout study? commitments? i. an up-to-date title search? h. indicate completion bonding require- j. the mortgage? ments? k. ground leases? i. establish procedures for reviewing con- l. assigned tenant leases or letters of intent struction loan applications? to lease? j. detail methods for disbursing loan m. a copy of the takeout commitment? proceeds? n. a copy of the borrower’s application to k. detail project inspection requirements and the takeout lender? progress reporting procedures? o. the tri-party buy-and-sell agreement? l. require agreements by borrowers for p. inspection reports? completion of improvements according q. disbursement authorizations? to approved construction specifications, r. undisbursed loan proceeds and contin- and cost and time limitations? gency or escrow account reconcilements? 2. Are construction lending policies and s. insurance policies? objectives appropriate to the size and 5. Does the branch employ standardized check- sophistication of the branch, and are they lists to control documentation for individual compatible with changing market conditions? files and perform audit reviews for adequacy? 6. Does the documentation file indicate all of the borrower’s other loans and deposit account relationships with the branch and a DOCUMENTATION summary of other construction projects being financed by other banks? Does the 3. Does the branch require and maintain the branch analyze the status of these projects following documentation: and the potential effect on the borrower’s a. the contractor’s payment of: financial position? • employee withholding taxes? 7. Does the branch use tickler files that: • builder’s risk insurance? a. control scheduling of inspections and • worker’s compensation insurance? disbursements?

Branch and Agency Examination Manual September 1997 Page 1 3110.4 Real Estate Construction Loans: Internal Control Questionnaire

b. assure prompt administrative follow-up 16. Does the branch require that cost estimates on items sent for: of more complicated projects be reviewed • recording? by qualified personnel: experienced in-house • attorney’s opinion? staff, an architect, construction engineer, or • expert review? independent estimator? 8. Does the branch maintain tickler files that 17. Are commitment fees required on approved provide advance notice (such as 30 days’ construction loans? prior notice) to staff of the expiration dates for: a. the takeout commitment? CONSTRUCTION LOAN b. hazard insurance? AGREEMENT c. worker’s compensation insurance? d. public liability insurance? 18. Is the construction loan agreement signed before an actual loan disbursement is made? 19. Is the construction loan agreement reviewed REVIEWING LOAN by counsel and other experts to determine APPLICATIONS that improvement specifications conform to: 9. Does branch policy require a personal guar- a. building codes? antee from the borrower on construction b. subdivision regulations? loans? c. zoning and ordinances? 10. Does branch policy require personal comple- d. title and/or ground lease restrictions? tion guarantees by the property owner and/or e. health and handicap access regulations? the contractor? f. known or projected environmental pro- 11. Does the branch require a construction bor- tection considerations? rower to contribute equity to a proposed g. specifications required under the National project in the form of money or real estate? Flood Insurance Program? If so, indicate the form of equity contributed. h. provisions in tenant leases? 12. Does the project budget include the amount i. specifications approved by the perma- and source of the builder’s and/or owner’s nent lender? equity contribution? j. specifications required by the completion 13. Does the branch require: or performance bonding company and/or a. background information on the borrow- guarantors? er’s, contractor’s, and major subcontrac- 20. Does the branch require all change orders to tors’ development and construction be approved in writing by the: experience, as well as other projects a. branch? currently under construction? b. branch’s counsel? b. payment history information from sup- c. permanent lender? pliers and trade creditors on the afore- d. architect or supervising engineer? mentioned’s previous projects? e. prime tenants bound by firm leases or c. credit reports? letters of intent to lease? d. detailed current and historical financial f. completion bonding company? statements, including cash flow-related 21. Does the construction loan agreement set a information? date for project completion? 14. Do the borrower’s project cost estimates 22. Does the construction loan agreement require include: that: a. land and construction costs? a. the contractor not start work until autho- b. off-site improvement expenses? rized to do so by the branch? c. soft costs, such as organizational and b. on-site inspections be permitted by the administrative costs, and architectural, lending officer or an agent of the branch engineering, and legal fees? without prior notice? d. interest, taxes, and insurance expenses? c. disbursement of funds be made as work 15. Does the branch require an estimated cost progresses, supported by documentation breakdown for each stage of construction? that the subcontractors are receiving pay-

September 1997 Branch and Agency Examination Manual Page 2 Real Estate Construction Loans: Internal Control Questionnaire 3110.4

ment and that the appropriate liens are 26. Are unsecured credit lines to contractors or being released? developers, who are also being financed by d. the branch be allowed to withhold dis- secured construction loans, supervised by bursements if work is not performed the construction loan department or the according to approved specifications? officer supervising the construction loan? e. a percentage of the loan proceeds be 27. Does the branch have adequate procedures retained pending satisfactory completion to determine whether construction appraisal of the construction? or evaluation policies and procedures are f. the lender be allowed to assume prompt consistently being followed in conformance and complete control of the project in the with regulatory requirements, and that the event of default? If a commercial project, appraisal or evaluation documentation sup- are the leases assignable to the branch? ports the value indicated in the conclusions? g. the contractor carry builder’s risk and worker’s compensation insurance? If so, has the branch been named as mortgagee INSPECTION or loss payee on the builder’s risk policy? h. periodic increases in the project’s value 28. Are inspection authorities noted in the: be reported to the builder’s risk and title a. construction loan commitment? insurance companies? b. construction loan agreement? 23. In addition to the aforementioned points, c. tri-party buy-and-sell agreement? does the construction loan agreement for d. takeout commitment? residential tract construction loans require: 29. Are inspections conducted on an irregular a. branch authorization for individual tract basis? housing starts? 30. Are inspection reports sufficiently detailed b. periodic sales reports be submitted to the to support disbursements? branch? 31. Are inspectors rotated from project to c. periodic reports on tract houses occupied project? under a rental, lease, or purchase option 32. Are spot checks made of the inspectors’ agreement be submitted to the branch? work? d. limitations on the number of speculative 33. Do inspectors determine compliance with houses and the completion of one tract plans and specifications as well as the prior to beginning another? progress of the work? If so, are the inspectors competent to make the determination?

COLLATERAL DISBURSEMENTS 24. Are liens filed on non-real estate construction improvements, i.e., personal property 34. Are disbursements: that is movable from the project? a. advanced on a prearranged disbursement 25. When entering into construction loans, does plan? the branch, consistent with supervisory loan- b. made only after reviewing written inspec- to-value limits: tion reports? a. limit the loan amount to a reasonable c. authorized in writing by the contractor, percentage of the appraised value of the borrower, inspector, subcontractors, project when there is no prearranged and/or lending officer? permanent financing? d. reviewed by a branch employee who had b. limit the loan amount to a percentage of no part in granting the loan? the appraised value of the completed e. compared to original cost estimates? project when subject to the branch’s own f. checked against previous disbursements? takeout commitment? g. made directly to subcontractors and c. limit the loan amount to the floor of a suppliers? takeout commitment that is based upon h. supported by invoices describing the achieving a certain level of rents or lease work performed and the materials occupancy? furnished?

Branch and Agency Examination Manual September 1997 Page 3 3110.4 Real Estate Construction Loans: Internal Control Questionnaire

35. Does the branch obtain waivers of subcon- records performed or adequately reviewed tractor’s and mechanic’s liens as work is by persons who do not also: completed and disbursements are made? a. issue official checks or drafts? 36. Does the branch obtain sworn and notarized b. handle cash? releases of mechanic’s liens from the gen- c. reconcile subsidiary records to general eral contractor at the time construction is ledger controls? completed and before final disbursement is 47. Are the subsidiary real estate construction made? loan records reconciled at least monthly to 37. Does the branch periodically review undis- the appropriate general ledger accounts? bursed loan proceeds to determine their Are reconciling items adequately investi- adequacy to complete the projects? gated by persons who do not also handle 38. Are the borrower’s undisbursed loan pro- cash or prepare/post subsidiary controls? ceeds and contingency or escrow accounts 48. Are loan statements, delinquent account independently verified at least monthly by collection requests, and past-due notices someone other than the individuals respon- reconciled to the real estate construction sible for loan disbursements? loan subsidiary records? Are the reconciliations handled by a person who does not also handle cash? TAKEOUT COMMITMENT 49. Are inquiries about construction loan balances received and investigated by persons 39. Does counsel review takeout agreements who do not also handle cash? for acceptability? 50. Are documents supporting recorded credit 40. Does the branch obtain and review the adjustments subsequently checked or tested permanent lender’s financial statements to by persons who do not also handle cash? determine the adequacy of its financial 51. Is a delinquent accounts report generated resources to fulfill the takeout commitment? daily? 41. Is a tri-party buy-and-sell agreement signed 52. Are loans in excess of supervisory LTV before the construction loan is closed? limits identified in the branch’s records and 42. Does the branch require takeout agreements are the aggregate amounts of such loans to include a force majeure (an act of God reported at least quarterly to the board of clause) that provides for an automatic directors? extension of the completion date in the 53. Does the branch maintain a daily record event that construction delays occur for summarizing note transaction details (loans reasons beyond the builder’s control? made, payments received, and interest collected) to support applicable general ledger account entries? COMPLETION BONDING 54. Are note and liability trial balances frequently reconciled to the general ledger by REQUIREMENTS employees who do not process or record loan transactions? 43. Does the branch require completion insurance for all construction loans? 44. Has the branch established minimum financial standards for borrowers who are not LOAN INTEREST AND required to obtain completion bonding? Are COMMITMENT FEES these standards observed in all cases? 45. Does counsel review completion insurance 55. Are the preparation and posting of loan bonds for acceptability? interest and fee records performed or adequately reviewed by persons who do not also: LOAN RECORDS a. issue official checks or drafts? b. handle cash? 46. Are the preparation, addition, and posting 56. Are any independent interest and fee com- of subsidiary real estate construction loan putations made and compared or adequately

September 1997 Branch and Agency Examination Manual Page 4 Real Estate Construction Loans: Internal Control Questionnaire 3110.4

tested to loan interest by persons who do not this area? If not, indicate any additional also: examination procedures deemed necessary. a. issue ofﬁcial checks or drafts? 58. Based on the information gathered, evaluate b. handle cash? the internal controls in this area (i.e. strong, satisfactory, fair, marginal, unsatisfactory).

CONCLUSION

57. Is the information covered by this ICQ adequate for evaluating internal controls in

Branch and Agency Examination Manual September 1997 Page 5 Real Estate Construction Loans Audit Guidelines Effective date July 1997 Section 3110.5

Refer to the Credit Risk Management, Audit accounts are authorized in accordance with Guidelines, section of this manual for items the terms of the loan agreement and if applicable to Real Estate Construction Loans. they are supported by inspection reports, certiﬁcates of completion, individual bills, 1. Using appropriate sampling techniques, select or other evidence. loans from the trial balance and: c. Review disbursement ledgers and autho- a. Review loan agreement provisions for rizations and determine if authorizations hold back or retention, and determine if are signed according to the terms of the undisbursed loan funds and/or contin- loan agreement. gency or escrow accounts are equal to d. Verify debits in the undisbursed loan pro- retention or holdback requirements. ceeds accounts to inspection reports, indi- b. If separate interest reserves are main- vidual bills, or other evidence supporting tained, determine if debit entries to those disbursements.

Branch and Agency Examination Manual September 1997 Page 1 Securities Broker and Dealer Loans Effective date July 1997 Section 3120.1

Some branches provide lending services to stock ships. Borrowers are typically nonproducers or brokerage firms using stock of listed corpora- nonprocessors of the commodity and include tions as collateral. To promote efficiency in the individuals, trading companies, manufacturers, pledging of collateral, the Stock Clearing Cor- or broker/dealers. The loan may represent a poration, a wholly-owned subsidiary of the New direct investment in the commodity or the car- York Stock Exchange, transfers stock ownership rying of a forward or futures position in the through computer book entries and thus elimi- commodity. The commodity being purchased nates the physical movement of the securities. generally secures the borrowing. Common pur- The operating department of the Stock Clearing poses for commodity loans include: Corporation, Central Certificate Service (CCS), handles the technical aspects of that operation. • The temporary holding by a trader of a com- Brokerage firms deposit shares of eligible modity under contract for sale or in anticipa- securities with CCS. The stock certificates rep- tion of sale in the near term. resenting those shares are registered in the name • The holding of a commodity by an entity in of a common nominee. CCS has physical con- anticipation of price appreciation for that trol of the securities while they are on deposit. commodity. Loan arrangements are made between the broker • The holding of a commodity by a manufac- and the lending branch with the broker instruct- turer or fabricator awaiting transformation ing CCS, through written authorization, to debit into some other product. the firm’s account and credit that of the branch. CCS sends a copy of the authorization to the The focus of the examination of the branch’s branch and will not reverse the entry or make commodity lending area is on the lending policy partial withdrawals without written authoriza- and the control exercised over the collateral. The tion from the branch. Participating financial policy should address under what circumstances institutions receive daily printouts, showing their and conditions commodity loans will be made, position in the program by broker name and type particularly whether the branch will grant loans of security. Because of adequately protected to finance a speculative position in a commod- controls employed by Stock Clearing Corpora- ity. For secured loans, collateral margin require- tion, examiners should accept the daily position ments should be included in the policy. printouts without further verification. Control of the collateral is important. Gener- ally, the commodity will be held in a bonded warehouse, bank, or other depository institution. COMMODITY LOANS The branch should control title to the commodity. Because commodity markets can become Loans to carry investments in commodities entail volatile, collateral positions should be moni- the same basic criteria as in all credit relation- tored frequently for compliance with the policy.

Branch and Agency Examination Manual September 1997 Page 1 Securities Broker and Dealer Loans Examination Objectives Effective date July 1997 Section 3120.2

1. To determine if policies, practices, proce- 4. To determine the scope and adequacy of the dures, objectives, and internal controls audit function. regarding securities broker and dealer loans 5. To determine compliance with applicable are adequate. laws and regulations. 2. To determine if branch ofﬁcers are operating 6. To recommend corrective action when poli- in conformance with established guidelines. cies, practices, procedures, or internal con- 3. To evaluate the adequacy of collateral, credit trols are deﬁcient or when violations of law quality, and collectibility. or regulations have been noted.

Branch and Agency Examination Manual September 1997 Page 1 Securities Broker and Dealer Loans Examination Procedures Effective date July 1997 Section 3120.3

1. If selected for implementation, complete or i. Reports furnished to the head office. update the Internal Control Questionnaire j. Loans classified during the preceding for this area. examination. 2. Based on the evaluation of internal controls k. A listing of loans charged off since the and of the work performed by internal/ preceding examination. external auditors, ascertain the scope of the 9. Review the information received and per- examination. form the following: 3. Test for compliance with policies, practices, a. For miscellaneous loan debit and credit procedures, and internal controls in conjunc- suspense accounts: tion with performing the remaining exami- • Discuss with management any large or nation procedures. Additionally, obtain a old items. listing of any deficiencies noted in the latest review by internal/external auditors and • Perform additional procedures as determine if corrections have been deemed appropriate. accomplished. b. For loans classified during the previous 4. Request the branch to supply: examination, determine disposition of a. Schedule of approved lines for each loans so classified by transcribing: dealer, including outstanding balances. • Current balances and payment status, b. Delinquent interest billings and date or billed amount of past due interest. • Date loan was repaid and sources of 5. Obtain a trial balance of all dealer accounts payment. and: c. For loan commitments and other contin- a. Verify balances to departmental controls gent liabilities, analyze if: and the general ledger. • The borrower has been advised of the b. Review reconciling items for reasonable- contingent liability. ness. • The combined amounts of the current 6. Using an appropriate sampling technique, loan balance and the commitments or select borrowers to be reviewed. contingent liabilities exceed the cutoff. 7. Using the trial balance, transcribe the fol- d. Select loans that require in-depth review lowing information for each borrower based on information derived when per- selected onto the credit line cards: forming the above steps. a. Total outstanding liability. 10. For those loans selected in step 6 above and b. Amount of approved line. for any other loans selected while perform- 8. Obtain from the appropriate examiner the ing the above steps, transcribe the following following schedules, if applicable to this information from the branch’s collateral area: record onto the credit line sheets: a. Past due loans. a. A list of collateral held, including date of b. Loan commitments and other contingent entry and amount advanced. liabilities. b. A brief summary of the agreement c. Miscellaneous loan debit and credit sus- between the branch and the dealer. pense accounts. c. Evidence that the proper documentation d. Loans considered problem loans by is in place. management. d. Details of any other collateral held. e. Each officer’s current lending authority. 11. The examiner should be aware that certain f. Current interest rate structure. stock-secured transactions with and for bro- g. Any useful information obtained from kers and dealers are exempt from the mar- the review of the minutes of the loan gin restrictions of Regulation U. Refer to committee or any similar committee. the regulation, which can be found in the h. Reports furnished to the loan and dis- Federal Reserve Regulatory Service, for a count committee or any similar complete description of such transactions committee. that include the following:

Branch and Agency Examination Manual September 1997 Page 1 3120.3 Securities Broker and Dealer Loans: Examination Procedures

a. Temporary advances to finance cash b. Loans on which collateral documenta- transactions. tion is deficient. b. Securities in transit or transfer. c. Recommended corrective action when c. Day loans. policies, practices, or procedures are d. Temporary financing of distributions. deficient. e. Arbitrage transactions. d. Other matters regarding the condition of f. Credit extended pursuant to hypotheca- the department. tion. 14. Prepare appropriate comments for the work- g. Emergency credit. papers and the examiner-in-charge stating h. Loans to specialists. your findings with regard to: i. Loans to odd-lot dealers. a. The adequacy of written policies relating j. Loans to OTC market makers. to securities broker and dealer loans. k. Loans to third-market makers. b. The manner in which branch officers are l. Loans to block positioners. conforming with established policy. m. Loans for capital contributions. 12. At this point, the examiner needs to decide c. Schedules applicable to the department whether further examination and testing is that were discovered to be incorrect or needed. If further work is warranted, refer incomplete. to the audit guidelines. After reviewing the d. The competence of departmental audit guidelines, proceed to step 13. management. 13. Discuss with appropriate officer(s) and pre- e. Internal control deficiencies or exceptions. pare summaries in appropriate report form f. Other matters of significance. of: 15. Update the workpapers with any informa- a. Delinquent loans. tion that will facilitate future examinations.

September 1997 Branch and Agency Examination Manual Page 2 Securities Broker and Dealer Loans Internal Control Questionnaire Effective date July 1997 Section 3120.4

Review the branch’s internal control, policies, COLLATERAL practices, and procedures for making and servicing loans. The branch’s system should be 9. Are multi-copy, prenumbered records main- documented in a complete and concise manner tained that: and should include, where appropriate, narra- a. Detail the complete description of collat- tive descriptions, flowcharts, copies of forms eral pledged? used, and other pertinent information. b. Are computer generated or typed? 10. Are receipts issued to customers covering each item of negotiable collateral POLICIES deposited? 11. If applicable, are the functions of receiving 1. Has a policy been adopted specifically and releasing collateral to borrowers and of addressing securities broker and dealer loans making entries in the collateral register that: performed by different employees? a. Establishes standards for determining 12. Are appropriate steps with regard to Regu- broker and dealer credit lines? lation T being considered in granting broker b. Establishes minimum standards for docu- and dealer loans? mentation? 13. Concerning commodity lending: 2. Are such loan policies reviewed at least annually to determine if they are compatible a. Is control for the collateral satisfactory, with changing market conditions? i.e., stored in the branch’s vault, another 3. Is a daily record maintained summarizing bank, or a bonded warehouse? loan transaction details, i.e., loans made, b. If collateral is not stored within the payments received, and interest collected to branch, are procedures in effect to ascer- support applicable general ledger account tain the authenticity of the collateral? entries? c. Does the branch have a documented and 4. Are frequent note and liability ledger trial recorded security interest in the proceeds balances prepared and reconciled with con- of the future sale or disposition of the trolling accounts by employees who do not commodity and the existing collateral process or record loan transactions? position? 5. Is an exception report produced and reviewed d. Do credit files document that the by operating management that encompasses financed positions are and remain fully extensions, renewals, or any factors that hedged? would result in a change in customer account 14. Concerning loans to commodity brokers status? and dealers: 6. Do customer account records clearly indicate accounts that have been renewed or a. Does the branch maintain a list of the extended? major customer accounts of the brokers or dealers to whom it lends? If so, is the list updated on a periodic basis? b. Is the branch aware of the broker/ LOAN INTEREST dealer’s policy on margin requirements and the basis for valuing contracts for 7. Is the preparation and posting of interest margin purposes, i.e., pricing spot versus records performed and reviewed by appro- future? priate personnel? c. Does the branch attempt to ascertain 8. Are any independent interest computations whether the positions of the broker/ made and compared or adequately tested to dealer’s clients that are indirectly initial interest records by appropriate financed by branch loans remain fully personnel? hedged?

Branch and Agency Examination Manual September 1997 Page 1 3120.4 Securities Broker and Dealer Loans: Internal Control Questionnaire

CONCLUSION 16. Based on the information gathered, evaluate the internal controls in this area (i.e. strong, 15. Is the information covered by this ICQ satisfactory, fair, marginal, unsatisfactory). adequate for evaluating internal controls in this area? If not, indicate any additional examination procedures deemed necessary.

September 1997 Branch and Agency Examination Manual Page 2 Securities Broker and Dealer Loans Audit Guidelines Effective date July 1997 Section 3120.5

1. Verify the accuracy of the trial balance. e. Determine whether interest payments are 2. Test reconciling items to the extent consid- delinquent and trace to inclusion in delin- ered necessary. quency report. 3. Using an appropriate sampling technique, f. Determine that appropriate action has been select broker and dealer loans and: taken to bring delinquent accounts to a a. Prepare and mail conﬁrmation forms to current status. dealers (information conﬁrmed should 4. Review collateral records and: include the loan balance and date of entry). a. Determine the reason for differences b. After a reasonable time period, mail sec- between the branch’s collateral records ond requests. and the actual items held by the branch. c. Follow up on any no-replies or excep- b. Investigate other differences to the extent tions, and resolve differences. considered necessary. d. Obtain a list of the most recent broker and dealer interest billings and check calculation of interest report.

Branch and Agency Examination Manual September 1997 Page 1 Securities Activities Effective date July 1997 Section 3130.1

This section addresses securities activities in the ing Activities Manual. Additional reference mate- broadest meaning of the term. It is divided into rial includes: three sections: Investment Securities, Trading Securities, and Other, which includes resale and • FFIEC’s Supervisory Policy Statement on repurchase transactions. Securities Activities as of January 10, 1992. • SR 93-69—‘‘Risk Management and Internal Controls for Trading Activities of Banking Organizations.’’ INVESTMENT SECURITIES • SR 95-17—‘‘Evaluating the Risk Manage- ment and Internal Controls of Securities and Since January 1, 1994, investment securities Derivative Contracts Used in Nontrading activities of branches are subject to FASB State- Activities.’’ ment No. 115 (Accounting for Certain Invest- ments in Debt and Equity Securities). Under this The rationale behind FASB creating the AFS standard, all branches are required to segregate category and allowing institutions to report AFS their investment securities portfolios into three securities at fair value is that it presents a more categories: (1) held-to-maturity, (2) available- accurate and realistic picture of an institution’s for-sale, and (3) trading securities. The held-to- ﬁnancial condition. The inclusion of net unreal- maturity category replaces the former held-for- ized gains and losses with Tier 1 capital pro- investment category. The available-for-sale cate- vides incentives to institutions to hold securities gory is new, and the trading category is the same that have depreciated or appreciated in value, as before. thereby reducing market volatility. However, although market volatility is reduced, bank’s Held-to-maturity (HTM) securities are debt capital ratios are subject to increased volatility securities that the branch has both the intent and since their assets will be marked-to market ability to hold until maturity. The branch will while liabilities remain at book value. continue to report HTM securities at amortized In addition to any restrictions imposed by cost. state law or regulation, under Section 7(c)(2) of the International Banking Act of 1978, all Available-for-sale (AFS) securities are deﬁned branches may only hold the types of investment as debt or equity securities for which the branch securities that may be held by national banks does not have the positive intent and ability to and state member banks. See 12 USC 24(7); 12 hold to maturity, yet does not intend to trade CFR Part 1. State-licensed branches, addition- actively as a part of its trading account. AFS ally, may only hold those types of investment securities transactions must be reported at fair securities permitted under state law. It should be value with any unrealized gains and losses noted that branches must obtain Federal Reserve reported directly as a separate component of approval, before commencing commodity or equity capital. Thus, unrealized changes in these equity-linked transactions. See 12 CFR 208.128 securities’ value will have no effect on the (made applicable to branches by 12 USC reported earnings of the branch. 3105(c)(2)). For branches, investment securities include Trading securities are those debt and equity U.S. government obligations and certain domes- securities that a branch buys and holds princi- tic corporate debt securities; as well as various pally for the purpose of selling in the near term. federal agency bonds; state, county, and munici- Trading securities will continue to be reported at pal issues; special revenue bonds; and industrial fair market value with unrealized gains or losses revenue bonds. Securities included in the invest- reported directly in the income statement as a ment account should provide a reasonable rate part of the branch’s earnings. of return as well as provide the necessary liquidity the branch requires. Accordingly, an This section will deal only with investment investment account should contain some securi- securities, or those categorized as HTM and ties that may be quickly converted into cash by AFS. A complete discussion of trading securi- sale or by maturity. Hence, liquidity and mar- ties is contained in the Federal Reserve’s Trad- ketability are of the utmost importance. A bond

Branch and Agency Examination Manual September 1997 Page 1 3130.1 Securities Activities is a liquid asset if its maturity is short and if The basic objectives of a sound investment there is reasonable assurance that it will be paid policy are the same for all financial institutions at maturity. It is marketable if it may be sold but the emphasis placed on each objective will quickly at a price commensurate with its yield vary, according to the individual branch’s needs. and quality. The highest quality bonds have The basic objectives include: either or both of those two desirable qualities. Occasionally, it may be difficult to distinguish • Minimizing risks. between a loan and a security. Loans generally • Generating a favorable return on investments, result from direct negotiations between a bor- without undue compromise of the other rower and a lender. A branch may refuse to grant objectives. a loan unless it and the borrower can agree to • Providing for and managing liquidity. terms. A security, on the other hand, is usually • Meeting any applicable pledge requirements. acquired through a third party, a broker or dealer • Temporary use of excess funds. in securities. Most securities have standardized terms, which can be compared to the terms of The investment policy must encompass more other market offerings. Because the terms of than a philosophical description of objectives. If most loans do not lend themselves to such policy development is delegated to local branch comparison, the average investor may not accept management, the examiner should verify that the terms of the lending arrangement. Thus, an head office management has reviewed or is individual loan cannot be regarded as a readily aware of the policy and the branch’s level of marketable security. compliance. An interesting hybrid between a security and a loan is a private placement. A private placement is a security transaction whereby the issuer did not involve any "public offering" but rather TYPES OF INVESTMENT offered the securities privately. The securities SECURITIES are not reviewed by the SEC, and are offered and sold only to those parties who the issuer The investment policy should include guidelines believes are (1) sufficiently experienced to evalu- on the quality and quantity of each type of ate merits and risks of the investment, or (2) able security to be held. Credit quality is of major to bear the risk of the investment. Through importance. negotiation, both parties may tailor the offering to meet their needs. The issuer saves securities U. S. government obligations are the highest registration costs and the investor makes an quality investments and are the most readily investment for a specified length of time at a marketable. They are riskless from a credit stated rate of return. Both investor and issuer standpoint but are subject to price fluctuations complete the transaction privately without being because of changes in money market interest subject to regulatory and public scrutiny. The rates. Longer-term issues tend to fluctuate more major disadvantage of private placements is the widely than shorter-term issues. All things being lack of a secondary market, and therefore it may equal, maturity, credit, etc., smaller coupon be highly illiquid. Although private placements securities are more volatile than larger coupon have many characteristics of loans, for regula- securities. tory reporting purposes they are considered securities. Federal agency securities are also of very high quality. Similar investments that enjoy wide acceptance in the banking community are U.S. government guaranteed public housing author- INVESTMENT POLICY ity issues. New housing authority and public housing authority notes or bonds generally pro- The branch should have an investment policy, vide the investor with tax exempt income and a which was developed in conjunction with and full faith and credit guaranty of the U.S. approved by its head office, to control and government. monitor the branch’s investment activities. This policy should include guidelines for personnel Other tax exempt bonds have varying levels of involved in securities activities. indirect U.S. government support. Pre-refunded

September 1997 Branch and Agency Examination Manual Page 2 Securities Activities 3130.1 or escrowed bonds are often fully and directly unfavorable market aspect. Except for high secured by obligations issued by or otherwise quality issues of larger municipalities, munici- supported by the full faith and credit of the pal bonds often are not readily marketable and, United States. Certain municipal housing bonds as a result, may produce sizeable spreads are partially payable from rental subsidies and/or between bid and ask prices. The spread may be mortgage credit insurance provided by federal so wide, it may cost the selling bank a sizeable agencies. Pools of partially guaranteed student portion of a year’s interest. loans are sometimes pledged for payment of municipal higher education bonds. There are numerous programs that provide federal backing for municipal bonds. Care must be taken to BOND RATINGS distinguish between those issues that are federally guaranteed and those that are not. Monthly rating service publications are useful in determining the investment quality of municipal High quality municipal bonds frequently are and corporate obligations. The standard bond desirable because of their tax exempt status. rating symbols, as shown on the following page, Many municipal bonds, however, possess an are listed in the order of their credit quality.

Standard & Poor’s Moody’s Description

Bank Quality Investments

AAA Aaa Highest grade obligations.

AA Aa High grade obligations

A A-1, A Upper medium grade

BBB Baa-1, Baa Medium grade, on the borderline between deﬁ- nitely sound obligations and those containing predominantly speculative elements. Generally, the lowest quality bond that may qualify for bank investment.

Speculative and Defaulted Issues (High Yield or Noninvestment Grade)

BB Ba Lower medium grade with only minor investment characteristics.

B B Low grade, default probable.

Ccc, cc, c, D Caa, Ca, C Lowest rated class, may be in default, extremely poor material prospects.

Provisional or Conditional Rating

Rating-P Con. (Rating) Debt service requirements are largely dependent on reliable estimates as to future events.

Branch and Agency Examination Manual September 1997 Page 3 3130.1 Securities Activities

Although the analyses of major rating agen- highest grades and unrated securities of equiva- cies are basically sound and updated frequently, lent quality, defaulted securities and sub- it should be kept in mind that ratings are only investment-quality stocks. As noted in the fol- evaluations of probabilities. In order to deter- lowing chart, securities in grades below the four mine appropriate credit limits to a particular highest grades and unrated securities of equiva- counterparty, bond ratings should be supple- lent quality will be valued at market price. The mented by the branch’s own credit analysis of market value will be classified substandard, and the issuer. the depreciation will be classified doubtful. Sub-investment-quality securities are those in Depreciation in defaulted securities and sub- which the investment characteristics are dis- investment-quality stocks will generally be clas- tinctly or predominantly speculative. This group sified loss; market value will be classified sub- includes securities in grades below the four standard.

SECURITY CLASSIFICATIONS

Type of Security Classiﬁcation

Substandard Doubtful Loss

Investment-quality XXX XXX XXX

Sub-investment-quality, except— Market Market XXX Value Depreciation

Sub-investment-quality, municipal Book XXX XXX general obligations Value

Defaulted securities and Market XXX Market sub-investment-quality Value Depreciation stocks, except—

Defaulted municipal general obligations:

Interim XXX Book XXX Value

Final, i.e., when market is reestablished Market XXX Market Value Depreciation

As a matter of policy, an institution should and stocks acquired through DPC transactions. not acquire securities until it has assessed the Credit analysis is always necessary to determine creditworthiness of the issuer and determined if an investment is appropriate for the branch to that the risk exposure conforms with its policies. own. According to Federal regulation (12 CFR, At a minimum, the examiner should expect such Section 1.8) it is incumbent upon management a policy to require credit reviews on all transac- to demonstrate that it has exercised prudence in tions before purchase, annual internal credit acquiring all investment securities. reviews, and more frequent credit updates on all The examiner should be mindful, however, nonrated issues, municipal obligations with a that as part of a larger organization, the branch credit rating that has declined, special revenue may operate soundly outside of the parameters and other debt obligations with limited or no normally considered acceptable due to its unique marketability, speculative and defaulted issues, role within the FBO’s network. When tradi-

September 1997 Branch and Agency Examination Manual Page 4 Securities Activities 3130.1 tional liquidity analysis results in unsatisfactory and unsound practice to record and report hold- findings, the examiner should discuss with man- ings of securities that result from trading trans- agement the influence of the branch’s relation- actions using accounting standards that are ships with related offices. intended for investment portfolio transactions; Policy guidelines for risk diversification therefore, the discipline associated with account- should be formulated in conformity with legal ing standards applicable to trading accounts is and prudent investment restrictions. Concentra- necessary. Securities held in trading accounts tions resulting from the obligations of a single or must be periodically marked-to-market with related issuer, credit ratings, geographic and unrealized gains or losses recognized in current type distribution may all be compatible with income. Prices used in periodic revaluations sound investment policy. In many cases, con- should be obtained from sources that are inde- centrations would not be considered unwar- pendent of the securities dealer doing business ranted but, in all cases, it is essential that with the branch. investment concentrations be monitored at the head office level. The investment policy should also take into Covered Calls consideration the applicable federal and state income tax laws. Finally, the investment port- The writing of covered calls is an option strat- folio should be reviewed at least annually by egy that, for a fee, grants the buyer of the call head office management and quarterly by senior option the right, but not the obligation to pur- officers of the branch. Sufficient analytical data chase a security owned by the option writer at a must be provided to allow head office manage- pre-determined price before a specified future ment to make an informed judgment of the date. The option fee1 received by the writing investment policy’s effectiveness. Such reviews (selling) depository institution provides income should consider the information discussed in and has the effect of increasing the effective this section and the current market value of the yield on the portfolio asset ‘‘covering’’ the call. portfolio. Management should maintain clear lines of Covered call programs have been promoted authority and responsibility for acquiring secu- as hedging strategies because the fee received rities and managing risk. This includes setting by the writer can be used to offset a limited appropriate limits on risk taking, creating amount of potential loss in the price of the adequate systems for measuring risk, providing underlying security. If interest rates rise, the call effective internal controls, and implementing a option fee can be used to partially offset the comprehensive risk reporting and risk manage- decline in the market value of a fixed rate ment review process. security or the increased cost of market rate liabilities used to carry the security. However, there is no assurance that an option fee will completely offset the price decline on the secu- TRADING SECURITIES rity or the increased cost of liabilities and the resulting reduced spread between the institution’s return on assets and funding costs. The following section deals with securities portfolio trading but does not include derivative- As a practical matter, the gain on a security related activity. For an in-depth discussion of covered by a written call is limited to the derivative-related activity, refer to the Federal amount of the difference between the carrying Reserve’s Trading Activities Manual. value of the security and the strike price at Trading in the investment portfolio is charac- which the security will be called away. The terized by a high volume of purchase and sale potential for losses on the covered security is not activity, which, when considered in light of a similarly limited. In an effort to obtain higher short holding period for securities, clearly dem- yields, some portfolio managers have mistak- onstrates management’s intent to profit from enly relied on the theoretical hedging benefits of short-term price movements. In this situation, a failure to follow accounting and reporting standards applicable to trading accounts may result 1. Recognition of option fee income should be deferred until the option is exercised or expires. The covered call writer in a misstatement of the branch’s income and a shall value the option at the lower of cost or market value at filing of false regulatory reports. It is an unsafe each report date.

Branch and Agency Examination Manual September 1997 Page 5 3130.1 Securities Activities covered call writing, and have purchased extended sections 1001-False Statements or Entries and maturity U.S. government or Federal agency 1005-False Entries. securities. This practice can significantly increase risks taken by the branch by contributing to a maturity mismatch between its assets and its funding. Coupon Stripping Institutions should only initiate a covered call program for securities when head office and Coupon stripping involves detaching unmatured branch management have specifically approved coupons from securities and selling either the a policy permitting this activity. This policy coupons or the remaining stripped security. must set forth specific procedures for controlling Such transactions are often motivated by anxiety covered call strategies, including recordkeeping, for immediate income recognition or by tax reporting, and review of activity, as well as considerations. This practice significantly dimin- providing for appropriate management informa- ishes the worth, marketability, and liquidity of tion systems to report the results. Since the the securities. purchaser of the call acquires the ability to call U.S. government obligations are the most the security away from the institution that writes common type of security used for coupon strip- the option, the ability of that institution to ping. Corporate or municipal issues may be used continue to hold the security rests with an but are not viewed as attractive alternatives outside party. Securities held to maturity against because of credit risk and early redemption which call options have been written should features. therefore be redesignated as available for sale The Internal Revenue Service has ruled that and reported at fair value. However, when the the proceeds from the sale of unmatured cou- option contract requires the writer to deliver pons constitute ordinary income and are included held-to-maturity securities, or when manage- in the taxable income for the year in which the ment has a pattern of practice of delivering held- sale occurred. A branch can increase current to-maturity securities when called, manage- period taxable income to utilize a prior year’s ment’s intent to hold other securities to maturity tax loss carry-forward by selling all or a portion may be called into question. of the unmatured coupons of their securities. However, if an option contract requires the Similarly, an ex-coupon security may be sold at writer to settle in cash, rather than delivering an its discounted value. The difference between the investment portfolio security, the institution writ- sale proceeds and the cost basis of the security is ing the option maintains the ability to hold the recognized as a current period tax loss. security and, thus, the security may be reported There are a limited number of dealers that as held-to-maturity. In this case, the option must participate in wholesale and retail trading and still be reported at fair value. reoffering of detached coupons and ex-coupon securities. That activity is generally viewed as inappropriate for branch dealers; the marketabil- Adjusted Trading ity and liquidity shortcomings attendant with either the coupons or the securities result in Adjusted trading is a practice involving the sale uncertain suitability for customer purchase with- of a security to a broker or dealer at a price out complete customer disclosure and consent. above the prevailing market value and the Ex-coupon securities or stripped coupons are simultaneous purchase and booking of a differ- distinctly different from securities that have all ent security, frequently a lower grade issue or the unmatured coupons attached. The ex-coupon one with a longer maturity, at a price greater security and resulting coupons generally: than its market value. Thus, the broker or dealer is reimbursed for losses on the purchase from • Have a diminished and uncertain market value the institution and ensured a profit. Such trans- and impaired practical liquidity. actions inappropriately defer the recognition of • Are not, absent adequate customer disclosure, losses on the security sold and establish an suitable for sale to customers or as repurchase excessive reported value for the newly acquired agreement collateral with customers. security. Consequently, such transactions are • Are not considered good delivery items by prohibited and may be in violation of 18 USC securities dealers.

September 1997 Branch and Agency Examination Manual Page 6 Securities Activities 3130.1

If a branch has engaged or elects to engage in General Guidance such transactions, they must be reported as follows: Under the FFIEC policy statement, the banking • The book value must be allocated between the agencies call for special management of principal portion and the coupons at the time mortgage-backed products. A general principle the security is divided. This allocation will be underlying this policy is that mortgage-backed based upon the present value of each compo- products possessing average life or price vola- nent (principal and coupons) at the time of tility in excess of a benchmark fixed rate 30-year sale using the yield to maturity at the time the mortgage-backed pass-through security are security was purchased as the discount rate. ‘‘high-risk mortgage securities’’ and are not suitable investments. All high-risk mortgage • The profit or loss on the portion sold must be securities, defined later in this section, acquired recognized during the period in which the sale by depository institutions after February 10, occurred as other income or other expense. It 1992, must be carried in the institution’s trading will be the difference between that portion of account or as assets available for sale. Mortgage- the book value, allocated as above to the backed products that do not meet the definition portion sold, and the actual selling price of of a high-risk mortgage security at the time of that portion. The portion retained will be purchase may be reported as held to maturity, carried on the books of the branch at its available for sale, or held for trading, as appro- allocated portion of the book value. Detached priate. Branches must ascertain no less fre- coupons or principal portions held by a branch, quently than annually whether such products either as a result of purchase or of stripping have become high-risk mortgage securities. securities held for its own account, will be Branches generally should hold mortgage- reported as other notes, bonds and debentures, backed products that meet the definition of a and not as U.S. Treasury securities, obliga- high-risk mortgage security only to reduce inter- tions of other U.S. government agencies and est rate risk in accordance with safe and sound corporations, or obligations of states and practices.2 Furthermore, depository institutions political subdivisions in the United States. that purchase high-risk mortgage securities must demonstrate that they understand and are effectively managing the risks associated with these instruments. Levels of activity involving high- Special Guidance on risk mortgage securities should be reasonably related to a branch’s capacity to absorb losses, Mortgage-Backed Products and level of in-house management sophistication and expertise. Appropriate managerial and Some mortgage-backed products exhibit consid- financial controls must be in place and the erably more price volatility than mortgages. branch must analyze, monitor, and prudently Some mortgage pass-through securities can adjust its holdings of high-risk mortgage secu- expose investors to significant risk of loss if not rities in an environment of changing price and managed in a safe and sound manner. This price maturity expectations. volatility is caused in part by the uncertain cash Prior to taking a position in any high-risk flows that result from changes in the prepayment mortgage security, branch management should rates of the underlying mortgages. conduct an analysis to ensure that the position In addition, because these products are com- will reduce the overall interest rate risk. Liquid- plex, a high degree of technical expertise is required to understand how their prices and cash flows may behave in various interest rate and 2. Notwithstanding the provisions of the Board’s supervi- prepayment environments. Moreover, because sory policy generally requiring that high-risk mortgage secu- the secondary market for some of these products rities be used only for the purpose of reducing interest rate risk, this supervisory policy is not meant to preclude an can be relatively thin, they may be difficult to institution with strong capital and earnings and adequate liquidate should the need arise. Finally, there is liquidity that has a closely supervised trading department from additional uncertainty because new variants of acquiring high-risk mortgage securities for trading purposes. these instruments continue to be introduced and The trading department must operate in conformance with well-developed policies, procedures, and internal controls, their price performance under varying market including detailed plans prescribing specific position limits and economic conditions has not been tested. and control arrangements for enforcing these limits.

Branch and Agency Examination Manual September 1997 Page 7 3130.1 Securities Activities ity and price volatility of these products also • Average Life Sensitivity Test. The expected should be considered prior to purchasing them. weighted average life of the mortgage-backed Circumstances in which the purchase or reten- product: tion of high-risk mortgage securities is deemed — Extends by more than 4.0 years, assuming by the appropriate regulatory authority to be an immediate and sustained parallel shift contrary to safe and sound practices for deposi- in the yield curve of plus 300 basis points, tory institutions will result in criticism by exam- or iners, who may require the orderly divestiture of — Shortens by more than 6.0 years, assuming high-risk mortgage securities. Purchases of high- an immediate and sustained parallel shift risk mortgage securities prior to February 10, in the yield curve of minus 300 basis 1992, generally will be reviewed in accordance points. with previously-existing supervisory policies. • Price Sensitivity Test. The estimated change Securities and other products, whether carried in the price of the mortgage-backed product is on or off the balance sheet (such as CMO swaps, more than 17 percent, due to an immediate but excluding servicing assets), having risk and sustained parallel shift in the yield curve characteristics similar to high-risk mortgage of plus or minus 300 basis points.4 securities will be subject to the same supervisory treatment as high-risk mortgage securities. In applying any of the above tests, all of the Long-term zero coupon bonds also exhibit underlying assumptions (including prepayment significant price volatility and may expose an assumptions) for the underlying collateral must institution to considerable risk. Disproportion- be reasonable. All of the assumptions under- ately large holdings of these instruments may be lying the analysis must be available for exam- considered an imprudent investment practice, iner review. For example, if an institution’s which will be subject to criticism by examiners. prepayment assumptions differ significantly from In such instances, examiners may seek the the median prepayment assumptions of several orderly disposal of some or all of these securi- major dealers as selected by examiners, the ties. Assets slated for disposal are to be reported examiners may use these median prepayment as assets available for sale at their market value. assumptions in determining if a particular mortgage backed product is high risk. The above tests may be adjusted to consider significant movements in market interest rates, Definition of ‘‘High-Risk Mortgage to fairly measure the risk characteristics of new Security’’ mortgage-backed products, and to take such action that is deemed appropriate to prevent In general, any mortgage-backed product that circumvention of the definition of a high-risk exhibits greater price volatility than a bench- mortgage security and other such standards. mark fixed rate thirty-year mortgage-backed Generally, a CMO floating-rate debt class pass-through security will be deemed to be high will not be subject to the average life and risk. For purposes of the FFIEC policy state- average life sensitivity tests described above if it ment, a ‘‘high-risk mortgage security’’ is defined bears a rate that, at the time of purchase or at a as any mortgage-backed product that at the time of purchase, or at a subsequent testing date, meets any of the following tests.3 In general, a 4. When performing the price sensitivity test, the same mortgage derivative product that does not meet prepayment assumptions and same cash flows that were used any of the three tests below will be considered to to estimate average life sensitivity must be used. The only be a ‘‘nonhigh-risk mortgage security.’’ additional assumption is the discount rate assumption. First, assume that the discount rate for the security equals the yield on a comparable average life U.S. Treasury security • Average Life Test. The mortgage-backed prod- plus a constant spread. Then, calculate the spread over uct has an expected weighted average life Treasury rates from the bid side of the market for the greater than 10.0 years. mortgage derivative product. Finally, assume the spread remains constant when the Treasury curve shifts up or down 300 basis points. Discounting the aforementioned cash flows by their respective discount rates estimates a price in the plus 3. When the characteristics of a mortgage derivative prod- and minus 300 basis point environments. uct are such that the first two tests cannot be applied (such as The initial price will be determined by the offer side of the with IOs), the mortgage derivative product remains subject to market and used as the base price from which the 17 percent the third test. price sensitivity test will be measured.

September 1997 Branch and Agency Examination Manual Page 8 Securities Activities 3130.1 subsequent testing date, is below the contractual chased as an investment may later fall into the cap on the instrument. (An institution may high-risk category. When this occurs, the branch purchase interest rate contracts that effectively may continue to designate the mortgage-backed uncap the instrument.) For purposes of this product as held to maturity, providing that policy statement, a CMO floating-rate debt class management still maintains the positive intent is a debt class whose rate adjusts at least and ability to hold the security to maturity. annually on a one-for-one basis with the debt Furthermore, examiners should consider any class’s index. The index must be a conventional, unrecognized net depreciation in held-to-maturity widely-used market interest rate index such as high-risk securities when reviewing earnings the London Interbank Offered Rate (LIBOR). and evaluating liquidity risk. Inverse floating rate debt classes are not included Once a mortgage-backed product has been in the definition of a floating rate debt class. designated as high-risk, it may be redesignated as nonhigh-risk only if, at the end of two consecutive quarters, it does not meet the defi- Supervisory Policy for Mortgage-Backed nition of a high-risk mortgage security. Upon Products redesignation as a nonhigh-risk security, it does not need to be tested for another year. Prior to purchase, a branch must determine whether a mortgage-backed product is high- risk. A prospectus supplement or other support- High-Risk Mortgage Securities ing analysis that fully details the cash flows covering each of the securities held by the A branch may, generally, only acquire a high- institution should be obtained and analyzed risk mortgage backed product to reduce its prior to purchase and retained for examiner overall interest rate risk. (Branches meeting the review. In any event, a prospectus supplement previously mentioned guidance regarding the should be obtained as soon as it becomes use of these securities in a trading account may available. also purchase these securities for trading purposes.) A branch that has acquired high-risk mortgage securities to reduce interest rate risk Nonhigh-Risk Mortgage Securities needs to frequently assess its interest rate risk position and the performance of these securities. Mortgage-backed products that do not meet the Since interest rate positions constantly change, a definition of high-risk mortgage securities, at branch may determine that these high-risk mort- the time of purchase, should be reported as held gage securities no longer reduce interest rate to maturity, available for sale, or held for trad- risk. Therefore, mortgage backed products that ing, as appropriate. Branches must ascertain and are high-risk when acquired shall not be reported document prior to purchase and no less fre- as held-to-maturity securities at amortized cost. quently than annually thereafter that nonhigh- In appropriate circumstances, examiners may risk mortgage securities that are held to maturity seek the orderly divestiture of high-risk mort- remain outside the high-risk category. If a branch gage securities that do not reduce interest rate is unable to make these determinations through risk. Appropriate circumstances are those in internal analysis, it must use information derived which the examiner determines that continued from a source that is independent of the party ownership of high-risk mortgage securities rep- from whom the product is being purchased. resents an undue safety and soundness risk to Standard industry calculators used in the the branch. This risk can arise from the size of mortgage-related securities market place are the branch’s holdings of high-risk mortgage acceptable and are considered independent securities in relation to its earnings and head sources. In order to rely on such independent office capital, management’s inability to demon- analysis, institutions are responsible for ensur- strate an understanding of the nature of the risks ing that the assumptions underlying the analysis inherent in the securities, the absence of internal and the resulting calculation are reasonable. monitoring systems and other internal controls Such documentation will be subject to examiner to appropriately measure the market and cash review. flow risks of these securities, management’s A mortgage-backed product that was not a inability to prudently manage its overall interest high-risk mortgage security when it was pur- rate risk, or similar factors.

Branch and Agency Examination Manual September 1997 Page 9 3130.1 Securities Activities

A branch that owns or plans to acquire • Adequate information systems; high-risk mortgage securities must have a moni- • Procedures for periodic evaluation of high- toring and reporting system in place to evaluate risk mortgage securities and their actual per- the expected and actual performance of such formance in reducing interest rate risk; and securities. The institution must conduct an analy- • Appropriate internal controls. sis that shows that the proposed acquisition of a high-risk mortgage security will reduce the The branch’s senior management should regu- institution’s overall interest rate risk. Subse- larly (at least quarterly) review all high-risk quent to purchase, the branch must evaluate at mortgage securities to determine whether these least quarterly whether this high-risk mortgage instruments are adequately satisfying the inter- security has actually reduced interest rate risk. est rate risk reduction objectives set forth in the The branch’s analyses performed prior to the portfolio policy. The branch’s senior manage- purchase of high-risk mortgage securities and ment should be fully knowledgeable about the subsequently thereafter must be fully docu- risks associated with prepayments and their mented and will be subject to examiner review. subsequent impact on its high-risk mortgage This review will include an analysis of all securities. Failure to comply with this policy assumptions used by management regarding the will be viewed as an unsafe and unsound interest rate risk associated with the branch’s practice. assets, liabilities and off-balance sheet positions. Analyses performed and records constructed to justify purchases on a post-acquisition basis are unacceptable and will be subject to examiner OTHER MORTGAGE-BACKED criticism. Reliance on analyses and documenta- PRODUCTS tion obtained from a securities dealer or other outside party without internal analyses by the There are advantages and disadvantages in own- institution are unacceptable and reliance on such ing these products. A branch must consider the third-party analyses will be subject to examiner liquidity, marketability, pledgeability, and price criticism. volatility of each of these products before invest- Management should also maintain documen- ing in them. It may be unsuitable for a branch to tation demonstrating that it took reasonable commit significant amounts of funds to long- steps to assure that the prices paid for high-risk term stripped mortgage-backed securities, residu- mortgage securities represented fair market als, and zero coupon bonds, which fluctuate value. Generally, price quotes should be obtained greatly in price. from at least two brokers prior to executing a trade. If, because of the unique or proprietary nature of the transaction or product, or for other Stripped Mortgage-Backed Securities legitimate reasons, price quotes cannot be obtained from more than one broker, manage- Stripped mortgage backed securities (SMBS) ment should document the reasons for not consist of two classes of securities with each obtaining such quotes. class receiving a different portion of the monthly In addition, a branch that owns high-risk interest and principal cash flows from the under- mortgage securities must demonstrate that it has lying mortgage-backed securities. In its purest established the following: form, an SMBS is converted into an interest- only (IO) strip, where the investor receives • A head office approved portfolio policy which 100 percent of the interest cash flows, and a addresses the goals and objectives the branch principal-only (PO) strip, where the investor expects to achieve through its securities receives 100 percent of the principal cash flows. activities, including interest rate risk reduction All IOs and POs have highly volatile price objectives with respect to high-risk mortgage characteristics based, in part, on the prepayment securities; of the underlying mortgages and consequently • Limits on the amounts of funds that may be on the maturity of the stripped security. Gener- committed to high-risk mortgage securities; ally, POs will increase in value when interest • Specific financial officer responsibility for and rates decline, while IOs increase in value when authority over securities activities involving interest rates rise. Accordingly, the purchase of high-risk mortgage securities; an IO strip may serve, theoretically, to offset the

September 1997 Branch and Agency Examination Manual Page 10 Securities Activities 3130.1 interest rate risk associated with mortgages and related to their effectiveness as a risk manage- similar instruments held by a branch. Similarly, ment vehicle. In other words, the highest yield- a PO may be useful as an offset to the effect of ing ABS residuals have limited risk manage- interest rate movements on the value of mort- ment value due to a complicated ABS structure gage servicing. However, when purchasing an and/or unusual collateral characteristics that IO or PO, the investor is speculating on the make modeling and understanding the economic movements of future interest rates and how cashflows difficult. Alternatively, those residu- these movements will affect the prepayment of als priced for modest yields generally have the underlying collateral. Furthermore, those positive risk management characteristics. SMBS that do not have the guarantee of a In conclusion, it is important to understand government agency or a government-sponsored that a residual cashflow is highly dependent agency as to the payment of principal and upon the prepayments received. Caution should interest have an added element of credit risk. be exercised when purchasing a residual inter- As a general rule, SMBS cannot be consid- est, especially higher yielding interests, because ered as suitable investments for all branches. the risk associated over the life of the ABS may SMBS, however, may be appropriate holdings warrant an even higher return in order to for branches that have highly sophisticated and adequately compensate the investor for the inter- well-managed securities portfolios, mortgage est rate risk assumed. Purchases of these equity portfolios, or mortgage banking functions. In interests should be supported by in-house evalu- such branches, however, the acquisition of SMBS ations of possible rate of return ranges in com- should be undertaken only in conformance with bination with varying prepayment assumptions. carefully developed and documented plans pre- Holdings of ABS residuals should be accounted scribing specific positioning limits and control for in the manner discussed under stripped arrangements for enforcing these limits. These mortgage-backed securities and should be plans should be approved by head office man- reported as Other Assets on regulatory reports. agement and their terms should be vigorously enforced. Some branches may account for their SMBS Other Zero Coupon or Stripped holdings in accordance with Financial Account- Products ing Standards Board Statement Number 91 (FASB No. 91), which requires that the carrying The interest and/or principal portions of U.S. amount be adjusted when actual prepayment government obligations are sometimes sold in experience differs from prepayment estimates. the form of stripped coupons, stripped bonds Other branches may account for their SMBS (principal), STRIPS, or propriety products, such holdings at market value or the lower of cost or as CATS or TIGRs. Original issue discount market value. bonds (OIDs) have also been issued by a number of municipal entities. Longer maturities of these instruments can exhibit extreme price Asset-Backed Securities Residuals volatility. Accordingly, disproportionately large, long-maturity holdings (in relation to the total Residuals are the excess of cashflows from portfolio) of zero coupon securities may be asset-backed securities (ABS) transactions after unsuitable for investment holdings for financial the payments due to the bondholders and the institutions. trust administrative expenses have been satisfied. This cashflow is extremely sensitive to prepayments and thus has a high degree of STRUCTURED NOTES interest rate risk. Generally, the value of residual interests in This sub-section highlights the growing use of ABS rises when interest rates rise. Theoretically, structured notes by banking organizations and a residual can be used as a risk management tool the need for examiners to ensure that banks that to offset declines in the value of fixed-rate hold these instruments do so according to their mortgage or ABS portfolios. However, it should own investment policies and procedures and be understood by all residual interest purchasers with a full understanding of the risks and price that the yield on these instruments is inversely sensitivity of these instruments under a broad

Branch and Agency Examination Manual September 1997 Page 11 3130.1 Securities Activities range of market conditions. Some of these structured notes should determine whether these instruments can expose investors to significant factors are compatible with their investment losses as interest rates, foreign exchange rates, horizons and with their overall portfolio and other market indices change. Accordingly, strategies. examiners should be mindful of these securities, There are a wide variety of structured notes, whether they are used in a branch’s trading, with names such as single- or multi-index float- investment, or trust activities. ers, inverse floaters, index-amortizing notes, Structured notes, many of which are issued by step-up bonds, and range bonds. These simple, U.S. government agencies, government- though sometimes cryptic, labels can belie the sponsored entities, and other organizations with potential complexity of these notes and their high credit ratings, are debt securities whose possibly volatile and unpredictable cashflows, cashflows are dependent on one or more indices which can involve both principal and interest in ways that create risk characteristics of for- payments. Some notes employ ‘‘trigger levels,’’ wards or options. They tend to have medium at which cashflows can change significantly, or term maturities and reflect a wide variety of caps or floors, which can also substantially cashflow characteristics that can be tailored to affect their price behavior. the needs of individual investors. The critical factor for examiners to consider is As previously noted, the federal bank regula- the ability of management to understand the tory agencies have established price and effec- risks inherent in these instruments and to man- tive maturity standards for mortgage-backed age the market risks of their institution in a products based on specified scenarios. Institu- satisfactory manner. Therefore, examiners should tions should ensure that they meet these regula- evaluate the appropriateness of these securities tory requirements and should employ similar branch-by-branch, with a knowledge of manage- techniques in controlling the exposures of struc- ment’s expertise in evaluating such instruments, tured notes. The scenarios specified for assess- the quality of the institution’s relevant informa- ing the market risk of these products should be tion systems, and the nature of its overall sufficiently rigorous to capture all meaningful exposure to market risk. This evaluation may effects of any options. For example, in assessing include a review of the institution’s ability to interest rate risk, scenarios such as 100, 200 and conduct stress tests. Failure of management to 300 basis point parallel shifts in yield curves understand adequately the dimensions of the should be considered as well as appropriate risks in these and similar financial products can non-parallel shifts in structure to evaluate poten- constitute an unsafe and unsound practice for tial basis, volatility and yield curve risks. banks. Structured notes may offer certain advantages When making investment decisions, some over other financial instruments used to manage institutions may focus only on the low credit market risk. In particular, they may reduce risk and favorable yields of these notes and counterparty credit risk, offer operating efficien- either overlook or underestimate their market cies and lower transaction costs, require fewer and liquidity risks. Consequently, where these transactions, and address more specifically an notes are material, examiners should discuss institution’s risk exposures. Risk to principal is their role in the institution’s risk management typically small. Accordingly, when they are process and assess management’s recognition of analyzed and managed properly, structured notes their potential volatility. can be acceptable investments and trading products for banks. Structured notes, however, can also have OTHER characteristics that cause them to be inappropriate holdings for many institutions. They can Resale and Repurchase Agreement have substantial price sensitivity; they can be Activities (REPOS) complex and difficult to evaluate; and they may also reflect high amounts of leverage relative to Repos typically involve short-term U.S. govern- fixed income instruments with comparable face ment securities purchased for the branch’s own values. Their customized features and embed- account or acquired under an agreement to resell ded options may also make them difficult to and then sold under the counterparties agree- price and can reduce their liquidity. Conse- ment to repurchase. The rate of interest received quently, branches considering the purchase of and paid is generally dictated by prevailing

September 1997 Branch and Agency Examination Manual Page 12 Securities Activities 3130.1 market rates. Profits are based on a small spread These transfers may be accomplished through between interest earned and interest paid. Since participations, purchases/sales, and asset swaps both the profit margin and inherent risk are with other affiliated or nonaffiliated entities. minimal, repos are generally used to satisfy a Examiners should be alert to situations where a branch’s short-term funding needs. A branch branch’s intention seems to be the concealment may attempt to improve profits by increasing the of low quality securities for the purpose of volume of such transactions by using the pro- avoiding examination scrutiny and possible clas- ceeds of completed transactions to finance an sification. Refer to the section on Credit Risk inventory of assets to be used in further repur- Management for further information. If situa- chase arrangements. An alternative method of tions are uncovered where it is determined that a increasing profits is to increase the earnings transfer of securities was undertaken for legiti- yield of the instruments employed in these mate reasons, the examiner should make certain transactions by lowering the quality or by mis- that the securities have been properly recorded matching the maturity of the resale and repur- on the books of the acquiring branch at a chase agreements. reasonable or fair market value during the Risks inherent in repos should be controlled examination of that branch. by policy guidelines that:

• Establish account limits. Selection of Securities Dealers • Require approximately matched asset and liability maturities with guidelines for acceptable Speculative activity often occurs when an invest- levels of asset and liability mismatches. ment portfolio manager follows the advice of • Provide for reasonable collateral margin and securities dealers who, in order to generate valuation techniques. commission income, encourage speculative prac- • Subject the underlying securities of a resale tices that are unsuitable for the investment agreement to periodic market valuation in portfolio. order to determine market exposure. It is common for investment portfolio man- • Mandate credit approvals for parties providing agers to rely on the expertise and advice of a securities acquired under agreements to resell. securities sales representative for recommenda- • Insist that characteristics of the money market tions of proposed investments, investment strat- instruments be compatible with the branch’s egies, and the timing and pricing of securities own investment standards. transactions. Accordingly, it is important for branch management to know the securities firms and the personnel with whom it deals.An investment manager should not engage in securities Other Issues for Examiner transactions with any securities dealer that is Consideration unwilling to provide complete and timely disclosure of its financial condition. Branch man- This section contains several important issues agement must review the dealer’s financial state- examiners should consider when examining ments and make a judgment about the ability of investment portfolios. It covers (1) transfers of the dealer to honor its commitments. An inquiry low quality securities, (2) the selection of secu- into the general reputation of the dealer also is rities dealers, and (3) unsuitable investment necessary. practices. Head office management should review and approve, or at least closely monitor, the list of securities firms with whom local branch man- Transfers of Low Quality Securities agement is authorized to do business.The following securities dealer selection standards are Low quality securities, broadly defined, include recommended but are not all inclusive. The depreciated or sub-investment grade securities dealer selection process should include: of questionable quality. As with other poor quality assets, the transfer of such securities • A consideration of the ability of the securities from the branch to another branch or financial dealer and its subsidiaries or affiliates to fulfill institution may be made to avoid detection and commitments as evidenced by capital strength classification during regulatory examinations. and operating results disclosed in current

Branch and Agency Examination Manual September 1997 Page 13 3130.1 Securities Activities

financial data, annual reports, credit reports, sider prohibiting employees who are directly etc. involved in purchasing and selling securities for • An inquiry into the dealer’s general reputation the branch from conducting their own personal for financial stability and fair and honest securities transactions with the same securities dealings with customers, including an inquiry firm employed by the branch unless approved of past or current customers of the securities and under periodic review by local and head dealer. office management. Local and head office man- • An inquiry of appropriate state or federal agement may also wish to adopt a policy appli- securities regulators and securities industry cable to officers or employees, concerning the self-regulatory organizations, such as the receipt of gratuities or travel expenses from National Association of Securities Dealers, approved dealer firms and their personnel. concerning any formal enforcement actions against the dealer or its affiliates or associated personnel. Objectionable Investment Practices • An inquiry, as appropriate, into the background of the sales representative to deter- Local and head office management is respon- mine his or her experience and expertise. sible for the prudent administration of branch • A determination of whether the branch has investments in securities. An investment port- appropriate procedures to establish possession folio traditionally has been maintained to pro- or control of securities purchased. Purchased vide earnings, liquidity, and a means of diversi- securities and repurchase agreement collateral fying risks. When investment transactions are should only be kept in safekeeping with sell- entered into in anticipation of taking gains on ing dealers when (1) local and head office short-term price movements, the transactions management is completely satisfied as to the are no longer characteristic of prudent invest- creditworthiness of the securities dealer, ment activities and should be conducted in a (2) the aggregate value of securities held in securities trading account. Securities trading is safekeeping in this manner is within credit viewed as an unsuitable activity when con- limitations that have been approved by local ducted in a branch’s investment account. Secu- and head office management for unsecured rities trading should take place only in a closely transactions and (3) at least two signatures are supervised trading account. Acquisitions of the required for the sale/release of the security. various forms of zero coupon, stripped obligations, and asset backed securities residuals will The process of managing relationships with receive increased regulatory attention and, securities dealers may affect the branch’s code depending upon the circumstances, may be con- of ethics or conduct as it relates to employee sidered unsuitable for a branch. activities. Specifically, the branch should con-

September 1997 Branch and Agency Examination Manual Page 14 Securities Activities Examination Objectives Effective date July 1997 Section 3130.2

1. To determine if policies, practices, proce- 5. To determine if the branch is properly dures, and internal controls regarding securi- accounting for its securities. ties activities are adequate. 6. To determine compliance with applicable 2. To determine if branch employees are oper- laws and regulations. ating in conformance with the established 7. To recommend corrective action when poli- internal and supervisory guidelines. cies, practices, procedures, or internal con- 3. To determine the scope and adequacy of the trols are deﬁcient or when violations of laws internal and external audit functions as it or regulations have been noted. relates to this area. 4. To determine the overall quality of the investment portfolio and how that quality relates to the soundness of the branch.

Branch and Agency Examination Manual September 1997 Page 1 Securities Activities Examination Procedures Effective date July 1997 Section 3130.3

1. If selected for implementation, complete or independently tested as a documented update the Internal Control Questionnaire part of the branch’s audit program, those for this section. prices should be accepted. If the inde- 2. Obtain a list of deficiencies noted in the pendence of the prices cannot be estab- previous examination report or by internal lished, test market values by reference to and external auditors, and determine if man- one of the following sources: agement has adequately addressed the • Published quotations, if available. deficiencies. • Appraisals by outside pricing services, 3. Review the branch’s investment policy and if performed. determine its adequacy. Ascertain whether • If market prices are provided by the the policy has been revised since the previ- branch and cannot be verified by ref- ous examination. erence to published quotations or other 4. Review the reconcilement of the investment sources, test those prices by using the security trial balances to the general ledger. comparative yield method to calculate 5. Review management reports for accuracy approximate yield to maturity as and completeness. follows: 6. Review policies for classifying transactions – Annual Interest as held to maturity, available for sale, or – Par Value and Book Value trading. – Number of Years to Maturity 7. Review policies for classifying investment – Branch Provided Market Price + Par securities for credit or transfer risk. Value 8. Obtain a list of securities categorized as d. Compare the branch provided market held to maturity, available for sale, and price and the examiner calculated trading including: approximate yield to maturity to an a. Descriptions of securities held (par, book, independent, publicly offered yield or and market values). market price for a similar type of invest- b. Names of issuers. ment with similar rating, trading volume, c. Issuers’ countries of domicile. and maturity or call characteristics. d. Interest rates. e. Investigate significant market value e. Pledged securities. variances. f. Internal credit rating. 10. To the extent practical under the circum- 9. Reflecting the scope of the examination, stances, perform a credit analysis of: select investments for review. If transaction a. Selected obligors on securities purchased volume permits, include all securities pur- under agreements to resell. chased since the prior examination in the b. All defaulted issues. population of items to be reviewed. Per- 11. Classify speculative and defaulted issues form the following procedures for each according to the following standards (except investment: those securities with transfer risk where a a. For rated issues: more severe classification may be warranted): • Compare the branch’s internal ratings a. The entire book value of speculative to the most recent published ratings. grade municipal general obligation secu- • Verify CUSIP. rities, which are not in default, will • Check prospectus. be classified substandard. Market depre- b. For unrated issues: ciation on other speculative issues • Perform a credit analysis to determine should be classified doubtful. The remain- if the issues can be considered ing book value usually is classified speculative. substandard. c. If market prices are provided to the b. The entire book value of all defaulted branch by an independent party (excludes municipal general obligation securities affiliates and securities dealers selling will be classified doubtful. Market depre- investments to the branch) or if they are ciation on other defaulted bonds should

Branch and Agency Examination Manual September 1997 Page 1 3130.3 Securities Activities: Examination Procedures

be classified loss. The remaining book c. Determine if the volume of trading value usually is classified substandard. activity in the investment portfolio seems c. Market depreciation on nonexempt stock unwarranted. If so: should be classified loss. • Review investment account daily led- d. Report comments should include: gers and transaction invoices to deter- • Description of issue. mine if sales were matched by a like • How and when each issue was acquired. amount of purchases. • Default date. • Determine whether the branch is financ- • Date interest paid to. ing a dealer’s inventory. • Rating at time of acquisition. • Compare purchase and sale prices with • Comments supporting the classification. independently established market prices as of trade dates, if appropriate. The 12. With regard to potential unsafe and unsound carrying value should be determined investment practices, review the list of by the market value of the securities as securities purchased and/or sold since the of the trade date. prior examination and: 13. Discuss with appropriate officer(s) and pre- a. Determine if the branch engages one pare report comments on: securities dealer or salesperson for virtu- a. Defaulted issues. ally all transactions. If so: b. Speculative issues. • Evaluate the reasonableness of the c. Incomplete credit information. relationship on the basis of the dealer’s d. Absence of necessary legal opinions. location and reputation. e. Significant changes in maturity • Compare purchase and sale prices to scheduling. independently established market prices f. Shifts in the rated quality of holdings. as of trade dates, if appropriate. g Concentrations. b. Determine if investment account securi- h. Unbalanced earnings and risk ties have been purchased from the considerations. branch’s own trading department. If so: i. Unsafe and unsound investment practices. • Independently establish the market j. Apparent violations of laws, rulings, and price, as of trade date. regulations (including compliance with • Review trading account purchase and FAS 115). sale confirmations and determine if the k. Market value depreciation, if significant. security was transferred to the invest- l. Weaknesses in supervision. ment portfolio at market price. m. Policy deficiencies. • Review controls designed to prevent 14. Update workpapers with any information gains trading. that will facilitate future examinations.

September 1997 Branch and Agency Examination Manual Page 2 Securities Activities Internal Control Questionnaire Effective date July 1997 Section 3130.4

Review the branch’s internal controls, policies, included on internal watch lists and subject practices, and procedures regarding purchases, to the same scrutiny as problem credits? sales, and servicing of the investment portfolio. 10. Are stress tests appropriately performed for The branch’s system should be documented in a high risk securities? complete, concise manner and should include, where appropriate, narrative descriptions, flowcharts, copies of forms used, and other pertinent information. For information on trading securi- CUSTODY OF SECURITIES ties, refer to the Trading Activities Manual. 11. Do procedures preclude the custodian of the branch securities from: a. Having sole physical access to securities? POLICIES b. Preparing release documents without the approval of authorized persons? 1. Has local and head office management c. Preparing release documents not subse- adopted written investment securities poli- quently examined or tested by a second cies that outline: custodian? a. Objectives? d. Performing more than one of the follow- b. Permissible types of investments? ing transactions: c. Diversification guidelines to prevent • execution of trades, undue concentration? • receipt or delivery of securities, d. Maturity schedules? • receipt and disbursement of proceeds? e. Limitations on quality ratings? 12. Are securities physically safeguarded to f. Policies regarding exceptions to standard prevent loss or unauthorized removal or policy? use? g. Valuation procedures and frequency? 13. Are securities, other than bearer securities, 2. Are investment policies reviewed at least held only in the name or nominee of the annually by local and head office manage- branch? ment to determine if they are compatible 14. Are bearer securities safeguarded with changing market conditions? appropriately? 3. Are securities designated at time of purchase as to whether they are held-to- maturity, available-for-sale, or trading? Who is responsible for the designation? RECORDS 4. Have policies been established governing the transfer of securities between the held- 15. Do subsidiary records of investment secu- to-maturity, available-for-sale, and trading rities show all pertinent data describing the accounts? Who is authorized to change a security; its location; pledged or unpledged security’s designation? status; premium amortization; discount 5. Do individual officers have set investment accretion; and interest earned, collected, limits? and accrued? 6. Do security transactions require dual 16. Is the preparation and posting of subsidiary authorization? records performed or reviewed by persons 7. Are investment securities subject to credit who do not also have sole custody of reviews prior to purchase, and are annual securities? reviews performed on nonrated issues and 17. Are subsidiary records reconciled, at least issues with significant deterioration? monthly, to the appropriate general ledger 8. Are securities purchases within prescribed accounts and are reconciling items investi- approval limits? gated by persons who do not also have sole 9. Are below investment grade securities custody of securities?

Branch and Agency Examination Manual September 1997 Page 1 3130.4 Securities Activities: Internal Control Questionnaire

PURCHASES, SALES AND to determine if the securities delivered are REDEMPTIONS the securities purchased?

18. Is the preparation and posting of purchase, sale, and redemption records performed or reviewed by persons who do not also have CONCLUSION sole custody of securities or authorization to execute trades? 21. Is the information covered by this ICQ 19. Are supporting documents, such as brokers’ adequate for evaluating internal controls in conﬁrmations and account statements for this area? If not, indicate any additional recorded purchases and sales, checked or examination procedures deemed necessary. reviewed subsequently by persons who do not also have sole custody of securities or 22. Based on the information gathered, evaluate authorization to execute trades? the internal controls in this area (i.e. strong, 20. Are purchase conﬁrmations compared to satisfactory, fair, marginal, unsatisfactory). delivered securities or safekeeping receipts

September 1997 Branch and Agency Examination Manual Page 2 Securities Activities Audit Guidelines Effective date July 1997 Section 3130.5

1. Verify the accuracy of the investment account • Determining the period to maturity or trial balances. call date. 2. Test the reconciliations of the trial balances • Calculating the amount of premium to the general ledger. remaining to be amortized or discount 3. If investments are held in safekeeping at remaining to be accreted. locations outside the branch, request the • Determining that book value is reflected safekeeping agent to provide lists of securi- properly in the general ledger. ties held including name, description, par • Investigating any discrepancies. value, interest rate, due date, pledge status, • Scanning previously tested amortization and payment date of next coupon. or accretion schedules for investments 4. Using appropriate sampling techniques, select acquired before the prior audit and certain investments and: investigating any significant departure a. For investments held at the branch: from these schedules. • Examine and count the securities. 5. Test gains and losses on disposal of invest- • Compare details of certificates to trial ment securities since the prior audit by sam- balances. pling investment sales records and: • If securities are pledged to secure the a. Determining sales price by examining branch’s liabilities, determine that they invoices or brokers’ advices. are properly segregated from other b. Checking computation of book value on securities. settlement date. • Determine if coupons are intact. c. Calculating gain or loss and tracing the • Investigate any discrepancies. amount to its proper recording in the b. For investments not held at the branch: general ledger. • Compare trial balance details to safe- d. Determining that the general ledger prop- keeping receipts and the safekeeping erly reflects the disposal of the investment agent’s confirmation list. and other related accounts. • Determine that pledge status, if any, is e. Determining that sales were approved by properly noted on the safekeeping agent’s local and head office management or a confirmation list. designated committee. • Investigate any discrepancies. 6. Test accrued interest by: c. For investments purchased since the prior a. Determining the branch’s method of cal- audit: culating and recording interest accruals. • Verify cost by examining invoices, bro- b. Determining that interest accruals are not ker’s advices, or other independent being made on defaulted issues. sources. c. Randomly selecting certain transactions • Determine that the securities were prop- and: erly recorded in the general ledger. • Determining the interest rate and last • Determine that purchases were approved interest payment date of coupons and by local and head office management. money market instruments. d. For investments purchased at a premium • Calculating accrued interest and com- or discount, test book value by: paring it to the trial balance(s). • Determining the branch’s method of 7. If the branch is engaged in mortgage-backed calculating and recording amortization or high risk securities, evaluate the interest of premiums and accretion of discounts. risk exposure associated with the various • Determining the gross amount of pre- instruments by performing independent stress mium or discount at purchase date. tests.

Branch and Agency Examination Manual September 1997 Page 1 Funds Management and Liquidity Effective date July 1997 Section 3200.1

Funds management is an essential element of that of the FBO. While a branch, on a stand sound planning and financial management for alone basis, may be able to obtain sufficient any financial institution. A sound basis for funding at a reasonable cost (by either increas- evaluating funds management requires under- ing funding sources or converting assets to standing the branch, its customer mix, the nature cash), from a market standpoint, there is no of its assets and liabilities, and its economic and distinction between the branch and the FBO. competitive environment. No single theory can Even if all of the branch’s assets consisted of be applied universally to all branches. The high-quality, liquid securities, liquidity would purpose of funds management is to ensure still be influenced by the market perception of adequate liquidity and effectively manage the the FBO as a whole. spread between interest earned and interest paid. In evaluating funds management and liquid- Therefore, funds management has two compo- ity, the examiner should begin with an under- nents: liquidity and interest rate risk manage- standing of the FBO’s current financial situation ment. This section primarily addresses liquidity. and be familiar with any potential liquidity Interest rate risk management is addressed in concerns that could affect the branch.1 Gener- Section 3210 of this manual, and should be read ally, if the FBO is in sound financial condition in conjunction with this section. and has satisfactory market ratings, the evaluation of liquidity at the branch will be a lesser concern. In such a case, the examiner should limit the analysis of liquidity to (1) reviewing LIQUIDITY information supporting the adequacy of liquidity at the FBO, (2) developing a thorough under- Liquidity is defined as the ability to meet asset standing of the branch’s funds management and and liability obligations without delay, including liquidity profile, and (3) reviewing how the the funding of loan commitments. In a sound branch’s funding and liquidity are guided and liquidity management system, it is essential for monitored, either directly or indirectly, by the a branch to provide for fluctuations in its bal- head office and/or a U.S. regional office. ance sheet and meet immediate or day-to-day In contrast, if the FBO’s current financial obligations as opposed to providing funds for condition or market perception raises concerns long-term growth. regarding funds management and liquidity, the A branch generally has both internal and examiner should conduct a more in-depth evalu- external sources of liquidity. Internal sources of ation of branch liquidity. The evaluation should liquidity include short-term, high-quality assets consider the branch’s funds management profile that are readily convertible to cash at a reason- with close attention to: (1) funding sources; able cost. External sources of liquidity include (2) liquidity and funding gaps; (3) funds man- borrowings from related offices of the foreign agement policy guidance from the head office; banking organization (FBO), other financial (4) current economic and market conditions; and institutions, and overnight or short-term (5) the adequacy of the contingency funding depositors. plan. The examiner should be prepared to make The price of liquidity is a function of general recommendations to address any identified or market conditions and the market’s perception potential concerns at the branch and, if appro- of the FBO. Generally, the higher the risk profile priate, at other U.S. or U.S.-managed or con- of the FBO, the higher the FBO’s cost of funds trolled offshore operations. and the greater its need to meet liquidity demands FBOs with multiple U.S. operations may cen- through the management of its liabilities. Gen- tralize funds management and liquidity at a erally, the market perception of the branch can regional U.S. office. The examination of such a be no better than the market perception of the regional U.S. office, therefore, should include an FBO. evaluation of funds management and liquidity

1. This information is available to examiners as a part of the FBO’s annual strength of support assessment. Examiners BRANCH/FBO RELATIONSHIP should review this assessment as a part of the pre-examination planning process, and be prepared to consider this information Liquidity at a branch is closely integrated with in evaluating the branch’s funds management and liquidity.

Branch and Agency Examination Manual September 1997 Page 1 3200.1 Funds Management and Liquidity for the branch’s entire area of responsibility, additional information on funding transactions including any U.S.-managed or controlled off- with related parties, refer to Section 3240, Due shore operations. From/Due To Related Parties. The evaluation of funds management and liquidity should also consider the branch’s cost and distribution of funds; economic and market FUNDS MANAGEMENT AND trends; levels of liquid assets; future earnings LIQUIDITY PROFILE capacity; asset quality; concentrations; customer mix; the nature and mix of its assets and The examiner should understand and evaluate liabilities, including maturity, currency and the branch’s funding and liquidity profile. repricing mismatches; and its anticipated fund- Regardless of the condition of the FBO, the ing needs. Generally, these considerations are branch’s funding profile, or whether the branch more significant if the branch manages its own manages its own funding needs, this review funding and liquidity needs. should begin with an understanding of the FBO’s funds management guidelines and practices for The remaining discussion is applicable to the branch. Head office should provide branch branches that are not simply net users of funds management with funds management and liquid- and have some degree of control over their ity guidelines and some method of daily moni- funds management. toring compliance with these guidelines. Gener- ally, the greater the complexity of the branch or its responsibilities in funds management and liquidity, the more comprehensive the guide- POLICY GUIDANCE lines and monitoring practices. A major point to consider in evaluating branch Branch management is expected to maintain liquidity is whether the FBO views the branch as policies and procedures approved by head office a net user or provider of funds. The examiner that facilitate the development of funding and should determine if the FBO has been a consis- liquidity strategies. Policies and procedures tent supplier of funds, or whether the branch acts should provide an outline of goals regarding the as a dollar funding vehicle for the FBO. This FBO’s asset and liability management, liquidity, determination, which is particularly important if off-balance-sheet exposure, degree of risk toler- the FBO raises liquidity concerns, will be evi- ance, and other relevant factors. The individual dent from the trend in the net ‘‘Due From’’ or committee responsible for funds management position with related parties. The examiner decisions, including monitoring anticipated fund- should review a period of branch quarterly ing needs, funding strategies, guidelines and Reports of Assets and Liabilities (FFIEC 002) to limitations, should be specified in the policies determine the direction, volume, and frequency and procedures. The depth of these policies and of the flow of funds between the branch and its procedures will depend upon the degree to head office or other related parties, including which branch management is responsible for U.S.-managed or controlled offshore operations. funds management. In some cases, the head The examiner should take into consideration office or U.S. regional management is largely that an analysis of quarter-end reports may not responsible for funds management at the branch. provide a true picture of ongoing activities due In other cases, responsibility rests with local to certain types of balance sheet window dress- branch management. ing activities employed by the branch. Average Policy statements should address limitations statements of condition should be obtained in on funding sources to avoid a concentration to order to get a true picture of branch liquidity any one source or grouping. They also should over time. From a supervisory viewpoint, a net identify alternative funding sources, the degree due to position is regarded more favorably than of support dictated by the FBO, and the nature a net due from position because it provides a of that support. Interest rate sensitivity match- cushion for nonrelated depositors and creditors. ing, maturity matching, and the use of financial However, any recommendations related to the derivatives may be addressed under these poli- branch’s funding role should be considered in cies or in a separate interest rate risk policy. relation to the FBO’s overall financial condition Written procedures should provide staff with a and other factors discussed in this section. For reference document on the day-to-day proce-

September 1997 Branch and Agency Examination Manual Page 2 Funds Management and Liquidity 3200.1 dures in funding and provide for a system of a good reputation affords its branches easier internal control in critical areas, such as separa- access to funds at market rates. tion of duties, proper completion of reports, and The ability to obtain additional funding monitoring of limits. Refer to Interest Rate Risk sources represents liquidity potential. The mar- Management, Section 3210 for additional infor- ginal cost of liquidity or the cost of incremental mation on policies and procedures. funds acquired is of paramount importance in evaluating liability sources of liquidity. Consid- eration must be given to factors such as how MANAGEMENT INFORMATION frequently the branch must regularly refinance SYSTEMS maturing liabilities and an evaluation of the branch’s ongoing ability to obtain funds under An effective Management Information System normal market conditions. The obvious diffi- (MIS) is integral to making sound funds man- culty in estimating the latter is that until the agement and liquidity decisions and is a factor branch goes to the market to borrow, it cannot in evaluating the branch’s financial controls. determine with complete certainty that funds Reports containing certain basic information will be available at a price that will maintain a should be prepared and reviewed regularly by positive yield spread. Changes in money market management. Report content and format will conditions or the FBO’s reputation and/or finan- vary among branches; however, an effective cial strength may cause a rapid deterioration in a MIS will contain reports detailing liquidity needs branch’s capacity to borrow at a favorable rate. and the sources of funds available to meet those In this context, liquidity potential represents the needs. Typically MIS may include the follow- ability to attract funds in the market, when ing: the maturity distribution of assets and needed, at reasonable cost compared to asset liabilities, and the related gaps, including maxi- yield. mum and minimum liquidity needs; expected Frequently, the base rate for funding costs on funding of commitments; asset yields; liability money market transactions is available only to costs; net interest margins and variances (both the largest and most financially sound institu- from prior months and budget); funding vol- tions. Some branches may pay in excess of the umes by liability, customer, market, and base rate for money market funds, with the overnight/short-term funds; and exceptions to differential denoting the market’s perception of policy guidelines and limits. Refer to Section the FBO and home country conditions. The size 3410, Management Information Systems, for of the premium compared to other FBOs can be additional information. a rough indication of the stability of funding sources in this market. As indicated earlier, if the FBO carries a rating of AAA or AA by an independent rating agency, it is unlikely that FUNDING AND LIQUIDITY funding and liquidity will be an examination PRACTICES issue. If the FBO carries a lower rating or has no market presence, the probability that there may A branch responsible for its own funding and be funding and liquidity concerns grows propor- liquidity needs may meet those needs by tionately and funds management and liquidity manipulating its asset structure through the sale are more critical. or planned runoff of short-term or readily marketable assets. As an alternative, the branch could transfer to the head office or other related offices, a block of assets that would serve to FUNDING AVAILABILITY reduce its asset base and increase liquidity. As a matter of general practice, however, a branch Management at the branch and head office must can meet its liquidity needs by manipulating its be constantly aware of the composition, charac- liability structure to access discretionary fund- teristics, and diversification of its funding ing sources or derive funds from its intercom- sources. If possible, the branch should secure pany funding base. The ability of a branch to funding lines from multiple sources. In certain access discretionary funding sources is ulti- instances, the branch may be using suballocated mately a function of the position and reputation lines from its head office. With multiple source of the FBO in the money markets. An FBO with advised discretionary lines of credit, the branch

Branch and Agency Examination Manual September 1997 Page 3 3200.1 Funds Management and Liquidity is much better positioned to manage usage and could defeat the attempts of the FBO to aid the rotation in order to ensure availability of funds branch in the event of a liquidity crisis. For this at competitive pricing. The role of the FBO in reason, the examiner should investigate home this circumstance would be to provide backup country funding restrictions. resources and to be the ultimate lender for contingency purposes. Nevertheless, many interbank credit agreements contain escape provisions, known as mate- TRANSFER RISK rial adverse change clauses, that enable the CONSIDERATIONS lending bank to refuse to allow the borrowing bank to draw on advised credit lines. Banking The stability and availability of funding should organizations experiencing considerable prob- be related to the distribution of assets, taking lems, particularly those relating to asset quality into consideration certain assets subject to trans- and/or liquidity, have found that these facilities fer risk. Potential liquidity problems may exist are no longer available. Such escape provisions when a branch relies heavily on the U.S. money should be considered in the assessment of funds market for funding, while its assets are concen- management and liquidity. trated in a country with serious economic problems. In such a case, the branch is typically in a net due from position with the FBO and prob- CONTINGENCY FUNDING lems may arise if the FBO or borrowers do not have ready access to U.S. dollars to meet their obligations. Refer to Section 6020, Transfer Examiners should determine if management at Risk, for additional information. the branch has an effective contingency plan that identifies minimum and maximum liquidity needs both in normal and adverse market conditions, and weighs alternative courses of action OFF-BALANCE-SHEET to meet these needs. The branch may rely on CONSIDERATIONS back-up funding lines or support from the head office or other related offices to meet unforeseen The nature, volume and anticipated usage of liquidity demands. In this case, examiners should off-balance- sheet activity must be factored into comment on the FBO’s ability to meet these the assessment of funds management and liquid- needs. ity. The potential for funding contingent liabilities varies widely, but the most likely to require funding are loan commitments. Economic con- HOME COUNTRY FUNDING ditions and the business cycle may also influ- RESTRICTIONS ence anticipated usage. The branch should have sufficient existing funding sources to provide for An FBO’s home country may impose restric- anticipated usage, in view of the nature and tions on capital outflows. Such impediments volume of its contingent liabilities.

September 1997 Branch and Agency Examination Manual Page 4 Funds Management and Liquidity Examination Objectives Effective date July 1997 Section 3200.2

1. To assess the branch’s ability to obtain stable for liquidity and if the branch can effectively funding sources from related and unrelated meet anticipated and potential liquidity needs. parties. 4. To determine if internal management reports 2. To determine if reasonable local policies, provide the necessary information for procedures, and parameters have been estab- informed liquidity decisions and monitoring lished and approved by the head office for their results, and that reports are regularly the branch’s liquidity position and if the provided and reviewed by head office. branch is operating within those established 5. To recommend corrective action when poli- guidelines. cies, practices, procedures, or internal con- 3. To evaluate the management of assets, liabili- trols are deficient or when violations of law ties, and off-balance-sheet positions to deter- or regulations have been noted. mine if management is planning adequately

Branch and Agency Examination Manual September 1997 Page 1 Funds Management and Liquidity Examination Procedures Effective date July 1997 Section 3200.3

1. Evaluate the funding relationship between b. Evaluating primary and secondary sources the branch and the FBO. Consider the rea- of funds. sons why the branch is in a net due from or c. Determining whether funding and liquid- due to position with related offices and affili- ity requirements are factored into the bud- ates of the FBO. geting process and are based on growth 2. Review the Funds Management and Liquid- projections, changes in the branch’s asset ity policies, practices, and procedures and and liability mix, and other anticipated test for compliance. Ensure that there are: changes. a. Lines of authority and responsibility for 4. Evaluate the effectiveness of the internal liquidity management decisions. management reporting system in providing b. Formal mechanisms to coordinate funds for adequate liquidity management. management and liability decisions. 5. Discuss the following issues with manage- c. Methods to identify liquidity needs and ment and summarize findings in the workpa- the means to meet those needs. pers and, to the degree necessary, for the d. Guidelines for the level of liquid assets examination report: and funding sources in relation to antici- a. The quality of the branch’s planning and pated and potential needs. the current ability of the branch to meet e. Appropriate controls and supervision of anticipated and potential liquidity needs. the volume of loan commitments and b. The quality of administrative control and other off-balance sheet exposure that may internal management reporting systems. impact funding and liquidity. 6. Update the workpapers with any information 3. Determine if management has planned prop- that will facilitate future examinations. Dis- erly for liquidity and if the branch has cuss with senior branch management the adequate sources of funds to meet anticipated findings of the examination regarding the or potential needs by: branch’s funding and liquidity policies and a. Reviewing the internal management reports practices, and document the discussion in the detailing liquidity requirements and sources workpapers. of liquidity.

Branch and Agency Examination Manual September 1997 Page 1 Funds Management and Liquidity Internal Control Questionnaire Effective date July 1997 Section 3200.4

1. Is the FBO in less than satisfactory condi- making ongoing liquidity management tion and subject to liquidity concerns? decisions and for monitoring the results of 2. Is the FBO subject to market disciplinary those decisions? pricing? 7. Do management reports include the follow- 3. Does the FBO’s home country impose ing: restrictions on capital outflows? a. Maturity distribution of assets and 4. Has the branch and head office manage- liabilities? ment, consistent with its duties and respon- b. Expected funding commitments? sibilities, adopted funds management poli- c. Asset yields and liability costs? cies, practices and procedures which include: a. Lines of authority, and responsibility d. Net interest margin and variance analysis for funds management and liquidity (e.g., previous month, quarter, year-to- decisions? date and budget reporting)? b. A formal mechanism to coordinate funds e. Funding volumes by type of liability management and liquidity decisions? (e.g., overnight/short-term funds), cus- c. A method to identify funding and liquid- tomer and market? ity needs and the means to meet those f. Exceptions to policy guidelines and needs? limits? d. A contingency funding plan that pro- 8. Does the planning and budgeting function vides guidelines for the level of liquid consider funding and liquidity requirements? assets and other sources of funds in 9. Does the branch’s contingency funding plan relationship to anticipated and potential address: needs? a. Minimum and maximum liquidity needs e. An adequate system of internal controls and alternative courses of action to meet in critical areas, such as separation of those needs? duties, proper MIS reporting and moni- b. Alternative sources of funding? toring of limits? c. Orderly asset liquidation? f. Transfer risk considerations? 5. Does the FBO view the branch as net user 10. Have adequate discretionary (back-up) lines or provider of funds? of credit been established? If the branch is a net user of funds: 11. Are advised discretionary lines of credit a. Does the branch have a funding and containing adverse change clauses consid- liquidity profile that identifies the branch ered by branch management in its contin- as a non-risk taker? gency funding plan? b. Are funds management and liquidity 12. Is the information covered by this ICQ decisions centralized at an FBO location adequate for evaluating internal controls in within the U.S. that is subject to regula- this area? If not, indicate any additional tory supervision? examination procedures deemed necessary. If the branch is a net provider of funds, 13. Based on the information gathered, evaluate answer the following questions; otherwise the internal controls in this area (i.e., strong, proceed to question 12. satisfactory, fair, marginal, unsatisfactory). 6. Have internal management reports been prepared that provide an adequate basis for

Branch and Agency Examination Manual September 1997 Page 1 Interest Rate Risk Management Effective date July 1997 Section 3210.1

Interest rate risk (IRR) is an aspect of normal ences in the maturities or repricing dates of asset banking operations that became increasingly and liability positions, and cash flows. However, important in the United States with the deregu- risk may remain in a given branch’s portfolio in lation of interest rates in the early 1980s. The which long and short positions of different phaseout of interest rate controls and increased maturities are well hedged against a uniform competitiveness, the latter of which was partly change in all interest rates, but not against a due to the growing presence of foreign banks in change in the shape of the yield curve where U.S. markets, significantly increased the flexibil- interest rates of different maturities change by ity of banks in adjusting their IRR profiles. This varying amounts. This type of risk is called flexibility has been further enhanced by the ‘‘yield-curve risk.’’ Similarly, a branch may be development of new financial instruments used well hedged against yield curve risk but exposed to hedge against or profit from interest rate to ‘‘basis risk,’’ in which the prices of particular changes. assets and liabilities, as well as hedging instru- In order to maintain profitability, safety, and ments, are not perfectly correlated. For example, soundness, institutions should fully comprehend three-month interbank deposits priced at LIBOR, the risks associated with changes in interest three-month Eurodollars and three-month Trea- rates and should have adequate policies and sury bills all pay three-month interest rates. systems in place for controlling these risks. In However, these three-month rates are not per- this regard, the branch and its head office fectly correlated with each other and spreads management both have important responsibilities. between their yields may vary over time. As a The head office is responsible for providing result, three-month Treasury bills, for example, clear policy guidance to branch management on funded by three-month interbank deposits are controlling and monitoring IRR. The policies not a perfectly hedged position. Given a rise or provided to branch management by the head decline in interest rates, a branch’s interest rate office should indicate acceptable levels of risk- exposure can be viewed as the potential for taking, given the branch’s role in the foreign change in its reported earnings. banking organization (FBO), and establish pro- Focusing on the sensitivity of a branch’s cedures and controls to ensure that there is an reported earnings to changes in interest rates adequate system for measuring IRR and moni- represents an accounting perspective of IRR toring compliance with established limits. In assessment. In general, this approach involves this regard, there should also be a reporting assessing the effect that changing rates might process that demonstrates adherence with estab- have on the revenues produced by interest- lished limits and an adequate system of internal earning assets, the expense of interest-bearing controls. liabilities, and the resulting net interest income It is recognized that, as part of a larger entity, of the branch. Risk to current earnings measures IRR management for certain branches may be the timing of income effects, which can help risk centralized within the FBO. Whether or not the managers determine what action to take regard- branch is responsible for managing its IRR, ing exposure. there should be evidence at the branch, in the form of IRR policy guidelines, management reports, etc., showing how this risk is being effectively identified, measured, and controlled RISK MEASUREMENT for the branch. The following discussion pro- TECHNIQUES vides an overview of IRR considerations, which the examiner should use in reviewing, to the Branches can use a variety of methods to mea- extent applicable, this area of risk within the sure their IRR exposure. The three most com- branch. mon generic methods are maturity gap analysis (used to measure the interest rate sensitivity of earnings), duration analysis, and simulation mod- INTEREST RATE RISK eling. While these methods highlight different facets of IRR, many branches use them incom- IRR is defined as a branch’s vulnerability to bination or use hybrid methods that combine changes in interest rates. IRR arises from differ- features of each.

Branch and Agency Examination Manual September 1997 Page 1 3210.1 Interest Rate Risk Management

Maturity Gap Analysis ments, the value of which can change dramatically without affecting short-term interest income. Maturity gap analysis begins with constructing a Some simple forms of maturity gap analysis maturity gap report. This report categorizes identify only the amount of assets and liabilities asset and liability accounts, including off- at risk and ignore basis risk. Basis risk refers to balance-sheet items, according to the time the likelihood that changes in interest rates a remaining to their maturities in specific time branch pays on liabilities and earns on its assets periods, known as repricing buckets. These are not perfectly correlated. That risk is present, buckets vary from branch to branch, but most even when the assets and liabilities are matched branches include time bands of overnight, over- in terms of their maturity or repricing periods. night to one month, one month to three months, Despite these shortcomings, most branches use three months to six months, six months to one maturity gap analysis or some variant, as one year, and beyond one year. Categorizing assets component of IRR measurement. Many branches and liabilities lacking definitive repricing time elaborate on the simple gap framework in order frames into specific time periods (or buckets) to gain insight into the more complex aspects of varies by institution. As a result, the assump- IRR. tions used by each institution should be reviewed While the maturity gap of an institution is a by the examiner to ensure that they are reason- widely used indicator of IRR, it is not a suffi- able. This approach reflects the accounting or cient measure for gauging overall exposure current earnings orientation of gap reports. when taken alone. A branch’s condition and For each time period or bucket, rate-sensitive size, complexity of the balance-sheet and off- liabilities (RSL) are subtracted from rate- balance-sheet activities (if any), degree of com- sensitive assets (RSA) to yield the dollar matu- petition, and sophistication of the markets being rity mismatch or gap . The gap measure is either served also must be considered. For example, a a positive or negative dollar amount and is the small, retail-oriented branch may have moder- primary tool used to assess the impact of changes ately large negative gap positions but may not in interest rates on the institution’s net interest be exposed to major risks. Factors that may income. minimize such risks are the branch’s strong core deposit base within its target market. A negative gap (liability sensitive) indicates that more liabilities than assets will reprice in a given time period. During periods of rising interest rates, net interest income would be Duration Analysis adversely affected because the interest expense on liabilities during that period would show a Duration analysis is used to calculate the greater increase relative to the increase in inter- weighted average maturity of the cash flows est earnings on assets. If rates decline, a bank emanating from financial instruments. In con- with a negative gap would expect its earnings to trast to the simple average nominal cash flows, be enhanced because more liabilities than assets duration provides more meaningful, analytical would reprice at lower rates. measures of a stream of cash flows. The duration Conversely, a positive gap (asset sensitive) measure can be used to calculate the percentage indicates that more assets than liabilities will change in the present value of a stream of cash reprice in a given time period. In this case, flows that is generated by a one percentage point earnings tend to increase as interest rates increase change in interest rates. Duration analysis can because more assets than liabilities reprice at measure the exposure of a branch’s current higher rates. income to changes in interest rates. The maturity gap of an institution is the most Duration analysis can complement gap analy- basic measure of IRR. It is a static measure that sis. Using gap repricing data and selected rate assumes the current balance sheet remains con- data, duration provides a more accurate measure stant through time and a given change in interest of IRR. Duration analysis, unlike gap analysis, rates is not reversed over time. For this reason, accounts for the time value of money by calcu- it may not accurately reflect a branch’s true risk lating the present value of future cash flows. In exposure. In addition, its emphasis on the risk to so doing, it properly aggregates the branch’s short-term earnings inadequately addresses the repricing mismatches or gaps. Thus, duration rate sensitivity of longer-term fixed rate instru- can be used to analyze the risk standing of a

September 1997 Branch and Agency Examination Manual Page 2 Interest Rate Risk Management 3210.1 branch with a complicated series of repricing internal and external environment, the results mismatches. Like gap analysis, duration analy- obtained will not be meaningful. sis generally assumes that the repricing structure of a branch’s assets and liabilities remains constant. In addition, duration analysis requires information on cash flows that may not always ASSESSMENT OF IRR be available. MANAGEMENT Used in conjunction with maturity gap analysis, duration analysis can add significant insights Examiners should focus on the presence of clear into the IRR exposure of an institution. How- and comprehensive policies with corresponding ever, duration also has some limitations, in appropriate internal controls when assessing the particular: management of IRR. The policies should outline the following: the objectives of risk manage- • The duration measure becomes less accurate ment, clear lines of authority and communica- as the amount of the interest rate change tion, and limits on the vulnerability of net increases; interest income to changes in interest rates. Risk • The duration of different instruments will management systems and procedures should be change at different rates as time passes, result- adequate and consistent with the stated policies ing in a hedged position becoming unhedged of risk management. over time; and, Strong internal management controls need to • Duration alone does not address the dispersion be maintained given the potential impact of of cash flows in a branch’s portfolio. interest rate exposure on a branch’s earnings. These controls include policies, risk measurement systems, and reporting mechanisms. Each Simulation Modeling of these should be reviewed from two perspectives: Simulation techniques attempt to overcome the limitations of both the static gap and duration • Does management understand and effectively measures by computer-modeling the branch’s administer IRR controls? interest rate sensitivity. Such modeling involves • Do these controls establish reasonable param- making assumptions about the future course of eters considering the specific IRR profile of interest rates and changes in a branch’s business the branch? activity and estimating their effect on the branch’s net interest income. Branches can In larger branches, IRR may be managed by develop their own simulation packages or choose an Asset/Liability Management Committee from a variety of commercially available (ALCO), which is composed of senior branch packages. managers who represent units that undertake A simulation model can provide branch man- IRR. ALCO is responsible for formulating and agement with an important tool for understand- administering branch strategy with regard to ing the measurement of, and assisting in the IRR, which is based on management’s view of management of, IRR, and for evaluating the the future interest rate environment, the branch’s branch’s exposure under a variety of interest relative ability to adjust to changing market rate scenarios. Simulation techniques can also conditions, and the head office’s risk-acceptance play an integral planning role in evaluating the level. The activities of ALCO, including the effect of alternative business strategies on risk implementation of IRR policies, should be exposure. Unlike other methods, simulation can reviewed for approval by the head office. anticipate the effect of changes in customer Additionally, in the cases where IRR manage- behavior induced by interest rate changes (such ment is centralized at a particular branch of the as time deposit rollovers, in retail branches). FBO, the following question must be consid- The usefulness of simulation techniques ered: Is the process of transferring a given depends on the validity of the underlying branch’s IRR to the portfolio of the branch assumptions and the accuracy of the basic struc- housing the centralized IRR management func- ture upon which the model is run. If these tion adequately governed by appropriate poli- assumptions do not fairly reflect the branch’s cies and accurate reporting mechanisms?

Branch and Agency Examination Manual September 1997 Page 3 3210.1 Interest Rate Risk Management

POLICIES (as previously discussed) and management’s adaptation and analysis of that assessment. These The need for established and properly super- systems should be: vised IRR policies has increased greatly in recent years. An adequate policy facilitates the • Consistent with established limits; development of a prospective plan that consid- • Comprehensive, covering the rate risk associ- ers the branch’s goals regarding its asset and ated with all asset, liability, and off-balance liability mix, off-balance-sheet activities, liquid- sheet accounts; ity, risk tolerance, and other relevant factors. • Capable of identifying excessive exposure; The policy should establish responsibility for • Capable of measuring the impact of rate IRR management decisions and provide a mecha- changes on the branch’s chosen target nism for the necessary coordination among dif- account(s); ferent departments of the branch, or between • Flexible, so that the introduction of new different branches of the FBO, as appropriate. instruments and changes in strategy can be In addition to establishing responsibility for absorbed and accounted for; and, planning and day-to-day IRR decisions, the • Able to suggest strategies for corrective action. policy should set forth certain guidelines:

• Interest rate exposure limits should be established relative to reasonable forecasts and REPORTING MECHANISMS assumptions; • Limits should be based on the potential impact Strong lines of communication and authority are of interest rate changes on the branch’s net essential to the timely execution and adjustment interest income; of a branch’s IRR strategy because earnings can • Individual limits should be set for units that be rapidly eroded by unexpected rate changes. incur IRR; In particular, when risk management responsi- • Clear lines of authority and communication bilities are delegated to those most familiar with should be established for the implementation particular products or markets, the need for and execution of strategies; and, communication becomes stronger, so that posi- • For those branches that are not authorized to tions in one market are not excessively magni- incur or manage IRR, the policy should clearly fied by positions elsewhere. outline procedures for accurately and effec- Coordination between the branch and head tively transferring the IRR incurred by its office management and business units that incur normal business activities to a designated IRR is essential to the successful control of IRR. branch or other office of the FBO responsible This is especially important when the business for the centralized management of IRR. unit incurring IRR is another branch of the FBO. Controls should focus on the following: In most cases branches accomplish the transfer of IRR incurred by a given transaction by • Branch and head office management should be entering into an offsetting, "mirror" transaction regularly apprised of the nature and results of with the office responsible for managing the risk management decisions undertaken by the branch’s IRR. As an example, if a branch branch; entered into a five-year, fixed- rate loan, it could • Branch and head office management should be book a five-year, fixed-rate liability to the related provided with periodic status reports detailing office to fund the loan; the maturity and princi- risk exposure; pal amount should be matched. • Treasury management should have periodic contact with branch line managers responsible for undertaking risk; RISK MANAGEMENT SYSTEMS • Risk-taking units should be aware of limits established by head office and/or branch man- The effectiveness of assessing IRR through the agement, with limit exceptions regularly moni- use of a risk management system depends to a tored and communicated to senior manage- large degree on the branch’s ability to measure ment; and, its exposure. Risk management systems are • Units not allocated risk limits should provide based on a quantitative assessment of exposure the branch responsible for its IRR manage-

September 1997 Branch and Agency Examination Manual Page 4 Interest Rate Risk Management 3210.1

ment with reports detailing not only the unit’s cases, a FBO may have to pay an additional current positions, but potential or planned spread over interbank rates for perceived coun- transactions, as well. try risk, liquidity risk, or credit risk. For branches required to pay such additional spreads, the size and volatility of these premiums should be PRICING considered in the institution’s pricing mechanism.

Conclusions drawn from the analysis of the branch’s interest rate sensitivity position rest upon the assumption that the branch has an HEDGING adequate asset-pricing mechanism. A pricing mechanism that is not attuned to the branch’s The examiner should keep in mind that risk may cost of funds, overhead costs, and credit risk be reduced by hedging activities when determin- will not allow the branch to maintain an adequate ing the extent of IRR exposure at the branch. net interest margin on an ongoing basis. Thus, These activities may be explicit and easily the examiner should bear in mind the interde- quantifiable or they may be implicit and difficult pendence of pricing methods and interest rate to measure from the branch’s management sensitivity when assessing the branch’s ability to information system. maximize and maintain the spread between Types of explicit hedging activities include interest earned and interest paid. instruments such as futures, interest rate swaps, An important component of pricing is the cost forwards, options, and various hybrid products. of funds. Bankers generally price from either the Types of implicit hedging might include interest average cost of funds or the marginal cost of rate caps and floors on commercial loans; limits funds. The average cost of funds is a weighted on the amount of rate adjustment allowed for average of all of the rates paid on interest- products, such as adjustable rate mortgages; or bearing liabilities. The marginal cost of funds is even investment policies that might set internal defined as the cost of the additional funds stop loss limits on various longer-term portfolio needed to support asset growth and is consid- positions. Explicit hedging strategies can either ered by many bankers to be the more econom- be matched to a specific asset or liability ically appropriate method. This view is taken (‘‘micro’’ hedges) or be designed to reduce the because funds on the balance sheet already overall level of risk in a position (‘‘macro’’ or support assets held and the cost of those funds ‘‘portfolio’’ hedging). should not enter into the pricing decision for Institutions engaged in hedging activities new assets. should have clearly defined policies that outline The marginal cost of funds is not, however, specific hedge strategies and explain how those always the best method of pricing because the strategies reduce risk. Individuals responsible branch may be replacing assets, instead of for hedging activity should be designated and growing. If the branch is only changing its asset overall position limits should be established. mix to compensate the organization for its credit Internal controls should be established to include risk, its average cost of funds, plus overhead and a system that measures the degree to which a repricing considerations, represent a more hedge is meeting its stated objective of reducing appropriate pricing measure. Additionally, mar- risk (hedge effectiveness). Finally, branch man- ket forces, which include the demand for and agement should regularly provide reports to the availability of funds, should be considered as head office that, at a minimum, show gains or complements to cost factors when making pric- losses on hedge instruments and estimates of ing decisions. The market in which the branch hedge effectiveness. operates often dictates the pricing mechanism Finally, some entities now use derivative used. instruments in managing IRR. The individual Branches most often obtain funds from the regulatory agencies have issued policy state- domestic interbank money market; however, ments regarding derivative instruments. The offshore sources, including related branches and examiner should consult with his/her respective the head office, are frequently used. In many agency for guidance.

Branch and Agency Examination Manual September 1997 Page 5 Interest Rate Risk Management Examination Objectives Effective date July 1997 Section 3210.2

1. To evaluate the policies regarding interest 4. To determine if internal management report- rate risk (IRR) formulated by branch and ing systems provide the information neces- head office management, including the limits sary for informed interest rate management established for the branch’s IRR profile. decisions. 2. To determine if the branch’s IRR profile is 5. To recommend corrective action when inter- within those limits. est rate management policies, practices, pro- 3. To evaluate the management of the branch’s cedures, or internal controls are deficient in IRR, including the adequacy of the methods controlling and monitoring IRR. and assumptions used to measure IRR.

Branch and Agency Examination Manual September 1997 Page 1 Interest Rate Risk Management Examination Procedures Effective date July 1997 Section 3210.3

1. Determine if there were concerns in the eters used in the measurement system(s), previous examination report regarding IRR, and whether this individual or committee and if corrective action was required. reviews the principal assumptions and 2. Determine if IRR is managed at the branch parameters on a regular basis and updates level or at another level within the FBO. them as needed. a. If IRR is managed at the branch level, c. Determine who is responsible for imple- proceed to procedure #3. menting strategic decisions. Ensure that b. If IRR is managed at a higher level the scope of that individual’s authority is within the FBO: reasonable. Determine if any one indi- • Determine if adequate procedures are vidual exerts undue influence over the in place for any activities at the branch economic forecasts and management which are required by the managing decisions. level within the FBO (i.e. personnel d. Assess branch management’s knowledge authorized and steps necessary for call- of IRR in relation to the size and coming in funding requirements). plexity of the branch. In particular, assess • Provide a description of the activities management’s understanding of the meth- conducted by the managing level ods used by the branch to measure the within the FBO. risk. • Proceed to procedure #10. e. Determine if new products or hedging 3. Review the branch’s written policies and instruments are adequately analyzed procedures for reasonableness. At a mini- before purchase. mum, policies should cover: 6. Assess senior management (i.e. lead U.S. a. Definition and measurement of accept- office for FBO or head office) oversight of able risks, including acceptable levels of IRR management. The assessment should interest rate exposure. include the following: b. Net interest margin goals. a. Determine how frequently the policy is c. Sources and uses of funds. reviewed and approved by senior man- d. Off-balance-sheet activities that affect agement (at least annually). interest rate exposure. b. Determine whether the results of the e. Responsibilities within the branch for measurement system provide clear and IRR management activities. reliable information and whether the f. Reporting mechanisms. results are communicated to senior man- 4. Evaluate the internal controls and/or the agement at least quarterly. Reports to internal audit function. Determine whether senior management should identify the internal mechanisms are adequate to ensure branch’s current position and relation- compliance with established limits on IRR. ship to policy limits. Prepare a brief description of the branch’s c. Determine the extent to which excep- internal controls/audit for IRR management tions to policies and resulting corrective and identify areas in need of improvement. measures are reported to senior manage- 5. Evaluate management practices. The evalu- ment, including the promptness of such ation should include, but not be limited to, reporting. the following: 7. Evaluate the risk measurement system(s) a. Determine who is responsible for mak- used by the branch, which should be con- ing IRR management decisions (indi- sistent with the size and complexity of its vidual, committee or other), and whether on- and off-balance-sheet activities. The this is appropriate, given the level of evaluation should include the following: experience and sophistication of the a. Evaluate whether the risk measurement individuals and the nature of the branch’s system’s structure and capabilities are activities. adequate to accurately assess the risk b. Determine who is responsible for mak- exposure of the branch, support the ing principal assumptions and param- institution’s risk management process,

Branch and Agency Examination Manual September 1997 Page 1 3210.3 Interest Rate Risk Management: Examination Procedures

and serve as a basis for internal limits adequacy of the net interest margin, based and authorizations. on an analysis of the components of the b. Evaluate whether the risk measurement margin (i.e., interest expense and interest system is operated with sufficient disci- income). If the margin or any component is pline to accurately assess the risk expo- unusually high or low, determine: sure of the branch, support the institu- a. If goals have been established for net tion’s risk management process, and interest earnings. serve as a basis for internal limits and b. Management’s success in meeting estab- authorizations. lished goals. c. Determine whether the assumptions are c. The effect of the branch’s IRR position reasonable given current business condi- on meeting established goals. tions and the institution’s strategic plan, d. The effect of the branch’s pricing poli- and whether assumptions about future cies on meeting established goals. business are sensitive to changes in inter- e. The effect of any premium charged the est rates. branch on borrowed funds resulting from 8. Evaluate the branch’s exposure to IRR by: any perceived liquidity risk, country risk, a. Reviewing reports regularly prepared by or credit risk on meeting established management for controlling and moni- goals. toring IRR. f. The effect of the branch’s credit risk appetite on the margin. b. Reviewing ‘‘variance reports,’’ i.e., reports g. The effect of interoffice pricing policies that compare predicted and actual results. for borrowed funds from related offices, Comment on whether the risk measure- and the reliance on these funds, on the ment system has made reasonably accu- margin. rate predictions in earlier periods. 10. Write in appropriate report format and dis- c. Determining whether the level of risk is cuss with management: within the limits management has set. a. The quality of management’s ability to d. Determining the stability of interest mar- control and monitor IRR. gins under varying economic conditions b. The level of the branch’s IRR exposure or simulations (causes of significant fluc- and an assessment of the associated tuations should be identified). degree of risk. e. Determining the branch’s ability to adjust c. The quality of the related administrative its interest rate exposure, or its ability to controls and internal management report- effectively transfer its interest rate expo- ing systems. sure to the designated unit of the FBO d. The effect of IRR management decisions for IRR management. on earnings. 9. Contact the examiner responsible for ana- 11. Update the workpapers with any informa- lyzing income and expense to determine the tion that will facilitate future examinations.

September 1997 Branch and Agency Examination Manual Page 2 Interest Rate Risk Management Internal Control Questionnaire Effective date July 1997 Section 3210.4

Complete the following questions only if IRR is 3. Is the bank in compliance with its policies, managed at the local level. If IRR is managed at and is it adhering to its written procedures? another level within the FBO, determine that If not, are exceptions and deviations: adequate procedures are in place for any activity a. Approved by appropriate authorities? required of the branch by the managing office. b. Made infrequently? c. Nonetheless consistent with safe and 1. Has branch and head office management sound banking practices? adopted an IRR management policy that 4. Does senior management review and approve includes: the policy at least annually? a. Risk management philosophy and objec- 5. Did senior management review positions, tives regarding IRR? and the relationship of these positions to b. Clear lines of responsibility to either established limits, at least quarterly? manage IRR or transfer the branch’s IRR 6. Were exceptions to policies promptly positions to the appropriate unit of the reported to the senior management? FBO assigned the IRR management 7. Does one individual exert undue influence function? over interest risk management activities? c. Defining and setting of limits on IRR 8. Discuss with senior management the branch’s exposure? internal risk measurement model(s) regard d. Specific procedures for reporting and to the following: approvals necessary for exceptions to a. Has (Have) internal model(s) been audited policies and limits? (by internal or external auditors)? e. Plans or procedures management will b. Does one individual control the model- implement if IRR falls outside estab- ing process, or otherwise exert undue lished limits? influence over the risk measurement f. Specific IRR measurement system(s)? process? g. Acceptable activities used to manage or c. Is the model reconciled to source data to adjust the institution’s IRR exposure, assure data integrity? including, when applicable, procedures d. Are principal assumptions and param- for the transfer of IRR to the unit assigned eters used in the model reviewed peri- the IRR management function? odically by senior management? h. The individuals or committees who are e. Are the workings of, and the assump- responsible for IRR management tions used in, the internal model decisions? adequately documented and available for i. A process for evaluating major new prod- examiner review? ucts and their IRR characteristics? 2. Have internal management reports been f. Is the model run on the same scenario(s) prepared that provide an adequate basis for for which the institution’s limits are making interest rate management decisions established? and for monitoring the results of those g. Does management compare the histori- decisions? Specifically: cal results of the model to actual results? a. Are reports prepared on the branch’s IRR exposure, using an appropriate measurement method? CONCLUSION b. Is historical information on asset yields, cost of funds, and net interest margins 9. Is the information covered by this ICQ readily available? adequate for evaluating internal controls in c. Are interest margin variations, both from this area? If not, indicate any additional the prior reporting period and from the examination procedures deemed necessary. budget, regularly monitored? 10. Based on the information gathered, evaluate d. Is sufficient information available to per- internal controls in this area (i.e. strong, mit an analysis of the cause of interest satisfactory, fair, marginal, unsatisfactory). margin variations?

Branch and Agency Examination Manual September 1997 Page 1 Borrowed Funds Effective date July 1997 Section 3220.1

Borrowed funds include all nondeposit liabili- U.S., and should determine the purpose of the ties, exclusive of long-term subordinated debt, borrowing and the reason for the level and flow such as capital notes and debentures. Common of funds to various offices. forms of direct borrowing include Federal funds For FBOs with a controlling interest in a U.S. purchased (overnight and term), bills payable to commercial bank, a borrowing relationship the Federal Reserve, interbank deposits (domes- between the commercial bank and offices of the tic or foreign), due bills, short sales from trading FBO must be explored fully to ensure there are securities, and overdrafts on deposit accounts no violations of Sections 23A and 23B of the due from other depository institutions. Indirect Federal Reserve Act, inasmuch as the FBO is forms of borrowing include rediscounted cus- considered a foreign bank holding company. tomer paper, trade bills and bankers accep- Additional information on intercompany borrow- tances, securities borrowed, and assets sold with ing and funding relationships is contained in the endorsement or guarantee of the FBO or Section 3240, Due From/Due To Related Offices. subject to a repurchase agreement. If an FBO issues commercial paper in the U.S., the issuance is generally through a U.S. subsidiary and reflected on the books of the branch as a balance FEDERAL FUNDS PURCHASED due to related institutions. The day-to-day use of Federal funds is common- When a branch manages its borrowed funds place among U.S. banking organizations, includ- position independently from other FBO offices, ing branches of FBOs. The most frequent type a complete analysis of its borrowing activities of Federal funds transaction is unsecured, for since the previous examination should be done. one day, and repayable the following business The principal sources of borrowings, the range day. The rate is usually determined by overall of amounts, frequency, length of time indebted, money market rates and by the available supply concentration of borrowings, and reasons of and the demand for funds. Most transactions advanced by management for such borrowings are in units of $1 million, although the trading of should be explored. Some of the more fre- smaller amounts is fairly common depending quently used sources and instruments that pro- upon individual situations. In some instances, vide short-term, nondeposit funds are discussed where the selling and buying relationship below. between two financial institutions is a more or less continuing one, a line of credit may be established on a funds-available basis. Although the most common transaction is on an ‘‘over- INTRACOMPANY/INTERCOMPANY night’’ unsecured basis, the selling of funds can BORROWING also be on a secured basis and for longer periods of time such as term Federal funds. While term A principal borrowing relationship frequently Federal funds are quite common, the selling of exists between a branch and its head office. The funds on a secured basis is quite rare. Secured branch may also have borrowing relationships borrowing is usually done in instances of severe with other related branches or affiliated compa- credit risk and/or perceived default. However, nies. The head office frequently serves as a according to the Federal Reserve Act, Section primary funding source for the branch, but the 23A(c)(1), if an FBO owns a domestic, FDIC- level and nature of borrowing may be deter- insured subsidiary bank, any extensions of credit mined by other factors, including the branch’s by the domestic bank to the FBO must be done role in the overall funding strategy of the FBO. on a secured basis. For example, an FBO will designate one U.S. branch (generally the branch located in the FBO’s home state) to provide the funding to all other U.S. branches. To develop a complete INTERBANK DEPOSITS AND understanding of the borrowing relationship of BORROWINGS the branch with the head office and other related offices, the examiner must gain an understand- Interbank deposits are not defined as borrowings ing of the funding strategy of the FBO in the for regulatory purposes, and continue to be

Branch and Agency Examination Manual September 1997 Page 1 3220.1 Borrowed Funds reflected as deposits. Interbank deposit instru- chase agreement was sold, the branch could be ments include certificates of deposits (CDs), exposed to the risk of loss in the event that the Eurodollar deposits or takings (Euro-CDs) and buyer is unable to perform and return the deposits taken under separate borrowing agree- securities. This possibility is more likely if the ments. These funds are generally obtained securities are physically transferred to the insti- through the branch’s money market deposit tution or broker with which the branch has taking activities. However, narrowly defining entered into the repurchase agreement. For this these instruments as deposits instead of borrow- reason, branches should avoid, if possible, pledg- ings is not universally accepted and, in fact, the ing excessive collateral. However, most transac- negotiable money market CD and Euro-CD are tions today do not involve the physical transfer widely recognized as primary borrowing vehi- of securities, rather they involve a book entry cles. Dependence on CDs and Euro-CDs as system which can reduce settlement risk. The sources of funds is discussed in Section 3230, branch should obtain sufficient financial infor- Deposit Accounts. mation on and analyze the financial condition of Negotiable CDs and Euro-CDs are generally those institutions and brokers with whom they used by wholesale branches. They consist of engage in repurchase transactions. deposits over $100,000 and are not considered Branches engaging in repurchase agreements core funds. The major distinction between Euro- should include these transactions when calculat- CDs and negotiable CDs is that Euro-CDs are ing their interest rate sensitivity positions. In primarily funds from offshore sources. With addition, the degree to which a branch borrows more diverse products entering the market, float- through repurchase agreements should be ana- ing rate CDs and floating rate Euro-CDs are lyzed with respect to its liquidity needs, and becoming more popular. contingency plans should provide for alternate sources of funds in the event of a run-off of repurchase agreement liabilities. REPURCHASE AGREEMENTS

Instead of resorting to direct borrowing, a branch LINES OF CREDIT FROM may sell assets to another bank or some other CORRESPONDENT BANKS party and simultaneously agree to repurchase the assets at a specified time or after certain Lines of credit with correspondent banks may be conditions have been met. Securities and loans on an advised or unadvised basis. Advised (also are often sold under repurchase agreements to know as committed or fee paid) lines of credit generate temporary working funds. Agreements provide a reliable source of back-up funding to of this nature are frequently used because the the branch, in that the correspondent bank is cost of this type of secured borrowing is gener- committed to lend under the specified terms of ally lower than that of unsecured borrowings, the credit facility. Unadvised lines of credit are such as Federal funds purchased. Repurchase not committed facilities and access to such agreements should not be confused with resale funds can be denied by the correspondent bank. agreements (also known as reverse repurchase On occasion, branches negotiate loans from agreements). The usual terms for sale of secu- their principal correspondent banks. The loans rities under a repurchase agreement require that, are usually for short periods and may or may not after a stated period of time, the seller repur- be secured. Lines of credit to finance trade chases the same securities at a predetermined transactions evidenced by letters of credit can price or yield. U.S. government and agency result in the correspondent bank financing the securities are the most common type of instru- branch for an additional period of time, after a ments sold under repurchase agreements because sight draft drawn under a letter of credit has they are exempt from reserve requirements. been presented at the correspondent bank. Management should be aware of certain considerations and potential settlement risks associated with repurchase agreements entered into SHORT-TERM DEBT in large volume with institutional investors and/or brokers. If the value of the underlying Short-term borrowings may be found in a branch, securities exceeds the price at which the repur- both on a direct and indirect basis. Borrowings

September 1997 Branch and Agency Examination Manual Page 2 Borrowed Funds 3220.1 on a direct basis are usually evidenced by common form of long-term debt is direct term promissory notes, or through accounts with the borrowings from correspondent banks. Branches head ofﬁce or a correspondent bank. Indirect are usually more interested in attracting long- forms of borrowing include notes and trade bills term funds through the U.S. capital markets for rediscounted; notes, acceptances, import drafts, their head ofﬁce than issuing long-term debt for or trade bills sold with the branch’s endorsement their own utilization. or guarantee; notes and other obligations sold subject to repurchase agreements; and acceptance pool participations.

LONG-TERM DEBT

On an infrequent basis, long-term debt borrowings may be found in a branch. The most

Branch and Agency Examination Manual September 1997 Page 3 Borrowed Funds Examination Objectives Effective date July 1997 Section 3220.2

1. To determine if the policies, practices, pro- 5. To determine if the existing level of bor- cedures, and internal controls regarding borrowed funds is consistent with the branch’s rowed funds are adequate. activities. 2. To determine if branch officers are operating 6. To determine if the existing rates paid are in in conformity with the established guidelines line with concurrent market rates. of the head office. 7. To recommend corrective action when poli- 3. To determine the scope and adequacy of the cies, practices, procedures, or internal con- internal/external audit function as it relates to trols are deficient or when violations of law borrowed funds. or regulations have been noted. 4. To determine compliance with laws and regulations as it relates to borrowed funds.

Branch and Agency Examination Manual September 1997 Page 1 Borrowed Funds Examination Procedures Effective date July 1997 Section 3220.3

1. If selected for implementation, complete or a. The adequacy of written policies regard- update the Internal Control Questionnaire. ing borrowings. 2. Determine if deficiencies noted at the previ- b. The manner in which branch officers are ous examination or by internal/external audits operating in conformance with established have been addressed by management. policy. 3. Determine the purpose of each type of bor- c. The existence of any unjustified borrow- rowing and whether the branch’s borrowing ing practices. posture is justified in light of its role within d. Any violation of laws or regulations. the FBO’s network and other relevant e. Recommended corrective action when circumstances. policies, practices, or procedures are defi- 4. Determine if the branch has adequate contin- cient; violations of laws or regulations gency plans for alternate sources of funds exist; or when unjustified borrowing prac- and if these contingency funding lines are tices are being pursued. periodically tested for availability. 6. Update the workpapers with any information 5. Prepare, in appropriate report form, and dis- that will facilitate future examinations. cuss with appropriate management:

Branch and Agency Examination Manual September 1997 Page 1 Borrowed Funds Internal Control Questionnaire Effective date July 1997 Section 3220.4

POLICY a. Handle cash? b. Issue official checks and drafts? 1. Has the head office approved a written policy c. Prepare all supporting documents required which: for payment of debt? a. Outlines the objectives of the branch’s 4. Are subsidiary records for borrowed funds borrowings? reconciled with the general ledger accounts b. Describes the branch’s borrowing philoso- at an interval consistent with borrowing phy relative to risk considerations, i.e., activity, and are the reconciling items inves- leverage/growth, liquidity/income? tigated by persons who do not also: c. Provides for risk diversification in terms a. Handle cash? of staggered maturities, rather than solely b. Prepare or post to the subsidiary records on cost? for borrowed funds? d. Limits borrowings by amount outstand- 5. Has it been determined that borrowings from ing, specific type, or total interest expense? U.S. bank subsidiaries conform with applica- e. Limits or restricts execution of borrow- ble regulatory restrictions? ings by branch officers? 6. Are corporate resolutions properly prepared f. Provides a system of reporting require- as required by creditors and are copies on file ments to monitor borrowing activity? for reviewing personnel? g. Requires subsequent approval of 7. Are monthly reports furnished to the head transactions? office management reflecting the activity of h. Provides for review and revision of estab- borrowed funds, including amounts outstand- lished policy at least annually? ing, interest rates, interest paid to date, and anticipated future activity?

RECORDS CONCLUSION 2. Does the branch maintain subsidiary records for each type of borrowing, including proper 8. Is the information covered by this ICQ identiﬁcation of the obligee and a written adequate for evaluating internal controls in conﬁrmation? this area? If not, indicate any additional 3. Is the preparation, addition, and posting of examination procedures deemed necessary. the subsidiary borrowed funds records per- 9. Based on the information gathered, evaluate formed or adequately reviewed by persons the internal controls in this area (i.e. strong, who do not also: satisfactory, fair, marginal, unsatisfactory).

Branch and Agency Examination Manual September 1997 Page 1 Borrowed Funds Audit Guidelines Effective date July 1997 Section 3220.5

1. Using an appropriate sampling technique, 3. Examine supporting documents for accuracy select items for review of supporting docu- and trace applicable entries, including pro- mentation, including terms, balances, and ceeds, to detail records and to the general other appropriate details, and request a posi- ledger. tive confirmation from the lender. Control all 4. Test interest computations for accuracy and answered confirmations and investigate any trace entries to appropriate accounts. reported differences. Include all confirma- 5. Examine transactions for adherence with tions in the workpapers and document the terms of borrowing arrangements. disposition of all exceptions or no-replies. 6. Review all borrowings requiring head office 2. To the extent appropriate, review collateral- approval for appropriate documentation and ized transactions for the sufficiency of secu- authorization. rity to cover the lender’s requirements and ensure that the branch’s assets pledged as collateral are clearly identified.

Branch and Agency Examination Manual September 1997 Page 1 Deposit Accounts Effective date July 1997 Section 3230.1

U.S. branches of foreign banking organizations REGULATION K SUBPART B (FBOs) may hold deposits, which represent SECTION 211.21(B)—CREDIT funds that branch customers have advanced and BALANCES the branch is obligated to repay on demand, after a specific period of time, or after expiration As defined in Regulation K, Subpart B, Section of some required notice period. Definitions of 211.21(b), Credit Balances, U.S. agencies, as deposit types (i.e., demand, savings, and NOW opposed to branches, of FBOs are not allowed to accounts and their respective availabilities) are accept deposits from U.S. citizens or residents. outlined in the Federal Reserve Board’s Regu- Agencies may, however, maintain credit bal- lation D and in the instructions to the Report ances for U.S. citizens and residents, in addition of Assets and Liabilities of U.S. Branches and to taking deposits from foreign residents. Obli- Agencies of Foreign Banks (FFIEC 002). The gations are not considered credit balances unless nature, type, and level of deposits that a branch they meet all of the following conditions: may accept is dependent on a variety of factors, including the licensing agency, applicable • Arise out of, or are incidental to the exercise state restrictions, Federal Deposit Insurance of other lawful banking powers, such as the Corporation insurance status, and the limitations disbursement of loan proceeds, receipt of wire imposed based on the type of office, i.e., depo- transfer activities, or arise out of letter of sitory or nondepository office. Management credit transactions; should have policies in place to ensure compli- • Serve a specific purpose; ance with all applicable deposit-taking • Are not solicited from the general public; restrictions. • Are not used to pay routine operating expenses The majority of U.S. branches of FBOs do not in the United States, such as salaries, rent, or maintain FDIC insurance and are therefore sub- taxes; ject to relevant notification requirements • Are withdrawn, within a reasonable period of described in the Federal Deposit Insurance- time, after the specific purpose for which they Insured and Uninsured Branches section of this were placed has been accomplished; and manual. These wholesale branches generally • Are drawn upon in a manner reasonable in may accept deposits over $100,000 or from U.S. relation to the size and nature of the account. nonresidents. Branches, however, can accept deposits of less than $100,000 from residents The agency’s Report of Assets and Liabilities provided the branch’s total retail deposits do not should correctly show such credit balances. exceed 1 of its total deposits. Refer to FDIC The remaining discussion applies to those Rules and Regulations Part 346 for additional branches that rely heavily on retail deposits as a information. Licensing agencies may apply addi- funding source. tional deposit-taking restrictions, which should be incorporated into the review’s scope. Unin- sured branches (non-FDIC-insured) may face legal limitations on deposits but generally have DEPOSIT DEVELOPMENT AND greater flexibility in taking borrowed funds. RETENTION PROGRAM Examiners should review the documentation supporting deposit and borrowed funds transac- Branch management should adopt and imple- tions to determine that they are properly identi- ment a development and retention program for fied and reported. all types of deposits because of competition for Guidelines applicable to offices with FDIC- funds, the need for most individuals and corpo- insured deposits are also available in the section rations to minimize idle funds, and the effect of on Federal Deposit Insurance- Insured and disintermediation (the movement of deposits to Uninsured Branches. other higher- yielding markets) on a branch’s Some branches use private banking depart- deposit base. The review of a branch’s deposit ments to gather and retain large deposit bases. development and retention program and the For more information on these depart- methods used to determine the volatility and ments, see the Private Banking section in this composition of the deposit structure are impor- manual. tant elements of the examination process. The

Branch and Agency Examination Manual September 1997 Page 1 3230.1 Deposit Accounts deposit development and retention program is various examination procedures should be suf- often included in the funds management policy ficient to allow the examiner to evaluate the and should contain a marketing strategy, projec- composition of both volatile and core deposits. tions of deposit structure and associated costs, Management’s lack of such knowledge could and a formula for comparing results against lead to an asset/liability mismatch, which could projections. cause problems at a later date. Ultimately, the examiner should be satisfied that management has properly planned for the branch’s future. Marketing Strategy Examiners must analyze the present and potential effect deposit accounts have on the In determining its market strategy, management financial profile of the branch, particularly with must first consider many factors, including: regard to the quality and scope of management’s planning. The examiner’s efforts should be • The composition of the market area economic directed to the various types of deposit accounts base, especially the countries targeted by the that the branch uses for its funding base. The private banking, corporate banking, or corre- examiners assigned to funds management and to spondent banking departments; analytical review of the branch’s income and • The ability to employ deposits profitably; expenses should be informed of any significant • The adequacy of current operations (staffing change in interest-bearing deposit account and systems) and the location and size of activity. banking quarters relative to its volume of For branches with a significant deposit base, business; interest paid on deposits can represent the larg- • The degree of competition from banks and est expense to the branch. Additional costs nonbank financial institutions and their pro- associated with deposits include general operat- grams to attract deposit customers; and ing costs, promotional and advertising costs, and • The effects of the local and foreign economies changes in required reserves. As a result, interest- and the monetary and fiscal policies of the bearing deposit accounts employed in a margin- local and foreign government on the branch’s ally profitable manner could have significant market area. and lasting effects on branch earnings. Refer to the Income and Expense Section of this manual After a deposit program is developed, man- for additional information. agement must continue to monitor those factors and correlate any findings to determine if adjustments are needed. The long term success of any Comparing Results to Projections deposit program relates directly to the ability of management to detect the need for change at the Management should have a formula in place for earliest possible time. comparing results against projections. Projec- tions should be periodically reviewed and updated throughout the fiscal year. Actual results Deposit Structure and Associated should be periodically compared to projections Costs and material variances should be identified and reviewed by management. Typically, the branch’s Management should not only look at deposit annual budget will include projections for depos- growth but also at the characteristics of the its and associated costs. Refer to the Income and deposit structure. Management must be able to Expense section of this manual for additional determine what percentage of the overall deposit information on comparing actual results to those structure is centered in stable or core deposits, in projected. fluctuating or seasonal deposits, and in volatile deposits to properly invest such funds in view of anticipated or potential withdrawals. SPECIAL DEPOSIT-RELATED It is important that internal reports with infor- ISSUES mation concerning the composition of the deposit structure be provided periodically to both branch The examiner should keep in mind the following and head office management. In analyzing the issues during an examination to ensure that the deposit structure, information gathered by the branch is in compliance, where applicable.

September 1997 Branch and Agency Examination Manual Page 2 Deposit Accounts 3230.1

Abandoned Property Law banking functions (UCC 4-104(a)(3)). For branches with retail deposit-taking activities, a State abandoned property laws are generally banking day generally includes, at a minimum, called escheat laws. Although escheat laws vary operation of a teller window and the bookkeep- from state to state, they normally require a ing and loan departments. Items received on a branch to remit the proceeds of any deposit nonbanking day or after the cut-off hour on a account to the state treasurer when: banking day may be processed as if received on the following banking day. • The deposit account has been dormant for a A branch that violates the cut-off hour could certain number of years; and be subject to civil liability for not performing its • The owner of the account cannot be located. duties under other provisions of the UCC (see UCC 4-202, 4-213, 4-214, 4-301, and 4-302). Service charges on dormant accounts should bear a direct relationship to the cost of servicing the accounts to ensure that the charges are not Foreign Currency Deposits excessive. Management should have policies and procedures in place to review and document Branches are permitted to accept deposits the basis on which service charges on dormant denominated in foreign currency. Branches accounts are assessed. There have been occa- should notify customers that such deposits are sions when, because of excessive charges, there subject to foreign exchange risk. The branch were no proceeds to remit at the time the converts such accounts to the U.S. dollar equiva- account became subject to escheat requirements lents for reporting to the Federal Reserve. and courts have required banks to reimburse the Examiners should verify that all reports are in state. (Refer to the discussion on dormant order and evaluate the branch’s use of such accounts in the subsequent Potential Problem funds and management of the accompanying Areas section.) foreign exchange risk. Foreign currency denominated accounts are not subject to the requirements of Regulation CC, Availability of Funds Bank Secrecy Act and Collection of Checks. For additional information, examiners may refer to the Federal Examiners should be aware of the Bank Secrecy Reserve’s supervisory guidance letter, SR-90-3 Act when examining the deposit area and follow (IB), Foreign (Non-U.S.) Currency Denomi- up on any unusual activities or arrangements nated Deposits Offered at Domestic Depository noted. The Act was implemented by the Trea- Institutions. sury Department’s Financial Recordkeeping and Reporting of Currency and Foreign Transactions Regulation. For further information, see the International Banking Facilities Federal Reserve’s Bank Secrecy Act Manual, Section 208.14 of the Federal Reserve’s Regu- An International Banking Facility (IBF) is a set lation H, and other supervisory material. The of asset and liability accounts segregated on the Federal Reserve’s Bank Secrecy Act Manual books of a branch. IBF activities are essentially also includes information on ‘‘Know Your Cus- limited to accepting deposits from and extend- tomer’’ guidelines. ing credit to foreign residents (including banks), other IBFs, and the institutions establishing the IBF. IBFs are not required to maintain reserves Banking Hours and Processing of against their time deposits or loans. When Demand Deposits examining an IBF, the examiner should follow the special examination procedures in the Inter- The Uniform Commercial Code (UCC) allows a national Banking Facility section of this manual. bank or branch to establish a banking day cut-off hour of 2:00 p.m. or later for the handling of items received for deposit or presented for Reserve Requirements payment (UCC 4-108). A banking day is deﬁned as the part of a day on which the bank or branch Under the Monetary Control Act of 1980 and is open to the public for substantially all of its the Federal Reserve’s Regulation D, Reserve

Branch and Agency Examination Manual September 1997 Page 3 3230.1 Deposit Accounts

Requirements of Depository Institutions, improper posting of items, and provide for branches are subject to reserve requirements in periodic internal supervisory review of account the following instances: activity are essential to efficient deposit administration. • It is an insured branch, and its parent foreign The deposit suspense account is used to bank has total worldwide consolidated bank process unidentified, unposted, or rejected items. assets in excess of $1 billion; or Characteristically, items posted to such accounts • It is an insured branch, and is controlled by a clear in one business day. The length of time an foreign company or by a group of foreign item remains in control accounts often reflects companies that own or control foreign banks on the branch’s operational efficiency. This that in the aggregate have total worldwide deposit type has a higher risk potential because consolidated bank assets in excess of $1 bil- the transactions are incomplete and require lion; or manual processing to be completed. Due to the • It is a branch that is eligible to apply to need for human interaction and the exception become an insured bank under section 5 of the nature of these transactions, the possibility of Federal Deposit Insurance Act. misappropriation exists. Official checks are a type of demand deposit, For reserve requirement purposes, there are and include bank checks, cashier’s checks, two categories of deposits: transaction accounts expense checks, interest checks, dividend pay- and nontransaction accounts. Refer to the Fed- ment checks, certified checks, and money or- eral Reserve’s Regulation D and the FFIEC 002 ders. Official checks reflect the branch’s prom- instructions for specific definitions of the vari- ise to pay a specified sum upon presentation of ous types of deposits. Branches may choose to such checks. Because accounts are controlled maintain reserves for discount window access. and reconciled by branch personnel, it is important that appropriate internal controls are in place to ensure that account reconcilement is POTENTIAL PROBLEM AREAS segregated from check origination. Operational inefficiencies, such as unrecorded checks that The following paragraphs discuss the types of have been issued, can result in a significant deposit accounts and related activities that have understatement of the branch’s liabilities. Mis- above-average risk and, therefore, require the use of official checks may result in substantial examiner’s special attention. losses through theft. Cash collateral, undisbursed loan proceeds, and various loan escrow accounts are also sources of potential loss. The risk lies in ineffi- Branch-Controlled Deposit Accounts ciency or misuse if the accounts become overdrawn or if funds are diverted for other purposes, Branch-controlled deposit accounts, such as sus- such as the payment of principal or interest on pense, official checks, cash collateral, dealer branch loans. Funds deposited to these accounts reserves, and undisbursed loan proceeds are should be used only for their stated purposes. used to perform many necessary banking functions. However, the absence of sound administrative policies and adequate internal controls regarding these accounts can cause significant Brokered Deposits loss to the branch. To ensure that such accounts are properly administered and controlled, branch Brokered deposits represent funds the branch and head office management must ensure that obtains, directly or indirectly, by or through any operating policies and procedures are in effect deposit broker for deposit into one or more that establish acceptable purpose and use; deposit accounts. Thus, brokered deposits include appropriate entries; controls over posting entries; both those in which the entire beneficial interest and the length of time an item may remain in a given branch deposit account or instrument unrecorded, unposted, or outstanding. Internal is held by a single depositor and those in which controls that limit employee access to branch- the deposit broker pools funds from more than controlled accounts, determine the responsibil- one investor for deposit in a given branch ity for frequency of reconcilement, discourage deposit account.

September 1997 Branch and Agency Examination Manual Page 4 Deposit Accounts 3230.1

A small or medium-sized branch’s depen- acceptance of brokered deposits and guidelines dence on the deposits of customers who reside on interest payments. outside of or conduct their business outside of The use of brokered deposits should be the branch’s normal service area should be reviewed during all on-site examinations, even closely monitored by branch and head office for those institutions not subject to the FDIC’s management, and analyzed by the examiner. restrictions. In light of the potential risks accom- Such deposits may be the product of personal panying the use of brokered deposits, the exami- relationships or good customer service; how- nation should focus on: ever, large out-of-area deposits are sometimes attracted by liberal credit accommodations or by • The rate of growth and the credit quality of the offering significantly higher interest rates than loans or investments funded by brokered competitors offer. Deposit growth due to liberal deposits; credit accommodations generally proves costly • Whether brokered funds are in turn sold to in terms of the credit risks taken relative to the branch customers; benefits received from corresponding deposits, • The corresponding quality of loan files, docu- which may be less stable. Deposit development mentation, and customer credit and deposit and retention policies should recognize the lim- information; its imposed by prudent competition and the • The ability of branch management to adequately branch’s service area. evaluate and administer these credits and Banking organizations have historically relied deposits and manage the resulting growth; to a limited extent upon funds obtained through • The degree of interest-rate risk involved in the deposit brokers to supplement their traditional funding activities and the existence of a pos- funding sources. A concern regarding the activi- sible mismatch in the maturity or rate- ties of deposit brokers is that the ready avail- sensitivity of assets and liabilities; ability of large amounts of funds through the • The composition and stability of the deposit issuance of such obligations undercuts market sources and the role of brokered deposits in discipline, particularly in insured depository the branch’s overall funding position and institutions. To compensate for the high rates strategy; and typically offered for brokered deposits, institu- • The effect of brokered deposits on the branch’s tions holding them tend to seek assets that carry risk standing and whether or not the use of commensurately high yields. These assets can brokered deposits constitutes an unsafe and often involve excessive credit risk or cause the unsound banking practice. branch to take on undue interest-rate risk through a mismatch in the maturity of assets and liabilities. Check Kiting In light of these concerns, certain restrictions on the use of brokered deposits were developed Check kiting occurs when a depositor with under section 301 of the Federal Deposit Insur- accounts at two or more banks draws checks ance Corporation Improvement Act of 1991 against the uncollected balance at one bank to (FDICIA), which apply to federally-insured take advantage of the float (i.e., the time required branches. Section 301 of FDICIA amended for the bank of deposit to collect from the section 29 of FDIA to prohibit undercapitalized paying bank); and the depositor initiates the institutions from accepting funds obtained, transaction with the knowledge that sufficient directly or indirectly, by or through any deposit collected funds will not be available to support broker for deposit into one or more deposit the amount of the checks drawn on all of the accounts. Adequately capitalized institutions may accounts. accept such funds only if they first obtain a The key to this deceptive practice, the most waiver from the FDIC, while well-capitalized prevalent type of check fraud, is the ability to institutions may accept such funds without draw against uncollected funds. However, draw- restriction. Refer to FDIC regulations and guide- ing against uncollected funds in and of itself lines for information on how these requirements does not necessarily indicate kiting. Kiting only are applied to federally-insured branches. Each occurs when the aggregate amount of drawings examination should include a review for com- exceeds the sum of the collected balances in all pliance with the FDIC’s limitations on the accounts. Nevertheless, because drawing against

Branch and Agency Examination Manual September 1997 Page 5 3230.1 Deposit Accounts uncollected funds is the initial step in the kiting The primary risk is payment against uncollected process, management should closely monitor funds, which could be a method of extending this activity. The requirements of Regulation unsecured credit to a depositor. Absent proper CC, Availability of Funds and Collection of and complete documentation regarding the cred- Checks, increased the risk of check kiting and itworthiness of the depositor, paying items should be addressed by management in the against uncollected funds could be considered branch’s policies and procedures. an unsafe or unsound banking practice. Further- By allowing a borrower to draw against more, such loans, even if properly documented, uncollected funds, the branch is extending credit might exceed the branch’s prudential lending that should be subject to an appropriate approval limit, if applicable, for loans to one customer. process. Accordingly, management should Examiners should routinely review a branch’s promptly investigate unusual or unauthorized practices in this area to ensure that such prac- activity because the last bank to recognize check tices are conducted prudently. If undue or kiting and pay on the uncollected funds suffers undocumented credit risk is disclosed or if the loss. Check kiting is illegal, and all sus- lending limits are exceeded, appropriate correc- pected or known check kiting operations should tive action should be taken. be reported pursuant to established regulatory policy. Branch management should maintain internal controls to preclude loss from kiting and the examiner should remember that, in most Deposit Sweep Programs/Master Note cases, kiting is not covered under Blanket Bond Arrangements Standard Form 24. Deposit sweep programs/master note arrangements (sweep programs) can be implemented on a branch level or on a FBO level. On a branch Delayed Disbursement Practices level, these sweep programs exist primarily to facilitate cash management needs of branch Although Regulation CC, Availability of Funds customers, thereby retaining customers who and Collection of Checks, stipulates time frames might otherwise move their account to an entity for funds availability and return of items, delayed offering higher yields. On a FBO level, the disbursement practices (also known as remote sweep programs are maintained with customers disbursement practices) can present certain risks, at the branch level and the funds are upstreamed especially concerning cashier’s checks, which to the FBO as part of its overall funding strategy. have next-day availability. Delayed disburse- Sweep programs use an agreement with the ment is a common cash management practice branch’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 investments. These tial distances from the payee or on institutions obligations include such instruments as commer- located outside the Federal Reserve cities when cial paper, program notes, and master note alternate and more efficient payment arrange- agreements. ments are available. Such practices deny deposi- For insured branches, the disclosure agree- tors the availability of funds to the extent that ment regarding the sale of these types of non- funds could otherwise have been available ear- deposit debt obligations should include a state- lier. A check drawn on an institution remote ment indicating that these instruments are not from the payee often results in increased possi- federally insured deposits or obligations of or bilities of check fraud and in higher processing guaranteed by an insured depository institution. and transportation costs for return items. In addition, insured branches and their related Delayed disbursement arrangements could parties and subsidiaries that have issued or plan give rise to supervisory concerns because a to issue nondeposit debt obligations should not branch may unknowingly incur significant credit market or sell these instruments in any public risk through such arrangements. The remote area of the branch where retail deposits are location of institutions offering delayed disburse- accepted, including any lobby area of the branch. ment arrangements often increases the collec- This requirement exists to convey the impres- tion time for checks by at least a day or more. sion or understanding that the purchase of such

September 1997 Branch and Agency Examination Manual Page 6 Deposit Accounts 3230.1 obligations by retail depositors of the federally- lems and are not considered appropriate. The insured branch can, in the event of default, result absence of a clear ability to redeem overnight or in losses to individuals who believed they had extremely short-term liabilities when they become acquired federally-insured or guaranteed due should generally be viewed as an unsafe and obligations. unsound banking activity.

Branch Policies and Procedures Funding Strategies

Banking organizations with sweep programs A key principle underlying the Federal Reserve’s should have adequate policies, procedures, and supervision of banking organizations is that internal controls in place to ensure that the FBOs should operate in a way that promotes the activity is conducted in a manner consistent with soundness of their U.S. operations. FBOs are safe and sound banking principles and in accor- expected to avoid funding strategies or practices dance with all banking laws and regulations. that could undermine public confidence in the Branch policies and procedures should further liquidity or stability of their U.S. operations. ensure that deposit customers participating in a Any funding strategy should maintain an adequate sweep program are given proper disclosures and degree of U.S. dollar liquidity at the U.S. opera- information. When a sweep program is used as tion and the FBO, if appropriate. Branch man- part of a funding strategy for a FBO or a agement should avoid, to the extent possible, nonbank affiliate, examiners should ensure that allowing sweep programs to serve as a source of liquidity and funding strategies are carried out in funds for inappropriate uses at the FBO or at an a prudent manner. affiliate. Concerns exist in this regard, because funding mismatches can exacerbate an otherwise manageable period of financial stress and, Application of Deposit Proceeds in the extreme, undermine public confidence in the FBO’s viability. In view of the extremely short-term maturity of most sweep accounts, branches are expected to exercise great care when investing the proceeds. Funding Programs Branches, from which deposit funds are swept, have a fiduciary responsibility to their customers In developing and carrying out funding pro- to ensure that such transactions are conducted grams, FBOs should give special attention to the properly. Appropriate uses of the proceeds of use of overnight or extremely short-term liabili- deposit sweep funds are limited to short-term ties because a loss of confidence in the issuing bank obligations, short-term U.S. government organization could lead to an immediate funding securities, or other highly liquid, readily market- problem. Thus, FBOs relying on overnight or able, investment-grade assets that can be dis- extremely short-term U.S. dollar funding sources, posed of with minimal loss of principal.1 Use of should maintain a sufficient level of superior- such proceeds to finance mismatched asset posi- quality assets that can be immediately liquidated tions, such as those involving leases, loans, or or converted to cash with minimal loss, at least loan participations, can lead to liquidity prob- equal to the amount of those U.S. dollar funding sources.

1. Some banking organizations have interpreted language in a 1987 letter signed by the Secretary of the Board as condoning funding practices that may not be consistent with the principles set forth in a subsequent supervisory letter dated Dormant Accounts September 21, 1990, as well as with prior Board rulings. The 1987 letter involved a limited set of facts and circumstances A dormant account is one in which customer- that pertained to a particular banking organization; it did not establish or revise Federal Reserve policies on the proper use originated activity has not occurred for a prede- of the proceeds of short-term funding sources. In any event, termined period of time. Because of this inac- banking organizations should no longer rely on the 1987 letter tivity, dormant accounts are frequently the target to justify the manner in which they use the proceeds of sweep of malfeasance and should be carefully con- programs. Banking organizations employing sweep programs are expected to ensure that these programs conform with the trolled by a branch. Branch management should policies contained in this manual section. establish standards that speciﬁcally outline the

Branch and Agency Examination Manual September 1997 Page 7 3230.1 Deposit Accounts branch’s policy for the effective control of of branch management, with oversight from dormant accounts, addressing: head office, to review overdrafts as they would any other extension of credit. In most cases, • The types of deposit categories that could overdrafts outstanding for more than 30 days, contain dormant accounts, including demand, which lack mitigating circumstances, should be savings, and official checks; considered for charge-off. • The length of time without customer-originated activity that qualifies an account to be identified as dormant; Payable-Through Accounts • The controls exercised over the accounts and their signature cards, that is, prohibiting release A payable-through account is an accommoda- of funds by a single branch employee; and tion offered to a correspondent bank or other • The follow-up by the branch when ordinary customer by a U.S. banking organization, branch mailings, such as account statements whether they have a domestic or foreign charter, and advertising flyers, are returned to the whereby drafts drawn against client subaccounts branch because of changed addresses or other at the correspondent are paid upon presentation reasons for failure to deliver. by the U.S. banking institution. The subaccount holders of the payable-through bank are generally non-U.S. residents or owners of businesses Employee Deposit Accounts located outside of the United States. Usually, the contract between the U.S. banking organization Historically, examiners have discovered various and the payable-through bank purports to create irregularities and potential wrongdoing through a contractual relationship, solely between the reviews of employee deposit accounts. As a two parties to the contract. Under the contract, result, if employees are permitted to maintain the payable-through bank is responsible for accounts at the branch, branch policy should screening subaccount holders and maintaining establish standards that segregate or specially adequate records with respect to such holders. encode employee accounts and encourage peri- The examiner should be aware of the potential odic internal supervisory review. In light of for money laundering through payable-through these concerns, examiners should review related accounts and should refer to the Bank Secrecy branch procedures and practices, taking appro- Act Manual for examination procedures. priate measures when warranted.

Zero-Balance Accounts Overdrafts Zero-balance accounts (ZBAs) are demand The size, frequency, and duration of deposit deposit accounts, used by a branch’s corporate account overdrafts are matters that should be customers, through which checks or drafts are governed by branch policy and controlled by received for either deposit or payment. The total adequate internal controls, practices, and proce- amount received on any particular day is offset dures. Overdraft charges should be significant by a corresponding debit or credit to the account enough to discourage abuse. Overdraft authority before the close of business, to maintain the should be approved in the same manner as balance at or near zero. ZBAs enable a corporate lending authority and should never exceed the treasurer to effectively monitor cash receipts and employee’s lending authority. Systems for moni- disbursements. For example, as checks arrive toring and reporting overdrafts should empha- for payment, they are charged to a ZBA, with size a secondary level of administrative control the understanding that funds to cover the checks that is distinct from other lending functions so will be deposited before the end of the banking account officers, who may be less than objec- day. Several common methods used to cover tive, do not allow influential customers to exploit checks include: their overdraft privileges. An examiner should also be aware that Regulation O addresses the • Wire Transfers; payment of overdrafts to executive officers of a • Depository Transfer Checks—a bank-prepared federally-insured branch. It is the responsibility payment instrument used to transfer money

September 1997 Branch and Agency Examination Manual Page 8 Deposit Accounts 3230.1

from a corporate account in one bank to day (referred to as a daylight overdraft between another bank; the account holder and the branch). If these • Concentration Accounts—a separate corporate checks are not covered, an overdraft occurs, demand deposit account at the same bank used which will be reflected on the branch’s financial to cover deficits or channel surplus funds statement. relative to the ZBA; and The absence of prudent safeguards and a lack • Extended Settlement—a cash management of full knowledge of the creditworthiness of the arrangement that does not require the corpo- depositor may expose the branch to large, rate customer to provide same-day funds for unwarranted, and unnecessary risks. Moreover, payment of its checks. the magnitude of unsecured credit risk may exceed prudent limits. Examiners should rou- Because checks are covered before the close tinely review cash management policies and of business on the day they arrive, the branch’s procedures to ensure that branches do not engage exposure is not reflected in the financial state- in unsafe and unsound banking practices, mak- ment. The branch, however, assumes risk by ing appropriate comments in the report of paying against uncollected funds, thereby creat- examination, as necessary. ing unsecured extensions of credit during the

Branch and Agency Examination Manual September 1997 Page 9 Deposit Accounts Examination Objectives Effective date July 1997 Section 3230.2

1. To determine if the policies, practices, pro- 4. To determine the scope and adequacy of the cedures, and internal controls regarding audit function. deposit accounts are adequate. 5. To determine compliance with applicable 2. To determine if branch ofﬁcers and employ- laws and regulations. ees are operating in conformance with the 6. To recommend corrective action when poli- branch’s established guidelines. cies, practices, procedures, or internal con- 3. To evaluate the deposit structure and deter- trols are deﬁcient or when violations of law mine its characteristics and volatility. or regulations have been noted.

Branch and Agency Examination Manual September 1997 Page 1 Deposit Accounts Examination Procedures Effective date July 1997 Section 3230.3

1. Determine it deficiencies noted at the pre- • Maturity reports vious examination or by internal/external d. For deposit sweep programs/master note audits have been adequately addressed by arrangements: management. • List individually by deposit type and 2. Check applicable restrictions on the nature, amount type, and level of deposits that can be e. For brokered deposits: maintained by the branch. • List individually by deposit type, 3. If selected for implementation, complete the including amount and rate ICQ. f. For foreign currency deposits: 4. In conducting an examination, the examiner • List of accounts and currency type should use available branch copies of print- g. For employee deposit accounts: outs plus transactions journals, microfiche, • List individually by deposit type, or other visual media to minimize expense including amount and rate to the branch. However, if copies of these • Overdrafts reports are not available, the examiner • Monthly account activity, including should determine and request the informa- dollar and transaction volume tion necessary to complete the examination 5. If an agency, for credit balances: procedures and, if required, the internal a. Review the agency’s policy to ensure control questionnaire. Obtain or prepare, as compliance with Subpart B Section applicable, the reports indicated below, 211.21(b) of Regulation K dealing with which are used for a variety of purposes, credit balances. including the assessment of deposit volatility and liquidity, adequacy of internal con- b. Determine that controls are in place to trols, verification of information contained monitor compliance with the regulation. on required regulatory reports, and assess- c. Select a sample of credit balances and ment of loss. review transaction activity to determine a. For demand deposits and other transac- if such balances are being used in accor- tion accounts: dance with the regulation. • Trial balance 6. Review the reconcilements of all types of • Overdrafts deposit accounts and verify the balances to • Unposted items department controls and the general ledger, then: • Nonsufficient funds (NSF) report • Dormant accounts a. Determine if reconciliation items are legitimate and if they clear within a • Uncollected funds reasonable time frame. • Due to banks b. Retain custody of all trial balances, only • Trust department funds if necessary and practical. • Significant activity 7. Test documentation on the underlying trans- • Suspected kiting report actions reported as borrowed funds to ensure • Matured certificates of deposits with- that these do not better fit the definition of out an automatic renewal feature deposits. Refer to the Borrowed Funds sec- • Large balance report tion of this manual and appropriate sections b. For official checks: of the Board’s Regulation D for additional • Trial balance(s) guidance. If determined to be deposits, c. For time deposits: include such transactions in the review of • Trial balance(s) deposits. • Unposted items 8. Review the reconciliation process for branch • Dormant Accounts controlled accounts, such as official checks • Trust department funds and escrow deposits, by: • Large balance report a. Determining if reconciling items are • Money market accounts legitimate and if they clear within a • Negotiable certificates of deposits reasonable time frame.

Branch and Agency Examination Manual September 1997 Page 1 3230.3 Deposit Accounts: Examination Procedures

b. Scanning activity in such accounts to management of significant activity in determine the potential for improper this area has been instituted diversion of funds for various uses, such • Appropriate employees clearly under- as: stand the mechanics of drawing against • Political contributions uncollected funds and the risks • Loan payments (principal or interest) involved, especially in the area of • Personal use potential check kiting operations c. Determine if checks are being processed d. Upon completing steps 10.a., 10.b., and before their related credits. 10.c., the examiner should: 9. Review the branch’s operating procedures • Cross-reference overdraft and uncol- and reconciliation process relative to sus- lected funds reports to examiner loan pense accounts and determine if: line sheets; a. The disposition of unidentified items is • For those depositors not cross refer- completed in a timely fashion. enced in the preceding step, review the b. Reports are generated to periodically credit files of depositors with signifi- inform management of the type, age, and cant overdrafts, if available, or the amounts of items in such accounts. credit files of depositors who fre- c. Employees responsible for clearing sus- quently draw significant amounts pense account times are not shifting the against uncollected funds; items between accounts. • Request management to charge off 10. Evaluate the effectiveness of the policies, overdrafts deemed to be uncollectible procedures, and management’s reporting by examiners; and methods regarding overdrafts and drawings • Submit a list of the following items to against uncollected funds. the appropriate examiner: a. Concerning overdrafts, determine if: — Overdrafts considered loss, indicat- • Officer-approval limits have been ing borrower and amount. established — Aggregate amounts overdrawn 30 • A formal system of review and approval days or more, for inclusion in past is in effect due statistics. b. Ascertain the existence of formal over- 11. Review the branch’s deposit development draft protection, and, if it exists: and retention policy, which is often included • Obtain a master list of all depositors in the funds management policy. with formal overdraft protection a. Determine if the policy addresses deposit • Obtain a trial balance indicating structure and related interest costs, includ- advances outstanding and compare it ing the percentages of time deposits and with the master list to ensure compli- demand deposits of: ance with approved limits • Individuals • Cross-reference the trial balance or • Corporations master list to examiner loan line sheets b. Determine if the policy requires periodic • Review credit files on significant for- reports to management, comparing the mal agreements not cross-referenced accuracy of projections with results. above c. Assess the reasonableness of the policy c. Concerning drawings against uncol- and ensure that it is routinely reviewed lected funds, determine if: by management. • The uncollected funds report reflects 12. If a deposit sweep program/master note balances as being uncollected until arrangement exists, review for approval of they are actually received related policies and procedures by head • Management is comparing reports of office management. significant changes in balances and 13. For branches with deposit sweep programs/ activity volume to uncollected funds master note arrangements (sweep programs), reports compare practices for adherence to approved • Management knows the reasons why a policies and procedures, including a review depositor is frequently drawing against of: uncollected funds a. The purpose of the sweep program: is it • A reporting system to inform senior strictly a customer accommodation trans-

September 1997 Branch and Agency Examination Manual Page 2 Deposit Accounts: Examination Procedures 3230.3

action or is it intended to fund certain • Signed documents properly disclose assets at the foreign banking organiza- the name of the obligor and type of tion (FBO) level or at an affiliate? Review instrument into which the depositor’s funding transactions in light of liquidity funds will be swept. If funds are being and funding needs of the FBO by refer- swept into U.S. government securities ring to the manual section on Funds held by the branch or FBO, verify that Management and Liquidity. adequate confirmations are provided to b. The eligibility requirements used by the customers in accordance with the Gov- branch to determine the types of custom- ernment Securities Act of 1986. (This ers and accounts that may participate in a Act requires that all transactions sub- sweep program, including: ject to a repurchase agreement be con- • A list of customers participating in firmed in writing at the end of the day sweep programs, with dollar amounts of initiation and that the confirmation of deposit funds swept on the date of covers specific securities. If any other examination. securities are substituted that result in • The name of the recipient(s) of swept a change of issuer, maturity date, par funds and: amount, or coupon rate, another con- — If an affiliate of the branch (i.e., firmation must be issued at the end of FBO), a schedule of the instru- the day during which the substitution ments into which the funds were occurred. Because the confirmation or swept, including the effective ma- safekeeping receipt must list specific turity of these instruments. securities, pooling of securities for any type of sweep program involving gov- — If an unaffiliated third party, deter- ernment securities is not permitted. mine if the branch adequately Additionally, if funds are swept into evaluates the third party’s financial other instruments, similar confirmation condition at least annually. Verify procedures should be applied.) if a fee is received by the branch • Conditions of the sweep program are for the transaction and, if so, that stated clearly, including the dollar it 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 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, pre-payment 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 branch has issued or plans exceeded 270 days and the amount is to issue nondeposit debt obligations in $25,000 or more (as stipulated by SEC any public area of the branch where policy). Ongoing sweep program dis- retail deposits are accepted, including closures should occasionally be sent to any lobby area of the branch. the customer to ensure that the terms e. Completed sweep program documents to of the program are updated and the determine if: customer understands the terms. • In the case of federally-insured f. In the case of federally-insured branches, branches, signed documents boldly dis- samples of advertisements (newspaper, close that the instrument into which radio and television spots, etc.) by the deposit funds will be swept is not branch for sweep programs to determine insured by the FDIC and is not an if the advertisements: obligation of or guaranteed by the • Boldly disclose that the instrument branch. into which deposit funds are swept is • Proper authorization for the instrument not insured by the FDIC and is not an exists between the customer and an obligation of, or guaranteed by, the authorized representative of the branch. branch.

Branch and Agency Examination Manual September 1997 Page 3 3230.3 Deposit Accounts: Examination Procedures

• Are not enclosed with insured deposit b. Select, at a minimum, the 10 largest statements mailed to customers. accounts to determine if the retention of g. Whether the sweep program has had a those accounts depends on: negative effect on branch liquidity or has • Criticizable loan relationships. the potential to undermine public confi- • Liberal service accommodations, such dence in the branch. Additionally: as permissive overdrafts and drawings • Review the branch’s Federal funds and against uncollected funds. other borrowing activities to ascertain • Interbank correspondent relationships. whether borrowings appear high. If so, • Deposits obtained as a result of special compare the branch’s borrowing activ- promotions. ity with daily balances of aggregate • A recognizable trend with respect to: sweep transactions on selected dates, — Frequent significant balance to see if a correlation exists. fluctuations. • If sweep activity is significant, com- — Seasonal fluctuations. pare the rates being paid on swept — Nonseasonal increases or decreases deposits with the yields received on in average balances. the invested funds and with the rates c. Elicit management’s comments to deter- on other overnight funding instru- mine, to the extent possible: ments, such as fed funds, to determine • The potential renewal of large CDs if they are reasonable. that mature within the next 12 months. 14. Forward the following to the examiner • If a significant dollar volume of assigned to Funds Management and accounts is concentrated in customers Liquidity: engaged in a single business or industry. a. The amount of any deposit decline or 16. Test for compliance with the applicable deposit increase anticipated by manage- laws and regulations listed below by per- ment (the time period will be determined forming the following procedures: by the examiner performing liquidity and a. For federally-insured branches, Regula- funds management). tion O (12 CFR 215), Loans to Executive b. A listing by name and amount of any Officers, Directors, and Principal Share- depositor controlling a significant per- holders of Member Banks: centage of total deposits. • Review the overdraft listing to ensure c. A maturity schedule of certificates of that the branch has not paid an over- deposit, detailing maturities within the draft on any account of an executive next 30, 60, 90, 180, and 360 days. officer, unless the payment is made d. An assessment of the overall character- according to: istics and volatility of the deposit — A written, preauthorized, interest- structure. bearing extension of a credit plan 15. Assess the volatility and the composition of providing for a method of repay- the branch’s deposit structure. ment or a. Review the list of time certificates of — A written, preauthorized transfer deposit of $100,000 or more and related from another account of that execu- management reports to determine: tive officer. • The aggregate dollar volume of bearer Payment of inadvertent overdrafts in CDs, if significant. an aggregate amount of $1,000 or less • The aggregate dollar volume of accounts is not prohibited, provided the account of depositors by country. is not overdrawn more than five busi- • If the branch is paying competitive ness days and the executive officer is rates on CDs. charged the same fee charged other • The aggregate dollar volume of money customers in similar circumstances. market CDs with interest rates higher Overdrafts are extensions of credit and than current publicly quoted rates must be included when considering within the industry, if significant. each insider’s lending limits and other • The dollar amount of brokered CDs, if extensions of credit restrictions and the any. aggregate lending limit for all outstand-

September 1997 Branch and Agency Examination Manual Page 4 Deposit Accounts: Examination Procedures 3230.3

ing extensions of credit by the branch nation date. In cases where a branch to all insiders and their related interests. issues nondeposit, uninsured obliga- b. 12 USC 1972(2), Loans to Executive tions that are classified as deposits in Officers, Directors, and Principal Share- the calculation of reserve require- holders of Correspondent Banks: ments, examiners should determine if • Review the overdraft listing to ensure these items are properly categorized. that no preferential overdrafts exist e. Local escheat laws: from the branch under examination to • Determine if the branch is adhering to the executive officers, directors, or prin- the local escheat laws with regard to cipal shareholders of its correspondent all forms of dormant deposits, includ- bank. ing official checks. c. Section 301 of the Federal Deposit 17. If applicable, determine if the branch is Insurance Corporation Improvement Act appropriately monitoring and limiting the of 1991. Refer to the section on Federal foreign exchange risk associated with for- Deposit Insurance-Uninsured and Insured eign currency deposits. Branches of this manual for procedural 18. Discuss overall findings with branch man- guidance. agement and prepare report comments on: d. Regulation D (12 CFR 204), Reserve a. Policy deficiencies. Requirements of Depository Institutions: b. Noncompliance with policies. • Review the accuracy of the deposit c. Weaknesses in supervision and reporting. data used in the branch’s reserve d. Violations of laws and regulations. requirement calculation for the exami- e. Possible conflicts of interest.

Branch and Agency Examination Manual September 1997 Page 5 Deposit Accounts Internal Control Questionnaire Effective date July 1997 Section 3230.4

OPENING DEPOSIT ACCOUNTS REGULATION K SUBPART B SECTION 211.21(B)—CREDIT 1. Are the opening of new accounts and access BALANCES to unused new account records and certificate of deposit (CD) forms handled by an 6. Does the agency have a written policy that employee who is not a teller or who cannot addresses credit balances? make internal entries to customer accounts 7. Does the agency refuse to accept deposits or general ledger? from residents of the United States? 2. Does the branch have a written ‘‘Know 8. Does the agency’s system for monitoring Your Customer’’ policy? credit balances include a continuing review a. Do new account applications require suf- of checks drawn on the account to ensure ficient information to clearly identify the that the checks are not being used to pay for customer? routine operating expenses in the United b. Are ‘‘starter’’ checks issued only after States? verification of data on new transaction 9. Do customer deposit files contain sufficient account applications? documentation that show the foreign nature of the deposit or foreign citizenship or c. Are checkbooks and statements mailed residency of the customer? only to the address of record? If not, is a 10. Are private banking officers or other agency satisfactory explanation and description personnel who solicit or open deposit obtained for any other mailing address accounts knowledgeable of the regulation’s (post office boxes, friend or relative, limitations on the agency’s deposit-taking etc.)? powers? d. Are employees responsible for opening new accounts trained to screen depositors for signs of check kiting? DEPOSIT ACCOUNT RECORDS e. Will the branch open new accounts with incomplete documentation? 11. Is the preparation of input and posting of 3. Are accounts referred to the branch by subsidiary demand deposit records per- representative offices? If so, are the repre- formed and/or adequately reviewed by per- sentatives employees of the foreign banking sons who do not also: organization? Are accounts referred to the a. Accept or generate transactions? branch by other related offices or affiliates? b. Issue official checks and/or handle funds If so, who refers them and why are they transfer transactions? booked at the branch? Do these representa- c. Prepare or authorize internal entries tives receive ‘‘Know Your Customer’’ (return items, reversals, and direct training? charges, such as loan payments)? 4. Are new account applications and signature d. Prepare supporting documents required cards reviewed by an officer prior to open- for disbursements from an account? ing the account? e. Perform maintenance on the accounts, such as change of address, stop payments, holds, etc.? 12. Does the branch perform reconciliations for each deposit account category by individu- CLOSING DEPOSIT ACCOUNTS als not engaged in accepting or preparing transactions or in data entry to customers’ 5. Are signature cards for closed accounts accounts? promptly pulled from the active account file 13. Do periodic reports prepared for manage- and placed in a closed file? Are closed ment provide an aging of adjustments and account lists circulated to the appropriate differences and detail the status of signifi- management? cant adjustments and differences?

Branch and Agency Examination Manual September 1997 Page 1 3230.4 Deposit Accounts: Internal Control Questionnaire

14. Are in-process, suspense, interoffice and f. Require a written request from the cus- other accounts related to deposit accounts tomer and verification of the customer’s controlled or closely monitored by persons signature before releasing an account who do not have posting or reconcilement from the controlled environment? duties? 20. Are accounts for which contact cannot be 15. Are periodic reports prepared for manage- reestablished and do not reflect recent ment on open items in suspense, in-process, activity removed from active files and interoffice and other deposit accounts and clearly classified as dormant? do the reports include aging of items and the 21. Before returning a dormant account to active status of significant items? status, are transactions reactivating the 16. Does the branch segregate the deposit account verified, independent confirmations account files of: obtained directly from the customer, and a. Employees and officers? approval obtained for an officer who cannot b. The business interests of, or controlled approve transactions on dormant accounts? by, employees and officers? 17. Are posting and check filing separated from statement preparation? INACTIVE ACCOUNTS 18. Are statements mailed or delivered to all 22. Are demand accounts that have been inac- customers, as required by the branch’s tive for one year and time accounts that deposit account agreement and in a con- have been inactive for three years classified trolled environment that precludes any as inactive? If not, state the time period. individual from receiving any statement not 23. Does the branch periodically review the specifically authorized by the customer or inactive accounts to determine if they should branch policy? be placed in a dormant status and are decisions to keep such accounts in active files documented? DORMANT ACCOUNTS AND RETURNED MAIL HOLD MAIL 19. Does the branch have formal policies and 24. Does the branch have a formal policy and procedures for the handling of dormant procedure for handling statements and docu- accounts and customers’ transaction and ments that a customer requests not to be interest statements that are returned by the mailed but will be picked up at a location post office as undeliverable? Does the within the branch? Does the policy: policy: a. Require that statements will not be held a. Require statements to be periodically by an individual (an account officer, mailed on dormant accounts? If so, how branch manager, bookkeeper, etc.) who often? could establish exclusive control over b. Prohibit the handling of such statements entries to and delivery of statements for by (1) account officer and (2) other customer accounts? individuals with exclusive control of b. Discourage such arrangements and grant accounts? them only after the customer provides a c. Require positive action to follow up on satisfactory reason for the arrangement? obtaining new addresses? c. Require the customer to sign a statement d. Require that statements and signature describing the purpose of the request and cards for accounts that cannot be con- the proposed times for pick-up and des- tacted (the mail is returned more than ignate the individuals authorized to pick once or marked ‘‘deceased’’) be placed up the statement? into a controlled environment? d. Require maintenance of signature cards e. Require the branch to change the address for individuals authorized to pick up on future statements to the department of statements and compare the authorized the branch (controlled environment) des- signatures to those who sign for state- ignated to receive returned mail? ments held for pick-up?

September 1997 Branch and Agency Examination Manual Page 2 Deposit Accounts: Internal Control Questionnaire 3230.4

e. Prohibit the delivery of statements to a. Is the computation of the uncollected officers and employees requiring special funds position based on reasonable check attention, unless it is part of the formal collection criteria? ‘‘hold mail’’ function? b. Can the reports or a separate account 25. Is a central record maintained in a control activity report reasonably be expected to area that does not originate entries to cus- detect potential kiting conditions? tomers’ accounts and identify each ‘‘hold c. If reports are not generated for time mail’’ arrangement, the designated location transaction accounts, is a system in place for pick-up, and the scheduled pick-up to control drawings against uncollected times? Does the control area: funds? a. Maintain current signature cards of indi- 35. Do authorized officers review the uncol- viduals authorized to pick up statements? lected funds reports and approve drawings b. Obtain signed receipts showing the date against uncollected funds within established of pick-up and compare the receipts to limits? the signature cards? 36. Are accounts that frequently appear on the c. Follow up on the status of statements not uncollected funds and/or kite suspect reports picked up as scheduled? reviewed, regardless of account balances? 26. Does management review activity in ‘‘hold (For example, accounts with simultaneous mail’’ accounts that have not been picked large debits and credits can reflect low up for extended periods of time (for exam- balances.) ple, one year) and, where there is no activity, place the accounts in a dormant status? OTHER MATTERS

OVERDRAFTS 37. Are account maintenance activities (change of address, status changes, rate changes, 27. Are officer overdraft authorization limits etc.) separated from data entry and recon- formally established? ciling duties? 28. Does the branch require an authorized offi- 38. Do all internal entries, other than service cer to approve overdrafts? charges, require the approval of appropriate 29. Is an overdraft listing prepared daily for supervisory personnel? demand deposit and time transaction 39. If not included in the internal/external audit accounts? program, are employees’ and officers’ 30. For branches processing overdrafts that are accounts, accounts of their business inter- not automatically approved (‘‘pay none’’ ests, and accounts controlled by them peri- system), is the insufficient funds report odically reviewed for unusual or prohibited circulated among branch officers? activity? 31. Are overdraft listings circulated among the 40. For unidentified deposits: officers? a. Are deposit slips kept under dual control? 32. Are the statements of accounts with large b. Is their disposition approved by an overdrafts reviewed for irregularities? appropriate officer? 33. Is a record of large overdrafts included in 41. For returned checks, unposted items, and the monthly report to head office manage- other rejects: ment and does it include the overdraft a. Are daily listings of such items prepared? origination date? b. Are all items reviewed daily and is disposition of items required within a reasonable time period? If so, indicate the time period. UNCOLLECTED FUNDS c. Are reports prepared for management showing items not disposed of within the 34. Does the branch generate a daily report of established time frames? drawings against uncollected funds for 42. Are accounts with a ‘‘hold-balance’’ status— demand deposits and time transaction those accounts on which court orders have accounts? been placed, those pledged as security to

Branch and Agency Examination Manual September 1997 Page 3 3230.4 Deposit Accounts: Internal Control Questionnaire

customers’ loans, those pending the clear- 49. If reconcilements are not part of the overall ing of a large check, and those where the deposit reconciliation function: owner is deceased ‘‘blocked-out’’ for trans- a. Are outstanding checks listed and recon- actions unless approved by appropriate ciled regularly to the general ledger? If management? so, how often? 43. For signature cards on deposit accounts: b. Is permanent evidence of reconcilements a. Are procedures in effect to guard against maintained? the substitution of false signatures? c. Is there clear separation between prepa- Describe the procedures. ration of checks, data entry, and b. Are signature cards stored to preclude reconcilement? physical damage? c. Are signatures compared for withdraw- d. Are the reconcilements reviewed regu- als and cashed checks? Describe the larly by an authorized officer? procedures. e. Are reconcilement duties rotated on a formal basis in branches where size precludes full separation of duties between OFFICIAL CHECKS, MONEY data entry and reconcilement? f. Are authorized signatures and endorse- ORDERS, AND CERTIFIED ments checked by the filing clerk? CHECKS 50. For supplies of official checks: 44. Are separate general ledger accounts main- a. Are records of unissued official checks tained for each type of official check? maintained centrally and at each location 45. As to the types of checks issued: storing them? a. Are multicopy checks and certified check b. Are periodic inventories of unissued forms used? If not, are detailed registers checks independently performed? of disbursed checks maintained? c. Do the inventories include a description b. Are all checks prenumbered and issued of all checks issued out of sequence? in sequence? d. If users are assigned a supply, is that c. Is check preparation and issuance sepa- supply replenished on a consignment rate from recordkeeping? basis? d. Is the signing of checks in advance 51. Are procedures in effect to preclude certifi- prohibited? cation of checks drawn against uncollected e. Do procedures prohibit issuance of a funds? check before the credit is processed? 46. Is the list authorizing branch personnel to sign official checks kept current? Does the list include changes in authorization limits, delete employees who no longer work at the CONCLUSION branch, and indicate employees added to the list? 52. Is the information covered by this ICQ 47. Are appropriate controls in effect over check adequate for evaluating internal controls in signing machines (if used) and certification this area? If not, indicate any additional stamps? examination procedures deemed necessary. 48. Are voided checks and certified check forms 53. Based on the information gathered, evaluate promptly defaced and filed with paid the internal controls in this area (i.e. strong, checks? satisfactory, fair, marginal, unsatisfactory).

September 1997 Branch and Agency Examination Manual Page 4 Deposit Accounts Audit Guidelines Effective date July 1997 Section 3230.5

It should be noted that some audit guidelines tigate significant items used to reconcile may not be easily implemented due to the and follow through to disposition. foreign residence of many branch customers. h. Review the reports on drawings against Therefore, the examiner should exercise judge- uncollected funds and significant changes ment in implementing these guidelines. to determine possible kiting. Request 1. Test the addition of all trial balances and the statements and copies of checks and reconciliation to the general ledger. deposit media to further investigate those 2. Using appropriate techniques, sample depos- selected. If the period for preparing its of all types from their respective trial uncollected funds reports is not at least balances and: 3 days, perform the following steps: a. Where appropriate, verify that essential • Look at 5 days of reports on uncol- account documentation contains, in a lected funds, large balances, and sig- conspicuous manner, disclosure of the nificant changes for unusual depositor accounts’ noninsured FDIC status. activity. Select account names and b. Where necessary, prepare and mail con- numbers that appear on the reports firmation forms, followed by second twice or more and eliminate large requests, to selected depositors. depositors who are known to deposit c. Follow up on any no-replies or excep- cash or their own checks to corporate tions and resolve differences. clearing accounts. 3. For transaction accounts selected in step 2: • For the remaining accounts, review a. Verify the computation of service charges canceled checks and deposit slips or for at least one account from each type of cash letter items to determine if checks transaction account selected and trace paid and checks deposited are con- them to the appropriate income account. trolled by the same or related parties. b. Determine, on a test basis, if insufficient i. Determine that collections deposited in funds and overdraft charges are properly escrow funds are properly credited and collected and trace them to the appropri- that debits made against the account are ate income account. for proper disbursements. c. Determine the reasons for statements j. Review the debit and credit entries made noted for ‘‘no mail’’ or ‘‘hold for pick on dormant accounts and determine up’’ and examine appropriate authoriza- validity and conformity to branch policy. tion signed by the customer. 4. For time deposit accounts selected in step 2: d. Determine if a properly signed authority a. Determine the reasons for savings account to charge is in evidence for accounts that statements noted for ‘‘hold for pick-up’’ have an automatic deduction by the or ‘‘no mail’’ and examine appropriate branch. authorizations signed by the customers. e. Investigate branch-controlled accounts, such as dealers’ reserves and cash/ b. Determine that accounts pledged are collateral accounts, to determine the noted on the trial balance to prevent validity of entries and of notification withdrawal of funds without officer procedures to the customer of activity. approval. f. Determine if unidentified funds are prop- c. Review the debit and credit entries to erly segregated, that disposition is on a dormant accounts and determine validity timely basis, and that items are trans- and conformity to branch policy. ferred to a dormant account after one d. Verify and detail the written contracts year. between the branch and its trust depart- g. Mail cut-off statements to include debit ment regarding the trust department’s and credit memos and drafts, and mail an time open account. appropriate reconciling form to due to e. Determine if unidentified funds are prop- banks accounts selected. Have the recon- erly segregated and if disposition is on a cilement completed and returned. Inves- timely basis. Ensure that items are trans-

Branch and Agency Examination Manual September 1997 Page 1 3230.5 Deposit Accounts: Audit Guidelines

ferred to a dormant account after one inventory of unissued checks by type. year. Reconcile the inventory to control ledger 5. For official checks: and resolve any differences. a. If accounts are on computer, reconcile 6. Compare the accounts selected from the last the cut-off statements as of the audit date audit to the current trial balance to deter- to bookkeeping totals and run a list of mine if any of those accounts were closed duplicate outstanding checks. or, if none were noted, select accounts from b. If accounts are manual, run a tape listing the closed account list and send confirma- of the outstanding checks or the check tions. register and balance to the general ledger 7. Review stop-payment orders and compare a totals. representative number to the trial balance to c. Review the copies of the outstanding determine if accounts are properly noted. checks for unusual items, stale-dated 8. Obtain or prepare a schedule showing the checks or any checks to persons or orga- accrued interest balances and the deposit nizations that may be in violation of the balances at each quarter-end since the last Foreign Corrupt Practices Act or Federal audit and investigate significant fluctuations Campaign Acts. or trends. d. Determine that stale checks are segre- 9. Test interest expense by computing interest gated and review the entries to ascertain expense based on average deposits and validity. interest rates on a quarterly basis. Compare e. Determine that all outstanding checks the computed amount to the actual recorded have been included as liabilities by con- expenses. trolling paid checks for a number of days 10. If the branch uses prenumbered CD forms, after the audit has begun and: determine that certificates are issued in • Indicate any checks paid before the numerical order. Inventory the unissued cer- liability was posted. tificates and reconcile the inventory to the • Inspect the paid checks for authorized control list and resolve any differences. signatures and endorsements. f. Determine if the branch is issuing checks in numerical sequence and make an

September 1997 Branch and Agency Examination Manual Page 2 Due From/Due To Related Ofﬁces Effective date July 1997 Section 3240.1

Head office and other offices of the foreign branch’s current and future interoffice funding banking organization (FBO) frequently serve as position, if any. In conducting this review, a primary funding source for a branch, in which special attention should be paid to any funding case the branch will be in a net due to position relationship between the branch and a U.S. with related offices. This situation is commonly affiliate bank owned or controlled by the FBO. found in a wholesale branch or a branch that is Such a relationship should be scrutinized to restricted by its license from accepting deposits. verify compliance with Sections 23A and 23B Funding for these offices is typically provided of the Federal Reserve Act. If any apparent by related offices and/or interbank borrowings. violations are noted, they should be referred to A retail branch, on the other hand, may be able the appropriate regulator. to accept deposits and thus be a net provider of The FBO’s annual strength-of-support assess- funds to related offices or in a net due from ment also provides a basis for reviewing the position. Examiners will find that the overall branch’s net due from/due to position. The level, nature, and significance of the branch’s strength-of-support assessment is an important funding relationship with related offices is influ- factor to consider when the branch is in a net enced by a number of factors, including com- due from position. In developing these assess- parative funding costs in the home country ments, the U.S. banking supervisors make deter- versus the United States and the branch’s role, if minations about the financial strength of an FBO any, in the overall U.S. funding strategy of the as well as the adequacy of home country super- FBO. The examiner’s role is to evaluate these vision and the overall condition of the home factors, identify any concerns, and recommend country financial system. The strength-of-support corrective action, if appropriate. assessment is considered when reviewing The evaluation of the branch’s funding rela- branches in a net due from position. (See the tionship with related parties is part of the overall Strength-of-Support Assessment for Foreign evaluation of the branch’s liquidity position and Banking Organizations section of this manual should thus be conducted jointly. This section for more guidance on this subject.) If necessary, provides specific guidance on the interoffice the branch may be required to maintain a net funding aspect of liquidity, which should be due to related parties position or may be sub- supplemented by referring to the Funds jected to other prudential limitations, including Management and Liquidity section of this asset maintenance requirements and growth manual. restrictions. To evaluate a funding relationship between a From a supervisory viewpoint, a net due to branch and its related offices or affiliates, exam- position is regarded favorably because it pro- iners should begin by reviewing the branch’s vides a cushion for nonrelated depositors and most recent quarterly call report-Report of Assets creditors. A net due from position with related and Liabilities (FFIEC 002), the annual assess- parties should be reviewed carefully. The review ment of the FBO’s combined U.S. operations, should consider any information on the under- and the FBO’s annual strength-of-support lying assets represented by a net due from assessment. A review of recent FFIEC 002 related party account. For example, the due from reports will give the examiner information on head office account may be used to fund export the branch’s historical level and trend in inter- financing from the home country with payment office funding, which should be used in discus- of the head office account scheduled to come sions with management on the nature of the from the receiving party. branch’s future interoffice funding position. In addition to providing funding to related Schedule M of the call report summarizes the entities, branches may also provide U.S. dollar gross due from/due to position with related clearing services. Such transactions would flow parties and shows whether the branch is in a net through the due from/due to accounts and would due to or due from related parties position. consist of checks and other clearing items For FBOs with multiple U.S. operations, the denominated in U.S. dollars. The branch would, U.S. operations assessment should provide in turn, clear and process the items typically information on the past level and flow of funds through its U.S. correspondent bank for payment. among its combined U.S. operations, which The due from/due to accounts may also con- should also provide a basis for reviewing the tain allocations for loan loss reserves and other

Branch and Agency Examination Manual September 1997 Page 1 3240.1 Due From/Due To Related Offices contingencies, which would normally flow Due from/due to accounts are sometimes used through earnings and be deducted from capital to effect asset transfers from one office to in a stand-alone operation. Such allocations another. Such transfers should be scrutinized must be identified and fully explored by the and reconciled to ensure propriety. For example, examiners in order to ensure that the branch’s problem loans may be transferred to head office, financial risks are being covered. offshore, or other U.S. and non-U.S. branches. The branch’s current period profit and loss is Such transfers should be revealed in the due included in the due from/due to subledger from/due to accounts, and should be communi- accounts with a due to a (credit) balance repre- cated to the examiner-in-charge. senting profit and a due from (debit) balance A branch with an asset maintenance require- representing a loss. Accumulated but unremitted ment will need to keep accurate daily records of profit or accumulated but unreimbursed loss also the due from/due to related office positions in may be included in this account. Note that this order to accurately track and report its adher- situation only applies to the profit and loss ence to the asset maintenance requirement to the segment of the accounts. For example, a very regulators. The gross due from/due to related profitable branch could have a net due from office positions are factored into the computa- related parties position for reasons related to tion for the asset maintenance requirement. (See funding but the profit and loss subledger of this the Asset Maintenance section of this manual account should reveal a due to (profit) balance. for more details on this subject.)

September 1997 Branch and Agency Examination Manual Page 2 Due From/Due To Related Ofﬁces Examination Objectives Effective date July 1997 Section 3240.2

1. To determine if the policies, practices, pro- 5. To evaluate the branch’s net due from/due to cedures, and internal controls regarding due position with related parties in relation to the from/due to accounts are adequate. FBO’s strength-of-support assessment and 2. To determine if branch officers are operating the overall assessment of its combined U.S. in conformance with the established guide- operations. lines from head office. 6. To determine that all due from and due to 3. To evaluate the nature of all related accounts accounts are reasonably and accurately to determine character, volatility, level, flow reported. of funds, and compliance with appropriate 7. To recommend corrective action when poli- laws. cies, practices, procedures, or internal con- 4. To determine the scope and adequacy of the trols are deficient or when violations of law audit function with respect to the branch’s or regulations have been noted. related parties position.

Branch and Agency Examination Manual September 1997 Page 1 Due From/Due To Related Ofﬁces Examination Procedures Effective date July 1997 Section 3240.3

1. Determine the related parties position in 6. Identify what interest, if any, is paid and accordance with the instructions to the received on due from/due to accounts to Report of Assets and Liabilities. determine if the rates are above or below 2. Review the FFIEC 002 report and the market rates. Share this information with appropriate due from/due to schedule and the examiner evaluating earnings. reconcile the figures to the general ledger to 7. For accounts that represent reserves, deter- ensure accuracy. mine the precise nature of these reserves, 3. Obtain a listing of any deficiencies noted in identifying all activity since the previous the latest review conducted by internal/ examination. Share this information with external auditors with respect to the branch’s the examiner-in-charge and the examiners related parties position, and determine if in charge of loan administration and earn- appropriate corrections have been made. ings, if applicable. 4. Review the branch prepared reconcilement 8. Determine if any transfers of loans have of related party accounts, match the closing occurred between examinations. If so, review balances to the general ledger and the cut- the entries and share this information with off statement, and ensure that departmental the examiner in charge of loan review. controls over entries to the proper accounts 9. Review the workpapers associated with the within the general ledger are being fol- profit and loss accounts to ensure that lowed, then: reported earnings or losses are properly a. Determine the reasonableness of any reflected in the due from/due to accounts unusual items noted in the reconciliation. with head office. Note whether provisions b. Determine if any old open items have for general reserves are taken through been charged off and, if so, were the earnings. charge-offs appropriate and within head 10. If the branch is in a net due from position, office policy. determine if it represents a concentration c. Determine if any large or unusual items (greater than or equal to 25 percent) of the are outstanding, and review related branch’s net assets and assess the potential correspondence. risks of such a concentration. d. Determine if any overdrafts exist in related party accounts, and determine 11. Identify any office on which the branch how these overdrafts are monitored and relies heavily for funding and share this approved by head office. Share this information with the examiner reviewing information with the examiner evaluat- liquidity. ing loans. 12. If the branch is operating under a supervi- e. Retain custody of all trial balances, only sory agreement that limits net due from if necessary and practical. positions or imposes an asset maintenance 5. For each account, determine the purpose requirement, test check for accuracy of (e.g., funding, lending, clearing, reserve reporting to the regulators. allocation, etc.) and the level of volatility. 13. Update the workpapers with any informa- Ensure that the purpose of the account is tion that will facilitate future examinations. consistent with the balances and the volatility.

Branch and Agency Examination Manual September 1997 Page 1 Due From/Due To Related Ofﬁces Internal Control Questionnaire Effective date July 1997 Section 3240.4

Review the branch’s controls, policies, prac- there are no significant deficiencies in areas tices, and procedures for obtaining and servicing not covered in this questionnaire that impair loans, placements, deposits, and borrowed funds any controls? Explain negative answers from related parties. The branch’s system should briefly and indicate any additional exami- be documented in a complete and concise man- nation procedures deemed necessary. ner and should include, where appropriate, nar- 8. Based on a composite evaluation, as evi- rative descriptions, flowcharts, copies of forms denced by answers to the foregoing ques- used, and other pertinent information. tions, internal control is considered (adequate/inadequate). 1. Does the branch have in place a written policy approved by branch and head office In the event the branch is in a net due from management that: position greater than or equal to 25 percent of a. Outlines the objectives of due from/due net assets, conduct the following procedures. to related accounts? b. Describes the branch’s philosophy rela- 9. Carefully review the FBO’s strength-of- tive to funding and clearing needs, support assessment to determine whether reserve policies, overdraft policies and any concerns exist with respect to its gen- approval limits, and proper recognition eral ability to support its U.S. operations. If of profits and losses? so, determine the extent to which the branch c. Provides a system of reporting require- depends on head office or related parties for ments to monitor interoffice activity? contingency funding, and any effect on the d. Provides for review and revision of ability of the branch to meet third party established policy at least annually? obligations. Discuss any concerns with the 2. Does the branch maintain subsidiary records examiner-in-charge for further guidance. for each related office? 10. If the branch is in a net due from position 3. Is the preparation, addition, and posting of greater than or equal to 25 percent of net the subsidiary related accounts records per- assets with an affiliate located in a country formed or adequately reviewed by persons other than its home country, determine: who do not also: a. If the affiliate is a financial institution a. Handle cash, telex, or wire transfers? that has been assigned a strength-of- b. Issue official checks and drafts? support assessment or has received a c. Prepare all supporting documents required rating by an independent agency. for payment of debt? b. If the affiliate is not a financial institu- 4. Are subsidiary related account records rec- tion, discuss the nature and future of this onciled with the general ledger accounts at funding relationship with branch man- an interval consistent with interoffice activ- agement. Discuss any concerns with the ity and are the reconciling items investi- examiner-in-charge. gated by persons, who do not also: 11. Is the branch reconciling its accounts with a. Handle cash, telex, or wire transfers? related parties at an interval consistent with b. Prepare general ledger entries. the interoffice activity, and is there a system c. Prepare or post to the related party’s to identify and monitor old items or large borrowed funds records? items? 5. Are interest computations, if any, checked 12. Are extensions of credit being granted to or by persons who do not have access to cash? are loans being transferred to related par- 6. Do monthly reports furnished to the head ties? Are the credit extensions performing? office reflect the activity of related accounts, At the time of transfer, were the assets including amounts outstanding, overdrafts, performing? interest rates, interest paid to date, and 13. Are the due from time deposits with related anticipated future activity? parties performing? 7. Is the foregoing information an adequate a. Are the placements continually renewed basis for evaluating internal control in that or is there actual payment at maturity?

Branch and Agency Examination Manual September 1997 Page 1 3240.4 Due From/Due To Related Ofﬁces: Internal Control Questionnaire

b. If the branch is providing funding to an 14. Does the net due from related parties posi- offshore related financial institution, tion represent a concentration of transfer determine the purpose of the funding and risk to any one country that could have a its utilization. significant impact on the repayment of the • Is the entity well capitalized? branch’s third party liabilities? • Are the funds used to lend to ICERC 15. If the branch is operating under an asset classified countries? Are these loans to maintenance requirement, is it appropriately finance trade transactions and are these monitoring and accurately reporting due loans performing? from/due to related office positions to the • Is the entity purchasing problem loans regulators in the asset maintenance from the branch? If so, this relation- computation? ship should be closely scrutinized because the branch may be funding the sale of its problem assets through the placement of funds with the purchasing entity.

September 1997 Branch and Agency Examination Manual Page 2 Due From/Due To Related Ofﬁces Audit Guidelines Effective date July 1997 Section 3240.5

1. Using an appropriate sampling technique, 2. Examine supporting documents for accuracy select items for review of supporting docu- and trace applicable entries, including pro- mentation, including terms, balances, and ceeds, to detail records and to the general other appropriate details, and request a posi- ledger. tive confirmation from the related office. 3. Test check interest computations for accu- Control all answered confirmations and racy and trace entries to appropriate accounts. investigate any reported differences. Include 4. Examine transactions for consistency with all confirmations in the workpapers and docu- the stated purpose of the related accounts. ment the disposition of all exceptions or no-replies.

Branch and Agency Examination Manual September 1997 Page 1 Off-Balance-Sheet Activities Effective date July 1997 Section 3300.1

Contingent liabilities, also referred to as off- sure due to transactions originating and settling balance-sheet items, should be analyzed as part during the same day); liquidity risk (i.e., lack of of the branch’s overall risk management assess- funds to honor commitments leading to higher ment. Potential exposure, funding sources, the borrowing costs); country risk; and litigation adequacy of risk management, and internal con- risk. Of these, the major risk to consider would trols for off-balance-sheet risks are specific mat- be credit risk, interest rate risk, and market risk. ters that should be considered. It is essential that a system of controls be in As a regular part of their operation, some place to limit off-balance-sheet risk. These con- branches are involved in originating financial trols, including policies, procedures, recordkeep- contracts that may result in the acquisition of ing systems, and audit coverage, should be certain assets and liabilities at some future date, sufficiently detailed to ensure proper perfor- under certain conditions. Generally accepted mance evaluation by branch and head office accounting principles do not consider these management, auditors, and regulatory authorities. contracts in themselves to be assets or liabilities Formal written policies, stating goals and and, thus, do not recognize them on the face of strategies and setting limitations at various lev- the balance sheet. These off-balance-sheet items els, are necessary to prevent abuses and to act as are quite diverse in nature and purpose and may benchmarks against which performance may be include such instruments as firm loan commit- gauged. A limit should be placed on an activi- ments, standby letters of credit, foreign exchange, ty’s total volume. In addition, limits should be financial futures, forward contracts, options, established for individual customers, and param- interest rate swap contracts, and other derivative eters set for traders. Procedures should be in products. place to ensure that operations are consistent Greater competition, marketing innovations, with written policies. Comprehensive record- and government deregulation have changed the keeping and reporting are needed for adequate focus of attention from contingent liabilities. In audit coverage and management information. addition to assessing the risk in off-balance- Most importantly, branch management should sheet instruments, examiners must also assess be aware of all off-balance-sheet activity and the risk of off-balance-sheet activities. Branches ensure that controls and procedures are in place are now involved in a wide spectrum of banking to identify and monitor attendant risk. activities designed to generate fee income, such The purpose of this section is to serve as a as securities clearance and brokerage activities, concise reminder of the major types of off- data processing services, and investment and balance-sheet items. Examination objectives, management advisory services. As the branches examination procedures, and internal control find more avenues of non-traditional banking questionnaires for these items are found in the activities available to them, they may expand the appropriate sections of this manual, the Federal scope of services offered to customers. These Reserve’s Trading Activities Manual, and other new activities may involve risks which are similar material developed by the other federal difficult to quantify, such as legal risk, or repu- and state bank supervisory agencies. For further tational risk. guidance in this area, examiners should consult In recent years, there has been significant with their respective agencies. growth in the volume of contingent liabilities Contingent liabilities containing primarily related to various derivative products. At the credit risk include the following categories: same time, growth in standby letters of credit enhancements has moderated due to global risk- based capital considerations. There are many types of risks which the COMMITMENTS TO MAKE OR examiner should be aware of: principal (posi- PURCHASE LOANS OR TO tion), credit, and settlement risk (i.e., loss of EXTEND CREDIT IN THE FORM principal due to default by a contractual party); OF LEASE FINANCING interest rate (basis), market, and foreign exchange ARRANGEMENTS risk (i.e., depreciation of principal amount or loss of income due to rate, market or currency These transactions include the portion of com- fluctuations); daylight overdraft risk (i.e., expo- mitments that obligate the branch to extend

Branch and Agency Examination Manual September 1997 Page 1 3300.1 Off-Balance-Sheet Activities credit in the form of loans (including credit card the other party to the participation to pay the lines), participations in loans, lease ﬁnancing amount of its participated share to the accepting receivables, or similar transactions. This cate- bank at the maturity of the acceptance, whether gory would include commitments for which the or not the account party defaults. branch has charged a commitment fee or other consideration or otherwise has a legally binding commitment. PARTICIPATIONS IN ACCEPTANCES ACQUIRED BY THE SUBJECT BRANCH STANDBY LETTERS OF CREDIT Participations in acceptances of other banks A standby letter of credit provides for payment acquired by the branch (nonaccepting bank) to the beneﬁciary by the issuing bank in the include such transactions that provide for the event of default or nonperformance by the nonaccepting bank to pay the amount of its account party (the issuing bank’s customer) participated share to the accepting bank at the upon the presentation of a draft or documenta- maturity of the acceptance, whether or not the tion required in the letter of credit. A standby account party defaults. letter of credit, typically, is unsecured and is Contingent liabilities containing interest, mar- payable against a simple statement of default or ket, and credit risk include the following nonperformance. Refer to this manual’s section categories: on Letters of Credit for additional information.

FUTURES AND FORWARD COMMERCIAL AND SIMILAR CONTRACTS LETTERS OF CREDIT Futures and forward contracts are tools for use A commercial documentary letter of credit is an in asset and liability management, and can be instrument in which a bank (issuing bank) used by branches to effectively hedge portions undertakes to pay a party (beneficiary) named in of their portfolios against interest rate risk. the instrument a sum of money on behalf of the Branches that engage in futures and forward bank’s customer (account party). This type of contract activities should only do so in accor- letter of credit is used most commonly to pro- dance with safe and sound banking practices, vide a bank’s credit and possible financing to a with levels of activity reasonably related to the commercial contract for the shipment of goods branch’s business needs and capacity to fulfill from seller to buyer. The beneficiary will be paid its obligations under the contracts. In managing when the terms of the letter of credit are met and their assets and liabilities, branches should evalu- the required supporting documents are submit- ate the interest rate risk exposure resulting from ted to the paying or negotiating bank. Refer to their overall activities to ensure that the posi- this manual’s section on Letters of Credit for tions they take in futures and forward contract additional information. markets will reduce their risk exposure. Policy objectives should be formulated in light of the branch’s entire asset and liability mix. Defini- tions of futures and forward contracts are as PARTICIPATIONS IN follows: ACCEPTANCES CONVEYED TO OTHERS BY THE SUBJECT • Futures contracts are standardized contracts BRANCH traded on organized exchanges to purchase or sell a specified security, money market instru- A banker’s acceptance is a time draft or bill of ment, or other financial undertaking on a exchange that has been drawn on and accepted future date at a specified price. Accordingly, by a banking institution for payment by that the credit exposure is to the exchange and is institution at some future date. Participations in generally considered to be negligible. How- acceptances conveyed to others by the accepting ever, this may not be the case for exchanges in bank include such transactions that provide for less developed countries.

September 1997 Branch and Agency Examination Manual Page 2 Off-Balance-Sheet Activities 3300.1

• Forward contracts are over-the-counter con- buy the securities at the other party’s option. tracts for forward placement or delayed deliv- Exchange trading is conducted in options speci- ery of securities in which one party agrees to fying delivery of debt securities, money market purchase and another to sell a specified secu- instruments, or futures contracts specifying rity at a specified price for future delivery. delivery of debt securities. Contracts specifying settlement in excess of 30 days following trade date are considered to be forward contracts. Forward contracts are not traded on organized exchanges, generally FOREIGN EXCHANGE have no required margin payments, and can CONTRACTS only be terminated by agreement of both parties to the transaction. These are contracts to exchange one currency for another as of a specified date and time at a specified rate of exchange (price). Delivery of STANDBY CONTRACTS the currency may be spot (two or less business AND OTHER OPTION days) or forward (more than two business days). ARRANGEMENTS

Standby contracts and other option arrangements are also tools for asset and liability INTEREST RATE SWAP management which, when properly used, can CONTRACTS reduce the risks of interest rate ﬂuctuations. Standby contracts are optional delivery forward Interest rate swap contacts are private, over-the- contracts on U.S. government and agency secu- counter contracts between counterparties for rities, arranged between securities dealers and exchanging interest payments for a speciﬁed customers. The buyer of a standby contract (put period based on a notional principal amount. option) acquires, upon paying a fee, the right to Entities generally enter into interest rate swaps sell securities to the other party at a stated price for interest rate risk management; namely, to at a future time. The seller of the standby (the manage the interest rate exposures arising from issuer) receives the fee and must stand ready to asset and liability positions.

Branch and Agency Examination Manual September 1997 Page 3 Guarantees Issued Effective date July 1997 Section 3310.1

Branches do not have the authority to issue customary for the importer (buyer) to obtain guarantees or sureties, except as may be inci- immediate possession of the goods by providing dental or usual in carrying on their banking the shipping company with a bank guarantee, business. Such an instance may occur when a often called a steamship guarantee, which branch has a substantial interest in the perfor- relieves the shipping company of liability result- mance of the transaction involved or has a ing from release of the goods without proper or segregated deposit sufﬁcient to cover its total complete negotiable title documents. Usually, potential liability. the guarantee relies on a counter-guarantee issued A branch may also guarantee or endorse notes to the branch by the importer. or other obligations sold by the branch for its All types of guarantees issued are to be own account. The amount of the obligations recorded as contingent liabilities by the branch. covered by such guarantee or endorsement is to Usually, the party for whom the guarantee was be recorded as a contingent liability on the issued will reimburse the branch should it be records of the branch. Furthermore, such liabili- required to pay under the guarantee; however, in ties are included in computing the aggregate certain situations, some other designated party indebtedness of the branch, which may be sub- may reimburse the branch. That other party may ject to limitations imposed by any applicable be designated in the guarantee agreement with law or regulation. the branch or in the guarantee instrument itself. A common example of a guarantee is a The branch may also be reimbursed from seg- steamship letter of guarantee. Frequently, in an regated deposits held, pledged collateral, or by a international sale of goods, the merchandise counter-guarantor. Letters of credit, as distin- arrives at the importer’s (buyer’s) port and the guished from guarantees, are discussed in a complete negotiable bills of lading are either separate section of this manual. lost or delayed in transit. In such instances, it is

Branch and Agency Examination Manual September 1997 Page 1 Guarantees Issued Examination Objectives Effective date July 1997 Section 3310.2

1. To determine if policies, practices, proce- 5. To determine compliance with applicable dures, and internal controls regarding guar- laws and regulations. antees issued are adequate. 6. To recommend corrective action when poli- 2. To determine if branch officers are operating cies, practices, procedures, or internal con- in conformance with established guidelines. trols are deficient or when violations of law 3. To evaluate the portfolio for credit quality, or regulations have been noted. collectibility, and collateral sufficiency. 4. To determine the scope and adequacy of the audit function, as it applies to guarantees.

Branch and Agency Examination Manual September 1997 Page 1 Guarantees Issued Examination Procedures Effective date July 1997 Section 3310.3

Refer to the Credit Risk Management, Exami- records and in the reports of assets and nation Procedures section of this manual for liabilities of the branch and that such examination procedures related to the risk liabilities are included in computing the assessment of guarantees. aggregate indebtedness of the branch. b. Determine which guarantees are subject to 1. For guarantees issued in the selected review individual loan limitations to any one sample, check central liability ﬁle on borrow- customer. Combine guarantees with any er(s) indebted above the selected cutoff review other extensions of credit to the account line or borrower(s) displaying credit weak- party by the issuing branch subject to loan ness or suspected of having additional liabil- limitations. ity in loan areas. 3. Determine if the trial balance contains expired 2. Determine compliance with any applicable guarantees. If so, determine the branch’s laws and regulations pertaining to guarantees policies, practices, and procedures for dispos- issued by performing the following steps: ing these guarantees. a. Determine that the obligations covered by 4. Update the workpapers with any information such guarantees or endorsements are that will facilitate future examinations. shown as contingent liabilities on the

Branch and Agency Examination Manual September 1997 Page 1 Guarantees Issued Internal Control Questionnaire Effective date July 1997 Section 3310.4

Review the branch’s internal controls, policies, 4. Is a daily record maintained, summarizing practices, and procedures for issuing and servic- guarantee transaction details, i.e., guarantees ing guarantees. issued, guarantees canceled or renewed, payment made under guarantees, and fees col- 1. Has branch and head office management lected, which support ledger entries? adopted written policies pertaining to guar- 5. Are blank guarantee forms safeguarded dur- antees issued that: ing banking hours and locked in the vault a. Establish procedures for reviewing guar- overnight? antee applications? 6. Are all guarantees issued recorded as contin- b. Define qualified guarantee account parties? gent liabilities and assigned consecutive c. Establish minimum standards for docu- numbers? mentation in accordance with the Uniform 7. Are all guarantees issued recorded on indi- Commercial Code? vidual customer (account party) liability 2. Are policies reviewed at least annually to ledgers? determine if they are compatible with changing market conditions? CONCLUSION

RECORDS 8. Is the information covered by this ICQ adequate for evaluating internal controls in 3. Are the subsidiary guarantees issued records this area? If not, indicate any additional balanced daily with the general ledger and examination procedures deemed necessary. are reconciling items adequately investigated 9. Based on the information gathered, evaluate by persons who do not normally handle the internal controls in this area (i.e. strong, guarantees? satisfactory, fair, marginal, unsatisfactory).

Branch and Agency Examination Manual September 1997 Page 1 Guarantees Issued Audit Guidelines Effective date July 1997 Section 3310.5

1. Test the addition of trial balances and their i. Test the pricing of any negotiable collat- reconciliation to the general ledger. eral held. 2. Using an appropriate sampling technique, j. Determine that collateral margins are rea- select guarantees issued from the trial bal- sonable and in line with branch policy and ance and: legal requirements. a. Prepare and mail confirmation forms to k. List all collateral discrepancies and account parties and beneficiaries. Guaran- investigate. tees serviced by other institutions, either l. Determine if any collateral is held by an whole guarantees or syndicate participa- outside custodian or has been temporarily tions, should be confirmed only with the removed for any reason. servicing institution (or lead bank). Guar- m. Forward a confirmation request on any antees serviced for other institutions, either collateral held outside the branch. whole guarantees or syndicate participa- n. Determine that each file contains docu- tions, should be confirmed with the buy- mentation supporting counter-guarantees, ing institution and the account party. Con- if applicable. firmation forms should include account party’s name, guarantee number, amount, o. Review guarantee participation agree- fee charged, and a brief description of any ments for such items as fees charged the collateral or counter-guarantee held. account party or remittance requirements b. After a reasonable time, mail second and determine whether the account party requests. has complied. c. Follow up on any no-replies or exceptions p. If the branch paid a beneficiary under its and resolve differences. guarantee, review disbursement ledgers d. Examine written guarantee instruments and authorizations to determine whether for completeness and terms, and verify payment was effected in accordance with amount to the trial balance. the terms of the guarantee agreement and e. Check to see that required initials of the whether the branch was recompensed by approving officer are on the guarantee the account party. instrument. 3. Review fees collected accounts by: f. Check to see that the signature on the a. Reviewing and testing procedures for guarantee is authorized. accounting for fees collected and for han- g. Compare any collateral held with the dling any adjustments. description on the collateral register. b. Scanning fees collected for any unusual h. Determine that the proper assignments, entries and following up on any unusual hypothecation agreements, etc., are on items by tracing them to initial and sup- file. porting records.

Branch and Agency Examination Manual September 1997 Page 1 Letters of Credit Effective date July 1997 Section 3320.1

Letters of credit are the most widely used means of settling payments. Because a revo- instrument to finance international trade trans- cable credit can be canceled or changed without actions. The two major types of letters of credit notice, the beneficiary should not rely on the used are the commercial documentary letter of credit, but rather on the willingness and ability credit and the standby letter of credit. of the buyer to meet the terms of the underlying contract. The letter of credit may be sent to the beneficiary directly by the issuing bank or through COMMERCIAL DOCUMENTARY the beneficiary’s bank or through the issuing LETTERS OF CREDIT bank’s correspondent located in the same place as the beneficiary. The correspondent may act as This type of letter of credit is used most com- an ‘‘advising bank’’ that is, it may act as an monly to provide a bank’s credit and possible agent of the issuing bank in forwarding the letter financing to a commercial contract for the ship- on to the beneficiary without any commitment to ment of goods from seller to buyer. A commer- pay on its part. Advised letters of credit will bear cial documentary letter of credit is a letter issued a notation by the advising bank that it makes by a bank (issuing bank) on behalf of its ‘‘no engagement’’ or words to that effect. An customer (account party), a buyer of merchan- irrevocable advised letter of credit is, therefore, dise, to a seller (beneficiary), authorizing the an undertaking to pay by the issuing bank but seller to draw drafts up to a stipulated amount, not by the advising bank. under specified terms and undertaking to pro- Some beneficiaries (sellers), particularly those vide eventual payment for drafts drawn. The not familiar with the issuing bank, request that beneficiary will be paid when the terms of the the buyer have the issuing bank ask the advising letter of credit are met and the required support- bank to add its ‘‘confirmation’’ to the issuing ing documents are submitted to the paying or bank’s irrevocable letter of credit. Confirmed negotiating bank. letters of credit are evidenced by the confirming The issuance and negotiation by banks of bank’s notation: ‘‘We undertake that all drafts letters of credit are governed by Article 5 of the drawn . . . will be honored by us’’ or similar Uniform Commercial Code and the Uniform words. The beneficiary of a confirmed credit has Customs and Practice for Documentary Credits a definite commitment to pay from a bank in his published by the International Chamber of Com- or her country and does not need to be con- merce. All letters of credit must be issued cerned with the willingness or ability of the issuing bank to pay. One bank may play more • In favor of a definite beneficiary. than one role. For example, an advising bank • For a specific amount of money. may add its confirmation and be designated in • In a form clearly stating how payment to the the letter as the paying bank. beneficiary is to be made and under what Payment terms of a letter of credit usually conditions. vary from sight to 180 days, although other • With a definite expiration date. terms sometimes are used. The letter will specify on which bank drafts are to be drawn. If the draft Commercial letters of credit are issued in is drawn at sight, the bank will effect payment either irrevocable or revocable form. An irrevo- upon presentation of the draft provided the cable letter of credit cannot be changed without terms of the credit have been met. If the draft is the agreement of all parties. Conversely, a revo- a time draft, the drawee bank can accept the cable letter of credit can be canceled or amended draft (by stamping ‘‘Accepted’’ on the face of by the issuing bank at any time, without notice the draft), which then can be held by either the to or the agreement of the beneficiary. seller or the seller’s bank or the accepting bank An irrevocable letter of credit constitutes a until maturity. Alternatively, the accepted draft definite commitment by the issuing bank to pay, can be sold or discounted. (Refer to the Bankers’ provided the beneficiary complies with the let- Acceptances section.) ter’s terms and conditions. In contrast, the revo- Certain categories of commercial letters of cable credit is not truly a bank credit but serves credit, such as ‘‘back-to-back’’, ‘‘transferable’’, as a device that provides the buyer and seller a ‘‘deferred payment’’, ‘‘revolving’’, and ‘‘red

Branch and Agency Examination Manual September 1997 Page 1 3320.1 Letters of Credit clause’’ credits, contain specific elements of cally reinstated without specific amendments to risk. Although these types of credits are infre- the credit. Such credits allow for flexibility in quently seen, branches should exercise caution commercial dealings between exporters and in their issuance and/or negotiation. importers; however, credits of this type usually specify a maximum overall amount which can A back-to-back letter of credit is one where a be drawn for control purposes. Credits of this commercial letter of credit (master credit) is type can revolve in relation to time or value, and used as security to support the issuance of a be cumulative or non-cumulative. In practice, second credit to another supplier (seller). The the vast majority of letters of credit are non- beneficiary (seller) of the credit becomes the revolving. Since the maximum exposure under applicant of the second letter of credit. In other an irrevocable revolving credit can be large, words, the beneficiary assumes the role of a most revolving credits are issued in revocable middleman between the actual supplier and the form. ultimate buyer of the merchandise. The difference between the master credit amount and the Originally the clause in the letter of credit was back-to-back credit is the middleman’s profit. written in red ink to draw attention to the special Bank-to-back credits are most frequently seen in nature of the credit. Hence, the name Red situations where the exporter (middleman) is Clause Credits. The use of this clause permits unable to purchase merchandise on his own the beneficiary to obtain an advance or pre- credit rating. shipment advances from the advising or confirming bank. Its purpose is to provide the seller A transferable letter of credit enables the credit. Any advances are the responsibility of original beneficiary to transfer the rights of the issuing bank. Interest is normally charged by payment to one or more beneficiaries. These the bank making the advance until documents credits are normally seen when the original are presented and the bank is reimbursed by the beneficiary acts as an agent and does not supply issuing bank. some or all of the merchandise or does not have Documentation is of paramount importance in the financial resources or credit necessary to all letter of credit transactions. The branch is purchase the merchandise. In some instances, required to examine all documents with care to the beneficiary may wish to keep the supplier determine that they conform to all of the terms and applicant ignorant of each other (so as to and conditions of the letter of credit. Ultimate protect his profit as middleman) by requesting repayment often depends upon the eventual sale the advising bank to substitute his own name for of the goods involved. Thus, the proper handling that of the applicant. The rights in a transferable and accuracy of the documents required under letter of credit may not be transferred by the the letter of credit is of primary concern. second beneficiary to a third party unless otherwise stated.

Deferred payment letters of credit are similar to a commercial letter of credit in that they STANDBY LETTERS OF CREDIT provide for payment at some date after shipment of the goods. However, this type of credit does A standby letter of credit provides for payment not require a time draft to be presented for to the beneﬁciary by the issuing bank in the payment. The merchandise is released without event of default or nonperformance by the payment. Instead, the issuing bank undertakes to account party (the issuing bank’s customer) reimburse the paying bank at some future date upon the presentation of a draft or the documen- as stipulated in the credit. Deferred payment tation, as required in the letter of credit. Although credits are discouraged by banks since no debt a standby letter of credit may arise from a instrument exists to discount. The obligation commercial transaction, it usually is not linked represents a direct liability of the bank and is directly to the shipment of goods from seller to booked in a manner similar to the liability buyer. It may cover performance of a construc- booked for an acceptance. tion contract, serve as an assurance to a bank that the seller will honor his or her obligations A revolving letter of credit allows for the under warranties, or relate to the payment of a amount of the credit to be renewed or automati- purely monetary obligation, for example, when

September 1997 Branch and Agency Examination Manual Page 2 Letters of Credit 3320.1 the credit is used in backing payment of com- Private Export Funding Corporation (PEFCO) mercial paper. is a private corporation, incorporated in 1970, Under all letters of credit, the banker expects for the purpose of making U.S. dollar loans to the account party to be financially able to meet foreign importers to finance purchases of goods his or her commitments. A banker’s payment or services of U.S. manufacture or origin. All under a commercial letter of credit for the loans made by PEFCO are unconditionally guar- customer’s account is usually reimbursed imme- anteed by Eximbank. diately by the customer and does not become a loan. However, payment under a standby letter Commodity Credit Corporation (CCC) is a of credit generally occurs because the account U.S. government agency which provides com- party has defaulted on its primary obligation. mercial credit and political risk guarantees to That default can be a result of the customer facilitate the financing of U.S. commodity being unable to pay or of a dispute between the exports such as wheat and corn. beneficiary and the account party. A standby letter of credit transaction involves Agency for International Development (AID) greater potential risk for the issuing bank than is the largest unit of the International Develop- does a commercial documentary letter of credit. ment Co-operation Agency, administers most of Unless the transaction is fully secured, the issuer the bilateral foreign aid programs of the U.S. of a standby letter of credit retains nothing of government. AID provides U.S. dollars through value to protect against loss, whereas a commer- loans and grants for foreign assistance recipients cial documentary letter of credit may provide to purchase, principally from the U.S., products the bank with title to the goods being shipped. needed in connection with development pro- To reduce the risk of a standby letter of credit, grams and related technical and professional the issuing bank’s credit analysis of the account services. party should be equivalent to that applicable to a borrower in an ordinary loan situation. For International Bank for Reconstruction and reporting purposes, standby letters of credit are Development (IBRD) is a transnational organi- shown as contingent liabilities in the branch’s zation organized for the purpose of financing Report of Assets and Liabilities. Depending on infrastructure and development projects in lesser any applicable state and federal laws and regu- developed countries. lations, standby letters of credit may be subject to prudential limitations. Inter-American Development Bank (IADB), the oldest and largest regional multilateral development institution, was established in 1959 to help accelerate social and economic develop- GOVERNMENT AND AGENCY ment projects in Latin America and the Caribbean. GUARANTEED LETTERS OF CREDIT Overseas Private Investment Corporation (OPIC) is a self-sustaining U.S. government The process of foreign trade also is facilitated by corporation whose principal purpose is to pro- various U.S. government agencies and interna- mote economic growth in developing nations by tional organizations. Some programs guarantee encouraging U.S. private investment in those payments under letters of credit issued by com- countries. OPIC promotes its objectives princi- mercial banks under programs to promote U.S. pally by insuring U.S. investors against political exports or at the request of international orga- risks and financing selected investment projects nizations which reimburse banks for letters of through direct loans or loan guarantees. credit issued on their behalf. The most common government agencies include the following:

The Export-Import Bank of the United States ANTI-BOYCOTT REGULATIONS (Eximbank) is an independent agency of the U.S. government which facilitates the ﬁnancing The Export Administration Act of 1973 prohib- of U.S. exports through guarantying debt obli- its banks from taking or knowingly agreeing to gations acquired from U.S. exporters or through take actions that support any boycott against a direct lending activities. country friendly to the United States. Under

Branch and Agency Examination Manual September 1997 Page 3 3320.1 Letters of Credit anti-boycott regulations (which are issued by the may try to add improper language orally rather Department of Commerce and enforced by the than in writing. Boycott language includes Office of Anti-Boycott Compliance), U.S. banks clauses or requirements such as: are required to report letters of credit they receive that include illegal boycott terms or • Certification that the goods are not of a conditions and should establish an ongoing pro- particular origin, such as Israeli or South gram to review all letters of credit. These African; regulations apply to both domestic and overseas • Certification that any supplier or provider of branches of all U.S. banks. services does not appear on the Arab blacklist; The anti-boycott provisions prohibit banks • The condition, ‘‘Do not negotiate with black- from opening, negotiating, confirming, or pay- listed banks’’, or words to that effect; ing international letters of credit that contain illegal terms or conditions. The improper lan- • A request not to ship goods on a Israeli carrier guage is most often seen in documentary letters or on a vessel or carrier that calls at Israel en of credit, sight reimbursements, and pass-on route to a boycotting country; and letters of credit, but may also appear in drafts • A request for a certificate stating the origin or and wire payments. Often, a bank’s customer the goods or the destination of the goods.

September 1997 Branch and Agency Examination Manual Page 4 Letters of Credit Examination Objectives Effective date July 1997 Section 3320.2

1. To determine if objectives, policies, prac- 5. To determine compliance with applicable tices, procedures, and internal controls laws and regulations. regarding letters of credit are adequate. 6. To recommend corrective action when poli- 2. To determine whether branch officers are cies, practices, procedures, or internal con- operating in conformance with established trols are deficient or when violations of law guidelines. or regulations have been noted. 3. To determine the scope and adequacy of the audit function. 4. To evaluate the portfolio for documentation and collateral sufficiency, credit quality, and collectibility.

Branch and Agency Examination Manual September 1997 Page 1 Letters of Credit Examination Procedures Effective date July 1997 Section 3320.3

1. Analyze the following specific types of let- gation, e.g., default on loans, perfor- ters of credit (when applicable) to determine mance of contracts, or relating to if: maritime liens. a. For Red Clause Letters of Credit (Packing d. For Deferred Payment Letters of Credit Credits): (trade-related): • Clean advance or anticipatory drawing • The letter of credit calls for drawing of finance to the beneficiary (exporter or sight drafts with the provision that such agent) is authorized under the letter of drafts are not to be paid until a specified credit. period after presentation and surrender • The beneficiary undertakes to deliver of shipping documents to the branch. within the expiration date the shipping • The branch’s liability for outstanding documents called for in the letter of letters of credit calling for deferred credit. payment is reflected as contingent lia- • The foreign bank makes advances to the bility until such documents presented beneficiary and is paid by drawing its under the letter of credit are honored. own draft on the opening bank or the • The branch has received, approved, and beneficiary is authorized to draw its acknowledged receipt of the documents draft on the issuing bank and the drafts thereby becoming directly liable to pay received charged to the importer. the beneficiary at a determinable future b. For Back-to-Back Letters of Credit: date(s). • The backing letter of credit is properly • Payment will be made to the beneficiary assigned as collateral to the bank issu- in a specified number of months or ing the letter of credit. quarterly, semiannually, annually, or • The terms of the letter of credit issued beyond. (If the branch has advanced are identical to the backing credit except money to the beneficiary against the that: deferred payment letter of credit, with — The beneficiary and account party its proceeds assigned as collateral to are different. repay the advance, the transaction should — The amount may be less but not be treated as a loan rather than a deferred more than the backing credit. payment letter of credit). — The expiration date is reduced by e. For Clean Deferred Payment Letters of sufficient time to allow completion Credit: of the transaction before the backing • Such deferred payment credits call for letter of credit expires. future payment against simple receipt • The beneficiary of the backing letter of without documents evidencing an under- credit is a regular customer of the branch lying trade transaction. opening the second letter of credit. • Such letters of credit are shown as direct c. For Standby Letters of Credit: liabilities on the branch’s records when • They represent undertakings to pay up drafts are presented by the beneficiary to a specific amount upon presentation and received by the branch. of a draft(s) and/or documents before a f. For Authority To Purchase: specified date. • The authority to purchase is with • They represent obligations to a benefi- recourse to the drawer, without recourse ciary on part of the issuer to: to the drawer, or without recourse to the — Repay money borrowed by or drawer but confirmed by the negotiating advanced to or for the account party. bank. — Make payment on account of any g. For Agency for International Develop- indebtedness undertaken by the ment (AID) Letters of Credit: account party. Make payment on • The branch or foreign banking organi- account of default by the account zation (FBO) has an AID letter of com- party in the performance of an obli- mitment authorizing the transaction.

Branch and Agency Examination Manual September 1997 Page 1 3320.3 Letters of Credit: Examination Procedures

• The branch has checked to make sure (A spot check should be made of these that all documents, including those pre- credits to ensure that the branch has not sented by the beneficiary, comply with committed to an engagement under the the terms of both the letter of credit and letters of credit.) the AID commitment. k. For Other Types of Letters of Credit: • A letter of agreement between the branch • Any of the following U.S. government or FBO and the foreign government agencies and international organizations exists whereby the branch or FBO has reimburse the branch for issuing letters recourse should AID fail to reimburse of credit on their behalf: the branch or FBO. — International Bank for Reconstruc- h. For Commodity Credit Corporation (CCC) tion and Development (IBRD). Letters of Credit: — Inter-American Development Bank • The branch or FBO has a CCC letter of (IADB). commitment authorizing the branch or — Overseas Private Investment Corpo- FBO under examination to issue letters ration (OPIC). of credit to beneficiaries supplying eli- 2. Determine that the amount of standby letters gible commodities to foreign importers. of credit does not exceed the prudential • In instances where the branch has issued limitations on loans imposed by any applica- standby letters of credit in favor of the ble state and federal law (including limita- CCC, the following requirement has tions to any one customer or on aggregate been met: extensions of credit). — At least 10 percent of the financed a. Combine standby letters of credit with any amount is confirmed, i.e., guaran- other nonaccepted loans to the account teed by a U.S. bank for commercial party by the issuing branch for the pur- credit risk. The total value of the pose of applying any state and federal credit is advised through a U.S. loan limitations to any one customer. bank. b. A standby letter of credit is not subject to i. For the Export-Import Bank of the United loan limitations imposed by applicable States: law in the following instances: • The branch or FBO has an agency • Prior to or at the time of issuance of the agreement from Eximbank stating: credit, the issuing branch is paid an — Eximbank has entered into a line of amount equal to the branch’s maximum credit with a foreign borrower. liability under the standby letter of — The amount of the line. credit. — The branch or FBO has been desig- • Prior to or at the time of issuance, the nated to issue the letter of credit(s). branch has set aside sufficient funds in a — Any payments made under an segregated, clearly earmarked deposit Eximbank approved letter of credit account to cover the branch’s maximum will be reimbursed by Eximbank. liability under the standby letter of • The branch has checked to make sure credit. that all documents, including those pre- 3. Determine that the credit standing of the sented by the beneficiary, comply with account party under any standby letter of the terms of both the letter of credit and credit is the subject of credit analysis equiva- the Eximbank agreement. lent to that applicable to a potential borrower j. For Advised (Notified) Letters of Credit: in an ordinary loan situation. • The branch is only advising the beneficiary without responsibility on its part.

September 1997 Branch and Agency Examination Manual Page 2 Letters of Credit Internal Control Questionnaire Effective date July 1997 Section 3320.4

POLICIES employees who do not process or record letter of credit transactions? 1. Has branch and head office management adopted written letter of credit policies that: a. Establish procedures for reviewing letter COMMISSIONS of credit applications? b. Define qualified customers? 10. Is the preparation and posting of commis- c. Establish minimum standards for docu- sions (fees) performed or reviewed by per- mentation in accordance with the Uni- sons who do not also: form Commercial Code? a. Issue official checks or drafts? d. Establish procedures to ensure that let- b. Handle cash? ters of credit are issued and confirmed 11. Are any independent commission computa- under approved credit lines? tions made and compared or adequately 2. Are letter of credit policies reviewed at least tested to initial commission records by per- annually to determine if they are compatible sons who do not also: with changing market conditions? a. Issue official checks or drafts? b. Handle cash?

RECORDS DOCUMENTATION 3. Is the preparation and posting of subsidiary letter of credit records performed or reviewed 12. Are the terms, dates, weights, description of by persons who do not also: merchandise, etc. shown on invoices, ship- a. Issue official checks or drafts? ping documents, delivery receipts, and bills b. Handle cash? of lading scrutinized for differences with 4. Are the subsidiary letter of credit records those detailed in the letters of credit instru- (control totals) balanced daily with the ments? Has the branch developed proce- appropriate general ledger accounts, and are dures, such as a document checklist, to reconciling items adequately investigated ensure that all documents required by the by persons who do not normally handle letter of credit are presented? letters of credit and post records? 13. Are procedures in effect to determine if: 5. Are delinquencies arising from the nonpay- a. The above documents are signed when ment of instruments relating to letters of required? credit prepared for and reviewed by man- b. All discrepancies have been resolved agement on a timely basis? with the agreement of all parties. 6. Are inquiries regarding letter of credit bal- c. All copies of letters of credit are initialed ances received and investigated by persons by the officer who signed the original who do not normally process documents, letter of credit? handle settlements, or post records? d. All amendments to letters of credit are approved by an officer? 7. Are bookkeeping adjustments checked and approved by an appropriate officer? 8. Is a daily record maintained that summarizes letter of credit transaction details, i.e., DEFERRED PAYMENT LETTERS letters of credit issued, payments received, OF CREDIT and commissions and fees collected, to support applicable general ledger account 14. Are deferred payment letters of credit: entries? a. Recorded as direct assets and liabilities 9. Are letter of credit record copies and liabil- of the branch after it approves and agrees ity ledger trial balances prepared and rec- to honor the beneficiaries’ documents for onciled monthly with control accounts by payment?

Branch and Agency Examination Manual September 1997 Page 1 3320.4 Letters of Credit: Internal Control Questionnaire

b. Included in ‘‘other assets’’ and ‘‘other confirmed and at frequent intervals there- liabilities’’ in the call report? after? c. Determines that customer payments of letters of credit issued are promptly STANDBY LETTERS OF CREDIT posted? d. Determines all delinquencies arising from 15. Are standby letters of credit segregated or the nonpayment of instruments relating readily identifiable from other types of let- to letters of credit? ters of credit and/or guarantees? e. Ensures expired letters of credit are closed according to branch policy generally 15 to 30 days after expiration. 21. Are all letters of credit recorded and assigned OTHER consecutive numbers? 22. Are lending officers frequently informed of 16. Are outstanding letter of credit record cop- maturing letters of credit and letter of credit ies and unissued forms safeguarded during lines? banking hours and secured in the vault 23. Is documentation stored in a fireproof vault? overnight? 24. Are procedures in place for positive identi- 17. Are advised letters of credit recorded as fication of the beneficiary prior to release of memoranda accounts, separate from letters funds to ensure that the true beneficiary of credit issued or confirmed by the branch? receives the funds? 18. Are letters of credit that have been issued with reliance upon a bank, whether on behalf of, at the request of, or under an agency agreement with the bank, recorded CONCLUSION as contingent liabilities under the name of that bank? 26. Is the information covered by this ICQ 19. Are any commission rebates approved by adequate for evaluating internal controls in an officer? this area? If not, indicate any additional 20. Does the branch have an internal review examination procedures deemed necessary. system that: 27. Based on the information gathered, evaluate a. Reexamines collateral items for negotia- internal controls in this area (i.e. strong, bility and proper assignment? satisfactory, fair, marginal, unsatisfactory). b. Test check values assigned to collateral when the letter of credit is issued or

September 1997 Branch and Agency Examination Manual Page 2 Letters of Credit Audit Guidelines Effective date July 1997 Section 3320.5

1. Test the addition of the trial balances and the b. Scanning commissions for any unusual reconciliation of the trial balances to the entries and following up on any unusual general ledger. items by tracing them to initial and sup- 2. Review the commission accounts relating to porting records. issuing, amending, conﬁrming, and negotiat- 3. Review all unpaid letters of credit and ascer- ing letters of credit by: tain that management has sound policies and a. Reviewing and testing procedures for procedures for resolving disputes. accounting for commissions and the handling of adjustments.

Branch and Agency Examination Manual September 1997 Page 1 Trading Activities Effective date July 1997 Section 3330.1

Trading activities include the purchase or sale of should be clear. The objective(s) will usually fit a wide range of financial instruments for specu- into one or more of the following categories: lative or hedging purposes. The range of trading speculation, hedging, providing a service to instruments has experienced substantial growth customers, or facilitating other business in recent years. The most common instruments transactions. seen at branches include derivative products, Trading policies should be reviewed and foreign exchange, and securities. To conduct a should contain, at a minimum, the following: thorough review of a trading operation, the Federal Reserve Trading Activities Manual • A list of approved trading products and (‘‘TAM’’) should be used as a primary refer- approved brokers; ence. However, the TAM is very detailed, and is • Authorization for every trader to conduct applicable primarily to the most active and trades; complex trading operations. The TAM is divided • Reporting lines for trading and back office into two sections. The first section of the TAM staff; discusses different types of trading risk plus • Guidelines for the frequency of preparing specific detail on examination objectives, proce- management reports; dures, and internal control questionnaires for the • Guidelines for calculating open positions; core areas of any trading operation. The second • Procedures for estimating the risk inherent in section describes financial instruments that are open positions; essential to the examiner’s understanding and • Position limits and stop-loss limits for each successful implementation of a trading activities product and each trader; and, examination. These guidelines should be tai- • Procedures for obtaining approval to trade a lored by the examiner based on the size and new product. sophistication of the branch and information from recent audits and examinations with input If traders have exceeded the limits established from the examiner-in-charge. in the policies, determine whether traders and The objective of examining the trading func- management took appropriate action, and whether tion is to ensure that management has adequate details of the instance(s)were documented and systems to identify and measure the risks of the communicated to senior management. activities, and has taken appropriate measures to Traders’ prior experience and the level of manage the risk. The systems established by ongoing training should be reviewed for management should be commensurate with the adequacy. The traders’ journals should be risks taken. Additionally, it is important to reviewed to determine whether profit and loss determine whether risk exposures are excessive and open positions agree with official internal relative to the branch’s risk profile. records, activities conducted are consistent with The following information is intended to the strategy and objectives stated by manage- provide general guidelines for reviewing a small, ment, transactions are accurately reported, and noncomplex trading operation, where only a few unauthorized transactions are being conducted. types of instruments are being traded. The general approach is to evaluate the office’s policies, procedures, limits, and the content and accuracy of management information reports. In MANAGEMENT INFORMATION addition, operational controls are reviewed to REPORTS ensure that adequate segregation of duties exist between the traders and the back office. Management reports should contain sufficient information to provide management with an adequate level of understanding of the branch’s trading activities. Reports should detail trader POLICIES, PROCEDURES AND positions, daily revaluation of open positions, LIMITS interest sensitive gaps, and profit and loss. The accuracy of management reports should be tested Management’s objective(s) for the trading func- using subsidiary records to recalculate figures. tion and the method used to establish strategies Reported figures for open positions should also

Branch and Agency Examination Manual September 1997 Page 1 3330.1 Trading Activities be compared to limits established in the policies. the attention of the appropriate operations Generally, reports for open positions and inter- manager. est sensitivity should be prepared daily, and Examiners should review the various methods those for profit and loss and revaluations should of settlement or the range of products traded, be prepared at least weekly. At a minimum, the and any exceptions to commonly accepted prac- frequency of reports should be consistent with tices should be noted. Unsettled items should be limits. For example, if the policy establishes an monitored closely by the branch. Settlement risk intra-day open position limit, the profit and loss should be controlled through the continuous should be calculated several times during the monitoring of movement of the branch’s money day. and securities and by the establishment of counterparty limits. Internal audits of the branch’s trading activi- OPERATIONAL CONTROLS ties should be conducted regularly. The frequency of internal audits will depend upon the Examiners must evaluate the effectiveness of complexity and level of activity of the branch’s established operational controls within the trad- trading operations. The scope of the audits ing function. These controls should cover seg- should include a review of trading risk manage- regation of duties, systems for reconciling trad- ment. Procedures for following up on audit ing positions, profits and losses, and value at exceptions should be adequate. The examiner risk; and should establish a system for settling should review the internal audit reports to deter- trade transactions. In addition, internal audits of mine the severity of deficiencies identified, and the office’s trading activities should be con- should determine whether management imple- ducted regularly. mented corrective action in a timely manner. Segregation of duties will ensure that instances Generally, the head trader has regular meet- of fraud or embezzlement, or violations of ings with senior management. If minutes of regulations are minimized. There is a clear need these meetings are maintained, the minutes to separate trading personnel from control of should be reviewed to determine the following: receipts, disbursements and custody functions. Persons executing transactions should not con- • management was adequately informed of the firm, reconcile, revalue, or clear transactions or risks taken; control the disbursement of funds, securities or • circumstances when traders exceeded limits other payments. Persons initiating transactions were reported to management; should not confirm trades, revalue positions, • management was informed when market con- approve or make general ledger entries, or ditions were unfavorable to existing positions; resolve disputed trades. • any improper activities or defalcation were Reconciliations should be performed on a disclosed; and information in the minutes is timely basis. Persons performing reconciliations accurate. should be independent of the person responsible for the input of transaction data. In addition, If minutes are not maintained, or meetings are segregation must occur between persons recon- not held, the examiner should recommend the ciling and persons confirming transactions. Any branch do so if the amount of activity warrants discrepancies should be brought immediately to such a practice.

September 1997 Branch and Agency Examination Manual Page 2 Income and Expense Effective date July 1997 Section 3400.1

Traditional ratio and peer earnings analyses provides important information on the nature are not relevant at a branch because earnings and efficiency of the branch’s operations. The are largely influenced by the role of the evaluation of earnings will consider, primarily, branch within the foreign banking organization the effectiveness of a branch’s comprehen- (FBO). sive risk management procedures as it affects Some FBOs maintain a U.S. presence to meet budgetary performance. Accordingly, variances certain global portfolio considerations. As a to budgets should be reviewed. Persistent result, their U.S. operations may likely engage in variances or exceptions may indicate poor a wide range of activities similar to those of planning or unrealistic projections, barring U.S. domestic banks. Other FBOs may have changes in economic and market conditions and different objectives in establishing a U.S. pres- other external factors or influences from the ence, such as to provide funding and clearing head office, which are beyond the branch’s services. A branch may also benefit from unique control. relationships that have a positive effect on its The accuracy and integrity of earnings pre- earnings, such as interest free funds, advances sented in risk management reports should be from the head office or managing assets not evaluated. For instance, reported earnings that reflected on its books. Therefore, earnings should do not properly reflect potential losses in the be evaluated primarily against budgeted num- branch’s credit risk exposures or accrued income bers, which should be based on the branch’s on nonperforming loans may raise questions strategic plan. The examiner should also deter- about the effectiveness of financial and account- mine the role that the earnings and revenue ing controls. The examiner should keep in mind, structure plays in the context of the overall U.S. however, that the consolidated benefits derived operations and objectives of the FBO. Com- by the FBO, as a result of maintaining a market ments may be warranted as to the adequacy of presence to facilitate a global banking service such results. network, may offset any earnings deficiencies or In establishing the budget, management should continued loss operations. Accordingly, the assess the broad range of financial and opera- branch’s strategic plan and function within the tional risk exposures, which are encompassed in FBO and standards used by the head office to the strategic plan. Projections should take into evaluate earnings performance must be ascer- account not only the composition, quality, and tained and analyzed. risk structure of branch assets but also the Examining the changes in earnings over time internal control environment under which the (a trend analysis) is a fundamental method for assets are booked. Further, management’s abil- evaluating earnings. The trend in overall ity to prepare realistic budgets and meet bud- earnings and trends in earnings components geted projections would indicate some measure should be reviewed to the extent that the branch’s of effective planning and control over the strategic plan has not changed significantly. Any branch’s activities. To maximize effectiveness, significant changes or variances in profits or any budget projections should be periodically of the components of income and expense should reviewed and updated as conditions change be investigated. Improving, deteriorating, and throughout the fiscal year. Actual results should even flat earnings can be the result of not only be periodically compared to budget and material changes in economic conditions but also of variances identified and reviewed by management’s actions or influence over earn- management. ings through intrabank transactions. Some profitability ratios have been used, including net interest income/average assets (net interest margin) and net operating income/average assets, GENERAL EXAMINATION to make such an assessment. While providing a APPROACH basis for analysis, particularly in year-to- year comparisons, earnings ratios can vary Earnings are not a rated component of the significantly among branches, depending on branch rating system, although the level of the nature of branch activity and the earnings or absence of earnings may affect degree of support or influence exerted by head rating components. The review of earnings also office.

Branch and Agency Examination Manual September 1997 Page 1 3400.1 Income and Expense

PROFIT CENTERS AND COST in a regional office function. If the fees for these CENTERS services are not directly related to or based on the fair value of goods and services received, the Generally, branches will function as profit cen- branch’s earnings can be affected. Services could ters or cost centers. As an independent profit include electronic data processing, audit and center, a branch will likely have a broad earning credit review, credit management, and foreign asset base and could have substantial off-balance- exchange and correspondent banking services. sheet activities. The branch would likely offer a broad array of products and services. Thus, earning assets and fee-based services would be Funding Sources primary sources of income. Examiners should consider the income distribution and the relative A branch that is funded through borrowings profitability and stability of the various sources from related entities may have its cost of funds of income. adjusted above or below market rates or even As a cost center, the branch would serve a priced below the FBO’s cost of funds. The head more narrowly defined central purpose of either office might also provide an interest free capital providing a service to the head office or the allocation, or fund the branch’s reserves at no FBO’s customer network, such as a provider of cost. In these ways, the head office can either funds to other bank offices. As such, the branch subsidize or reduce the branch’s net interest would likely offer only a limited number of income. products or services. Earnings at such offices will generally be less than robust. Accordingly, profitability as a factor in evalu- Transfer of Assets ating the branch is diminished. In these instances traditional ratio and trend analysis is not rel- The FBO may also transfer assets to or from a evant and alternate analysis techniques should branch’s books, which also will affect earnings. be employed. The examiner should determine The transfer of nonperforming and other prob- the standards that head office management uses lem loans from the branch to the head office or in evaluating the branch’s performance. This another branch of the FBO will improve a analysis will focus on the branch’s strategic plan branch’s earnings and, conversely, negatively or primary function, for example, to serve as a affect the earnings of any branch designated by source of liquidity for the head office or other the FBO as a workout branch. Low quality loans branches, to service the FBO’s trade-related maintained on a branch’s books would reduce business or to give the FBO a presence in a interest income to the extent that full interest particular geographic location as part of its payments are not received. The transfer of such global banking network. assets from the books of a branch would improve the quality of its assets, support its net interest income, and reduce its need for loan loss provisions and charge-offs. High quality earning FACTORS AFFECTING EARNINGS assets may also be transferred to a branch’s books from the head office. This may occur with The Mission of the Office start-up offices or branches that cannot otherwise generate earning assets at a level to sustain The level of earnings would generally be driven operations and fund the cost of doing business. by the branch’s mission. In this context, internal factors could significantly influence earnings to the extent that a branch’s earnings are essen- Accounting Considerations tially managed by the head office. To make this determination, examiners should carefully evalu- Earnings at a branch may also be distorted to ate reported income for unusually high or low some extent because of the effect of home profit margins. For example, a branch may have country accounting standards, administrative, ancillary functions from which it incurs addi- tax, or other external influences. Accordingly, in tional expense or receives supplementary income, reviewing earnings, the examiner should adjust such as managing an offshore book or providing branch income and expense statements to cor- management or technical services to other offices respond with U.S. generally accepted accounting

September 1997 Branch and Agency Examination Manual Page 2 Income and Expense 3400.1 principles. If statements cannot be adjusted, the interoffice transactions. The management of examiner’s written analysis must take into con- interest rate risk also can affect earnings. An sideration major accounting aberrations. More aggressive or speculative funding policy, whereby commonly seen accounting exceptions may the branch is permitted to maintain large interest include: rate sensitivity gaps, could result in material increases or decreases in margins. • Recognizing interest income on loans, which, according to U.S. standards, should be placed on nonaccrual status. Asset Yields • All U.S. offices of a foreign bank may be combined for income tax purposes; accord- An analysis of asset yields should provide a ingly, taxes might be calculated by a regional measure of the branch’s ability to invest funds in office and the branch may not accrue for taxes. earning assets that provide a rate of return over • Failure to record unrecognized gains and losses the cost of funds. The analysis of asset yields on trading assets and certain off-balance sheet and cost of funds should include whether market contracts in accordance with FASB 115 and rates are paid for funds borrowed from the FIN 39 can affect both asset valuations and interbank markets and the level and cost of earnings. interoffice funding activities. If market rates of interest are not charged on interoffice borrowings or paid on interoffice placements, net inter- ANALYTICAL REVIEW est income can be materially distorted. For example, if a branch is a net user of head office Interest Income or interoffice funds, rates on intrabank borrowings could be adjusted upward or downward to Recognizing that branch earnings are primarily increase or reduce the branch’s cost of funds, evaluated against budgeted numbers, a compari- which would flow through to net interest income. son of detailed balances on a period-to-period A branch that is a net provider of funds to the basis also should be performed to assess trends bank may be required to charge below market in account balances. Such a review also would rates to other offices of the FBO. This situation provide the examiner with an understanding of would have an adverse affect on gross interest branch operations and help to identify potential income and apply downward pressure to the net problem situations. The analysis of net interest interest margin. income will give an indication of management’s The level of nonperforming assets would also ability to borrow at attractive rates and invest adversely affect net interest income. Nonper- those funds with maximum profitable results. forming and renegotiated credits either provide The level and trend of net interest income no income or provide a reduced rate of income should be established and evaluated. As with to the extent that the assets are no longer any financial institution, the composition of net profitable relative to the cost of funds and the interest income should be reviewed for quality cost of doing business. and stability. In analyzing net interest income, the computation of net interest margin (interest income Reserves minus interest expense, divided by average earnings assets) is helpful, although the potential Regulatory agencies have long recognized that distortion of net interest income through inter- an allowance for loan loss reserves is only office transactions can limit the usefulness of the meaningful for the bank as a whole and not on a ratio. When discussing growth in earnings, the branch by branch basis. Accordingly, branches examiner should clearly differentiate between of FBOs are not required to establish separate increases due to rates or yields versus volumes loan loss reserves on the books of each branch, of earning assets. An improvement in net inter- but may do so voluntarily, or to meet local est income, as a percentage of earning assets, requirements. Provisions for loan loss reserves may reflect favorably on management’s ability may either be transferred to the branch from the to invest its funds at favorable yields or its head or regional office, or may be directly ability to find less expensive sources of funds. charged against the branch’s earnings. However, However, it also may reflect changes in rates on unlike at stand-alone operations that are sepa-

Branch and Agency Examination Manual September 1997 Page 3 3400.1 Income and Expense rately capitalized, concerns arising from inad- should note that ‘‘extraordinary’’ as used in the equate loan loss reserves are not key issues at a context of the examination report is not the same branch. as deﬁned in U.S. generally accepted accounting principles.

Other Income and Expenses Offshore Shell Branches Examiners should analyze the composition, level, and trend of other income and expenses. Non- Earnings for offshore shell branches should be interest income would include trading commis- maintained separately from those of the U.S. sions and fees, deposit service charges, and branch. As such, report comments should be letter of credit fees, among other items. Nonin- limited to the income and expenses of the U.S. terest expense includes personnel and occu- branch. Earnings for the offshore branch are pancy expense, and other operating expenses frequently commingled in the U.S. branch’s that arise from the normal activities of the management reports. The U.S. branch may branch. An analysis of these components would absorb the offshore shell branch’s indirect be especially valuable when evaluating a limited expenses, such as personnel expenses, without purpose branch or a branch that is suffering charging a fee. The significance of these indirect operating losses. Fees for intrabank services expenses varies depending upon the relationship provided or received from related entities should of the U.S. branch to the offshore shell branch. also be reviewed. Earnings can be materially However, because the allocation of these expenses distorted if market rates are not charged for are ultimately under the direction of head office these services. management, exception should not be taken to this practice. Also, examiners, generally should not question the tax implication to the U.S. Extraordinary Gains or Losses branch if the branch and the offshore shell branch file a combined federal income tax return. Extraordinary gains or losses result from any- However, expenses between a branch and a thing outside the normal operations of a branch related U.S. banking subsidiary of the foreign and should be analyzed carefully for their effect banking organization should be properly allo- on earnings. Generally, extraordinary gains or cated and in accordance with applicable laws losses result from the sale or disposal of assets and regulations. and because of accounting changes. Examiners

September 1997 Branch and Agency Examination Manual Page 4 Income and Expense Examination Objectives Effective date July 1997 Section 3400.2

1. To review and understand the branch’s of the branch’s strategic plan, and current strategic plan and mission within the FBO, economic conditions. specifically the earnings objectives. 7. To determine and comment on whether 2. To assess management’s ability to prepare income reported to the head office, under realistic earnings projections and the effec- the FBO’s accounting procedures, accu- tiveness of the overall budgeting program rately reflect true earnings, when adjusted for monitoring and controlling income and for head office subsidies and the charges expense. related to likely future loan losses. 3. To evaluate the reasonableness of perfor- 8. To evaluate the adequacy of financial and mance targets given the branch’s strategic accounting controls relating to income and plan and mission objectives, particularly expense. with respect to budget variances. 9. To evaluate the effect on earnings of any 4. To determine whether budgets are reasonable. unusual and extraordinary gains or losses. 5. To determine to what extent earnings are 10. To recommend corrective action when poli- affected by such factors as above or below cies, practices, procedures, or internal con- market interoffice funding, interoffice trans- trols are deficient. fers, and interoffice expense allocations. 6. To analyze the level of significant trends in income and expense, particularly in terms

Branch and Agency Examination Manual September 1997 Page 1 Income And Expense Examination Procedures Effective date July 1997 Section 3400.3

1. Determine to what degree the branch is a j. There is evidence that sources of interest profit center. If it is a profit center, calculate and other revenues have changed since the the net interest margin and review the trend. prior examination. Consider the following: k. There are any differences between branch a. To what degree does the agency raise its accounting practices and U.S. regulatory own funds and set its own cost of funds? accounting standards and generally b. How is the pricing of loans and funds accepted U.S. accounting principles. determined? Is it market driven or con- 4. Obtain and review planning procedures, profit trolled by other factors? plans, budgets, mid-and long-range financial c. Are transfer costs to affiliates reasonable, plans, economic advisory reports, and any in relation to the services provided? related progress reports and: d. To what extent do transfer costs/benefits a. Compare actual results to budgeted affect net earnings? amounts. 2. Determine if any significant changes have b. Determine the impact of specific goals occurred in: that have been set. a. The branch’s operations. b. Accounting practices in U.S. or home c. Determine the frequency of planning country. revisions. c. The branch’s financial reporting. d. Determine how planning revisions are d. General business conditions in U.S. or triggered. home country. e. Determine who initiates plan revisions. e. Tax codes in the U.S. or home country. f. Determine whether explanations are 3. Obtain current financial statements, internal required for significant variations and operating reports, interim financial state- whether causes are ascertained to implements, reports filed with the Federal Reserve, ment corrective action. daily statements of assets and liabilities, and g. Determine the sources of input for fore- other available financial information. Look casts, plans, and budgets. for the development or continuation of 5. Review ledger accounts for unusual entries. adverse trends and other significant or unusual Examples of such items include: trends or fluctuations. Primary considerations a. Significant deviations from the normal should include whether: amounts of recurring entries. a. Significant structural changes are occur- ring in the branch that may affect the b. Unusual debit entries in income accounts earnings stream. or unusual credit entries in expense b. The branch is making use of tax carry- accounts. backs or carryforwards. c. Significant entries from an unusual source, c. Earnings are static or declining, as a such as a journal entry. percentage of total resources. d. Significant entries in other income or d. Income before securities gains and losses, other expense, which may indicate fees or is decreasing as a percentage of total service losses on an off-balance-sheet revenues. activity (i.e., financial advisory or under- e. The ratio of operating expense to operat- writing services). ing revenue is increasing. 6. Investigate conditions of interest dis- f. Income and expense trends are inconsistent. closed by the procedures in the preceding g. The spread between interest earned and steps by: interest paid is decreasing. a. Discussing exceptions or questionable h. Loan losses are increasing. findings with the examiner responsible for i. Provisions for loan losses, if applicable, conducting those aspects of the examina- are sufficient to cover loan losses and tion that are most closely related to the whether overall reserves at an adequate item of interest to determine if a satisfac- level. tory explanation already has been obtained.

Branch and Agency Examination Manual September 1997 Page 1 3400.3 Income And Expense: Examination Procedures

b. Reviewing copies of workpapers prepared other examiners or management, and by internal auditors or management that deciding whether extensions of examina- explain account fluctuations from prior tion or verification procedures are periods or from budgeted amounts. necessary. c. Discussing unresolved items with 7. Review with officers and prepare, in appro- management. priate report format, listings of deficiencies d. Reviewing underlying supporting data and in and deviations from policies, practices, records, as necessary, to substantiate procedures, internal controls, and adverse explanations advanced by management. trends. e. Performing any other procedures consid- 8. Prepare a complete set of workpapers to ered necessary to substantiate the authen- support examiner conclusions and discuss all ticity of the explanations given. material findings with management. f. Reaching a conclusion as to the reasonableness of any explanations offered by

September 1997 Branch and Agency Examination Manual Page 2 Management Information Systems Effective date July 1997 Section 3410.1

Management information systems (MIS) should operational controls. The examiner should review gather, interpret, and communicate information and evaluate the sophistication and capability of regarding the branch’s business activities and the branch’s computer systems and software, their inherent risks. Accurate, informative, and which should be capable of supporting, process- timely MIS are essential to the prudent opera- ing, and monitoring the branch’s changing risk tion of any branch office. In fact, the examiner’s profile. Generally, in evaluating the individual assessment of the quality of the MIS is an branch management information system, the important factor in the overall evaluation of the examiner should focus on its overall effective- risk management process, which is discussed in ness in monitoring the branch’s level of risk the ROCA Rating System section of this manual. within established parameters rather than its In the evaluation of MIS, examiners should form. determine the extent to which the risk manage- Other considerations in evaluating the MIS ment function monitors and reports the branch’s include: risk exposures to local and head office management.1 Risk exposure levels and other signifi- • Whether reports are presented in a format that cant measures such as profit and loss statements is easily read and understood by senior should be reported to managers who supervise management; but do not, themselves, have operational respon- • Whether the branch has personnel with suffi- sibilities in the area of activity. Frequent reports cient expertise to maintain MIS; should be made as warranted by the activity and • Whether reports are updated and customized type of risk. Reports to head office management to reflect changes in the business environment may occur less frequently, but examiners should or management’s requirements; determine whether the frequency of reporting is • Whether an adequate reconcilement procedure sufficient for head office to maintain proper is in place to ensure the integrity of data oversight over the branch’s activities. inputs; and The form and content of the MIS will relate to • Whether the system is independently audited the branch’s operations and organization, poli- by internal and external personnel with suffi- cies and procedures, and management reporting cient expertise to perform a comprehensive lines. Examiners will find that the form of review of management reporting, financial branch management information systems will applications, and systems capacity. vary substantially with no particular structure shown to be optimum. MIS, however, generally Management reporting summarizes the take two forms: computing systems with busi- branch’s day-to-day operations, including risk ness applications and management reporting. exposure. Reports also serve to provide manage- For branches with extensive lending or trading ment with an overall view of business activity operations, a computerized system should be in for strategic planning. Reporting may be con- place. For branches with more limited opera- ducted via telephone, computer, correspon- tions in terms of risk and size, an elaborate dence, meetings, periodic management reports, computerized system may not be cost effective. audits, and examination reports. Examiners Not all management information systems are should evaluate the reporting process to deter- fully integrated within the branch or within the mine whether it is sufficiently comprehensive FBO. Generally, this aspect should be evaluated for sound decision-making both on a day-to-day based on the complexity and degree of risk in level and for future planning. To the extent that the branch’s activities. problems in specific areas of the branch may Examiners should expect to see varying relate to inaccurate or inadequate reporting, the degrees of manual intervention and should deter- examiner also should review results and com- mine whether the integrity of the data is pre- ments from other areas of the examination. served through proper controls, which will fac- If the branch has extensive reporting require- tor into the overall assessment of the branch’s ments, it is not necessary to review each report. Instead the examiner should summarize the 1. FBOs with multiple U.S. offices may establish an inter- monitoring process in each area, giving only mediate or regional U.S. reporting line. Such a reporting line should be evaluated to ensure that proper oversight by head such information as is needed to justify the office management is achieved. evaluation.

Branch and Agency Examination Manual September 1997 Page 1 3410.1 Management Information Systems

Formal management reports will usually be to prevent manipulation or fraud. For branches generated by control personnel within the branch, operating in a less automated environment, report independent from line management. Where line preparation should be evaluated in terms of managers have input, the senior managers should timeliness and data accuracy. Cross checking be well aware of potential weaknesses in the and sign off by the report preparer and reviewer data provided. Risk reporting should be assessed with appropriate authority promote a proper and performed independently of line manage- operational controls environment. ment to ensure objectivity and accuracy and

September 1997 Branch and Agency Examination Manual Page 2 Management Information Systems Examination Objectives Effective date July 1997 Section 3410.2

RISK MANAGEMENT OPERATIONAL CONTROLS

1. To determine if the policies, practices, pro- 6. To determine the scope and adequacy of the cedures, and internal controls regarding MIS audit function for MIS and management are adequate. reporting. 2. To determine that risk management report- 7. To verify that only authorized users have ing summarizes the quantifiable and non- access to automated systems. quantifiable risks of the branch to all appro- 8. To determine that the software applications priate management levels both at the local relating to risk reporting, pricing, and other office and at the head office in a timely applications are fully documented and sub- manner to ensure compliance with estab- ject to independent review. lished risk parameters. 9. To determine that the automated systems 3. To determine whether management report- and manual processes are designed with ing provides adequate information for stra- sufficient audit trails to evaluate and ensure tegic planning to the extent conducted by data integrity. local branch management. 4. To evaluate computer systems, communication networks, and software applications in terms of their ability to support and control OTHER the branch’s activities. 5. To determine that the functions of auto- 10. To recommend corrective action when MIS mated systems and reporting processes are policies, practices, procedures, or internal well understood by staff and are fully docu- controls are deficient. mented.

Branch and Agency Examination Manual September 1997 Page 1 Management Information Systems Examination Procedures Effective date July 1997 Section 3410.3

These procedures represent a comprehensive list regional management, if applicable. Can of processes and activities to be reviewed during branch data be accessed directly by them? a full scope examination. The examiner-in- 7. Review lists of ongoing or planned infor- charge will establish the general scope of the mation systems projects. Determine whether examination and work with the examination the priority of projects is justified given staff to tailor specific areas for review as cir- branch management’s strategic goals and cumstances warrant. The procedures selected the recent mix of business activity. will be based on internal audit comments, pre- 8. Review, for frequency, the branch manag- vious examination workpapers, a general review er’s attendance at periodic meetings with of the activity to be examined, and the judge- head office to report on branch activities. ment of the examiner and examiner-in-charge.

OPERATIONAL CONTROLS

RISK MANAGEMENT 9. Obtain copies of internal and external audits for MIS and management reporting. Review 1. Obtain a flowchart of management reports findings and management’s responses to and system flows, and review information determine whether appropriate corrective to identify important risk points. action is taken by management. 2. Review the policies and procedures for MIS 10. Obtain an overview of the system’s func- and management reporting, including the tional features with the financial institu- scope, quality, and frequency of manage- tion’s systems administrator. Browse the ment reports. Determine whether head system with the administrator. Determine office management is receiving adequate whether passwords are used and access to and timely information to effectively moni- the automated system is restricted to tor branch operations. approved users. 3. Review the functional applications such as 11. If the branch has a number of independent credit administration, risk monitoring, data bases for credit administration, risk liquidity and funds management, trade settle- monitoring, etc., determine the types of ment, accounting, revaluation, etc., to deter- reconciliations performed, the frequency of mine the combination of automation and data base reconciliation, and the tolerance manual intervention for management report- for variance. Generally, independent data ing. Compare findings with examiners bases have more potential for data error. reviewing specific products or business 12. Determine the usage of financial applica- lines. tions on terminals that are not part of the 4. Determine whether the range of risk man- mainframe, minicomputer, or local area net- agement reports is adequately documented work. For example, traders may use their in terms of inputs (data bases, data feeds own written spreadsheet to monitor risk external to the branch, economic and mar- exposure or for reconciliation. ket assumptions), computational features, 13. Determine whether the processing and pro- and outputs (report formats, definitions). duction of reports is segregated from line Evaluate the documentation for thorough- management and staff. Where line manage- ness and comprehensiveness. ment has influence, how does the branch 5. Determine whether the range of reports validate summary data and findings? (risk management, past due and nonperforming loans, financial performance, and operational controls) provides valid results to OTHER evaluate business activities and for strategic planning. 14. Ensure that the branch has considered the 6. Comment on the branch’s automated com- impact of the century date change (year munications with the head office and/or U.S. 2000) on its computer systems, and has

Branch and Agency Examination Manual September 1997 Page 1 3410.3 Management Information Systems: Examination Procedures

taken steps to correct any problems. Deter- 15. Recommend corrective action when poli- mine the extent of management’s: cies, practices, procedures, internal controls a. awareness and due diligence or MIS are deﬁcient. b. risk assessment c. solution implementation and testing d. contingency planning

September 1997 Branch and Agency Examination Manual Page 2 Management Information Systems Internal Control Questionnaire Effective date July 1997 Section 3410.4

RISK MANAGEMENT prehensive for the level of reporting necessary for the branch? 1. Is management reporting adequate for the 9. Are third party vendors provided with volume and complexity of the branch’s adequate lead time to make changes to range of activities? Are reports complete? existing programs? Is sufficient testing Do they have clear formats? Are exceptions performed before system upgrades are highlighted? implemented? 2. Does local and head office management 10. Are planned enhancements or development have adequate information to monitor the projects given appropriate priority based on changing risk profile of the branch? Does management’s stated goals? the branch have written policies regarding 11. Does the system design account for the the type and frequency of reports to be different pricing conventions and accrual submitted to a regional or head office level? methods across the range of products in use Do the reports accurately convey the con- at the branch? Evaluate the range of system dition of the branch and the information limitations for processing and valuation required in accordance with written poli- across the range of products utilized by the cies? How often does branch management branch. Assess the possible impact on communicate with its regional and head accuracy of management reporting. offices on an informal basis? 3. Is the risk measurement and management system sufficiently flexible to stress test the OPERATIONAL CONTROLS range of portfolios managed by the branch? Does the system provide usable and accu- 12. Is management reporting prepared on a rate output? If the branch does not perform sufficiently independent basis from line man- automated stress testing, what process is agement? Are appropriate segregation of used to minimize quantifiable risks in duties in place for report preparation? Is the adverse markets? data accurate? 4. Do reports provide information on the 13. Is the scope of the audit coverage compre- branch’s activities that is adequate for sound hensive? Are audits for MIS and reporting planning? Are profitable and unprofitable available? Are findings discussed with man- activities clearly identified? agement? Has management implemented 5. Do reports segregate positions by legal corrective action for deficiencies in a timely entity when appropriate? manner? 6. Do policies and procedures address the 14. Is access to the automated systems adequately range of system development and technical protected? maintenance at the branch, including the a. Do access rights, passwords, and logon use of outside vendors and consul- IDs protect key data bases from corrup- tants? Does the branch or FBO have a tion? comprehensive computer policy? If the b. Are ‘‘write or edit’’ commands restricted branch uses personal computers, there should to a limited set of individuals? be a written policy to address access, devel- c. Are specific functions assigned to a lim- opment, maintenance, and other relevant ited set of individuals? Are access rights issues. reviewed periodically? 7. Are there functional specifications for the d. Does the system have an audit report for system? Are they adequate for the current monitoring user access? range of automated systems at the branch? e. Is access logon information stored in Do they address both automated and manual records for audit trail support? input and intervention? 15. Is management information provided from 8. Does the branch have flowcharts or narra- mainframe, minicomputers, local area net- tives that indicate the data flow from input works, a single user personal computer, or a through reporting? Is this information com- combination of the above?

Branch and Agency Examination Manual September 1997 Page 1 3410.4 Management Information Systems: Internal Control Questionnaire

16. Identify the key data bases used for the reconciliation personnel sufﬁciently range of management reports. familiar with the information to identify a. Are direct electronic feeds from external ‘‘contaminated’’ data? services, such as Reuters, Telerate, and 17. Is the branch’s computer system capable of Bloomberg employed? How are incom- handling year 2000 calculations? plete data feeds identiﬁed? Can market data be overridden by users? How does the branch ensure the data integrity of data feeds or manually input rates, yields, CONCLUSION or prices from market sources? b. Are standard instructions set within the 18. Is the information covered by this ICQ automated systems? Can these be over- adequate for evaluating internal controls in ridden? Under what circumstances? this area? If not, indicate any additional c. For merging and combining data bases, examination procedures deemed necessary. how does the branch ensure accurate 19. Based on the information gathered, evaluate output? internal controls in this area (i.e. strong, d. What periodic reconciliations are per- satisfactory, fair, marginal, unsatisfactory). formed to ensure data integrity? Are

September 1997 Branch and Agency Examination Manual Page 2 Other Assets and Other Liabilities Effective date July 1997 Section 3420.1

OTHER ASSETS Scope of other assets review

The term ‘‘other assets,’’ as used in this section, Examiners assigned to review other assets must includes all balance sheet asset accounts not obtain a detailed breakdown of such accounts, covered specifically in other areas of the exami- with a description of each account and the date nation. Such accounts often may be quite insig- each item was posted. Certain accounts, such as nificant to the overall size of the branch. How- Other Real Estate Owned, may be reviewed by ever, significant subquality assets may be examiners assigned to other areas of the branch. discovered in accounts of some branches lack- Refer to Section 3090 for information on other ing proper internal controls and procedures. real estate owned. The remaining accounts should be reviewed and evaluated by examiners assigned to this section. The major factor in deciding which accounts Types of Accounts are to be reviewed is materiality; however, even accounts with small balances may require atten- Types of other assets frequently found in tion. Net balance accounts must be grossed up. branches include the various temporary holding The examiner should then evaluate whether to accounts such as suspense, teller, transit, and analyze the nature and quality of each indivi- bookkeeping differences having debit balances. dual item based upon its impact on the overall Those accounts should be used only for tempo- soundness or risk standing of the branch. In this rary recording, until the offsetting entry is regard, it is important that the examiner verify received or fully identified and posted to the the existence of the asset, the proper valuation of appropriate account. Branches will also have the asset, the adequacy of the accounting and more permanent accounts recorded in other disposition controls, and the quality of the assets such as premises and furniture, lease- asset. hold improvements, purchased computer soft- An examiner should verify the existence of ware, and deferred payment letters of credit. the assets selected by ensuring adequate support- Nothing should be allowed to remain in the ing documentation. The examiner should also temporary holding accounts (‘‘difference verify that ownership of the asset rests with the accounts’’) for any significant length of time, branch. The date the asset was acquired or first usually no more than a few business days. posted also is important. Temporary accounts Branches should have written procedures to such as suspense, should be cleared of stale ensure that difference accounts are reconciled items. and closed out on a timely basis. In any event, Proper valuation and reporting of other asset all difference accounts should be closed out at accounts is another potential area of concern for least monthly. the examiner. Assets are generally acquired General categories of other assets common to through purchase, trade, repossession, prepay- branches on the accrual system are prepaid ment of expenses, or accrual of income. Gener- expenses and income earned not collected. ally, assets purchased, traded, or repossessed are Prepaid expenses represent cash outlay for goods transferred at their fair market value. Prepaid and services, the benefits of which will be expenses and income accrued are booked at realized in future periods. Income earned and cost. An examiner should be particularly alert in not collected results from the differences between identifying those assets that lose value over time accrual and cash-basis accounting. to ensure that they are appropriately depreciated There are an unlimited number of account or amortized. All intangible assets should be titles that could be included in the other assets regularly amortized, and management should category, from bond coupons to art objects, have a system in place to confirm the valuation antiques, and coin and bullion. The examiner of the remaining book balance of the intangible must design specific procedures for review and assets. The examiner should ensure that the testing to fit the particular account and situation book balance of key personnel life insurance and must document the scope of the review in policies owned by the branch value the surren- the workpapers. der charge, if any.

Branch and Agency Examination Manual September 1997 Page 1 3420.1 Other Assets and Other Liabilities

The examiner should assess the quality of the erly recognized. This review should also deter- asset. Refer to Section 6010.1, Asset Quality mine that matters, such as pending tax litigation, Classifications, for information on the classifi- equipment contracts, and accounts payable, have cation of assets. been recorded properly and are being discharged The examiner should ensure that the controls in accordance with their terms and requirements. concerning other assets protect the branch’s Various miscellaneous liabilities may be found ownership rights, that the accounts are properly within the accounts, such as deferred credits, valued and accurately reported, and that activity suspense, and other titles denoting pending sta- is monitored regularly by management. A branch tus. The number of possible items that could be with good controls and review procedures will included are unlimited and the accounts should periodically charge off all uncollectible or be reviewed to determine that they are used unreconcilable items. However, the examiner properly and that all such items are clearing in must frequently go beyond the general ledger the normal course of business. Because of the control accounts and scan the underlying sub- variety of such accounts, the examiner must sidiary ledgers to determine that posting errors develop specific examination procedures to fit and/or the common practice of netting certain the particular account and situation. accounts against each other do not cause significant balances to go unnoticed because of the lack of proper detail. Scope of other liabilities review

Examiners assigned to review other liabilities OTHER LIABILITIES are responsible for obtaining the branch’s breakdown of those accounts and determining when ‘‘Other liabilities,’’ as used in this section, include they are to be reviewed under other sections of all balance sheet liability accounts not covered this manual. They must ensure that examiners in in other specific liability categories or in other charge of those other sections receive the nec- areas of the examination. The accounts often essary information. The remaining accounts may be quite insignificant to the overall size of should be reviewed and evaluated by examiners a branch. In some branches, specific accounts assigned to this section. are established for control purposes and appear The major emphasis in examining this area on the balance sheet as other liabilities. For should be on the adequacy of the controls and reporting, however, these accounts must be procedures employed by the branch in promptly assigned to specific liability categories or netted recording the proper amount of liability. With- from related asset categories, as appropriate. out proper management attention, these accounts may be misstated, either advertently or inadvert- ently. For instance, fraudulent entries in sus- Types of Accounts pense or interbranch accounts could be rolled over every other day to avoid stale dates causing A general category of other liabilities common shortages to be effectively concealed for indefi- to branches using accrual systems is expenses nite periods of time. accrued and unpaid. These accounts represent Like other assets, other liability accounts with periodic charges to income based on anticipated small balances may be significant and net bal- or contractual payments of funds to be made at ance accounts should be grossed up. Scanning a later date. The accounts include items such as account balances may disclose a recorded liabil- interest on deposits, taxes, and expenses incurred ity but it does not aid in determining whether in the normal course of business. There should liability figures are accurate. Therefore, it is be a correlation between the amount being important to review information obtained from accrued on a daily or monthly basis and the branch counsel handling litigation because these amount due on the stated or anticipated payment documents might reveal a major understatement date. of liabilities. Determining accurate balances in The examiner should review other liability other liability accounts requires an in-depth accounts to determine that accounts, such as review of source documents or other accounts deferred taxes (credit balance), are being prop- from which the liability arose.

September 1997 Branch and Agency Examination Manual Page 2 Other Assets and Other Liabilities Examination Objectives Effective date July 1997 Section 3420.2

1. To determine if policies, practices, proce- 5. To evaluate the scope and adequacy of the dures, and internal controls regarding other audit function. assets and other liabilities are adequate. 6. To determine compliance with laws and 2. To determine that branch ofﬁcers and regulations. employees are operating in conformance with 7. To recommend corrective action when poli- established guidelines. cies, practices, procedures, or internal con- 3. To evaluate the validity and quality of all trols are deﬁcient or when violations of laws other assets. or regulations have been noted. 4. To determine that other liabilities are properly recorded.

Branch and Agency Examination Manual September 1997 Page 1 Other Assets and Other Liabilities Examination Procedures Effective date July 1997 Section 3420.3

1. Complete or update the Internal Con- 7. If the branch has outstanding customer trol Questionnaire, if selected for liabilities under deferred payment letters of implementation. credit, obtain and forward a list of names 2. Based on the evaluation of internal controls and amounts to the examiner assigned to and the work performed by internal/external Credit Risk Management. auditors, determine the scope of the 8. Review the balance of any other liabilities examination. owed to officers or their interests and inves- 3. Test for compliance with policies, practices, tigate, by examining applicable supporting procedures, and internal controls in conjunc- documentation, whether they have been used tion with performing the remaining exami- to record unjustified amounts or amounts nation procedures. Obtain a listing of any for items unrelated to branch operations. deficiencies noted in the latest review by 9. Develop and note in the workpapers any internal/external auditors from the examiner special programs considered necessary to assigned to Internal and External Audits, properly analyze any remaining other assets and determine if appropriate corrections or other liabilities account. have been made. 10. Test for compliance with applicable federal 4. Obtain a trial balance of other asset and and state laws and regulations. other liability accounts and: 11. For other asset items that are determined to a. Verify or reconcile balances to depart- be stale, abandoned, uncollectible, or car- mental controls and general ledger. ried in excess of estimated values and for b. Review reconciling items for other liability items that are determined to reasonableness. be improperly stated, request management 5. Scan the trial balances for: to make the appropriate entries on the a. Obvious misclassifications of accounts branch’s books after consulting with the and, if any are noted, discuss reclassifi- examiner-in-charge. cation with appropriate branch personnel 12. Prepare in appropriate report form and dis- and furnish a list to appropriate examin- cuss with appropriate officer(s): ing personnel. b. Large, old, or unusual items and, if any a. Violations of laws and regulations. are noted, perform additional procedures b. Criticized other assets. as deemed appropriate being certain to c. The adequacy of written policies relating appraise the quality of other assets. to other assets and other liabilities. c. Other asset items that represent advances d. Recommended corrective action when to related organizations, officers, employ- policies, practices, or procedures are ees or their interests, and, if any are deficient. noted inform the examiner assigned to 13. Update the workpapers with any informa- Credit Risk Management. tion that will facilitate future examinations. 6. Determine that amortizing other asset accounts are being amortized over a reasonable period relative to their economic life.

Branch and Agency Examination Manual September 1997 Page 1 Other Assets and Other Liabilities Internal Control Questionnaire Effective date July 1997 Section 3420.4

Review the branch’s internal controls, policies, 7. Is approval required to pay credit balances practices, and procedures concerning other assets in receivable accounts? and other liabilities. The branch’s systems should 8. Do credit entries to receivables accounts, be documented in a complete and concise man- other than payments, require the approval ner and should include, where appropriate, nar- of an officer independent of the entry rative descriptions, flow charts, copies of forms preparation? used, and other pertinent information. 9. Does charge off of a nonamortizing other asset initiate review of the item by a person 1. Has the branch formulated written policies not connected with entry authorization or and procedures governing both other asset posting? and other liability accounts? 10. Are invoices and bills proved for accuracy, 2. Does the branch maintain subsidiary records prior to payment? Who has the authority to and supporting documentation of items com- pay the invoices and up to what amount? prising other assets and other liabilities? 11. Are all payroll tax liabilities verified to 3. Is the preparation of entries and posting of appropriate tax returns and reviewed by an subsidiary other asset and other liability officer to ensure accuracy? records performed or tested by persons who do not also have direct control, either physical or accounting, of the supporting data or related assets? CONCLUSION 4. Are the subsidiary records balanced at least monthly to the appropriate general ledger 12. Is the information covered by this ICQ accounts by persons who do not also have adequate for evaluating internal controls in direct control, either physical or accounting, this area? If not, indicate any additional of the supporting data or related assets? examination procedures deemed necessary. 5. Are the items included in suspense accounts 13. Based on the information gathered, evaluate aged and regularly reviewed for propriety internal controls in this area (i.e. strong, by responsible personnel? satisfactory, fair, marginal, unsatisfactory). 6. Are receivables reviewed at least monthly for collectibility by someone other than the originator of the entry?

Branch and Agency Examination Manual September 1997 Page 1 Other Assets and Other Liabilities Audit Guidelines Effective date July 1997 Section 3420.5

1. Obtain or prepare detailed lists of other assets b. Review the balance of interest accrued to and other liabilities, including a breakdown outstanding interest-bearing liabilities for of subsidiary ledgers. reasonableness. 2. Within each category of other assets, use an c. Review the balance of the reserve for both appropriate sampling technique to select spe- current and deferred taxes for reasonable- cific items and: ness by examining the worksheets and a. Where appropriate, verify the original bal- computations. ance of the item from an invoice or other d. Review the reasonableness and complete- supporting document. ness of the balance reflected for reserves b. Examine documentation for additions to for other expenses. any given item since the previous audit. 5. Within each general category of other liabili- c. Where amortization is applied to a given ties, use an appropriate sampling technique item, review the computations for the to select specific items for further review. For period since the previous audit to deter- each item selected, determine that the bal- mine mathematical accuracy and the rea- ance is reasonably stated by examining sup- sonableness of estimated life. porting documentation. d. Determine the reasonableness of the cur- 6. Review accounts not sampled, for items that rent balance by reviewing the remaining appear unusual in nature or amount and estimated life, collectibility, etc. examine supporting documentation. e. Prepare any special programs considered necessary to properly analyze and test 7. Using an appropriate sampling technique, specific accounts. select expense checks issued since the exami- 3. Determine that interbranch and affiliate trans- nation date and: actions clear in the normal course of business a. Determine whether the expense was by actually reviewing the entries to the incurred before or after the examination account for several days and examining the date by examining the vendor’s invoice or debit and credit tickets. Special attention other supporting documentation. should be given to entry dates, authorizing b. For expenses incurred prior to the exami- initials, and validity or reasonableness of the nation, trace the amount to the detail list item. of other liabilities. 4. If a branch is on an accrual basis of c. Discuss with appropriate branch officials, accounting: any significant items incurred prior to and a. Review the branch’s system of recording recorded after the examination date. liabilities for interest, taxes, and other expenses.

Branch and Agency Examination Manual September 1997 Page 1 Private Banking Effective date July 1997 Section 3430.1

This section describes the activities of private department should be viewed as a serious weak- banking services and provides insight into ness and criticized in the examination report. adequate safeguards. The portions concerning hold mail, dormant accounts, and overdrafts are also applicable to the Deposit Accounts section REVIEW OF DEPOSIT ACCOUNTS of this manual because they can affect all types AND REVIEW OF ACCOUNT of accounts and account holders. DOCUMENTATION Private banking departments may offer a wide array of products and services to their clients, Private banks often assist clients in forming including, but not limited to, trust services (by shell corporations of PICs. PICs are generally referral to or in association with an affiliated incorporated in bank secrecy (tax haven) coun- trust entity), investment advisory services, for- tries such as the Cayman Islands, Bahamas, eign exchange trading, lending, letters of credit, British Virgin Islands, and Netherlands Antilles bill paying, credit cards, and deposit services. to maintain the clients’ confidentiality, and/or Private banking generally markets its services to for tax or trust related reasons. The beneficial high net worth individuals and, if the client has owners of the shell corporations are typically a business, may entice them to develop a cor- foreign residents. porate banking relationship. Private banking Reviewing the list of accounts for private accounts may be opened in the name of an banking clients may provide insight into some individual, a commercial business, a trust, or a of the activities conducted by private banking. private investment corporation (PIC) registered For instance, the review may reveal that the in offshore havens. branch allows accounts that disguise the true identity of the client through the use of fictitious The relationship between the private banker or code name accounts, accounts in the name of and the client is carefully cultivated by the a PIC, or blind/numbered trust accounts. Man- banker; therefore, it is common for clients to agement must be able to provide documented follow private bankers to different financial files on the identity of the ultimate account institutions because of the level of trust that has holder and details on the account relationship. been developed. As a result, private banking Examiners should carefully scrutinize the rea- clients may delegate a significant amount of sons for these types of accounts and ensure that discretionary financial authority to private bank- they do not compromise the institution’s com- ers. Some private banking departments have pliance with the Financial Recordkeeping and small staffs that make the segregation of duties Reporting regulations, and the Federal Reserve’s normally found in banking activities difficult to ‘‘Know Your Customer’’ guidelines. maintain. This combination of trust in the pri- Reviewing account documentation should vate banker and difficulty in segregating duties reveal that the branch has an adequate quality exposes private banking activities to possible control program in place for opening accounts account manipulation. As a result, the private that includes a follow-up system for obtaining banking area must have compensating internal missing or date-sensitive documents. Addition- controls to ensure proper supervision and safe- ally, account documentation reviews should show guarding of client accounts. how the branch documents its client relation- Examiners should understand the nature and ships and implements its "Know Your Cus- scope of the private banking activities. Addition- tomer" policy. ally, examiners should carefully evaluate the An integral part of an effective ‘‘Know Your policies, procedures, internal controls, credit Customer’’ policy is a comprehensive knowl- reviews, and audits surrounding private banking edge of both the customer and the types of to ensure that internal controls exist to detect transactions carried out by the customer. As a fraud and prevent losses to both the branch general rule, a financial institution should never and/or customers. Internal and external audits establish a business relationship until the iden- should provide an excellent source of informa- tity of a potential customer is satisfactorily tion concerning the adequacy of policies, proce- verified. Accordingly, the ’’Know Your Cus- dures and controls of private banking. The lack tomer’’ policy should clearly identify the type of of an internal audit of the private banking documentation needed before a relationship can

Branch and Agency Examination Manual September 1997 Page 1 3430.1 Private Banking be formerly established. If a potential customer abuse by branch personnel. Examiners should refuses to produce any of the requested infor- carefully review the policies, procedures, and mation, the relationship should not be estab- controls over dormant accounts. Effective con- lished. Likewise, if requested follow-up infor- trols over dormant accounts should include: mation is not forthcoming, any relationship already begun should be terminated. • A specified period of time between the last The purpose of the business relationship customer-originated activity and its classifica- should also be identified. Incoming client funds tion as dormant. may be used for various purposes such as • Segregation of signature cards for dormant establishing deposits, funding investments, accounts. securitizing loans, paying bills, or establishing • Blocking of the account so that entries cannot PICs or trusts. The ‘‘Know Your Customer’’ be posted to the account without review by procedures established by the institution allow more than one member of senior management for the collection of sufficient information to outside of private banking. develop a ‘‘transaction profile’’ for each customer. The primary objective of such procedures is to enable the institution to predict with relative certainty the types of transactions in which OVERDRAFTS/EXTENSIONS OF a customer is likely to engage. Internal systems CREDIT should then be developed for monitoring transactions which are inconsistent with the custom- Private banking clients often pledge their assets, er’s transaction profile. The level, detail and including cash, mortgages, marketable securi- documentation of ‘‘Know Your Customer’’ ties, land, and/or buildings to securitize loans. information should be greater for customers Loan proceeds are used for a variety of pur- with larger balances and transaction volumes. poses, including, but not limited to, recapitaliz- (Examiners may refer to the Federal Reserve’s ing the client’s business(s) or providing working Bank Secrecy Act Manual and other similar capital. Branch management should demon- examination material for more information). strate understanding of each specialty business and should know what would affect the value of any collateral or business being financed. Loans HOLD MAIL to private banking clients may not be of sufficient size to be covered during the review of Private banking clients and in particular, inter- asset quality. However, it is important to ensure national private banking clients, are often pro- that a sampling of private banking loans and vided hold mail service. Hold mail clients elect contingent liabilities are reviewed. In many to have bank statements and other documents instances, loans and other credit-related activi- maintained at the institution rather than mailed ties for private banking clients are collateralized to their home address. In most cases, this service by cash or marketable securities; therefore, credit is provided because the client’s country of underwriting standards and procedures may not residence has an unreliable or limited postal be as complete or stringent as prudent banking system or for security reasons. Controls over practice would dictate. hold mail accounts should be carefully reviewed Loans backed by cash or negotiable collateral because the clients do not receive their state- are common in private banking. An extension of ments promptly, and therefore, relinquished their credit based solely on collateral, even if the ability to detect unauthorized transactions in a collateral is cash, does not guarantee repayment. timely manner. One of the key controls that There are at least three ways in which a branch should be part of any hold mail operation is to can lose its collateral: forfeiture through the have a process for ensuring that the back office seizure of assets by a government agency; theft receives customer account statements. or manipulation by a dishonest employee; and errors such as the inadvertent release of collateral by an employee. While the collateral DORMANT ACCOUNTS enhances the branch’s position, it should not be used as a substitute for regular credit analyses Accounts that are inactive for a prolonged period and prudent lending practices unless the branch of time could be subject to manipulation and makes a separate determination of the creditwor-

September 1997 Branch and Agency Examination Manual Page 2 Private Banking 3430.1 thiness of the client. A client may be considered other monthly consumer charges. Policies, pro- creditworthy if the branch performs its due cedures, and controls over this area should be diligence by adequately documenting that its reviewed to ensure that they are adequate and client’s funds were derived from legitimate protect the customer and the branch from fraud means and can verify that the use of the loan or abuse. proceeds are for legitimate purposes. Examiners should ensure that policies and procedures for extending credit to private banking clients are in place and are being followed. SALE OF NON-DEPOSIT The branch’s credit review function should also INVESTMENT PRODUCTS sample private banking loans and ensure compliance with established policies. Loan files Private banking departments are increasingly should contain sufficient information to assess offering investment products to their clients the quality of the credit, the proper approvals, under discretionary or nondiscretionary arrange- and the purpose and source of repayment. Dur- ments. In addition, private banking departments ing the review of private banking loans, exam- may also offer treasury services, portfolio man- iners should ensure that loan files include docu- agement, financial planning advice and offshore mented background information on the client’s services. source of wealth and occupation, the purpose of Although fiduciary and agency activities are the loan, and the source of repayment (other circumscribed by formal trust laws, clients may than collateral). Ambiguous purposes such as delegate varying degrees of authority (discre- personal investments or working capital, and tionary versus nondiscretionary) over assets liquidation of cash collateral for source of under management to the institution. In all repayment, are generally not acceptable. Weak- cases, the terms under which the assets are nesses in this area could result in noncompliance managed are fully described in a formal agree- with the Financial Recordkeeping and Reporting ment, also known as the ‘‘governing instru- regulations (See the Federal Reserve’s Bank ment’’, between the customer and the institu- Secrecy Act Manual and other similar examination. The agreement should address the duties tion material for details). that a fiduciary is obliged to perform for its Loans secured by cash or marketable securi- beneficiaries or customers, keeping the assets of ties should have files containing pledge/ the customers separate and distinct from those assignment documents, which serve to perfect of the branch, and avoiding any circumstances the branch’s security interest. In addition, pro- that may conflict with the branch’s fiduciary cedures should be implemented to monitor and obligations. A client’s portfolio may consist of a document the value of the collateral. Documen- mixture of instruments bearing varying degrees tary exceptions should be listed as technical of market and credit risk which should be exceptions. appropriate to the client. Assets under manage- Documented financial statements that support ment may include deposits, securities, loans, credit decisions and guarantees may be present. items held in safekeeping, and other products. Financial statements should never be waived merely because the loan is secured by cash or Examiners should determine, through discus- marketable securities. sions with private banking personnel, the types of products being offered to clients. Clients may be offered a wide range of products. Examiners should also determine the level of discretionary BILL PAYING SERVICES authority delegated to private banking personnel in the management of these activities and the Private banking departments often provide bill documentation required from customers to paying services for their clients. If this service is execute transactions on their behalf. Private provided, examiners should ensure that an agree- banking personnel should not be able to execute ment between the customer and the client exists transactions on behalf of their clients without for this service and that it has been reviewed by proper documentation from clients or indepen- legal counsel. Typically, a client might request dent verification of client instructions. that the branch debit a deposit account for credit On February 16, 1994, federal and thrift card bills, utilities, rent, mortgage payments, or regulatory agencies released a joint statement on

Branch and Agency Examination Manual September 1997 Page 3 3430.1 Private Banking retail sales of mutual fund and other non-deposit branches, the premises in this statement are investment products by federally insured insti- applicable to uninsured branches. tutions. It reaffirms the agencies belief that retail Examiners should ensure that the branch has customers must be fully informed about risks agreements with customers covering the terms associated with non-deposit investment products. of any asset management or other services Branches recommending or selling such prod- provided, and that the agreements are on file. An ucts should ensure that customers are fully evaluation of private banking personnel’s ability informed that the products: (1) are not FDIC- and competence to provide the services offered insured; (2) are not deposits or other obligations should also be assessed. If the branch executes of the institution and are not guaranteed by the transactions or performs back-office functions, institution; and (3) involve investment risks, the examiner should refer to the Securities including possible loss of principal. Examiners Activities section of this manual for further should refer to this statement for further guid- guidance. ance. While this statement addresses insured

September 1997 Branch and Agency Examination Manual Page 4 Private Banking Examination Objectives Effective date July 1997 Section 3430.2

1. To determine if policies, practices, proce- 3. To recommend corrective action when poli- dures, and internal controls covering private cies, procedures, practices, or internal con- banking activities are adequate and are being trols are deﬁcient or when violations of laws followed by branch personnel. or regulations have been noted. 2. To determine the scope and adequacy of the audit function.

Branch and Agency Examination Manual September 1997 Page 1 Private Banking Examination Procedures Effective date July 1997 Section 3430.3

The examiner should refer to the sections of this 1. If selected for implementation, complete or manual listed below as well as other applicable update the internal control questionnaire. supervisory agency manuals for further informa- 2. Review policies and procedural manuals, and tion on examination procedures: internal control activities to determine their adequacy. • Deposit Accounts section for examination 3. Assess the adequacy of the internal audit procedures covering deposit accounts, hold function as it relates to private banking. mail, dormant accounts and overdrafts. 4. Determine, through a discussion with man- • Credit Risk Management section for examina- agement, what types of products are offered tion procedures for extensions of credit. to private banking clients. • Federal Reserve’s Bank Secrecy Act Manual 5. Review the agreements covering the prod- or other similar examination material for ucts offered by private banking to determine examination procedures to check private bank- that they adequately protect the branch and ing activities for compliance with the Finan- the customer. cial Recordkeeping and Reporting regulations. 6. Assess private banking personnel’s level of competency to provide the services being The various state and federal agencies may offered to clients, i.e., education, experience, differ in terms of speciﬁc practices and method- licenses, and the branch’s training program. ologies used to implement the following guidelines. For further guidance in this area, examiners should consult with their respective agencies.

Branch and Agency Examination Manual September 1997 Page 1 Private Banking Internal Control Questionnaire Effective date July 1997 Section 3430.4

POLICIES AND PROCEDURES 8. Do the management reports cover the following: 1. Does the branch have up-to-date policies a. Credit. and procedures regarding private banking b. Overdrafts. activities? c. Cash and deposit activity. 2. Do the policies and procedures cover the d. Limit exceptions. following: e. Past-due accounts. a. Deﬁnition of the products offered. f. Missing documents. b. Client account opening procedures. g. Daily activity. c. Client background checking procedures. h. Off-balance-sheet exposure (e.g., letters d. Account monitoring procedures. of credit). e. Token name account requirements. i. Sale of non-deposit investment products. f. Account ofﬁcer’s responsibilities. g. Documentation requirements. h. Segregation of duties. AUDIT COVERAGE

9. Does the audit report provide management with an adequate appraisal of the private OFFICE OF FOREIGN ASSETS banking function? CONTROL AND REGULATION 10. Does the audit report cover all of the necessary control concerns and procedures 3. Are private banking customers reviewed listed in this internal control questionnaire? against the Ofﬁce of Foreign Assets Control 11. Do management responses indicate that and Regulation’s (OFAC) listing of blocked prompt and appropriate corrective action is accounts of foreign individuals and coun- taken when exceptions are noted? tries? (Refer to the Other Compliance Mat- ters section of this manual for more information on OFAC). DEPOSIT ACCOUNTS

Refer to the Deposit Accounts section of this TOKEN NAMES manual when reviewing deposit account activities managed by the private banking staff. 4. Does the branch maintain a listing of all token name accounts and is there sufficient documentation to ascertain the customer’s ‘‘true’’ identity? HOLD MAIL 5. Does management periodically review all accounts? 12. Does the branch have a ‘‘hold harmless’’ 6. Are there agreements on file that adequately statement for hold mail accounts? Are hold outline the branch’s powers and limits of mail accounts tested to ensure hold harm- liability? less statements are on file and are signed by customers? 13. Are hold mail statements kept in a secured area and segregated from the private bank- MANAGEMENT INFORMATION ing area? SYSTEMS 14. How is hold mail released to customers? (It should not be given to private bankers to 7. Are complete and accurate management deliver to the customer). reports received by private banking admin- 15. Are customers required to sign a form istrators and senior management on a timely acknowledging receipt of their hold mail? Is basis? the signature verified against signature

Branch and Agency Examination Manual September 1997 Page 1 3430.4 Private Banking: Internal Control Questionnaire

cards? Does the form list what mail was 27. Is the overdraft report reviewed and signed received? by management on a daily basis? If not, 16. What items are kept in hold mail files? when is it reviewed? Are approvals within 17. Are hold mail customers required to pickup established limits? hold mail within a specified period? What 28. Is there an overdraft aging report and is it procedures are followed if hold mail is not reviewed by management? picked up within specified periods? 18. Does an adequate audit trail exist in the hold Refer to the Deposit Accounts section of this mail area? manual for further questions. 19. Does the internal audit function adequately review the hold mail function?

Refer to the Deposit Account section of this BILL PAYING SERVICES manual for more questions. 29. Is there an agreement between the customer and the branch covering bill paying services? Does it specify what bills are to be DORMANT ACCOUNTS paid? 30. What support documents are required as 20. Over what time period does an account back-up for bill payments? become dormant? Are dormant accounts 31. Are there adequate dual controls and review blocked on the computer system or are all of the bill paying function? transactions on dormant accounts reviewed for authenticity? 32. Is confidential bill paying information, such 21. If the appropriate time defining a dormant as credit card numbers with expiration dates, account has elapsed and the account is not safeguarded? placed on dormant status, is the reason 33. Are official checks used for bill paying documented? properly controlled and inventoried? 22. Are signature cards for dormant accounts segregated and under dual control? 23. Who maintains the list of dormant accounts CREDIT CARDS and is there dual control/segregation of duties in place to reactivate dormant 34. Does the branch provide credit cards to its accounts? Does the reactivation require customers? approval from an officer outside the private 35. Are there adequate procedures to safeguard banking department? the cards while they are in the branch’s 24. Does the branch comply with the escheating custody? State requirements for dormant accounts? 36. Does the customer acknowledge receipt of 25. Does the internal audit function review the card upon delivery? for compliance with dormant account procedures?

Refer to the Deposit Account section of this CONCLUSION manual for more questions. 37. Is the information covered by this ICQ adequate for evaluating internal controls in OVERDRAFTS this area? If not, indicate any additional examination procedures deemed necessary. 26. Is there an overdraft approval schedule with 38. Based on the information gathered, evaluate limits for each ofﬁcer? Are the limits internal controls in this area (i.e. strong, reasonable? satisfactory, fair, marginal, unsatisfactory).

September 1997 Branch and Agency Examination Manual Page 2 Operational Controls Introduction Effective date July 1997 Section 4000.1

Operational risk arises from the potential that institutions, where size and complexity do not inadequate information systems, operational warrant a full scale internal audit function, may problems, breaches in internal controls, fraud, or rely on regular reviews of essential internal unforeseen catastrophes will result in losses or controls conducted by other institution person- compromise the financial or reputational integ- nel. Personnel performing these reviews should rity of the FBO. be independent of the function they are assigned The ‘‘O’’ component of ROCA assesses the to review. Given the importance of appropriate effectiveness of the branch’s operational con- internal controls to banking organizations of all trols, including accounting and financial con- sizes and risk profiles, the results of audits or trols. The assessment is based on the expectation reviews, whether conducted by an internal that branches should have a system of internal auditor or by other personnel, should be controls consistent with the size and complexity adequately documented, as should manage- of their operations. This system is complement’s responses to them. In addition, commu- mented by an independent internal audit func- nication channels should exist that allow nega- tion that may range from an internal system of tive or sensitive findings to be reported directly self-checks to a system that includes head office to the FBO’s senior management. audits or external audits. In this regard, internal Because the audit function is an integral part audit and control procedures should ensure that in the branch’s assessment of its internal control operations are conducted in accordance with system, examiners must review the control internal guidelines and regulatory policies. In environment at every examination. These reviews addition, controls should be in place to ensure assist in the identification of significant risks, that all reports and analyses provided to the head and facilitate a comprehensive evaluation of the office and branch senior management are timely branch’s internal control structure. These reviews and accurate. also provide information for determining the An institution’s internal control structure is procedures to be completed during the exami- critical to the safe and sound functioning of the nation. In addition, examiners should evaluate organization, in general, and to its risk manage- the independence and competence of the person- ment system, in particular. Establishing and nel conducting control assessments and should maintaining an effective system of controls is meet with the internal auditors or other person- one of management’s more important responsi- nel and review internal control risk assessments, bilities. These controls include the enforcement work plans, reports, and workpapers. of official lines of authority, and the appropriate When examiners detect significant internal separation of duties in areas such as trading, control weaknesses, affecting both the ‘‘O’’ custodial, and back-office. Appropriately segre- component rating as well as the composite gating duties is probably the most fundamental rating, special audit procedures may be required. and essential element of a sound internal control Supervisory policy (SR 96-27) offers guidance system. Failure to implement and maintain for the implementation of special audit proce- adequate separation of duties is an unsafe and dures intended to reduce the risk of losses due to unsound practice and can lead to serious losses misconduct or fraud, and to promote prompt or compromise the financial and reputational correction of situations that can cause an unsafe integrity of the institution. Serious lapses or and unsound banking environment. Significant deficiencies in internal controls may warrant internal control weaknesses in the operations of supervisory action, including formal enforce- one office may be an indication that similar ment action. When properly structured, internal weaknesses exist at other offices of the FBO. To controls promote effective operations, produce ensure proper supervision, the coordinating reliable financial and regulatory reports, safe- Reserve Bank, in consultation with other federal guard assets, and ensure compliance with laws, and state regulatory authorities, will determine regulations, and internal policies and procedures. to what extent the special audit procedures Ideally, internal controls are tested by an should be applied to the other U.S. operations of independent internal auditor who reports directly the FBO. In some cases, it may be acceptable to to the regional or head office. However, smaller have the special audit procedures performed by

Branch and Agency Examination Manual September 1997 Page 1 4000.1 Operational Controls: Introduction the internal audit staff of the branch. However, if cedures must be conducted by regional or head the adequacy of the internal audit function is ofﬁce audit staff, or by external auditors as among the reasons why internal controls are speciﬁed in SR 96-27. considered to be less than satisfactory, the pro-

September 1997 Branch and Agency Examination Manual Page 2 Internal and External Audits Effective date July 1997 Section 4010.1

This section provides guidelines and criteria for dards were used as a guide in developing understanding and evaluating the work per- the Internal, External, and Regulatory Audit formed by internal and external auditors and Examination Procedures and Audit Function home country regulators. For information on Questionnaire. internal loan review, refer to the Credit Risk Some of the factors that should be considered Management section of this manual. by the examiner in reviewing and evaluating the internal audit function are the independence and competence of the internal auditors and the INTERNAL AUDITS effectiveness of the audit program. In addition, the examiner should review the internal audit An internal audit program, fully adequate to the reports completed since the last examination and branch’s asset size, complexity of operations, management’s responses. and type of risk exposures is a key factor in evaluating the branch. In instances where the branch is too small to support an internal audi- Independence of Internal Auditors tor, alternative means of providing coverage must be substituted. One alternative would be The ability of the internal audit function to periodic visits by head office or regional head- achieve its audit objectives depends, in large quarters auditors who would perform an internal part, on the independence maintained by audit review or evaluation. Another option would be personnel. Frequently, the independence of to outsource the internal audit function to an internal auditors can be determined by the independent accounting or consulting firm whose reporting lines within the organization and to scope includes a review of internal controls whom or at what level audit results are reported. along with a financial review. No matter who In most circumstances, the internal audit func- administers the internal audit program, the guid- tion at the branch is under the ultimate direction ing criteria on which to evaluate its adequacy of the FBO’s chief internal auditor and/or should be the frequency and scope of the cov- executive management or a committee thereof. erage of the branch’s high risk areas based on a The auditor’s responsibilities should be risk assessment. Its adequacy will have a bear- addressed in a job description with reporting ing on the evaluation of the branch’s operational lines delineated in the personnel policy and controls and compliance components. audit results documented in audit committee Internal auditors are responsible for assessing minutes. If possible, examiners should review the soundness and adequacy of a branch’s these documents and the reporting process fol- accounting, operating, and administrative con- lowed by the auditor in order to subsequently trols. The assessment is intended to ensure that evaluate the tasks performed by the internal these controls promptly and accurately record audit function. The internal auditor should be transactions and properly safeguard assets against given the authority necessary to perform the job, loss. Additional responsibilities of internal including free access to any records necessary auditors should include determining the bank’s for the proper conduct of the audit. Furthermore, compliance with applicable laws and regula- internal auditors generally should not have tions, evaluating the effectiveness of administra- responsibility for supervising the accounting tive controls and procedures, and evaluating the system, other aspects of the branch’s accounting efficiency of operations. function, or any operational function. Internal auditors perform tests and other procedures as part of their audit program that enable them to reach their conclusions. In many instances, audit programs include internal con- Competence of Internal Auditors trol questionnaires and audit procedures similar to those found in this manual. Detailed stan- The responsibilities and qualifications of inter- dards have been promulgated by professional nal auditors may vary depending on the size and associations of internal auditors, such as the complexity of a branch’s operations and on the Bank Administration Institute (BAI) and the emphasis placed on the internal audit function Institute of Internal Auditors (IIA). These stan- by the FBO. In many branches, the internal audit

Branch and Agency Examination Manual September 1997 Page 1 4010.1 Internal and External Audits function is performed by an individual or group Internal Audit Program Adequacy and of individuals whose sole responsibility is inter- Effectiveness nal auditing. In other branches, particularly small ones, internal audit may be performed by The examiner should consider the following head office or regional auditors. factors when assessing the adequacy of the The qualifications discussed below should not internal audit program: be viewed as minimum requirements but should be considered by the examiner in evaluating the • Scope and frequency of the work performed; work performed by the internal auditors or audit • Risk-based assessments that tailor scope; departments. Examples of the type of qualifica- • Parties contributing to the audit program’s tions an internal audit department manager objectives and scope; should have are: • Documentation of the work performed; • Conclusions reached and reports issued; and • Academic credentials comparable to other • Management’s response to audit findings. branch officers, who have major responsibilities within the organization; The scope of the program of internal audit • Commitment to a program of continuing edu- must be sufficient to attain the audit objectives, cation and professional development; which should be established by parties indepen- • Audit experience and organizational and tech- dent of branch management. The frequency with nical skills commensurate with the responsi- which the audit procedures are performed should bilities assigned; be based on an evaluation of the risk associated with each area of audit interest. Among the • Oral and written communication skills; and factors that the auditor should consider in • An understanding of the audit objectives and assessing risk are the nature of the specific procedures performed by the audit staff. operation of the specific assets, liabilities and off-balance sheet activities under review, the In considering the competence of the internal existence of appropriate policies and internal audit staff, the examiner should review the control standards, the effectiveness of operating educational and experience qualifications required procedures and internal controls, and the poten- by the FBO for filling positions in the internal tial materiality of errors or irregularities associ- audit department, certified proficiency by a pro- ated with the specific operation. fessional association, and the ongoing training To further assess the adequacy and the effec- available for those positions. The examiner tiveness of the internal audit program, it would should also review and assess the ability of the be ideal to obtain the audit work programs and auditor to check compliance with U.S. laws and analyses that clearly indicate the procedures regulations. performed, the extent of testing, and the basis In a small branch, the internal audit function for the conclusions reached; however, this infor- may be a one-person department hired on a full mation is not always available to the examiner. or part time basis. The internal auditor may plan Work programs serve as the primary evidence and perform all procedures personally or may of the audit procedures performed and, as such, direct staff borrowed from other departments. In they should be written and should cover all areas either case, the examiner should expect, at a of a branch’s operations. Each program should minimum, that the internal auditor possesses provide a clear, concise description of the audit qualifications similar to those of an audit depart- work required, and individual audit procedures ment manager as previously discussed. should be presented in a logical manner. The The final measure of the competence of the detailed procedures included in the program will internal auditor is the quality of the work vary depending on, among other factors, the size performed, the ability to independently commu- and complexity of the branch’s operations. Typi- nicate the results of that work, and the ability to cal audit procedures include the: follow up on deficiencies noted during the audit work. Accordingly, the examiner’s conclusions • Use of surprise examinations, where with respect to an auditor’s competence should appropriate; also reflect the adequacy of the audit program • Maintenance of control over records selected and the audit reports. for audit;

September 1997 Branch and Agency Examination Manual Page 2 Internal and External Audits 4010.1

• Evaluation of the branch’s policies and pro- only a general description of significant find- cedures and the system of internal control; ings. Auditors must bear in mind that their • Verification of selected transactions and/or ultimate accountability demands that findings of balances by the review of supporting docu- major significance be brought to the attention of mentation, and/or direct confirmation and senior management at the branch and head appropriate follow-up of exceptions. office. The standards do not require the auditor to The internal auditor should follow the specific recommend corrective action. In practice, how- procedures included in all work programs to ever, auditors find that management often expects reach audit conclusions that will satisfy the suggestions for corrective action, particularly related audit objectives. when the technical aspects of controls are involved. By suggesting corrective action, the auditor demonstrates a positive approach to the organization’s problems. In making suggestions, Internal Audit Report Standards auditors should recognize that their recommendations may not be the only means of achieving The auditor has a responsibility to report the the control purpose intended. The focus of results of all audit work performed. Some audi- concern should be the control purpose and not tors prefer to report only significant exceptions; the particular means selected from a range of however, this practice reinforces a negative acceptable choices. view of the audit function. The auditor’s respon- The timeliness with which audit findings are sibility to evaluate control systems and ongoing reported is very important and often critical for operations carries with it an obligation to report effective response. When timeliness is critical, the results of that evaluation. Without a report, the auditor should communicate findings management does not have positive assurance promptly and not await the preparation and that auditing is meeting its commitments. Con- completion of a formal report. Findings should sequently, management can only assume that be communicated to the manager whose opera- adequate coverage is maintained and that the tion is directly affected and appropriate head systems of control are functioning adequately, office management. effectively, and efficiently. The extent and frequency of audit reports Each audit report should contain an opinion required by head office varies with the organi- on the adequacy, effectiveness, and efficiency of zation. At least annually, however, the auditor the systems of control and the quality of ongo- for the branch should formally report to head ing operations; the degree of compliance with office management directly responsible for the previously evaluated systems of control, or an branch. Head office is entitled to a report that explanation of why an opinion cannot be measures audit performance against plan and expressed. Each auditor should develop stan- provides information normally required to estab- dard language for rendering an opinion. Stan- lish accountability. The auditor should use this dardization of language minimizes mis- opportunity to promote an understanding of the understanding and promotes recognition of cir- audit function and how it serves the organization. cumstances that require responsive action. When an adverse opinion is expressed, the report shall contain a statement about the exposures that may exist in the absence of corrective action. Internal Audit Review Every audit report should identify the area audited and disclose all matters that the auditor The Examination Procedures section describes believes require responsive action by the recipi- the steps the examiner should follow when ent. Auditors should clearly distinguish between conducting a review of the work performed by those matters to which they take exception and the internal auditor. those that are reported for other reasons. The The examiner’s review and evaluation of the degree of detail reported is largely a matter of internal audit function is a key element in judgment, influenced greatly by the preferences determining the scope of the examination. In of management. Sometimes, management pre- most situations, the competence and indepen- fers to have all audit findings reported, no matter dence of the internal auditors may be reviewed how minor. At other times, management prefers on an overall basis; however, the adequacy and

Branch and Agency Examination Manual September 1997 Page 3 4010.1 Internal and External Audits effectiveness of the audit program should be For insured depository institutions, FDICIA, determined separately for each examination area. through its amendments to the FDIC Act, The examiner should assess if the work per- requires annual independent audits for all FDIC- formed by the internal auditor is reliable. It is insured banks and insured branches that have often more efficient for the examiner to deter- total assets in excess of $500 million. mine the independence and/or competence of Independent audits enhance the probability the internal auditor before addressing the that financial statements and reports to regula- adequacy and/or effectiveness of the audit pro- tory authorities and other financial statement gram. If the examiner concludes that the internal users will be accurate and help detect conditions auditor possesses neither the independence nor that could adversely affect banking organiza- the competence deemed appropriate, the exam- tions or the public. The independent audit pro- iner must also conclude that the internal audit cess may also subject the internal controls and work performed is not reliable. Accordingly, a the accounting policies, procedures, and records review of such work may not be necessary. of each banking organization to periodic review. The frequency of internal audit procedures External auditors frequently conduct financial should be based on an evaluation of the risk audits and certain other procedures and services. associated with each area of interest. There may In the case of financial audits, these must be be situations in which the associated risk is conducted by Certified Public Accountants considered minimal due to the materiality of the (CPAs) in conformance with applicable profes- amounts involved, the internal control proce- sional standards. Occasionally, however, nonfi- dures followed, the bank’s history in a particular nancial reviews may be performed by individu- area, or other factors. als who are not CPAs but who are familiar with The examiner should indicate in the report of the service or operational requirements in ques- examination any significant deficiencies concern- tion. In other instances, head office may con- ing the internal audit function. Furthermore, sider the internal audit program sufficient to the examiner should review with management satisfy the requirement. Head office should par- any significant deficiencies noted in the previous ticipate in the audits, at least to the extent of report of examination to determine if these appraising the FBOs’ policies and the proce- concerns have been appropriately addressed. dures used to attain policy objectives, including the review of any applicable regulatory report of examination with the auditors. EXTERNAL AUDITS External auditors and consultants are often engaged to conduct in-depth reviews of the The objective of an external financial audit is operations of specific departments, such as com- different from the objectives of an internal audit mercial loans or data processing. Such reviews or a branch examination. The examiner is inter- might focus on operations procedures, personnel ested in the work performed by external auditors requirements, or other specific areas of interest. for three principal reasons. First, situations will Upon completion of such reviews, the auditors arise where internal audit work is not being may recommend that the branch, among other performed or where such work is deemed to be things, strengthen controls and/or increase effi- of limited or no value to the examiner. Second, ciency. External auditors and other specialists the work performed by external auditors may may be employed to assist management in affect the amount of testing the examiner must specialized fields, such as taxation and manage- perform. Third, audits and other reports ren- ment information systems. dered by external auditors often provide the examiner with information pertinent to the examination of the branch. The major factors that should be considered in evaluating the work External Audit Opinions of external auditors are similar to those applicable to internal auditors, namely, the competence The external auditor generates various types of and independence of the auditors and the opinions and other documents, which typically adequacy of the audit program. include: Many U.S. branches and agencies of FBOs are required by state law or the head office to have • The standard unqualified opinion, generally a certain audit procedures performed periodically. one-page document.

September 1997 Branch and Agency Examination Manual Page 4 Internal and External Audits 4010.1

• A management letter in which the auditor head office before commencing their work. Such confidentially presents detailed findings and letters include, among other things, the scope of recommendations to management. the audit, the period of time to be covered by the • Reports from the auditor to regulators during audit, and the reports expected to be rendered. In the audit period. many cases, the highlights of these matters will be summarized in the body of the letter with The major types of standard audit opinions greater detail being provided in schedules or are not explicitly identified by the auditor. These appendices to the letter. Procedures may be opinions will generally not have a heading or specific by audit area. That is, the auditor may other statement in the report that identifies its provide a capsulized description of procedures type. Terminology used in the report suggests with regard to cash and due from banks, loans, the type of opinion issued. The major types of deposits, etc. In addition, if there are any limi- standard audit opinions and brief examples of tations on the scope of the audit, the letter may corresponding text are as follows: specify any auditing procedures that are to be omitted, such as confirmation of loans or depos- • The unqualified opinion—sometimes referred its, if the auditor is expected to render an to as a ‘‘clean opinion.’’ This type states that opinion on the branch’s financial statements. the financial statements are ‘‘presented fairly’’ in conformity with GAAP and that the necessary audit work was done. This report is often referred to as the standard audit report and Review of the External Audit by the may include additional explanatory language Examiner regarding particular issues. • The qualified opinion—indicates that financial The examination procedures section describes statements are presented fairly in all material the steps to be followed by the examiner in respects ‘‘except for’’ the effects of a particu- conducting a review of the CPAs and the work lar matter. Such matters may include the lack they perform. of sufficient evidential matter, restrictions on U.S. regulatory agencies have generally con- the scope of audit work, or minimal depar- cluded that, in view of their objectives regarding tures from GAAP in preparing the financial the reliance to be placed on work performed by statements. This type of report is not neces- CPAs and in view of the professional and ethical sarily negative but indicates that the examiner standards of the public accounting professions, should ask additional questions of management. only in unusual situations should the examiner • A disclaimer—expresses no opinion on the conduct an in-depth review of the competence financial statements. CPAs may issue a dis- and independence of the CPA or of the adequacy claimer when they have concluded that sub- of the CPA’s audit. One situation that the exam- stantial doubt surrounds the means used to iner should investigate would be a recent change compile financial statements but that no con- in CPAs by the FBO, particularly if the change clusive evidence pinpointing the type of non- was made after an audit was commenced. conformance to GAAP could be identified. It ordinarily will not be necessary to make This disclaimer is intended to indicate that the specific tests to determine independence. How- CPA is not assuming any responsibility for ever, there may be occasions when the examiner these statements. may have sufficient reasons to question the • An adverse opinion—concludes that the finan- independence of a CPA or the quality of his or cial statements are not presented fairly or are her work. For example, the examiner may in ‘‘significant nonconformance with U.S. become aware that, during the period of a CPA’s GAAP.’’ Disclaimers may also be issued when professional engagement, which includes the auditors have concluded that the scope of their period covered by the financial statements on review has been significantly restricted. which the CPA has expressed an opinion, the CPA or a member of his or her firm—

Engagement Letters • Had a direct ﬁnancial interest in the FBO; • Was connected with the FBO in a capacity A branch should require that external auditors equivalent to that of a member of management submit engagement letters to the branch or its or was a director of the FBO;

Branch and Agency Examination Manual September 1997 Page 5 4010.1 Internal and External Audits

• Maintained, completely or in part, the books their external auditors and to make similar and records of the FBO and did not perform arrangements regarding auditor attendance at audit tests with respect to such books and meetings with examiners. records; or Generally Accepted Auditing Standards • Had a loan from the FBO (as discussed (GAAS) require that the external auditor can earlier). consider regulatory authorities as a source of competent evidential matter when conducting In these and similar instances, the CPA would an audit of the financial statements of a banking not have complied with professional standards. organization. Accordingly, the external auditor The examiner should determine the scope of may review communications from and make the CPA’s audit or examination by reviewing the inquiries of the regulatory authorities. most recent report and management letter, if Generally, the U.S. regulatory agencies encour- any, issued by the CPA. If the audit is in age auditors to attend examination exit confer- progress or will begin in the near future, the ences upon completion of the examiner’s field examiner should also review any engagement work or other meetings concerning examination letter to the branch from the CPA. If available, findings between supervisory examiners and a the examiner also should obtain and review any branch’s management. Branches should ensure adjusting journal entries suggested by the CPA that their external auditors are informed in a at the conclusion of the examination. This pro- timely manner of scheduled exit conferences cedures should be done to determine whether and other relevant meetings with examiners and such entries were the result of breakdowns in the of the FRB’s policies regarding auditor atten- internal control structure and procedures for dance at such meetings. financial reporting. When other conferences between examiners Under certain circumstances, a CPA may and management are scheduled (those that do issue a qualified or adverse opinion or may not involve examination findings that are rel- disclaim an opinion on a branch’s financial evant to the scope of the external auditor’s statements. In such circumstances, the examiner work), the branch should first obtain the approval should first determine the reasons for the par- of the appropriate regulatory agency for the ticular type of opinion issued. If the matters auditor to attend the meetings. The Interagency involved affect specific areas of the branch’s Policy Statement of July 23, 1992, does not operations, a review of this work performed by preclude regulators from holding meetings with the CPA may help the examiner understand the management without auditor attendance or from problem that gave rise to this opinion. requiring that the auditor attend only certain portions of the meetings. The interagency policy statement was issued to improve coordination and communication Communication Between External between external auditors and examiners. Auditors and Examiners Examination personnel should provide branches with advance notice of the start date of the On July 23, 1992, the Federal Reserve and the examination, when appropriate, so management other federal bank and thrift regulatory agencies can inform external auditors in advance and (FDIC, OCC, and OTS) issued an interagency facilitate the planning and scheduling of their policy statement on coordination and communi- audit work. cation between external auditors and examiners. The policy statement provides guidelines regarding information that should be provided by federally-insured depository institutions to their Meetings and Discussions Between external auditors and meetings between external External Auditors and Examiners auditors and examiners in connection with safety and soundness examinations. While the policy An external auditor may request a meeting with statement focuses on insured depository institu- regulatory authorities involved in the supervi- tions and their external auditors, bank holding sion of the branch, during or after completion of companies and U.S. branches of foreign banks examinations, to inquire about supervisory mat- that are examined by the Federal Reserve are ters relevant to the branch under audit. External encouraged to provide similar information to auditors should provide an agenda in advance.

September 1997 Branch and Agency Examination Manual Page 6 Internal and External Audits 4010.1

The regulatory authorities will generally request erally require that external auditors be given that management of the branch under audit be access to the information described above, insti- represented at the meeting. In this regard, exam- tutions and their auditors are reminded that iners generally will only discuss with an auditor information contained in examination reports those examination findings that have been pre- and supervisory discussions—including any sented to bank management. summaries or quotations—is confidential super- In certain cases, external auditors may wish to visory information and must not be disclosed to discuss with examiners matters relevant to the any party without the written permission of the FBO, without bank management representation. issuing agency. Unauthorized disclosure of con- External auditors may request such confidential fidential supervisory information may lead to meetings with the regulatory authorities and civil or criminal actions, fines, and other vice versa. penalties.

Information Required to be Made Available to External Auditors

Section 112 of FDICIA pertains to depository AUDIT PROGRAM OVERSIGHT institutions insured by the FDIC that have engaged the services of an external auditor to audit Because auditors’ reporting lines may signifi- the banking organization within the past two cantly affect the overall objectivity and thor- years. It requires insured branches to provide the oughness of the audit findings and conclusions, auditor with copies of the most recent Report of an analysis of their structure should be factored Assets and Liabilities (call report) and report of into the evaluation of the audit program’s effec- examination and pertinent correspondence or tiveness. When internal and external auditors reports received from a U.S. regulatory agency. report solely to senior management of the branch, This information is to be provided to the exter- rather than head office management, their inde- nal auditor by the insured branch under audit, pendence may be compromised. As a result, not by a regulatory agency. they will not, in all likelihood, maintain the In addition, insured branches must provide same objectivity in evaluating the branch’s the independent auditor with: operations. Auditors should certainly report relevant audit findings to branch management; • A copy of any supervisory memorandum of however, organizational and official audit report- understanding or written agreement between a ing lines should ensure auditors’ independence federal or state banking agency and the FBO and objectivity. or branch put into effect during the period The independence of internal and external covered by the audit. auditors is increased when they report to a • A report of any formal action initiated or separate audit officer, department, or committee taken by a federal or state banking agency not otherwise involved in the affairs of the during such period or any civil money penalty branch. The auditors’ independence is enhanced assessed with respect to the FBO or branch or when some type of objective third party takes an any institution-affiliated party. active role in approving the internal and external audit scope and plan. Regulatory personnel should ascertain if the This independent party’s duties may include banking organization is in compliance with the overseeing the internal audit function, such as requirements of section 112 of FDICIA (12 approving salary, hiring, and firing decisions USC 1831m(h)) and report instances of noncom- relating to senior staff level positions; approving pliance in the Compliance section of the report or recommending the appointment of external of examination. auditors and the scope of external audits and other services; providing the opportunity for auditors to meet and discuss findings apart from CONFIDENTIALITY OF branch management; reviewing with manage- SUPERVISORY INFORMATION ment and external auditors the year-end financial statements; and meeting with regulatory While the policies of regulatory authorities gen- authorities.

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MANAGEMENT’S RESPONSE TO Head office and branch senior management THE AUDITS should receive copies of management’s responses, along with copies of the audit reports. The audit Head office management should require that staff and head office should follow-up on the branch management respond formally to audit responses given by management to ensure that findings and take appropriate corrective action. all matters are properly and effectively resolved The audit process is not complete until the in a timely manner. The examiners must also auditor is satisfied that audit findings have follow up on management’s responses to ensure received appropriate attention. By requiring man- that responses are fully implemented. agement to respond formally to audit findings, head office contributes to the effectiveness of the audit function and increases the likelihood that the findings will receive appropriate attention. REGULATORY EXAMINATIONS Auditors should not be accountable for implementation of corrective action, which is the Home country regulators may examine their responsibility of branch and head office manage- respective banks in the United States periodi- ment. However, the audit program’s structure cally. If these examinations occur, the examiner should include means of (1) securing manage- should find out the scope and frequency of the ment’s plans to address audit comments and examinations and obtain a copy of any report, if (2) verifying these plan’s effectiveness in cor- available. If a copy of this regulatory report is recting identified problems. available, the examiner should determine if It is imperative that management respond to there are any significant deficiencies or matters all internal and external audits and regulatory that have a bearing on the FBO’s operations in examinations. Management responses should be the United States. As a matter of courtesy, the timely and address all findings in the reports, home country regulators should contact the U.S. unless specifically noted in the audit report that bank supervisors before any on-site examina- a response is not necessary. Responses should tions and agree to meet with them before and include concrete solutions that have already after the conclusion of their examinations to been put in place or that will be implemented in share the scope and results of such visitations. a timely manner. Repeat problems noted in the audit report are to be given the highest priority.

September 1997 Branch and Agency Examination Manual Page 8 Internal and External Audits Examination Objectives Effective date July 1997 Section 4010.2

1. To determine whether internal and external 4. To determine the adequacy of the frequency audit or regulatory examination functions and scope of the audit program, which should exist and are consistent with the institution’s include testing for compliance with applica- size, complexity of operations, level of ble U.S. statutory and regulatory requirements. growth, and nature of weaknesses. 5. To determine based upon the above criteria 2. To evaluate the independence and compe- whether the work performed by internal tence of those who carry out the internal and and/or external auditors is reliable. external audit function. 6. To recommend corrective action when poli- 3. To determine the adequacy of the procedures cies, practices, procedures, or internal con- performed by the internal and external trols are deﬁcient or when violations of laws auditors. or regulations have been noted.

Branch and Agency Examination Manual September 1997 Page 1 Internal and External Audits Examination Procedures Effective date July 1997 Section 4010.3

Some of these procedures will not be applicable branch. If auditors are based at the head to every branch, particularly at branches that do office, the examining agency may wish to not have internal auditors on site. arrange a meeting with the auditors when Before reviewing any specific audit proce- they visit the United States. dures, the examiner should first determine the 3. Auditors’ and Audit Staff Qualifications— independence and competence of the internal Review the biographical data of and inter- auditors. If the examiner believes the auditors view the internal audit department manager, are both independent and competent, he or she to determine his or her ability to manage the should then determine the acceptability of their internal audit department. Review the bio- work. Based on the answers to the audit function graphical data of the audit department staff to questions and on the auditors’ work, the exam- determine their qualifications for their del- iner must then determine the scope of the egated responsibilities. examination. At a minimum, the examiner should 4. Content and Utilization of the Audit Scope review the scope and frequency of the audit and Frequency Schedule—Review the audit program and the results of the most recent audit. schedule and ascertain that all high risk areas The program and related supporting documen- have adequate and timely coverage. Obtain tation should be completed in an organized input from members of the examination team manner and should be retained as part of the who are reviewing individual areas to deter- examination workpapers. mine additional high risk areas. Determine whether the audit department’s program is Upon completion of the program, the exam- annually reviewed and approved by head iner should be able to formulate a conclusion on office. the adequacy of audit coverage. Conclusions involving weaknesses in the internal audit work 5. Documentation of the work performed— being performed at the branch should be sum- Review the audit work programs to ascertain marized for the report of examination. Signifi- that the work programs satisfy the audit cant recommendations should be discussed objectives and indicate the procedures per- with branch management and noted in the ques- formed, the extent of testing, and the basis tionnaire and in the report of examination. If for the conclusions reached. recommendations are made verbally, a memo- 6. Audit Department’s Formal Reporting randum of the discussion with management Procedures— should be prepared and included in the a. Review the audit reports issued since the workpapers. previous examination for: — the auditor’s opinion on the adequacy, 1. Determine whether the branch utilizes a sys- effectiveness, and efficiency of the tem of self checks in lieu of a formal audit systems of control and quality of program. If so, determine the adequacy of ongoing operations; this system and assess whether proper proce- — the timeliness with which the findings dures are in place to ensure its independence were reported; from those responsible for implementing the — the identification of the areas audited; system. and 2. Independence of the Audit Function—Assess — the disclosure of all matters that require the independence of the internal auditor by attention. reviewing the reporting lines within the b. Ascertain that the distribution of the audit organization and to whom or at what level report followed the required reporting audit results are reported. Interview the in- lines. ternal audit department manager and observe c. Ascertain that a written response to the the operation of the audit department to report was provided by the recipient in a determine its functional responsibilities and timely manner and that it addressed the reporting lines. Interviews during the exami- matters requiring attention. nation may not be practical if auditors are d. Review the audit department’s follow-up based in the home country or at another U.S. procedures for adequacy.

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7. If CPAs and/or consulting ﬁrms have been of any important accounting or control engaged by the FBO for statement certiﬁca- problems. tion, branch reviews, or appraisal of the audit 8. If possible, review the most recent home function, review the most recent reports country regulatory examination report. and/or management letters to become aware

September 1997 Branch and Agency Examination Manual Page 2 Internal and External Audits Audit Function Questionnaire Effective date July 1997 Section 4010.4

Review the documentation, as instructed in the AUDITOR’S QUALIFICATIONS examination procedures, in order to answer the following audit function questions. Where 11. Are the auditor’s academic credentials com- appropriate, supporting documentation and per- parable to other branch officers having major tinent information should be retained or noted responsibilities within the organization? under comments. 12. Is he/she certified (or in the process of becoming certified) as a Chartered Bank Auditor, Certified Internal Auditor, or Cer- tified Public Accountant (CPA)? Does the ORGANIZATIONAL STRUCTURE auditor hold any other type of foreign coun- OF THE AUDIT DEPARTMENT try professional designation? If yes, which one(s)? 1. Has the head office delegated responsibility 13. Does he/she communicate and relate well for the audit function? If so, to whom? with all levels of personnel? 2. Does the auditor report independently to the 14. Does the auditor demonstrate a commit- head office or a party with objective over- ment to continuing education and a current sight of the audit function? Describe. knowledge of the latest developments in 3. If not, to whom does the auditor directly banking and auditing technology? report? Do these reporting lines jeopardize the independence of the audit function? 4. Are those in charge of the audit function AUDIT STAFF QUALIFICATIONS qualified for their particular responsibilities? 5. Do individuals charged with audit oversight The following questions need to be addressed if meet with and review reports issued by the there is an audit staff on site at the branch: auditor independent of branch personnel? If so, how often? 15. Is the audit staff sufficient in number to 6. Do the minutes of any meetings of audit perform its tasks in a timely and complete oversight groups indicate an appropriate manner? interest in auditors’ activities and findings? 16. Is the staff adequately experienced in auditing and banking? What are the educational backgrounds of the staff? 17. Are members of the staff experienced in any INDEPENDENCE OF THE AUDIT specialized activities conducted by the FUNCTION branch, e.g., EDP, foreign exchange trading, trust, etc.? 7. Is the audit department functionally segre- 18. Is there a formal audit training program in gated from operations in the organizational effect? structure? 19. If needed, does management have plans to 8. Are the budget, performance, salary, and improve its audit capability? other benefits of the auditor established, reviewed, and/or approved independent of the branch? If not, describe. CONTENT AND UTILIZATION OF 9. Are the reporting procedures of the auditor THE AUDIT FREQUENCY AND independent of the influence of any person- SCOPE SCHEDULE nel whose duties or responsibilities are covered in the audit’s scope? 20. Does the auditor perform a risk assessment? 10. Do the responsibilities of the audit staff If not, how are the scope and frequency of include any duties or back-up duties that audits determined? Is the resulting audit compromise dual controls, e.g., preparation program formalized and on record as a or approval of general ledger entries, offi- commitment that can be analyzed and cial checks, daily reconcilements, etc.? reviewed?

Branch and Agency Examination Manual September 1997 Page 1 4010.4 Internal and External Audits: Audit Function Questionnaire

21. Are all important branch functions and 32. Is the auditor a member of an executive services included in the audit scope? systems planning or steering committee? If 22. Does the audit program include procedures not, does the auditor have access to and necessary to reasonably ensure compliance review the minutes of such committees? with applicable U.S. laws and regulations, 33. Does an audit representative review the including the Bank Secrecy Act? activities of systems design teams for audit 23. Does the internal audit department have and internal control requirements? Is the access to all reports, records, and minutes? specialized training and experience of the 24. Is the program periodically reviewed, audit staff sufficient to support effective where necessary, to adapt it to changing reviews? conditions? 34. Does the audit department avoid over- 25. Does the frequency and scope schedule participation in systems design, modifica- require approval by a party with objective tion, and conversion? audit oversight? If so, by whom and has 35. Is the auditor’s ‘‘sign-off’’ on new or modi- such approval been obtained? fied systems restricted to control and audit 26. Does the auditor periodically report his/her trail features? progress in completing the frequency and scope schedule to a party with objective audit oversight? 27. Do audit procedures ensure that items on AUDIT DEPARTMENT’S FORMAL the audit scope are looked at with sufficient REPORTING PROCEDURES detail to ensure adequate review? 28. Are controls on opening and closing general 36. Does the auditor submit formal reports? If ledger and subsidiary accounts adequate so, to whom? and is the auditor formally advised of any 37. Do the reports convey to the reader the changes? auditor’s general observation of the condi- 29. If the branch has automated systems, does tion of the operation of the department or the program call for the application of function? independently prepared computer programs a. Do they adequately reflect the scope of that employ the computer as an audit tool the audit? for surveillance and/or possible off-site b. Do they contain an opinion of the auditor testing? regarding the adequacy, effectiveness, 30. Are all service-related activities not specifi- and efficiency of internal controls? cally manifested in general ledgers accounts c. Do they call for a prompt response, subject to adequate periodic review, e.g., where appropriate? supervisory regulations, security, vacation 38. Are exceptions and recommendations policy, purchases, travelers checks, and resolved and implemented on a timely basis? safekeeping? 39. Are audit reports submitted promptly? 40. Does branch management respond to all internal and external audits? AUDIT DEPARTMENT a. Are management’s responses completed promptly? Are they written? PARTICIPATION IN REVIEWING b. Does the head office or branch senior SYSTEMS DESIGN PROJECTS management receive copies of manage- AND MAJOR OPERATIONAL ment’s responses? PROCEDURE CHANGES OR MODIFICATIONS

The following questions will be addressed by EXTENT TO WHICH AUDIT IS examiners: COMPUTER PROGRAMS ARE USED AND THEIR 31. Is there a formal or informal procedure for EFFECTIVENESS notifying the auditor of contemplated new systems or systems modiﬁcations in the The following questions are to be addressed if early planning stages? audit computer programs are used:

September 1997 Branch and Agency Examination Manual Page 2 Internal and External Audits: Audit Function Questionnaire 4010.4

41. What audit computer programs are used and 51. Has the same public accounting firm been what are their purposes? engaged for the prior two years? If not, 42. Is any member of the audit staff qualified to obtain a reason for change. write and/or appraise the quality of audit 52. Have management letters from the external computer programs? auditors or other reports from consultants 43. Is the auditor satisfied that he/she has suf- been presented to management since the ficient ‘‘free access’’ to the computer files? last examination? 44. Are audit programs run on the auditor’s 53. Do deficiencies in management letters request? receive appropriate attention? a. If operators run audit programs, are they 54. Are the notes pertaining to the financial supervised by the auditor? statements reviewed for any information b. If not, how are they controlled? that may allude to significant accounting or 45. Do direct verification programs allow the control problems? auditor flexibility in selecting the criteria to 55. Does the report of examination and/or the be used in determining the sample? management letter submitted by the public 46. Have procedures been established for the accounting firm comprehensively define the development and maintenance of documen- scope of the examination conducted? tation for audit computer programs? Are they adhered to? 56. Do the external auditors receive a copy of 47. Are changes to audit programs controlled? the most recent statutory and/or regulatory examination report(s) and reports of assets and liabilities, as may be required or appropriate? Do they receive copies of pertinent EXTERNAL AUDIT ACTIVITIES correspondence, including supervisory letters and management’s responses, if any, The following questions are to be addressed if between the branch and the examining an external audit has been performed: authority? 48. Where state or federal regulations or stock exchange listing require an independent CPA audit, did the branch comply? a. Was an opinion rendered by the accounting firm and if so, was it unqualified? HOME COUNTRY REGULATORY b. If the opinion was qualified, has the EXAMINATION ACTIVITIES auditor taken appropriate action in the resolution of any deficiencies? 57. Do home country regulators periodically 49. Does the FBO’s policy prohibit loans to its examine the branch in the United States? If external auditor or the engagement of an so, do they produce a report? If yes, then the external auditor who is a shareholder? If following questions will be addressed. not, has head office considered the materi- 58. Does the branch’s internal auditor have ality of any existing transactions regarding access to examination reports produced by the auditor’s independence? the home country regulators? 50. Has an external auditor been engaged to 59. Does the branch investigate the reasons for perform special reviews of specific depart- adverse comments and recommendations in ments or areas of the branch since the the examination reports? previous examination? If deficiencies were cited, have they been corrected?

Branch and Agency Examination Manual September 1997 Page 3 Internal and External Audits Audit Guidelines Effective date July 1997 Section 4010.5

AUDIT MANUAL ation of existing internal controls has been made, such as through the use of 1. Has responsibility for the establishment and an internal control questionnaire or maintenance of the audit manual been memorandum? clearly assigned? 18. Does the audit manual include a provision 2. Does the audit manual require approval by for a review and update of the procedures the head office, the audit committee, or for each audit, where required, upon its others? If so, has such approval been completion? obtained? 19. Does the audit manual make provision for 3. Is the content of the audit manual indepen- the maintenance of a permanent file for dent of adverse influence of other interests, audits conducted? such as operating management or indepen- 20. Does the audit manual contain provisions dent CPAs? for the formal, standardized preparation and 4. Is the audit manual current and are proce- maintenance of workpapers? dures for keeping the manual current 21. Are applicable statutory and regulatory adequate? requirements included in the audit 5. Does the audit manual contain the scope procedures? and objective of each audit? 6. Does it require that valid deviations from audit procedures be officially approved by audit management? MAINTENANCE OF AUDIT 7. Do audit procedures provide for the follow-up RECORDS of exceptions noted in previous audits? 8. Does it prescribe that each audit procedure 22. Are workpapers arranged and maintained in be cross-referenced to the appropriate audit two groups for filing and reference in: workpapers? a. The current file? 9. Must an auditor initial each program step as b. The permanent file? testimony of his/her performance? 23. Is a reasonable retention schedule and 10. Does it prescribe that full control be estab- departmental index maintained for audit lished at the time of entry over the records records? selected for audit? 24. Are audit procedures complied with during 11. Is proof of control records required? each audit? 12. Are direct verification programs covering 25. Do the workpapers contain evidence of all all forms of customer deposit, loan, safe- significant deviations from audit procedures keeping, collateral, collection, and trust with the approval of audit management? accounts included? 26. Are procedures for preparing and maintain- 13. Are flow charts called for as evidence of ing workpapers adhered to? thorough analytical auditing? 27. Do workpapers contain a copy of the audit 14. Do the procedures employ scientific sam- report, an adequate index, an internal con- pling techniques with acceptable reliability trol questionnaire, audit procedures, and and precision? other appropriate material? 15. Does the audit manual provide for the 28. Are workpapers numbered, indexed, and resolution of exceptions and deficiencies? cross referenced to audit procedures and the 16. Does the audit manual contain provisions workpaper index? for report format and content and an expres- 29. Is each workpaper dated and initialed by the sion of the opinion of the auditor regarding preparer? Are sources of data clearly shown? the adequacy, effectiveness, and efficiency Are tick marks explained? of internal controls? 30. From the workpapers, can it be determined 17. For each audit, do audit procedures provide how various sample sizes were determined, a documented method of assuring audit judgment or scientific, including range and management that a proper study and evalu- confidence level?

Branch and Agency Examination Manual September 1997 Page 1 4010.5 Internal and External Audits: Audit Guidelines

31. Do workpapers show that supervisory per- 33. Is the branch in compliance with applicable sonnel of the audit department have reviewed statutory and/or regulatory requirements? the workpapers and resultant ﬁndings? 32. Are all signiﬁcant and/or unresolved exceptions noted in workpapers required to be included in the report?

September 1997 Branch and Agency Examination Manual Page 2 Internal Control Effective date July 1997 Section 4020.1

U.S. branches of foreign banking organizations • The branch’s organizational structure. are expected to have a fully effective system of • The functioning of committees internal controls similar to those required of U.S. • Methods of assigning authority and banks. Although internal controls should pro- responsibility. vide for an internal audit program (which is • Management’s control methods for monitor- separately covered in Section 4010 of this ing and following up on performance, includ- manual), this section applies to the review and ing internal auditing. evaluation of a branch’s existing internal control • Personnel policies and practices. environment. An examiner should review the • Various external influences that affect a internal audit program in conjunction with the branch’s operations and practices, such as review of internal controls in order to fully examinations by bank regulatory agencies. understand the branch’s internal control system. The concept of operational efficiency and the The accounting system consists of the meth- related control procedures are not addressed in ods and records established to identify, assemble, this manual because such considerations gener- analyze, classify, record, and report a branch’s ally fall outside the responsibilities of an exam- transactions and to maintain accountability for iner. That, however, is not intended to inhibit or the related assets and liabilities. An effective prevent an examiner from commenting on accounting system gives appropriate consider- operational inefficiencies, particularly in instances ation to establishing methods and records that where inefficiencies have a significant impact on will: the condition or risk standing of a branch. • Identify and record all valid transactions. • Describe, on a timely basis, the transactions in INTERNAL CONTROL sufficient detail to permit proper classification STRUCTURE of transactions for financial reporting. • Measure the value of transactions in a manner The internal control structure consists of the that permits recording their proper monetary policies and procedures established to provide value in the financial statements. reasonable assurance that specific objectives • Determine the time period in which transac- will be achieved. The Statement on Auditing tions occurred to permit recording of transac- Standards No. 55, ‘‘Consideration of the Inter- tions in the proper accounting period. nal Control Structure in a Financial Statement • Properly present the transactions and related Audit’’ (effective January 1, 1990), describes disclosures in the financial statements. the three elements of an internal control structure. These elements are: the control environ- Control procedures are those policies and ment, the accounting system, and control proce- procedures, in addition to the control environ- dures. The elements, as described below, need to ment and accounting system, that management be considered in the review and evaluation of a has established to provide reasonable assurance branch’s internal control system.1 that specific branch objectives will be achieved. Control procedures have various objectives and The control environment reflects the overall are applied at various organizational and data attitude, awareness, and actions of branch and processing levels. They may also be integrated head office management regarding the impor- into specific components of the control environ- tance of control and its emphasis. The control ment and the accounting system. Control proce- environment includes the following: dures should include:

• Management’s philosophy and operating style. • Authorization of transactions and activities— Transactions and activities should be approved by appropriate management. 1. The description of the three elements of an internal • Segregation of duties—By assigning different control structure was taken from the ‘‘Codiﬁcation of State- people the responsibilities of authorizing trans- ments on Auditing Standards’’ published by the American Institute of Certiﬁed Public Accountants, 1990 (Source: State- actions, recording transactions, and maintain- ment on Auditing Standards No. 55). ing custody of assets, the chance of any

Branch and Agency Examination Manual September 1997 Page 1 4020.1 Internal Control

person being in a position to both perpetrate trols, management review of reports that sum- and conceal errors or irregularities in the marize the detail of account balances, and user normal course of his/her duties, is reduced. review of computer-generated reports should • Dual controls—Requiring two different people be conducted. to perform one sensitive task, such as opening the vault or signing checks, also reduces the The applicability and importance of specific risk of defalcation. When two individuals control environment factors, accounting meth- must act in collusion to conduct fraud or ods and records, and control procedures that a defalcation, it is much less likely to occur. branch establishes should be considered in the • Job descriptions—In all departments, job context of: descriptions should be well-defined and provide for logical flow of work. If employees • The branch’s size. have responsibilities for other offices or affili- • Its organization characteristics. ates of the FBO, particularly those that share • The nature of its business. facilities with the branch, these responsibili- • The diversity and complexity of its operations. ties should be clearly defined and, when • Its methods of processing data. appropriate, disclosed or made clear to branch • Its applicable legal and regulatory require- customers and the public in general. ments. • Policies—Policies regarding hiring practices, annual salary reviews, merit increases, perfor- Establishing and maintaining an internal con- mance evaluations, promotions, and vacations trol structure is an important management should be established and clearly understood. responsibility. To provide reasonable assurance Adequate procedures should be in place to that a branch’s objectives will be achieved, the ensure that screening procedures are applied internal control structure should be under to personnel hired for sensitive positions. Any ongoing supervision by management to deter- doubts about an individual’s qualifications mine that it is operating as intended and that should be resolved before an employee is it is modified, as appropriate, for changes in hired. conditions. • Consecutive absence—Branch policy should require employees in sensitive positions to be absent from their duties for a minimum number of days. Prudent banking practice dictates INTERNAL CONTROL that employees in sensitive positions be absent OBJECTIVES for ten consecutive days. In some instances, absence due to a business trip may be accept- In general, good internal control exists when no able; however, it is necessary for someone one is in a position to make significant errors or else to perform the employee’s duties for that perpetrate significant irregularities without timely period of time. In establishing the policy, detection. Therefore, a system of internal con- branches should follow any applicable laws, trol should include those procedures necessary regulations, or guidelines of their licensing or to ensure timely detection of failure of account- insuring authority(ies). ability, and such procedures should be per- • Documents and records—Adequate docu- formed by competent persons who have no ments and records should be used to ensure incompatible duties. The following standards the proper recording of transactions and events, are encompassed within the description of inter- such as monitoring the use of pre-numbered nal control. shipping documents. • Accessibility safeguards—Adequate safeguards Existence of Procedures—The existence of over access to and use of assets and records, prescribed internal control procedures is neces- such as computer programs and data files, sary but not sufficient for effective internal should be in place. control. Prescribed procedures that are not actu- • Reconciliations—Independent checks on per- ally performed do nothing to establish control. formance and proper valuation of recorded Consequently, the examiner must give thought- amounts, such as clerical checks, reconcilia- ful attention not only to the prescribed set of tions, comparison of assets with recorded procedures but also to the practices actually accountability, computer-programmed con- followed. This step can be accomplished through

September 1997 Branch and Agency Examination Manual Page 2 Internal Control 4020.1 inquiry, observation, testing, or a combination internal controls is to identify the various key thereof. functions applicable to the area under review. For each position identified, the following ques- Competent Performance—For internal con- tions should be asked: trol to be effective, the required procedures must be performed by competent persons. Evaluation • Is this a critical position? That is, can a person of competence undoubtedly requires some degree in this position either make a significant error of subjective judgment because attributes, such that will affect the recording of transactions or as intelligence, knowledge, and attitude are perpetrate material irregularities of some type? relevant. Thus, the examiner should be alert for • If an error is made or irregularity perpetrated, indications that employees have failed so sub- what is the probability that normal routines stantially to perform their duties that a serious will disclose it on a timely basis? That is, what question is raised concerning their abilities. controls exist that would prevent or detect significant errors or the perpetration of signifi- Independent Performance—Employees who cant irregularities? have access to branch assets should not also • What are the specific opportunities open to the (a) have access to the related accounting records, individual to conceal any irregularity, and are (b) perform related review operations, or there any mitigating controls that will reduce (c) immediately supervise the activities of other or eliminate these opportunities? employees who maintain the records or perform the review operations. Otherwise, such employ- Although all employees within a branch may ees may be able both to perpetrate and conceal be subject to control, not all have financial defalcations. Therefore, duties concerned with responsibilities that can influence the accuracy the custody of assets are incompatible with of the accounting and financial records or have recordkeeping duties for those assets, and duties access to assets. It is those positions, with the concerned with the performance of activities are ability to influence the records and with access incompatible with the authorization or review of to assets, with which the examiner is primarily those activities. In judging the independence of concerned. Once those positions have been iden- a person, the examiner must avoid looking at tified, the examiners must exercise their profes- that person as an individual and presuming the sional knowledge of branch operations to con- way in which he or she would respond in a given ceive of any possibilities open to a person situation. For example, an individual may be the holding a particular position. The question is not sole check signer and an assistant may prepare whether the individual is honest but whether monthly branch reconcilement. If the assistant situations exist that might permit an error to be appears to be a competent person, it may seem concealed. By directing attention to such situa- that an independent reconcilement would be tions, an examiner will also consider situations performed and anything amiss would be reported. that may permit unintentional errors to remain Such judgments are potentially erroneous. No undetected. established tests exist by which the psychologi- When reviewing internal controls, an essen- cal and economic independence of an individual tial part of the examination is alertness to in a given situation can be judged. The position indications that adverse circumstances may exist. must be evaluated, not the person. If the position Adverse circumstances may lead employees or in which the person acts is not an independent officers into courses of action they normally one, in itself, then the work should not be would not pursue. An adverse circumstance to presumed to be independent, regardless of the which the examiner should be especially alert is apparent competence of the person in question. when the personal financial interests of key In the example cited above, the function per- officers or employees depend directly on oper- formed by the assistant should be viewed as if it ating results or financial condition. Although the were performed by the supervisor. Hence, review of internal control does not place the incompatible duties are present in that situation. examiner in the role of an investigator or detec- tive, an alert attitude toward possible conflicts of interest should be maintained throughout the EXAMINATION PROCEDURES examination. Branches staffed by members of the same family, branches completely domi- An effective way to begin an on-site review of nated by a strong personality, or departments in

Branch and Agency Examination Manual September 1997 Page 3 4020.1 Internal Control which supervisors rely unduly on their assistants part of the branch’s operating system, such as require special alertness on the part of the budget procedures that include a careful com- examiner. These and other similar circum- parison of budgeted and actual amounts by stances should be considered in preparing the competent management personnel. Mitigating questionnaire. It is not the formality of the controls also may be informal. For example, in particular factor that is of importance but rather small branches, management may be sufficiently its effect on the overall operation under review. involved in daily operations to know the pur- When circumstances that may affect answers to pose and reasonableness of all expense disburse- the basic questions exist, a notation of the ments. That knowledge, coupled with the circumstances should be made along with con- responsibility for signing checks, may make clusions concerning their impact on the irregularities by non-managers unlikely, even if examination. disbursements are otherwise under the control of The examiner should also be alert for devia- only one person. tions from established policies, practices, and Sometimes, when a substantial portion of the procedures by branch personnel. Examples of accounting work is accomplished by computer, such deviations include situations when instruc- the procedures are so different from conventions and directives are not revised to reflect tional accounting methods that the principles current practices, employees find short cuts for discussed herein seem inapplicable. Care should performing their tasks, changes in organization be taken to resist drawing such a conclusion. and activities that may influence operating pro- The discussion of internal control presented here cedures in unexpected ways, and employees and its evaluation is purposely stated in terms duties are rotated in ways that have not been sufficiently general to apply to any system. previously considered. These and other circum- Perpetration of defalcations requires direct or stances may serve to modify or otherwise change indirect access to appropriate documents or prescribed procedures giving the examiner an accounting records. As such, perpetration requires inadequate basis for evaluating internal control. the involvement of people and, under any sys- Furthermore, the examiner should consider tem, computerized or not, there will be persons other existing accounting and administrative who have access to assets and to records. Those controls or other circumstances that might coun- with access may include computer operators, teract or mitigate an apparent weakness or programmers, their supervisors, and other related impair an established control. Controls that personnel. mitigate an apparent weakness may be a formal

September 1997 Branch and Agency Examination Manual Page 4 Internal Control Examination Objectives Effective date July 1997 Section 4020.2

1. To determine the adequacy of the internal in the branch’s business or strategic plan as control structure (i.e. the control environ- well as laws and regulations. ment, accounting system, and control proce- 4. To recommend corrective action when inter- dures) in relation to the branch’s size and nal control policies, practices, or procedures complexity. are deﬁcient or when violations of laws or 2. To determine the level of adherence to pro- regulations have been noted. cedures and systems. 3. To evaluate whether the system of controls is regularly reviewed to keep pace with changes

Branch and Agency Examination Manual September 1997 Page 1 Internal Control Examination Procedures Effective date July 1997 Section 4020.3

1. Using methods such as reviewing completed h. Any indications of adverse circumstances examiner workprograms and accompanying or conflicts of interest surrounding workpapers, directly observing and discuss- employees or officers which could lead ing policies and procedures with branch per- them into courses of action they would sonnel, and testing when appropriate, deter- normally not pursue; mine the following: i. Any internal control deficiencies or viola- a. The adequacy of policies and any deviations of law noted; and tions from established policies, practices, j. Any other comments regarding the and procedures by branch personnel adequacy of internal controls. (including personnel policies); 2. Discuss findings with senior management of b. The effectiveness of the accounting sys- the branch. During the discussion, elicit man- tem to: agement’s responses for corrections of defi- • identify and record transactions; and, ciencies and/or violations. • provide sufficient detail to properly clas- 3. Write, in appropriate report format, general sify, value, and record the date of trans- remarks regarding internal control that may actions for financial reporting; include: c. The adequacy of internal control proce- a. The quality of internal control policies, dures given the type and level of risks practices, and procedures; posed by the size and complexity of the b. The lines of authority and responsibility branch; for reviewing, approving, and monitoring d. The lines of authority and responsibility adherence to policies and procedures; for reviewing, approving, and monitoring c. The general adherence to internal control adherence to policies and procedures; policies, practices, and procedures; e. The existence of adequate job descriptions d. The competency and independence of perfor all employees; sonnel performing the internal control f. The competence of persons performing procedures; and, the required procedures; e. Any deficiencies and violations noted. g. The separation of duties of persons who have access to branch assets;

Branch and Agency Examination Manual September 1997 Page 1 Emergency Preparedness Measures Effective date July 1997 Section 4030.1

The purpose of an emergency preparedness plan records, documentary evidence of credit exten- is to identify the actions to be taken to minimize sions, contingent liabilities, and funds place- financial business loss in the event of a disaster. ment. The plan should indicate how the required All financial institutions, including a branch, are records will be restored or recovered, where the expected to have an emergency preparedness appropriate support from outside vendors will plan, which has been approved by senior man- be obtained, and how much manpower will be agement at the branch and/or appropriate man- needed to restore operations. Written agree- agement levels at its head office. When a branch ments with outside vendors should be in force experiences an emergency or disaster situation and copies readily accessible. in the United States, the assistance the head office can provide may be limited due to geographic distance and differences in time zones. Therefore, a branch must be self-sufficient and ALTERNATE OPERATING have adequate contingency plans in place to HEADQUARTERS restore operations. The emergency preparedness plan (‘‘plan’’) should contain pre- and post- An alternate operating site should be designated emergency operations procedures, and the actions in a different city or vicinity from the branch. In required during the emergency. The procedures selecting an alternate operating site, consider- should be tested and the results documented. ation should be given to having a separate power The plan should address the continuity of man- grid, different water main, and central telephone agement, the reconstruction of essential records, stations from the branch. The optimal alternate an alternate operating headquarters, and the site could be another banking site of the FBO, protection of personnel. In addition, the plan located in a different state, which would be able should give a time table for reconstruction of the to provide EDP and communications support. critical operations. The alternate site should be remote enough so that it can be used in the event of a local disaster (i.e., fire, flood, earthquake, hurricanes, civil CONTINUITY OF MANAGEMENT disturbance, etc.). In the event this type of alternate site is not available, or is prohibitively Continuity of management is critical to the expensive, the emergency preparedness plan decision-making process during an emergency should have in-depth and well-thought out pro- and, therefore, should be documented in the cedures to restore branch operations at another plan, along with necessary telephone numbers. location in a timely manner. The emergency preparedness plan should also ensure that an officer is available in a post- emergency situation to take official action. PROTECTION OF PERSONNEL

Because most branches do not own their prem- RECONSTRUCTION OF ises, security and shelter protection for person- ESSENTIAL RECORDS nel is partially dependent on the owner of the premises. Building evacuation and emergency Contingency plans should address the restora- operation procedures should be detailed in the tion of electronic data processing (EDP) facili- branch’s plan and be readily accessible to all ties and the restoration of other areas within the personnel. Training in panic control, evacuation branch, including communications, electronic procedures, and self-protection should be given funds transfer, signature cards and customer to branch personnel at least annually.

Branch and Agency Examination Manual September 1997 Page 1 Emergency Preparedness Measures Examination Objectives Effective date July 1997 Section 4030.2

1. To determine if the emergency preparedness adequate for them to properly perform their policies, practices, procedures, and internal emergency responsibilities. controls are adequate. 4. To recommend corrective action when poli- 2. To determine if branch officers are operating cies, practices, procedures, or internal con- in conformance with the established guide- trols are deficient or when violations of laws lines from head office. or regulations have been noted. 3. To determine whether the level of training among branch officers and employees is

Branch and Agency Examination Manual September 1997 Page 1 Emergency Preparedness Measures Examination Procedures Effective date July 1997 Section 4030.3

1. Obtain the branch’s emergency preparedness cedures, and self-protection, and the program and determine whether it addresses documentation of such training; the following: • Distribution of the plan to appropriate a. Continuity of Management employees. • Succession plans for senior officers and e. Other administrative personnel; • The designation of an emergency/security • The designation of a senior level officer officer. responsible for re-opening the branch; • The notification of head office and local • The informing of designated substitute regulatory authorities of actions taken personnel of their duties under the plan. during an emergency. b. Record and Asset Protection and 2. Determine if the branch’s contingency Reconstruction program has been approved by appro- • The duplication and remote storage of priate management levels at the head essential records; office, and how frequently the program • The remote storage of important PC is reviewed. applications; 3. Determine the type of training branch • Procedures for the reconstruction or personnel receive for emergency situa- recovery of records and post-emergency tions and assess their knowledge of procedures, and the testing of these their responsibilities in the event of an procedures; emergency. c. Alternate Location 4. Determine how frequently the branch • The designation of an alternate location tests its emergency preparedness pro- which is sufficiently removed from the gram, and how deficiencies are tracked main site and written agreements for the after tests are completed. use of the alternate site; • The notification of the alternate site to 5. Determine if the branch has designated customers and third party contractors in an emergency/security officer. the instances when the alternate site is 6. Determine if resolutions have been used; adopted by head office to enable avail- • Plans for emergency operations at its able or surviving branch officers to alternate location, and the testing of take official action. such plans; 7. Determine if copies of these resolu- • The maintenance of copies of these tions and the emergency preparedness plans at each site, and the requirement plan have been stored off-site for safe- that all officers have copies; keeping and are readily accessible. • Plans for personnel assembly at the 8. Determine if, in the case of an emer- alternate site or at rendezvous points; gency, the re-opening team will receive • Senior level management monitoring of regular updates from local authorities conditions at the alternate site and as to when the orginial premises can be reporting back regularly to head office accessed. and local regulatory authorities. 9. Determine if there are arrangements to d. Personnel Protection notify head office, the regulatory • Group employee training regarding authorities, customers and vendors of operation of the emergency prepared- the re-opening of the original premises ness plan, panic control, evacuation pro- when it occurs.

Branch and Agency Examination Manual September 1997 Page 1 Cash Accounts Effective date July 1997 Section 4040.1

Cash accounts include U.S. and foreign coin and upon presentation. A separate control of all such currency on hand and in transit, clearings, and items usually is maintained on the branch’s cash items. general ledger and is supported by a subsidiary record of individual amounts and other pertinent data. CASH In addition to those items carried in the separate account entitled cash items on the Most branches maintain a certain amount of U.S. general ledger, some branches will have several currency and some may have foreign currency sources of internal float, in which irregular cash on hand. Each branch should establish policies items can be concealed. Such items include any and procedures appropriate for the level of cash memoranda slips; checks returned by other maintained at the branch. banks; checks of officers, employees, and their interests; checks of affiliates; debits purporting to represent currency or coin shipments; notes, CLEARINGS usually past-due; and all aged and unusual items of any nature that might involve fictitious entries, Clearings are checks, drafts, notes, and other manipulations or uncollectible accounts. items that a branch has cashed or received for If the cash items are not in the process of deposit that are drawn on other local banks and collection, they should be included on the are cleared directly with them. Such items branch’s books in an appropriate account and usually can be exchanged more efficiently among shown under other assets. These are items that local banks, than through correspondent banks are payable upon presentation but which the or the Federal Reserve System. Some branches branch has elected to accumulate for forwarding also provide clearing services for other foreign to the payor on a periodic basis. If the items are banks, including central banks. not immediately payable in cash upon presentation or if they were not paid when presented and, after a predetermined period of time, require further collection effort, they also should be CASH ITEMS included in a noncash asset account, such as cash items not in process of collection and Cash items are checks or other items in the shown under other assets. process of collection that are payable in cash

Branch and Agency Examination Manual September 1997 Page 1 Cash Accounts Examination Objectives Effective date July 1997 Section 4040.2

The following should be undertaken only if 3. To determine the scope and adequacy of the warranted by significant cash volume or activity. internal and external audit function. 4. To recommend corrective action when poli- 1. To determine if the policies, practices, and cies, practices, procedures, or internal con- procedures and internal controls regarding trols are deficient or when violations of law cash accounts are adequate. or regulations have been noted. 2. To determine if officers and employees are operating in conformance with established guidelines.

Branch and Agency Examination Manual September 1997 Page 1 Cash Accounts Examination Procedures Effective date July 1997 Section 4040.3

The purpose of this section is to determine documentation, whether defalcations and/or whether the branch has established appropriate mysterious disappearances of cash since the policies and procedures to ensure compliance preceding examination have occurred. If so, with the regulations and provide for an effective have they been properly reported, pursuant to internal control environment. current requirements of the applicable bank This section will not be applicable to branches supervisory agencies? that do not maintain cash on premises. 6. Review foreign currency control ledgers and dollar book value equivalents for: 1. Based on the evaluation of internal controls a. Accuracy of calculations and booking and any applicable comments by internal and procedures. external auditors, determine the scope of the b. Unusual fluctuations. examination. c. Concentrations. 2. If included in the scope of the examination, complete or update the Cash Accounts sec- d. Unusual items. tion of the Internal Control Questionnaire. 7. In keeping with the scope of the examination, 3. Test for compliance with policies, practices, review compliance with the Financial Rec- procedures, and internal controls in conjunc- ordkeeping and Reporting of Currency and tion with performing the remaining examina- Foreign Transactions Act, 31 CFR 103. tion procedures. Obtain a listing of any Examination policies and procedures in this deficiencies noted in the most recent review regard may be found in the Federal Reserve’s by internal or external auditors and deter- Bank Secrecy Act Manual and other similar mine if appropriate corrections have been examination material prepared by the other made. federal and state banking agencies. 4. Obtain a detailed listing of all cash items, 8. Prepare comments on deficiencies or viola- including any bank items that are carried in tions of law or regulations noted above for the general ledger under other assets. Verify inclusion in the examination report. listings to general ledger balances and scan 9. Prepare a complete set of workpapers to for propriety and conformity to branch policy. support conclusions reached. Include any 5. Determine, by discreet corroborative inquiry information that will facilitate future of responsible branch officials and review of examinations.

Branch and Agency Examination Manual September 1997 Page 1 Cash Accounts Internal Control Questionnaire Effective date July 1997 Section 4040.4

Review the branch’s internal controls, policies, c. Scrutinized for employee items? practices, and procedures for cash accounts. The d. Reviewed for large or repeat items? system should be documented in a complete and 8. Are holdover items: concise manner and should include, where a. Appropriately identified in the general appropriate, narrative descriptions, flowcharts, ledger? copies of forms used, and other pertinent information. b. Handled by an independent section of the department? 1. Regarding vault control: c. Reviewed periodically by responsible a. Is a register maintained that is signed by supervisory personnel to determine that the individuals opening and closing the items are clearing on a timely basis? vault? 9. Are foreign currency control ledgers and b. Is the vault under dual control? dollar book value equivalents posted c. Are combinations changed periodically accurately? and every time there is a change in 10. Is each foreign currency revalued at least custodianship? monthly and are profit and loss entries 2. Does an officer or other designated indi- passed to the appropriate income accounts? vidual review the disposition of all cash 11. Are revaluation calculations, including the items over a specified dollar limit? rates used, periodically reviewed for accu- 3. Does the branch have an adequate charge- racy by someone other than the foreign off policy for uncollected cash items? currency tellers? 4. Do the branch’s present procedures forbid 12. Does the internal or external auditor peri- the holding of overdraft checks in the cash odically review revaluation calculations, item account? including the verification of rates used and 5. Are all cash items reviewed at least monthly the resulting general ledger entries? at an appropriate level of management? 6. Are cash items recommended for charge off, reviewed, and approved by a branch officer with no operational responsibilities? 7. Are returned items: CONCLUSION a. Handled by an independent section of the department or delivered unopened to 13. Is the information covered by this ICQ personnel not responsible for preparing adequate for evaluating internal controls in cash letters or handling cash? this area? If not, indicate any additional b. Reviewed periodically by responsible examination procedures deemed necessary. supervisory personnel to determine that 14. Based on the information gathered, evaluate items are being handled correctly by this the internal controls in this area (i.e. strong, section and are clearing on a timely satisfactory, fair, marginal, unsatisfactory). basis?

Branch and Agency Examination Manual September 1997 Page 1 Cash Accounts Audit Guidelines Effective date July 1997 Section 4040.5

CASH difference is discovered by the examiner, the cash should be immediately recounted 1. Immediately upon arrival, determine the by the teller in the presence of the examiner. location of all cash and cash items to be If the difference is not resolved, an officer controlled. should be called in to count the cash, and 2. Establish control over all necessary items both the officer and the teller should be (consider the use of seals) and, using appro- required to sign the cash sheet reflecting the priate sampling techniques, select funds to actual amount of cash counted. be counted and assign personnel to the 7. Review all after-hours items to ensure their various funds. There should be no move- validity and trace the items to their final ment of cash or securities in to or out of the disposition. vault area unless such movement is con- 8. Detail all items on the cash sheet other than trolled by an examiner. All compartments in cash found in the cash compartments, even the vault should be sealed (including lock- though they may not be required in the ers reported to contain other than cash) until reconciliation process. all items are counted and control is no 9. Prepare a listing of proof sheets and verify longer necessary. (Note: Sealing of vaults or reconcile the total to the branch’s daily containing other than cash is to be per- statement and to the general ledger as of the formed by examiners responsible for those examination date. (Note: The branch’s daily areas.) cash form may be appropriate for this 3. Inquire if the branch has incoming or out- purpose.) going cash shipments and confirm such 10. Review the teller’s proof sheets for the day amounts. If bagged items are on hand, note and ascertain that all balances are reason- contents without counting and control bags able in relation to operating requirements to armored car pick-up, etc., and confirm and/or branch policy. Note any balances in balances with the recipient on a test basis. excess of reasonable amounts in the work- This step applies to Payroll Cash, Change papers for subsequent discussion with an Fund Cash, Mutilated Money, Fed Ship- appropriate branch official. ments, etc. Examine on a test basis subse- 11. For each foreign currency held, verify quent payments for bagged cash. approximate U.S. dollar carrying values by 4. Obtain a copy of the teller’s proof sheets as obtaining current bid bank note rates for the of the close of business for the day of foreign currencies on hand. Using those the examination, and retain them for the rates, convert each foreign currency into workpapers. U.S. dollar equivalents. The resulting U.S. dollar values should be verified with the 5. Count and verify cash (both U.S. currency amount shown on the branch’s general led- and foreign currency) to the proof sheets. ger for reasonableness. Count foreign currency in separate totals 12. Check the accuracy of foreign currency for each currency. If after-hours transac- revaluations and that resulting profit or tions have been conducted, the debit and losses are properly posted to appropriate credit totals must be included in the recon- income accounts. (Foreign cash may be cilement between actual cash counted and revalued with other foreign currency ledger the closing cash figure reflected on the and future exchange contracts by the teller’s proof sheets. The custodian of the branch’s accounting/auditing department.) cash and the examiner must both remain with the cash until the verification procedure is completed. 6. Transcribe cash count information to a blank CASH ITEMS cash sheet and retain for the workpapers. Upon completion of the count, obtain the 13. Prepare lists of outstanding items. teller’s signature on the workpaper and 14. Verify totals to the daily statement controls release control over the fund. If a material and to the general ledger.

Branch and Agency Examination Manual September 1997 Page 1 4040.5 Cash Accounts: Audit Guidelines

15. Using an appropriate sampling technique, 23. Prepare and mail a positive confirmation select items for review of supporting docu- request for each individual item selected. mentation and request confirmation of payor. The receiving bank will balance the indi- 16. Review all cash items selected to determine vidual items to the cash letter total and will if they are legitimate, that they are being list any return items or other exceptions. processed on a current basis, and that they During this process the auditor should be contain no items from officers or employees. alert for unusual items, such as employee 17. Scrutinize any additional cash items that are checks that have been deliberately mis- not segregated in a control account to ensure routed. their validity. 24. Place confirmation requests in the related 18. Investigate, through inquiry or other appro- cash letters and maintain control over the priate means, any unusual, stale, or recur- cash letters until they are picked up for ring items and confirm their reasonableness delivery. or final disposition. All items not in the process of collection should be transferred 25. Cross-reference the control copies of the to an appropriate noncash suspense account. confirmations to the schedule noted in 19. Prepare a list of items recommended for step 21. charge off and ascertain that appropriate 26. Control all returned (answered) confirma- entries are made. tions and investigate and resolve any 20. Release control of the cash items. reported differences. Include all confirmations in the workpapers and document the disposition of all exceptions. CLEARINGS 27. Beginning on the audit date and for a period of 3 business days subsequent to the audit 21. Prepare a schedule of all clearings by bank date, obtain all incoming returned items. name and cash letter total. Determine that Review the items and investigate any old or the combined total agrees to the final recap unusual items. Ascertain whether any items and to the general ledger. relate to officers or employees. 22. Select a number of individual clearing amounts for confirmation.

September 1997 Branch and Agency Examination Manual Page 2 Consigned Items and Other Nonledger Control Accounts Effective date July 1997 Section 4050.1

Branches may provide a number of customer customers’ valuables for short periods of time services, which normally do not result in assets while customers are on vacation or temporarily and liabilities subject to entry on the general out of the area. Although it is a convenience for ledger. These customer services may include branch customers, many financial institutions providing customer safekeeping, renting safe attempt to discourage the practice by emphasiz- deposit boxes, selling travelers’ checks, pro- ing the benefits of a safe deposit box. When it is viding collection services, and providing custo- not possible or practical to discourage a cus- dian accounts. It is the branch’s responsibility to tomer, the same procedures that are employed in properly maintain and safeguard all consigned handling collateral must be followed. Items to items. Branches can ensure the necessary con- be stored should be inventoried by two persons trol and review of consigned items through the and maintained under dual control in the branch’s use of nonledger control or memorandum vault. A multi-copy, pre-numbered, safekeeping accounts. These nonledger control accounts con- receipt should be prepared with a detailed sist of ledger cards for customer safekeeping description of the items accepted. Sealed pack- and safe deposit box facilities, inventory listings ages with contents unknown to the branch should for travelers’ checks, registers for collection never be accepted for safekeeping. The branch items, and registers for custodian accounts. It is may or may not charge a fee for the service but essential that branch policy provides for proper if it is the branch’s policy to engage in such internal controls, operating procedures, and safe- activity, a definite fee schedule should be guards. In all cases, control totals must be adopted. generated and the function balanced daily. Proper insurance protection must also be obtained to Custodian Accounts—Branches may act as protect against claims arising from mishandling, custodians for customers’ investments such as negligence, mysterious disappearance, or other stocks, bonds, or gold. That service may involve unforeseen occurrences. A brief description of simply physically storing the investments and the customer service activities involving con- recording sales, purchases, dividends, and inter- signed items is provided below. est or it may be expanded to include actually managing the account. Managing the account would include advising when to sell or buy certain investments and meeting the recording CUSTOMER SAFEKEEPING requirements. The examiner should refer to Section 3430, ‘‘Private Banking’’ and their Safe Deposit Boxes—The branch and the cus- respective agencies for guidance on advisory tomer enter into a contract whereby the branch investment management activities. receives a fee for renting safe deposit boxes of various sizes. In return for that fee, the branch assumes the responsibility of exercising reasonable care and precaution against loss of the COLLECTION ITEMS box’s contents. When a loss does occur, unless the branch can demonstrate it has maintained the The collection department is one of the most required standard of care, it could be held liable. diversified areas in the branch. It engages in The required standard of care is defined as that receiving, collecting, and liquidating items, which would be taken by a reasonably prudent which generally require special handling and for and careful person engaged in the same busi- which credit normally is given only after final ness. Two different keys are required to open the payment is received. Insofar as collection items box and the customer and the branch each have are concerned, the branch acts as agent for its one. The customer is not required to disclose the customers or correspondents and receives a fee contents of the box to the branch. Generally, the for that service. The importance and value of branch may only gain access to the box without customer assets under branch control demand the presence of the customer with a court order. the use of accounting procedures adequate to provide a step-by-step historical summary of Safekeeping—In addition to items held as each item processed. An audit trail must be collateral for loans, branches occasionally hold developed to substantiate the proper handling of

Branch and Agency Examination Manual September 1997 Page 1 4050.1 Consigned Items and Other Nonledger Control Accounts all items and to reduce the branch’s potential Rarely does the branch receive sufﬁcient rev- liability. enues to cover its cost of handling the above- mentioned transactions. However, branches that choose to compete at a retail level often must CONSIGNED ITEMS offer a full range of services. Such a branch assumes the responsibility and the related con- The most common item held on consignment by tingent liability to properly maintain the assets branches is an inventory of unissued travelers’ of others and to properly record all transac- checks. Travelers’ checks have gained wide- tions involved with the above functions. If an spread popularity because of the possibility of employee should, by fraud or negligence, permit refund if they are lost or stolen. They are issued unauthorized removal of items held for safekeep- for a fee or commission shared by the consignor ing or issue travelers’ checks improperly, the and the issuing institution. Generally, a working branch may be held liable for losses realized. supply of unissued travelers’ checks is main- Therefore, it is imperative that branches offering tained at the teller line or selling station, and a these retail services maintain adequate bonding reserve supply is maintained under dual control on all employees wherever contingent liabilities in the branch’s vault. exist.

September 1997 Branch and Agency Examination Manual Page 2 Consigned Items and Other Nonledger Control Accounts Examination Objectives Effective date July 1997 Section 4050.2

1. To determine if the policies, practices, pro- 3. To determine the scope and adequacy of the cedures, and internal controls regarding con- audit function. signed items and other nonledger control 4. To recommend corrective action when poli- accounts are adequate. cies, practices, procedures, or internal con- 2. To determine if branch ofﬁcers and employ- trols are deﬁcient. ees are operating in conformance with the established guidelines.

Branch and Agency Examination Manual September 1997 Page 1 Consigned Items and Other Nonledger Control Accounts Examination Procedures Effective date July 1997 Section 4050.3

1. If selected for implementation, complete or assigned to Internal and External Audits and update the Consigned Items and Other Non- determine if appropriate corrections have ledger Control Accounts section of the Inter- been made. nal Control Questionnaire. 4. Obtain a listing of consigned items and other 2. Based on the evaluation of internal controls nonledger control accounts from the branch. and the work performed by internal/external 5. Scan any existing control accounts for any auditors, determine the scope of the significant fluctuations and determine the examination. cause of fluctuations. 3. Test for compliance with policies, practices, 6. Prepare in appropriate report form and dis- procedures, and internal controls in conjunc- cuss with appropriate officer(s)any recom- tion with performing the remaining examina- mended corrective action when policies, prac- tion procedures. Obtain a listing of any tices, or procedures are deficient. deficiencies noted in the latest review by 7. Update the workpapers with any information internal/external auditors from the examiner that will facilitate future examinations.

Branch and Agency Examination Manual September 1997 Page 1 Consigned Items and Other Nonledger Control Accounts Internal Control Questionnaire Effective date July 1997 Section 4050.4

Review the branch’s internal controls, policies, 14. Has a standard fee schedule for this service practices, and procedures for consigned items been adopted? and other nonledger items. The branch’s system 15. Are all collections of rental income recorded should be documented in a complete and con- when received? cise manner and should include, where appro- 16. Are all safe deposit boxes, where the priate, narrative descriptions, flow charts, copies lessee is delinquent in rent, flagged or of forms used, and other pertinent information. otherwise marked so that access will be Items marked with an asterisk require substan- withheld until rent is paid? tiation by observation or testing. 17. Is a file maintained of all attachments, notices of bankruptcy, letters of guardian- ship, and letters testamentary, which have been served on the branch? SAFE DEPOSIT BOXES 18. Is an acknowledgment of receipt of all property and a release of liability signed 1. Has counsel reviewed and approved the upon termination of occupancy? lease contract in use that covers the rental, 19. Are locks changed when boxes are surren- use, and termination of safe deposit boxes? dered, whether or not keys are lost? *2. Is a signed lease contract on file for each 20. Is drilling of boxes witnessed by two safe deposit box in use? individuals? 3. Are receipts obtained for keys to the safe 21. Are the contents of drilled boxes invento- deposit box? ried, packaged, and placed under dual 4. Are officers or employees of the branch control? prohibited from acting as a deputy or *22. Are all extra locks and keys maintained having the right of access to safe deposit under dual control? boxes, except their own or one rented jointly with a member of their family? *23. Are such items segregated from branch- owned assets and maintained under dual 5. Is the guard key to safe deposit boxes control? maintained under absolute branch control? 24. Is there a set charge or schedule of charges 6. Does the branch refuse to hold, for renters, for this service? any safe deposit box keys? 7. Is each admittance slip signed in the presence of the safe deposit clerk and are the time and date of entry noted? ITEMS IN SAFEKEEPING 8. Are admittance slips filed numerically? 9. Are vault records noted for joint tenancies 25. Do branch policies prohibit holding items and co-rental contracts requiring the pres- in safekeeping free of charge? ence of two or more persons at each 26. Are duplicate receipts issued to customers access? for items deposited in safekeeping? 10. Are the safe deposit boxes locked when 27. Are the receipts prenumbered? permitting access, and is the renter’s key *28. Is a safekeeping register maintained to removed and returned to the customer? show details of all items for each customer? 11. Is the safe deposit clerk prohibited from *29. Is a record maintained of all entries to assisting the customer in looking through custodial boxes or vaults? the contents of a box? 30. Does the branch refuse to accept sealed 12. Does the safe deposit clerk witness or packages when the contents are unknown? confirm the re-locking of the box? 31. If the branch has accepted sealed packages 13. Is each vault booth, after being used but for safekeeping and the contents are not before being assigned to another renter, described, has the approval of the branch’s examined by an attendant to be sure the counsel been obtained? previous renter did not leave anything of 32. When safekeeping items are released, are value behind? receipts obtained from the customer?

Branch and Agency Examination Manual September 1997 Page 1 4050.4 Consigned Items and Other Nonledger Control Accounts: Internal Control Questionnaire

CUSTODIAN ACCOUNTS *45. Are permanent registers or memorandum accounts maintained for incoming and out- (Note that in a bank, these accounts may be going collection items? handled by the bank’s trust department and 46. Are serial numbers or prenumbered forms would thus be reviewed in a separate examina- assigned to each collection item and all tion of that department. However, fiduciary related papers? activities of U.S. branches of FBOs should be *47. Are all incoming tracers and inquiries included in safety and soundness examinations.) handled by an officer or employee not connected with the processing of collec- 33. Does the branch have written contracts on tion items? hand for each account that clearly define 48. Is a record kept to show the various the functions to be performed by the collection items that have been paid and branch? credited as a part of the day’s business? 34. Has branch counsel reviewed and approved 49. Is an itemized daily summary made of all the type and content of the contracts being collection fees showing collection num- used? bers and amounts? 35. Does the branch give customers duplicate 50. Are employees handling collection items receipts with detailed descriptions, includ- periodically rotated, without advance noti- ing dates of coupons attached, if applica- fication, to other branch duties? ble, for all items accepted? *51. Is the employee handling collection items 36. Are those receipts prenumbered? required to make settlement with the cus- 37. Do branch procedures prohibit its holding tomer on the same business day that pay- any investments not covered by a sale or ment of the item is received? purchase order in this department? 52. Does the branch have an established pol- 38. Are all orders for the purchase and sale of icy of not allowing the customer credit investments properly authorized in the until final payment is received? account contract or signed by customers? *53. Have procedures been established, includ- 39. For coupon securities held by the branch: ing supervision by a branch officer, for a. Is a tickler file or other similar system sending tracers and inquiries on unpaid used to ensure prompt coupon redemp- collection items in the hands of tion on accounts where the branch has correspondents? been authorized to perform that service? 54. In the event of nonpayment of a collection b. Are procedures in effect to prevent item, is the customer notified and is the clipping of coupons where the branch is item promptly returned? not authorized to conduct that service? 55. Are the files of notes entered for collection c. Have procedures been adopted to ensure clearly and distinctly segregated from prompt customer credit when coupon branch-owned loans and discounts? proceeds or other payments are received? 56. Are collection notes maintained under *40. Are all investment items handled in this memorandum control, and is the control area maintained under dual control? balanced regularly? 41. Have procedures been established for 57. Are collection files locked when the withdrawal and transmittal of items to employee handling such items is absent? customers? *58. Are vault or locked storage facilities pro- *42. Does an officer review and approve all vided for collection items containing withdrawals before the transaction is negotiable documents? effected? 59. Does the collection teller turn over all cash 43. Has a standard fee schedule for this service to the paying teller at the close of business been adopted? each day and start each day with a standard change fund? 60. Has a standard fee schedule been adopted COLLECTION ITEMS for this service? 61. Is the fee schedule always followed and, if 44. Is access to the collection area controlled? not, is proper officer approval obtained for If so, indicate how? any deviations?

September 1997 Branch and Agency Examination Manual Page 2 Consigned Items and Other Nonledger Control Accounts: Internal Control Questionnaire 4050.4

62. Is a permanent record maintained for reg- and put in the vault at night over weekends istered mail? or holidays or is it otherwise protected? 67. Are remittances for sales made on a regularly scheduled basis, if not daily? CONSIGNED ITEMS

*63. Is the reserve stock of consigned items CONCLUSION maintained under dual control? 64. Are working supplies kept to a reasonable 68. Is the information covered by this ICQ minimum, i.e., two or three days’ supply, adequate for evaluating internal controls in and adequately protected during banking this area? If not, indicate any additional hours? examination procedures deemed necessary. *65. Is a memorandum/control account main- 69. Based on the information gathered, evalu- tained for consigned items? ate the internal controls in this area (i.e. *66. Is the working supply safeguarded when strong, satisfactory, fair, marginal, the employee handling such items is absent unsatisfactory).

Branch and Agency Examination Manual September 1997 Page 3 Consigned Items and Other Nonledger Control Accounts Audit Guidelines Effective date July 1997 Section 4050.5

SAFE DEPOSIT BOXES 10. Using an appropriate sampling technique, select certain closed items for examination 1. Compare the number of rental contracts in and: force to the total number of safe deposit a. Examine the register form and custom- boxes. er’s release. 2. Determine the current status of rental pay- b. Compare customer’s signature on release ments on all boxes rented. to other signature copy on file. 3. Determine the reasons for any deviation c. If any of the items appear altered or from established fee schedules. unusual, confirm correctness of informa- 4. Using an appropriate sampling method, test tion with owners. check vault entry records for proper signa- 11. Review policies, fee schedule, and proce- ture(s) of authorized persons. dures for collection of fees for these services and perform appropriate tests to ensure 5. Inspect and reconcile the following to inven- compliance. Confirm that branch policies tory control records maintained by the prohibit holding items in safekeeping free branch: of charge. a. Keys for unrented boxes. b. Extra locks and keys kept for replace- ment purposes. c. Contents of any drilled safe deposit CUSTODIAN ACCOUNTS boxes. 12. Control all items held in custodian accounts 6. Obtain numbers of safe deposit boxes uti- through the use of seals or otherwise. lized by the branch and prepare a workpaper 13. Using an appropriate sampling technique, detailing all items contained therein. select accounts for review and: a. Examine the contract for each account selected. b. Verify the vault contents to the receipt SAFEKEEPING copy on hand. c. Review transactions and determine com- 7. Control all items held in safekeeping through pliance with written contractual use of seals or otherwise. authorizations. 8. Obtain the safekeeping register to verify d. If items in an account selected for review that receipt forms are issued in numerical are held in safekeeping elsewhere, consequence and to account for all numbers firm by direct communication. issued. Also, check unused forms for the e. If any items in the accounts selected next number to be issued, and test complete- appear altered or if there appears to be a ness of numerical sequence of unissued discrepancy between the receipt and what forms. is held in the vault, confirm the items 9. Using an appropriate sampling technique, held with customers. select items for test and: 14. Using an appropriate sampling technique, a. Verify the items selected and check the select closed accounts for review and: vault contents to the receipt copies on a. Review the register form and customer’s hand. release. b. If any items selected for review are held b. Compare the customer’s signature on in safekeeping elsewhere, confirm their release to the signature copy on file. existence by direct communication. c. If any of the account items appear altered c. If any of the items selected for review or unusual, confirm correctness of infor- appear altered or there seems to be a mation with owners. discrepancy between the receipt and what 15. Review policies and procedures for collec- is held in the vault, independently con- tion of fees for this service and perform firm the items with customers. appropriate tests to ensure compliance.

Branch and Agency Examination Manual September 1997 Page 1 4050.5 Consigned Items and Other Nonledger Control Accounts: Audit Guidelines

COLLECTION ITEMS accordance with established policy and that branch income accounts are being credited 16. In the event that permanent registers or on a daily basis. memorandum controls are maintained, prepare a trial balance of each account so controlled. Review the register and determine whether: CONSIGNED ITEMS a. all collections are indexed in the register. b. complete histories of the origin and final 22. Control all items held on consignment disposition of each collection item are through the use of seals or otherwise. recorded. 23. Inventory unissued and spoiled items on c. receipts are issued to customers for all hand and confirm totals to memorandum/ items received for collection. control accounts maintained at the branch. 17. In the case of unusual, altered, or long 24. Compare and reconcile memorandum outstanding items, prepare and mail confir- accounts to latest consignor statement. mation requests to customers. 25. Prepare and mail to consignor, a confirma- 18. Using an appropriate sampling technique, tion request on items inventoried. select representative items and: 26. Follow up and clear any confirmation a. Review all supporting documents. exceptions. b. To the extent possible, determine the authenticity of each item selected, and trace and clear each item through final payment, including appropriate credit to OTHER NONLEDGER CONTROL customer. ITEMS NOT COVERED ABOVE 19. Test postings of collections on detailed records to determine that disbursement of 27. Perform verification procedures considered funds collected is in accordance with cus- appropriate in light of any special circum- tomers’ instructions. stances encountered. 20. Determine that credit is given promptly, on 28. Prepare a workpaper documenting proce- the same day received, for all collections dures used, conclusions reached, and rec- settled. ommendations made. 21. Test appropriate records to determine that collection of fees for this service is in

September 1997 Branch and Agency Examination Manual Page 2 Payments System Risk and Electronic Funds Transfer Activities Effective date July 1997 Section 4060.1

Branches and other depository institutions use ment is due or at all. On those occasions when payment systems both to transfer funds related payments are not settled on the same day, to their own operations and to transfer funds on daylight overdrafts may result in overnight (or behalf of their customers. The need for same- interday) overdrafts. day settlement transactions has precipitated financial institutions’ increased reliance on electronic funds transfer (EFT) systems. Financial TYPES OF PAYMENTS SYSTEMS institutions commonly use their EFT operations to make and receive payments, buy and sell The many thousands of payments made each securities, and transmit payment instructions to day result in transfers of balances among banks correspondent banks worldwide. In the United and between banks and Federal Reserve Banks. States, most of the dollar value of all funds Additionally, branches make their own pay- transfers is concentrated in two electronic payments in connection with carrying out the busi- ment systems: Fedwire, which is a Federal ness of banking. Branches can make interbank Reserve service, and the Clearing House Inter- payments through accounts that they hold with a bank Payments System (CHIPS), which is a correspondent bank. private settlement system owned and operated by the New York Clearing House Association. The flow of funds through these systems is extremely large compared to the reserve and Electronic Funds Transfer Systems clearing-account balances maintained by the Fedwire financial institutions participating in the systems. The efficiency of a payments system depends The Federal Reserve System operates a national to a large extent, on the certainty of settlement funds-transfer system, Fedwire, and acts as a of payments. Final settlement occurs when pay- clearinghouse for transactions executed over the ment obligations between payments system par- system. Fedwire provides for the electronic ticipants are extinguished with final and irrevo- transfer of immediate and irrevocable payments cable funds. In cash transactions payments, between participating institutions and functions payment and settlement occur simultaneously. as both a clearing and settlement facility for On occasion, settlement may not occur on the funds and securities transfers, which average same day. Without settlement, the recipient of a more than $1 trillion per day. payment faces the uncertainty of not receiving The Fedwire funds-transfer system is a real- the value of funds that has been promised. The time, gross-settlement, credit-transfer system. exposure to this uncertainty is generally referred Each funds transfer is settled individually on the to as payments system risk. The examiner’s role books of the appropriate Federal Reserve Bank is to ensure that branches effectively monitor as it is processed and is considered a final and and control their exposure to this risk. irrevocable payment. A depository institution The amount and subsequently the velocity of that sends a funds transfer irrevocably autho- funds transfers that must be settled exposes a rizes its Reserve Bank to charge its account for branch to many types of specific risk under the the transferred amount and further authorizes general category of payments system risk. In the Reserve Bank of the receiving institution to particular, there is liquidity risk, which is the transfer the same amount to the account of the risk that a counterparty may be temporarily receiving institution. The Federal Reserve guar- unable to cover its obligation to the bank at the antees immediate availability of funds. Once the time settlement is supposed to occur. There is Federal Reserve Bank credits the receiving also credit risk, which is the risk that another institution’s account or delivers the advice of participant in the payments system will fail to payment, the Federal Reserve Bank will not settle at the end of the day. The provision of reverse credit for the payment. Therefore, there intraday credit (often referred to as daylight is no settlement risk to the recipient of a Fedwire overdrafts or daylight credit) exposes partici- transfer. The Federal Reserve Bank assumes the pants to payments system risk because the risk if the sending bank does not settle its provider of the credit may be unable to collect position at the Reserve Bank at the end of the final funds from the receiver at the time pay- business day. If the sending branch does not

Branch and Agency Examination Manual September 1997 Page 1 4060.1 Payments System Risk and Electronic Funds Transfer Activities settle its position at the Reserve Bank at the end correspondent bank. This is an acceptable prac- of the business day, the Federal Reserve may be tice as long as the branch has adequate internal at risk for daylight overdrafts. The use of control procedures. daylight overdrafts is not encouraged, and banks are subject to credit limits and specific charges set by the Federal Reserve. Furthermore, such Message Systems daylight overdraft privileges can be revoked at any time. The message systems employed by institutions Branches can access Fedwire in several ways. and corporations to originate payment orders are Many large branches link branch computer indispensable components of funds-transfer facilities and the Federal Reserve over leased activities. Unlike payments systems, which trans- telephone lines. Lower volume users usually mit actual debit and credit entries, message have dial-up access using microcomputers and systems process administrative messages and Fedline software. Some users are off-line, instructions to move funds. The actual move- requiring a separate call to the Federal Reserve ment of the funds is then accomplished by for each transaction. initiating the actual entries to debit the originating customer’s account and credit the beneficiary’s account. If the beneficiary’s account or the CHIPS beneficiary bank’s account is also with the originator’s bank, the transaction is normally The Clearing House Interbank Payments System handled internally through ‘‘book entry.’’ If the (CHIPS) is a funds-transfer network owned and beneficiary-related accounts are outside the origi- operated by the New York Clearing House nating customer’s bank, the transfer may be Association (NYCHA) to deliver and receive completed by use of a payments system such as U.S. dollar payments between domestic or for- Fedwire or CHIPS. The means of arranging eign banks that have offices located in New York payment orders ranges from manual methods City. The network consists of a small number of (for example, memos, letters, telephone calls, settling participants (large U.S.-chartered banks fax messages, or standing instructions) to elec- that settle end-of-day balances with each other) tronic methods using telecommunications net- and a larger number of nonsettling participants works. These networks may include those oper- who maintain accounts with one of the settling ated by the private sector, such as SWIFT or banks. Although a large volume of CHIPS Telex, or other networks operated internally by payments are for settlement of U.S.-dollar particular financial institutions. foreign-exchange contracts and Eurodollar invest- Even though the transfers initiated through ments, there are a significant number of domes- systems such as SWIFT and Telex do not result tic business-related transactions. The interbank in the immediate transfer of funds from the settlement of payments will normally be com- issuing branch, they do result in the issuing pleted by the end of the business day. Unlike branch having an immediate liability, which is Fedwire, a credit received through CHIPS may payable to the disbursing institution. Therefore, not be a final settlement and can be reversed the operating controls of these systems should later in the day. To avoid such reversals, CHIPS be as stringent as the ones implemented for has a number of risk-management tools in place. systems such as Fedwire and CHIPS. Nevertheless, the receiving institution is subject to some level of intraday credit exposure through the sending institution (or its settling participant) until final settlement is achieved at the end SWIFT of the business day. Society for Worldwide Interbank Financial Tele- communications (SWIFT) is a nonprofit coop- Manual Systems erative of member banks serving as a worldwide interbank telecommunications network based in Not all financial institutions employ an elec- Brussels, Belgium. It is the primary system tronic funds transfer system. Branches which employed by financial institutions worldwide to execute only a small number of EFT transac- transmit either domestic or international pay- tions may execute EFTs by a telephone call to a ment instructions.

September 1997 Branch and Agency Examination Manual Page 2 Payments System Risk and Electronic Funds Transfer Activities 4060.1

TELEX In 1992, the Board of Governors approved a policy that established fee assessments for an Several private telecommunications companies institution’s use of Federal Reserve daylight offer worldwide or interconnected services that credit. Along with the daylight overdraft fee provide a printed permanent record of each policy, the Federal Reserve adopted a modified message transmitted. Telex is the primary mes- method of measuring daylight overdrafts that sage system for institutions that do not have more closely reflects the timing of actual trans- access to SWIFT. The Telex systems do not actions affecting an institution’s intraday Fed- include built-in security features. Telex users eral Reserve account balance. exchange security codes, and senders sequen- The objective of daylight overdraft fees is to tially number messages sent to another provide a financial incentive for institutions to institution. control their use of intraday Federal Reserve credit and to explicitly recognize the risks inherent in the provision of intraday credit. PAYMENTS SYSTEM RISK (PSR) Daylight overdraft fees induce institutions to make business decisions concerning the amount Payments system activity gives rise to three of intraday Federal Reserve credit they are forms of risk: direct credit risk to the Federal willing to use based on the cost of using that Reserve in the event that an institution may be credit. As a result, institutions should establish unable to cover its intraday overdraft arising intraday credit limits for customers that actively from a transfer of funds or receipt of book- entry use payment services. securities; private direct credit risk to institu- Under the Federal Reserve’s PSR program, tions extending daylight credit through private each institution that maintains an account at a settlement systems; and systemic risk, the pos- Federal Reserve Bank is assigned or may estab- sibility that the failure of one participant in a lish a net debit cap, which determines the transfer system will cause other participants to amount of intraday Federal Reserve credit that fail to meet their obligations. the institution may use. U.S. branches and agencies of foreign banks are typically treated the same as domestic institutions under the Federal Reserve’s PSR policy. SUPERVISORY POLICY However, several unique considerations affect OVERVIEW the way in which the policy is applied to U.S. branches and agencies of foreign banks. In 1985, the Board of Governors of the Federal In general, net debit caps for foreign banks Reserve System adopted a policy to reduce the are calculated in the same manner as for domes- risks that large-dollar payments systems bring to tic banks, that is, by applying cap multiples for the Federal Reserve Banks, the banking sys- one of the six cap categories to a capital mea- tems, and other sectors of the economy. An sure. However, the determination of an appro- integral component of the Federal Reserve’s priate capital measure, known as the U.S. capital PSR policy is a program to control the use of equivalency, is substantially different for foreign intraday Federal Reserve credit. banks and depends on whether the bank is based The PSR policy further established limits, or in a country that has signed or adopted the caps, on the amount of Federal Reserve daylight standards of the Basle Capital Accord. In addi- credit that may be used by a depository institution, special provisions regarding collateralization during a single day and over a two-week tion of overdrafts, allocation of caps, and capital- period. These limits are sufficiently flexible to reporting requirements also apply to foreign reflect the overall financial condition and opera- banks. tional capacity of each institution using Federal Reserve payment services. The policy also permits Reserve Banks to protect themselves from the risk of loss by requiring institutions to post Self-Assessment Caps collateral to cover daylight overdrafts in certain circumstances or by restricting the account Depository institutions that use intraday Federal activity of institutions that incur frequent or Reserve credit in amounts that exceed 40 per- excessive overdrafts. cent of their risk-based capital on a single day or

Branch and Agency Examination Manual September 1997 Page 3 4060.1 Payments System Risk and Electronic Funds Transfer Activities on average over a two-week period must estab- If a foreign bank has a deposit-taking subsid- lish their daylight overdraft caps through the iary in the United States, that U.S. institution self-assessment process. should be evaluated separately, and its data Unlike other institutions participating in the should be backed out of the foreign parent’s data large payment systems, branches and agencies before the self-assessment. Thus, the foreign of foreign banks lack a true U.S. corporate entity parent should not ‘‘double count’’ the capital, against which risk can be evaluated. As a result, assets, or liabilities of its U.S. subsidiaries in its the self-assessment is necessarily based upon self-assessment. For more information, refer to the foreign-based corporate entity to which the the Guide to the Federal Reserve’s Payments branch(es) and/or agency(ies) belong. This analy- System Risk Policy, which is available from any sis looks to the consolidated entity and all Reserve Bank. branches and agencies of that entity are combined for purposes of developing a single assessment and adhering to cross-system net ELECTRONIC FUNDS TRANSFER debit caps. MANAGEMENT (EFT) For foreign banks with access to the large payment systems in more than one Federal Branches should ensure that prudent banking Reserve District, a single branch or agency and practices are followed in all funds-transfer Reserve Bank will be designated as the primary activities, and establish guidelines for types of contact points for administering this program. allowable transfers. Procedures should be in That branch or agency will maintain the self- effect to prevent transfers drawn against uncol- assessment file for all branches and agencies of lected funds. Transfers should not be initiated the same foreign bank for the examiner review. against simple ledger balances unless preautho- The Administrative Reserve Bank will be rized credit lines have been established for that responsible for monitoring the consolidated posi- account. tion for all branches and agencies of the foreign Errors and omissions or fraudulent alteration bank. of the amount of a transfer or the account Foreign banks usually lack the type of peer number to which funds are to be deposited could data generally available for domestic institu- result in losses to the branch. Losses may tions. Even where it does exist, the data rarely include total loss of the transferred funds, loss of correspond to that of U.S. counterparts because availability of funds, interest charges, and of different accounting standards. Nonetheless, administrative expenses associated with the the absence of peer data does not absolve recovery of the funds or correction of the foreign institutions from going through the same problem. type of analysis as their U.S. counterparts. Management is responsible for assessing Indeed, the same general expectations on per- inherent risks in the EFT system, establishing formance relative to peers means including U.S. policies and controls to protect the institution peers as well as home country peers, if they against unreasonable exposures, and monitoring expect to rate themselves ‘‘above average’’ or the effectiveness of safeguards. Regulatory agen- ‘‘strong.’’ cies will ensure that each financial institution Facts regarding a foreign bank’s home coun- has evaluated its own risks realistically and has try may have significant mitigating consider- adequate accounting records and internal con- ations particularly where local practices result in trols to keep exposures within reasonable, estab- substantial ‘‘hidden reserves,’’ involve signifi- lished limits. cant government support of institutions, or result The risk associated with any computerized in other distortions of financial data in ways that EFT system can be reduced if management can be shown to indicate different degrees of implements the controls that are available on the risk than, in fact, actually exists. Explanations of system. For example, the authority to enter, such factors should be well documented in the verify, and send transfers can be segregated. self-assessment file. While such factors can Also the dollar amount of the transactions can often cause what would otherwise be regarded be limited. as an unsatisfactory rating to be upgraded to Effective risk management requires that— satisfactory, further upgrading is unlikely to be acceptable unless the extent of the hidden sup- • Reasonable credit limits be established and port is quantified. payments in excess of such limits involving

September 1997 Branch and Agency Examination Manual Page 4 Payments System Risk and Electronic Funds Transfer Activities 4060.1

significant credit risk be properly approved by Personal Identification Numbers appropriate lending authorities; • Banks have adequate recordkeeping to deter- One way for financial institutions to authenticate mine the extent of any intraday overdrafts and transfers initiated over the telephone is through potential overnight overdrafts before releasing the use of personal identification numbers (PIN) payments, and issued to each customer. When a customer • Institutions responsible for settling the posi- requests a transfer, the customer’s identity is tion of others should properly monitor respon- verified by comparing the PIN that is supplied dents’ accounts and assign responsibility for with the customer PIN request form that is on this function to an appropriate supervisory file. At a minimum, the following safeguards for level of management. these types of transfers should be implemented:

• All customers should be requested to sign an agreement whereby the branch is held harmless in the event of an unauthorized transfer if AUTHENTICATION OR the branch follows routine authentication pro- VERIFICATION METHODS cedures. The customer is responsible for informing the branch about changes relating The same due care that financial institutions use to individuals authorized to execute EFTs. when executing EFT transactions must also be These procedures should minimize the risk to used when accepting EFT requests from custom- the branch in the event someone is able to ers. Management must implement security pro- execute a fraudulent transaction. These proce- cedures for ensuring that the transfer requests dures are described in detail in the UCC are authentic. As stated in the Uniform Com- section 4A-202, Authorized and Verified Pay- mercial Code (UCC) section 4A-201, security ment Orders. procedures may require the use of algorithms, or • All transactions over a specific dollar amount other codes, identifying works or numbers, en- should be re-verified by a callback routine. cryption, call-back procedures, or similar secu- The branch should require that the person rity devices. Authorized and verified payment being called for re-verification is someone orders are detailed in the UCC section 4A-202. other than the person who initially requested the transaction. • Whenever new PINs are issued, they should Signature Verification be mailed in sealed, confidential envelopes (preferably computer- generated) by someone who does not have the ability to execute wire One method to verify the authenticity of a transfers. customer’s EFT request is to verify the custom- • The number of branch employees with access er’s signature; however, this procedure cannot to the PINs should be very limited. be performed when the customer requests the transaction by telephone. Some financial institutions have implemented policies whereby the customer completes and signs a transfer request, Tape Recording and then faxes the request to the bank. This is not, however, a safe EFT procedure because, Tape recording EFT requests made over the although the branch can verify the signature on telephone is another internal control practice. the faxed request, it cannot be certain that the Likewise, when possible, verifying and record- transfer request is legitimate. Any document ing the incoming telephone number (caller- that is transmitted electronically can be altered I.D.). The laws addressing telephone recording (for example, by changing the amount or account vary by state. Some states require that the caller number); the alteration can occur before the be informed that the conversation is being document is digitized or after. In most instances, recorded; other states do not have this require- these alterations cannot be detected by the ment. Regardless of the state’s law, the branch receiving entity. If there is any question about a should inform callers that, for their protection, document’s authenticity, the transaction should conversations are being recorded. Moreover, be reconfirmed through other sources. branches should have in place a policy for

Branch and Agency Examination Manual September 1997 Page 5 4060.1 Payments System Risk and Electronic Funds Transfer Activities archiving the taped telephone records and should Bank examiners are responsible for ensuring retain them for a specified period of time. that financial institutions have evaluated their own risks realistically and have provided internal controls that are adequate to keep the expo- Statements of Activity sures within acceptable limits. Examiners should consider the following Some larger branches have implemented a pro- internal control guidelines when reviewing poli- cedure whereby customers are electronically cies and procedures covering funds-transfer sent a summary statement at the end of each day activities. that lists the transfers executed and received on their behalf. The statement can be sent through • Job descriptions for personnel responsible for a fax machine, personal computer, or remote a branch’s EFT activities should be well printer. This procedure can help towards quickly defined, and provide for the logical flow of identifying any unauthorized transfers. work and adequate segregation of duties. • No single person in an EFT operation should be responsible for all phases of the transaction. Test Keys • All funds transfers should be reconciled at the end of each business day. The daily balancing EFT requests can also be authenticated by using process should include a reconciliation of both test keys. A test key is a calculated number that the number and dollar amount of messages is derived from a series of codes that are transmitted. contained in a test-key book. The codes in a • All adjustments required in the processing of test-key book represent such variables as the a transfer request should be approved by a current date, hour of the day, receiving institu- branch’s supervisory personnel, with the rea- tion, receiving the account number, and amount sons for the adjustment documented, particu- of the transfer. The value derived from these larly in the case of requests as of a past or variables equals the test key. The financial future date. institution or corporate customer initiating the transfer will give its EFT information, along • Only authorized persons should have access to with the test-key value. The receiving institution EFT equipment. will recalculate the test key and, if the two test keys equal the same amount, the EFT request is Considerable documentation is necessary to considered authenticated. Test-key code books maintain adequate accounting records and audit- should be properly secured to prevent unautho- ing control. Many branches maintain transfer- rized access or fraudulent use. The use of test request logs, assign sequence numbers to incom- keys has declined in recent years as more and ing and outgoing messages, and keep an more institutions implement personal computer- unbroken electronic copy of all EFT messages. based EFT systems. At the end of each business day, employees who are independent of the transfer function should ensure that all EFT documents are accounted for by comparing request forms to the actual INTERNAL CONTROL transfers. Supervisory Evaluation Examiners should review the funds-transfer operations to determine that there are accurate Branch management is responsible for assessing and reliable recordkeeping systems, prompt and the inherent risks in the EFT systems it uses, efficient handling of all transactions, appropriate establishing policies and controls to protect the separation of duties, adequate audit coverage, institution against unreasonable exposures, and and recognition by management of the risks monitoring the effectiveness of such safeguards. associated with those activities.

September 1997 Branch and Agency Examination Manual Page 6 Payments System Risk and Electronic Funds Transfer Activities Examination Objectives Effective date July 1997 Section 4060.2

1. To determine if electronic funds transfer 4. To determine that senior management is objectives, policies, practices, procedures, informed of the current status of and any and internal controls are adequate. exposure relative to funds transfer operations. 2. To determine if branch ofﬁcers and other 5. To determine compliance with applicable funds transfer personnel are operating in laws and regulations. conformance with established guidelines. 6. To obtain initiation of corrective action when 3. To determine the scope and adequacy of the objectives, policies, procedures or internal audit function as it relates to funds transfer controls are deﬁcient or when violations of activities. laws or regulations have been noted.

Branch and Agency Examination Manual September 1997 Page 1 Payments System Risk and Electronic Funds Transfer Activities Examination Procedures Effective date July 1997 Section 4060.3

1. If selected for implementation, complete or nal audit report and determine if appropriate update the Internal Control Questionnaire for corrections have been made. this area. 4. Review the bank’s policies with respect to 2. Based upon an evaluation of internal controls electronic funds transfers and determine their and work performed by internal/external reasonableness. auditors, determine the scope of the 5. For institutions incurring daylight overdrafts, examination. determine that senior management has 3. Test for compliance with policies, practices, reviewed and approved the institution assess- procedures, and internal controls in conjunc- ment and sender net debit cap in conform- tion with performing the remaining examina- ance with the Federal Reserve Board’s policy tion procedures. Also, obtain a listing of any statement on risk reduction on large-dollar deﬁciencies noted in the most current inter- payment systems.

Branch and Agency Examination Manual September 1997 Page 1 Payments System Risk and Electronic Funds Transfer Activities Internal Control Questionnaire Effective date July 1997 Section 4060.4

Review the branch’s internal controls, policies, 14. Are all messages and transfer requests that practices and procedures regarding wire transfer require testing authenticated by the use of a activities. The branch’s system should be docu- test key? mented in a complete, concise manner and 15. Are test codes verified by someone other should include, where appropriate, narrative than the person receiving the initial transfer descriptions, flowcharts, copies of forms used request? and other pertinent information. 16. Are call-back or other authentication procedures performed on all transfers that do not have a test key or signature card on file? 17. Do mail transfer requests include a test SIGNATURE CARD word as an authentication procedure? CONSIDERATIONS 18. Does the branch’s test key formula incorporate a sequence number resulting from an 1. Does management maintain a current list of agreement between the branch and the branch personnel authorized to initiate trans- customer? fer requests? 19. Does the branch have procedures in opera- 2. Does the branch limit the number of autho- tion for the issuance and cancellation of test rized employees? keys? 3. Are authorized employee signature cards 20. Is the responsibility for issuing and cancel- kept under dual control? ing test keys assigned to someone who is 4. Does the branch maintain a current list or not responsible for testing the authenticity card file of authorized signers for customers of transfer requests? who use the branch’s funds transfer services? 5. Does the branch limit the number of authorized signers for branch customers? TELEPHONE TRANSFER 6. Are customer signature cards maintained REQUESTS under dual control or otherwise protected? 7. Do customer signature cards limit the 21. Has the branch established guidelines for amount of funds that an individual is autho- what information should be obtained from a rized to transfer? person making funds transfer request by 8. Does the branch advise its customers to telephone? maintain their lists of authorized signers 22. Does that information include a test word under dual control? authentication code? 9. Do branch personnel compare the signature 23. Does the branch use a call-back procedure on an original mail request with the autho- that includes a test code authentication to rized signature on file? verify telephone transfer requests? 24. Does the branch limit call-back to transactions over a certain dollar amount? 25. Does the branch maintain a current list of TEST KEY CONSIDERATIONS persons authorized to initiate telephonic funds transfers and messages? 10. Are the files containing test key formulas 26. Does the branch have procedures in effect maintained under dual control or otherwise to prohibit persons who receive telephone protected? transfer requests from transmitting those 11. Are only authorized personnel permitted in requests? the test key area or allowed access to 27. Does the branch use devices that record all computers, teletapes or terminals? incoming and outgoing transfer requests? 12. Does the branch maintain an up-to-date test 28. Does the branch advise its customers in key file? written contracts, by audible bleeping sig- 13. Does management maintain a list of those nals, or by informing the caller that tele- persons who have access to test key files? phone calls are being recorded?

Branch and Agency Examination Manual September 1997 Page 1 4060.4 Payments System Risk and Electronic Funds Transfer Activities: Internal Control Questionnaire

29. Are pre-numbered or sequentially num- or by a person divorced from any money bered (at a central location after initiation) transfer operations? transfer request forms used? 41. Are all pre-numbered forms, including 30. Are transfer requests recorded in a log or cancellations, accounted for in the daily another branch record at origination? reconcilement? 31. Is the log or record of transfer requests 42. Is the daily reconcilement of funds transfer reviewed daily by supervisory personnel? and message request activity reviewed by 32. Do the records of transfer requests contain: supervisory personnel? • A sequence number? 43. Is the balancing of the daily activity sepa- • An amount transferred? rate from the receiving, processing and • The person, firm or institution making sending functions? request (also specific transferror)? 44. Does the wire transfer department verify • The date? that work sent to other branch departments • The test code authentication? agrees with its totals? • Paying instructions? 45. Is someone responsible for reviewing all • Authorizing signatures for certain types transfer requests to determine that they have and dollar amount transfers? been properly processed? 46. Are all rejects and/or exceptions reviewed by someone not involved in the receipt, preparation or transmittal of funds? WIRE TRANSFER REQUESTS 47. If the institution accepts transfer requests after the close of business or transfer 33. Does the branch have teletype or computer requests with a future value date, are they terminal equipment capable of receiving properly controlled and processed? and transmitting messages and funds trans- 48. Are Federal Reserve Bank statements fer information? reviewed daily to determine if there are 34. Are the functions of receipt, testing and ‘‘open’’ funds transfer items and the reasons transmission of funds transfer requests perfor the outstanding items? formed by different employees? 49. Are corrections, overrides, open items, 35. Are incoming and outgoing messages time reversals and other adjustments reviewed stamped or sequentially numbered for and approved by an officer? control? 50. Does the wire transfer department or another 36. Do incoming and outgoing messages include area of the branch have procedures in effect a test word or code as a means of message to prohibit transfers of funds against accounts authentication? that do not have preauthorized credit avail- 37. Is an unbroken copy of all messages kept ability and have uncollected balances? throughout the business day? 51. Does the branch maintain adequate records 38. Is that copy reviewed and controlled by as required by the Currency and Foreign someone not connected with operations in Transactions Reporting Act of 1970 (also the wire transfer area? known as the Bank Secrecy Act)? 52. Have managing officers adopted written procedures or flowcharting to serve as a training tool? ACCOUNTING, PROCESSING, 53. Does management and/or the audit depart- AND SYSTEMS ment undertake a periodic review to ensure that work is being performed in accordance 39. Does the wire transfer department of the with established policy? branch prepare a daily reconcilement of 54. Is the audit department promptly informed funds transfer activity by dollar amount and when a change is made in systems or number of messages? method of operation? 40. Is a daily reconcilement of funds transfer 55. Are all general ledger tickets, automated activities performed in another area of the transaction cards or other supporting docu- branch, i.e., correspondent banks, accounting, ments initialed?

September 1997 Branch and Agency Examination Manual Page 2 Payments System Risk and Electronic Funds Transfer Activities: Internal Control Questionnaire 4060.4

PERSONNEL 70. Are terminals and other hardware in the wire transfer area shut down after normal 56. Has the branch taken steps to ensure that working hours? Are they regulated by screening procedures are applied to person- automatic time-out controls or time-of-day nel hired for sensitive positions in the wire controls? transfer department? 71. Are passwords suppressed when entered in 57. Does the branch prohibit new employees terminals? from working in sensitive areas of the wire 72. Are operator passwords frequently changed? transfer operation? If so, how often? 58. Are temporary employees excluded from 73. Is supervisory approval required for termi- working in sensitive areas? If not, is the nal access made at other than authorized number of such employees limited? times? 59. Are statements of indebtedness required of 74. Are passwords restricted to different levels employees in sensitive positions of the wire of access such as data ﬁles and transactions transfer function? that can be initiated? 60. Are employees subject to unannounced 75. Is terminal operator training conducted in a rotation of responsibilities regardless of the manner that will not jeopardize the integrity size of the institution? of live data or memo ﬁles? 76. Are employees prohibited from taking keys 61. Are relatives of employees in the wire for sensitive equipment out of the wire transfer function precluded from working in transfer area? the same institution’s bookkeeping or data 77. Does the branch maintain back-up communi- processing departments? cations systems? 62. Does the branch’s policy require that employ- 78. Are back-up systems periodically tested by ees take a minimum number of consecutive branch personnel? days as part of their annual vacation? Is this 79. Does the use of back-up equipment require policy being enforced? approval by supervisory personnel? 63. Does management reassign employees who have given notice of resignation or been given termination notices, from sensitive areas of the wire transfer function? CONTINGENCY PLANS

80. Have written contingency plans been developed for partial or complete failure of the PHYSICAL SECURITY systems and/or communication lines between the branch and the New York Clearing House, 64. Is access to the wire transfer area restricted Federal Reserve Bank, data centers and/or to authorized personnel? servicer companies? 65. Are visitors to the wire transfer area iden- 81. Are these contingency plans reviewed regu- tiﬁed, required to sign in and be accompa- larly and tested periodically? nied at all times? 82. Has management distributed these plans to 66. Is written authorization given to those all wire transfer personnel? employees who remain in the wire transfer 83. Are sensitive information and equipment area after normal working hours? Who adequately secured before evacuation in an gives such authority? Are security guards emergency and is further access to the informed? affected areas denied by security personnel? 67. Are branch terminal operators or others in wire transfer operations denied access to computer areas or programs? CREDIT EVALUATION AND 68. Do procedures prohibit computer personnel APPROVAL from gaining access to branch terminals or test key information? 84. Have customer limits been established for 69. Does wire transfer equipment have physical Fedwire, CHIPS, and Cash Wire exposure and/or software locks to prohibit access by which include consideration of intraday and unauthorized personnel at all times? overnight overdrafts?

Branch and Agency Examination Manual September 1997 Page 3 4060.4 Payments System Risk and Electronic Funds Transfer Activities: Internal Control Questionnaire

a. Are groups of afﬁliated customers 89. If payments exceed the established limits, included in such limits? are steps taken in a timely manner to obtain b. How often are the limits reviewed and covering funds? updated? 90. When an overnight overdraft occurs, is a c. Are the customer limits reviewed by determination made as to whether a fail senior management? How frequently? caused the overdraft? If so, is this properly 85. Does the branch make payments in antici- documented? Is adequate follow-up made pation of the receipt of covering funds? If to obtain the covering funds in a timely so, are such payments approved by ofﬁcers manner? with appropriate credit authority? 86. Are intraday exposures limited to amounts expected to be received the same day? CONCLUSION 87. Are intraday overdraft limits established in consideration of other types of credit facili- 91. Is the information covered by this ICQ ties for the same customer? adequate for evaluating internal controls in 88. Is an intraday posting record kept for each this area? If not, indicate any additional customer showing opening collected and examination procedures deemed necessary. uncollected balances, transfers in, transfers 92. Based on the information gathered, evaluate out, and the collected balances at the time the internal controls in this area (i.e. strong, payments are released? satisfactory, fair, marginal, unsatisfactory).

September 1997 Branch and Agency Examination Manual Page 4 Compliance Introduction Effective Date July 1997 Section 5000.1

Head office management should develop adequate are properly trained in meeting regulatory policies and procedures to ensure that the branch requirements on an ongoing basis. In addition, is in compliance with all applicable U.S. federal the training program should ensure that branch and state laws and regulations, including report- personnel are informed of U.S. and state laws ing and special supervisory requirements. and regulations to which the branch may be To the extent possible given the size, risk subject. profile and organizational structure of the branch, The scope of the branch’s audit function also these responsibilities should be vested in a should ensure that the branch is meeting all branch official or compliance officer whose applicable regulatory requirements. The head function is separate from line management. The office should ensure that the audit team is compliance officer should be qualified and qualified to audit its U.S. branch operations for familiar with U.S. and state laws and regulations. compliance with U.S. and state laws, regula- Branch management and the compliance offi- tions, and regulatory reporting requirements. cer should ensure that all appropriate personnel

Branch and Agency Examination Manual September 1997 Page 1 Financial Recordkeeping and Reporting Regulations Effective date July 1997 Section 5010.1

Information, plus the examination objectives Board’s Bank Secrecy Act Manual and other and examination procedures relating to this similar examination material of the other federal section are available in the Federal Reserve and state banking agencies.

Branch and Agency Examination Manual September 1997 Page 1 Asset Maintenance Effective date July 1997 Section 5020.1

Asset maintenance was originally developed as supervisory action for the U.S. operations of a a method of ensuring that, in the event of a foreign banking organization. This action may liquidation, sufficient assets would be available relate to supervisory concerns raised in deter- to effect repayment to depositors and liability mining the financial strength of the FBO, includ- holders. Although asset maintenance is not a ing circumstances in the home country that capital equivalent, branches under asset mainte- could adversely affect the FBO’s U.S. opera- nance have some of the characteristics of a tions. Asset maintenance, in these instances, separately capitalized entity. In fact, in the early may be necessary, even though the U.S. opera- stages of asset maintenance, ratios of 108 per- tions are in satisfactory condition. cent and 105 percent were established to be As a result of statute, regulation, or supervi- roughly equivalent to the then-prevailing capital sory agreement, special requirements and guide- ratios of U.S. domestic banks. lines for determining the amount of eligible Generally, asset maintenance is defined as the assets and calculating the asset maintenance maintenance of eligible assets in a branch in a percentage may be required by the appropriate particular state, covering a specified percent- regulatory agency. These requirements will age of a branch’s third party liabilities. The necessitate the maintenance of specific records asset maintenance calculation is determined by at the branch. A branch under asset maintenance dividing eligible assets by liabilities requiring will also be required to periodically report asset cover. maintenance compliance to the appropriate regu- Asset maintenance is generally defined and lators. Examiners should determine whether the enforced by the licensing agency. Examiners daily record and the monthly report for asset should consult the appropriate regulation of the maintenance are appropriately maintained and appropriate agency to define and calculate the reported. ratio. Asset maintenance may also be imposed by regulators through the issuance of supervisory action. The supervisory imposition of asset maintenance has significant effects on the branch ASSET MAINTENANCE depending upon the percentage imposed. When CALCULATION imposed at levels above 100 percent, a branch must maintain a net due to related parties The first part of the asset maintenance calcula- position at all times. This effectively prevents tion requires a determination of eligible assets. the branch from providing net funding to the To determine eligible assets, the examiner head office or other related offices. Asset main- deducts the ineligible assets from the gross asset tenance levels below 100 percent would have position of the branch. Ineligible assets fall the effect of limiting the net due from related into two categories: those that are Ineligible parties position. by Statute, and those that are Ineligible by Asset maintenance requirements will differ by Examiner. state. Some states do not require coverage for all third party liabilities booked at the branch (e.g. IBF deposits). Therefore, even though a branch Assets Ineligible By Statute meets the state’s asset maintenance requirements, the branch may still be in a net due from Generally, assets that are Ineligible By Statute affiliates position. In the event of a financially might include the following: weak FBO, regulators may consider expanding the asset maintenance requirements to further • Any type of asset not specifically identified as define eligible assets and liabilities to ensure eligible by statute or regulation by the appro- adequate coverage of all third party deposits. priate licensing agency; State licensing authorities may impose asset • Any other asset that fails to meet specific maintenance as a requirement of licensure within eligibility standards contained in the statute or that state. The FDIC imposes asset maintenance regulation by the appropriate licensing agency. as a requirement for receiving deposit insurance. Asset maintenance may also be imposed at The specific assets that are Ineligible By individual branches or FBO offices as a form of Statute will vary according to the requirements

Branch and Agency Examination Manual September 1997 Page 1 5020.1 Asset Maintenance contained in federal and state laws and regula- sure. In addition, all accrued interest on assets tions. The following is representative of some of subject to a Loss, Doubtful, Substandard, or the requirements that may be imposed. Any Value Impaired classification is usually asset for which: disallowed. An examiner may also disallow any loan or • Evidence of indebtedness (original signed note other credit exposure that is not supported by or loan agreement) is not held in the United sufficient credit information (in English) to per- States or the state within which the branch is mit an evaluation of the creditworthiness or licensed; other risks inherent in the asset. Examiners are • Evidence of indebtedness is in transit within to exercise prudence in disallowing assets for the FBO system, either outside the United this reason. States or outside the state in which the branch Situations may arise where an asset can be is licensed; disallowed for both statutory and discretionary • Repayment is to be made in funds not freely reasons. For example, a loan may be disallowed convertible to U.S. dollars; by statute because the evidence of indebtedness • Reclassification to an expense category is is not held in the state where the branch is pending. located. Additionally, the loan may be classified Substandard, Doubtful, Loss, or Value Impaired. In addition requirements may be imposed on: In this case, the branch (for periodic reporting to the regulators) and/or the examiner can disallow • Types of securities and depreciation; the asset by statute and classify the loan. Of • The documentation and collection of loans; course, no further disallowance is made on the • The type, location, holding, and depreciation basis of the asset classification. of fixed assets; Where an asset is controlled jointly by the • All amounts due from the head office and branch and a related party, it is necessary to other depository and nondepository offices determine whether the branch has independent and affiliates, including income accrued but control ( i.e. the ability to withdraw the asset uncollected on such amounts. without a cosignatory). If so, the item should not be disallowed simply because another office The balance of any asset disallowed at the retains signing authority. preceding examination will be treated as ineli- By definition, a certificate-less security (those gible until the underlying reasons for the disal- represented by advises or confirmations) cannot lowance have been removed. be in the owner’s possession. Nevertheless, this type of security may be an eligible asset, even if the depository is located outside the state where Assets Ineligible By Examiner the branch is located, provided that both of the following conditions are met: (1) The security is If an examiner, during the course of an exami- held by the depository in the name of the branch nation, determines that the value of any nonmar- or in the name of an unrelated broker, agent, or ketable bond, note, debenture, or any other asset custodian (the exchange member) who is located would preclude complete repayment, the examin the state where the branch is licensed; and iner may consider that asset ineligible for asset (2) The asset is properly shown on the branch’s maintenance purposes. The portion considered records so as to permit the appropriate regula- unrecoverable is disallowed. tors to freeze the account immediately upon Disallowances of classified assets will differ taking possession of the branch. based on the criteria or guidelines used by the Reserves maintained at the local Federal various regulatory agencies. The following for- Reserve Bank, pursuant to Regulation D, and mula is representative of some of the disallow- assets pledged to the FDIC, in connection with ances that may be used: Loss—100 percent of deposit insurance regulations, are eligible assets. book value; Doubtful—50 percent of book value; Securities held by the Federal Reserve Bank as Substandard—20 percent of book value, and collateral against possible borrowing are eligible Value Impaired—100 percent of the amount on the same basis as if held by the branch. The equivalent to the Allocated Transfer Risk amount of any borrowing must be deducted Reserve, plus 20 percent of any residual expo- from the value determined.

September 1997 Branch and Agency Examination Manual Page 2 Asset Maintenance 5020.1

Liabilities Requiring Coverage • Amounts due and other liabilities to other offices, agencies, branches, and affiliates of Once eligible assets are determined, the asset the FBO, including unremitted profits; maintenance computation requires a determina- • Reserves for loan losses and other tion of liabilities requiring cover. Generally, contingencies; liabilities requiring cover include all liabilities • Any other liability, as specifically required by of a branch and may even include certain statute, regulation, or the appropriate regulators. contingent liabilities, as determined by the appropriate regulators. The liabilities will be adjusted to exclude the following:

Branch and Agency Examination Manual September 1997 Page 3 Asset Maintenance Examination Objectives Effective date July 1997 Section 5020.2

1. To determine if internal policies, procedures, 5. To evaluate specific books and records that and guidelines regarding asset maintenance may be required for the continual monitoring are adequate. of asset maintenance. 2. To determine that branch officers and 6. To determine whether the internal audit func- employees are operating in conformance with tion adequately reviews asset maintenance established guidelines. compilation, review, and reporting. 3. To determine compliance with laws and regu- 7. To recommend corrective action when poli- lations or supervisory requirements. cies, practices, procedures, or internal con- 4. To evaluate the accuracy of periodic asset trols are deficient or when violations of laws maintenance reports submitted to the appro- or regulations have been noted. priate regulators.

Branch and Agency Examination Manual September 1997 Page 1 Asset Maintenance Examination Procedures Effective date July 1997 Section 5020.3

The following procedures will determine if the branch has appropriate agreements evidenc- branch under examination has established satis- ing the acquisition and credit documentation. factory periodic reporting, operating standards, 9. Review credit classifications for appropriate and audit procedures regarding asset mainte- inclusion in asset maintenance reports. nance. Examiner discretion is required in apply- 10. Review credits that have been classified ing these procedures. and/or are considered as problems by management. If credits have been internally 1. Review applicable statutes, regulations, classified, test whether they and their asso- and/or supervisory requirements for asset ciated accrued interest receivable have been maintenance. appropriately removed from eligible assets. 2. Test compliance with policies, practices, 11. Determine whether any of the loans trans- procedures, and internal controls for appro- ferred were nonperforming at the time of priate asset maintenance monitoring. transfer, classified at the previous examina- 3. Obtain the most recent asset maintenance tion, or, for any other reason, were consid- report filed with the regulators and deter- ered to be of questionable quality. mine its accuracy. If necessary, review pre- 12. Scan the delinquency lists submitted to the vious submissions to determine any trends head office to determine that reports are in reporting errors. sufficiently detailed to evaluate risk factors 4. Verify that eligible assets, as included in the that could possibly identify credits that filed reports, are correct. Ensure that, in might be considered Ineligible By Examiner. addition to credits, categories such as due 13. Compile a listing of all loans not supported from related parties, securities, fixed assets, by current and satisfactory credit informa- and other assets have been appropriately tion, collateral documentation, and evi- adjusted. dences of indebtedness. 5. Test check the asset maintenance computa- 14. Ascertain whether loans are purchased on a tion for accuracy with statutory and super- recourse basis and are sold on a nonrecourse visory requirements. Ensure that liabilities basis. requiring cover have been appropriately 15. Verify that asset maintenance monitoring adjusted. and reports filed with appropriate regulators 6. Review assets considered ineligible by the are reviewed for compliance by branch branch for appropriateness and compliance management and that internal controls are with laws, regulations, and supervisory adequate. requirements. 16. Organize and prepare a listing of violations 7. Determine that assets purchased by the of asset maintenance laws, regulations, and branch are properly reflected at fair market supervisory requirements. value. While fair market value may be 17. Prepare the following examination report difficult to determine, it should, at a mini- pages: mum, reflect both the rate of return being • Ineligible Assets earned on such assets and an appropriate • Asset Maintenance and Pledge Schedule risk premium. Determine that appropriate 18. Prepare comments for the Compliance and write-offs are taken on any assets sold by Violation of Laws and Regulations pages, if the branch at less than book value. necessary. 8. Review credits acquired from another lend- 19. Prepare a complete set of workpapers to ing institution as a result of a purchase, support conclusions and examination report participation, or asset swap since the previ- pages and discuss all material findings with ous examination, to determine that the management.

Branch and Agency Examination Manual September 1997 Page 1 Asset Pledge and Capital Equivalency Deposits Effective date July 1997 Section 5030.1

Asset pledge or capital equivalency deposit • Types of assets available for pledging or accounts may be established as a requirement deposit (i.e., certificates of deposit, U.S. gov- for licensing a branch. These accounts are ernment securities, etc.); designed to provide a ready source of liquid • Conducting transactions (i.e., regulatory assets to begin to pay for the expenses of a approval for deposits and withdrawals and liquidation, in the event it became necessary to direct confirmation to the licensing authority take possession of a branch. may be required). Federal and state licensing authorities may prescribe, by statute or regulation, requirements Asset pledge or capital equivalency deposit and conditions under which the branch will accounts, in severe problem situations, can also establish, maintain, and conduct an asset pledge be used as a form of supervisory follow-up or capital equivalency deposit account. These action. When severe problem situations are conditions and requirements will vary from one encountered, the licensing authority may require regulatory agency to another. However, the fol- an upward adjustment by the branch in the lowing represents some of the conditions or balance of the applicable account. This may be requirements that may be imposed: done by increasing the, normally required, specific dollar amount and/or the variable amount, • Balance in the account may be a specific based on a specified percentage of third party dollar amount and/or a variable amount based liabilities. The amount of the increase should be on a specified percentage of third party liabili- sufficient to give the regulators additional funds ties (i.e., related party liabilities and other to cover expenses associated with a branch specific liabilities are usually excluded); liquidation. • Guidelines for establishing the account (i.e., account must be held by a third party, in the name of the licensing authority);

Branch and Agency Examination Manual September 1997 Page 1 Suspicious Activities Effective date July 1997 Section 5040.1

Current information on this topic is available in Manual and similar examination material of the the Federal Reserve Board’s Bank Secrecy Act other federal and state banking agencies.

Branch and Agency Examination Manual September 1997 Page 1 International Banking Facilities Effective date July 1997 Section 5050.1

The Board of Governors of the Federal Reserve • Prohibiting the lending to or accepting of System amended Regulations D and Q effective deposits from a U.S. resident, other than the December 3, 1981, to permit U.S. depository branch establishing the IBF or other IBFs; institutions, Edge and Agreement Corporations • Prohibiting the acceptance of transaction and U.S. branches and agencies of FBOs to accounts; establish International Banking Facilities (IBFs) • Prohibiting the issuance of negotiable or bearer in the United States. instruments; The Board’s objective was to enhance the • Requiring nonbank deposits to carry a mini- international competitive position of banking mum maturity or required notice period of two institutions in the United States by permitting, business days; bank deposits can be made through an institution’s IBF, similar deposit with overnight maturities; reserve and tax treatment afforded to offshore banking offices. As a result, an IBF was permit- • Subjecting nonbank customer transactions to a ted to maintain a lower rate of reserves on IBF minimum deposit or withdrawal amount of liabilities maintained in excess of IBF assets. $100,000, except to close out an account or When adjustments to the deposit reserve require- withdraw accumulated interest; ments were made in September 1990, an IBF’s • Requiring the IBF to notify its nonbank cus- relative advantage with respect to deposit tomers, in writing, at the time an account reserves was effectively eliminated. However, in relationship is first established that the depos- some states, there still remain tax advantages to its received by the IBF may be used only to maintaining IBFs. Furthermore, many FBOs support its non-U.S. operations, and exten- continue to use their IBFs as funding vehicles on sions of credit by the IBF may be used only to the assumption that former reserve requirements finance the customers’ non-U.S. operations. In may be reestablished. the case of customers that are foreign affiliates Examinations of IBFs are ordinarily con- of U.S. residents, the IBF is required to obtain ducted in conjunction with examinations of the acknowledgment of the receipt of such notice. branches operating those facilities, and follow the same supervisory procedures. Branches may book off-balance-sheet items While a branch is not required to establish a in the IBF, provided the customer and the separate organization for IBF operations, it is transactions comply with applicable regulations. required to segregate on its books, the asset and Generally, off-balance-sheet items are booked at liability accounts included in the IBF. an IBF to take advantage of favorable tax rates In general, IBFs may accept deposits from or to hedge IBF assets and liabilities. Examiners and extend credit to non-U.S. residents or other should review the reasons for booking such IBFs. The Board’s rules impose various restric- items in the IBF and determine the appropriate- tions and limitations on the type of business in ness of such action. which an IBF can engage. These restrictions In addition, certain states impose further were designed to avoid complicating the con- restrictions and requirements governing the duct of domestic monetary policy and insulate establishment and maintenance of IBFs. The U.S. economic activity from IBF transactions. examiner should review these restrictions and As outlined in Regulation D, Section 204.8, requirements prior to establishing the scope of these restrictions include: the review.

Branch and Agency Examination Manual September 1997 Page 1 International Banking Facilities Examination Objectives Effective date July 1997 Section 5050.2

1. To determine if policies, practices, proce- 4. To determine compliance with laws and dures, and internal controls regarding IBFs regulations. are adequate. 5. To recommend corrective action when poli- 2. To determine if branch ofﬁcers are operating cies, practices, procedures, or internal con- in conformance with the established trols are deﬁcient or when violations of laws guidelines. or regulations have been noted. 3. To determine the scope and adequacy of the audit function.

Branch and Agency Examination Manual September 1997 Page 1 International Banking Facilities Examination Procedures Effective date July 1997 Section 5050.3

1. Complete or update the Internal Control verify that written confirmation is Questionnaire if selected for implementation. obtained acknowledging receipt of the 2. Review applicable statutes, regulations, Board of Governors’ policy. (Note: IBF and/or supervisory requirements for asset transactions with foreign governments maintenance. and official institutions are treated in the 3. Review IBF ledgers to determine that IBF same manner as IBF transactions with accounts are clearly segregated from the foreign banks, i.e. written notice of the establishing entity’s books. (Note: IBF led- non-U.S. use of funds is not necessary.) gers may be integrated with the establishing f. Nonbank deposits meet the minimum entity’s general ledger or may be main- maturity or required notice period for tained as a separate general ledger. If the withdrawal of two business days. ledgers are included with the establishing g. Nonbank time deposits and withdrawals entity’s regular accounts, the IBF accounts (except for account closings and with- must be clearly labeled. IBF assets need not drawals of accumulated interest) meet balance with IBF liabilities.) the minimum size transaction amount of 4. Determine the adequacy of the internal $100,000. audit procedures used to check compliance h. Deposit confirmations state that funds with applicable regulations. Obtain a list of are being placed in an IBF and that the any deficiencies noted in the latest review depositor must abide by IBF restrictions performed by the internal auditors and deter- as defined by the Board of Governors of mine if corrections have been made. the Federal Reserve System. 5. In addition to verifying application of the 6. Review all intrabank transactions for an branch’s standard review, analysis, and/or appropriate time period to determine that: documentation of IBF-booked credits and a. All transactions with the U.S. offices of deposits, evaluate the adequacy of proce- the IBF’s own branch are clearly dures by reviewing a sample of accounts to identifiable. ensure that: b. Eurocurrency liabilities are properly a. All deposits, extensions of credit, and reported by the IBF’s establishing branch. off-balance-sheet items are extended to 7. Review IBF purchases from and sales to or accepted from qualified customers, third parties to determine that: i.e., foreign residents, other IBFs, and offices of the branch establishing the a. Such assets are IBF eligible assets, and IBF. appropriate notices and acknowledg- b. Nonbank extensions of credit are used ments have been provided and uses of only to finance the non-U.S. operations proceeds documented. of the customer. b. The transactions are at arms length, with- c. Nonbank deposits are used only to sup- out recourse. port the non-U.S. operations of the c. The transactions are not conducted with customer. affiliates, other than the branch establish- d. Nonbank customers are provided written ing the IBF. notice of the Federal Reserve Board of 8. Review all IBF-related regulatory reports, Governors’ policy statement at the time e.g., the FFIEC-002 and FR 2951, if appli- the deposit or credit relationship is first cable, to determine their timely submission established advising of the requirement and accuracy. regarding the non-U.S. use of deposits 9. Discuss apparent violations and procedural and credit extensions. deficiencies with appropriate officer(s). e. In the case of loans to or deposits from 10. Prepare comments in appropriate report form foreign affiliates of U.S. corporations, for all violations and deficiencies noted.

Branch and Agency Examination Manual September 1997 Page 1 International Banking Facilities Internal Control Questionnaire Effective date July 1997 Section 5050.4

DEPOSITS dents, other IBFs, and the branch establishing the IBF? 1. Are all deposits from foreign residents, 10. Do credits consist only of loans, advances, other IBFs, or offices of the branch estab- placements, securities, or any other form of lishing the IBF? credit transaction? 2. Do liabilities consist only of time deposits, 11. Have procedures been developed to reason- borrowings, placements taken, or similar ably ensure that credits granted are being instruments? used only to finance operations outside the 3. Has it been determined that no banker’s United States? acceptances, certificates of deposit or other 12. Is documentation available to substantiate liabilities have been issued in negotiable or that funds are only being utilized outside bearer form? the United States? 4. Do all foreign nonbank deposits meet the minimum maturity or notice period to withdraw of two business days? 5. Do nonbank time deposits or withdrawals INTRABANK TRANSACTIONS (except closeouts or withdrawals of accu- 13. Are all transactions with the U.S. offices of mulated interest) meet the minimum size the IBF’s own branch or other IBFs clearly transaction amount requirement of $100,000? identifiable? 6. Have procedures been established to ensure that nonbank deposits received from non- 14. Are Eurocurrency liabilities to the IBF being U.S. residents or foreign affiliates of U.S. properly reported by the U.S. offices of the corporations are used only to support the IBF’s own branch? non-U.S. operations of the depositor or its affiliates located outside the United States? 7. Does the branch provide written notice to OTHER each of its nonbank customers at the time a deposit or credit relationship is first estab- 15. Is the establishing branch properly main- lished, advising of the Board’s policy taining segregated or otherwise identifiable regarding the use of IBF deposits and loans accounts for its IBF operations? outside the United States? 16. Do all assets and liabilities and off-balance- 8. In the case of loans to or deposits received sheet items of the IBF qualify under the from foreign affiliates of U.S. corporations, definitions in Regulations D and Q and is a written confirmation obtained from other regulatory provisions applicable to such customers, acknowledging receipt of IBFs? the Board of Governors’ policy statement? 17. Are IBF-related regulatory reports filed in a timely manner and were they found to be correct? EXTENSIONS OF CREDIT 18. Is management thoroughly familiar with the provisions of Regulations D and Q and the 9. Are extensions of credit granted only to limitations and restrictions established by qualified customers, that is, foreign resi- the Board of Governors for IBFs?

Branch and Agency Examination Manual September 1997 Page 1 Review of Regulatory Reports Effective date July 1997 Section 5060.1

The regulatory agencies rely on the timely and ing report involves some degree of knowing or accurate filing of regulatory reports by domestic reckless behavior on the part of the filer and the and foreign financial institutions. Data collected intentional or negligent submission of inaccu- from regulatory reports facilitate early identifi- rate information to the Federal Reserve. cation of problem situations. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) and the Federal Deposit Insurance Corporation Improvement Act of 1991 FEDERAL RESERVE (FDICIA) amended various banking statutes to REGULATORY REPORTS enhance the Federal Reserve’s authority to assess MONITORING SYSTEM civil money penalties against state member banks, bank holding companies and FBOs that The Federal Reserve System has a Regulatory file late, false, or misleading regulatory reports. Reports Monitoring Program (program) to iden- The civil money penalties also can be assessed tify those banking institutions under its supervi- against individuals who cause or participate in sion that file late and false reports. Each Reserve such filings including those who sign officially Bank maintains records of late and false report- submitted reports. ers and submits summary reports of these records to Board staff after every reporting period. To promote consistent treatment under the program, the Reserve Banks may not grant grace FILING periods or extensions of the submission dates of regulatory reports. In addition, the program The Federal Reserve has identified a late regu- requires Board staff responsible for enforcement latory report as an official copy of a report that actions to consult with Reserve Bank staff to is not received by the Reserve Bank or its ensure that appropriate follow-up supervisory designated electronic collection agent in a timely actions are taken, and that the Federal Reserve manner. The filing of a completed original addresses all instances of chronic late and false report is timely in the following cases: regulatory reporting through civil money penalties or other enforcement proceedings. • The report is received by the Reserve Bank at the end of the reporting day on the submission deadline, including reports filed electronically; • The report is mailed first class and is post- REVIEW OF REGULATORY marked no later than the third calendar day REPORTS preceding the submission deadline, no matter when the report is received by the district Review of regulatory reports involves determin- Federal Reserve Bank. In the absence of a ing whether the management of the branch has postmark, an institution may be called upon to submitted all required reports to the Federal provide proof of timely mailing, if the report Reserve in a timely and accurate manner. The has been received after the submission dead- examiner assigned to a specific department in line; or the branch is responsible for reviewing those • The completed original report is delivered to reports relating to that department and verifying an overnight package delivery service on the that the reports are accurate, meet statutory and day before the submission deadline. An insti- regulatory requirements, and agree with the tution may be called upon to provide proof of branch’s financial records. The examiner-in- timely delivery to the service, if the report has charge is to consolidate the findings of the been received after the submission deadline. examination team and submit a list of regulatory reporting errors to the appropriate Reserve Bank The filing of a false report generally involves staff, who will determine the extent to which the the submission of mathematically incorrect data, branch will be required to file amended reports. such as addition errors or transpositions, the Examiners should discuss with Reserve Bank submission of call reports without appropriate staff any regulatory report that is considered schedules, or the inadvertent filing of inaccurate misleading as such a report could lead to the information. Conversely, the filing of a mislead- issuance of suspicious activities report(s) against

Branch and Agency Examination Manual September 1997 Page 1 5060.1 Review of Regulatory Reports the involved branch and/or individual(s). In U.S. Branches and Agencies of Foreign Banks addition, management should be reminded that (FFIEC 002). civil money penalties may be assessed or other The branch should submit the completed call enforcement proceedings may be initiated against reports to the appropriate supervisory agencies regulatory report filers who are chronically late no more than 30 calendar days after the report or repeatedly file seriously inaccurate reports. date. The Federal Reserve acts as the collecting Branches should maintain efficient internal and processing agent of the call report for the systems and procedures to ensure that reporting federal supervisory authorities. is made in accordance with the appropriate The examiner should carefully review the regulatory requirements. They should develop report to ensure that all pertinent data has been clear, concise, and orderly workpapers to sup- reported and is properly categorized in accor- port the compilation of data. Preparation of dance with the call report instructions. To review proper workpapers not only provides a logical a particular branch’s call report, the examiner tie between report data and the branch’s finan- must first understand the branch’s accounting cial records but also facilitates accurate report- methods and the information located in, and the ing and verification. relationships between, the branch’s general led- A branch’s internal control program for regu- ger and subsidiary ledgers. Workpapers used in latory reports should ensure that all required the preparation of the report and supplementary reports are submitted on time and are accurate. schedules will aid the examiner in understand- The specific internal controls employed by a ing the branch’s system. branch to meet those objectives depend largely on the volume of reports, the scope of a branch’s operations, and the complexity of its accounting Other Regulatory Reports system. Other regulatory reports include the following:

REQUIRED REGULATORY 1. Weekly Report of Assets and Liabilities REPORTS by Large U.S. Branches and Agencies of Foreign Banks. (FR 2069) This section describes the regulatory reports Frequency: Weekly. required to be submitted by the branch to the Voluntary series-branches selected by Federal Reserve. In addition to the list of reports Board staff that had more than $1.1 billion outlined below, the examiner should also review in total assets in March 1991. the reports that monitor compliance with asset maintenance requirements, which are applicable 2. Report of Transaction Accounts, under state law or are required for federally- Other Deposits and Vault Cash (FR 2900) licensed or -insured branches. For additional Frequency: Weekly. information on state requirements, refer to the Aggregate worldwide assets in excess of Summary of Key State Statutes in the appendix $1 billion. of this manual. 3. Monthly Report of Foreign Currency Deposits (FR 2915) Frequency: Monthly Report of Assets and Liabilities of Aggregate worldwide assets in excess of U.S. Branches & Agencies of Foreign $1 billion. Banks (FFIEC 002 and 002S) 4. Report of Certain Eurocurrency All branches are required to file a report of Transactions (FR 2951) assets and liabilities (known as the call report), Frequency: Weekly. as of the last day of each calendar quarter. Aggregate worldwide assets in excess of Details of the appropriate reporting guidelines, $1 billion. along with the specific report form to be filed, are found in the Instructions for Preparation 5. Country Exposure Report for U.S. of the Report of Assets and Liabilities of Branches and Agencies of

September 1997 Branch and Agency Examination Manual Page 2 Review of Regulatory Reports 5060.1

Foreign Banks (FFIEC 019) • Custody Liabilities to Foreigner (BL-2); Frequency: Quarterly. • Intermediary’s Notification of U.S. Nonbank Direct claims on foreigners in excess of Borrowing From Foreigners, Payable in Dol- $30 million. lars (BL-3); • Claims on Foreigners, Payable in Dollars 6. Monthly Consolidated Foreign (BC); Currency Report (FFIEC 035) Frequency: Monthly. • Part 1. Claims on Foreigners (BQ-1); Part 2. Commitments to purchase foreign cur- Domestic Customers’ Claims on Foreigners rency or U.S. dollar exchange of more than Held by Reporter; $1 billion. Other criteria may be used for • Part 1. Liabilities to and Claims on Foreigners selection. Verify reporting status during Payable in Foreign Currencies (BQ-2); examination. Part 2. Domestic Customers’ Claims on For- eigners (in foreign currencies); 7. Weekly Foreign Currency Report (FC-1) • Purchases & Sales of Long-Term Securities Frequency: Weekly. by Foreigners (S). Foreign exchange contracts aggregating $100 million or more. Other criteria may Applicable laws and regulations require be used for selection. Verify reporting branches to file certain reports relating to spe- status during examination. cific business activities. For example, branches are required to file reports associated with lost The following U.S. Treasury Department and stolen securities, transfer agent activities, reports are collected to gather information on municipal securities dealer activities, govern- international capital movements by U.S. banks ment securities broker and dealer activities, (and their Edge Act and agreement corpora- criminal referrals, and BSA reporting. Specific tions), other depository institutions, interna- comments relating to these activities are dis- tional banking facilities, bank holding compa- cussed under in the Other Compliance Matters nies, and U.S. branches and agencies of foreign section of this manual. The examiner-in-charge banks; a U.S. $15 million (or equivalent) thresh- should identify all applicable reporting require- old applies to reporting institutions: ments of the branch and coordinate the review of those reports. • Liabilities to Foreigners, Payable in Dollars (BL-1);

Branch and Agency Examination Manual September 1997 Page 3 Review of Regulatory Reports Examination Objectives Effective date July 1997 Section 5060.2

1. To determine that required reports are being 4. To recommend corrective action when poli- ﬁled on time. cies, practices, procedures, or internal con- 2. To determine that contents of reports are trols are deﬁcient or when violations of laws accurate. or regulations have been noted. 3. To determine the adequacy of the internal audit function as it relates to reviewing and preparing the regulatory reports.

Branch and Agency Examination Manual September 1997 Page 1 Review of Regulatory Reports Examination Procedures Effective date July 1997 Section 5060.3

1. Complete or update the Internal Control liabilities during their examination of the Questionnaire if selected for implementation. various departments. 2. Determine the branch’s historical record of e. Determine that the reports are prepared in submitting timely and accurate reports by accordance with Federal Reserve and/or reviewing workpapers. other applicable instructions. 3. Depending on the scope of the examination, 4. Review scope of internal audit to determine select certain regulatory reports or portions if it covers the preparation and review of of reports for review. Obtain the most recent regulatory reports. filing of the selected reports or portions of 5. Prepare comments in appropriate report form reports and perform the following: and discuss with management recommended a. Reconcile the line items shown on the corrective action when policies, practices or reports to the appropriate general ledger, procedures are deficient or when reports have subsidiary ledgers, or daily statements. been filed incorrectly, late, or not at all. The b. Obtain the workpapers applicable to each comments must include, if applicable, the line item and reconcile individual items to name(s) and the as of date(s) of amended the reports. report(s) and the date of filing, amount of, c. Determine the accuracy of electronic and explanation of any material difference. reporting systems used in the preparation 6. Update the workpapers with any information of reports. that will facilitate future examinations. d. Determine whether other examiners have uncovered any misstatement of assets or

Branch and Agency Examination Manual September 1997 Page 1 Review of Regulatory Reports Internal Control Questionnaire Effective date July 1997 Section 5060.4

1. Are regulatory reports accurate and submit- rized officer responsible for the prepara- ted in a timely manner? tion of the reports? 2. Is there adequate separation of duties to 5. Do regulatory report workpapers: ensure that the raw data used to complete a. Leave a clear audit trail from the raw data regulatory reports is compiled by one person to the finished report, and are they readily and verified by another person before available for inspection? submission? b. Meet record retention standards under 3. After the regulatory reports are prepared but applicable laws and regulations? before their submission, are they checked by: a. The supervisor of the department preparing the report, who takes personal respon- CONCLUSION sibility for its accuracy and submission on a timely basis? 6. Is the information covered by this ICQ b. Branch personnel who have no part in the adequate for evaluating internal controls in report’s preparation? this area? If not, indicate any additional 4. If regulatory reports are produced examination procedures deemed necessary. electronically: 7. Based on the information gathered, evaluate a. Are accurate reports produced in a form the internal controls of this area (i.e. strong, acceptable to the applicable regulatory satisfactory, fair, marginal, unsatisfactory). agencies? b. Are changes to the electronic systems documented and approved by an autho-

Branch and Agency Examination Manual September 1997 Page 1 Other Compliance Matters Effective date July 1997 Section 5070.1

FBOs are subject to various other federal and investigations, it became apparent that, in many state laws and regulations not discussed else- instances, these activities were concealed from where in this manual. Similar to domestic bank- the outside auditors and others by maintaining ing organizations, FBOs operating in the United off-the-book bank accounts or otherwise circum- States are required to be knowledgeable of these venting the system of internal accounting laws and regulations and to establish policies, controls. practices, procedures, and internal controls to As a result of these investigations, Congress ensure compliance. passed the Foreign Corrupt Practices Act of The following discussion is divided into two 1977 (Act). This Act consists of two separate sections: Safety and Soundness Rules and Regu- groups of rules: (a) those that prohibit the lations and Consumer Compliance Regulations. offering or payment of bribes to certain foreign State-licensed branches should refer to their officials, and (b) those requiring the mainte- state statutory codes for specific statutes that nance of complete accounting books and records may apply. Additionally, federally-insured and an effective system of accounting controls. branches are subject to the wide variety of laws Section 78DD-1 applies to any issuer of and regulations applicable to all federally- securities registered on a U.S. national securities insured depository institutions. exchange. Thus, if an FBO has issued securities On January 17, 1978, the three federal bank so registered, the prohibition on certain corrupt supervisory agencies issued a joint policy state- practices applies to the FBO. Section 78DD-2, ment to address their concern regarding the however, applies to any domestic concern, which potential for improper payments by banks and is defined in subsection (h)(1)(B) to include any bank holding companies in violation of the corporation which has its principal place of Foreign Corrupt Practices Act and the Federal business in the United States. Generally, ques- Election Campaign Act. While not widespread, tions of specific applicability of provisions of the federal bank supervisory agencies were con- this Act to U.S. branches and agencies of FBOs cerned that such practices could reflect adversely should be referred to appropriate legal counsel. on the banking system and constitute unsafe and unsound banking practices, in addition to their possible illegality. Antibribery Provisions The potential devices for making political payments in violation of the law could include These provisions of the Act prohibit any U.S. compensatory bonuses to employees, designated company or business entity (and its officers, expense accounts, fees or salaries paid to offi- directors, agents, employees, and shareholders cers, and preferential or zero interest rate loans. acting on its behalf) from using the mails, In addition, political contributions could be telephone, transportation, or any other instru- made by providing equipment and services with- mentality of interstate or foreign commerce out charge to candidates for office. corruptly, in furtherance of an offer, payment, promise to pay, authorization of the payment of any money, or other thing of value to: SAFETY AND SOUNDNESS RULES AND REGULATIONS • An official of a foreign government or instrumentality of a foreign government; Foreign Corrupt Practices Act— • A foreign political party or official thereof or 15 USC 78DD-1, 78DD-2 a candidate for political office; or, • Any other person the payor knows of or has Beginning in 1973, the Securities and Exchange reason to know, who will pay or give the Commission (SEC) became aware of conduct by money or value to those listed above, some companies involving the use of corporate funds for illegal domestic political contribu- where the purpose is to influence an act or tions. Subsequent SEC investigations, revealed decision (including a decision not to act) of the instances in which some of the largest U.S. recipient in his official capacity or to induce the corporations had secretly engaged in the bribery recipient to use his or her influence to affect or of foreign officials. In the course of these influence an act or decision of the government

Branch and Agency Examination Manual September 1997 Page 1 5070.1 Other Compliance Matters or instrumentality, in order to assist such com- The second regulation prohibits a director or pany or entity in obtaining, retaining, or direct- officer of an issuer from making or causing to be ing business for itself or another person. made a materially false or misleading statement, These provisions do not apply to payments to and from omitting to state or cause another any employee whose duties are essentially min- person to omit a material fact necessary to make isterial or clerical. a statement not misleading to an accountant, external or internal, in connection with an audit of the financial statements or preparation of Accounting Provisions required reports. Conviction of a willful violation of these accounting provisions carries a Although the obligation to maintain accurate possible $10,000 fine or up to five years impris- books and records and to have an adequate onment, or both. system of internal accounting controls has been acknowledged by responsible corporations for a long time, this obligation was not previously Federal Elections Campaign Act— explicitly established into law until the passage 2 USC 441B of the Act. Applying essentially to all companies whose securities are publicly traded in the The Federal Elections Campaign Act (FECA), United States, the Act requires them to: enacted in 1971, was designed to curb potential abuses in the area of federal election financing. • Make and keep books, records, and accounts, In general, FECA regulates the making of cam- which, in reasonable detail, accurately and paign contributions and expenditures in connec- fairly reflect the transactions and dispositions tion with primary and general elections to fed- of the assets of the issuer; and eral offices and specifically bans campaign • Devise and maintain a system of internal contributions by national banks. The Office of accounting controls sufficient to provide rea- the Comptroller of the Currency has, by regula- sonable assurance that: tion (12 CFR 28.101(4)), made this provision — Transactions are executed in accordance applicable to federal branches and agencies.1 with management’s general or specific FECA does not specifically address the making authorizations; of contributions and expenditures by banks or — Transactions are recorded as necessary other corporations to advocate positions on issues (1) to permit preparation of financial state- that are the subjects of public referenda. As ments in conformity with generally originally enacted, FECA required disclosure of accepted accounting principles or any other contributions received or expenditures made; criteria applicable to such statements and however, amendments to the law in 1974 and (2) to maintain accountability for assets; 1976 imposed additional limitations on contri- — Access to assets is permitted only in butions and expenditures as well. The 1974 accordance with management’s general or amendments also established the Federal Elec- specific authorization; and, tion Commission (Commission) to administer — The recorded accountability for assets is FECA’s provisions. The Commission is respon- compared with the existing assets at rea- sible for adopting rules to carry out FECA, for sonable intervals and appropriate action is rendering advisory opinions, and for enforcing taken with respect to any difference. the Act. The Commission was reorganized as a result of the FECA Amendments of 1976 and it Acting under its authority to issue regula- has since issued regulations interpreting the tions, the SEC issued regulations, which became statute Title 11 of the CFR. effective on March 23, 1979, concerning falsi- fications of records and the making of false, misleading, or incomplete statements to audi- 1. 2 USC 441a, however, limits campaign contributions by tors. The first of these regulations says that no any person. The definition of person in 2 USC 431(h) is very person shall, directly or indirectly, falsify or broad and could include the U.S. branches and agencies of cause to be falsified, any book, record or account FBOs. Accordingly, any questions in this area should be subject to the provisions of the law described referred to appropriate legal counsel. In addition, 2 USC 441e prohibits campaign contributions by foreign nationals (the above, that is, those used for making reports definition of which excludes U.S. citizens and U.S. permanent under the SEC laws. resident aliens).

September 1997 Branch and Agency Examination Manual Page 2 Other Compliance Matters 5070.1

Contributions and Expenditures Separate Segregated Funds and Political Committees The words contribution and expenditure are defined broadly by FECA and the Commission’s FECA allows the establishment and administra- regulations to include any loan, advance, deposit, tion by corporations of separate segregated funds purchase, payment, distribution, subscription, to be utilized for political purposes (2 USC gift of money, or anything of value that is made Section 441b(b)(4)). While corporate monies for the purpose of influencing the nomination or may not be used to make political contributions election of any person to federal office. The or expenditures, corporations may bear the costs payment by a third party of compensation for of establishing and administering these separate personal services rendered without charge to a segregated funds, including payment of rent for candidate or political committee is also treated office space, utilities, supplies, and salaries. as a contribution by FECA, although the term These costs need not be disclosed under FECA. does not include the value of personal services Commission regulations also permit a corpora- provided by an individual without compensation tion to exercise control over its separate segre- on a volunteer basis. gated fund. In practice, most corporate segregated funds Although loans are included in the definitions are administered by a group of corporate per- of contribution and expenditure under FECA, a sonnel, which, if the fund receives any contri- specific exemption is provided for bank loans butions or makes any expenditures during a made in the ordinary course of business and in calendar year, constitutes a political committee, accordance with applicable banking laws and as defined by FECA. As such, it is required to regulations. The Commission’s regulations profile a statement of organization with the Com- vide further that extensions of credit to a candi- mission, to keep detailed records of contribu- date, political committee, or other person in tions and expenditures, and to file with the connection with a federal election may be treated Commission reports identifying contributions in as a loan, and not a contribution, if they are on excess of $200 and candidates who are recipi- terms substantially similar, in risk and amount, ents of contributions from the fund. to those made to nonpolitical debtors. The Solicitation of contributions to corporate seg- regulations also provide that a debt may be regated funds by political committees must be forgiven only if the creditor has treated it in a accomplished within the precise limits estab- commercially reasonable manner, including mak- lished by FECA. All solicitations directed to ing efforts to collect the debt, which are similar corporate employees must satisfy the following to the efforts it would make with a nonpolitical requirements: (1) the contribution must be debtor. In considering whether a particular trans- entirely voluntary, (2) the employee must be action is a contribution or a loan, it is expected informed of the political purposes of the fund at that a factor would be the extent to which the the time of the solicitation, and (3) the employee creditor may have departed from its customary must be informed of his or her right to refuse to credit risk analysis. contribute without reprisal. Beyond those basic FECA and the implementing regulation per- requirements, FECA distinguishes between mit certain limited payments to candidates or executive and administrative personnel and other their political committees. For example, pay- employees. The former and their families may ment of compensation to a regular employee, be solicited any number of times, while the latter who is providing a candidate or political com- and their families may only be solicited through mittee with legal or accounting services, which a maximum of two written solicitations per year, are solely for the purpose of compliance with and these solicitations must be addressed to the the provisions of the FECA, is exempt from the employees at their homes. Solicitations may definitions of contribution and expenditure. The also be directed to corporate stockholders and Commission’s regulations also permit occa- their families in the same manner as to executive sional use of a corporation’s facilities by its and administrative personnel. shareholders and employees for volunteer politi- Although a corporation or a corporation and cal activity; however, reimbursement to the its subsidiaries may form several political com- corporation is required for the normal rental mittees, for purposes of determining the statu- charge for anything more than occasional or tory limitations on contributions and expendi- incidental use. tures, all committees established by a corporation

Branch and Agency Examination Manual September 1997 Page 3 5070.1 Other Compliance Matters and its subsidiaries are treated as one. Thus, the Bribery Amendments Act of 1985 to narrow the total amount that all political committees of a scope of 18 USC 215 by adding a new element, corporation and its subsidiaries may make to a namely, an intent to corruptly influence or reward single candidate is $5,000 in any federal election an officer in connection with financial institution (provided that the committees are qualified multi- business. candidate committees under FECA). This law now specifically excepts the pay- Violation of FECA by any corporation is ment of bona fide salary, wages, fees or other punishable by a fine of not more than $25,000, compensation paid, or expenses paid or reim- and any director or officer of any corporation bursed in the usual course of business. In who consents to any contribution or expenditure addition, the law now requires the financial by the corporation in violation of FECA is institution regulatory agencies to publish guide- subject to fine or imprisonment or both. lines to assist employees, officers, directors, State laws concerning this matter should also agents, and attorneys of financial institutions in be reviewed by the examiner. However, FECA complying with the law. The branch’s internal preempts state law with respect to election to code or written policy should prohibit such federal office. persons from (1) soliciting for themselves or for a third party (other than the branch itself) anything of value from anyone in return for any business, service, or confidential information of Bank Bribery Act—18 USC 215 the branch and from (2) accepting anything of value (other than bona fide salary, wages, and The Comprehensive Crime Control Act of 1984 fees) from anyone in connection with the busi- amended the federal bank bribery law to pro- ness of the branch, either before or after a hibit employees, officers, directors, agents, and transaction is discussed or consummated. In attorneys of financial institutions from seeking addition, the code/policy may specify appropri- or accepting anything of value in connection ate exceptions to the general prohibition of with any transaction or business of their finan- accepting something of value in connection with cial institution. The definition of a financial branch business. institution in 18 USC 20(9) includes a U.S. Furthermore, the branch’s code of conduct or branch or agency of an FBO. The amended law written policy should provide that if a branch also prohibited anyone from offering or giving official is offered or receives something of value anything of value to employees, officers, direc- beyond what is permitted in the policy, that tors, agents, or attorneys of financial institutions branch official must disclose that incident to an for or in connection with any transaction or appropriately designated official of the financial business of the financial institution. Because of institution. The branch should maintain such its broad scope, the 1984 Act raised concerns disclosures. A branch official’s full disclosure that it might have made unlawful what had evidences good faith when it is made in the previously been considered acceptable conduct. context of properly exercised supervision and In July 1985, the Department of Justice issued control. Management should review the disclo- a Policy Concerning Prosecution Under the New sures and determine that what is accepted is Bank Bribery Statute. In that policy, the Justice reasonable and does not pose a threat to the Department discussed the basic elements of the integrity of the branch. Thus, the prohibitions of prohibited conduct under Section 215, and indi- the bank bribery statute cannot be avoided by cated that cases to be considered for prosecution simply reporting to management the acceptance under the new bribery law entail breaches of of various gifts. fiduciary duty or dishonest efforts to undermine The business luncheon or holiday season gift financial institution transactions. Because the from a customer generally is not a violation of statute was intended to reach acts of corruption the statute if: (1) its acceptance is based on a in the banking industry, the Justice Department family or personal relationship existing indepen- expressed its intent not to prosecute insignificant dent of any business of the financial institution, gift giving or entertaining that does not involve (2) the benefit is available to the general public a breach of fiduciary duty or dishonesty. under the same conditions on which it is avail- Congress decided that the broad scope of the able to the branch, or (3) the benefit would be statute provided too much prosecutorial discre- paid for by the branch as a reasonable business tion. Consequently, Congress adopted the Bank expense if not paid for by another party. What is

September 1997 Branch and Agency Examination Manual Page 4 Other Compliance Matters 5070.1 reasonable in one part of the country may appear official because of such person’s position with lavish in another part. Thus, the branch may the branch. establish, in its own code/policy, a range of If the value of the item or benefit offered or dollar values, which cover the various benefits received exceeds $100, the offense is a felony that its officials may receive from those doing or punishable by up to thirty years imprisonment seeking to do business with the branch. and a fine of up to $1,000,000 or three times the In addition to the exceptions discussed above, value of the bribe or gratuity, whichever is the branch may describe other appropriate greater. If value does not exceed $100, the exceptions to the general prohibition in its code offense is a misdemeanor punishable by up to of conduct or written policy, such as those that: one year imprisonment and a maximum fine of $1,000. • Permit acceptance of meals, refreshments, travel arrangements, accommodations, or entertainment, all of reasonable value and in the course of a meeting or other occasion the Foreign Assets Control Regulation purpose of which is to hold bona fide business discussions, provided that the expenses would The function of the Office of Foreign Assets be paid for by the branch as a reasonable Control (OFAC) of the U.S. Department of the business expense, if not paid for by another Treasury is to promulgate and administer regu- party; lations dealing with the economic sanctions that • Permit acceptance of loans from other branches the U.S. government imposes against certain or financial institutions on customary terms to foreign countries, against the nationals of those finance proper and usual activities of branch countries, and against the specially designated officials, such as home mortgage loans, except nationals of those countries. Under the Interna- where prohibited by law; tional Emergency Economic Powers Act, the President can impose sanctions such as trade • Permit acceptance of advertising or promo- embargoes, freezing of assets, import sur- tional material of reasonable value, such as charges, etc. These sanctions usually entail the pens, pencils, note pads, key chains, calen- freezing of a country’s assets and are politically dars, and similar items; motivated. Branches must block funds transfers • Permit acceptance of discounts or rebates on that (1) are remitted by or on behalf of a blocked merchandise or services that do not exceed individual or entity; (2) are remitted to or those available to other customers; through a blocked entity; or (3)are remitted in • Permit acceptance of gifts of reasonable value connection with a transaction in which a blocked that are related to commonly recognized events individual or entity has an interest. If a branch in or occasions, such as a promotion, new job, the U.S. receives instructions to make a payment wedding, retirement, Christmas, or bar or bat that falls into one of these categories, it is mitzvah; required to execute the payment order and place • Permit the acceptance of civic, charitable, the funds into a blocked account. A payment educational, or religious organizational awards order cannot be canceled or amended after the for recognition of service and accomplishment. U.S. branch has received it. Once assets or funds are blocked, they may be released only by A serious threat to the branch’s integrity specific authorization from the U.S. Treasury. occurs when its officials become involved in A ‘‘specially designated national’’ is a person outside business interests or employment that or entity who acts on behalf of one of those give rise to a conflict of interest. Such conflicts countries under economic sanction by the U.S. of interest may evolve into corrupt transactions The designation is done by the U.S. Secretary of that are covered under this Act. Accordingly, the State. Dealing with such nationals is prohibited. branch is encouraged to prohibit in its code/ Moreover, their assets or accounts in the U.S. are policy, branch officials from self-dealing or frozen. In certain cases, however, the Treasury otherwise trading on their positions with the Department can issue a license to a designated branch or accepting a business opportunity from national. This license can then be presented by someone doing or seeking to do business with the customer to the institution, allowing the the branch, which is not available to other institution to debit his/her account. The license persons or which is made available to the branch can be either general or specific. The general

Branch and Agency Examination Manual September 1997 Page 5 5070.1 Other Compliance Matters license is not a document but a provision in the • limitations on interstate banking; regulation itself authorizing certain transactions; • exemptions from the nonbanking prohibitions the branch must request the customer to sign an of the BHCA and the IBA; affidavit stating that the particular transaction is • the approval of the establishment of an office covered by a general license. The specific license of a foreign bank in the U.S.; is a document (with U.S. Treasury seal, signa- • the termination of a foreign bank’s branch or ture of OFAC’s Chief of Licensing and control agency; number) issued by OFAC on a case-by-case • the examination of an office of a foreign bank basis to a specific individual or company allow- in the U.S.; ing an activity that otherwise is prohibited by • the disclosure of supervisory information to a the regulations; the branch must request to see foreign supervisor; and the original license. • the limitations on loans to one borrower by Blocking an account allows only credits to be state branches and state agencies of a foreign posted to a customer’s account. If OFAC imposes bank. the blocking of an account, then the account cannot be used to settle claims, i.e., the branch is The following is a brief summary of Regula- prohibited from offsetting the account; no deb- tion K: iting is allowed. Assets can also be blocked whereby the Treasury Department exercises powers and privileges associated with owner- Section 211.21—Definitions ship of all property and interests in property of the sanctioned country’s government, its agen- This section includes all the definitions for this cies, instrumentalities, and controlled entities in subpart. Included in this section is the definition the United States or within the possession or of agency and credit balances. Refer to the control of U.S. persons. An institution’s corre- Deposit Accounts section of this manual for spondent banks accounts can also be blocked or additional information on credit balances. frozen. The branch is not allowed to tell its customer if his/her account has been blocked by OFAC. Section 211.22—Limitation on Interstate A 602 Request is a national emergency inquiry Banking requested by the U.S. Secretary of State. The U.S. government does not need an injunction This section addresses the designation of a home order for this request, and the recipient of such state for the foreign organization. The Federal a request must respond to the inquiry. Reserve Bank District in which a foreign organization’s home state is located, is considered Any violation of the regulations implement- the organization’s ‘‘responsible Reserve Bank.’’ ing the sanctions subjects the violator to criminal prosecution. Criminal penalties for violating sanctions range up to 12 years in prison and $1 million in corporate fines and $250,000 in Section 211.23—Nonbanking Activities of individual fines, per incident. In addition, civil FBOs penalties of up to $250,000 per violation may be This section exempts certain FBOs from the imposed administratively. nonbanking prohibitions of the BHCA and IBA. An organization must qualify for exemption from these prohibitions by meeting certain asset, revenue, and net income requirements. If an Regulation K, International Banking organization does not meet the qualifications, or Organizations—12 CFR 211 ceases to be eligible for the exemption, the organization may apply to the Federal Reserve The Board of Governors of the Federal Reserve Board for a specific determination of its eligi- System’s Regulation K, Subpart B was issued bility. Refer to the regulation for details. If an under the authority of the Bank Holding Com- organization qualifies for this exemption, it may pany Act of 1956 (BHCA) and the International engage in certain activities and investments Banking Act of 1978 (IBA). It applies to FBOs cited in the regulation. Refer to the regulation with respect to: for a listing of such activities and investments.

September 1997 Branch and Agency Examination Manual Page 6 Other Compliance Matters 5070.1

Section 211.24—Approval of Offices of Section 211.27—Disclosure of Supervisory Foreign Banks; Procedures for Information to Foreign Supervisors Applications; Standards for Approval; Representative-Office Activities and As the title suggests, this section addresses the Standards of Approval; Preservation of disclosure of information to a foreign banking Existing Authority regulatory or supervisory authority. Refer to the regulation for details. This section addresses the application procedures and approval process for branches, agencies, representative offices, and commercial lend- Section 211.28—Limitation on Loans to ing companies of foreign banks. The section One Borrower also lists the activities in which a representative office may engage. In addition, this section Except as otherwise provided in this section, the requires uninsured federal and state branches, aggregate of all outstanding loans and exten- uninsured state branches, all state agencies, and sions of credit at one time to a single borrower all representative offices to file a suspicious by all state and federal branches and agencies of activity report in accordance with the Federal the same FBO are subject to the limitations and Reserve Board’s Regulation H. other provisions of section 5200 of the Revised Statutes (12 USC 84). Section 5200 of the Revised Statutes (12 USC 84) limits loans and Section 211.25—Termination of Offices of extensions of credit to a person outstanding at Foreign Banks one time which are not fully secured, to 15% percent of the unimpaired capital and unimpaired This section addresses the grounds under which surplus for the association. Separate from and in a foreign bank may be required to terminate the addition to this 15% limitation, loans and exten- activities of its representative office, commercial sions of credit to a person outstanding at one lending company subsidiary, or state branch or time which are fully secured by readily market- agency. The section also includes termination able collateral having a market value, are limited procedures. The license of a federal branch or to 10% of unimpaired capital and unimpaired agency would be terminated by the OCC. A surplus of the association. In the case of a state branch or agency license can only be branch, the ‘‘unimpaired capital and unimpaired terminated by the respective state’s banking surplus of the association’’ is the unimpaired authority. capital and unimpaired surplus of the FBO as reported on the FBO’s Annual Report of FBO (FR Y-7). Section 5200 allows for some exemp- Section 211.26—Examination of Offices tions to these limits; however, the examiner and Affiliates of Foreign Banks should place the burden of proof upon the branch to justify qualifications for these This section requires an annual on-site exami- exemptions. nation of each branch, agency, or commercial lending company of a foreign bank by: Regulation D, Reserve Requirements • the Federal Reserve Board; of Depository Institutions— 12 CFR 204 • the FDIC, if the branch is FDIC insured; • the OCC, if the branch or agency is licensed The Board of Governors of the Federal Reserve by the Comptroller; or System’s Regulation D was issued under the authority of section 19 (12 USC 461) and other • the state supervisor, if the branch or agency is provisions of the Federal Reserve Act and of licensed by the state. section 7 of the IBA (12 USC 3105). The regulation relates to the reserves that depository To the extent possible, these examinations institutions are required to maintain. The reserve should be coordinated with all the regulatory requirements apply to a foreign bank’s branch or agencies; and the examination of all U.S. offices agency located in the U.S., in the following of the FBO should be conducted simultaneously. instances:

Branch and Agency Examination Manual September 1997 Page 7 5070.1 Other Compliance Matters

• its parent bank has total worldwide consoli- is contained in the Board’s Municipal Securities dated bank assets in excess of $1 billion; Dealer Examination Manual. The Board has • its parent bank is controlled by a foreign developed a separate Report of Examination of company or group of foreign companies that Municipal Securities Dealer Activities. own or control foreign banks that in the aggregate have total worldwide consolidated bank assets in excess of $1 billion; or Government Securities Broker and Dealer • the branch is eligible to apply to become a Activities FDIC-insured bank. If a branch acts as a government securities Refer to the regulation for information on the broker and/or dealer, it may have to file notice calculation and maintenance of reserves. Sec- with the Board as a government securities bro- tion 5060 of this manual also addresses the ker and/or dealer pursuant to section 15C(a)(1)(B) regulatory reports required to calculate reserves. of the Securities Exchange Act of 1934, by filing The examiner assigned the review of regulatory Form FR G-FIN. A discussion of the branch’s reports should determine whether any violations responsibilities as a government securities bro- of Regulation D exist. ker and/or dealer, filing requirements, and other information, including examination procedures is contained in the Board’s Procedures for the Examination of Government Securities Activi- Bank Secrecy Act—31 USC 5311, et ties. The Board has developed a separate Sum- seq. and 31 CFR Part 103, et seq./ mary Report of Examination of Government Regulation H, Section 208.14 Securities Broker/Dealer or Custodial Activities.

Refer to the Federal Reserve System’s Bank Secrecy Act Manual for information on these rules and regulations. Lost and Stolen Securities Reporting and Inquiry Requirements— 17 CFR 240.17F-1 Transfer Agent Activities A branch with deposits insured by the Federal If a branch acts as a transfer agent for the stock Deposit Insurance Corporation (reporting insti- of its holding company or any other equity tution) must register with the Securities and security, it may have to register with the Board Exchange Commission’s designee, Securities of Governors as a transfer agent, pursuant to the Information Center, Inc. (SIC) and report lost, requirements of Regulation H (section 208.8(f)), missing, stolen, or counterfeit securities to the by filing uniform interagency Form TA-1. A SIC. Each insured branch is responsible for discussion of the responsibilities of a branch as contacting the SIC to determine if securities a transfer agent, the reports and filing require- coming into its possession, whether by pledge, ments, and other information, including exami- transfer or some other manner, have been pre- nation procedures, are contained in the Board’s viously reported as missing, lost, stolen, Transfer Agent Examination Manual. The Board or counterfeit, except in certain limited has developed a separate Report of Examination circumstances. of Transfer Agents. All functions within a branch that handle or process securities are subject to the reporting requirements. Only the transfer agent function is Municipal Securities Dealer Activities exempt from the inquiry requirements. Accord- ingly, all branch departments likely to be A branch that is a municipal securities dealer affected, including the trust, investment, transfer must register with the SEC and with the Board agent, custody or dealer departments, and the as a municipal securities dealer, pursuant to SEC lending operations as relating to margin loans, Rule 15Ba2-1, by filing Form MSD. A discus- should be familiar with the requirements set out sion of the responsibilities as a municipal secu- in 17 CFR 240.17F-1. rities dealer, filing requirements, and other Securities exempt from the reporting require- information, including examination procedures, ments are:

September 1997 Branch and Agency Examination Manual Page 8 Other Compliance Matters 5070.1

• Registered securities of the U.S. government business days after discovery or as soon as and federal agencies thereof; certificate numbers can be ascertained. • Securities that have not been assigned CUSIP Copies of all reports required to be filed under numbers; and, 17 CFR 240.17F-1 must also be submitted to the • Bond coupons. registered transfer agent for the issue being reported and, if criminal activities are suspected, Securities exempt from the inquiry require- to the Federal Bureau of Investigation. Copies of ments are: filed or received Forms X-17F-1A must be maintained in an easily accessible place for • Securities received directly from the issuer or three years. its agent at issuance; • Securities received from another reporting institution or from a Federal Reserve Bank or CONSUMER COMPLIANCE branch; REGULATIONS • Securities received from a customer of the reporting institution in the name of the cus- Since the late 1960s, Congress has enacted a tomer or nominee; and, number of consumer protection and civil rights • Securities that are a part of a transaction of laws directly related to the activities of financial $10,000 or less (aggregate face value for institutions. Traditionally, these laws have been bonds or market value for stocks). enforced by the domestic institution’s primary federal regulator; for example, the Board of Governors conducts consumer compliance Reporting Lost, Missing, Stolen or examinations for state member banks. More Counterfeit Securities recently, as part of the Federal Deposit Insur- ance Corporation Improvement Act of 1991, Form X-17F-1A must be filed with the SIC Congress expanded the authority of the Board within one business day after the discovery of: and other federal banking agencies to enforce consumer statutes for certain types of FBOs. • A theft or loss of any security, when there is a Specifically, the Federal Reserve System is substantial indication of criminal activity; responsible for enforcing consumer laws in the • A security that has been lost or missing for case of state-licensed agencies and state-licensed two business days; or uninsured branches of FBOs, commercial lend- • A security that is counterfeit. ing companies owned or controlled by FBOs and organizations operating under section 25 or The form must be filed within two business 25(a) of the Federal Reserve Act (Edge Act and days of notification of nonreceipt when Agreement corporations). In addition, the Office (1) delivery of securities sent by the branch is of the Comptroller of the Currency is respon- made by mail or by draft and payment is not sible for conducting these examinations for received within ten business days and confirma- federally-licensed, uninsured branches of FBOs tion of nondelivery has been made by the and the Federal Deposit Insurance Corporation receiving institution and (2) delivery is made in is responsible for federally-insured branches of person and no receipt is maintained by the FBOs. branch. If securities sent by the branch, either in The scope of a typical compliance examina- person or through a clearing agency, are lost in tion for these institutions includes the Equal transit and the certificate numbers of the secu- Credit Opportunity Act, the Home Mortgage rities can be determined, the branch must supply Disclosure Act, the Truth in Lending Act, the the receiving institution with the certificate num- Fair Credit Reporting Act, the Fair Debt Collec- bers of the securities within two business days tion Practices Act, the Electronic Fund Transfer from the date of the request from the receiving Act, the Federal Trade Commission Act, and the institution. The delivery of lost or missing Expedited Funds Availability Act. The degree to securities to the branch must be reported within which FBOs operating in the U.S. conduct one business day after discovery and notification activities covered by these laws and regulations of certificate numbers. Securities that are con- vary, but often these institutions conduct far sidered lost or missing as a result of counts or fewer such activities than a typical domestically- verifications must be reported no later than ten chartered bank.

Branch and Agency Examination Manual September 1997 Page 9 5070.1 Other Compliance Matters

Examinations of entities of FBOs should be available to the public and must post a notice of conducted using existing regulatory policies and availability in their public lobby. procedures for domestically-chartered bank compliance examinations. Examiner guidelines for conducting compliance examinations and inves- Regulation E/Electronic Funds tigating consumer complaints are contained, for example, in the Board of Governor’s Consumer Transfer Act Compliance Handbook and various supervisory The Electronic Funds Transfer Act provides Consumer Affairs letters. These guidelines consumer protection for all transactions using a describe the examination procedures to be used debit card or other electronic means to debit or in connection with loan file sampling, reporting credit an account. For example, it also limits a and correcting violations, and rating branches consumer’s liability for unauthorized electronic for compliance. Of particular importance are fund transfers, restricts issuance of debit cards, violations that require reimbursement of over- and requires certain disclosures. charges and violations that trigger corrective action under the Board’s Regulation B/Fair Housing Act Policy Guide. Following is a description of some of the Regulation Z/Truth In Lending Act regulations and consumer protection laws that Federal Reserve System examiners enforce. This Regulation Z implements the federal Truth in information is provided primarily as reference Lending Act, which is contained in Title I of the material; examiners should consult the detailed Consumer Protection Act and Section 1204 of handbooks mentioned earlier for specific exami- the Competitive Equality Banking Act of 1987. nation guidance in this area. The Truth in Lending Act requires disclosure of certain costs and terms of credit including the finance charge and the annual percentage rate so that a consumer can compare the prices of credit Regulation B/Equal Credit from different sources. It also limits liability on Opportunity Act lost or stolen credit cards. In addition, it provides consumers the right to cancel certain The Equal Credit Opportunity Act prohibits home-secured loans. Over the years, the Truth in discrimination against an applicant for credit Lending Act has been amended by several acts. because of age, sex, marital status, religion, A summary of the provisions of each of the Acts race, color, national origin, or receipt of public follows. assistance. It also prohibits discrimination because of a good faith exercise of any rights under the federal consumer credit laws. The law Consumer Leasing Act also contains notification requirements for consumers and small businesses that have been The Consumer Leasing Act requires disclosure denied credit. of certain costs and terms of consumer leases, so that consumers can compare the prices of leasing from different sources. Regulation C/Home Mortgage Disclosure Act Fair Credit and Charge Card Disclosure Act The Home Mortgage Disclosure Act requires certain lending branches to report annually on The Fair Credit and Charge Card Disclosure Act their originations and purchases of home pur- requires disclosures on (1) credit and charge chase and home improvement loans and appli- cards and (2) applications and pre-approved cations for such loans. The type of loan, location solicitations for cards, whether issued by finan- of property, race or national origin, sex, and cial institutions, retail stores, or private compa- income of the applicant or borrower are reported nies. Information such as APRs, annual fees, to supervisory agencies. Branches are required and grace periods must be provided in tabular to make information regarding their lending form. The Act also requires card issuers that

September 1997 Branch and Agency Examination Manual Page 10 Other Compliance Matters 5070.1 impose an annual fee to provide disclosures provide cosigners with a notice explaining their before annual renewal. In addition, card issuers credit obligation as a cosigner. It also prohibits that offer credit insurance must inform custom- the pyramiding of late charges. ers of any increase in rate or substantial decrease in coverage should the issuer decide to change insurance providers. Regulation CC/Expedited Funds Availability Act

Fair Credit Billing Act The Expedited Funds Availability Act requires that all banks (including branches of FBOs), The Fair Credit Billing Act establishes proce- savings and loan associations, savings banks, dures for the prompt correction of errors on and credit unions to make funds deposited into open-end credit accounts. It also protects a checking, share draft, and NOW accounts avail- consumer’s credit rating while the consumer is able according to specified time schedules, and settling any disputes. to disclose their funds availability policies to their customers. The law does not require an institution to delay the customer’s use of depos- Home Equity Loan Consumer Protection ited funds but instead limits how long any delay Act may last. The regulation also establishes rules designed to speed the return of unpaid checks. The Home Equity Loan Consumer Protection Act requires lenders to disclose terms, rates, and conditions (APR, miscellaneous charges, pay- Fair Credit Reporting Act ment terms, and information about variable rate features) for home equity lines of credit with the The Fair Credit Reporting Act establishes pro- applications and before the first transaction under cedures for correcting mistakes on a person’s the home equity plan. If the disclosed terms credit record and requires that a consumer’s change, the consumer can refuse to open the record only be provided for legitimate business plan and is entitled to a refund of fees paid in needs. It also requires that the record be kept connection with the application. The Act also confidential. A credit record may be retained limits the circumstances under which creditors seven years for judgements, liens, suits, and may terminate or change the terms of a home other adverse information, except for bankrupt- equity plan after it is opened. cies, which may be retained ten years. If a consumer has been denied credit, a cost-free credit report may be requested within 30 days of Regulation AA/Credit Practices Rule denial. (issued under the Federal Trade Commission Act) Fair Debt Collection Practices Act The Credit Practices Rule prohibits lenders from using certain remedies such as confessions of The Fair Debt Collection Practices Act is judgement; exemption waivers; wage assign- designed to eliminate abusive, deceptive, and ments; and nonpossessory, nonpurchase money, unfair debt collection practices. It applies to security interests in household goods in connec- third party debt collectors or those who use a tion with consumer credit contracts. The rule name other than their own in collecting con- also prohibits lenders from misrepresenting a sumer debts. cosigner’s liability and requires that lenders

Branch and Agency Examination Manual September 1997 Page 11 Other Compliance Matters Examination Objectives Effective date July 1997 Section 5070.2

1. To determine whether the branch has poli- 5. To determine if the branch has complied cies and procedures covering applicable with the other reporting requirements requirements of the Foreign Corrupt Prac- regarding securities and transfer agent tices Act, Federal Election Campaign Act, activities, where applicable. Bank Bribery Act, and Foreign Assets Con- 6. To determine if the branch has complied trol Regulation, and to determine the effec- with reporting requirements regarding Trans- tiveness of such procedures to ensure com- fer Agent, Municipal Securities Dealer, and pliance and detect violations. Government Securities Broker/Dealer activi- 2. To determine if the branch has made ties, where applicable. improper or illegal payments in violation of 7. To determine if the branch has complied the Foreign Corrupt Practices Act, Federal with the SEC’s lost and stolen securities Election Campaign Act, Bank Bribery Act, reporting and inquiry requirements, if or the Foreign Assets Control Regulation, applicable. and, regardless of legality, to determine 8. To determine if branch ofﬁcers and other whether they constitute an unsafe and personnel are operating in conformance with unsound banking practice. established branch guidelines. 3. To determine if the branch is in compliance with the requirements of Regulation K and 9. To determine the extent and severity of Regulation D, where applicable. violations noted, if any. 4. To determine if the branch has policies and 10. To recommend corrective action when poli- procedures covering applicable require- cies, practices, procedures, or internal con- ments of the Bank Secrecy Act, and deter- trols are deﬁcient. mine the effectiveness of such procedures to 11. To ensure that prompt corrective action is ensure compliance and detect violations. taken with respect to all violations noted.

Branch and Agency Examination Manual September 1997 Page 1 Other Compliance Matters Examination Procedures Effective date July 1997 Section 5070.3

1. Determine whether the branch has a policy 5. Analyze the general level of internal con- or policies prohibiting improper or illegal trols to determine whether there is sufficient payments, bribes, kickbacks, or loans cov- protection against improper or illegal pay- ered by applicable provisions of the Foreign ments being irregularly recorded on the Corrupt Practices Act, Federal Election organization’s books. Campaign Act, Bank Bribery Act, or For- 6. Examiners should be alert, in the course of eign Assets Control Regulation. Also, deter- their usual examination procedures, for any mine whether the branch has a policy transactions or the use of organization ser- addressing the requirements of the Bank vices or equipment, which might indicate a Secrecy Act. violation of the statutes. 2. Determine whether the policy(s), if any, has 7. Determine whether the branch is in compli- been effectively communicated to officers, ance with Regulation K by reviewing the employees, or agents of the organization to activities and investments in which the ensure compliance. branch engages. 3. Review any investigation or study per- 8. For the responsible Federal Reserve Bank, formed by or on behalf of the head office determine whether the FBO is in compli- that evaluates policy or operations associ- ance with Section 211.28 of Regulation K. ated with the payment of funds and finan- 9. Consult with the examiner assigned ‘‘Review cial recordkeeping requirements for pos- of Regulatory Reports’’ to determine if any sible violation of the statutes mentioned instances of noncompliance with Regula- above. tion D have occurred. 4. Review and analyze any internal or external audit program employed by the branch to 10. Review the procedures in effect regarding determine whether the internal and external the filing of Form X-17F-1A (Missing, auditors have established appropriate rou- Lost, Stolen, or Counterfeit Securities tines to identify improper or illegal pay- Report). ments under the statutes. In connection with 11. Review the procedures in effect regarding the evaluation of the adequacy of any audit compliance with the inquiry requirements program, the examiner should: under Lost and Stolen Securities Reporting a. Determine whether the auditor is aware and Inquiry Requirements (17CFR 240.17 of the provisions of the Foreign Corrupt F-1). Practices Act, Federal Election Cam- 12. Review manual or automated OFAC accounts paign Act, Bank Bribery Act, and For- and wire transfer screening systems. Ensure eign Assets Control Regulation, and that periodic OFAC updates are incorpo- whether audit programs are in place that rated into the monitoring system in a timely check for compliance with these laws. manner. b. Review such programs and the results of any audits.

Branch and Agency Examination Manual September 1997 Page 1 Other Compliance Matters Internal Control Questionnaire Effective date July 1997 Section 5070.4

FOREIGN CORRUPT PRACTICES ried, not hourly paid, employees who have ACT policy making, managerial, professional, or supervisory responsibilities), employees of 1. Has the branch adopted written policies that the branch or family members of such prohibit the offering or payment of improper persons? or illegal payments, bribes, kickbacks, or 10. If an allowable contribution is made, did the loans to or from foreign government offi- branch properly record the transaction with- cials, officials of a foreign government out trying to conceal the activity? instrumentality, a foreign political party or official thereof, a candidate for foreign political office, or to a person that the BANK BRIBERY ACT branch employee believes will give such money to those foreign officials? 11. Has the branch adopted a code of conduct or 2. Has this policy been communicated to all written policy that prohibits branch officials branch employees? from: 3. If an allowable payment is made, did the a. Soliciting for themselves or a third party branch properly record the transaction with- anything of value from anyone in return out trying to conceal the activity? for any business, service, or confidential 4. Does the allowable payment consist only of information of the branch or the FBO, as a payment made to expedite or secure the applicable? performance of a routine governmental b. Accepting anything of value from any- action by a foreign official, foreign political one, whose intent is to corruptly influ- party, or foreign party official? ence or reward the branch official in connection with branch business, either before or after a transaction is discussed FEDERAL ELECTION CAMPAIGN or consummated? ACT 12. Does the code or policy describe prohibited conduct, including conflicts of interest? Does 5. Has the branch adopted written policies that it describe appropriate exceptions, includ- prohibit it from making contributions or ing a range of internally acceptable dollar expenditures in connection with any elec- amounts for the various benefits that the tion to any political office or to any primary branch official may receive from those doing election, political convention, or caucus or seeking to do business with the branch? held to select candidates for political office? 13. Does the branch have its employees sign a Does the policy also prohibit political con- written acknowledgment of having received tributions made by providing equipment a copy of this code or policy? Is an acknowl- and services without charge to candidates edgment signed each time there are changes for office? to the code or policy? 6. Has this policy been communicated to all 14. When a branch official is offered or given a branch employees? gift by a customer, does the branch official 7. The statute allows the branch to establish a prepare a disclosure statement describing separate segregated fund for political pur- such incident? poses by a corporation, labor organization, 15. Does management regularly review the dis- membership organization, cooperative, or closure(s) to ascertain if it is reasonable? corporation without capital stock. If the branch has established such a fund, were contributions requested and obtained from FOREIGN ASSETS CONTROL employees on a strictly voluntary basis? REGULATION 8. Are such solicitations only made a maximum of twice a year? 16. Does the branch have a written procedure 9. Are such solicitations only made to execu- for monitoring compliance with the tive or administrative personnel (i.e., sala- regulation?

Branch and Agency Examination Manual September 1997 Page 1 5070.4 Other Compliance Matters: Internal Control Questionnaire

17. Does the branch have a policy that addresses according to Regulation D? If so, have transacting business with countries against adequate reserves been maintained? (Refer which sanctions have been imposed by the to the Review of Regulatory Reports ICQ) U.S.? 28. Review the branch’s system for compliance 18. Does the branch refuse to transact business with the reporting and inquiry requirements with those countries or specially designated of the lost and stolen securities provisions nationals so listed by the statute? of 17 CFR 240.17f-1. 19. Does the branch report all blockings to the a. Has the branch registered as a direct or Office of Foreign Assets Control (OFAC) indirect inquirer with the Securities within ten days of occurrence? Information Center, Inc.? 20. If the branch does conduct a transaction b. Are reports submitted within one busi- with a national from an economically sanc- ness day of discovery when: tioned country, did the customer obtain a • Theft or loss of a security is believed license from OFAC allowing it to undertake to have occurred through criminal such transaction? activity? 21. Does the branch’s system for monitoring • A security has been missing or lost for compliance with the statute include a con- two business days, except in certain tinuing review of its customer country lists cases? and customer names to ensure that it is not • A security is counterfeit? dealing with customers from sanctioned c. Are reports submitted by the branch, as a countries or designated nationals? delivering institution, within two busi- 22. Are OFAC updates incorporated into the ness days of notification of nonreceipt monitoring system in a timely manner? when: 23. Do customer files contain sufficient docu- • Delivery is made in person and no mentation that show the foreign citizenship receipt is maintained by the branch? or residency of the customer? • Delivery of securities is made by mail 24. Are private banking officers or other branch or via draft and payment is not received personnel who solicit loans or open deposit within 10 business days and confirma- accounts cognizant of prohibited countries tion of nondelivery has been made by under the regulation? the receiving institution? • Securities are lost in transit and the certificate number(s) can be REGULATION K determined? d. Are reports submitted by the branch, as a 25. Are the activities in which the branch receiving institution, within one business engages permissible under Regulation K? day of discovery and notification of the 26. Does the branch monitor the total loans and certificate number(s) when: extensions of credit extended to each single • Securities are delivered through a clear- borrower? ing agency and the delivering institu- a. Is this information given to the branch’s tion has supplied the certificate num- U.S. regional headquarters of head office bers within the required two business for determination of compliance with days after request? section 211.28 of Regulation K? • Securities are delivered over the win- b. If this is an examination of the U.S. dow and the delivering institution has regional headquarters of the FBO, is the a receipt and supplies the certificate organization in compliance with section number(s) within the required two busi- 211.28 of Regulation K? ness days after request? c. If the branch reports directly to the head e. Are securities that are considered to be office, is documentation sufficient to sup- lost or missing as a result of counts or port compliance with section 211.28 of verifications reported no later than ten Regulation K? business days after discovery or as soon after as the certificate number(s) can be REGULATION D ascertained? 29. Are copies of those reports submitted to the 27. Is the branch required to maintain reserves registered transfer agent for the issue and

September 1997 Branch and Agency Examination Manual Page 2 Other Compliance Matters: Internal Control Questionnaire 5070.4

the Federal Bureau of Investigation, in the 33. Are copies of Form X-17F-1A and subse- case of suspected criminal activity? quent confirmations and other information 30. Are all recoveries of securities reported received maintained for three years in an within one business day of recovery or easily accessible location? finding? (Note: Only the institution that initially reported the security as missing can make a recovery report.) 31. Are inquiries made when the branch takes in any security that is not: CONCLUSION a. Received directly from the issuer or 34. Is the information covered by this ICQ issuing agent at issuance? adequate for evaluating internal controls in b. Received from another reporting institu- this area? If not, indicate any additional tion or Federal Reserve Bank in its examination procedures deemed necessary. capacity as fiscal agent? c. Received from a branch customer and is 35. Based on the information gathered, evaluate registered in the name of the customer or the internal controls in this area (i.e. strong, its nominee? satisfactory, fair, marginal, unsatisfactory). 32. Are all reports made on Form X-17F-1A or facsimile?

Branch and Agency Examination Manual September 1997 Page 3 Asset Quality Introduction Effective date July 1997 Section 6000.1

Although a branch relies on the financial and standby letters of credit, and loan commitments. managerial support of the FBO as a whole, the The assessment will take into consideration evaluation of asset quality in a branch is impor- (1) the level, distribution, and severity of expo- tant in assessing the effectiveness of credit and sure classified for credit and transfer risk, spe- transfer risk management1 and in the event of a cially mentioned, or listed as Other Transfer possible liquidation of a branch. Risk Problems, and (2) the level and composi- In evaluating asset quality, the examiner will tion of nonperforming and reduced rate assets. assess the branch’s assets and off-balance sheet If the FBO is in less than satisfactory condi- exposure as of the examination date. These tion and the branch is in a net due from affiliate would include, but not be limited to: place- position, the asset quality rating may be nega- ments, investments, loans, bankers acceptances, tively affected. Additional procedures for evaluating assets and off- balance sheet exposure can be found in 1. While credit and transfer risk are identified as part of the the Risk Management section of this manual. evaluation of asset quality, the effectiveness of the branch’s credit and transfer risk management are evaluated under risk This section of the manual discusses the classi- management. fication of assets and off-balance sheet exposure.

Branch and Agency Examination Manual September 1997 Page 1 Asset Quality Classiﬁcations Effective date July 1997 Section 6010.1

According to the methodology established by ASSESSMENT OF CREDIT their respective state or federal agency, examin- QUALITY ers will select a sample of assets and off-balance sheet exposures (contingencies) to review in The evaluation of each extension of credit should order to evaluate the credit risk exposure to the be based upon the fundamental characteristics branch. The credit review includes analyzing affecting the timely collectibility of that particu- individual credits and documenting the findings, lar credit, including at a minimum: discussing the findings with branch management, and assigning asset quality ratings to each • The original source of repayment and the bor- credit based on the examiner’s best judgment rower’s continuing ability to utilize that source; concerning the degree of risk inherent in the • The purpose of the credit relative to its source of repayment; credits and the likelihood of an orderly repayment. The credit review also allows for the • The underwriting of the credit relative to its purpose, terms and structure; evaluation of the branch’s internal risk rating/ grading process. • The overall financial condition and resources of the borrower, including the current and This section discusses criteria used to assign stabilized cash flow, debt service capacity, and asset quality ratings to extensions of credit that future prospects; exhibit potential problems or well-defined weak- • The credit history of the borrower; and, nesses. These criteria are primarily based upon • The types of secondary and tertiary sources of the degree of risk and likelihood of orderly repayment available, such as guarantor sup- repayment. Extensions of credit that exhibit port and the collateral’s value and cash flow. potential weaknesses are categorized as special (The undue reliance on secondary sources of mention, while those that exhibit well-defined repayment should be questioned, and the weaknesses and a distinct possibility of loss are branch’s policy about permitting such a prac- categorized as classified. The term classified is tice should be reviewed.) subdivided into more specific subcategories ranging from least to most severe: substandard, The longer the borrower has the branch’s doubtful, and loss. The weighted classified assets funds or a contractual right to obtain funds, the and contingencies ratio represents weighted greater the risk of some adverse development in classifications as a percentage of total claims the borrower’s ability to repay the funds. Con- on nonrelated parties plus classified contingen- fidence in the borrower’s repayment ability is cies, and is the standard measure of the overall usually based upon past financial performance asset quality (‘‘A’’ ROCA component) of the and projections of future performance. Failure to branch. meet projections is a credit weakness but does In reviewing asset quality, examiners identify not necessarily mean the asset should be criti- the amount and severity of credit and transfer cized or classified. On the other hand, the risk exposures at the branch. This section dis- inability to generate sufficient cash flow to ser- cusses credit risk and provides guidelines for the vice the debt is a well-defined weakness that jeopardizes the repayment of the debt and, in classification of the FBO’s loan portfolio and most cases, merits classification. The extent and credit substitutes. The more severe classifica- nature of a shortfall in the operating figures, the tion, whether due to transfer risk or credit risk, support afforded by assigned collateral, and/or takes precedence over the less severe classifica- that provided by cosigners, endorsers, or guar- tion. For additional guidelines on the classifica- antors, should influence the severity of the tion of due from banks, placements, securities, classification. other real estate owned and other assets, see those sections of this manual. For guidelines on transfer risk classification refer to the Transfer Risk section of this manual. The following Specially Mentioned Category section provides guidelines for the classification of the FBO’s loan portfolio and credit A specially mentioned extension of credit has substitutes. potential weaknesses that deserve manage-

Branch and Agency Examination Manual September 1997 Page 1 6010.1 Asset Quality Classifications ment’s close attention. If left uncorrected, these collectibility of one portion of the credit than potential weaknesses may result in deterioration another. of the repayment prospects for the credit or in Extensions of credit that exhibit well-defined the branch’s credit position at some future date. credit weaknesses may warrant classification Specially mentioned credits are not adversely based on the description of the following three classified and do not expose a branch to suffi- classification categories: cient risk to warrant adverse classification. How- ever, because specially mentioned credits can be Substandard—A substandard credit is inad- indicative of emerging credit problems, exam- equately protected by the current sound worth iners are to consider the level and trend of these and paying capacity of the obligor or of the credits in their analysis of the branch’s assets collateral pledged, if any. Credits so classified and off-balance-sheet items. must have a well-defined weakness or weak- Extensions of credit that might be detailed in nesses that jeopardize the repayment of the debt. this category include those where: They are characterized by the distinct possibility that the branch will sustain some loss if the • Lending officers may be unable to properly deficiencies are not corrected. Loss potential, supervise the credit because of an inadequate while existing in the aggregate amount of sub- loan or credit agreement; standard credits, does not have to exist in • Questions exist regarding the condition of individual credits classified substandard. and/or control over collateral; • Economic or market conditions may unfavor- Doubtful—A credit classified doubtful has all ably affect the obligor in the future; the weaknesses inherent in one classified sub- • Obligor’s operations may show a declining standard with the added characteristic that the trend or an imbalanced position in the balance weaknesses make collection or repayment in sheet, but not to the point that repayment is full, on the basis of currently existing facts, jeopardized; or conditions, and values, highly questionable and • Deviations from other prudent lending prac- improbable. The possibility of loss is extremely tices are present. high but because of certain important and reasonably specific pending factors, which may The Special Mention category is not to be work to the advantage and strengthening of the used to identify a credit that has as its sole credit, its classification as an estimated loss is weakness credit data or documentation excep- deferred until its more exact status may be tions that are not material to the repayment of determined. Pending factors include proposed the asset. It is also inappropriate to use this merger, acquisition, or liquidation procedures; category to list credits that bear risks usually capital injection; perfecting liens on additional associated with a particular type of financing. collateral; and refinancing plans. Any type of credit, regardless of collateral, Examiners should avoid classifying an entire financial stability, and responsibility of the credit doubtful when collection of a specific obligor, involves certain risks. For example, a portion seems highly probable. An example of loan secured by accounts receivable has a cer- proper utilization of the doubtful category is the tain risk, but the risk must have increased case of a company being liquidated, where the beyond that which existed at origination to trustee-in-bankruptcy has indicated a minimum categorize the credit as special mention. A rapid disbursement of 40 percent and a maximum of increase in receivables for reasons that are 65 percent to unsecured creditors, including the unknown to the branch, concentrations that lack branch. In that situation, estimates are based on proper credit support, lack of on-site audits, or liquidation value appraisals, with asset values other similar matters could lead the examiner to yet to be realized. By definition, the only portion question the quality of the receivables and of the credit that is doubtful is the 25 percent possibly special mention the loan. difference between 40 and 65 percent. A proper When classifying a credit, it may not be classification of such a credit would show 40 per- appropriate to list the entire amount under one cent substandard, 25 percent doubtful and 35 per- credit quality category. This situation is com- cent loss. monly referred to as a ‘‘split classification’’ and Examiners should avoid repeating a doubtful may be appropriate in certain instances, espe- classification at subsequent examinations. The cially when there is more certainty regarding the time between examinations should be sufficient

September 1997 Branch and Agency Examination Manual Page 2 Asset Quality Classifications 6010.1 to resolve pending factors. That is not to say that ate when well-defined weaknesses continue to situations do not occur to necessitate continua- be present in the remaining recorded balance. In tion of the doubtful classification. However, the such cases, the remaining recorded balance examiner should avoid undue continuation if would generally be classified no more severely repeatedly, over the course of time, pending than substandard. events do not occur and repayment is again A more severe classification than substandard deferred awaiting new developments. for the remaining recorded balance would be appropriate if the loss exposure cannot be rea- Loss—Assets classified loss are considered sonably determined, e.g., where significant risk uncollectible and of such little value that their exposures are perceived, such as might be the continuance as bankable assets is not warranted. case for bankruptcy situations or for loans col- This classification does not mean that the asset lateralized by properties subject to environmen- has absolutely no recovery or salvage value but tal hazards. In addition, classification of the rather it is not practical or desirable to defer remaining recorded balance would be appropri- writing off this basically worthless asset even ate when sources of repayment are considered though partial recovery may be effected in the unreliable. future. Writing off a loss asset or the portion of an asset identified as loss ensures that the value of the branch’s assets are properly reflected on its Report of Assets and Liabilities. A loss asset Formally Restructured Loans should not remain on the branch’s books while it attempts a long-term recovery. Rather, losses For a formally restructured loan, the focus of the should be taken in the period in which they examiner’s analysis is on the ability of the surface as being uncollectible. borrower to repay the loan in accordance with its modified terms. Classification of a formally Branch management should maintain a record restructured loan would be appropriate, if, after of all loss assets or the portion of assets identi- the restructuring, well-defined weaknesses exist fied as loss that have been written off for that jeopardize the orderly repayment of the loan regulatory reporting purposes or for which a in accordance with reasonable modified terms. specific reserve has been established. Branch The classification treatment previously dis- records should also demonstrate that these loss cussed for a partially charged-off loan also assets have been fully reported to the head would generally be appropriate for a formally office. For further information on the treatment restructured loan, when partial charge-offs have of loss assets, examiners should refer to their been taken. Troubled loans, whose terms have respective agency’s policy. been restructured, should be identified in the branch’s internal credit review system and closely monitored by management. Risk man- Partially Charged-Off Loans agement of the branch should not be criticized for continuing to carry loans having weaknesses that result in classification as long as the man- Based upon consideration of all relevant factors, agement has a well-conceived and effective an evaluation may indicate that a credit has workout plan for such borrowers and effective well-defined weaknesses that jeopardize collec- internal controls to manage the level of these tion in full but that a portion of the loan may be loans. This principle holds for individual credits, reasonably certain of collection. When an insti- even if portions or segments of the industry to tution has taken a charge-off or a specific which the borrower belongs are experiencing reserve in an amount that is sufficient, so that the financial difficulties. remaining recorded balance of the loan (a) is being serviced (based upon reliable sources) and (b) is reasonably certain of collection, classification of the remaining recorded balance may The Role of Guarantees not be appropriate. For example, when the remaining recorded balance of an asset is secured The original source of repayment and the bor- by readily marketable collateral, the portion that rower’s intent and ability to fulfill the obligation is secured by this collateral would generally not without reliance on third party guarantors will be classified. Classification would be appropri- be the primary basis for the review and classi-

Branch and Agency Examination Manual September 1997 Page 3 6010.1 Asset Quality Classiﬁcations

fication of assets. However, examiners may also have other significant investments in the project, consider the support provided by guarantees. whose other sound projects are cross- The presence of a guarantee from a ‘‘financially collateralized or otherwise intertwined with the responsible guarantor’’ may be sufficient to credit, or whose guarantee is collateralized by preclude or reduce the severity of classification. readily marketable assets that are under the For purposes of this discussion, a guarantee control of a third party. from a ‘‘financially responsible guarantor’’ has In general, only guarantees that are legally the following attributes: enforceable will be relied upon. However, all legally enforceable guarantees may not be • The guarantor must have both the financial acceptable. In addition to the guarantor’s finan- capacity and willingness to provide support cial capacity and willingness to perform, it is for the credit; expected that the guarantee will not be subject to • The nature of the guarantee is such that it can significant delays in collection or undue com- provide support for repayment of the indebt- plexities or uncertainties about the guarantee. edness, in whole or in part, during the remain- The nature of the guarantee is also considered ing loan term; and, by examiners. For example, some guarantees for • The guarantee is legally enforceable. real estate projects only pertain to the development and construction phases of the project. As These attributes are discussed in more depth such, these limited guarantees would not be below. relied upon to support a troubled loan after the completion of those phases. Financial Capacity of Guarantor—The branch Examiners should also consider the branch’s must have sufficient information concerning the intent to enforce the guarantee and whether guarantor’s financial condition, income, liquid- there are valid reasons to preclude it from ity, cash flow, contingent liabilities, and other pursuing the guarantee. A history of timely relevant factors (including credit ratings, when enforcement and successful collection of the full available) to demonstrate the guarantor’s finan- amount of guarantees will be a positive consid- cial capacity to fulfill the obligation. In addition, eration in the classification process. it is important to consider the number and Guarantees issued by the head office of the amount of guarantees currently extended by a branch for credits on the books of the branch guarantor in order to determine that the guaran- lend no additional support to credits. The branch tor has the financial capacity to fulfill all of the and its head office are one legal entity. Guaran- contingent claims that exist. tees from affiliates of the foreign banking organization may offer some additional support if the Guarantor’s Willingness to Repay—Examiners affiliate is a separate legal entity. However, normally rely on the analysis of the guarantor’s adequate financial information must be available financial strength and assume a willingness to to support financial capacity. Nevertheless, such perform unless there is evidence to the contrary. affiliate guarantees do not stand entirely alone Examiners give due consideration to those guar- and do not offer the kind of support similar to antors that have demonstrated their ability and that of a third party guarantee. willingness to fulfill previous obligations in their evaluation of current guarantees on similar facilities. An important consideration will be whether previously required performance under Off-Balance-Sheet Items guarantees was voluntary or the result of legal or other actions by the lender to enforce the guar- The principal off-balance-sheet credit transac- antee. Examiners do not give credence to guar- tions likely to be encountered during loan antees from obligors who have reneged on reviews are standby letters of credit (SBLCs), obligations in the past, unless there is clear and loan commitments. When evaluating off- evidence that the guarantor has the ability and balance-sheet credit transactions for potential intent to honor the specific guarantee obligation classification or special mention, careful consid- under review. Examiners also consider the eco- eration should be given as to whether the branch nomic incentives for performance from guaran- is irrevocably committed to advance additional tors. This includes guarantors who have already funds under the credit agreement. If the branch partially performed under the guarantee, who must continue to fund the commitment and a

September 1997 Branch and Agency Examination Manual Page 4 Asset Quality Classifications 6010.1 potential weakness exists that if left uncorrected Guidelines for Special Mention and may at some future date result in the deteriora- Classified Credit Comments tion of repayment prospects or the branch’s credit position, the amount of the commitment An examiner must present, in written form, may be categorized as special mention. If there well-supported comments relating to assets and is a well-defined weakness that jeopardizes contingencies subject to classification or special repayment of a commitment, classification may mention. Write-ups are mandatory when branch be warranted. management disagrees with the examiner’s For credit analysis purposes, SBLCs should assessment. Examiners should consult with their be treated as if they were loans to the account respective agency for guidance on when other parties. They are considered one type of instru- write-ups are required. A thorough understand- ment that a customer can use under the overall ing of all factors surrounding the credit is credit line that has been extended by the branch. required, so that only those germane to the In most cases, particularly with respect to credit credit’s collectibility are included. When por- enhancement-type SBLCs, the examiner will tions of the line are assigned different classifi- classify the SBLC if it is determined that the cations or are not classified, the comments account party will need to draw on the SBLC. In should clearly set forth the reason for such split such cases, the account party, having been treatment. financially unable to meet its underlying commitment, probably may not be able to reimburse Before a write-up is prepared, the examiner the branch for making payment on the SBLC. should recheck central liability files or other The same holds true for commitments to issue sources at the branch to determine that all SBLCs. If the branch has an unrevocable com- credits to the borrower have been noted and mitment to issue a SBLC and it is determined included. Consideration should be given to the that the account party will need to draw on the classification of accrued interest receivable. Clas- SBLC, examiners will classify the commitment. sification is suggested when the cumulative In the case of loan commitments, credit risk effect on classified percentages is significant or stems from the possibility that the creditworthi- the accrued interest is appropriately classified ness of the customer will deteriorate between loss. (See the Credit Risk Management section the time the commitment is made and the funds of this manual for a discussion of nonaccrual are advanced. status and the reversal of accrued interest for Refer to the Off-Balance Sheet-Activities and loans when nonaccrual status is appropriate). Letters of Credit sections of this manual for additional information on off-balance-sheet items.

Branch and Agency Examination Manual September 1997 Page 5 Transfer Risk Effective date July 1997 Section 6020.1

When financial institutions engage in interna- The criteria for these transfer risk categories tional lending, they undertake customary credit are as follows: risk, or the possibility of nonpayment due to an obligor’s weak financial condition or a lack of adequate collateral protection. International lend- Substandard ing also leads to country risk, which encompasses the entire spectrum of risks arising from Either, the country is not complying with its the economic, political, and social trends and external service obligations as evidenced by movements in a foreign borrower’s home arrearages, forced restructuring, or rollovers and, country. the country is not in the process of adopting an International lenders, in particular, bear the IMF or other suitable economic adjustment risk that a foreign borrower will be unable to program or is not adequately adhering to such a convert its local currency income into the cur- program; or the country and its bank creditors rency needed to repay the loan (i.e., transfer have not negotiated a viable rescheduling and risk). Transfer risk therefore, focuses on a bor- are unlikely to do so in the near future. rower’s capacity to obtain the foreign exchange required to service its cross-border debt. Because branches are typically oriented toward financing international trade and business, transfer risk Value Impaired can be a significant consideration in evaluating a The country has protracted arrearages as indi- branch, more so than at other types of financial cated by more than one of the following: institutions. Irrespective of its significance, the criteria and guidelines for evaluating transfer • The country has not fully paid its interest for risk exposures at branches are similar to those at six months; other U.S. financial institutions. • The country has not complied with IMF programs (and there is no immediate prospect for compliance); • The country has not met rescheduling terms TRANSFER RISK CRITERIA for over one year; and • The country shows no definite prospects for In 1979, the federal regulatory agencies adopted an orderly restoration of debt service in the uniform examination procedures for evaluating near future. and commenting on country risk factors resulting from international lending by banks in the United States. Under this system, examiners segregate country risk factors from the evalua- Loss tion of other lending risks. In December 1983, the federal banking agencies, through the Inter- A loss classification applies when the credit is agency Country Exposure Review Committee considered uncollectible and of such little value (ICERC), further adopted examination catego- that its continuance as a bankable asset is not ries for identifying credits that have been warranted. An example of such an asset is a loan adversely affected by transfer risk problems. to a country that has made an outright statement These categories include classified credits, i.e., repudiating obligations to banks, the IMF, or Substandard, Value Impaired, and Loss; Other other lenders. Transfer Risk Problems (OTRP); and Exposures Warranting Special Comment (EWSC). The examination of transfer risk entails identifying Other Transfer Risk Problems (OTRP) and reporting transfer risk credits according to these categories. To maintain uniformity of The OTRP designation is used to highlight all or examination approach, examiners are not free to a portion of those credits to: deviate from these guidelines or assign transfer risk designations other than as specified by • A country that is not complying with its ICERC. external debt service obligations but is taking

Branch and Agency Examination Manual September 1997 Page 1 6020.1 Transfer Risk

positive steps to restore debt service through So called pre-export financing transactions economic adjustment measures, generally as require close review as they may in fact be part of an IMF program; working capital advances. There must be a • A country that is meeting debt obligations but connection between the branch’s financing and noncompliance seems imminent; or the import or export of goods (self-liquidating • A country that has been classified previously, transactions) to be considered as a trade but recent debt service performance indicates transaction. classification is no longer warranted. How- ever, sustained resumption of orderly debt Performing bank generally includes all exten- service needs to be demonstrated. sions of credit to banks which are current.

Short-term loans generally have a maturity of Exposures Warranting Special one year or less. Comment Long-term loans exceed one year in tenor. EWSC categorizations are Strong, Moderately Strong, and Weak. A Strong country does not In assessing exposure by country, adjustments experience social, economic, or political prob- to determine net exposure are made for guaran- lems that could interrupt external debt repay- tees and collateral. Risk is transferred from the ment. Moderately Strong countries experience a country of borrower’s domicile to the country limited number of identifiable economic, social, the guarantor or collateral resides or is held. or political problems that do not presently threaten orderly external debt repayment. A Guarantees consist of those claims of the report- Weak country experiences many economic, ing institution to which a third party or affiliate social, or political problems. If not reversed, formally and legally obligates itself to repay the these problems could threaten orderly external reporting institution’s claims on the direct obli- debt repayment. gor if the latter fails to do so. Documents such as comfort letters, letters of awareness, or letters of intent that do not establish firm legal obligations are not considered guarantees for the purpose of Other Definitions transferring country risk. Guarantees cover the collateralization of claims if the collateral or the The ICERC committee generally accords a more guarantors’ source of funds is both (1) tangible favorable examination treatment to performing and liquid including readily marketable shares trade credits and performing bank credits. In this of stocks or bonds and (2) is held and realizable context, performing generally means that the outside of the country of the domicile of the credit is paying down in accordance with the borrower. In cases involving collateral, the existing terms of the indebtedness. domocile of the guaranteeing party is the country in which the collateral is held, unless the Trade transactions generally include the short- collateral is stocks or bonds in which case it is term financing of the importation or exportation the country of domicile of the party issuing the of goods/services between parties in two security. countries.

September 1997 Branch and Agency Examination Manual Page 2 Transfer Risk Examination Objectives Effective date July 1997 Section 6020.2

1. To evaluate the branch’s country exposure 5. To determine the effect of total transfer risk risk management system. To determine if the classifications and OTRP listings on overall branch’s policies, practices, procedures and asset quality. internal controls regarding the management 6. To determine the accuracy of the branch’s of transfer risk are adequate. transfer risk exposure reporting to senior 2. To determine if the branch is operating in branch and head office management. conformance with established guidelines. 7. To determine if the branch is properly pre- 3. To recommend corrective action when poli- paring the Country Exposure Report (FFIEC cies, practices, procedures, or internal con- 019), which is required to be filed quarterly trols are deficient or when violations of law with its district Reserve Bank. or regulation have been noted. 4. To evaluate the branch’s portfolio in order to determine the appropriate ICERC treatment ranging from loss to strong.

Branch and Agency Examination Manual September 1997 Page 1 Transfer Risk Examination Procedures Effective date July 1997 Section 6020.3

In reviewing asset quality, examiners identify ity claims on countries, which are treated as the amount and severity of transfer risk expo- Value Impaired, Substandard, or OTRP, should sures at the branch. Examiners should begin this be reviewed on a case-by-case basis. Because review by first evaluating all transfer risk credits the likelihood of funding even legally-binding for credit risk. The more severe classification, agreements is greatly diminished, the exposure whether due to transfer risk or credit risk, takes is listed but not classified. As a result, except precedence over the less severe classification. If when determined with reasonable certainty that the classifications are the same, the credit risk an indirect exposure will require funding, these designation takes precedence over the transfer items generally will be treated as OTRP. How- risk designation. Duplications should be avoided. ever, for those countries considered Loss for In some instances, particularly where addi- transfer risk purposes, performing bank and tional collateral has been pledged, the focus of performing trade credits should be classified as the risk may change and the transfer risk clas- Substandard. sifications may not be appropriate. Classifica- tions may also differ based on the type of exposure, e.g., performing bank and trade cred- PLACEMENT AND DISCUSSION its are generally less severely categorized than IN THE EXAMINATION REPORT short- and/or long-term loans. Information concerning the relative grouping In the examination report, transfer risk expo- and classification of countries and appropriate sures are reported and discussed separately from comments prepared by ICERC is furnished to commercial credit risk exposures. For this pur- examiners as required in the examination propose, separate report pages, i.e., Transfer Risk cess. In turn, examiners should discuss with and Items Subject to Classification and Items branch management only those ICERC designa- Listed for Special Mention, have been created tions for which the branch has actual exposure for credits subject to classification or comment. on its books. Because this information is sensi- The Transfer Risk page should contain a listing, tive in nature, adequate safeguards should be by country, of exposures subject to classification taken to ensure that it is not accessible to as a result of transfer risk considerations and of unauthorized personnel. In no event should the exposures listed as OTRP.2 For each country, complete listing of ICERC designations be examiners should provide commentary on each divulged. exposure classified for transfer risk or listed as As mentioned earlier, transfer risk categoriza- OTRP. The examiner’s commentary should be tions should be strictly followed; examiners may followed by the supporting write-ups prepared not deviate from the transfer risk assessments as by ICERC on each country. designated by ICERC. For exposures to coun- After identifying the amount and severity of 1 tries that are not reviewed by ICERC, examin- transfer risk exposure(s) at the branch, this ers should evaluate the exposures from a credit information is summarized on the Comparative risk standpoint only. In no instance should the Asset Quality Data examination report page examiner assign transfer risk assessments for (along with any credit risk classifications) and countries not rated by ICERC or use the prior discussed on the Asset Quality page. In those rating of a country before it was dropped from review by ICERC.

CONTINGENT LIABILITIES 2. While not subject to classification, significant OTRP In view of the variance in risk of different exposures should be considered by examiners as a judgmental factor in their general assessment of a branch’s asset quality. off-balance-sheet instruments, contingent liabil- This approach is similar to the consideration given to such factors as concentrations in the portfolio, including, for example, the level and composition of nonaccruing or reduced rate 1. Countries are selected for review by ICERC based on assets and concentrations to countries rated as EWSC. In this the amount of total exposure outstanding to U.S. financial regard, exposures categorized as EWSC, if material, can be institutions. mentioned in the report or listed on the Concentrations page.

Branch and Agency Examination Manual September 1997 Page 1 6020.3 Transfer Risk: Examination Procedures instances where the branch has other exposures tion. In those instances where branch and head of concern, which warrant special attention by office management rely on the data generated branch and head office management, comments for the Country Exposure Report and reporting in this respect should be included on the Asset exceptions are noted, comments should be Quality page. As discussed in the ROCA rating incorporated on the Operational Controls page. system, any comments relating to how the branch manages its transfer risk exposure should be discussed on the Risk Management page. RESERVING REQUIREMENTS Comments along these lines may relate to the effectiveness of the branch’s country exposure The regulations requiring banking institutions to reporting systems. Transfer risk classifications establish special reserves, i.e., an allocated trans- of any significance should be highlighted on the fer risk reserve or ATRR, against the risks Examination Conclusions and Comments page. presented in certain international assets3 are not applicable to branches of FBOs (Regulation K, Section 211.42). However, branches are expected CONCENTRATIONS to have policies in place for recognizing loss assets or writing down assets that are considered Certain U.S. branches may engage heavily in uncollectible and of such little value that their financing international business and trade from continuance as bankable assets is not warranted. their home countries or geographic regions. As In many instances, these policies stem from measured in terms of their total net assets, these home country regulations that are in place for branches may thus have significant concentra- the FBO as a whole. tions to those countries or regions, which should Separately, examiners should evaluate the be listed on the Concentrations page. However, amount of transfer risk inherent in a branch’s the degree to which these exposures pose any assets in the same manner as for other banking risk to the branch itself, and thus are commented institutions. If applicable, for assets that are on in the report of examination, is dependent classified Value Impaired, any amount on the upon a number of considerations, such as the books above the required ATRR percentage is overall composition of the branch’s portfolio; weighted at 100 percent; the residual amount is the branch’s business plan; the effectiveness of weighted at the same percentage as assets clas- the branch’s risk management techniques, includ- sified Substandard, or 20 percent. ing its country risk reporting systems; and the strength-of-support assessment of the foreign banking organization. Whether or not concen- COUNTRY EXPOSURE RISK trations are worthy of comment, examiners should ensure that all such exposures are within MANAGEMENT SYSTEM the branch’s internal policy limits and are monitored and periodically reported to the head As part of its overall risk management tech- office. niques, branch management should have in place a country exposure risk management system, which has been developed, in conjunction with, and approved by head office management. COUNTRY EXPOSURE REPORT Examiners should evaluate the effectiveness of (FFIEC 019) the system to monitor and control the branch’s country exposure by verifying adherence to Examiners are encouraged to review the Instruc- country suballocation limits and accurate report- tions for Preparing the Country Exposure Report. ing of country exposures submitted on the FFIEC Examiners are not expected to review the Coun- 019. The evaluation should include a review of try Exposure Reports filed between examina- the exposures for at least several countries. tions for accuracy; however, examiners should Material exceptions may be subject to comment conduct a spot check of the most recent report to on the Risk Management page in the report of verify that the reports are being prepared accu- examination. rately. Material reporting errors uncovered during the examination should initially be noted on the Compliance page in the report of examina- 3. Those assets included on the FFIEC 019.

September 1997 Branch and Agency Examination Manual Page 2 Transfer Risk: Examination Procedures 6020.3

The following procedures should be used by 4. Determine whether the branch is in compli- examiners in evaluating systems employed by ance with its country exposure limits. branches to monitor and control country risk elements in international loan portfolios: In preparing the risk management analysis examiners should consider factors such as: 1. Review the branch’s written policies covering transfer risk and the name, composition, • The quality of policies, practices, procedures and location of the committee responsible for and controls over the country exposure man- administration of transfer risk. agement area. 2. Review policies and: • The scope and adequacy of the internal loan a. Determine who initiates and who gives review system as it pertains to country final approval of country ratings and coun- exposure. try limits. • Causes of existing problems, if any. b. Determine how frequently, and by whom, • Commitments from branch management for country ratings and limits are reviewed correction of deficiencies. and changed. • Expectations for continued sound interna- c. Determine how the bank defines the rat- tional lending or correction of existing ings assigned to the various countries. deficiencies. d. Ascertain how country limits are determined. • The ability of branch management to monitor e. Determine who is responsible for moni- and control transfer risk. toring compliance with country limits. • The general level of adherence to internal f. Determine to what extent country limits policies, practices, procedures and controls. are viewed as guidelines which may be • The scope and adequacy of the branch’s exceeded. analysis of country conditions if the branch g. Determine if the branch has different sub- has responsibility for it. limits for private and public sector credits. h. Determine if the head office or a committee periodically reviews country ratings and limits, and evaluates the branch’s LDC DEBT performance against those standards. i. Determine how the system has been The crisis in the 1980s surrounding third world changed since the previous examination. debt spawned a trading market for Less Devel- 3. Review reports furnished to the head office oped Country (LDC) debt. The examiner may or appropriate committee to assure that com- refer to the Federal Reserve’s Trading Activities prehensive and accurate information is being Manual for further guidance concerning the submitted on a timely basis. review of LDC debt trading.

Branch and Agency Examination Manual September 1997 Page 3 Transfer Risk Internal Control Questionnaire Effective date July 1997 Section 6020.4

1. Has the head office adopted policies and 4. Prior to granting additional advances or com- limits for all non-U.S. on- and off-balance- mitments, are outstandings checked to appro- sheet exposure that: priate country limits? a. Establish country exposure limits for all 5. Are lending officers cognizant of specific activities? country limitations? b. Establish limits for distribution of assets 6. Are procedures for exceeding country limits and off-balance sheet exposure by type clearly defined? and maturity? 7. Does the scope of the branch’s asset quality c. Acknowledge concentrations of exposure review ensure that international risk assets within countries? outstanding and committed are within the 2. Are policies and limits reviewed at least branch’s foreign exposure limits? annually to determine if they are compatible 8. Does the branch have a formal reporting with changing market conditions? system on country risk? 3. Are country limits revised in response to 9. Does the reporting system provide complete substantive changes in economic, politi- risk exposure data readily and in sufficient cal, and social conditions within particular detail? countries?

Branch and Agency Examination Manual September 1997 Page 1 Federal Deposit Insurance—Uninsured and Insured Branches Effective date July 1997 Section 7010.1

The International Banking Act (IBA) of 1978 deposits that the appropriate state licensing amended the Federal Deposit Insurance Act and authority has determined, by regulation or order, allowed the U.S. branches of foreign banks to do not constitute engaging in domestic retail apply for deposit insurance. Part 346 of the deposit activities requiring deposit insurance FDIC’s Rules and Regulations and Section 28.8 protection. State licensing authorities may have of the Comptroller’s Regulations implement the similar requirements and exceptions as Part statute. Deposit insurance remained voluntary 346.4 of the FDIC’s Rules and Regulations. for branches engaged solely in wholesale bank- However, examiners must determine that a ing, but a branch with a domestic retail banking branch engaging in some retail deposit activity activity had to obtain deposit insurance. Domes- conforms to the exemptions allowed under local tic retail banking was defined as the acceptance State law. of initial deposits under $100,000. Exemptions Part 346.4 of the FDIC’s Rules and Regula- were permitted to allow branches conducting tions states that a foreign bank may not operate a incidental retail banking to avoid having to U.S. branch if the branch is uninsured and is obtain deposit insurance. In addition, a foreign engaged in domestic retail deposit activity bank could insure one or more of its U.S. (accepting an initial deposit of less than branches, but elect not to insure others. Edge $100,000), and is located in a state that requires Act and Agreement Corporations and U.S. agen- banks to have deposit insurance. Two excep- cies of foreign banks could not obtain coverage. tions are permitted : (1) Part 346.5 permits The Federal Deposit Insurance Corporation branches established under Section 5 of the Improvement Act of 1991 (FDICIA) amended International Banking Act to accept only those the IBA to disallow a de novo U.S. branch of a deposits as permitted to an Edge Act Corpora- foreign bank from obtaining deposit insurance if tion under Section 25(a) of the Federal Reserve it is engaged in retail banking activity. Already Act, and (2) Part 346.6 permits branches to existing insured branches were permitted to engage in certain retail deposit activities that do retain their FDIC insurance. A foreign bank not trigger a requirement for deposit insurance. seeking to engage in retail banking activities in Uninsured branches may accept initial deposits the United States is now expected to establish an of less than $100,000 from the following type of insured subsidiary bank. depositors or resultant activity: This chapter has two goals: • Any for-profit business entity; • To aid examiners at uninsured branches in • Any domestic or foreign government entity or determining that a branch is operating solely agency; as a wholesale bank or, if some retail deposits • Any international organization of two or more are being accepted, that the office is operating nations; within permissible exceptions. • Any funds received for transmission else- • To aid examiners at insured branches in where; and, determining that the branch is meeting record- • Any nonresident alien at the time of the initial keeping, pledge, and asset maintenance deposit. requirements. In addition, the branch is permitted to accept Because the requirements for uninsured other deposits under a de minimis rule. The total branches differ from those for insured branches, of such deposits shall not exceed 5 percent of the overview, examination objectives, and the average of the branch’s deposits from unre- examination procedures will be described lated third parties for the last 30 days of the most separately. recent calendar quarter. Moreover, the branch may not solicit or advertise for deposits from the general public. For state-licensed branches, the state licensing authority may have different de UNINSURED BRANCHES minimis rules and additional disclosure requirements. In the case of state-licensed branches, the branch A foreign bank may apply to the FDIC to is subject to restrictions on the acceptance of operate a branch that engages in domestic retail

Branch and Agency Examination Manual September 1997 Page 1 7010.1 Federal Deposit Insurance—Uninsured and Insured Branches deposit activity not otherwise included above. the FDIC must pay the branch’s insured deposi- An uninsured branch operating under Part 346.6 tors. The size of the pledge is normally five exemptions must notify depositors that it is an percent of the branch’s average liabilities for the uninsured office. Conversely, an uninsured last 30 days of the second and fourth calendar branch that is not operating under Part 346.6 quarters. The pledged assets must be placed at a exceptions need not notify depositors that their depository approved by the FDIC. deposits are uninsured. Where required, notifi- Part 346.19(d) describes the eight types of cation must include signs at teller windows and assets that may be pledged. At the end of the other locations where deposits are accepted second and fourth quarters, both the depository stating that deposits are not insured by the and the insured branch must file reports with the FDIC. Also, each signature card, passbook, and regional FDIC office listing and describing in instrument evidencing a deposit must include a detail the assets pledged. In addition, the insured bold face statement as follows: ‘‘This deposit is branch must report the average of the branch’s not insured by the FDIC.’’ These acknowledg- liabilities for the last thirty days of the respec- ments must be retained by the branch as long as tive quarter; the average is used to determine the the depositor maintains any deposit at the branch. size of the pledge requirement. The branch may Since 1989, the requirements for acknowledg- substitute one pledged asset for another between ments and their retention have included nego- reporting dates. Such substitutions normally do tiable certificates of deposit. not have to be reported to the FDIC, but must be of the type allowed by Part 346.19(d).

INSURED BRANCHES Asset Maintenance Insured branches have specific FDIC asset maintenance and asset pledge requirements that are Asset maintenance is the method used by the apart from any other asset maintenance, pledge, FDIC to ensure that foreign bank resources are or capital requirements of the federal or state retained in the branch. Part 346.20 of the FDIC’s licensing authorities. In addition, the FDIC Rules and Regulations sets forth the required requires the insured branch or group of insured amount of asset maintenance and the assets branches in a state to keep records and sets of eligible for inclusion in the asset maintenance accounts in the English language that accurately computation. reflect the business transactions of the branch on An insured branch normally must have eli- a daily basis. These records must be kept as gible assets in an amount not less than 106% of though the branch were a separate entity with its the preceding quarter’s average liabilities. assets and liabilities separate from the opera- Branches are permitted flexibility in that they tions of the head office and other branches, may compute the ratio either on a daily basis or agencies, subsidiaries, or affiliates of the foreign the Wednesday of each week. In some instances bank. The FDIC’s requirements are intended to the branch may be required to maintain the protect the insurance fund from losses in the 106% ratio on a daily basis. In other instances, event the branch must be liquidated and, as the percentage requirement may be higher. such, it is important that examination staff, The effectiveness of the asset maintenance regardless of agency, pay close attention to the requirement depends on limiting eligible assets insured branch’s compliance with these require- to those that meet minimum quality standards ments. For additional information, refer to the and are free from impediments to collectibility in Asset Maintenance section of this manual. the event the FDIC needs to take possession of the assets. Part 346.20(b) lists six classes of assets that are excluded from use as eligible Pledge of Assets assets:

Part 346.19 of the FDIC’s Rules and Regula- • Any asset due from the bank’s other offices or tions implements the pledged assets require- affiliates; ments for insured branches. The intent of the • Any asset classified Value Impaired, to the pledge requirement is to have highly marketable extent of the required Allocated Transfer Risk assets available to protect the fund in the event Reserves or equivalent write down, or Loss in

September 1997 Branch and Agency Examination Manual Page 2 Federal Deposit Insurance—Uninsured and Insured Branches 7010.1

the most recent state or federal examination • Any asset not in the branch’s actual posses- report; sion unless the branch holds title to such asset • Any deposit of the branch with a bank, unless and the branch maintains records sufficient to the bank has signed a waiver of offset enable independent verification of the branch’s agreement; ownership of the asset as determined at the • Any asset not supported by sufficient credit most recent state or federal examination; and, information to allow a review of the asset’s • Any intangible asset. credit quality as determined at the most recent state or federal examination;

Branch and Agency Examination Manual September 1997 Page 3 Federal Deposit Insurance—Uninsured and Insured Branches Examination Objectives Effective date July 1997 Section 7010.2

UNINSURED BRANCHES INSURED BRANCHES

1. To determine if policies, practices, proce- 6. To determine if policies, practices, procedures, and internal controls regarding noti- dures, and internal controls regarding asset fication procedures for uninsured branches pledge requirements and asset maintenance are adequate. requirements are adequate. 2. To determine if branch employees are 7. To determine if branch employees are operating in conformance with the estab- operating in conformance with established lished guidelines. guidelines. 3. To determine the scope and adequacy of the 8. To determine the scope and adequacy of the audit function. audit function. 4. To determine compliance with Part 346 and 9. To determine compliance with applicable any applicable state laws. laws and regulations. 5. To recommend corrective action when poli- 10. To recommend corrective action when policies, practices, procedures, or internal con- cies, practices, procedures, or internal controls are deficient or when violations of trols are deficient or when violations of applicable laws or regulations have been applicable laws or regulations have been noted. noted.

Branch and Agency Examination Manual September 1997 Page 1 Federal Deposit Insurance—Uninsured and Insured Branches Examination Procedures Effective date July 1997 Section 7010.3

UNINSURED BRANCHES applicable regulations. Obtain a list of any deficiencies noted in the latest review per- 1. Determine the adequacy of the internal audit formed by the internal auditors and deter- procedures used to check compliance with mine if corrections have been accomplished. Parts 346.4, 346.5, 346.6, and 346.7, and 7. Ascertain the adequacy of the branch’s pro- with any applicable state laws. cedures that ensure that: 2. Review audit procedures used to check com- a. The semiannual reports of pledged assets pliance with Part 346 and with any applicable made to the FDIC’s regional directors are state laws. Obtain a list of any deficiencies prepared correctly, including the amount noted in the latest review performed by the representing average liabilities for the 30 internal auditors, and determine if correc- calendar days of the second and fourth tions have been made. quarters per Part 346.19 of the FDIC’s 3. For a branch operating without Part 346.6 Rules and Regulations. exemptions, determine the adequacy of the b. The branch is maintaining on a daily basis branch’s procedures that ensure that it has no eligible assets in an amount not less than domestic retail deposit activity. Review 106% of the preceding quarter’s average deposit ledgers to ascertain that the branch book value of the branch’s liabilities per has not been engaging in domestic retail Part 346.20. deposit activity. c. The branch is pledging additional assets 4. Determine the adequacy of the branch’s pro- complying with higher asset maintenance cedures that ensure that a branch engaging in requirements or more frequent calcula- some retail deposit activity is conforming to tions of the asset maintenance ratio where the exemptions allowed in Part 346.6 and in directed by the FDIC. state law. In this case, verify that: a. The branch is confining its retail deposit d. The computations of eligible assets exclude activity to the six permitted exemptions. those assets listed in Part 346.20(b). All b. The branch is displaying conspicuously banks holding deposits of the branch have signs at windows or places where deposits signed waiver of offset agreements. are accepted that deposits are not insured e. The calculation of average book value of by the FDIC. the branch’s liabilities does not exclude c. The branch’s signature cards, passbooks, liabilities to less than wholly owned sub- and other instruments evidencing a deposit sidiaries of the foreign bank which are not have in bold face the following statement: wholly owned. ‘‘This deposit is not insured by the FDIC.’’ f. The branch’s workpapers adequately sup- d. The branch requires each depositor to port the calculations of eligible assets and execute a statement that acknowledges average book value of the branch’s that the initial and all future deposits are liabilities. not insured by the FDIC (if the branch is not using notification statements on its Insured branches are also subject to the signature cards, passbooks, and other requirements of Section 38 of the Federal instruments evidencing deposits). Deposit Insurance Act and Part 325 of the FDIC 5. Where required notification statements are Rules and Regulations, which require the branch not made in signature cards, passbooks, and to undertake prompt corrective action where it other instruments evidencing deposits, ascer- has failed to maintain required pledged assets tain that depositor acknowledgments are and eligible assets pursuant to Part 346. obtained showing that deposits are uninsured.

INSURED BRANCHES

6. Determine the adequacy of the internal audit procedures used to check compliance with

Branch and Agency Examination Manual September 1997 Page 1 Subsequent Events, Litigation, and Other Legal Matters Effective date July 1997 Section 7020.1

SUBSEQUENT EVENTS direct knowledge and often control of branch management. Accordingly, management is the As a practical matter, the examination is con- primary source of information about such mat- ducted and the report of examination is prepared ters. Examiners ordinarily do not possess legal as of a stated date. However, events or transac- skills and, therefore, should not make legal tions sometimes occur subsequent to the date of judgments on such information. The examiner examination (or the on-site date as of which should ask the branch’s management for infor- various examination procedures were performed) mation concerning litigation, claims, and assess- but before the date the report of examination is ments. If necessary, management may send a mailed that may have a significant effect on the letter of inquiry to its general counsel and to evaluation of a branch. Such events and trans- other counsel engaged to address more limited actions are referred to as subsequent events and matters. may be of two types. Information provided by management should One type includes those events or transactions include information about litigation, impending that provide additional evidence about condi- litigation, claims, and contingent liabilities. For tions that existed at the examination date. the purpose of these requests, the terms, impend- Examples of this type are the bankruptcy of a ing litigation, and contingent liabilities have the significant borrower or the resolution of out- following meanings: standing litigation. The second type includes those events that Impending litigation—litigation threatened provide evidence about conditions that did not against the branch by a third party but not exist at the date of examination. Examples of formally commenced. that type of event would be new litigation arising subsequent to the examination date but Contingent liabilities—matters other than litiga- before mailing the examination report or a tion or claims for which available information merger agreement signed subsequent to the indicates a reasonable possibility of impairing examination date. assets or increasing liabilities. Contingent liabili- All information that could materially affect the ties should include unasserted claims or assess- evaluation of the branch and becomes available ments. before mailing of the report of examination should be considered by the examiner in his or Information provided by management should her evaluation of the branch. Accordingly, all be as of the examination date and, if applicable, events or transactions that either significantly as of the date of counsel’s response. Any affect or have the potential to significantly affect responses provided by counsel should be as the evaluation of the branch should be reflected close to the completion of the examination as in the report of examination, regardless of practicable to allow sufficient time for a thor- whether they occurred before or subsequent to ough response and any follow-up, if necessary. the examination date.

LITIGATION AND OTHER LEGAL MATTERS

Events or conditions arising from litigation, claims, and assessments are matters within the

Branch and Agency Examination Manual September 1997 Page 1 Subsequent Events, Litigation, and Other Legal Matters Examination Objectives Effective date July 1997 Section 7020.2

1. To determine whether any events or transac- 2. To determine the effect of legal counsel’s tions have occurred subsequent to the exami- evaluation of litigation, impending litigation, nation date that have had or may have a claims, and contingent liabilities on the signiﬁcant impact on the present or future examiner’s overall conclusion regarding the soundness of the branch or the conclusions soundness of the branch. expressed in the report of examination.

Branch and Agency Examination Manual September 1997 Page 1 Subsequent Events, Litigation, and Other Legal Matters Examination Procedures Effective date July 1997 Section 7020.3

1. Obtain from the branch officer responsible c. Changes in senior officers. for legal matters a listing of impending or d. Any event or combination of events that threatened litigation, including follow-up have had or could have a material adverse information on litigation pending at the pre- effect on the branch, such as the default of vious examination. For each item, the follow- a bond issue in which the branch has ing information should be included: substantial holdings or the filing of bank- a. Nature of the litigation. ruptcy by a major borrower. b. Progress of case to date. e. New or discontinued services not requir- c. How management is responding or intends ing prior approval. to respond to the litigation. f. Execution of significant contracts, such as d. An evaluation of the likelihood of an for employment, leases, pensions, or other unfavorable outcome and an estimate, if fringe benefit programs. one can be made, of the amount or range g. Significant new contingent liabilities or of potential loss, and whether any reserves commitments other than those referred to have been established for any potential above. loss exposure. h. Significant changes in assets such as a 2. Obtain from the branch officer responsible shift in the amount of loans or investments for legal matters a listing of unasserted claims in special categories or unusual adjust- or assessments that management believes ments made after the date of the financial will probably be asserted and which, if statements reviewed at the examination. asserted, would have at least a reasonable possibility of an unfavorable outcome. For 6. Read minutes of all meetings of appropriate each item, the following information should committees (investment, loans, etc.) and be included: a. Verify with branch management whether a. Nature of the matter. minutes of all such meetings subsequent b. How management intends to respond if to the examination date are available for the claim is asserted. review. c. Possible exposure if the claim is asserted. b. For any meetings for which minutes have 3. Obtain from management, a listing of attor- not yet been prepared, contact appropriate neys and legal firms to whom litigation and branch personnel about what transpired at related matters have been referred. In addi- the meetings. tion, review a listing of any litigation noted 7. If specific violations of law or areas of in the most recent internal and external weakness have been reported to management audits, if applicable. earlier in the examination, determine the 4. Evaluate management’s listing of litigation, extent to which management has proceeded unasserted claims and assessments, and coun- toward corrective action. sel’s replies, if applicable, for the potential 8. If, after completing the foregoing proce- effect on the branch. dures, information is obtained that is deemed 5. Discuss with appropriate branch manage- to have a significant impact on the evaluation ment, the following: of the branch, discuss with the examiner-in- a. Changes in credit lines or transactions charge to determine appropriate follow-up with officers, related offices, and affiliates. procedures, including the preparation of com- b. Changes in significant accounting and ments for the examination report and work- management reporting policies. paper documentation.

Branch and Agency Examination Manual September 1997 Page 1 Survey of Foreign Regulation in Selected States Effective date July 1997 Section 7030.1

The following table prepared by the Conference and agencies in those states. It is intended to of State Bank Supervisors provides statutory serve as a preliminary reference only; speciﬁc and regulatory citations for selected states on a questions should be directed to the appropriate number of issues that may arise in connection state banking authority or qualiﬁed legal counsel. with examinations of state-licensed branches

Branch and Agency Examination Manual September 1997 Page 1 001Sre fFrinRglto nSlce States Selected in Regulation Foreign of Survey 7030.1 ae2 Page 1997 September CA CT FL GA IL NY TX WA

Other Real FCS 1 750(c) 2 No speciﬁc Subsection Section 7-1- 205 ILCS N/A. TBA 4 Section RCW 7 Estate Owned statue or 658.67(9) 263 OCGA 5/5(9), Rule 9.002, 5.002 30.42.160(3) regulation. (Title 38/ and 5.203; 7 Chapter II/Part TAC 5 12.91; 354) PM 6 1008

Debts FCS 750(b) No speciﬁc See above. 7-1-650(9) Rule (Title N/A. TBA Section RCW Previously and 1234 statue or regu- OCGA 38/Chapter 9.002 30.42.155(G) Contracted lation. II/Part 554)

Real Estate No state C.G.S. Section Section 655.60 No speciﬁc No state regu- N/A. TBA Section RCW 30.42.105 Appraisals regulations. 36a-261 FS & Rule 3C- state law; lations. 9.002; 7 TAC 100.600 FDIC Pt 323 is 12.91 used by the state.

Internal and No state No speciﬁc Subsection 7-1-487 OCGA N/A. N/A. Part 5 N/A. Not required by External Audits regulations. statue or regu- 663.09(2) FS; pending. statute or lation. Rule 3C- regulation. 15.012 FAC

rnhadAec xmnto Manual Examination Agency and Branch Bank Secrecy Penal Code C.G.S. Part Section 655.50 7-1-911; 7-1- No state No State N/A. Federal regula- & Money Sections XXIII of Chap- FS; Rule 3C- 912; 7-1-914; regulations. regulations. tions apply for Laundering ¶14160– ter 952 15.012 FAC; 7-1-915; 7-1- branch/agency. ¶14167 Rule 3C-1.022 916 OCGA FAC

Branch/Agency FCS 1700- C.G.S. Section Sections 7-1-713; 7-1- 205 ILCS SP 9 FB 101; TBA Section RCW Licensing 1711, 1725, 36a-428a 663.04 FS; 914; 7-1-915; 645/3- 205 BL 3 Section 9.003, 9.004, 30.42.060; Procedures 1726, 1750- 663.05 FS; 7-1-916 OCGA ILCS 645/9 201 9.005 and 30.42.090 and 1753; CCRS 8 663.55 FS; 9.007; 7 TAC WAC 10 50-32 10.11700– Chapter 3C-9 3.41 10.14188 FAC

Notes appear at the end of these tables. uvyo oeg euaini eetdSae 7030.1 States Selected in Regulation Foreign of Survey rnhadAec xmnto Manual Examination Agency and Branch CA CT FL GA IL NY TX WA

Branch/Agency FCS 1729, C.G.S. Section Sections 7-1-720 OCGA 205 ILCS BL Sections TBA Section RCW 30.42.300 Closing or 1763, 1775– 36a-428j, 36a- 663.11 FS; 645/19 40; 206; 605 9.009, 9.010 Termination 1785 428k, 36a- 663.06 FS; (11); 606 (4) and 9.001 Procedures 145(f) and Part 658.80–658.84 VIII of Chapter FS; 658.90 FS; 664c 658.94–658.96 FS; Rule 3C- 15.016 FAC

International No state No speciﬁc Section 7-1-721 and 7- 35 ILCS GRBB 11 N/A. Permitted under Banking regulations. statue or 655.071 FS; 1-732 OCGA 5/30(2) Part 19 FRB regula- Facilities regulation. Rule 3C- tions. 15.011 FAC; Chapter 3C-17 FAC

Deposit Taking FCS 1700(e), C.G.S. Section Section 7-1-716(e) 205 ILCS BL Section TBA 9.012 RCW 30.42.115 1700(n), 36a-428b 663.011 FS; OCGA 645/3 202-a; SR 12 (branch only). 1700(s), Rule 3C Part 323 1700(u), 1728, 15.003 FAC 1755, 1758, CCRS 10.14750– 10.15627

Legal Lending FCS 12211 C.G.S. Section Sections 7-1-718(b) and No limits 13 BL Sections TBA Section RCW Limits 36a-262 663.083 FS; 7-1-285 OCGA 103; 202-f 9.002 and 30.42.105, 658.48, 658.67, 5.203 30.04.111 658.49, 658.491, etme 1997 September 658.51 FS, Rule 3C- 15.003 FAC ae3 Page Notes appear at the end of these tables. 001Sre fFrinRglto nSlce States Selected in Regulation Foreign of Survey 7030.1 ae4 Page 1997 September CA CT FL GA IL NY TX WA

Permissible FCS 1220– C.G.S. Section Sections 7-1-718 OCGA 205 ILCS BL Sections TBA Section RCW 30.42.105 Lending 1239 36a-260, 36a- 663.06; 645/3 96 15; 103; 9.012 (Branch); RCW Activities 261, 36a-265 663.061, 202-f 30.42.180 and 36-266 663.64 FS; (Agency) Rule 3C- 15.003 FAC

Ineligible Assets See next item. Promulgation Subsections No state 205 ILCS SR Part 322 N/A. RCW of regulations 663.07(5) regulation. 645/13 30.42.120(2) in progress. & (6)

Asset FCS 1761 & C.G.S. Section Section 663.07 No state 205 ILCS BL Section N/A. RCW 30.42.120 Maintenance 1762; CCRS 36a-428c and FS; Rule 3C- regulation. 645/13 202-b; GRBB 10.16000– promulgation 15.006 FAC Part 52; SR 10.16226 of regulations Part 322 in progress.

Capital See previous See previous Section 663.07 7-1-718(b) See previous BL Section N/A. RCW 30.42.070 Equivalency item. item. FS; Rules 3C- OCGA item. 202-b; GRBB Deposits 15.006, 3C- Part 51; SR 140.007 FAC Part 322 rnhadAec xmnto Manual Examination Agency and Branch Credit Files FCS 1706; C.G.S. Section N/A. Required to be 205 ILCS GRBB 7 TAC 3.42 WAC 50-32- CCRS 36a-428h available and 645/13 Part 52 14 070 (Branch); 10.14725– in English. WAC 50-32- 10.14730 080 (Agency); RCW 30.42.200

Other Items 7-1-719 OCGA 1. Representa- 1. Representa- 1. Representa- Reports; 7-1- tive Office/ tive Office/ tive Office/ 710, 7-1-711 Licensing Pro- Licensing Pro- Licensing Pro- cedures: 205 cedures: SP FB cedures: TBA ILCS 650/4. 102. Section 9.006; 2. Authoriza- 2. Authoriza- 7 TAC 3.44 tion for Fidu- tion for Fidu- ciary Powers: ciary Powers 205 ILCS for branches/ 645/3. agencies: BL Section 201-b, SP FB 103.

Footnotes appear at the end of the table. uvyo oeg euaini eetdSae 7030.1 States Selected in Regulation Foreign of Survey rnhadAec xmnto Manual Examination Agency and Branch CA CT FL GA IL NY TX WA

Other Items 3. Registered 3. Permission Continued Agent: 205 to change ILCS 645/9. name of the banking institution: SB FB 104; BL Sec- tion 203. 4. Permission to change branch/ agency’s general manager or representative: SP FB 105.

1. Financial Code Section(s). 11. General Regulation of the Banking Board. 2. Applicable only in a Depository Agency or Branch Office. 12. Superintendent’s Regulations. 3. Banking Law. 13. No legal lending limits for foreign banking offices under Illinois law. 4. The Texas Banking Act. Section 14 of the Foreign Banking Office Act (205 ILCS 645/14) 5. Title 7, Texas Administrative Code. states, however, that the portion of loans to any one obligor in excess 6. Policy Memorandum. of 10 percent of eligible assets is considered ineligible and not included 7. Revised Code of Washington (state law). in the numerator of the asset maintenance ratio. 8. California Code of Regulations Section(s). 14. Maintenance of the evidence of indebtedness. 9. Supervisory Policies. 15. Section 96 is applicable to branches and agencies only, pursuant to 10. Washington Administrative Code (state rulings and regulations). banking department policy. etme 1997 September ae5 Page 7030.1 Survey of Foreign Regulation in Selected States

CONNECTICUT branch or agency are subject to the same restrictions and limitations applicable to a state char- Other Real Estate Owned—No speciﬁc statute or tered bank. Therefore, the legal lending limits of regulation. Section 36a-262 apply to foreign banks. Under Section 36a-428d, limitations based on the capi- Debts Previously Contracted—No speciﬁc statute tal stock or surplus of a state chartered bank are or regulation. deemed to refer to the dollar equivalent of the capital and surplus of the foreign bank. Real Estate Appraisals—Section 36a-261 sets forth the real estate appraisal requirements appli- Permissible Lending Activities—Section 36a- cable to state chartered banks which also apply 428b gives state branches and state agencies the to state branches and agencies of foreign banks. same lending authority as state chartered banks.

Internal and External Audits—No special statute Ineligible Assets—Regulations in progress. or regulation. Asset Maintenance—Section 36a-428c requires Bank Secrecy and Anti-Money Laundering—No a foreign bank with a state branch or state special statute or regulation concerning bank agency to hold assets in the state in an amount secrecy. Part XXIII of Chapter 952 of the prescribed by regulation. The promulgation of Connecticut General Statutes makes money laun- regulations addressing this is currently in dry an offense under the penal code. progress. Branch/Agency Licensing Procedures—Section 36a-428a sets forth the requirements for appli- Capital Equivalency Deposits—Section 36a- cation for a license and the factors that the 428c requires a foreign bank with a state branch Banking Commissioner must consider before or state agency to keep assets on deposit in this issuing a license. state in accordance with regulations. The promulgation of regulations addressing this is cur- Branch/Agency Closing or Termination rently in progress. Procedures—Section 36a-428j addresses revocation, suspension or failure to renew a license Credit Files—Section 36a-428h requires a for- as well as revocation of a license due to volun- eign bank to maintain or make available at its tary surrender, or dissolution of the foreign bank state branch, state agency or representative office or other termination or cancellation of its exist- appropriate books, accounts and records relating ence or authority. Section 36a-428k delineates to or reflecting transactions effected by such the procedure for voluntary liquidation of the branch, agency or office. business and property of the state branches and state agencies. Section 36a-145(f) sets forth the notice requirements applicable to branch closings. Part VIII of Chapter 664c concerns failure, receiverships, conservatorships and other emer- FLORIDA gency actions. Other Real Estate Owned—Subsection 658.67(9), FS, allows banks to acquire property to protect a International Banking Facilities—No special loan or investment previously made in good statute or regulation. faith. Certain limitations/restrictions apply. Deposit Taking—Section 36a-428b provides that the operations of a foreign bank at a state branch Debts Previously Contracted—See above. or state agency shall be conducted with the same rights and privileges as a state chartered bank at Real Estate Appraisals—Section 655.60, FS, the same location and thus authorizes deposit grants the Department the power to require that taking. appraisals be made on loans made by financial institutions under certain conditions. Rule 3C- Legal Lending Limits—Under Section 36a- 100.600 contains appraisal standards and poli- 428b, the operations of a foreign bank at a state cies for state financial institutions.

September 1997 Branch and Agency Examination Manual Page 6 Survey of Foreign Regulation in Selected States 7030.1

Internal and External Audits—Subsection fication to the Department before an IBF can be 663.09(2), FS, requires that audits be performed established. Rule 3C-15.011, FAC, provides of all agencies. Rule 3C-15.012, FAC, contains administrative rules for IBFs in more detail. the Minimum Audit Procedures for agencies. Deposit Taking—Section 663.011, FS, limits the Bank Secrecy and Anti-Money Laundering— deposits that agencies may receive from custom- Section 655.50, FS, requires that financial insti- ers. Rule 3C-15.003, FAC, discusses permissible tutions maintain records of large currency trans- activities for agencies, including deposit taking. actions and submit currency transaction forms on those transactions. Rule 3C-15-012, FAC, Legal Lending Limits—Section 663.083, FS, discussed areas that must be checked during an discusses lending limits of agencies and branches, audit to ensure that an agency is complying with and states that Sections 658.48 (Loans) and anti-money laundering policies and procedures. 658.67 (Investments), FS, may be applicable to Rule 3C-1.022, FAC, contains requirements for branches and agencies in certain circumstances. filing currency transaction reports. Other possible areas of regulation in the statutes are Sections 658.49 (Loans not exceeding Branch/Agency Licensing Procedures—Section $50,000), 658.491 (Commercial loans by finan- 663.04, FS, discusses the requirements for car- cial institutions), and 658.51 (Commodity loans), rying on a banking business by an international FS. Rule 3C-15.003, FAC, discusses permissible banking corporation. Section 663.05, FS, dis- activities of international offices, including loans. cusses the procedures for applying for an international office. Section 663.55, FS, discusses Permissible Lending Activities—Section 663.06, capital requirements to establish international FS, discusses the inability to perform permis- offices. Chapter 3C-9, FAC, discusses time sible activities when a license is surrendered, frames for processing applications. revoked, or terminated. Section 663.061, FS, allows international agencies to engage in any Branch/Agency Closing or Termination loan or investment that could be made by Procedures—Section 663.11, FS, discusses the domestic banks. Section 663.64, FS, discusses dissolution of an international banking corpora- permissible activities of international branches. tion and the effect such action would have on the Rule 3C-15.003, FAC, discusses permissible state-licensed office. Section 663.06, FS, dis- activities of international offices, including loans. cusses the surrender or termination of a license to operate an international office in relation to Ineligible Assets—Subsections 663.07(5) and performing permissible activities. Section 658.80, (6) discuss ineligible assets. FS, discusses the appointment of a receiver or liquidator. Section 658.81, FS, discusses notice Asset Maintenance—Section 663.07, FS, dis- requirements and court confirmation of appoint- cusses asset maintenance. Rule 3C-15.006, FAC, ment of the receiver/liquidator. Section 658.82, discusses the reporting of asset maintenance FS, discusses the powers and duties of a receiver. data to the Department. Section 658.83, FS, discusses the powers and duties of a liquidator. Section 658.84, FS, dis- Capital Equivalency Deposits—Section 663.07, cusses transfers and other acts in contemplation FS, discusses capital equivalency requirements. of insolvency. Section 658.90, FS, discusses Rule 3C-15.006, FAC, discusses the reporting of receivers and liquidators under supervision of capital equivalency data to the Department. the Department. Section 658.94, FS, discusses Rule 3C-140.007, FAC, provides further clarifi- what constitutes prima facie evidence of insol- cation of asset maintenance and capital equiva- vency. Section 658.95, FS, discusses how a bank lency requirements. would start procedures to voluntarily liquidate itself. Section 658.96, FS, discusses the proce- Credit Files—N/A. dures in voluntary liquidation. Rule 3C-15.016, FAC, discusses the surrender of an agency’s license. ILLINOIS

International Banking Facilities—Section Other Real Estate Owned—A foreign banking 655.071, FS, deﬁnes an IBF and requires noti- ofﬁce may own other real estate in the collection

Branch and Agency Examination Manual September 1997 Page 7 7030.1 Survey of Foreign Regulation in Selected States of its debts but may not hold title for more than and had amended its tax law in 1981 to provide five years unless a request for extension is for state tax exemption of income generated submitted in writing and approved by the Com- from IBF accounts. (35 ILCS 5/30(2)). missioner. The maximum time period is ten years. 205 ILCS 5/5(9), Rule (Title 38/Chapter Deposit Taking—The Certificate of Authority II/Part 354). issued to a foreign bank pursuant to Illinois statute provides full banking powers (205 ILCS Debts Previously Contracted—A foreign bank- 645/3). The deposit powers are not utilized by ing office may maintain assets it acquires in the bank if an agreement between the bank and collection of debt. A rule has been adopted for the Federal Reserve is signed pursuant to the the administration of these assets. Rule (Title IBA 78, which limits the deposit taking to that 38/Chapter II/Part 354). defined in section 25(a) of the FRA.

Real Estate Appraisals—No statutes or rules Legal Lending Limits—There are no legal lend- govern real estate appraisals. ing limits for foreign banking offices under Illinois law. However, Section 14 of the Foreign Internal and External Audits—Although no stat- Banking Office Act (205 ILCS 645/101) states utes or rules are in place governing internal and that the portion of loans to any one obligor in external audits, examiners will recommend that excess of 10 percent of eligible assets is consid- an internal program be maintained by the bank. ered ineligible and should not be included in the This could include personnel located at the numerator of the asset maintenance ratio. branch or at a regional office. A particular situation could be present that warrants recom- Permissible Lending Activities—205 ILCS 645/3 mendation for an outside audit. state that a foreign banking office may conduct a general banking business with the same, but no Bank Secrecy and Anti-Money Laundering—No greater rights and privileges, as a state bank. statutes or rules govern bank secrecy and anti- money laundering. Ineligible Assets—Ineligible assets are those assets not included in the numerator of the asset Branch Licensing Procedures—Foreign banks maintenance ratio. This ratio, as described in are required to receive a Certificate of Authority Section 13 of the Foreign Banking Office Act to operate a foreign banking office (branch) in (205 ILCS 645/31), is required to be maintained the State of Illinois. A foreign bank may estab- at all times. The following is a list of ineligible lish and maintain banking offices in the State. assets, although it is not all inclusive: (Refer to The application requires information that is Monthly Report of Statutory Requirements specifically stated in the statutes. (205 ILCS instruction book for details.) 645/3 through 205 ILCS 645/19) Additionally, the bank must indicate whether Illinois will be • Amounts due from head office, branches, the ‘‘home state’’ pursuant to the IBA 78; if not, agencies, and wholly-owned subsidiaries. an agreement must be signed with the Federal • Fixed assets. Reserve restricting the types of deposits to be • That portion of loans to one borrower in received at the Illinois office. Applications may excess of 10 percent of eligible assets. be obtained by contacting the State of Illinois, • Loans classified Loss and the designated loss Office of Banks and Real Estate. portion of Doubtful accrual accounts. • Loans not supported by proper credit Branch Closing or Termination Procedures—A documentation. branch closing or termination is identified in the • Difference between book value and the lower statutes. (205 ILCS 645/19) A voluntary surren- of par or market value of securities (amount der of the Certificate of Authority should be could be added or subtracted from assets accompanied by an affidavit stating there are no depending on book value relationship to lower liabilities of any kind remaining at the Illinois of par or market). office. Asset Maintenance—Section 13 of the Foreign International Banking Facilities—Illinois recog- Banking Office Act (205 ILCS 645/13) describes nizes the International Banking Facilities (IBF) a relationship of certain assets to certain

September 1997 Branch and Agency Examination Manual Page 8 Survey of Foreign Regulation in Selected States 7030.1 liabilities that may be maintained by a foreign Bank Secrecy and Anti-Money Laundering— banking office. This figure is the asset mainte- Federal regulations apply for branch/agency. nance ratio: ineligible assets divided by liabilities requiring cover; it is to be set by the Branch/Agency Licensing Procedures— Commissioner. Currently, the ratios are imposed Application must be approved by the Supervisor when Supervisory concerns exist at local, of Banking after investigating the proposal for national or global levels. The ratio, when compliance with conditions delineated in statute required, needs to be maintained at all times and and applicant has met all conditions precedent to is monitored via the Monthly Report of Statu- establishing an office in the state. tory Requirements and the on-site examinations. Branch/Agency Closing or Termination Capital Equivalency Deposits—Pledged asset Procedures—The Supervisor may suspend or requirements may be imposed when Supervi- revoke the Certificate of Authority of an alien sory concerns exist. bank for issues relating to violations of laws and regulations, conducting business in an unautho- Credit Files—Credit files are to be maintained at rized manner, and unresponsiveness to the the branch for all loans booked. Loans not Supervisor’s orders or directives as well as if the supported by proper documentation may be bank is in an unsafe or unsound condition, the deemed ineligible by the examiner in determin- bank cannot with safety continue business, or ing the asset maintenance ratio. Refer to (205 the alien bank’s country is unjustifiably refusing ILCS 645/13), which states, in part, the Com- state banks to operate in the alien bank’s coun- missioner shall have the right to determine the try. The Supervisor may take possession of an value of assets ...for purposes of computing the alien office as provided by statute. ratio. International Banking Facilities—Permitted under federal regulations (FRB); applicant must notify the local Federal Reserve Bank. State WASHINGTON revenue laws allow IBFs.

Other Real Estate Owned—An alien bank may Deposit Taking Branch Only—Any branch of an hold and convey real estate acquired at sale alien bank that filed its application before July under judgements, decrees, liens, or mortgage 27, 1978, and has designated Washington as its foreclosures against securities held by it. There home state pursuant to the International Banking is a five-year holding limit as a bank asset unless Act (IBA) of 1978 shall have the power to solicit an extension of time is granted by the Supervisor. and accept deposits the same as a state-chartered commercial bank, except that acceptance of Debts Previously Contracted—In order to pre- initial deposits of less than $100,000 shall be vent loss on debts previously contracted, a limited to deposits delineated by statute. (The branch may acquire shares in a corporation same as provided by the IBA.) Deposits must be provided that such shares are disposed of within either insured by the FDIC or arrangements two years from acquisition date. made for capital maintenance in accordance with provisions of RCW 30.42.120. Real Estate Appraisals—A branch has the power to make loans the same as a state-chartered Legal Lending Limits—The base for computing commercial bank; therefore, a branch must com- the applicable loan limitation is the entire capital ply with applicable state and federal regulations. and surplus of the alien bank. The loan limit is An agency can be involved in making loans only the same as a state-chartered commercial bank, for the financing of the international movement or 20 percent of the capital surplus of the bank, of goods and services, for operational needs, and with certain exceptions. for the purchase of fixed assets. If secured by real estate, the implication is that they must Permissible Lending Activities—An approved comply with state and federal regulations. branch of an alien bank shall have the same power to make loans and guarantee obligations Internal and External Audits—Not required by as a state-chartered commercial bank. An statute or regulation. approved agency may engage in the business of

Branch and Agency Examination Manual September 1997 Page 9 7030.1 Survey of Foreign Regulation in Selected States making loans and guaranteeing obligations for Capital Equivalency Deposits—Capital allo- the financing of the international movement of cated shall be maintained within the state at all goods and services and for all operational needs, times in cash or in Supervisor-approved (1)inter- including working capital and short-term oper- est bearing bonds, notes, debentures, or other ating needs for the acquisition of fixed assets. obligations of the United States, agency, or instrumentality thereof, or guaranteed by the Ineligible Assets—Assets ineligible for asset United States or the state of Washington, or maintenance calculations include amounts due (2) other such assets as the Supervisor may from head office and any other branch, agency, approve. Such capital must be deposited with a or other office or wholly-owned subsidiary of bank whose principal place of business is lo- the bank, except those amounts due from such cated in this state. The capital equivalency offices or subsidiaries located within the United deposits are held under tripartite agreement and States and payable in U.S. dollars. are held for the sole benefit of U.S.-domiciled creditors of such alien bank’s Washington state Asset Maintenance Branch Only—100 percent office and is subject to the Supervisor’s order of aggregate liabilities of such alien bank must without offset for the payment of such creditors. be held and payable at or through its office in this state. The funds so held are to be currency, Credit Files—A branch must maintain loan bonds, notes, debentures, bills of exchange, or records and controls that include the organizing other evidences of indebtedness or other obliga- and maintenance of credit files incorporating tions payable in the United States or in U.S. loan comments, credit analysis, financials, etc. funds, or, with the approval of the Supervisor, in The same is applicable to an agency. RCW funds freely convertible in U.S. funds or such 30.42.200 requires the books and accounts of an other assets as are approved by the Supervisor. office to be in the English language. Interoffice due from accounts are excluded from the calculation, except amounts due from offices or subsidiaries located within the United States and payable in U.S. dollars.

September 1997 Branch and Agency Examination Manual Page 10 Subject Index Section 8000.1

A Clearing House Interbank Payments System (CHIPS), 4060 Abandoned property law, 3230 Clearings, 4040 Account documentation, 3430 Collateralized mortgage obligations (CMOs), Acknowledgements, 1000 3030 Advances against collections, 3080 Collection items, 4050 Agencies, 1010 Commercial letters of credit, 3300 Allowance for loan loss reserves, 3400 Commercial loans, 3050 Annual Examination Plan, 2002 Commercial real estate loans, 3030 Anti-boycott regulations, 3320 Commitment letter, 2040 Appraiser qualifications, 3100 Commodity loans, 3120 Assessment of FBO’s combined U.S. Compliance, 5000 operations, 2002, 3240 Compliance Rating, 2003 Asset and liability management committee, Concentrations of credit, 3010 3210 Consigned items, 4050 Asset maintenance, 2040, 3240, 5020 Consumer compliance regulations, 5070 Asset quality, 6000, 2003 Contingency funding, 3200 Asset securitization, 3030 Contingency plans, 4030 Asset sensitive, 3210 Contingent liabilities, 3300 Asset yields, 3400 Corporate Restructuring, 3060 Asset-backed security residuals, 3130 Country/transfer risk, 3000, 3010 Asset-backed securities, 3030 Coupon stripping, 3130 Asset-based lending, 3020 Covered calls, 3130 Audit guidelines, 1020 Credit balances, 3230 Authentication or verification methods, 4060 Credit card receivables, 3030 Auto loans, 3030 Credit cards, 3430 Available-for-sale securities, 3130 Credit enhancement, 3030 Credit quality, 3050 B Credit risk management, 3000, 3010, 3050 Customer safekeeping, 4050 Bank Bribery Act, 5070 Customers’ liability on acceptances, 3040 Bank Secrecy Act, 3430, 3230, 5070 Bankers’ acceptances, 3040, 3080 Bankruptcy law and commercial loans, 3050 D Bill paying services, 3430 Boat loans, 3030 Daylight overdrafts, 4060 Bond ratings, 3130 Deposit accounts, 3230, 3430 Borrowed Funds, 3220 Deposit development and retention program, Branches, 1010 3230 Bridge loans, 3060 Deposit sweep programs, 3230 Brokered deposits, 3230 Discounted trade acceptances, 3080 Dormant accounts, 3230, 3430 Doubtful credit classification, 6000 C Due from banks, 3070 Due from/Due to related offices, 3200, 3240 Capital equivalency deposit accounts, 5030 Duration analysis, 3210 Cash and cash items, 4040 Cash-collateralized loans, 3430 Cash flow, 3050 Cease and Desist Order, 2040 E Charge-offs, 3010 Electronic filing of regulatory reports, 5060 Charged-off loans, 6000 Electronic funds transfer activities, 4060 Check kiting, 3230 Emergency Preparedness, 4030 Civil money penalties, 2040, 5060 Employee deposit accounts, 3230 Classification of assets, 6000 Engagement Letters, 4010

Branch and Agency Examination Manual September 1997 Page 1 8000.1 Subject Index

Enhanced framework for supervising the U.S. Held-to-maturity securities, 3130 operations of FBOs, 2000 High-risk mortgage security, 3130 Environmental liability, 3090 Hold mail, 3430 Eurodollar deposits, 3070 Home country accounting practices, 2001 Examination objectives and procedures, 1020 Home country supervision, 2001, 4010 Examination Scheduling and Examination Home country financial system, 2001 Plans, 2002 Home country funding restrictions, 3200 Export–Import Bank of the United States, 3080 External audit, 4010 I ICERC, 6020 F Income and expense, 3400 Factoring, 3080 Ineligible assets, 5020 Federal agency securities, 3130 Information required to be made available to Federal Deposit Insurance, 7010 external auditors, 4010 Federal Elections Campaign Act, 5070 Interbank credit agreements, 3200 Federal Funds purchased, 3220 Interbank deposits and borrowings, 3220 Fedwire, 4060 Interest income, 3400 FDICIA, 5060 Interest rate risk management, 3210 Fiduciary activities, 3430 Internal audit, 4000, 4010 Financial Analysis, 3050 Internal control, 4000, 4020, 4060 Financial Profile of the Foreign Banking Internal control questionnaire, 1020 Organization, 2001 International Banking Facility, 3230, 5050 Financial Recordkeeping and Reporting Intracompany/Intercompany borrowing, 3220 Regulations, 3430, 5010 Investment advisory services, 3430 Financing foreign receivables, 3080 Investment securities, 3130 FIRREA, 5060, 3100 IOs and POs, 3130 First-day letter, 2010 Floating rate notes, 3130 Foreign Assets Control Regulation, 5070 K Foreign Banking Organizations, 1010, 2000 Foreign Corrupt Practices Act, 5070 Know Your Customer, 3430 Foreign Credit Insurance Association, 3080 Foreign currency deposits, 3230 Foreign exchange, 3300 L Forfaiting, 3080 Land development loans, 3110 Format and use of manual, 1020 Legal risk, 3000 FR Y7, 2001 Legal lending limits, 3010 Funding costs, 3200 Legal matters, 7020 Funding sources, 3200, 3240 Letters of credit, 3320, 3300 Funding strategies, 3230 Leveraged buyouts, 3060 Funds management, 3200, 3240 Liability sensitive, 3210 Futures and forward contracts, 3300 Lines of credit from correspondent banks, 3220 G Liquidity and liquidity risks, 3000, 3200 General information, 1010 Loan commitments, 3300 Generally Accepted Accounting Principles, Loan review, 3010 4010 Loan sampling, 2020 Generally Accepted Auditing Standards, 4010 Loan workouts, 3110 Guarantees, 3310, 6000 Loan write-ups, 6000 Long-term debt, 3220 Loss credit classification, 6000 H Loss transfer risk classification, 6020 Hedging, 3210 Lost and stolen securities, 5060, 5070

September 1997 Branch and Agency Examination Manual Page 2 Subject Index 8000.1

M Rating system for U.S. branches and agencies of FBOs, 2003 Management information systems, 3200, 3410 Real estate appraisals, 3100 Market risk, 3000 Real estate construction loans, 3110 Maturity gap analysis, 3210 Real estate loans, 3100 Memorandum of Understanding, 2040 Record of home country support, 2001 Mezzanine financing, 3060 Red flags, 3050 Mortgage-backed securities, 3130 Mortgage derivative products, 3130 Regulation CC: availability of funds, 3230 Municipal bonds, 3130 Regulation D, 3230, 5070 Regulation K, 5070 Regulatory Reports, 5060 N Report of assets and liabilities - FFIEC 002, Net debit cap, 4060 5060 Non-deposit investment products, 3430 REPOS, 3130 Non-investment grade bonds, 3060 Repurchase agreements, 3220 Nonaccrual loans, 3010 Reputational risk, 3000 Reserve requirements, 3230 O Restructured loans, 3010, 6000 Risk assessment, 2010 Off-balance-sheet activities, 3200, 3300 Risk management rating, 2003, 3000 Off-balance-sheet items and activities, 6000, 3300 Office of Foreign Assets Control (OFAC), S 3430, 5070 Offshore shell branches - earnings 3400 Sales on consignment, 3080 Open account financing, 3080 Scope memorandum, 2010 Operational risk, 3000, 4000 Section 23A and 23B of the Federal Reserve Operational controls rating, 2003 Act, 3240 Options, 3130, 3300 Secured and Unsecured Transactions, 3050 Other assets, 3420 Securities and broker/dealer loans, 3120 Other compliance matters, 5070 Securities broker/dealer activities, 5070 Other liabilities, 3420 Securitization of commercial paper, 3030 Other real estate owned, 3090 Security agreement and financing statement, Other transfer risk problems, 6020 3020 Overdrafts, 3430, 3230 Security classifications, 3130 Self-assessment cap, 4060 P Senior debt, 3060 Shared National Credits, 3050 Participation in acceptances, 3300 Shell corporations, 3430 Pass-through and pay-through instruments, Short-term debt, 3220 3030 Simulation modeling, 3210 Payable-through accounts, 3230 Society for Worldwide Interbank Financial Payments system risk, 4060 Telecommunications (SWIFT), 4060 Pre-examination planning, 2010 Special mention, 6000 Pricing, 3210 Specially-designated nationals, 5070 Private investment corporation, 3430 Private banking, 3430 Specific reserves, 3010 Problem loans, 3050 Stage payment plan, 3110 Procedures for the completion of ICQs, 4020 Standby letters of credit, 3300, 3320 Profit centers and cost centers, 3400 State statutes, 7030 Progress payment plan, 3110 Static gap, 3210 Steamship letter of credit, 3310 Strength-of-Support Assessment for Foreign R Banking Organizations, 2001, 3200, 3240 Rate-sensitive assets and liabilities, 3210 Stripped mortgage-backed securities, 3130

Branch and Agency Examination Manual September 1997 Page 3 8000.1 Subject Index

Structured notes, 3130 U Substandard credit classification, 6000 Substandard transfer risk classifications, 6020 U.S. government securities, 3130 Supervisory follow-up actions, 2040 Uninsured and Insured Branches, 7010 Sureties, 3310 Unsecured front-money loans, 3110 Survey of foreign regulations in selected states, 7030 V Suspense accounts, 3420 Suspicious activities, 5040 Value impaired transfer risk classification, System of home country supervision, 2001 6020 T W Tax-exempt bonds, 3130 Weighted average cash flows, 3210 Telex, 4060 Working capital or seasonal loans, 3050 Term business loans, 3050 Workpapers prepared for examinations, 2030 Token names, 3430 Written Agreement, 2040 Trade transactions, 3040, 6020 Trading securities, 3130 Trading Activities, 3330 Z Transfer Agent Activities, 5070 Zero-coupon bond, 3130 Transfer risk, 2001, 6020 Zero-balance accounts, 3230

September 1997 Branch and Agency Examination Manual Page 4