International Effective date April 2009 Section 7000.0

The international sections focus on the exami- ¥ For foreign governments and foreign political nation of risks and activities associated with entities, see section 3000.1, ‘‘Deposit international lending, financing instruments, and Accounts.’’ international banking. In addition to the sections ¥ For international borrowed funds, see sec- that follow, information on the international tion 3010.1, ‘‘Borrowed Funds.’’ aspects of cash accounts, nostro accounts, for- ¥ For foreign investments and foreign banking eign collections, investments, and borrowed organizations, see section 4050.1, ‘‘Bank- funds can be found in the applicable domestic Related Organizations.’’ sections: Additional information on international activi- ¥ For foreign-currency cash accounts, see sec- ties can be found in the Bank Holding Company tion 2000.1, ‘‘Cash Accounts.’’ Supervision Manual, Trading and Capital- ¥ For due from foreign banksÐdemand (nostro Markets Activities Manual, FFIEC Bank accounts) and foreign collections (cash letters, Secrecy Act Anti-Money Laundering Examina- return items), see section 2010.1, ‘‘Due from tion Manual, and FFIEC Information Technol- Banks.’’ ogy (IT) Examination Handbook. ¥ For foreign investments, see section 2020.1, ‘‘Investment Securities and End-User Activities.’’

Commercial Bank Examination Manual April 2009 Page 1 International—Examination Overview and Strategy Effective date May 2005 Section 7000.1

Generally, the basic procedures used for the commitment to extend credit provided that cer- examination and verification of international tain collateral and documentary conditions exist. operations are the same as those used for other Foreign-exchange trading activities are similar domestic bank functions. However, some proce- to money-trading operations conducted at domes- dures are modified for different types of bank tic funding desks. Foreign-exchange positions assets and liabilities and contingent accounts, as are similar to commodity inventories carried at well as for separate laws and regulations that book value that are exposed to fluctuating mar- may be applicable. Documentation and account- ket prices. Separate international sections in this ing procedures for international operations may manual relate to these functions. also differ from those used in the domestic IBF activities are to be reviewed during the banking areas, but the same examination objec- examination of international operations. The tives apply. The examination process may also review of assets, internal controls, and operating include a review of international banking facili- procedures should be conducted using proce- ties (IBFs) and periodic visits to selected foreign dures similar to those used for offshore shell branches and subsidiaries to determine the safety branches. In addition, reports required to be and soundness of their operations and the filed by IBFs should be reviewed to ensure that adequacy of reporting procedures used by the they are prepared properly and filed in a head office or parent bank to monitor the foreign timely manner. office. Additional international banking activities, The increasingly global nature of economic such as direct lease financing, installment loans, activities has made international banking opera- real estate loans, real estate construction loans, tions more important to bank customers, import- ownership of bank premises and equipment, and ers and exporters of goods and services, and other real estate owned are to be examined domestic customers with overseas operations using the applicable procedures in section who require a source of international financial 2210.1, ‘‘Other Assets and Other Liabilities,’’ assistance. As service institutions, commercial and section 3020.1, ‘‘Assessment of Capital banks provide this assistance through global Adequacy.’’ International examinations will also networks of representative offices, branches, and require reference to other sections of this manual. affiliates, as well as through correspondent rela- Guidelines for using these other sections in tionships. These foreign networks also allow international examinations are provided below. banks to offer services outside their traditional market areas. Additionally, in 1981, the Board of Governors amended regulations to allow for the establishment of IBFs in the United States. WORKPAPERS The activities of these facilities are limited to accepting deposits from and extending credit to Workpapers should consist of written documen- foreign residents (including banks), other IBFs, tation of the examination procedures followed and the institution establishing the IBF. and of the conclusions reached during the ex- amination of international operations. The defi- Many domestic banking activities are also nition, purpose, quality standards, preparation, conducted internationally, including providing and organization of workpapers used in interna- cash and collection services, placing and taking tional examinations are the same as those dis- deposits, making investments, granting loans cussed in section 1030.1, ‘‘Workpapers.’’ and overdrafts, and borrowing. The international examiner will use the appropriate examination procedures for domestic operations when review- ing these activities. The examination procedures EXAMINATION STRATEGY for the international aspects of these and other activities are covered in the following interna- Careful planning and control are as important tional sections. in international examinations as they are in Similarly, other activities that are primarily domestic examinations. A number of the proce- international are similar to activities found in dures found in section 1000.1, ‘‘Examination the domestic banking area. For example, a Strategy and Risk-Focused Examinations,’’ also confirmed letter of credit represents a formal apply to international examinations.

Commercial Bank Examination Manual May 2005 Page 1 7000.1 International—Examination Overview and Strategy

When assigning work in the various exami- COMPUTER SERVICES nation areas, the examiner should consider the organization of the bank. For example, many During an examination that covers information banks have consolidated their foreign-exchange technology (IT) and electronic data processing trading and money market operations into a (EDP) services, provided either in-house or single division that is responsible for the externally, the examiner should review the con- bank’s global money market operations. Similar tents of the IT and EDP report of examination to situations may be encountered for other determine which sections may be applicable to international-related functions that are com- international operations. An IT-EDP examiner bined with domestic operations. Consequently, will generally perform the procedures in this the examination assignments should address section and should be consulted on matters those situations. applicable to international operations. In some examinations, the examiner may come across certain activities that are not addressed by any particular section of the international portion of this manual. In these ASSET AND LIABILITY instances, the examiner should extract the appro- MANAGEMENT priate objectives, examination procedures, and internal control questionnaires from the domes- Asset and liability management (see section tic sections of this manual. 4020.1) and interest-rate risk management (see section 4090.1) sections of the manual are The examiner must be certain that all types of completed by domestic examiners for the entire individual customer liabilities have been ana- bank, based, in part, on information prepared by lyzed on a consolidated basis, regardless of the examiners assigned to various international bank- office where they are booked. However, since ing activities. Whether applicable segments of the procedures for the collection and consolida- these sections will be completed during overseas tion of customer liabilities booked in overseas examinations depends on the type of overseas offices differ among banks, the examiner should examination conducted. determine whether the bank’s procedures are adequate. BANK-RELATED INTERNAL CONTROL ORGANIZATIONS

The examiner should use section 1010.1, The domestic examiner assigned to bank-related ‘‘Internal Control and Audit Function, Over- organizations (see section 4050.1) obtains and sight, and Outsourcing,’’ in the domestic portion circulates lists and information to the interna- of this manual to evaluate the objectives of and tional examiner concerning bank-related organi- the work performed by internal and external zations involved in international activities. auditors for the bank’s international operations. Besides determining the legality of the relation- The internal control section sets forth general ships, the international examiner should verify criteria to be considered in evaluating the work the accuracy and completeness of the informa- of internal and external auditors. tion obtained.

EXAMINATION PLANNING REVIEW OF REGULATORY REPORTS Examiners assigned to review the international activities of the bank should work closely with The domestic examiner assigned to review regu- commercial examiners, especially in those areas latory reports (see section 4150.1) circulates the in which international and domestic activities bank-prepared regulatory reports applicable to have a direct relationship. This cooperation international operations. The international includes the pre-examination analysis of the examiner will prepare any necessary comments bank and is intended to determine potential on the appropriate report format and will discuss problem areas and provide for adequate staffing. those comments with bank management.

May 2005 Commercial Bank Examination Manual Page 2 International—Examination Overview and Strategy 7000.1

LITIGATION AND OTHER also be made if on-site examinations of foreign LEGAL MATTERS, branches and subsidiaries are conducted. EXAMINATION-RELATED SUBSEQUENT EVENTS OVERALL CONCLUSIONS The international examiner should request from REGARDING CONDITION bank management a list of pending or threatened OF THE BANK litigation and subsequent events applicable to international operations of the bank. Comments The examiner-in-charge is typically responsible in the report should be limited to events or for overall conclusions regarding the condition transactions that could materially affect the of the bank. (See section 5020.1.) However, the soundness of the bank. (See section 4100.1.) examiner assigned to review international operations must use judgment in deciding which steps in this section should be omitted. For MANAGEMENT ASSESSMENT example, certain examination procedures relat- ing to earnings, liquidity, and ownership apply The overall evaluation of the management of to the entire bank and not to the international international operations should be made by area alone. However, international examiners the examiner assigned to review international should assist domestic examiners in developing operations who is in a position to identify the report comments when international activities strengths and weaknesses of the management have a significant impact on the analysis of these team. An appraisal of local management should areas.

Commercial Bank Examination Manual May 2005 Page 3 International—Glossary Effective date April 2009 Section 7010.1

Acceptance. A time draft (bill of exchange or subsidiary or any other subsidiary of that usance draft) drawn by one party and acknowl- company. edged by a second party. The drawee, known as After sight. When a draft bears this name, the the ‘‘acceptor,’’ stamps or writes the word time to maturity begins at its presentation or ‘‘accepted’’ on the face of the draft and, above acceptance. his or her signature, the place and date of Agent bank. The bank that leads and docu- payment. Once the draft is accepted, it carries an ments a syndicated loan. unconditional obligation on the part of the Aggregate limit. The total volume of unliqui- acceptor to pay the drawer the amount of the dated foreign-exchange contracts allowed to be draft on the date specified. A bank acceptance is outstanding at any one time. a draft drawn on, and accepted by, a bank. A Agreement corporation. A company chartered trade acceptance is a draft drawn by the seller of or incorporated under state law that, like an goods on the buyer and accepted by the buyer. Edge Act corporation, is principally engaged in See also Banker’s acceptance. international banking. See also Edge Act. Account-account dealing. Foreign-exchange Allocated transfer-risk reserve (ATRR). The dealing that involves settlement from bank-to- ATRR is a special reserve established and main- bank in the due from accounts. No third party tained for specified international assets pursuant (bank) is involved. to the International Lending Supervision Act of Account party. The party, usually the buyer, 1983.1 At least annually, the Federal Reserve who instructs the bank to open a letter of credit and the other federal banking agencies (federal and on whose behalf the bank agrees to make banking agencies) determine jointly— payment. • which international assets that are subject to Ad valorem. A term meaning ‘‘according to transfer risk warrant establishment of an value,’’ used for assessing customs duties that ATRR, are fixed as a percentage of the value stated on • the amount of the ATRR for the specified an invoice. assets, and Advance. (1) A drawing or payout of funds • whether an ATRR previously established for representing the disbursement of a loan, includ- specified assets may be reduced. ing disbursement in stages. (2) In international banking, an extension of credit, usually recur- When determining whether an ATRR is required ring, in which no instrument (other than a copy for particular international assets, the federal of the advice of an advance) is used as evidence banking agencies consider if the quality of a of a specified indebtedness, except in special banking institution’s assets has been impaired cases. A signed agreement must be on file in the by a protracted inability of public or private department and state the conditions applicable obligors in a foreign country to make payments to payments made to the borrower. This loan on their external indebtedness, as indicated by category does not include commercial account factors as to— overdrafts, but an advance may be created to finance payments effected under a commercial • whether such obligors have failed to make full letter of credit, to finance payments of collec- interest payments on external indebtedness, or tions, or to refinance a maturing loan. • whether such obligors have failed to comply Advance against documents. An advance made with the terms of any restructured indebted- on the security of the documents covering a ness, or shipment. • whether a foreign country has failed to comply Advised letter of credit. See Letter of credit— with any International Monetary Fund (IMF) advised. or other suitable adjustment program, or Advised line. A credit authorization that will • whether no definite prospects exist for the be made known to the customer. See also orderly restoration of debt service. Guidance line. Affiliate. With regard to a member bank, any 1. See 12 USC 3904(a). See also the Board’s January 9, 2003, approval of a revision to subpart D (on international company (including corporate or other forms of lending supervision) of Regulation K (12 CFR 211), Interna- a business entity) of which a member bank is a tional Banking Operations (69 Fed. Reg. 1158–1161).

Commercial Bank Examination Manual April 2009 Page 1 7010.1 International—Glossary

Also, when determining the amount of the tive seller of an asset or the price at which a ATRR, the federal banking agencies consider— market maker of an asset will sell. Assignment. The transfer in writing by one • the length of time the quality of the asset has person to another of title to personal property. been impaired, In banking, one bank may assign another the • what recent actions have been taken to restore right to receive loan principal and interest from a debt-service capability, borrower. The assignment of stocks or regis- • the prospects for restored asset quality, and tered bonds may be effected by filling in the • any other factors relevant to the quality of the form printed on the reverse of the asset. certificate. Association of International Bond Dealers The initial year’s provision for the ATRR will (AIBD). A private association founded in Zurich, be 10 percent of the principal amount of each Switzerland, in 1969 to establish uniform issu- specified international asset, or such greater or ing and trading procedures in the international lesser percentage determined by the federal bond markets. banking agencies. Additional provisions, if any, At sight. A term indicating that a negotiable in subsequent years will be 15 percent of the instrument is payable upon presentation or principal amount of each specified international demand. asset, or such greater or lesser percentage deter- At the money. A term used to refer to a call or mined by the federal banking agencies. put option whose strike price is equal (or virtu- The ATRR is established only by a charge to ally equal) to the current price of the asset on current income. The amounts charged cannot be which the option is written. included in the banking institution’s capital or Authority to pay. An advice from a buyer, sent surplus. (For these and other requirements, as by his or her bank to the seller’s bank, autho- well as for certain other accounting procedures rizing the seller’s bank to pay the seller’s for the ATTR, the reporting and disclosure of (exporter’s) drafts up to a fixed amount. The international assets, and the accounting for fees seller has no protection against cancellation or on international loans, see sections 211.43, modification of the instrument until the issuing 211.44, and 211.45 of Regulation K.) A bank- bank pays the drafts drawn on it, in which case ing institution does not have to establish an the seller is no longer liable to its bank. These ATRR if it writes down in the period in which instruments are usually not confirmed by the the ATRR is required, or has written down in seller’s American bank. prior periods, the value of the specified Authority to purchase. Similar to an authority international assets in the requisite amount for to pay, except that drafts under an authority to each such asset. purchase are drawn directly on the buyer. The Amortizing swap. A transaction in which the correspondent bank purchases them with or notional value of the agreement declines over without recourse against the drawer and, as in time. the case of the authority to pay, they are usually Appreciation. A rise in the value of a currency not confirmed by an American bank. This type relative to the market of another currency. of transaction is unique to Far Eastern trade. Arbitrage. Simultaneous buying and selling Baker Plan. Proposed in 1985, this initiative of foreign currencies, securities, or commodities encouraged banks, the IMF, and the World Bank to realize profits from discrepancies between to jointly increase lending to less developed exchange rates prevailing at the same time in countries (LDCs) that were having difficulty different markets, between forward margins for servicing their debt, provided the countries different maturities, or between interest rates undertook prudent measures to increase produc- prevailing at the same time in different markets tive growth. or currencies. Balance of payments. A term indicating a Asian currency unit. A foreign-exchange trad- nation’s external cash flow (to other countries, ing department of a bank located in Singapore whether positive or negative) for a given period that has received a license from the monetary of time, including trade, current financial, and authority in that country to deal in external capital inflows and outflows. currencies. Balance of trade. The difference between a Asked price. The price sought by any prospec- country’s total imports and total exports for a

April 2009 Commercial Bank Examination Manual Page 2 International—Glossary 7010.1 given period of time. A ‘‘favorable’’ balance of hedge is arranged, for example, when a three- trade exists when exports exceed imports. month interest risk in a revolving Eurodollar Band. The maximum range that a currency loan is hedged with a six-month futures contract may fluctuate from its parity with another cur- in Eurodollars. A change in the shape of the rency or group of currencies by official agreement. yield curve can bring about nonparallel move- Bank for International Settlements (BIS). ments in interest rates for the two different Established in 1930 in Basel, Switzerland, the maturities. BIS is the oldest functioning international finan- Basis swap. A transaction in which one cial organization. It provides a forum for fre- participant pays a floating rate of interest based quent consultation among central bankers on a on one index, and the other party pays a floating wide range of issues. rate of interest based on another interest-rate Banker’s acceptance. A time draft that has index. been drawn on and accepted by a bank. The Beneficiary. The person or company in whose bank accepting the time bill becomes primarily favor a letter of credit is opened or a draft is liable for payment. See also Acceptance. drawn. Banker’s acceptance liability. The moment Bid-asked spread. The difference between a the draft is accepted by the bank, a direct bid and the asked price, for example, the differ- liability is recorded in its ‘‘Acceptances ence between 0.4210 and 0.4215 would be a Executed’’ account. The contra account on the spread of 0.0005 or 5 points. asset side of the balance sheet is ‘‘Customer’s Bid rate. The price at which the quoting party Liability on Acceptances.’’ On the date of is prepared to purchase a currency or accept a maturity of the banker’s acceptance, the bank deposit. If the bid rate is accepted by the party to charges the customer’s account and retires the whom it was quoted, then that party will sell acceptance by paying the beneficiary or drawee currency or place or lend money at that price. of the draft. The bank’s liability records at this The opposite transaction takes place at the offer point are liquidated, and the transaction is rate. completed. Bilateral trade. Commerce between two Barter. The exchange of commodities using countries, usually in accordance with specific merchandise as consideration instead of money. agreements on amounts of commodities to be This scheme has been employed in recent years traded during a specific period of time. Balances by countries that have blocked currencies. due are remitted directly between the two Base rate. A rate used as the basis or foun- nations. dation for determining the current interest rate to Bill of exchange. An instrument by which the be charged to a borrower, such as the prime rate drawer orders another party (the drawee) to pay or London Interbank Offered Rate (LIBOR). a certain sum to a third party (the payee) at a Basel Capital Accord. An agreement among definite future time. The terms ‘‘bill of exchange’’ the central banks of leading industrialized and ‘‘draft’’ are generally interchangeable. countries, including those of Western Europe, Bill of lading. A receipt issued by a carrier to Canada, the United States, and Japan, to impose a shipper for merchandise delivered to the car- common capital requirements on their interna- rier for transportation from one point to another. tionally active banks to take into account bank A bill of lading serves as a receipt for the goods, risk exposure. document of title, and contract between the Basis. The cash or spot price minus the carrier and the shipper covering the delivery of futures price. the merchandise to a certain point or designated Basis risk. The risk associated with nonparal- person. It is issued in two primary forms: an lel movement of interest rates. Banks face ‘‘order bill of lading,’’ which provides for the exposure in two situations. The first occurs delivery of goods to a named person or to his or when an operator uses, for example, a Treasury her order (designee), but only on proper endorse- bill to hedge an interest-rate risk in Eurodollars. ment and surrender of the bill of lading to the The interest rates for T-bills and Eurodollars do carrier or its agents, and a ‘‘straight bill of not always move exactly parallel to each other. lading,’’ which provides for delivery of the The risk of this lack of parallel movement is goods only to the person designated by the bill basis risk. The second occurs when the period of of lading. time for which a financial risk exists is not • Clean bill of lading. A bill of lading in which identical with the period of time for which the the described merchandise has been received

Commercial Bank Examination Manual April 2008 Page 3 7010.1 International—Glossary

in ‘‘apparent good order and condition’’ and certificate, which indicates that the purchase is without qualification. recorded on the issuer’s books or recorded in • Ocean bill of lading. A document signed by another approved location. the captain, agents, or owners of a vessel Brady Plan. Proposed in 1989 and named furnishing written evidence for the convey- after then U.S. Treasury Secretary Nicholas ance and delivery of merchandise sent by sea. Brady, the Brady Plan sought to reduce the It is both a receipt for merchandise and a debt-service requirements of various developing contract to deliver it as freight. countries and to provide new loans (Brady • Order bill of lading. A bill of lading, usually bonds) to service existing obligations. drawn to the order of the shipper, that can Break-even exchange rate. The particular spot be negotiated like any other negotiable exchange rate that must prevail at the maturity instrument. of a deposit or debt in a foreign currency (which • Order ‘‘notify’’ bill of lading. A bill of lading has not been covered in the forward market) so usually drawn to the order of the shipper or a that there will be no advantage to any party from bank with the additional clause that the con- interest-rate differentials. signee is to be notified upon arrival of the Bulldog bonds. British pound sterling– merchandise. However, the mention of the denominated foreign bonds issued in London. consignee’s name does not confer title to the Bullion. Unminted precious metals (gold, sil- merchandise. ver) of standard or stipulated fineness in the • Stale bill of lading. A bill of lading that has form of bars, ingots, or nuggets. The value of not been presented under a letter of credit to gold bullion, usually in bars, used in the settle- the issuing bank within a reasonable time after ment of international balances is determined by its date, thus precluding its arrival at the port weight and degree of fineness. of discharge by the time the ship carrying the Buyer’s option contract. A contract in which related shipment has arrived. the buyer has the right to settle a forward • Straight bill of lading. A bill of lading drawn contract at any time within a specified period. directly to the consignee and therefore not See also Option contracts. negotiable. Buying rates. Rates at which foreign-exchange • Through bill of lading. A bill of lading used dealers will buy a foreign currency from other when several carriers are used to transport dealers in the market and at which potential merchandise, for example, from a train to a sellers are able to sell foreign exchange to those vessel or vice versa. dealers. • Unclean bill of lading. A bill of lading across C & I loans. Commercial and industrial loans. the face of which exceptions to the receipt of Cable. A message sent and delivered by an goods ‘‘in apparent good order’’ are noted. international record carrier via satellite or cable Examples of exceptions include burst bales, connections to a foreign country. ‘‘Cable’’ as rusted goods, and smashed cases. used in the international sections also includes Black market. A private market that operates messages transmitted by bank telex. The terms in contravention of government restrictions. ‘‘cable’’ and ‘‘telex’’ are generally used Blocked account. An account from which interchangeably. payments, transfers, withdrawals, or other deal- Call money. Funds placed with a financial ings may not be made without Office of Foreign institution without a fixed maturity date. The Asset Control (OFAC) or U.S. Treasury Depart- money can be ‘‘called’’ (withdrawn) at any time ment approval. Although the bank is prohibited by telephone. ‘‘Same day’’ call money means from releasing funds from these accounts, depos- the call must (usually) be made before 10:00 a.m. its may be accepted. Banks are subject to In addition, ‘‘24-hour,’’ ‘‘48-hour,’’ and ‘‘7-day’’ significant fines for releasing funds from blocked call money means the money must be called accounts. See also Office of Foreign Asset Con- one, two, or seven calendar days before the trol, Specially designated nationals. actual payment date. Although these are the Blocked currency. A currency that is prohib- most common varieties of call money, two ited by law from being converted into another parties can agree on different dates. foreign currency. Call option. A contract giving the purchaser Book-entry form. The method by which mar- the right, but not the obligation, to buy an asset ketable securities are issued with the buyer at a stated price on or before a stated date. receiving only a receipt rather than an engraved Capital controls. Governmental restrictions

April 2008 Commercial Bank Examination Manual Page 4 International—Glossary 7010.1 on the acquisition of foreign assets or foreign involved in the trip contemplated. liabilities by domestic citizens or restrictions on Chicago Board of Trade (CBT). A futures the acquisition of domestic assets or domestic exchange that merged with the Chicago Mercan- liabilities by foreign citizens. tile Exchange in 2007 and ceased to exist as an Cedel. Formerly one of the two main clearing independent entity. systems in the Eurobond market, Cedel, based in Chicago Board Options Exchange (CBOE). Luxembourg, began operations in 1971. Cedel An options exchange in which European foreign- ceased to exist as an independent entity as part of currency options on spot exchange are traded. a merger with Clearstream International clear- Chicago Mercantile Exchange (CME).A inghouse in 2000. The merger was completed in futures exchange. 2002. Clean collection. A collection in which a draft Central bank intervention. Direct action by a or other demand for payment is presented with- central bank to increase or decrease the supply of out additional attached documentation. currency to stabilize prices in the spot or forward Clean draft. A sight or time draft to which no market or to move them in a desired direction. On other documents, such as shipping documents, occasion, the announcement of an intention to bills of lading, or insurance certificates, are intervene might achieve the desired results. attached. This is to be distinguished from a Certificate of inspection. A document often documentary draft. See also Documentary draft. required for shipment of perishable goods in Clean risk at liquidation. A type of credit risk which certification is made as to the good that occurs when exchange contracts mature. condition of the merchandise immediately before There may be a brief interval (usually no more shipment. than a few hours) during which one of the Certificate of manufacture. A statement, some- parties to the contract has fulfilled its obliga- times notarized, by a producer who is usually tions, but the other party has not. During this also the seller of merchandise that manufacture period, the first party is subject to a 100 percent has been completed and that goods are at the credit risk, on the chance that, in the interval, an disposal of the buyer. event may prevent the second party from fulfill- Certificate of origin. A document issued by the ing its obligations under the contract. exporter certifying the place of origin of the Clearing corporation. A clearinghouse that merchandise to be exported. The information exists as an independent corporation rather than contained in this document is needed primarily to as a subdivision of an exchange. comply with tariff laws that may extend more Clearinghouse. A subdivision of an exchange favorable treatment to products of certain or an independent corporation through which all countries. trades must be confirmed, matched, and settled Chain. A method of calculating cross rates. daily until offset. For example, if a foreign-exchange trader knows Clearinghouse funds. Funds used in settle- the exchange rate for Japanese yen against U.S. ment of a transaction that are available for use or dollars and for Swiss francs against U.S. dollars, that become good funds after one business day. the ‘‘chain’’ makes possible a calculation of the Clearing House Interbank Payments System cross rates for Japanese yen against Swiss francs. (CHIPS). A computerized telecommunications Charges forward. A banking term used when network provided by the New York Clearing foreign and domestic bank commission charges, House Association (NYCHA), which serves as interest (if any), and government taxes in con- an automated clearinghouse for interbank funds nection with the collection of a draft are for transfers. account of the drawee. Closing a commitment. Allowing a covered Charges here. A banking term used when foreign-exchange position to expire on maturity foreign and domestic bank commission charges, or reversing it before maturity by a swap interest (if any), and government taxes in con- operation. nection with the collection of a draft are for Closing a position. Covering open long or account of the drawer. short positions by means of a spot operation Charter party. A contract, expressed in writ- and/or outright forward operation. ing on a special form, between the owner of a Comanager. A bank ranking just below that vessel and the one (the charterer) desiring to of lead manager in a syndicated Eurocredit or employ the vessel, setting forth the terms of the an international bond issue. The status of arrangement, such as freight rate and ports comanager usually indicates a larger share in the

Commercial Bank Examination Manual April 2008 Page 5 7010.1 International—Glossary loan or a larger bond allotment, and a larger Consular invoice. A detailed statement on the share in the fees, than banks of lower rank. character of goods shipped, which is duly certi- Comanagers may also assist the lead managers fied by the consul at the port of shipment. in assessing the market or determining terms of Required by certain countries, including the the loan. United States, its principal function is to accu- Combined transport document. A through bill rately record the types of goods and their quan- of lading that applies to more than one mode of tity, grade, and value for import duty and general transport. statistical purposes. Commercial paper. A short-term, unsecured Contract limit. A maximum limit on the total debt instrument issued by a corporation and sold gross notional principal amount of outstanding at a discount from its maturity value. contracts booked with one customer. Commercial transaction. A transaction Contract risk (counterparty risk). Risk that between a dealing bank and a nonbanking (com- the counterparty will default before settlement. mercial) party. Convertibility. Freedom to exchange a cur- Commodities Futures Trading Commission rency, under certain circumstances, without (CFTC). A U.S. regulatory body that regulates government restrictions or controls. exchange-based futures trading in the United Correspondent bank. A bank located in one States. geographic area that accepts deposits from a Commodity Credit Corporation (CCC).An bank in another region and provides services on instrument of the federal government whose behalf of this other bank. Internationally, many principal purpose is to provide the necessary banks maintain one account with a correspon- financial services to carry forward the public dent bank in each major country to be able to price-support activities, including government make payments in all major currencies. Corre- lending, purchasing, selling, storing, transport- spondent banks are usually established on a ing, and subsidizing certain agricultural reciprocal basis. commodities. Cost, insurance, and freight (C.I.F.). A price Common carrier. An individual, partnership, quotation under which the seller defrays all or corporation, such as a shipping line, railroad, expenses involved in the delivery of goods. or airline, that undertakes for hire to transport persons or commodities from place to place. Counterpart funds. Local currencies depos- Governed by special laws, common carriers ited in a special account by recipient govern- must accept all business offered them under ments that represent grant aid extended by their regulations. another government. Those funds, while remain- Compromises. Occasions when both parties ing the property of the recipient government, agree to alter the terms of an existing foreign- can generally be used only by agreement of the exchange contract. These alterations should be donor government. approved by an impartial bank officer and the Country exposure. A measurement of the operations personnel must be advised of each volume of assets and off-balance-sheet items compromise to avoid settlement in accordance considered to be subject to the risk of a given with the original terms. country. This measurement is based, in part, on Confirmation. The written communication to identifying the country of domicile of the entity the counterparty in a foreign exchange, inter- ultimately responsible for the credit risk of a bank deposit, or other money market transaction particular transaction. that recites all the relevant details agreed upon Country limit. The amount of money that a by phone or telex. bank has established as the maximum it is Confirmed letter of credit. See Letter of credit. willing to lend borrowers in a given country Consignment. The physical transfer of goods regardless of the type of borrower or the curren- from a seller (consignor), with whom the title cies involved. remains, to another legal entity (consignee), Country risk. Refers to the spectrum of risks who acts as a selling agent, selling the goods and arising from the economic, social, and political remitting the net proceeds to the consignor. environment of a given foreign country, which Consular documents. Bills of lading, certifi- could have favorable or adverse consequences cates of origin, or special forms of invoice that for foreigners’ debt and/or equity investments in carry the official signature of the consul of the that country. country of destination. Cover. The execution of an offsetting foreign-

April 2008 Commercial Bank Examination Manual Page 6 International—Glossary 7010.1 exchange trade to close or eliminate an open currency has to be viewed in terms of exchange exposure. liquidity and instrument liquidity. Exchange Covered interest arbitrage. The process of liquidity depends on the ease with which a taking advantage of a disparity between the net currency can be converted into and out of accessible interest differential between two another major currency. Instrument liquidity currencies and the forward exchange premium or depends on the ease with which a negotiable discount on the two currencies against each other. instrument denominated in that currency can be Crawling peg system. An exchange-rate sys- purchased and sold without noticeably affecting tem in which the exchange rate is adjusted every the market rate for that instrument. few weeks, usually to reflect prevailing inflation Currency swap. A contractual obligation rates. entered into by two parties to deliver a sum of Credit risk. The possibility that the buyer or money in one currency against a sum of money seller of foreign exchange or some other traded in another currency at stated intervals (or a instrument may be unable to meet his or her stated interval) or according to negotiated terms. obligation on maturity. See Swap. Credit swap. A link transaction wherein one Current account. Those items in the balance party places a deposit in one currency (probably of payments involving imports and exports of dollars) with a foreign bank during the period goods and services as well as unilateral transfers. that the foreign bank lends another currency to a Customs union. An agreement between two third party. The deposit serves as an inducement or more countries in which they arrange to for the transaction, and its value is considered in abolish tariffs and other import restrictions on pricing the loan. each other’s goods and to establish a common Cross-border exposure. The risk that arises tariff for the imports of all other countries. when an office of a bank, regardless of its Date draft. A draft drawn to mature on a fixed location or currency, extends credit to a bor- date, regardless of its acceptance. rower that is located outside the booking unit’s Daylight limit. The maximum net foreign- national border. exchange position that a bank will allow during Cross-currency risk. The risk associated with business hours. maintaining exchange positions in two foreign Dealer (or trader). A person who executes currencies as the result of one transaction. For foreign-exchange, interbank deposit, or other example, if a U.S. operator borrows Swiss francs money market trades for a dealing bank. at 5 percent and invests the proceeds in British Debt for equity swaps. Debt (usually LDC pounds at 12 percent, the cross-currency risk is government debt) that is discounted and the chance that the pounds will depreciate in exchanged for equity in local businesses (often value against the Swiss francs to such an extent newly privatized). that there will be a loss on the transaction in Debt swaps. The exchange of LDC loans spite of the favorable interest-rate differential. based on the prices quoted in the secondary Cross-default. A term used to describe a market. Swaps are often used to decrease expo- clause in a syndicated loan or bond contract that sure to certain countries. gives the lender the right to accelerate repay- Default risk. The risk to the holder of ment of the loan if the borrower defaults on debt securities that a borrower will not meet another loan. all promised payments at the times agreed Cross-hedging. The hedging of an asset with upon. a futures contract of a different asset. Del credere agent. A sales agent who, for a Cross rate. The ratio between the exchange certain percentage above his or her sales com- rates of two foreign currencies in terms of a mission, guarantees payment to the person for third currency. whom he or she is selling on shipments made to Currency futures and options contracts.An the seller’s customers. agreement that allows businesses or individuals Delivery. The offset of an obligation to buy or acquiring or selling foreign currencies to protect sell an asset by an actual transfer of title to the themselves against future fluctuations in cur- asset at a prearranged price. In the futures rency prices by shifting currency risk to some- market, the transfer or receipt of a cash instru- one willing to bear that risk. ment against a short or long futures contract. Currency liquidity. In a multicurrency invest- Delivery order. An order addressed to the ment portfolio, the liquidity of a given foreign holder of goods and issued by anyone who has

Commercial Bank Examination Manual April 2008 Page 7 7010.1 International—Glossary authority to do so, that is, by one who has the exchange-rate system in which some govern- legal right to order delivery of merchandise. A ment intervention still takes place. A govern- delivery order is not considered a good titled ment may announce that it will let its currency document. float, that is, it will let the currency’s value be Delivery risk. The possibility that a seller of determined by the forces of supply and demand foreign exchange, having collected the payment in the market. The government, however, may in local currency, may fail to deliver the secretly allow its central bank to intervene in the exchange in the foreign center where it was sold. exchange market to avoid too much appreciation Also called settlement risk. or depreciation of the currency. Delta of an option. The rate of change of the Discount. value of an option with respect to the price of the • Lending—To subtract from a loan, when it is underlying asset, reference rate, or index evalu- first made, the amount of interest that will be ated at the current market price of that underlier. due when it is repaid. Demand draft. A draft that is payable imme- • Foreign exchange—The amount by which the diately upon presentation to the drawee. This forward exchange rate of one currency against type of draft is also termed a ‘‘sight’’ or ‘‘pre- another currency is less than the spot exchange sentation’’ draft. rate between the two currencies. Deposit dealer. A term used in the United • Financial—A deduction from the face value States for bank personnel responsible for lend- of commercial paper, such as bills of exchange ing and borrowing funds in the interbank market. and acceptances, in consideration of cash the Deposit trader. A term used in Europe for seller has received before the maturity date. bank personnel responsible for lending and The rates of discount vary according to the borrowing funds in the interbank market. state of the given money market, the financial Depreciation. A drop in the value of a cur- standing of the persons involved, and other rency relative to the value of another currency. circumstances surrounding the transaction. Depth of the market. The amount of currency • Commercial—An allowance from the quoted that can be traded in the market at a given time price of goods, usually made by the deduc- without causing a price fluctuation. Thin mar- tion of a certain percentage from the invoice kets are usually characterized by wide spreads price. and substantial price fluctuations during a short Discount rate. Most commonly the rate at period of time. Strong markets tend to be which a Federal Reserve Bank (or, in many characterized by relatively narrow spreads of instances, foreign central banks) is prepared to stable prices. lend to financial institutions against eligible Derivative instrument. An instrument that is collateral. based on or derived from the value of an Dishonor. Refusal on the part of the drawee to underlying asset, reference rate, or index. For accept a draft or to pay it when due. example, interest-rate futures are based on Divergence indicator system. One aspect of various types of securities trading in the cash the European Monetary System that measures market. Some interest-rate options are derived the departure of a country’s economic policies from interest-rate futures. from the European Union’s ‘‘average.’’ The Devaluation.Anofficial act wherein the offi- measure of divergence is based exclusively cial parity of a country’s currency is adjusted on the movement of a country’s exchange rate downward to the dollar, gold, Special Drawing with respect to the euro. Rights (SDRs), or another currency. After a Dock receipt. A receipt issued by an ocean devaluation, there are more devalued currency carrier or its agent for merchandise delivered at units relative to the dollar, gold, SDRs, or other its dock or warehouse that is awaiting shipment. currency. See also Revaluation. Documentary collection. A collection in which Development bank. A lending agency that a draft is accompanied by shipping or other provides assistance to encourage economic documents. development. Documentary credit. A commercial letter of Direct quote. The method of quoting fixed credit providing for payment by a bank to the units of foreign exchange in variable numbers of named beneficiary, who is usually the seller of the local currency unit. Also called a ‘‘fixed’’ or merchandise, against delivery of documents ‘‘certain’’ quotation. specified in the credit. Dirty float (or Managed float).Afloating Documentary draft. A draft to which docu-

April 2008 Commercial Bank Examination Manual Page 8 International—Glossary 7010.1 ments are attached, that is delivered to the Edge Act. Incorporated as section 25A of the drawee upon acceptance or payment of the draft Federal Reserve Act, this act authorizes the and that ordinarily controls title to the Board of Governors to charter corporations merchandise. (Edge corporations) for the purpose of engaging Documents. The shipping and other papers in international or foreign banking or in other customarily attached to foreign drafts, consist- international operations. ing of ocean bills of lading, marine insurance Eligible acceptance. A banker’s acceptance certificates, and commercial invoices. Certifi- that meets Federal Reserve requirements related cates of origin and consular invoices may also to its financing purpose and term. be required. Eligible value date. A normal business day on Documents against acceptance (D/A). Instruc- which a payment to settle a money market tions given by an exporter to a bank that the transaction can be made. An eligible value date documents attached to a draft for collection are for a foreign-exchange transaction must be a deliverable to the drawee only against his or her business day in the home countries of both of acceptance of the draft. the currencies involved. Documents against payment (D/P). Instruc- Engineered swap transaction. A spot trans- tions given by an exporter to his or her bank that action and an offsetting forward transaction in the documents attached to a draft for collection which each of the two transactions is carried out are deliverable to the drawee only against his or with a different party. her payment of the draft. Eurobank. A bank that regularly accepts for- Domestic bond. A domestic debt security sold eign currency-denominated deposits and makes by an issuer in its own country and denominated foreign-currency loans. in that country’s currency. Eurobonds. Long-term debt securities denomi- Domicile. The place where a draft or accep- nated in a currency other than that of the country tance is made payable. or countries where most or all of the security is Draft. An order in writing signed by one party sold. (the drawer) requesting a second party (the Euroclear. Euroclear Clearance System Lim- drawee) to make payment at a determinable ited is one of two main clearing systems in future time to a third party (the payee). It may be the Eurobond market. Euroclear, which began accompanied by a bill of lading, which the bank operations in December 1968, is located in will surrender to the buyer upon payment of the Brussels and managed by Euroclear Bank SA. draft. The buyer may then claim the goods at the See also Cedel. office of the carrier who transported them to the Eurocurrency. The nonresident ownership of buyer’s place of business. See also Sight draft or one of the major western European currencies. Time draft. Eurocurrencies, similar to Eurodollars, are fre- Dragon bond. A bond issued by a foreign quently available for borrowing in the London borrower in an Asian or Pacific country (exclud- Interbank Market. ing Japan—see Samurai bond). Eurocurrency market. The money market for Drawee. The addressee of a draft, that is, the borrowing-and-lending currencies that are held person on whom the draft is drawn. in the form of deposits in banks located outside Drawer. The issuer or signer of a draft. the countries in which those currencies are Duration. A time-weighted present-value mea- issued as legal tender. sure of the cash flow of a loan or security that Eurodollars. Dollar deposit claims on U.S. takes into account the amount and timing of all banks that are deposited in banks located outside promised interest and principal payments asso- the United States, including foreign branches of ciated with that loan or security. U.S. banks. These claims, in turn, may be Duty. (1) Ad valorem duty (according to the redeposited with banks or lent to companies, value) is an assessment at a certain percentage individuals, or governments outside the United rate on the actual value of an article. (2) Specific States. duty is an assessment on the weight or quantity Eurodollar deposit rate. The interest rate at of an article without reference to its monetary which a quoting bank is willing to take whole- value or market price. (3) Drawback is a recov- sale Eurodollar funds with a particular maturity ery in whole or in part of duty paid on imported from other than an interbank participant. The merchandise at the time of reexportation, whether rate is usually one-eighth to one-sixteenth of one in the same or different form. percent lower than LIBOR.

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European Currency Unit (ECU). A portfolio asset at the strike price stated in the option currency used in the European Monetary System contract. as a community ‘‘average’’ exchange rate. It Exit bonds. Low-interest government bonds was also used in the private market as a means issued in LDCs that are equivalent to a portion of payment and as a currency of denomination of the country’s existing bank debt. Designed to for lending, borrowing, and trade. On January 1, facilitate debt management. 1999, the euro replaced the ECU. Expiration date. The last day on which an European Monetary System (EMS).An option may be exercised. arrangement introduced in March 1979 for eco- Export credit insurance. A system to insure nomic and monetary cooperation among the the collection of credits extended by exporters members of the European Union. The ultimate against various contingencies. In some coun- aim of the EMS is a single European currency tries, only noncommercial risks can be insured. and the establishment of a European central Export declaration. A document required by bank. the U.S. government for shipments abroad and European Union (EU). Formerly the European used to maintain statistics on our exports. Community, an economic association of Euro- Export-Import Bank of the United States pean countries founded by the Treaty of Rome in (Eximbank). An institution that provides inter- 1957. The goals of the EU are the removal of mediate and long-term nonrecourse financing trade barriers among countries, the formation of for U.S. exports when these facilities are not a common commercial policy toward non-EU available from commercial banks. All of the countries, and the removal of barriers restricting Eximbank’s shares are held by the U.S. Treasury. competition and the free mobility of factors of Export trading company (ETC). A company production. Members include Austria, Belgium, designed to facilitate U.S. exports. An ETC may Bulgaria, Cyprus, Czech Republic, Denmark, be an affiliate of a bank holding company. Estonia, Finland, France, Germany, Greece, Fail. Nonperformance of an obligation on the Hungary, Ireland, Italy, Latvia, Lithuania, Lux- specified day, for example, failure to make embourg, Malta, the Netherlands, Poland, Por- prompt settlement for either side of a foreign- tugal, Romania, Slovakia, Slovenia, Spain, exchange contract, usually due to a clerical or Sweden, and the United Kingdom. trader error. A fail usually leads to an interest Exchange contracts. Documents issued by adjustment for an overdraft in the paying or foreign-exchange dealers, banks dealing in for- receiving bank. eign exchange, and foreign-exchange brokers F.A.S. See Free alongside ship. confirming foreign-exchange transactions. Federal Deposit Insurance Corporation Exchange control or restrictions. Limits on Improvement Act of 1991 (FDICIA). This act free dealings in foreign exchange or of free had various aims, including the least-cost reso- transfers of funds into other currencies and other lution of troubled insured depository institu- countries. tions, improvement of bank supervision and examinations, and provision of additional Exchange control risk. The possibility of resources to the Bank Insurance Fund. defaults on obligations by imposing or reinforc- Federal funds. Deposits held by commercial ing exchange control. banks at a Federal Reserve Bank. Since reserve Exchange-rate differential. The difference requirements of commercial banks are satisfied between two exchange rates in a swap transaction. by federal funds, banks with deposits in excess Exchange rates. The price of one currency in of required reserves will lend the excess depos- terms of another. See also Spot exchange, Buy- its to banks with a reserve shortage at a market- ing rates, Fixed rate of exchange, Floating rate, determined interest rate, called the federal funds and Interbank rate of exchange. rate. Exchange reserves. The total amount of freely Federal Reserve System. The central bank of convertible foreign currencies held by a coun- the United States, created by the Federal Reserve try’s central bank. Act of 1913, consisting of the Board of Gover- Exchange risk. The possibility of a loss on an nors in Washington, D.C., and 12 regional open position as a result of an appreciation or Federal Reserve Banks. The Federal Reserve depreciation of the exchange. controls the country’s monetary base and has the Exercise. The use of the right given by an power to set reserve requirements, conduct open- option: purchase (if a call) or sale (if a put) of an market operations, and lend directly to banks.

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Fedwire. The large-value payment mecha- ity of the Federal Reserve over the U.S. opera- nism owned and operated by the Federal Reserve tions of foreign banks. System. Fedwire provides depository institu- Foreign bonds. Bonds issued by nonresidents tions with real-time settlement in the central but underwritten primarily by banks registered bank of funds transfers and book-entry securi- in the country where the issue is made. ties transfers made for their own account or on Foreign Credit Insurance Association (FCIA). behalf of their customers. An insurance company established under the Financial Institutions Reform, Recovery, and auspices of Eximbank. Insurers trade credits Enforcement Act of 1989 (FIRREA). The pur- granted by U.S. suppliers of products to purchas- pose of this act was to reform, recapitalize, and ers abroad who qualify as normal risks. The consolidate the federal deposit insurance system insurance protects the exporter, up to an agreed and to enhance the regulatory and enforcement percentage, against any nonpayment resulting powers of federal financial institutions’ regula- from commercial or political risks, or both. tory agencies. Eximbank provides reinsurance for the entire Fixed exchange-rate system. A system in portion of the commercial credit risk and is the which the exchange rate of a country’s currency sole insurer of the political risk. is tied to one major currency, such as the U.S. Foreign currency. The currency of any for- dollar. eign country that is the authorized medium of Fixed rate of exchange. A rate of exchange circulation and the basis for recordkeeping in set by a foreign government relative to the that country. Foreign currency is traded by dollar, gold, another currency, or perhaps Spe- banks either by the actual handling of currency cial Drawing Rights. It remains in effect as long and checks or by the establishment of balances as that government is willing or able to buy and in foreign currencies with banks in those sell at the set rates. countries. Fixed-rate payer. A position applicable to a Foreign deposits. Those deposits that are rate swap, in which the fixed payer pays the payable at a financial institution outside the fixed rate and receives the floating rate. jurisdiction of the U.S. government and in the Flexible rate of exchange. A rate of exchange currency of the country in which the depository subject to relatively frequent changes. It is is located. See also Nostro account. determined by market forces but subject to Foreign draft.Anofficial bank order drawn various floors or ceilings relative to the dollar, on a foreign correspondent bank to pay on gold, Special Drawing Rights, or another cur- demand to a designated payee a specific sum of rency when the rate fluctuates beyond certain foreign money or U.S. dollars at the drawee’s parameters. buying rate. Floating exchange-rate system. A system in Foreign exchange. The trading or exchange of which the values of the currencies of various a foreign currency in relation to another currency. countries relative to each other are established by supply and demand forces in the market Foreign-exchange futures contracts. Standard- without government intervention. ized contracts traded on an organized futures Floating rate. A rate of exchange that is exchange and settled through the clearinghouse determined completely by market forces, with of the exchange. Each contract defines the no floor or ceiling vis-a-vis the dollar, gold, currencies, contract amounts, and delivery dates Special Drawing Rights, or another currency. for its own contracts. Floating-rate notes. Bonds that pay interest at Foreign-exchange market. Communications an agreed margin above a market reference rate. between dealers and brokers to transact whole- The interest rate varies according to variations sale business in foreign exchange and in the market reference rate. Eurocurrencies. Floating-rate payer. A position applicable to Foreign-exchange rationing. A government a rate swap, in which the floating payer pays the requirement that all holders of bills of exchange floating rate and receives the fixed rate. relinquish them at a stipulated rate. F.O.B. See Free on board (destination or Foreign-exchange reserves (official). The vessel). reserves maintained by a central bank, which Foreign Bank Supervision Enhancement Act usually include gold and easily traded currencies (FBSEA). Part of the FDIC Improvement Act of of major industrial nations. 1991, FBSEA expanded the supervisory author- Foreign-exchange risk. The risk associated

Commercial Bank Examination Manual April 2008 Page 11 7010.1 International—Glossary with exposure to fluctuation in spot exchange for a price quotation under which the seller rates. undertakes at his or her risk and expense to load Foreign Investment Advisory Service (FIAS). the goods on a carrier at a specified location. Established in 1986, FIAS counsels developing Expenses subsequent thereto are for account of countries on attracting foreign capital. FIAS the buyer. operates under the aegis of the World Bank and Free on board (F.O.B.) (vessel). A term for a its affiliates, the International Finance Corpora- price quotation under which the seller delivers tion and the Multilateral Investment Guarantee the goods at his or her expense on board the Agency. steamer at the location named. Subsequent risks Foreign trade zone. An area where goods and expenses are for account of the buyer. may be received and stored without entering a Free port. A foreign trade zone, open to all country’s customs jurisdiction and without pay- traders on equal terms, where merchandise may ing duty. Sometimes called a ‘‘free trade zone.’’ be stored duty-free pending its reexport or sale Forward book. The aggregate of all forward within that country. contracts for a given currency or all currencies. Free trade area. An arrangement between Forward contract. A contract that obligates two or more countries for free trade among one party to sell and another to buy a specific themselves, although each nation maintains its asset for a specified price at a designated time. own independent tariffs toward nonmember Forward discount (‘‘at a forward discount’’). nations. It should not be confused with ‘‘free A phrase used to describe a currency whose trade zone,’’ which is synonymous with ‘‘for- forward price is cheaper than its spot price. eign trade zone.’’ Forward exchange. Foreign currency traded Fungible securities. Securities that are not for settlement beyond two working or business individually designated by serial number as days from today. belonging to a particular owner. Instead, a clear- Forward exchange position. The long or short ing system or depository institution credits own- position that a dealer may have in the forward ers with a given number of a particular bond market, as compared to spot dealing. issue (or other security issue). The owner may Forward exchange risk. The possibility of a have title to 50 bonds, but not to 50 specific loss on a covered position as a result of a change bonds with designated serial numbers. in the swap margin. Futures commission merchant (FCM).Afirm Forward-forward dealing. The simultaneous that is registered with the CFTC and legally purchase and sale of a currency for different authorized to solicit or accept orders from the forward dates. public for the purchase or sale of futures con- Forward premium (‘‘at a forward premium’’). tracts. Acts as an intermediary between a public A phrase used to describe a currency whose customer and a floor broker. forward price is more expensive than its spot Futures contract. An exchange-traded con- price. tract in which one party agrees to buy a security Forward purchase. An outright purchase of a and another agrees to sell a security in the forward contract. future. If held until maturity, the futures contract Forward rates. The actual rates at which may involve accepting (if long) or delivering (if foreign exchange for future delivery are quoted, short) the asset on which the futures price is bought, and sold. based. Forward swap. A transaction in which the Futures market. A market in which contracts initial fixed- and floating-rate payments are are traded for future delivery of commodities, deferred until a future period of time. currencies, and financial instruments. The pur- Forward transaction date. Value dates that chase or sale of a futures contract requires that a are more than two business days following the deposit, called margin, be maintained with a trade date. Regular forward dates are 30, 60, and broker. The market is designed in such a way 90 days from the trade date. that it is easy to get out of a contract or cancel. Free alongside ship (F.A.S.). A term for a The vast majority of participants, the buyers and price quotation under which the seller delivers sellers of futures contracts, do not intend to take merchandise free of charge to the steamer’s side delivery or deliver what they bought or sold. and pays lighterage expenses up to that destina- Futures contracts are used as an investment tion, if necessary. vehicle and as a vehicle for hedging positions. Free on board (F.O.B.) (destination). A term G-10 countries. The informal term for the

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Group of 10 countries, which consists of Bel- specified future date. The object is to defer a gium, Canada, France, Germany, Italy, Japan, profit or loss on the current purchase or sale by Luxembourg, the Netherlands, Sweden, the realizing a profit or loss on a future purchase or United Kingdom, and the United States. Switzer- sale. The hedge contract may run for a period land joined in 1984, but the name remains as is. that coincides with the expected liquidation of Gap. The period, in foreign-exchange trans- the asset or it may merely last for one, three, six, actions, between the maturities for purchases or twelve months to offset the exchange risk for and those for sales of each foreign currency an asset that is expected to be held for a long (exchange gap). In money market transactions, term, in which case the choice of the term of the the period between the maturities of placements hedge is a matter of relative cost and judgment. (loans) and the maturities of borrowing (depos- Also referred to as ‘‘covering.’’ its) of each currency (money market gap). The Host currency. See Local currency. former occurs when a currency is purchased Hot money. Funds temporarily transferred to against one currency and sold against another, a financial center and subject to withdrawal at each time for different maturities. The money any moment. market gap is created by lending an amount of a ICERC. See Interagency Country Exposure certain currency for a longer or shorter period Review Committee. than that for which the same currency is Impact loan. A loan specifically designated borrowed. by a government as important for the develop- Global bond. A temporary debt certificate ment of the country. It usually involves produc- issued by a Eurobond borrower, representing the tion for export. The term is most often used in borrower’s total indebtedness. The global bond regard to Japanese loans. will subsequently be replaced by individual Implied forward rate. The rate of interest at bearer bonds. which a borrowing or a lending transaction of a Global line. A bank-established aggregate shorter maturity may be rolled over to yield an limit that sets the maximum exposure the bank equivalent interest rate with a borrowing or a is willing to have to any one customer on a lending transaction of longer maturity. worldwide basis. See also Multicurrency line. Indirect quote. Quotation of a fixed unit of the Gray market. A forward market for newly local currency in variable units of foreign issued bonds that takes the form of forward currencies. contracting between market participants during Ineligible acceptance. An acceptance that the period between the announcement day of a does not meet the Federal Reserve eligibility new issue and the day final terms of the bond requirements for use at the discount window. issue are signed. Bonds are traded at prices stated In the money. A term used to refer to a call at a discount of premium to the issue price. option whose strike price is below or a put Group of Eight (G-8). A group of industrial- option whose strike price is above the current ized countries comprising Canada, France, price of the asset on which the option is written. Germany, Italy, Japan, Russia, the United King- Initial margin. The minimum deposit a futures dom, and the United States. exchange requires from customers for any futures Guidance line. An authorization, unknown to contract in which a customer has a net long or the customer, for a line of credit. If communi- short position. cated to the customer, the guidance line becomes Interagency Country Exposure Review Com- an advised line of credit commitment. mittee (ICERC). A nine-member joint commit- Hard currency. The term ‘‘hard currency’’ is tee of three federal regulatory agencies estab- a carryover from the days when sound currency lished to administer the country risk supervision was freely convertible into ‘‘hard’’ metal, that is, program. ICERC centralizes decision making gold. It is used today to describe a currency that for determinations about the creditworthiness of is sufficiently sound so that it is generally individual countries. accepted internationally at face value. Interbank offered rate (IBOR). The rate at Hedging. A transaction used by dealers in which banks will lend to other banks for a foreign exchange, commodities, or securities, as particular currency at a particular location. well as manufacturers and other producers, to Interest arbitrage. Involves the movement of protect against severe fluctuations in exchange short-term funds from one currency to another rates and prices. A current sale or purchase is for the purpose of investing idle funds at a offset by contracting to purchase or sell at a higher yield. However, the real yield advantage

Commercial Bank Examination Manual April 2008 Page 13 7010.1 International—Glossary in this situation is not merely the difference in rate falls below a strike rate. interest rates between the two investment Interest-rate futures. Interest-rate futures con- choices, but rather the difference in subtracting tracts offer a vehicle through which banks can the cost of transferring funds into the desired shift interest-rate risk to the market for financial currency and back again from the interest dif- futures. Interest-rate futures are analogous to ferential. There are four types of interest arbi- futures contracts on commodities. See also trage: (1) covered interest arbitrage (transfer of Futures market. short-term funds into a foreign currency for the Interest-rate swap. A contractual obligation sake of a higher yield, with the exchange risk entered into by two parties to deliver a fixed sum covered), (2) inward interest arbitrage (transfer of money against a variable sum of money at of short-term funds into local currency for a periodic intervals. It typically involves an higher yield), (3) outward interest arbitrage exchange of payments on fixed- and floating- (transfer of short-term funds into a foreign rate debt. If the sums involved are in different currency for a higher yield), and (4) uncovered currencies, the swap is simultaneously an interest arbitrage (transfer of short-term funds interest-rate swap and a currency swap. into a foreign currency for a higher yield, International Banking Act of 1978 (IBA). The without covering the exchange risk). principal legislation pertaining to the activities Interest negative. The commission charged of foreign banks in the United States. It estab- on foreign deposits on which no interest is lished a policy of national treatment of foreign allowed. banks with regard to their operations in the Interest parities. Differences at a given time United States. between interest rates charged in two financial International banking facility (IBF). A set of centers on short-term credits, investments, or asset and liability accounts segregated on the time deposits of identical maturities. books and records of a depository institution, Interest rate. The amount (generally expressed U.S. branch or agency of a foreign bank, or an as a per annum percentage) of money charged for Edge Act or agreement corporation. IBF activi- allowing another party the use of one’s money. ties are essentially limited to accepting deposits Interest-rate cap. A transaction whereby a from and extending credit to foreign residents bank pays a fee up-front and will later receive (including banks), other IBFs, and the institu- payments if a designated interest rate exceeds a tions establishing the IBF. IBFs are not required minimum threshold established in the contract. to maintain reserves against their time deposits If during the contract, interest rates do not or loans. IBFs may receive certain tax advan- exceed the threshold, the bank loses the initial tages from individual states. fee paid. By contrast, if interest rates exceed International Center for Settlement of Invest- the threshold, a bank will receive progres- ment Disputes (ICSID). See World Bank. sively higher payments to offset higher interest expense. The payment received represents the International Lending Supervision Act (ILSA). difference between the designated rate and the Enacted in 1983, the act requires U.S. banking threshold. agencies to consult with bank supervisory Interest-rate collar. The collar combines an authorities in other countries to achieve consis- interest-rate cap and a floor. A bank buys a cap tent policies and practices in international and pays a fee, which protects the institution lending. should interest rates exceed a stated threshold. International Monetary Fund (IMF). A spe- The bank simultaneously sells a floor and cialized agency of the United Nations, the IMF receives a fee to offset the cost of the cap. The encourages monetary cooperation, promotes collar establishes a band of interest rates for stable exchange policy, and makes short-term liabilities—rates cannot exceed the cap’s ceiling advances and standby credits to members or the floor’s minimum. experiencing temporary payments difficulties. Interest-rate differential. The difference Its resources come mainly from subscriptions of between the interest rates on two different members. currencies. Also the swap rate between two International Money Market of the Chicago currencies expressed as a per annum percentage Mercantile Exchange (IMM). The IMM is one premium or discount. of the world’s largest markets for foreign- Interest-rate floor. The floor obligates a seller currency and Eurodollar futures trading. to pay funds to the buyer if a specified interest International Swap Derivatives Association

April 2008 Commercial Bank Examination Manual Page 14 International—Glossary 7010.1

(ISDA). A trade association for derivative been opened in its favor. This occurs when the contracts. issuing bank does not have an office in the Intervention. The actions of a central bank country of the beneficiary and uses the facilities designed to influence the foreign-exchange rate of the advising bank. The advising bank is of its currency. The bank can use its exchange potentially liable only for its own error in reserves to buy its currency if it is under too making the notification. much downward pressure or to sell its currency Letter of credit—back-to-back. A letter of if it is under too much upward pressure. credit issued on the strength (or ‘‘backing’’)of Intracountry foreign-currency exposure. The another letter of credit, involving a related risk that exists whenever a subsidiary or a transaction and nearly identical terms. For branch lends, invests, places, or extends credit to example, ABC company in the United States entities that are located within the same country is designated as the beneficiary of an irrevoc- as the booking unit, but in a currency different able letter of credit confirmed by a U.S. bank from that of the country where the borrower and to supply XYZ company in Bolivia, whose bank the booking unit are located. issued the letter of credit, with goods to be Intraday position. The size of spot and for- purchased from a third company. The third ward positions allowed for a dealer during the company, however, will not fill ABC’s order business day, which may be larger than that unless it receives prepayment for the goods, allowed for the end of the date. Sometimes also either through cash or some other type of called ‘‘daylight’’ limits. financing. If ABC is unable to prepay in cash, Intrinsic value. The amount, if any, by which it will request its bank to issue a letter of the current market price of the underlying credit in favor of the third company. If ABC’s instrument is above the exercise price for calls bank agrees, the domestic credit is then and below the exercise price for puts. ‘‘backed’’ by the foreign letter of credit and Issue price. The price at which a new issue of a back-to-back letter-of-credit transaction securities is placed on sale. exists. Joint venture. The participation of two or Letter of credit—cash. A letter addressed more entities in a single business activity. Used from one bank to one or more of its correspon- to facilitate entry into a market in which other dents that makes available to a party named in forms of operation may be proscribed. the letter a fixed sum of money up to a future Last trading date. The final day on a futures specific date. The sum indicated in the letter is or options exchange when trading may occur in equal to an amount deposited in the issuing bank a given futures contract month or in a given by the party before the letter is issued. option series. Letter of credit—commercial. A letter Latin American Free Trade Association addressed by a bank, on behalf of a buyer of (LAFTA). Originally developed to create a com- merchandise, to a seller authorizing the seller to mon market in Latin America among member draw drafts up to a stipulated amount under countries, it has since been reorganized into the specified terms and undertaking conditionally or Latin American Integration Association unconditionally to provide payment for drafts (ALADI). Members include Argentina, Bolivia, drawn. Brazil, Chile, Colombia, Cuba, Ecuador, Mexico, • Confirmed irrevocable letter of credit—A let- Paraguay, Peru, Uruguay, and Venezuela. ter in which a bank in addition to the issuing Lead manager. The commercial or invest- bank is responsible for payment. ment bank with the primary responsibility for • Irrevocable letter of credit—A letter in which organizing a syndicated bank credit or bond the issuing bank waives all right to cancel or issue. This includes the recruitment of addi- in any way amend without consent of the tional lending or underwriting banks, the nego- beneficiary or seller. tiation of terms with the borrower, and the • Revocable letter of credit—A letter in which assessment of market conditions. the issuing bank reserves the right to cancel or Lending margin. The fixed percentage above amend that portion of the amount that has not the reference rate paid by a borrower in a been demanded before the actual payment or rollover credit or on a floating-rate note. negotiation of drafts drawn. Letter of credit—advised. An export letter of • Revolving credit—A letter in which the issu- credit issued by a bank that requests another ing bank notifies a seller of merchandise that bank to advise the beneficiary that the credit has the amount of credit when used will again

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become available, usually under the same Guaranteed L/C.’’ terms and without the issuance of another Letter of credit—import. A letter of credit letter. issued by a bank on behalf of a customer who is • Special clauses— importing merchandise into a country. Issuance — Green clause—Similar to the red clause of an import credit carries a definite commit- letter of credit below, except that advance ment by the bank to honor the beneficiary’s payment is made, generally upon presen- drawings under the credit. tation of warehouse receipts evidencing Letter of credit—irrevocable. A letter of credit storage of the goods. that cannot be modified or revoked without the — Red clause—A clause permitting the bene- customer’s consent or that cannot be modified or ficiary to obtain payment in advance of revoked without the beneficiary’s consent. shipment so that the seller may procure Letter of credit—negotiation. A letter of credit the goods to be shipped. requiring negotiation (usually in the locality of — Telegraphic transfer clause—A clause in the beneficiary) on or before the expiration date. which the issuing bank agrees to pay the The engagement clause to honor drafts is in favor invoice amount to the order of the nego- of the drawers, endorsers, or bona fide holders. tiating bank upon receipt of an authenti- Letter of credit—nontransferable. A letter of cated cablegram from the latter that the credit that the beneficiary is not allowed to required documents have been received transfer in whole or in part to any party. and are being forwarded. Letter of credit—reimbursement. A letter of Letter of credit—confirmed. A letter of credit credit issued by one bank and payable at a issued by the local bank of the importer and to second bank that, in turn, draws on a third bank which a bank, usually in the country of the for reimbursement of the second bank’s pay- exporter, has added its commitment to honor ment to the beneficiary. Those credits are gen- drafts and documents presented in accordance erally expressed in a currency other than that of with the terms of the credit. Thus, the benefi- the buyer (issuing bank) or the seller, and, ciary has the unconditional assurance that, if the because of wide acceptability, many are settled issuing bank refuses to honor the draft against in the United States through yet another bank as the credit, the confirming bank will pay (or the reimbursing agent. Upon issuance, the cor- accept) it. In many instances, the seller (exporter) respondent sends the reimbursing bank an autho- may ask that the letter of credit be confirmed rization to honor drawings presented by the by another bank when the seller is not familiar negotiating bank. with the foreign issuing bank or as a precaution Letter of credit—revocable. A letter of credit against unfavorable exchange regulations, that can be modified or revoked by the issuing foreign-currency shortages, political upheavals, bank up until the time payment is made. or other situations. Letter of credit—revolving. A letter of credit Letter of credit—deferred payment. A letter of issued for a specific amount that renews itself credit under which the seller’s draft specifies for the same amount over a given period. that the draft is payable at a later date, for Usually, the unused renewable portion of the example, 90 days after the bill-of-lading date or credit is cumulative as long as drafts are drawn 90 days after presentation of the documents. before the expiration of the credit. Letter of credit—export. A letter of credit Letter of credit—standby. A letter of credit or opened by a bank, arising from the financing of similar arrangement, however named or exports from a country. The issuing bank may described, that represents an obligation to the request another bank to confirm or advise the beneficiary on the part of the issuer— credit to the beneficiary. If confirmed, the credit • to repay money borrowed by or advanced to becomes a confirmed letter of credit, and, if or for the account party, advised, it becomes an advised (unconfirmed) • to make payment on account of any indebted- letter of credit. ness undertaken by the account party, or Letter of credit—guaranteed. A letter of credit • to make payment on account of any default by guaranteed by the customer (applicant) and the account party in the performance of an often backed by collateral security. In domestic obligation. banks, the payment of drafts drawn under this Letter of credit—straight. A credit requiring credit is recorded in the general-ledger asset presentation on or before the expiration date at account ‘‘Customer Liability—Drafts Paid Under the office of the paying bank. The engagement

April 2008 Commercial Bank Examination Manual Page 16 International—Glossary 7010.1 clause to honor drafts is in favor of the benefi- of securities to U.S. investors during the period ciary only. of initial distribution. Letter of credit—transferable. A credit under Long position. An excess of assets (and/or which the beneficiary has the right to give forward purchase contracts) over liabilities instructions to the bank called upon to effect pay- (and/or forward sale contracts) in the same ment or acceptance to make the credit available currency. A dealer’s position when the net in whole or in part to one or more third parties purchases and net sales leave him or her in a (second beneficiaries). The credit may be trans- net-purchased position. ferred only upon the express authority of the Loro accounts. Current accounts banks hold issuing bank and provided that it is expressly with foreign banks in a foreign currency on designated as transferable. It may be transferred behalf of their customers. in whole or in part, but may only be transferred Maintenance margin. The minimum equity a once. futures exchange requires in a customer’s Letter of credit—traveler’s. A letter of credit account for each futures contract subsequent to addressed to the issuing bank’s correspondents, deposit of the initial margin. authorizing them to negotiate drafts drawn by Managed float. See Dirty float. the beneficiary named in the credit upon proper Management fee. The fee received by lead identification. The customer is furnished with a banks as compensation for managing a large- list of the bank’s correspondents. Payments are syndicate financing. endorsed on the reverse side of the letter of Manager of participation. The original lender credit by the correspondent banks when they of any loan in which participations are later sold negotiate the drafts. This type of letter of credit and who generally has a fiduciary relationship is usually prepaid by the customer. with the other lenders. See also Agent bank. Letter of credit—usance. A letter of credit that Manager of syndicate. The bank that solicits calls for payment against time drafts, drafts the loan from the borrower and solicits other calling for payment at some specified date in the lenders to join the syndicate making the loan. future. Usance letters of credit allow buyers a Margin. The amount of money and/or securi- grace period of a specified number of days, ties that must be posted as a security bond to usually not longer than six months. ensure performance on a contract. London Interbank Offered Rate (LIBOR). The Marine insurance. Insurance for losses aris- rate at which, theoretically, banks in London ing from specified marine casualties. Marine place Eurocurrencies/Eurodollars with each other. insurance is more extensive than other types as London International Financial Futures it may provide not merely for losses arising Exchange (LIFFE). A London exchange where from fire, but also from piracy, wrecks, and most foreign-currency and Eurodollar futures, as well injuries sustained at sea. as foreign-currency options, are traded on spot • Average—A term in marine insurance signi- exchange. LIFFE was taken over by Euronext in fying loss or damage to merchandise. 2002 and subsequently merged with the New • General average—A loss arising from a vol- York Stock Exchange in 2007. untary sacrifice of any portion of a shipment Limits (bank customer—foreign-exchange and or cargo to prevent loss of the whole and for interbank). Maximum line amounts allowed with the benefit of all persons at interest. The value other banks for forward exchange transactions, of this loss is apportioned not only among all Eurocurrency and Eurodollar transactions, and the shippers, including those whose property payments arising from foreign-exchange trans- is lost, but also to the vessel itself. Until the actions on the same day. assessment is paid, a lien lies against the Listing. The formal process required to have a whole cargo. security regularly quoted on an exchange. Euro- • Particular average—A partial loss or damage bonds are usually listed so that they can be of merchandise caused by a peril insured purchased by those institutional investors who against and that does not constitute a general are constrained to invest in listed securities. average loss. Local-currency exposure. The amount of • Free of particular average (F.P.A.)—Insurance assets and non-balance-sheet items that are against partial loss regardless of the percent- denominated in the local currency of that country. age of the loss. Lock-up. The term used to refer to procedures • Casco insurance—Marine insurance on the followed in a Eurobond issue to prevent the sale ship itself (hull) that is usually purchased by

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the owners. happen when a currency is under pressure to • Cover note—English equivalent of American appreciate. A central bank in this situation can binder. establish capital-import controls and limit the • Open policy—A contract between an insur- amount of deposits that a bank can receive from ance company and a shipper by which all nonresidents. If market participants want to shipments made by the insured are automati- deposit more money in the country than the cally protected from the time the merchandise central bank will allow, interest rates will drop leaves the initial shipping point until delivery initially to zero and, if the pressure continues, at destination. produce negative interest. Any taxes that a Mark-to-market. The revaluation of a traded central bank may impose on foreign deposits asset or commodity to reflect the most recently can also create negative interest. available market price. Negative pledge. A contractual promise by a Market-maker. A bank or other financial borrower in a syndicated loan or a bond issue institution that gives two-sided (bid and offer) not to undertake some future action. One typical quotations. A market-maker stands prepared to negative pledge is that future new creditors will do business on either side of the market without not be given rights greater than those of existing knowing if the inquiring institution intends to creditors. buy or sell. Negotiable instruments. Written orders or Market order. An order that is to be executed promises to pay that may be transferred by immediately at the best available price in the endorsement or delivery, for example, by checks, market. bills of exchange, drafts, and promissory notes. Matched. A forward purchase is matched Governed by article 3 of the Uniform Commer- when it is offset by a forward sale for the same cial Code. date or vice versa. As a necessity, however, Negotiate. (1) Letters of credit—To verify when setting limits for unmatched positions, a that the documents presented under a letter of bank may consider a contract matched if the credit conform to requirements and then, if the covering contract falls within the same week or documents are in order, to pay the seller of the semimonthly period. goods. (2) Negotiable instruments—To transfer Maturity date. The settlement date or delivery possession of an instrument by a person other date for a forward contract. than the issuer to another person who thereby Medium-term notes. Intermediate-term notes becomes its holder. that carry a maturity between nine months and Net accessible interest differential. The differ- ten years. ence between the interest rates that can actually Merchant bank. A European form of an invest- be obtained on two currencies. This difference is ment bank. usually the basis of the swap rate between the Money market. A wholesale market for low- two currencies and, in most cases, is derived risk, highly liquid, short-term debt instruments. from external interest rates rather than domestic Multicurrency line. A line of credit that gives ones. These external rates, or Euro-rates, are the borrower the option of using any of the free from reserve requirements (which would readily available major currencies. increase the interest rate) and from exchange Multilateral exchange contract. An exchange controls (which would limit access to the contract involving two foreign currencies against money). each other, for example, a contract for U.S. Net exchange position. An imbalance between dollars against Swiss francs made in London or all the assets and purchases of a currency, and all a contract for British pounds against Japanese the liabilities and sales of that currency. yen made in New York. Also called an arbitrage Net position. A bank has a net position in a exchange contract. foreign currency when its assets (including future Multinational bank. A commercial bank contracts to purchase) and liabilities (including engaged in selling services or conducting opera- future contracts to sell) in that currency are not tions in more than one country. equal. An excess of assets over liabilities, includ- Nationalization. The act whereby a central ing future contracts, is called a net ‘‘long’’ government assumes ownership and operation position, and liabilities in excess of assets result of private enterprises within its territory. in a net ‘‘short’’ position. A net long position in Negative interest. A fee charged by a bank for a currency that is depreciating results in a loss accepting a deposit from a customer. This can because, with each day, the position is convert-

April 2008 Commercial Bank Examination Manual Page 18 International—Glossary 7010.1 ible into fewer units of local currency. A net Official rate. The rate established by a coun- short position in a currency that is appreciating try at which it permits conversion of its currency represents a loss because, with each day, satis- into that of other countries. faction of the position costs more units of local Offshore branch. Banking organization currency. designed to take advantage of favorable regula- Netting arrangement. Agreement by two coun- tory or tax environments in another country. terparties to examine all contracts settling in the Many of these operations are shell branches same currency on the same day and to agree to with no physical presence. exchange only the net currency amounts. Also Offshore dollars. The same as Eurodollars, applies to net market values of several contracts. but encompassing the deposits held in banks and Nominal interest rate. The interest rate stated branches anywhere outside of the United States, as a percentage of the face value of a loan. including Europe. Depending on the frequency of interest collec- Open contracts (open positions). The differ- tion over the life of the loan, the nominal rate ence between long positions and short positions may differ from the effective interest rate. in a foreign currency or between the total of Nonrevolving. A line of credit that cannot be long and short positions in all foreign curren- reused once it has been drawn down to a cies. Open spot or open forward positions that specified amount. have not been covered with offsetting trans- Nostro accounts. Demand accounts of banks actions. See also Net position. with their correspondents in foreign countries in Open interest. The total number of futures the currency of that country. These accounts are contracts for a particular asset that have not been used to make and receive payments in foreign liquidated by an offsetting trade or that have not currencies for a bank’s customers and to settle been fulfilled by delivery. maturing foreign-exchange contracts. Also called Open market operations. Purchases or sales due from foreign bank—demand accounts, our of securities or other assets by a central bank on balances with them, or due from balances. the open market. Novation. The substitution of a new party for Open position limit. A limit placed on the size one of the original parties to a contract. The of the open position in each currency to manage result is a new contract with the same terms, but off-balance-sheet items. at least one new party. Opening bank. The bank that draws up and Odd dates. Deals within the market are usu- opens the letter of credit and that makes pay- ally for spot, one month, two months, three ment according to the conditions stipulated. months, or six months forward. Other dates are Option contract. A contract giving the pur- odd dates, and prices for them are frequently chaser the right, but not the obligation, to buy adjusted with more than a mathematical differ- (call option) or sell (put option) an asset at a ence. Hence, most market deals are for regular stated price (strike or exercise price) on a stated dates, although commercial deals for odd dates date (European option) or at any time before a are common. stated date (American option). Offer rate. The price at which a quoting Organisation for Economic Co-operation and party is prepared to sell or lend currency. This Development (OECD). Founded as a successor is the same price at which the party to whom organization to the Organization for European the rate is quoted will buy or borrow if it Economic Cooperation (OEEC). The OEEC desires to do business with the quoting party. was originally established to administer aid The opposite transactions take place at the bid under the Marshall Plan during the post-World rate. War II period. The goals of the successor OECD Offering circular. A document giving a are to stimulate world trade, economic growth, description of a new securities issue, as well as and economic development. Members include a description of the entity making the issue. Australia, Austria, Belgium, Canada, Czech Office of Foreign Asset Control (OFAC).An Republic, Denmark, Finland, France, Germany, office within the U.S. Treasury Department that Greece, Hungary, Iceland, Ireland, Italy, Japan, administers U.S. laws imposing economic sanc- Korea, Luxembourg, Mexico, the Netherlands, tions against targeted hostile foreign countries. New Zealand, Norway, Poland, Portugal, Slovak While OFAC is responsible for administration of Republic, Spain, Sweden, Switzerland, Turkey, these statutes, all of the bank regulatory agen- the United Kingdom, and the United States. cies cooperate in ensuring compliance. Organization of American States (OAS).An

Commercial Bank Examination Manual April 2009 Page 19 7010.1 International—Glossary organization of 35 independent states of the Parity. A term derived from par, meaning the Americas formed to promote intergovernmental equivalent price for a certain currency or secu- cooperation in the Western Hemisphere. rity relative to another currency or security, or Organization of the Petroleum Exporting relative to another market for the currency or Countries (OPEC). A federation of oil-exporting security after making adjustments for exchange countries that sets petroleum prices for member rates, loss of interest, and other factors. countries. Members include Algeria, Angola, Parity grid. The system of fixed bilateral par Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, values in the European Monetary System. The Nigeria, Qatar, Saudi Arabia, United Arab Emir- central banks of the countries whose currencies ates, and Venezuela. are involved in an exchange rate are supposed to Out-of-the-money. A term used to refer to a intervene in the foreign-exchange market to call option whose strike price is above or to a maintain market rates within a set range defined put option whose strike price is below the by an upper and a lower band around the par current price of the asset on which the option is value. written. Participation. The act of taking part in a Outright. Forward exchange bought and sold syndicated credit or a bond issue. independently from a simultaneous sale or pur- chase of spot exchange. Par value. The official parity value of a Outright forward rate. A forward exchange currency relative to the dollar, gold, Special rate that is expressed in terms of the actual price Drawing Rights, or another currency. of one currency against another, rather than, as Paying agent. A bank or syndicate of banks is customary, by the swap rate. The outright responsible for paying the interest and principal forward rate can be calculated by adding the of a bond issue to bondholders on behalf of the swap premium to the spot rate or by subtracting bond issuer. the swap discount from the spot rate. Performance bond. A bond supplied by one Overbought. The position of a trader who has party to protect another against loss in the event bought a larger amount of a commodity or asset of the default of an existing contract. than he or she has sold. Placement memorandum. A document in a Overnight. A swap transaction involving syndicated Eurocredit that sets out details of the same-day settlement of the spot transaction proposed loan and gives information about the against a value date of the next business day on borrower. the forward contract. Political risk. Political changes or trends, Overnight position. A foreign-exchange or often accompanied by shifts in economic policy, money market position maintained overnight. that may affect the availability of foreign There is more risk involved in this position than exchange to finance private or public external in one maintained during the day because politi- obligations. The banker must understand the cal and economic events may take place at night subtleties of current exchange procedures and when the operator cannot react immediately to restrictions, as well as the possibilities of war, them. revolution, or expropriation in each country Override limit. The total amount of money with which the bank transacts business, regard- (measured in terms of a bank’s domestic cur- less of the actual currencies involved. See also rency) that the bank is willing to commit to all Country Risk. foreign-exchange net positions. Oversold. The position of a trader who has Portfolio investment. An investment in an sold a larger amount of a certain asset or organization, other than a subsidiary or joint commodity than he or she has bought. venture, in which less than 20 percent of the Over-the-counter (OTC). Transactions not voting shares are held. conducted in an organized exchange. OTC Position. A situation created through foreign- markets have no fixed location or listing of exchange contracts or money market contracts products. in which changes in exchange rates or interest Paris Club. An ad hoc group of western rates could create profits or losses for the creditor governments that meets informally under operator. the chairmanship of the French Treasury. Its Position book. A detailed, ongoing record of function is to start the process of rescheduling a country’sofficial debt.

April 2009 Commercial Bank Examination Manual Page 20 International—Glossary 7010.1 an institution’s dealings in a particular foreign chance that the spot rate may rise when the currency or money market instrument. trader has a net oversold position (a short Position risk. See Net position. position), or that the spot rate may go down Position-trader. A speculator in the futures when the operator has a net overbought position market who takes a position in the market for a (a long position). period of time. Rate swap. A transaction in which one par- Premium. The adjustment to a spot price that ticipant pays a fixed rate of interest on a notional is made in arriving at a quote for future delivery. amount for a given period of time and the other If a dealer were to quote $2.00 and $2.05 (bid pays a floating rate. and asked) for sterling, and the premiums for six Reciprocal rate. The price of one currency in months forward are 0.0275 and 0.0300, the terms of a second currency, when the price of forward quotes would be adjusted to $2.0275 the second currency is given in terms of the first. and $2.0800. The premium usually represents Recourse. The ability to pursue judgment for differences in interest rates for comparable a default on a negotiable instrument against instruments in two countries. However, in parties who signed the note. periods of crisis for a currency, the premium Representations. Statements made by a bor- may represent the market anticipation of a rower in a syndicated credit or bond issue higher price. describing the borrower’s financial condition. Price quotation system. A method of giving Representative office. A facility established in exchange rates in which a certain specified U.S. or foreign markets by a bank to sell its amount of a foreign currency (1 or 100, usually) services and assist clients; in the United States, is stated as the corresponding amount in local these offices cannot accept deposits or make currency. loans. Primary dealers. Securities firms that are Repurchase agreement (repo or RP). A holder recognized by the Federal Reserve System to of assets sells those assets to an investor with an buy and sell securities with the Fed. agreement to repurchase them at a fixed price on Private placement. The process of negotiating a fixed date. The security ‘‘buyer’’ in effect for the sale of securities, debt, equity, or a lends the ‘‘seller’’ money for the period of the combination thereof to a relatively small group agreement, and the terms of the agreement are of investors. structured to compensate the buyer for this. Protest. The formal legal process of demand- Dealers use repo extensively to finance their ing payment of a negotiable item from the positions. maker or drawee who has refused to pay. Reserve account. Those items in the balance Public Law (P.L.) 480. The most common of payments that measure changes in the central reference to the Agricultural Trade Develop- bank’s holdings of foreign assets (such as gold, ment and Assistance Act of 1954. Generally, convertible securities, or Special Drawing P.L. 480 authorizes the President to provide Rights). various types of assistance to American agricul- Reserve currency. A foreign currency held by tural exporters, such as making sales in the a central bank (or exchange authority) for the currency of the destination country. purposes of exchange intervention or the settle- Put. The ability of the bank to require repay- ment of intergovernmental claims. ment of the debt of a borrower by a third party Reserve requirements. Obligations imposed because of nonperformance of the borrower on commercial banks to maintain a certain through an agreement other than a formal percentage of deposits with the central bank or guarantee. in the form of central-bank liabilities. Put option. A contract giving the purchaser Retiming. Restructuring of the timing of inter- the right, but not the obligation, to sell a est payable on bonds. particular asset at a stated strike price on or Revaluation.Anofficial act wherein the par- before a stated date. ity of a currency is adjusted relative to the dollar, Rate risk. In the money market, the chance gold, Special Drawing Rights, or another cur- that interest rates may rise when an operator has rency, resulting in less revalued units relative to a negative money market gap (a short position) those currencies. (See also Devaluation.) Also, or that interest rates may go down when the the periodic computations of the current values operator has a positive money market gap (a (revaluations) of ledger accounts and unmatured long position). In the exchange market, the future purchase and sales contracts.

Commercial Bank Examination Manual April 2008 Page 21 7010.1 International—Glossary

Revolving credit. A line of bank credit that rities are traded following the time of their may be used at the borrower’s discretion. Inter- original issue. est is paid on the amount of credit actually in Selling concession. The share of total use, while a commitment fee is paid on the investment-banking fees accruing to the selling unused portion. group. Revolving into term. A commitment that Selling group. All banks involved in selling or allows a revolving line of credit (usually one marketing a new issue of bonds. Sometimes the to three years) with term provision at the term is used in reference to dealers acting only expiration of the revolver for an additional period as sellers and is intended to exclude reference to of time. Most common is a two-year revolver underwriters or managers. with a five-year, fully amortizing term portion. Seller’s option contract. A contract in which Revolving line of credit. A line of credit that the seller has the right to settle a forward permits successive drawings and payments at contract at his or her option anytime within a the borrower’s discretion. The funds available to specified period. See also Option contract. the borrower are replenished by any payments Selling rates. Rates at which dealers are of principal. prepared to sell foreign exchange in the market. Risk-management tools. Financial devices Settlement day. The day on which the actual (such as futures or options) that permit a transfer of two currencies or the transfer of borrower or lender of funds to protect against the money for an asset takes place at a previously risks of changing currency prices and/or interest arranged price. rates. Settlement price. The official daily closing Risk participation. An agreement whereby a price for a futures or option contract. This price bank shares the risk in an outstanding credit or is established and used by a clearinghouse to instrument. Credit-equivalent amounts of risk determine each clearing firm’s settlement participations are assigned based on the risk variation. category appropriate to the account party obli- Settlement risk. The possibility that a seller gor or, if relevant, to the nature of the collateral of foreign exchange or securities, having col- or guarantees. Usually treated as a direct credit lected the payment in local currency, may fail substitute. to deliver the exchange or securities to the Rollover. The process of selling new securi- buyer. ties to pay off old ones coming due, refinancing Settlement variation. The sum of all changes an existing loan, or extending a maturing for- in amount for each of a firm’s futures or options ward foreign-exchange contract. positions as calculated from each day’s settle- Rollover credit. A bank loan with an interest ment price. This amount is paid to or received rate periodically updated to reflect market inter- from the clearinghouse each day based on the est rates. The interest rate in the loan for each previous day’s trading. subperiod is specified as the sum of a reference Shell branch. See Offshore branch. rate and a lending margin. Shogun bonds. Foreign bonds issued in Tokyo Rollover date. The end of an interest period in and denominated in currencies other than the a revolving term loan. Japanese yen. The usual denomination is the Same-day funds. Federal funds, or the equiva- U.S. dollar. lent, used in the settlement of a transaction that Short position. An excess of liabilities (and/or will probably create an interest adjustment of forward sale contracts) over assets (and/or for- the trading rate to compensate for the difference ward purchase contracts) in the same currency. in the availability of the funds for use. A dealer’s position when the net of purchases Samurai bonds. Yen-denominated bonds issued and sales leaves the trader in a net-sold or by a foreign borrower in Japan. oversold position. Scalpers. Floor or pit traders in the futures Sight draft. A draft payable upon presentation market with short-term horizons who sell slightly to the drawee or within a brief period thereafter above the most recent trade and buy at a price known as ‘‘days of grace.’’ slightly below. Society for Worldwide Interbank Financial Seasoned securities. Securities that have Telecommunications (SWIFT). A telecommuni- traded in the secondary market for more than cations network established by major financial 90 days. institutions to facilitate messages among SWIFT Secondary market. A market in which secu- participants. These messages typically result in

April 2008 Commercial Bank Examination Manual Page 22 International—Glossary 7010.1 a monetary transaction between institutions. The action taking place the next working day after network is based in Brussels. the spot date. In the Eurocurrency market, a Soft currency. A currency that is not freely term used to describe a loan or deposit for value convertible into other currencies. on the spot date with maturity on the next Soft loans. Loans with exceptionally lenient working day after the spot date. repayment terms, such as low interest, extended Spot transaction. A transaction for spot amortization, or the right to repay in the cur- exchange or currency. rency of the borrower. Spread. The difference between the bid rate Sole of exchange. A phrase appearing on a and the offer rate in an exchange-rate quotation draft to indicate that no duplicate is being or an interest quotation. This difference is not presented. identical with the profit margin because traders Sovereign risk. The risk that the government seldom buy and sell at their bid and offer rates at of a country may interfere with the repayment of the same time. In another sense (for example, debt. Eurodollar loans priced at a mark-up over Space arbitrage. The buying of a foreign LIBOR), spread means a mark-up over cost, currency in one market and the selling of it for and, in this context, the spread is identical with a profit in another market. the profit margin. Special Drawing Rights (SDRs). International Square exchange position (or square-off).To paper money created and distributed to govern- make the inflows of a given currency equal to ments by the IMF in quantities dictated by the outflows of that currency for all maturity special agreements among its member countries. dates. This produces a square exchange position The value of SDRs is determined by the weighted in that currency. value of a ‘‘basket’’ of major currencies. Stabilization. The efforts by a lead manager in Specially designated nationals. Persons or a securities issue to regulate the price at which entities listed by OFAC. These persons or enti- securities trade in the secondary market, during ties are typically front organizations and are the period that the securities syndicate is still in subject to OFAC prohibitions. See also Blocked existence. account, Office of Foreign Asset Control. Sterilization. Intervention in the foreign- Speculation. The purchase or sale of a trading exchange market by a central bank in which the unit, usually on a forward basis, in hopes of change in the monetary base caused by the making a profit at a later date. The term is used foreign-exchange intervention is offset by open in the foreign-exchange, commodity, stock, and market operations involving domestic assets. option markets. Straight bill of lading. A bill of lading drawn Spot contract. A foreign-exchange contract directly to the consignee and therefore not traded in the interbank market in which the negotiable. See also Bill of lading. value date is two business days from the trade Strike price. The price at which an option date. buyer may purchase (if a call option) or sell (if Spot exchange (or spot currency). Foreign a put option) the asset upon which the option is exchange purchased or sold for immediate written. delivery and paid for on the day of the delivery. Subscription agreement. An agreement Immediate delivery is usually considered deliv- between a securities issuer and the managing ery in one to two business days after the banks that describes the terms and conditions of conclusion of the transaction. Many U.S. banks the issue and the obligation of the parties to the consider transactions maturing in as many as ten agreement. business days as spot exchange. Their reasons Subscription period. The time period between vary but are generally to facilitate revaluation the day on which a new securities issue is accounting policies and to initiate final confir- announced and the day on which the terms of mation and settlement verification procedures the issue are signed and the securities are on future contracts nearing maturity. See also formally offered for sale. Futures (or forward) exchange contract. Subsidiary. Entity in which a bank has a Spot month. The futures-contract month that modicum of control. Used to facilitate entry into is also the current calendar month. foreign markets in which other operations are Spot/next. In the foreign-exchange market, a proscribed. term used to describe a swap transaction for Sushi bonds. Dollar-denominated Eurobonds value on the spot date with the reverse trans- issued by Japanese companies and purchased

Commercial Bank Examination Manual April 2008 Page 23 7010.1 International—Glossary primarily by Japanese investors. These bond differs from a participation loan because the issues are typically managed by Japanese banks. banks participate at the outset and are known to Swap. The combination of a spot purchase or the borrower. sale against a forward sale or purchase of one Take-down. The receipt of the principal of a currency in exchange for another. The trading of loan by the borrower. one currency (lending) for another currency Tariff. A duty or tax on imports that can be (borrowing) for that period of time between either a percentage of cost or a specific amount which the spot exchange is made and the forward per unit of import. contract matures. See also Swap cost (or profit). Telegraphic transfer (TT) rate. The basic rate Swap arrangement—reciprocal. A bilateral at which banks buy and sell foreign exchange. agreement between central banks enabling each Buying rates for mail transfers, foreign-currency party to initiate swap transactions up to an drafts, traveler’s checks, and similar instruments agreed limit to gain temporary possession of the are all based on the TT rate. The TT rate may be other party’s currency. slightly less favorable than other rates because Swap cost (or profit). In a swap transaction, of the time required for collection. Foreign- the cost or profit related to the temporary move- currency time (usance) drafts also are bought at ment of funds into another currency and back the TT rate, but interest to maturity is deducted again. That exchange cost or profit must then be for the time which must elapse until maturity. applied to the rate of interest earned on the loan Telex. Direct communication between two or investment for which the exchange was used. banks or companies and organizations via satel- Furthermore, the true trading profits or losses lite or underwater cable. generated by the foreign-exchange trader cannot Tenor. A term designating payment of a draft be determined if swap profits or costs are as being due at sight, a given number of days charged to the exchange function rather than after sight, or a given number of days after the allocated to the department whose loans or date of the draft. investments the swap actually funded. Term structure. The level of interest rates on Swap and deposit. A combination of swap debt instruments of a particular type, viewed as transactions that enables the borrower to have a function of term to maturity. The interest-rate use of both currencies for the duration of the level may rise or fall with increasing maturity. transaction. Terms of trade. Relative price levels of goods Swap position. A situation in which the sched- exported and imported by a country. uled inflows of a given currency are equal to the Test key. A code used in transferring funds by scheduled outflows, but the maturities of those cable or telephone so that the recipient may flows are purposely mismatched. The expecta- authenticate the message. A test key generally tion in a swap position is that the swap rate consists of a series of numbers, including a fixed will change and that the gap can be closed at a number for each correspondent bank; a number profit. for the type of currency; a number for the total Swap rate. The difference between the spot amount; and, possibly, numbers for the day of exchange rate of a given currency and its for- the month and day of the week. A single number ward exchange rate. code indicates whether the total amount is in Swap-swap. A swap transaction involving thousands, hundreds, tens, or digits. To arrive at one forward maturity date against another for- a test number, the indicated numbers are totaled, ward maturity date. and the total amount usually precedes the text of Swaption. An option on a swap. It gives the the message. buyer the right, but not the obligation, to enter Third-country bills. Banker’s acceptances into an interest-rate swap at a future period of issued by banks in one country that finance the time. transport or storage of goods traded between Syndicate. A group of banks that acts jointly, two other countries. on a temporary basis, to loan money in a bank Tied loan. A loan made by a governmental credit (syndicated credit) or to underwrite a new agency that requires the borrower to spend the issue of bonds (bond underwriting syndicate). proceeds in the lender’s country. Syndicate leader. See Manager of syndicate. Time draft. A draft drawn to mature at a fixed Syndicate participation. Usually, a large credit time after presentation or acceptance. arranged by a group of lenders, each of whom Time value. The amount by which an option’s advances a portion of the required funds. It market value exceeds its intrinsic value.

April 2008 Commercial Bank Examination Manual Page 24 International—Glossary 7010.1

Tombstone. In a syndicated credit, an adver- Two-way rate. An exchange-rate or an interest- tisement placed in a newspaper or magazine by rate quotation that contains both a bid rate and banks to record their participation in the loan or, an offer rate. The size of the spread between the in a bond issue, to record their role in managing, two rates indicates the relative quality of the underwriting, or placing the bonds. quotation. Tomorrow next (tom/next). The simultaneous Unconfirmed letter of credit. See Letter of purchase and sale of a currency for receipt and credit—advised. payment on the next and second business day, Undervalued. Decline of the spot rate below respectively, or vice versa. purchasing power parities, so that the goods of Tradable amount. The minimum amount one county are cheaper than in another country. accepted by a foreign-exchange broker for the In relation to forward exchange, ‘‘undervalued’’ interbank market, for example, 100,000 Cana- means that forward premiums are narrower or dian dollars or 50,000 pounds sterling. forward discounts are wider than the interest Trade acceptance. A draft drawn by the seller parities between the two financial centers. (drawer) on the buyer (drawee) and accepted by Underwriting allowance. The share of total the buyer. Also called a trade bill, customer investment-banking fees accruing to the under- acceptance, and two-name trade paper. See also writing group. Acceptance. Underwriting syndicate. The banks, in a Trade accounts. Those parts of the balance of new securities issue, that agree to pay a mini- payments that reflect money spent abroad by the mum price to the borrower even if the secur- citizens of a country on goods and services and ities cannot be sold on the market at a higher the money spent by foreigners in the given price. country for goods and services. Uniform customs and practices for documen- Trader’s (or dealer’s) ticket (slip). The hand- tary credits. Sets of rules governing documen- written record of a foreign-exchange trade and/or tary letters of credit formulated by the Interna- placing and taking of deposits that is written by tional Chamber of Commerce. Includes general the dealer who executed the transaction. provisions, definitions, forms, responsibilities, Trading position worksheet. A record of documents, and the transfer of documentary incomplete transactions in a particular currency. letters of credit. Tranche. One of a number of drawings of Unmatched. A forward purchase is unmatched funds made by a borrower under a term loan. when a forward sale for the same date has not Transaction date. The date on which a con- been executed or vice versa. tract’s terms are negotiated and agreed on. Unmatured transactions. Trading transactions Transfer risk. The risk arising when a bor- that have not reached their settlement dates. rower incurs a liability in a currency that is not Usance. The period of time between presen- the currency in which revenues are generated. tation of a draft and its maturity. See also Tenor. The borrower may not be able to convert its Value-compensated. The payment or collec- local currency to service an international loan if tion of a settlement cost on an open forward foreign exchange is not generated. contract to cancel the contract rather than to Trending of rates. Quoting a slightly higher or execute an offsetting contract for the same lower two-way rate in order to reflect a prefer- maturity date. ence for either purchasing or selling. Value date. The date on which foreign Trust receipt. Used extensively in letter-of- exchange bought and sold must be delivered and credit financing, this is a document or receipt in on which the price for the exchange must be which the buyer promises to hold the property paid. received in the name of the releasing bank, Value-impaired. A category assigned by the although the bank retains title to the goods. The Interagency Country Exposure Review Commit- merchant is called the trustee, the bank the tee that indicates a country has protracted debt entruster. Trust receipts are used primarily to problems. allow an importer to take possession of the goods Value today. An arrangement by which spot for resale before payment to the issuing bank. exchange must be delivered and paid for on the Two-way quotation. A simultaneous quotation day of the transaction instead of two business of foreign-exchange buying and selling rates days later. implying the willingness of the bank to deal Value tomorrow. An arrangement by which either way. spot exchange must be delivered and paid for on

Commercial Bank Examination Manual April 2008 Page 25 7010.1 International—Glossary the business day following the transaction instead cable, telex, or telegram. of two business days after the transaction. Withholding tax. A tax imposed by a country Variationmargins. Positive or negative changes on the gross amount of payments to a foreign in the value of a security bought on margin or a lender from an in-country borrower. futures contract. These variations must be paid Within-line facility (or facilities). Subfacili- daily in cash. All securities bought or sold on ties of the line of credit that establish param- margin and futures contracts are marked to eters, terms, and conditions of various other market. facilities available for specific additional pur- Volatility. The standard deviation of changes poses or transactions. The aggregate sum of in the logarithm of an asset price, expressed at a all outstandings under within-line facilities yearly rate. The volatility is a variable that must not exceed the total of the overall line of appears in option formulas. credit. Volume quotation system. A method of giving World Bank (The International Bank for exchange rates in which a certain specified Reconstruction and Development). An interna- amount of local currency (usually 1 or 100) is tional financial organization whose purpose is to stated as the corresponding amount in foreign aid the development of productive facilities in currency. member countries, particularly in developing Vostro account. A demand account main- countries. The chief source of funds is capital tained for a bank by a correspondent bank in a contributions made by member countries, which foreign country. The nostro account of one bank vary with the financial strength of the country. is the vostro account of the other bank. See also Another funding source is the sale of long-term Nostro account. bonds. Warehouse receipt. An instrument that lists Writer. An individual who issues an option and is a receipt for goods or commodities and, consequently, has the obligation to sell the deposited in the warehouse that issues the receipt. asset (if the option is a call) or to buy the asset These receipts may be negotiable or non- (if the option is a put) on which the option negotiable. A negotiable warehouse receipt is is written if the option buyer exercises the made to the ‘‘bearer,’’ while a nonnegotiable option. warehouse receipt specifies precisely to whom Yankee bond. A dollar-denominated foreign the goods shall be delivered. There are several bond issued in the U.S. market. alternatives for releasing goods held under ware- Yield curve. The interest rates for each differ- house receipts: (1) the delivery of goods may be ent tenor or maturity of a financial instrument. A allowed only against cash payment or substitu- graph of the yield curve has interest rates on the tion of similar collateral; (2) some or all of the vertical axis and time-to-maturity on the hori- goods may be released against the trust receipt zontal axis. When longer maturities have higher without payment, or (3) a warehouseman may interest rates than shorter maturities, the curve is release a stipulated quantity of goods without a called a positive or upward-sloping yield curve. specific delivery order. Banks will accept a The opposite type of curve is called a negative, warehouse receipt as collateral for a loan only if downward-sloping, or inverted yield curve. the issuer of a receipt is a bonded warehouse- When interest rates are the same for all maturi- man. The bank must have protected assurances ties, the curve is called a flat yield curve. See for the authenticity of the receipt and the fact also Term structure. that the commodities pledged are fully available Yield to maturity. The rate of interest on a as listed on the warehouse receipt. bond when calculated as that rate of interest Wash. A transaction that produces neither which, if applied uniformly to future time profit nor loss. periods, sets the discounted value of future bond Wire. Often the words ‘‘wire’’ and ‘‘cable’’ coupon and principal payments equal to the are used interchangeably. In some cases, ‘‘wire’’ current market price of the bond. denotes messages sent within the confines of the Zero coupon bond. A bond that pays no United States, and ‘‘cable’’ refers to messages interest but that is redeemed at its face value at transmitted overseas. Others use ‘‘wire’’ to mean maturity. a transfer of funds by telephone rather than by

April 2008 Commercial Bank Examination Manual Page 26 International—Loan Portfolio Management Effective date May 1996 Section 7020.1

Although the methods of international loan ers. During times of heavy loan demand in one portfolio management are similar to those estab- category, an inflexible loan distribution policy lished for domestic lending, the additional risks could cause that category to be slighted in favor in international lending require specialized of another. expertise and careful management by the bank. Banks conducting international lending activi- Types of credits. The lending policy should state ties should establish strong policies that include the types of international credits that the bank not only the basic components found in domes- can make and set guidelines to follow in grant- tic policies but also the following segments. ing specific credits. The decision about the types of credits to be granted should be based on Geographic limits. The bank should delineate consideration of the expertise of the lending those countries or geographic areas where it can officers, deposit structure of the bank, and anti- lend profitably and soundly in accordance with cipated credit needs of its customers. Complex its objectives and in consideration of country credits requiring more than normal policing risks. International lending officers must know should be avoided unless or until the bank the specific country limits established by the obtains the necessary personnel to administer board of directors, and the bank should have a those credits properly. Types of credit that have monitoring system to ensure adherence to those resulted in an abnormal loss to the bank’s limits. The limits established will depend on international division should be controlled or each bank’s available financial resources, the avoided within the framework of stated policy. qualifications and skills of its staff, the extent of Syndications and other types of term loans its lending activities, and its further growth should be limited to a given percentage of the potential. bank’s stable funds. Maximum maturities. International credits should Distribution by category. Limitations based on be granted with realistic repayment plans. aggregate percentages of total international loans Maturity scheduling should be related to the in real estate, consumer credit, ship financing, or anticipated source of repayment, the purpose of other categories are common. Although loan the credit, the useful life of the collateral, and distribution policy may differ among banks, the degree of country risk. For term loans, a international loans are generally granted in the lending policy should state the maximum num- following categories: ber of months during which loans may be amortized. Specific procedures should be devel- • import and export financing oped for situations requiring balloon payments • loans to corporations or their overseas branches, and modifications to the original terms of a loan. subsidiaries, or affiliates with a parent guar- If the bank requires a cleanup (out-of-debt) antee or other form of support period for lines of credit, that period should be • loans granted to foreign local borrowers explicitly stated. including foreign entities of U.S. concerns that borrow without any form of support from the Loan pricing. Interest rates, fees, commissions, parent corporation and discounts on various loan types established • loans and placements to foreign banks or to by the loan policy must be sufficient to cover the overseas branches of U.S. banks costs of funds loaned, servicing of the loan • loans to foreign governments or foreign gov- (including general overhead), and probable ernmental entities losses, while providing for a reasonable rate of return. Periodic review allows the rates to be The categories of credit extensions that the adjusted to account for changes in costs and bank’s international division should engage in competitive factors. Additionally, the bank must and the nature of any limitations will depend on establish practices to ensure a continuous exami- the particular bank and its customers. Devia- nation of the relationships between loan pricing tions from policy limitations that have been and the cost of funds. approved by the board of directors or its desig- nated committee(s) should be allowed to meet Foreign-exchange risks. Lending policy should the changing requirements of the bank’s custom- include controls that minimize risks for loan

Commercial Bank Examination Manual May 1996 Page 1 7020.1 International—Loan Portfolio Management portfolios in one currency funded by borrowings significant differences between loan agreements in another. These activities must be identified drawn in the United States and those drawn and should be limited by the bank if— abroad. Nevertheless, the bank must ensure that its loan agreements with borrowers protect it • a particular foreign government is expected to adequately. Generally, few restrictive covenants impose stringent exchange controls; are required for international loans because of • the currencies involved are or will be subject competition in offshore markets and differing to wide exchange-rate fluctuations; or local practices. Nevertheless, the bank should • political, social, or economic developments insist on protective covenants when appropriate, are likely to intensify exchange risks. especially if the borrowers are small or medium- sized obligors. The bank also should ensure that Multicurrency credit commitments permit loan agreements provide for the borrower to borrowers to select from a specific list of cur- reimburse the lender for certain unanticipated rencies the one they prefer to use in each costs, including the imposition of taxes on rollover period. The listed currencies, however, interest withheld at the source without corre- may be unavailable or available only at a high sponding credits gained on the levy of U.S. taxes cost. The bank should protect itself by stating and the need to establish or increase bad debt in the loan agreement that its requirement reserves. to provide any of the currencies listed is sub- ject to availability at the time requested by Financial information. Current and complete the borrower. For detailed information on financial information is necessary at the incep- foreign-exchange risks, see section 7100, tion and throughout the term of an international ‘‘International—Foreign Exchange.’’ loan. The lending policy should specifically define financial-statement requirements for busi- Documentation and collateral. Trade financing nesses, foreign banks, foreign governments, other often represents a significant amount of an foreign public-sector entities, and individuals, international division’s lending activity. In this and it should include criteria for the requirement type of financing, the bank deals only in docu- of audited, nonaudited, fiscal, interim, oper- ments, while its customer is responsible for the ating, cash-flow, and other statements. The merchandise under the terms of the sales con- requirements should be defined clearly enough tract. The bank’s control of documents, espe- so that any credit data exception in the exami- cially title documents, is crucial. Lending offi- nation report is a clear exception to the bank’s cers and applicable personnel, therefore, must lending policy. be knowledgeable in handling documentation, The reliability of financial statements and which may be the bank’s ultimate support for accompanying information differs greatly among certain transactions. countries. In some countries, accounting stan- The bank must establish policies for taking dards and traditions are lax and audited state- overseas collateral as security for a loan to ments are virtually unknown. Financial informa- ensure that local required procedures are met. tion provided for tax-collection purposes in For example, in many countries, liens on fixed foreign countries may differ from that given in assets must be registered with the local govern- confidence to the bank to obtain credit. ment, depending on the type of asset. Lending In analyzing financial statements of foreign against current assets also requires special care entities, factors are present that do not exist and monitoring. The bank must know which when analyzing those of U.S. enterprises, such countries do not recognize the legality of trust as markedly different accounting concepts, the receipts as recognized in the United States. In wide use of ‘‘hidden reserves,’’ translation prob- other countries, borrowers sign powers of attor- lems, different methods of valuing assets, or ney or similar documents permitting lenders to unfamiliar and sharply different legal principles. take specifically defined collateral at any time. A general rule in analyzing local currency state- For these and other reasons, the bank must retain ments is not to translate figures to U.S. dollar local lawyers who are thoroughly familiar with equivalents. Fluctuating exchange rates can have that country’s laws, regulations, and practices a significant impact on the analysis of U.S. and who will check loan agreements, guaran- dollar equivalents over a period of time. If a loan tees, debt instruments, drafts, corporate resolu- is to be repaid in currency other than the tions, and other loan documentation. There are borrower’s domestic currency, an analysis of

May 1996 Commercial Bank Examination Manual Page 2 International—Loan Portfolio Management 7020.1 probable future foreign-exchange-rate move- The quality of management is the key to the ments is necessary to assess the borrower’s analysis of foreign banks and is best determined ability to generate sufficient local currency to by frequent visits by officers of the lending buy the necessary exchange. An analysis of the bank. Credit checks from other lenders should availability of exchange is also required to be required with periodic updates. Credit reports ensure full repayment at maturity. Financial are not available in all countries and, when Accounting Standards Board Statement No. 52, provided, are often incomplete or vague. Con- ‘‘Foreign-Currency Translation,’’ takes certain sequently, there is no substitute for firsthand translation adjustments out of earnings and information obtained from visits to overseas places them in a separate component of equity banks. capital (‘‘foreign-currency translation adjust- ments’’), thereby reducing the fluctuations in Country risk. Balance of payments; exchange earnings produced by changing exchange rates. control; and economic, political, and social Since the financial information provided is not information on each borrower’s home country always reliable, the bank’s policies should enable should be on file to enable the bank to assess it to determine by other means the capacity, the elements of country risk. The lack of this integrity, experience, and reputation of the for- information is as serious a weakness as the lack eign borrower. of financial information on the borrowers. For Extensions of credit to foreign banks consti- additional information, see section 7040, tute an important segment of an international ‘‘International—Transfer Risk.’’ division’s foreign loans. It is important to obtain information on the nature of the bank’s busi- Limits and guidelines for purchasing loans. ness; its assets, liabilities, and contingent Purchasing loans from dealers or correspondent accounts; and its record of past earnings. A banks is a common practice in banks with review of these data should lead to a determi- limited opportunities to generate international nation of the strength of the bank and its ability credit extensions on their own. However, these to meet its obligations in the foreseeable future. purchases may restrict a bank to low-profit loans At minimum, this review should include— at narrow spreads over a medium-to long-term period. Buying loans seldom builds relation- • the size and liquidity of primary and second- ships with borrowers since the relationship gen- ary reserves; erally stays with the bank originating the loan. • the nature of lending activities, including Therefore, the lending policy should limit the types and terms of loans, extent of collateral amount of paper purchased from any one out- held, and loss experience; side source and should state an aggregate limit • lending policies and controls in effect to on all these loans. ensure compliance with applicable lending laws and regulations; Limitation on aggregate outstanding loans. Limi- • the size and character of investments; tations on the total amount of loans outstanding • the size of fixed assets; relative to other balance-sheet accounts should • the size and nature of investments in subsidi- be established for the bank, with limits (or aries and other affiliates and the extent to sublimits) applicable to international loans which the bank will support those entities in clearly defined. Controls over the international times of difficulty; loan portfolio are usually expressed relative to • the source and nature of deposits and their deposits, capital structure, or total assets. volatility; • the nature and extent of other liabilities and Concentration of credits. The same types of contingent liabilities, including standby concentrations of credits found in a domestic facilities; loan portfolio may exist in the international • the earnings and dividend record and the portfolio. In international banking, however, an adequacy of capital; additional concentration involves loans to a • the activities of the bank in the foreign- foreign government, its agencies, and its majority- exchange and interbank markets; owned or -controlled entities. Loans to specific • the size and character of the bank’s interna- private businesses may be included in those tional business; and concentrations if an interrelationship exists in • the competency of management. the form of guarantees, moral commitments,

Commercial Bank Examination Manual May 1996 Page 3 7020.1 International—Loan Portfolio Management significant subsidies, or other factors indicating is systematic and progressively stronger. Guide- dependence on the government. The bank’s lines should be established to ensure that all directorate should evaluate the risks involved in accounts are presented to and reviewed by various concentrations and determine those con- senior management or the directorate for poten- centrations that should be avoided or limited. tial charge-off at a stated period of delinquency. The lending policy should also require that all concentrations in the international division be Other. The lending policy should be supple- reviewed and reported frequently. For a full mented with other written guidelines for specific discussion of this component, see section 2050, departments concerned with credit extensions, ‘‘Concentrations of Credits.’’ such as letters of credit, banker’s acceptances, and discounted trade bills. Written policies and Loan authority. The lending policy should procedures approved and enforced in those establish written limits for all international lend- departments should be referenced in the general ing officers. Lending limits also may be estab- lending policy of the bank. lished for group authority, allowing a combina- tion of officers or a committee to approve loans larger than those the members would be permit- Before a bank grants international credit, its ted to approve individually. The reporting pro- objectives, policies, and practices must be clearly cedures and the frequency of committee meet- established. The bank must consider its overall ings should be defined. If the bank operates size, financial resources, the nature of its cus- foreign branches, head office–delegated lending tomers, its geographic location, and the qualifi- authority should be clearly defined and under- cations and skills of its staff. An examiner stood by overseas lending officers. should review policies and practices to deter- mine if they are clearly defined and adequate to Nonperforming credits and charge-offs. The monitor the condition of the portfolio. If written lending policy should define nonperforming guidelines do not exist, there is a major defi- credit extensions of all types (delinquencies, ciency in the lending area, and the board of nonaccruals, or reduced rates) and should specify directors is not properly discharging its duties their accounting and reporting requirements. and responsibilities. If no exception is taken to Reports should be submitted regularly to the the objectives, policies, and practices, the inter- board of directors and senior management. The national loan portfolio can then be reviewed to management of banks with overseas branches ensure compliance. must take extra care to define and communicate The failure of the directors to establish a their banks’ policies and procedures on nonper- sound international lending policy, of the man- forming credits to ensure that all bank offices are agement to establish adequate written proce- properly identifying, accounting for, and report- dures, or of both to monitor and administer the ing credits. The reports should include sufficient international lending function within established detail to allow for the determination of risk guidelines has resulted in serious problems for factors, loss potentials, and alternative courses banks. Major sources and causes of loan trouble, of action to effect repayment of nonperforming as discussed in domestic ‘‘Loan Portfolio Man- credits. The policy governing delinquent credits agement,’’ section 2040, also apply to interna- should require a follow-up notice procedure that tional lending.

May 1996 Commercial Bank Examination Manual Page 4 International—Loan Portfolio Management Examination Objectives Effective date May 1996 Section 7020.2

1. To determine if policies, practices, proce- national loan portfolio and how that quality dures, and internal controls for international affects the soundness of the bank. loan portfolio management are adequate. 5. To prepare information on the bank’s lending 2. To determine if bank officers are operating function in a concise, reportable format. in conformance with the established bank 6. To determine compliance with applicable guidelines. laws and regulations. 3. To determine the scope and adequacy of the 7. To recommend corrective action when poli- audit function as it relates to international cies, practices, procedures, or internal con- lending procedures. trols are deficient or when violations of laws 4. To determine the overall quality of the inter- and regulations are cited.

Commercial Bank Examination Manual May 1996 Page 1 International—Loan Portfolio Management Examination Procedures Effective date March 1984 Section 7020.3

1. If selected for implementation, complete or • Purpose of the loan. update the International Loan Portfolio • Any action being taken to bring the Management section of the Internal Control loan current. Questionnaire. b. International loans on which interest is 2. Test for compliance with policies, practices, not being collected in accordance with procedures, and internal controls in conjuc- the terms of the loan. tion with performing the remaining exam- c. International loans the terms of which ining procedures. Also obtain a listing of have been modified by a reduction of any deficiencies noted in the latest review interest rate or principal payment or by a done by internal and external auditors from deferral of interest or principal. the examiner assigned to the audit review d. International loans for which repayment and determine if appropriate corrections terms have been restructured. have been made. e. International loan participations pur- 3. Request reports on the following from chased and sold and participations in the bank’s international division, by depart- consortium credits since the previous ment, as of the examination date unless examination. otherwise specified: f. International loans sold in full since the a. Past-due loans. This report should cover: previous examination. • Single payment and demand notes past g. International credits considered ‘‘prob- due. lem credits’’ by management (this report • Single payment and demand notes on may be either as of the examination date which interest is due and unpaid for or as of the date the report was last 30 days or more. submitted to the officer’s loan review • Consumer, mortgage and term loans committee(s), the loan and discount com- payable in regular installments on mittee(s), or the board of directors). which one installment is due and h. International credit commitments and unpaid for 30 days or more. other contingent liabilities. • Outstandings under cancelled advance i. Loans secured by stock of other banks (overdraft) facilities that are unpaid. and rights, interest, or powers of a sav- • Discounted (purchased) outgoing for- ings and loan association. eign bills matured and unpaid and j. Extensions of credit to employees, offi- advances secured by pledged delin- cers, directors, or their interests. quent foreign bills. k. Extensions of credit to executive offi- • Unauthorized overdrafts including any cers, directors, principal shareholders and resulting from customers not paying their interests of correspondent banks. the bank for banker’s acceptances or l. Miscellaneous loan debit and credit sus- drafts it paid. pense accounts. And should include the following m. Current interest rate structure. information: n. Current lending authorities of officers • Name of the obligor. and credit committee(s). • Original amount of the loan. 4. Obtain the following information: • Outstanding balance of the loan. a. A copy of written policies covering all • Date the loan was made. international lending functions. • Due date. b. A statement of whether a standing com- • Terms of the loan. mittee administers the lending function. • Number of payments the loan is c. Copies of reports furnished to the board delinquent. of directors for its meetings. • Date of the borrower’s last payment. d. Lists of directors, executive officers, prin- • Date to which interest is paid. cipal shareholders and their interests. For larger international loans, the report e. A summary of the officer borrowing should also include: report (debts to own and other banks).

Commercial Bank Examination Manual March 1994 Page 1 7020.3 International—Loan Portfolio Management: Examination Procedures

f. A list of previously charged-off loans 10. Compare the lists of directors, officers and approved by the directors. their related interests to determine: 5. Obtain a copy of the latest reports furnished a. Preliminary compliance with Regulation to the international loan and discount com- O (12 CFR 215) (loans to insiders). mittee(s). (The domestic loan and discount b. Preliminary compliance with established committee(s) sometimes handle(s) interna- policies. tional loans and discounts.) 11. Perform the following steps for past-due 6. Review international lending policies and loans: updates and abstract appropriate excerpts a. Compare the following to determine any on: material inconsistencies: a. Distribution of loans by category. • The past-due schedule received in b. Geographic area and country exposure step 3. Delinquency reports submitted limitations. to the board. c. Type of borrowing and industrial con- • List of loans considered ‘‘problem’’ centration limitations. loans by management. d. Lending authorities of committees and b. Scan the delinquency lists submitted to officers. the board of directors and senior man- e. Any prohibited types of international agement to determine that reports are loans. sufficiently detailed to evaluate risk f. Maximum maturities for various types of factors. international loans. c. Compile current aggregate totals of past- g. Interest rate structure. due paper. h. Minimum downpayment for various 12. Perform the following using the loan types of loans. commitments and contingent schedules obtained in step 3: i. Collateral appraisal policies including: a. Reconcile appropriate contingency totals • Persons authorized to perform to memoranda ledger controls. appraisals. b. Review reconciling items for reason- • Lending values of various types of ableness. assets. 13. Obtain the listing of Uniform Review of j. Financial information requirements by Shared National Credits and update the types of loans. listing based on information obtained in k. Guidelines for purchasing other banker’s step 3. acceptances and commercial paper. 14. Obtain the classifications and categories of l. Guidelines for loans to major sharehold- strong, moderately strong, and weak coun- ers, directors, officers, or their interests. tries from Interagency Country Exposure 7. When more than one international lending Review Committee meeting for which write- policy exists, determine if they are inter- ups have been made available and update nally consistent by reviewing the guidelines that data based on information obtained in previously obtained. step 3. 8. Review minutes of the bank’s international 15. Distribute the applicable schedules and other loan and discount committee(s) meetings to information obtained in the preceding steps obtain: to the examiners performing the loan exam- a. Present members and their attendance ination programs. Request that the examin- record. ers test the accuracy of the information. b. Scope of work performed. Also, request that they perform appropriate c. Any information considered useful in the steps in the separate program ‘‘Concentra- examination of specific loan categories tion of Credits.’’ or other areas of the bank. 16. Determine the general distribution and char- 9. Compare reports furnished to the board of acteristics of the international loan portfolio directors and the loan and discount commit- by: tee(s), and those received from the bank in a. Determining the percentage of total loans step 3 to determine any material differences in specific classes and geographic areas. and that the differences are transmitted to b. Comparing international loan category the board in a timely manner. distributions to policy guidelines.

March 1994 Commercial Bank Examination Manual Page 2 International—Loan Portfolio Management: Examination Procedures 7020.3

17. Obtain the results of the reviews performed • Weighted classified international cred- of the various segments of the international its to primary capital funds. division during the course of the examina- 18. Forward the totals of international division tion, and perform the following: loss and doubtful classifications to the a. Determine any nonadherence to inter- examiner assigned to analyze the adequacy nally established policies, practices, pro- of the bank’s capital. cedures, and controls. 19. Compare management’s list of ‘‘problem’’ b. Compare the various international divi- credits from step 3 to the examiner’s listing sion results to determine the extent of of international classified and criticized nonadherence and if it is systemwide. credits to determine the extent of manage- c. Organize internal guideline exceptions ment’s knowledge of its own international in order of relative importance. credit problems. d. Determine the aggregate amount of stat- 20. Determine, through an in-depth analysis of utory bad debts. information previously generated, the causes e. Organize violations by law and regulation. of existing problems or weaknesses within f. Review international credit classifica- the international division’s systems which tions and assets listed for special men- present potential for future problems. tion to determine: 21. Forward the following information to the • Inclusion of all necessary information. examiner assigned to analyze the bank’s • Substantiation of classification or loan loss reserves. criticism. a. A listing of international division g. Determine the aggregate amount of credit credits considered ‘‘problem’’ credits by extensions listed in each of the four management. levels of criticism. h. Compile a listing of all credit extensions b. A listing of classified and criticized cred- not supported by current and satisfactory its relating to the international division. credit information. c. A listing of previously charged-off loans. i. Compile a listing of all credit exten- 22. Organize the results of the examination of sions not supported by complete collat- the international lending function to facili- eral documentation. tate discussion with the examiner-in-charge j. Review the separate procedures for ‘‘Con- and, upon approval, with senior manage- centration of Credits’’ and determine: ment of the bank. • If all necessary data is included. 23. During discussion with senior management, • If there is substantiation for including structure inquiries in such a manner as to: specific items in the report of exami- a. Gain insight into management’s interna- nation as a concentration. tional lending philosophy. • If the concentration is undue or b. Elicit management responses for correc- unwarranted. tion of deficiencies. k. Compute the following ratios and 24. Write, in appropriate report format, general compare to computations from prior remarks which may include: examinations: a. The scope of the examination of the • Aggregate international division past international lending function. due paper to international division loans and overdrafts outstanding. b. The quality of internal policies, prac- • Aggregate international division ‘‘A’’ tices, procedures, and controls over the paper to international division past international lending function. due. c. The general level of adherence to inter- • Total international division past due, nal policies, practices, procedures, and nonaccural and renegotiated rate controls that govern the bank’s interna- credits to total international division tional lending function. credits. d. The scope and adequacy of the internal • Aggregate classified international cred- loan review system regarding interna- its to primary capital funds. tional credit extensions. • Aggregate classified international credit e. The quality of the entire international to total bank classified credits. credit portfolio.

Commercial Bank Examination Manual March 1994 Page 3 7020.3 International—Loan Portfolio Management: Examination Procedures

f. The competency of management with rection of credit control and quality respect to the international lending deficiencies. function. j. Credit extensions to insiders and their g. Causes of existing credit problems. interests. h. Expectations for continued sound inter- 25. Compile or prepare all information which national lending and correction of provides substantiation for your general existing credit control and quality remarks. deficiencies. 26. Update the workpapers with any informa- i. Promises made by management for cor- tion that will facilitate future examinations.

March 1994 Commercial Bank Examination Manual Page 4 International—Loan Portfolio Management Internal Control Questionnaire Effective date June 1985 Section 7020.4

Review the bank’s internal controls, policies, ment objectives and policies reviewed at practices, and procedures for managing the least annually to determine if they are bank’s loan portfolio. The bank’s system should compatible with changing market be documented in a complete and concise man- conditions? ner and include, where appropriate, narrative 3. Are the following reported to the board of descriptions, flowcharts, copies of forms used, directors or its designated committees (indi- and other pertinent information. cate which) at their regular meetings (at least monthly): 1. Has the board of directors, consistent with a. Past-due single payment loans (if so, its duties and responsibilities, adopted writ- indicate the minimum days past due for ten international loan portfolio management them to be included )? objectives and policies that: b. Loans on which interest only is past due a. Establish suggested guidelines for distri- (if so, indicate the minimum days past bution of international loans by different due for them to be included )? categories? c. Term loans on which one installment is b. Establish geographic area limits for past due (if so, indicate the minimum credits? days past due for them to be included c. Establish suggested guidelines for )? aggregate outstanding international d. Outstandings under overdraft facilities loans in relation to other balance sheet that are unpaid (if so, indicate the mini- categories? mum days past due for them to be d. Establish international loan authority of included )? committees and individual lending e. Discounted (purchased) outgoing foreign officers? bills matured and unpaid (or advances e. Define acceptable types of international collateralized by pledged delinquent for- loans? eign bills) (if so, indicate the minimum f. Establish maximum maturities for vari- days past due for them to be included ous types of international loans? )? g. Establish international loan pricing? f. Overdrafts resulting from a customer not h. Establish appraisal policy? paying the bank for banker’s acceptances i. Establish minimum financial information or drafts the bank paid (if so, indicate required at inception of the credits? minimum days past due for them to be j. Establish limits and guidelines for pur- included )? chasing paper? g. Total outstanding international loan k. Establish guidelines for loans to bank commitments? directors, officers, and their related h. Loans requiring special attention? interests? i. New loans and loan renewals or restruc- l. Establish collection procedures? tured loans? m. Define the duties and responsibilities of international loan officers and loan 4. Are reports submitted to the board or its committees? committees rechecked by a designated per- son for possible omissions prior to their n. Outline international loan portfolio man- submission? agement objectives that acknowledge: • Concentrations of credit within spe- 5. Are written applications required for all cific industries and relating to country international loans? credits? 6. Does the bank maintain credit files for all • The need to employ personnel international borrowers? with specialized knowledge and 7. Does the credit file contain information on: experience? a. The purpose of the loan? • Possible conflicts of interest? b. The planned repayment schedule? 2. Are international loan portfolio manage- c. The disposition of loan proceeds?

Commercial Bank Examination Manual March 1994 Page 1 7020.4 International—Loan Portfolio Management: Internal Control Questionnaire

d. The points to be raised regarding the e. Determines that notes and debt instru- borrower from which to base questions ments are being approved initially by the during officer calling programs? loan officer? e. Lending officer calls on customers and f. Ascertains that new international loans foreign countries? are within the limitations set for the 8. Does the bank require periodic submission borrower by corporate resolution? of financial statements by all international g. Rechecks liability ledgers to determine division borrowers whose loans are not that new loans have been accurately fully secured by readily marketable posted? collateral? h. Rechecks the preparation of maturity and 9. Is a tickler file maintained to assure that interest notices? current financial information is requested i. Examines entries to various general led- and received? ger loan controls? 10. Does the bank require submission of certi- j. Confirms collateral, loans, and discounts fied financial statements based on dollar with customers on a test basis? amount of commitment (if so, state the 19. Does the bank have an international loan dollar or equivalent minimum $ )? review section or the equivalent? 11. Are financial statements of foreign borrow- 20. Is the loan review section independent of ers spread in the credit file by local currency the international lending function? and U.S. dollar equivalents, if appropriate, 21. Are the initial results of the international on a yearly comparative basis? loan review process submitted to a person 12. Are borrower financial statements spread or committee which is also independent of with those of comparable borrowers in the the international lending function? same country? 22. Are all international loans exceeding a 13. Does the bank perform a credit investiga- certain dollar amount selected for review? tion on proposed and existing borrowers for 23. Do international lending officers recom- new loan applications? mend loans for review? 14. Does the bank have a periodic lending 24. Is a method, other than those detailed in officer call program for: steps 23 or 24, used to select international a. Customers? loans for review (if so, provide details)? b. Countries? 25. Are internal reviews conducted at least 15. Is it required that all international loan annually for all international lending areas? commitments be in writing? 26. In an officer identification system, are guide- 16. Are international lines of credit reviewed lines in effect which define the conse- and updated at least annually? quences of an officer withholding a loan 17. Are borrower’s outstanding liabilities from the review process? checked to appropriate lines of credit prior 27. Is the bank’s international problem loan to granting additional advances? list periodically updated by the lending 18. Is there an internal review system (it may be officers? a function of the internal audit department) 28. Does the bank maintain a list of interna- which covers each department and: tional loans reviewed, indicating the date of a. Rechecks interest, discounts, fees, the review and the credit rating? commissions, and maturity date 29. Does the loan review section prepare sum- computations? maries to substantiate credit ratings, includ- b. Re-examines debt instruments for proper ing pass loans? execution, receipt of all required support- 30. Are loan review summaries maintained in ing papers, and proper disclosure forms? a central location or in appropriate credit c. Determines that international loan files? approvals are within the limits of the 31. Are followup procedures in effect for inter- bank’s lending authorities? nally classified international loans, includ- d. Determines that international loans out- ing an update memorandum to the appro- standing and committed are within the priate credit file? bank’s foreign country or foreign cur- 32. Are officers and employees prohibited from rency limits? holding blank signed notes and other debt

March 1994 Commercial Bank Examination Manual Page 2 International—Loan Portfolio Management: Internal Control Questionnaire 7020.4

instruments in anticipation of future c. The cost factor of probable losses? borrowings? d. The programmed profit margin? 33. Are paid and renewed notes cancelled and 41. Does the international division main- promptly returned to customers? tain adequate and current country analysis 34. Do loan proceeds disbursed in cash require information? a customer receipt? 42. Has the international division conducted 35. Are international loan records retained in studies for those industries in which it is a accordance with record retention policy and substantial lender? legal requirements? 36. Are new notes microfilmed daily? 37. Is a systematic and progressively stronger CONCLUSION follow-up notice procedure utilized for delin- quent loans? 43. Is the foregoing information an adequate 38. Does the bank maintain loan interest, dis- basis for evaluating internal control in that count, fee, and commission rate schedules there are no significant deficiencies in for various types of international loans? areas not covered in this questionnaire that 39. Does the bank periodically update the impair any controls? Explain negative an- above rate schedules (if so, state normal swers briefly, and indicate any additional frequency )? examination procedures deemed necessary. 40. Does the bank maintain records in suffi- 44. Based on a composite evaluation, as evi- cient detail to generate the following infor- denced by answers to the foregoing mation by type of advance: questions, internal control is considered a. The cost of funds loaned? (adequate/inadequate). b. The cost of servicing loans, including overhead?

Commercial Bank Examination Manual March 1994 Page 3 International—Loans and Current Account Advances Effective date May 1996 Section 7030.1

A bank’s international division lends, either international financing treated as loans include directly or through state entities, to U.S. import- own acceptances purchased (discounted), other ers and exporters, foreign companies, multina- banker’s acceptances purchased, and discounted tional corporations, foreign banks, and foreign trade acceptances. governments. The terms of these lending activi- The same credit risks apply to international ties are consistent with the purpose of the division loans as to those made in domestic loan financing. departments, with the addition of country risk, Short-term working-capital loans to commer- which is the primary additional component that cial business enterprises commonly finance distinguishes an international loan from a domes- inventories or receivables arising from trade. tic loan. Country risk encompasses the entire Receivable pledges, warehouse receipts, and spectrum of risks arising from the economic, liens on inventory or commodities may be held social, and political environments of a foreign as collateral. However, in certain countries, country and from the governmental policies these forms of collateral are not legally recog- structured to respond to those conditions that nized and, therefore, the banks must be thor- may have adverse consequences for the repay- oughly familiar with applicable local laws, regu- ment of a foreign borrower’s debt. More spe- lations, and practices. Loans to foreign banks cifically, there is a risk associated with a bor- are usually short-term and unsecured. rower’s capacity to obtain the foreign exchange Medium-term lending (one to five years) required to service its cross-border debt (that is, generally represents capital goods financing, transfer risk). An obligor may have the financial shipping loans, and various specialized credits. means in its domestic currency to repay its Long-term loans (those exceeding five years) indebtedness, but nationalization, expropriation, are normally used to finance extensive projects governmental repudiation of external indebted- of multinational corporations, foreign govern- ness, the imposition of exchange controls, or ments, or foreign state entities. Government currency devaluation may preclude the lender guarantees of private long-term loans are com- from obtaining timely repayment. Apart from a mon when the project has significant importance nation’s outright repudiation of external debt, to a national economy. these developments might not result in an The methods of loan financing in an interna- uncollectible extension of credit; however, the tional division are the same as those for domes- delay in collection could adversely affect the tic lending. Loans in the international division condition of the lending bank. may be direct or discounted. In both of these This section is designed to apply to most instances, the bank holds a promissory note or types of loans and current account advances similar instrument evidencing indebtedness. Cur- found in an international division. However, rent account advances, however, are a category lending areas in many international divisions of loans unique to international banking. This and overseas branches are often segregated method of financing is an American substitute, into separate departments and differ substan- used by banks in the United States, for the tially from international loans and current European method of financing by overdrafts, account advances. Those are discussed in which is also a common lending method of separate sections of this manual: ‘‘Inter- overseas offices of U.S. banks. Current account national—Financing Foreign Receivables,’’ advances, like overdrafts, are extensions of credit ‘‘International—Banker’s Acceptances,’’ ‘‘Inter- in which no instrument of specific indebtedness national—Letters of Credit,’’ and ‘‘Inter- is used; however, a signed agreement is on file national—Guarantees Issued,’’ sections 7050, stating the conditions applicable to advances 7060, 7080, and 7090, respectively. made by the bank to the obligor. Other types of

Commercial Bank Examination Manual May 1996 Page 1 International—Loans and Current Account Advances Examination Objectives Effective date May 1996 Section 7030.2

1. To determine the adequacy of policies, prac- 4. To determine the scope and adequacy of the tices, procedures, and internal controls for audit function as it relates to international international loans and advances. lending procedures. 5. To determine compliance with applicable 2. To determine if bank officers are operating laws and regulations. in conformance with established bank 6. To recommend corrective action when poli- guidelines. cies, practices, procedures, or internal con- 3. To evaluate the portfolio for credit quality, trols are deficient or when violations of laws collectibility, and collateral sufficiency. and regulations are cited.

Commercial Bank Examination Manual May 1996 Page 1 International—Loans and Current Account Advances Examination Procedures Effective date October 2008 Section 7030.3

1. If selected for implementation, complete or interests (specify which officers are con- update the international lending section of sidered executive officers) the internal control questionnaire. i. miscellaneous loan-debit and credit- 2. Determine the scope of the examination on suspense accounts the basis of the evaluation of internal con- j. Interagency Country Exposure Review trols and the work performed by internal Committee (ICERC) determinations and external auditors. k. criticized Shared National Credits (appli- 3. Test for compliance with policies, practices, cable international division credits) procedures, and internal controls in conjunc- l. loans considered ‘‘problem loans’’ by tion with performing the remaining exami- management nation procedures. Also, obtain a listing of m. specific guidelines in the lending policy any deficiencies noted in the latest reviews n. current lending authorities of bank offi- done by internal and external auditors from cers and credit committees the examiner assigned to the audit review o. the current interest-rate lending structure and determine if appropriate corrections of the bank have been made. p. any useful information on international 4. Obtain a trial balance of the customer lia- division credit extensions resulting from bility records. the review of the minutes of the loan and a. Reconcile balances to department con- discount committee(s) and any other trols and the general ledger. credit committee(s) b. Review reconciling items for reason- q. reports on international division credit ableness. extensions furnished to the loan and 5. Using an appropriate technique, select bor- discount committee(s) and any other rowers for examination, review the loan and credit committee(s) collateral documentation, and prepare credit r. relevant reports furnished to the board of line cards. directors 6. Obtain the following information: s. loans criticized during the previous a. past-due, nonaccrual, and reduced-rate examination loans and advances 7. Review the information received and per- b. loans whose terms have been modified form the following procedures. by a reduction in interest rate or principal a. Loans transferred, either in whole or in payment or by a deferral of interest or part, to or from another lending institu- principal tion as a result of a participation, sale or c. loans transferred, either in whole or in purchase, or asset swap. part, to another lending institution as a • Participations only: result of a sale, participation, or asset — Test participation certificates and swap since the previous examination. records, and determine that the par- d. loans acquired from another lending ties share in the risks and contrac- institution as a result of a purchase, tual payments on a pro rata basis. participation, or asset swap since the — Determine that the bank exercises previous examination similar controls and procedures e. loan commitments and other contingent over loans serviced for others as liabilities for loans in its own portfolio. f. reports of the indebtedness of execu- — Determine that the bank, as lead or tive officers, principal shareholders, and agent in a credit, exercises similar their related interests to correspondent controls and procedures over syn- banks dications and participations sold as g. a list of correspondent banks for loans in its own portfolio. h. extensions of credit to major stockhold- • All transfers: ers of the bank and to bank employees, — Investigate any situations in which officers, and directors, and to their related loans were transferred immediately

Commercial Bank Examination Manual October 2008 Page 1 7030.3 International—Loans and Current Account Advances: Examination Procedures

before the date of examination to would be helpful to the other determine if any were transferred regulator to avoid possible criticism during b. Miscellaneous loan-debit and credit- the examination. suspense accounts. — Determine whether any of the loans • Discuss with management any large or transferred were either nonperform- old items. ing at the time of transfer or clas- • Perform additional procedures as con- sified at the previous examination. sidered appropriate. — Determine that the consideration c. Loan commitments and other contingent received for low-quality loans trans- liabilities. Analyze the commitment or ferred from the bank to an affiliate contingent liability together with the is properly reflected on the bank’s combined amounts of the current loan books and is equal to the fair balance, if any. market value of the transferred d. Loans criticized during the previous loans (while fair market value may examination. Determine disposition of be difficult to determine, it should loans so criticized by transcribing the at a minimum reflect both the rate current balance and payment status or of return being earned on such the date the loan was repaid and the loans as well as an appropriate risk source of repayment. premium). Section 23A of the Fed- • Investigate any situations in which all eral Reserve Act generally prohib- or part of the funds for the repayment its a state member bank from pur- came from the proceeds of another chasing a low-quality asset. loan at the bank or as a result of a — Determine that low-quality assets participation, sale, or swap with another transferred to the parent holding lending institution. company or a nonbank affiliate are • If repayment was a result of a par- properly reflected at fair market ticipation, sale, or swap, refer to step value on the books of both the 7a of this section for the appropriate bank and its affiliate. examination procedures. — If low-quality loans were trans- e. Shared National Credits. ferred to or from another lending • Compare the schedule of international institution for which the Federal loans and current account advances Reserve is not the primary regula- included in the Uniform Review of tor, prepare a memorandum to be National Credits program with the submitted to the Reserve Bank bank’s reports of international loans supervisory personnel. The Reserve outstanding. Bank will then inform the local • For each loan or advance so identified, office of the primary federal regu- transcribe appropriate information to lator of the other institution involved line cards. No further examination pro- in the transfer. The memorandum cedures are necessary for these credits. should include the following infor- f. ICERC credits. mation, as applicable: • Identify any loans that were selected (1) name of originating institution for review that are criticized for (2) name of receiving institution transfer-risk reasons by ICERC. (3) type of transfer (i.e., participa- • For each loan or advance so identified, tion, purchase or sale, swap) transcribe appropriate information to (4) date of transfer line cards. No further examination pro- (5) total number of loans trans- cedures are necessary for these credits. ferred 8. Transcribe or compare information from the (6) total dollar amount of loans above schedules to credit line cards, where transferred appropriate, and indicate any past-due (7) status of the loans when trans- status. ferred (e.g., nonperforming, 9. Prepare credit line cards for any interna- classified, etc.) tional loan not previously selected for review (8) any other information that that, on the basis of information derived

October 2008 Commercial Bank Examination Manual Page 2 International—Loans and Current Account Advances: Examination Procedures 7030.3

from the above schedules, requires an central liability file for borrowers indebted in-depth review. above the cutoff line or for borrowers dis- 10. Obtain customer liability and other informa- playing credit weakness or suspected of tion on common borrowers from examiners having additional liability in other lending assigned to cash items, overdrafts, and other areas. lending areas, and together decide who will 14. Transcribe significant liability and other review the borrowing relationship. Pass or information on officers, principals, and retain complete credit line cards. affiliations of borrowers selected for review. 11. Prepare collateral line cards for all borrow- Cross-reference line cards to borrowers, ers selected in the preceding steps. where appropriate. 12. Obtain credit files for all borrowers for 15. Determine the bank’s compliance with laws whom examiner credit line cards were pre- and regulations pertaining to international pared, and complete the credit line cards, lending by performing the following steps: where appropriate. To analyze the interna- a. Lending limits. tional loans, perform the following • Determine the bank’s lending limit as procedures: prescribed by state law. a. Analyze balance sheets and profit-and- loss figures as shown in current and • Determine advances or combinations preceding financial statements, and deter- of advances with aggregate balances mine the existence of any favorable or above the limit, if any. adverse trends or ratios. b. Section 23A, Relations with Affiliates (12 b. Review components of the balance sheet USC 371c), and section 23B, Restric- as shown in the current financial state- tions on Transactions with Affiliates (12 ments, and determine the reasonableness USC 371c-1), of the Federal Reserve of each item as it relates to the total Act, and the Board’s Regulation W. financial structure of the borrower. • Obtain a listing of loans to affiliates. c. Review supporting information for the • Test-check the listing against the bank’s major balance-sheet items and the tech- customer liability records to determine niques used in consolidation, and deter- its accuracy and completeness. mine the primary sources of repayment • Ensure that loans to affiliates do not and evaluate the adequacy of those exceed limits of section 23A and Regu- sources. lation W. d. Ascertain compliance with provisions of • Ensure that loans to affiliates meet the credit agreements. collateral requirements of section 23A e. Review digests of officers’ memoranda, and Regulation W. mercantile reports, credit checks, and • Determine that low-quality assets have correspondence to determine the exist- not been purchased from an affiliate. ence of any problems that might deter the contractual repayment programs of • Determine that all covered transactions the borrower’s indebtedness. with affiliates are on terms and condi- f. Relate collateral values to outstanding tions that are consistent with safe and debt, and determine when the collateral sound banking practices. was last appraised. • Determine that all transactions with g. Compare interest rates charged with the affiliates comply with the market- current interest-rate schedule of the bank, terms requirement of section 23B and and determine that the terms are within Regulation W. established guidelines. c. 18 USC 215, Receipt of Commission or h. Compare the original amounts of the Gift for Procuring Loans. customer’s obligations to the bank with • While examining the international lend- the lending officer’s authority. ing function, determine the existence i. Analyze secondary support afforded by of any possible cases in which a bank guarantors and endorsers. officer, director, employee, agent, or j. Ascertain compliance with the bank’s attorney may have received anything established international loan policy. of value for procuring or endeavoring 13. For loans selected for review, check the to procure any extension of credit.

Commercial Bank Examination Manual October 2008 Page 3 7030.3 International—Loans and Current Account Advances: Examination Procedures

• Investigate any such suspected — determine that loans to insiders instances. do not contain terms more favor- d. Federal Election Campaign Act (2 USC able than those afforded other 441b), Political Contributions and Loans. borrowers; • While examining the international lend- — determine that loans to insiders do ing area, determine the existence of not involve more than normal risk any loans in connection with any of repayment or present other political campaigns. unfavorable features; • Review each such credit to determine — determine that loans to insiders do whether it is made in accordance with not exceed the lending limits applicable banking laws and in the imposed by Regulation O; ordinary course of business. — if prior approval by the bank’s e. Regulation Y (12 CFR 225.7), Tie-In board was required for a loan to Provisions. While reviewing interna- an insider, determine that such tional credit and collateral files, espe- approval was obtained; cially loan agreements, determine whether — determine compliance with the any extension of credit is conditioned various reporting requirements for upon— insider loans; • obtaining or providing any additional — determine that the bank has made credit, property, or service from or to provisions to comply with the dis- the bank or its holding company (or a closure requirements for insider subsidiary of its holding company), loans; and other than a loan, discount, deposit, or — determine that the bank maintains trust service, or records of public disclosure • the customer not obtaining a credit, requests and the disposition of the property, or service from a competitor requests for a period of two years of the bank or its holding company (or after the dates of the requests. a subsidiary of its holding company), • Title VIII of the Financial Institutions other than a reasonable condition to Regulatory and Interest Rate Control ensure the soundness of the credit. Act of 1978 (FIRA) (P.L. 95–630), as f. Insider lending activities. The examina- amended by the Garn–St Germain tion procedures for checking compliance Depository Institutions Act of 1982, with the relevant law and regulation Loans to Executive Officers, Directors, covering insider lending activities and and Principal Shareholders of Corre- reporting requirements are as follows: spondent Banks. (The examiner should refer to the appro- — Obtain from, or request that the priate sections of the statutes for specific examiners reviewing due from definitions, lending limitations, reporting banks and deposit accounts verify, requirements, and conditions indicating a list of correspondent banks pro- preferential treatment.) vided by bank management, and • Regulation O (12 CFR 215), Loans to ascertain the profitability of those Executive Officers, Directors, and Prin- relationships. cipal Shareholders and Their Related — Determine that loans to insiders of Interests. While reviewing information correspondent banks are not made relating to insiders received from the on preferential terms and that no bank or appropriate examiner (includ- conflict of interest appears to ing loan participations, loans pur- exist. chased and sold, and loan swaps)— g. 12 USC 1828(v), Loans Secured by Bank — test the accuracy and completeness Stock. of information about international • While examining international loans, loans by comparing it with the trial determine the existence of any loans or balance or loans sampled; discounts that are secured by the in- — review credit files on insider loans sured financial institution’s own stock. to determine that required informa- • In each such case, determine that the tion is available; chief executive officer has promptly

October 2008 Commercial Bank Examination Manual Page 4 International—Loans and Current Account Advances: Examination Procedures 7030.3

reported such fact to the proper regu- — loans or extensions of credit to latory authority. foreign banks, h. 12 USC 83 (Rev. Stat. 5201), made — loans to executive officers of for- applicable to state member banks by eign branches of state member section 9, paragraph 6, of the Federal banks, Reserve Act (12 USC 324), Loans Secured — a statement of policy or the avail- by Own Stock (see also Federal Reserve ability of information to facilitate Regulatory Service 3–1505): supervision of foreign operations, • While examining international loans, and determine the existence of any loans — reporting and disclosure of interna- secured by the bank’s own shares or tional assets and accounting for capital notes and debentures. fees on international loans. • Confer with the examiner assigned k. Financial Recordkeeping and Reporting investment securities to determine of Currency and Foreign Transactions, whether the bank owns any of its own Retention of Credit Files. Review the shares or its own notes and operating procedures and credit file debentures. documentation, and determine if the • In each case in which such collateral or bank retains records of each extension of ownership exists, determine whether credit over $10,000, specifying the name the collateral or ownership was taken and address of the borrower, the amount to prevent a loss on a debt previously of the credit, the nature and purpose of contracted (DPC) transaction. the loan, and the date thereof. (See 31 • In each case of ownership, determine CFR 1010.410.) (Loans secured by an whether the shares or subordinated interest in real property are exempt.) notes and debentures have been held l. Export-Import Bank of the United States. for a period of not more than six Review extensions of credit to determine months. compliance with Eximbank’s lending i. Regulation U (12 CFR 221). While standards, policies, guidelines, and regu- reviewing credit files, check the follow- lations as they relate to direct lending ing for all loans that are secured directly programs, cooperative financing facili- or indirectly by margin stock and that ties, private export funding, exporter were extended for the purpose of buying credit programs, medium-term export or carrying margin stock: debt obligations, leasing, loan guaran- • Except for credits specifically exempted tees, export credit insurance, and dis- under Regulation U, determine that the count programs. required Form FR U-1 has been m. 7 CFR 1400–1499, Commodity Credit executed for each credit by the cus- Corporation. Determine the compliance tomer and that it has been signed and of international loans relating to Com- accepted by a duly authorized officer modity Credit Corporation programs. of the bank acting in good faith. n. 22 CFR 200–299, Agency for Interna- • Determine that the bank has not tional Development. Review to deter- extended more than the maximum loan mine the compliance of international value of the collateral securing such loans related to Agency for International credits, as set by section 221.7 of Development programs. Regulation U, and that the margin o. Section 909, International Lending requirements are being maintained. Supervision Act (12 USC 3908). Section • Determine compliance with other spe- 909 of the International Lending Super- cific exceptions and restrictions of the vision Act of 1983 (the act) requires that regulation as they relate to the credits FDIC-insured banks and Edge and agree- reviewed. ment corporations prepare a written eco- j. Regulation K (12 CFR 211) and Regula- nomic feasibility evaluation signed by a tion Y (12 CFR 225), International Bank- senior official of the banking institution ing Operations. for any proposed extension of credit by • Review all applicable sections, espe- the lead U.S. banking institution or insti- cially those concerned with— tutions, which individually or when

Commercial Bank Examination Manual April 2015 Page 5 7030.3 International—Loans and Current Account Advances: Examination Procedures

aggregated with credits of other U.S. responses to the foregoing questions would be banking institutions exceeds $20 million indicative of noncompliance with the statute per project, to finance the construction or and should be discussed with the appropriate operation of any mining operation, any level of bank management. Any apparent viola- metal or mineral primary processing tions should be cited in the examination report, operation, any metal fabricating facility along with a discussion of any remedial actions or operation, or any metal-making (semi- taken by bank management during the and finished) operation located outside examination. the United States or its territories or possessions. The act stipulates that the 16. Perform the appropriate steps in ‘‘Concen- evaluation shall consider the profit po- trations of Credit,’’ section 2050.3. tential, the competitive and economic 17. Discuss with appropriate officers, and pre- impact of the project, and the reasonable pare summaries in appropriate report form expectation of repayment. The act also of— mandates that any new evaluations be a. delinquent loans; reviewed by federal examiners in the b. violations of laws and regulations; context of every examination. The fol- c. loans not supported by current and com- lowing checklist should be used to test plete financial information; compliance with the requirements of the d. loans on which collateral documentation act: is deficient; • Does the banking institution have a e. concentrations of credit; written economic feasibility evalua- f. criticized loans; tion for all credit extensions by that g. inadequately collateralized loans; banking institution alone or in conjunc- h. extensions of credit to major sharehold- tion with other U.S. banking institu- ers, employees, officers, directors, and tions, which individually or when ag- their related interests; gregated with credits of other U.S. i. loans whose ultimate collection is ques- banking institutions exceed $20 mil- tionable for any other reason; and lion per project, to finance any of the designated projects? j. other matters regarding the condition of • Is the evaluation signed by a senior the department. officer of the examined or the lead U.S. 18. Provide details of classified international banking institution? participation loans that are not covered by • Does the evaluation consider the the Shared National Credit Program. Include following: the names and addresses of all participating — profit potential of the project state member banks and copies of the criti- — impact of the project on world cized loan comments. markets 19. Provide the examiner-in-charge with your — inherent competitive advantages findings on— and disadvantages of the project a. the adequacy of written policies relating over the entire life of the project to international loans; — the likely effect of the project on b. the manner in which bank officers are the overall long-term economic operating in conformance with estab- development of the country in lished policy; which it is located c. adverse trends within the international — the reasonable expectation of lending function; repayment from revenues gener- d. the accuracy and completeness of the ated by the project, without regard schedules obtained from ‘‘International— to any subsidy provided by the Loan Portfolio Management,’’ section government involved or any instru- 7020.3. mentality of any country e. internal control deficiencies or exceptions; f. recommended corrective action when Although the bank’s evaluation should be policies, practices, or procedures are done in a professional manner, examiners need deficient; not verify its accuracy. However, any negative g. the competency of management of the

April 2015 Commercial Bank Examination Manual Page 6 International—Loans and Current Account Advances: Examination Procedures 7030.3

international lending function; and 20. Update the workpapers with any informa- h. other matters of significance. tion that will facilitate future examinations.

Commercial Bank Examination Manual October 2008 Page 7 International—Loans and Current Account Advances Internal Control Questionnaire Effective date March 1984 Section 7030.4

Review the bank’s internal controls, policies, *6. Is a loan delinquency report prepared for practices, and procedures for granting and ser- and reviewed by management frequently vicing international loans. The bank’s system (if so, how often )? should be documented in a complete and con- *7. Are inquiries about loan balances received cise manner and include, where appropriate, and investigated by persons who do not narrative descriptions, flowcharts, copies of process loans, handle settlements, or post forms used, and other pertinent information. records? Items marked with an asterisk require substan- *8. Are bookkeeping adjustments checked and tiation by observation or testing. approved by an appropriate officer? 9. Is a daily record maintained summarizing loan transaction details, i.e., loans granted, POLICIES payments received, and interest collected, to support applicable general ledger ac- 1. Has the board of directors, consistent with count entries? its duties and responsibilities, adopted 10. Are frequent note (or record copy) and written international loan policies that: liability trial balances prepared and recon- a. Establish procedures for reviewing ciled monthly with control accounts by international loan applications? employees who do not process or record b. Define qualified borrowers? loan transactions? c. Establish minimum standards for docu- mentation in accordance with the Uni- form Commercial Code? INTEREST 2. Are international loan policies reviewed at least annually to determine if they *11. Is the preparation and posting of interest are compatible with changing market records performed or reviewed by persons conditions? who do not also: a. Issue official checks or drafts? b. Handle cash? RECORDS 12. Are any independent interest computations made and compared or adequately tested *3. Is the preparation and posting of subsidi- to initial interest records by persons who ary international loan records performed do not also: or reviewed by persons who do not also: a. Issue official checks or drafts? a. Issue official checks or drafts? b. Handle cash? b. Handle cash? *4. Are the subsidiary international loan records (control totals) balanced daily with the COLLATERAL appropriate general ledger accounts and reconciling items adequately investigated 13. Are multicopy, pre-numbered records main- by persons who do not normally handle tained that detail the complete description loans and post records? of collateral pledged? 5. Are the following properly recorded as 14. Are the functions of receiving and releas- ‘‘loans’’ for accounting and call report ing collateral to borrowers and of making purposes: entries in the collateral register performed a. Acceptances of other banks purchased? by different employees? b. Own acceptances purchased 15. Is negotiable collateral held under joint (discounted)? custody? c. Customer’s liability to the bank on 16. Are receipts obtained and filed for released drafts paid under letters of credit collateral? for which the bank has not been 17. Are securities valued and margin require- reimbursed? ments reviewed at least monthly?

Commercial Bank Examination Manual March 1994 Page 1 7030.4 International—Loans and Current Account Advances: Internal Control Questionnaire

18. When collateral support is the cash surren- eral when the loan is made and at der value of insurance policies, is a peri- frequent intervals thereafter? odic accounting received from the insur- c. Determines that items released on tem- ance company and maintained with the porary vault-out tickets are authorized policy? and have not been outstanding for an 19. Is a record maintained of entry to the unreasonable length of time? collateral vault? d. Determines that loan payments are 20. Are stock powers filed separately to bar promptly posted? negotiability and to deter abstraction of 28. Are all notes and advances recorded on a both the security and the negotiating register or similar record and assigned instrument? consecutive numbers? 21. Are securities out for transfer, exchange, 29. Are payment notices prepared and sent by etc., controlled by pre-numbered tempo- someone not connected with loan rary vault-out tickets? processing? 22. Are pledged deposit accounts properly 30. Are any notes signed by a customer in coded to negate unauthorized withdrawal blank and held in anticipation of future of funds? borrowings properly safeguarded? 23. Are acknowledgements received for 31. Are lending officers frequently informed pledged deposits held at other banks? of maturing loans and credit lines? 24. Is an officer’s approval necessary before collateral can be released or substituted?

CONCLUSION OTHER 32. Is the foregoing information an adequate 25. Are notes and advance slips safeguarded basis for evaluating internal control in that during bank hours and locked in the vault there are no significant deficiencies in overnight? areas not covered in this questionnaire 26. Are all loan rebates approved by an officer that impair any controls? Explain nega- and made only by official check? tive answers briefly, and indicate any 27. Does the bank have an internal review additional examination procedures deemed system that: necessary. a. Re-examines collateral items and sup- 33. Based on a composite evaluation, as evi- porting documentation for negotiability denced by answers to the foregoing and proper assignment? questions, internal control is considered b. Test checks values assigned to collat- (adequate/inadequate).

March 1994 Commercial Bank Examination Manual Page 2 International—Country Risk and Transfer Risk Effective date April 2009 Section 7040.1

When banks engage in international lending, spectrum of risks and factors that arise from the they undertake customary credit risk as denoted economic, social, and political environments of by the possibility of nonpayment because of an a foreign country that may have potential con- obligor’s weak financial condition or a lack sequences for foreigners’ debt and equity invest- of adequate collateral protection. International ments in that country. A detailed description of lending also bears risks associated with condi- these factors is described below. tions within a foreign borrower’s home country; these risks are commonly referred to as country risk. Conditions that may give rise to country risk include a country’s underlying economic, Macroeconomic Factors political, and social trends and movements that may have potential consequences for foreigners’ The first factor affecting country risk is the size debt and equity investments in that country. In and structure of a country’s external debt in addition to the adverse effect that deteriorating relation to its economy, more specifically— economic conditions and political and social unrest may have on the rate of default by • the current level of short-term debt and the obligors in a country, country risk includes the potential effect that a liquidity crisis would possibility of nationalization or expropriation of have on the ability of otherwise creditworthy assets, government repudiation of external borrowers in the country to continue servicing indebtedness, exchange controls, and currency their obligations, and depreciation or devaluation. An assessment about • to the extent the external debt is owed by the the level of country risk should reflect an evalu- public sector, the ability of the government to ation of the effect of prevailing (and possible generate sufficient revenues, from taxes and future) economic, political, and social condi- other sources, to service its obligations. tions on a country’s ability to sustain external debt service, as well as reflect the impact of The condition and vulnerability of the country’s these conditions on the credit risk of individual current account is also an important consider- counterparties located in the country. ation, including— Transfer risk is a facet of country risk. It is the possibility that an asset cannot be serviced in the • the level of international reserves, including currency of the payment because the obligor’s forward market positions of the country’s country lacks the necessary foreign exchange or monetary authority (especially when the has put restraints on its availability.1 exchange rate is fixed); The traditional examination approach to com- • the level of import coverage provided by the mercial credit risk is treated separately in other country’s international reserves; sections of this manual. The purpose of this • the importance of commodity exports as a section is to delineate the current examination source of revenue, the existence of any price- policies, objectives, and procedures for evaluat- stabilization mechanisms, and the country’s ing a bank’s country- and transfer-risk expo- vulnerability to a downturn in either its export sures and its management system for monitoring markets or the price of an exported commod- and controlling them. ity; and • the potential for sharp movements in exchange COUNTRY RISK rates and their effect on the relative price of the country’s imports and exports. Country or sovereign risk encompasses the entire The role of foreign sources of capital in meeting the country’s financing needs is another 1. Exchange controls are an example of transfer risk. The Interagency Country Exposure Review Committee (ICERC) important consideration in the analysis of coun- assigns ratings to foreign exposures based on its evaluation of try risk, including— the level of transfer risk associated with a country. See the Guide to the Interagency Country Exposure Review Commit- • the country’s access to international financial tee Process, which was issued in November 2008, for a comprehensive discussion of the operations of the ICERC. markets and the potential effects of a loss of See also section 7040.3. market liquidity;

Commercial Bank Examination Manual April 2009 Page 1 7040.1 International—Country Risk and Transfer Risk

• the country’s relationships with private-sector factionalism or armed conflicts are adversely creditors, including the existence of loan com- affecting the government of the country; mitments and the attitude among bankers • any trends toward government-imposed price, toward further lending to borrowers in the interest-rate, or exchange controls; country; • the degree to which the country’s legal system • the country’s current standing with multilat- can be relied on to fairly protect the interests eral and official creditors, including the ability of foreign creditors and investors; of the country to qualify for and sustain an • the accounting standards in the country and International Monetary Fund or other suitable the reliability and transparency of financial economic adjustment program; information; • the trend in foreign investments and the coun- • the extent to which the country’s laws and try’s ability to attract foreign investment in the government policies protect parties in elec- future; and tronic transactions and promote the develop- • the opportunities for privatization of ment of technology in a safe and sound government-owned entities. manner; • the extent to which government policies pro- Past experience has highlighted the importance mote the effective management of the institu- of a number of other important macroeconomic tion’s exposures; and considerations, including— • the level of adherence to international legal and business-practice standards. • the degree to which the country’s economy may be adversely affected through the conta- gion of problems in other countries; • the size and condition of the country’s bank- Institution-Specific Factors ing system, including the adequacy of the country’s system for bank supervision and any Finally, an institution’s analysis of country risk potential burden of contingent liabilities that a should consider factors relating to the nature of weak banking system might place on the its actual (or approved) exposures in the coun- government; try, including, for example— • the extent to which state-directed lending or other government intervention may have • the institution’s business strategy and its adversely affected the soundness of the coun- exposure-management plans for the country; try’s banking system, or the structure and • the mix of exposures and commitments, competitiveness of the favored industries or including the types of investments and bor- companies; and rowers, the distribution of maturities, the types • for both in-country and cross-border expo- and quality of collateral, the existence of sures, the degree to which macroeconomic guarantees, whether exposures are held for conditions and trends may have adversely trading or investment, and any other distin- affected the credit risk associated with coun- guishing characteristics of the portfolio; terparties in the country. • the economic outlook for any specifically targeted industries within the country; • the degree to which political or economic developments in a country are likely to affect Social, Political, and Legal Climate the institution’s chosen lines of business in the country (For instance, the unemployment rate The analysis of country risk should also con- or changes in local bankruptcy laws may sider the country’s social, political, and legal affect certain activities more than others.); climate, including— • for an institution involved in capital markets, its susceptibility to changes in value based on • the country’s natural- and human-resource market movements (As the market value of potential; claims against a foreign counterparty rises, the • the willingness and ability of the government counterparty may become less financially to recognize economic or budgetary problems sound, thus increasing the risk of nonpayment. and implement appropriate remedial action; This is especially true for over-the-counter • the degree to which political or regional derivative instruments.);

April 2009 Commercial Bank Examination Manual Page 2 International—Country Risk and Transfer Risk 7040.1

• the degree to which political or economic country-risk management process, they should developments are likely to affect the credit nevertheless take these country-risk factors into risk of individual counterparties in the country account, where appropriate, when assessing the (For example, foreign counterparties with creditworthiness of domestic counterparties. healthy export markets or whose business is Examiners should ensure that the overall credit- tied closely to supplying manufacturing enti- risk management process takes into account ties in developed countries may have signifi- indirect country risk where applicable in all cantly less exposure to the local country’s supervised institutions. economic disruptions than do other counter- To effectively control the risk associated with parties in the country.); and international activities, institutions must have a • the institution’s ability to effectively manage risk-management process that focuses on the its exposures in a country through in-country broadly defined concept of country risk. A or regional representation, or by some other sound country-risk management process includes arrangement that ensures the timely reporting effective oversight by the board of directors, of, and response to, any problems. adequate risk-management policies and proce- dures, an accurate country-exposure reporting system, an effective country-risk analysis pro- cess, a country-risk rating system, country- Risk-Management Process for exposure limits, ongoing monitoring of country Country Risk conditions, periodic stress testing of foreign exposures, and adequate internal controls and an Country risk has an overarching effect on an audit function. institution’s international activities and should explicitly be taken into account in the risk assessment of all exposures (including off- Oversight by the Board of Directors balance-sheet) to all public- and private-sector foreign-domiciled counterparties. The risk asso- If country risk is to be managed properly, the ciated with even the strongest counterparties in a board of directors must oversee the process country will increase if, for example, political, effectively. The board is responsible for periodi- social, or macroeconomic conditions cause the cally reviewing and approving policies govern- exchange rate to depreciate and the cost of ing the institution’s international activities to servicing external debt to rise. Country risk can ensure that they are consistent with the institu- occur in many different forms, and the nature of tion’s strategic plans and goals. The board is specific risks can change over time. A U.S. also responsible for reviewing and approving banking organization with significant direct or limits on country exposure and ensuring that indirect international exposure should have in management is effectively controlling the risk. place an effective country-risk management pro- When evaluating the adequacy of the institu- cess that is commensurate with the volume and tion’s capital and allowance for loan and lease complexity of its international activities. Exam- losses (ALLL), the board should take into iners should be continually evaluating the account the volume of foreign exposures and the adequacy of the country-risk management pro- ratings of the countries to which the institution cess at internationally active institutions, and is exposed. they should regularly update their assessments. An institution’s country-risk management pro- cess should give particular attention to any Policies and Procedures for Managing concentrations of country risk. Country Risk Country risk is not necessarily limited to institutions with direct international exposures. Bank management is responsible for implement- Domestic counterparties with significant eco- ing sound, well-defined policies and procedures nomic dependence on a foreign country or for managing country risk that— region (for example, through export depen- dence) can pose an indirect country risk to • establish risk-tolerance limits; institutions that do not have direct international • delineate clear lines of responsibility and activity. While institutions are not required to accountability for country-risk management incorporate indirect country risk into a formal decisions;

Commercial Bank Examination Manual April 2009 Page 3 7040.1 International—Country Risk and Transfer Risk

• specify authorized activities, investments, and at least annually, and does the institution have instruments; and an effective system for monitoring develop- • identify both desirable and undesirable types ments in the interim? of business. • Does the analysis take into account all aspects of the broadly defined concept of country risk, Management should also ensure that country- as well as any unique risks associated with risk management policies, standards, and prac- specific groups of counterparties the institu- tices are clearly communicated to the affected tion may have targeted in its business strategy? offices and staff. • Is the analysis adequately documented, and are conclusions concerning the level of risk communicated in a way that provides decision Country-Exposure Reporting System makers with a reasonable basis for determin- ing the nature and level of the institution’s To effectively manage country risk, the institu- exposures in a country? tion must have a reliable system for capturing • Given the size and sophistication of the insti- and categorizing the volume and nature of tution’s international activities, are the foreign exposures. The reporting system should resources devoted to the analysis of country cover all aspects of the institution’s operations. risk adequate? An accurate country-exposure reporting system • As a final check of the process, are the is also necessary to support the regulatory institution’s conclusions concerning a country reporting of foreign exposures on the quarterly reasonable in light of information available Country Exposure Report, FFIEC 009. from other sources, including external research The board of directors should regularly receive and rating services and the Interagency Coun- reports on the level of foreign exposures. If the try Exposure Review Committee (ICERC)? level of foreign exposures in an institution is significant,2 or if a country to which the institu- tion is exposed is considered to be high risk, Country-Risk Ratings exposures should be reported to the board at least quarterly. More frequent reporting is Country-risk ratings summarize the conclusions appropriate when a deterioration in foreign of the country-risk analysis process. The ratings exposures would threaten the soundness of the are an important component of country-risk institution. management because they provide a framework for establishing country-exposure limits that reflect the institution’s tolerance for risk. Country-Risk Analysis Process Because some counterparties may be more exposed to local country conditions than others, Although the nature of the country-risk analysis it is a common and acceptable practice for process and the level of resources devoted to it institutions to distinguish between different types will vary from institution to institution, depend- of exposures when assigning their country-risk ing on the size and sophistication of its interna- ratings. For example, trade-related and banking- tional operations, a number of considerations sector exposures typically receive better risk are relevant to evaluating the process in all ratings than other categories of exposure because institutions: the importance of these types of transactions to a country’s economy has usually moved govern- • Is there a quantitative and qualitative assess- ments to give them preferential treatment for ment of the risk associated with each country repayment. in which the institution is conducting or plan- The risk-rating systems of some institutions ning to conduct business? differentiate between public-sector and private- • Is a formal analysis of country risk conducted sector exposures. In some institutions, a coun- try’s private-sector credits cannot be rated less 2. For purposes of this guidance, concentrations of expo- severely than its public-sector credits (that is, sures to individual countries that exceed 25 percent of the the institution imposes a ‘‘sovereign ceiling’’ on institution’s tier 1 capital plus the ALLL are considered the rating for all exposures in a country). Both significant. However, in the case of particularly troubled countries, lesser degrees of exposure may also be considered are acceptable practices. to be significant. An institution’s country-risk ratings may dif-

April 2009 Commercial Bank Examination Manual Page 4 International—Country Risk and Transfer Risk 7040.1 fer from the ICERC-assigned transfer-risk rat- Country-Exposure Limits ings because the two ratings differ in purpose and scope. An institution’s internally assigned As part of their country-risk management ratings help it to decide whether to extend process, internationally active institutions additional credit, as well as how it should should adopt a system of country-exposure manage existing exposures. Such ratings should, limits. Because the limit-setting process often therefore, have a forward-looking and broad involves divergent interests within the institu- country-risk focus. The ICERC’s more narrowly tion (such as the country managers, the focused transfer-risk ratings are primarily a institution’s overall country-risk manager, and supervisory tool and should not replace a bank’s the country-risk committee), country-risk limits own country-risk analysis process. will usually reflect a balancing of several The ICERC only rates countries that are in considerations, including— default where U.S. banks’ aggregate exposures meet certain thresholds. Default occurs when a • the overall strategy guiding the institution’s country is not complying with its external debt- international activities, service obligations or is unable to service the • the country’s risk rating and the institution’s existing loan according to its terms, as evi- appetite for risk, denced by failure to pay principal and interest • perceived business opportunities in the coun- fully and on time, arrearages, forced restructur- try, and ing, or rollovers. The ICERC reviews countries • the desire to support the international business to which the aggregate exposure of U.S. banking needs of domestic customers. organizations is at least $1 billion for at least two consecutive quarters or between $200 mil- Country-exposure limits should be approved by lion and $1 billion if the exposure at five or the board of directors, or a committee thereof, more U.S. banks exceeds 25 percent of capital and communicated to all affected departments (tier 1 capital + ALLL). and staff. Exposure limits should be reviewed For purposes of determining whether a coun- and approved at least annually—and more fre- try meets the threshold for review by the ICERC, quently when concerns about a particular coun- aggregate exposure is based on the exposure try arise. reported in the most recent Country Exposure An institution should consider whether its Lending Survey, which is published quarterly by international operations are such that it should the Federal Financial Institutions Examination supplement its aggregate exposure limits with Council (FFIEC). The Country Exposure Lend- more discrete controls. Such controls might take ing Survey summarizes the aggregate, by coun- the form of limits on the different lines of try, exposures of U.S. banks, bank holding business in the country, limits by type of coun- companies, and Edge and agreement corpora- terparty, or limits by type or tenor of exposure. tions filing the FFIEC 009 regulatory reporting An institution might also limit its exposure to form (Country Exposure Report). Specifically, local currencies. Institutions that have both sub- aggregate exposure is the sum of ‘‘Transfer Risk stantial capital-market exposures and credit- Claims’’ and ‘‘Unused Commitments’’ and related exposures typically set separate aggre- ‘‘Guarantees and Credit Derivatives.’’3 gate exposure limits for each because exposures to the two lines of business are usually measured If a country in default does not meet at least differently. one of the exposure criteria for two consecutive Although country-by-country exposure limits quarters, the committee decides whether it should are customary, institutions should also consider continue to be reviewed based on the number of limiting (or at least monitoring) exposures on a banks with exposure and the trend of conditions broader (for example, regional) basis. A troubled in the country. country’s problems often affect its neighbors, and the adverse effects may also extend to geographically distant countries with close ties 3. The ‘‘Guarantees and Credit Derivatives’’ component through trade or investment. By monitoring and captures the notional value of credit derivatives sold. This controlling exposures on a regional basis, insti- measure is a conservative estimate of contingent liabilities tutions are in a better position to respond if the where a bank has taken exposure to a referenced credit in the given country. Netting does not take place in the reporting of adverse effects of a country’s problems begin to credit derivatives since counterparty positions may not offset. spread.

Commercial Bank Examination Manual April 2009 Page 5 7040.1 International—Country Risk and Transfer Risk

For institutions that are engaged primarily in Internal Controls and Audit direct lending activities, monthly monitoring of compliance with country-exposure limits is Institutions should ensure that their country-risk adequate. However, institutions with more vola- management process includes adequate internal tile portfolios, including those with significant controls and that an audit mechanism ensures trading accounts, should monitor compliance the integrity of the information used by senior with approved limits more frequently. Excep- management and the board to monitor compli- tions to approved country-exposure limits should ance with country-risk policies and exposure be reported to an appropriate level of manage- limits. The system of internal controls should, ment or the board so that it can consider for example, ensure that the responsibilities of corrective measures. marketing and lending personnel are properly segregated from the responsibilities of personnel who analyze country risk, rate country risk, and Monitoring Country Conditions set country limits.

The institution should have a system in place to monitor current conditions in each of the coun- tries where it is significantly exposed. The level TRANSFER RISK of resources devoted to monitoring conditions within a country should be proportionate to the Transfer risk focuses on a borrower’s capacity institution’s level of exposure and the perceived to obtain the foreign exchange required to ser- level of risk. If the institution maintains an vice its cross-border debt. The examination of in-country office, reports from the local staff are transfer risk entails (1) the identification of an obviously valuable resource for monitoring selected country exposures of a bank that are country conditions. In addition, periodic country considered significant relative to the bank’s visits by the regional or country manager are capital and the economic performance of the important to properly monitor individual expo- country; (2) the classifications of substandard, sures and conditions in a country. The institution value-impaired, and loss; (3) a determination as may also draw on information from rating agen- to the adequacy of mandated special reserves cies and other external sources. against certain international assets classified Communication between senior management value-impaired; (4) the analysis of those non- and the responsible country managers should be classified credits that warrant bank manage- regular and ongoing. The institution should not ment’s close attention and concentrations that rely solely on informal lines of communication warrant special comment; and (5) an in-depth and ad hoc decision making in times of crisis. assessment of the adequacy of the systems the Established procedures should be in place for bank employs to monitor and control this facet dealing with exposures in troubled countries, of international lending. Four report pages have including contingency plans for reducing risk been designed to reflect an examiner’s analysis and, if necessary, exiting the country. of the transfer-risk element in international lend- ing for a particular bank, as follows. The first page, ‘‘Selected Country Expo- Stress Testing sures,’’ merely lists, without comments, expo- sures that are deemed significant in relation to a Institutions should periodically stress-test their bank’s capital and the economic performance of foreign exposures and report the results to the the country. Exposures, depending on the coun- board of directors and senior management. As try grouping, are taken from the bank’s last used here, stress testing does not necessarily quarterly Country Exposure Report, FFIEC 009, refer to the use of sophisticated financial mod- and compared with the bank’s capital as of the eling tools, but rather to the need for all institu- same date. tions to evaluate in some way the potential The second page, ‘‘Classifications Due to impact different scenarios may have on their Transfer Risk,’’ reflects credits ICERC has clas- country-risk profiles. The level of resources sified because of their transfer risk. Totals in devoted to this effort should be commensurate each classification should be carried forward to with the significance of foreign exposures in the the ‘‘Summary of Classified Items’’ page, with institution’s overall operations. adjustments to eliminate those credits classified

April 2009 Commercial Bank Examination Manual Page 6 International—Country Risk and Transfer Risk 7040.1 because of commercial risk, in accordance with a combination of the amount outstanding in the instructions in section 7040.3. relation to the bank’s capital funds, the compo- In December 1983, the federal banking agen- sition of the portfolio, and the economic perfor- cies adopted examination categories for identi- mance of the country would warrant the bank to fying credits that have been adversely affected focus special attention on its exposure. by transfer-risk problems. In addition, the Inter- The fourth page, ‘‘Analysis of the Country national Lending Supervision Act of 1983 Exposure Management System,’’ presents in requires banks to establish and maintain a spe- narrative form an assessment of a bank’s system cial reserve when the value of international for monitoring and controlling its transfer-risk assets has been impaired by a protracted inabil- exposures. Included are comments relative to the ity of the borrowers in a country to make bank’s procedures for measuring exposure, the payments on external indebtedness or when no system for establishing country lending limits, definite prospects exist for orderly restoration of and the bank’s capability to analyze countries. debt service. Both issues are outlined in section Examination Conclusions and Comments in the 7040.3. report of examination may range from criticisms The third page, ‘‘Nonclassified Credits War- of weaknesses in the country-exposure- ranting Attention II; Concentrations of Transfer management system to high concentrations of Risk Warranting Special Comment,’’ identifies risk in potentially weak or problematic countries. exposures, as of the examination date, in which

Commercial Bank Examination Manual April 2009 Page 7 International—Country Risk and Transfer Risk Examination Objectives Effective date April 2009 Section 7040.2

COUNTRY-RISK MANAGEMENT CLASSIFICATIONS DUE TO TRANSFER RISK 1. If the bank is internationally active, to deter- mine the nature and extent of the bank’s 1. To evaluate the portfolio to identify those direct and indirect country-risk exposure. credits in countries considered subject to 2. If the bank has significant direct or indirect classification by the Interagency Country international exposure, to evaluate and deter- Exposure Review Committee (ICERC). mine whether it has in place an effective 2. To determine if the bank has adequately country-risk management process that is com- provided the required allocated transfer risk mensurate with the volume and complexity reserves for those international assets included of its international activities. in the country exposures classified value 3. To review and determine if the bank’s system impaired. of policies, procedures, and internal controls 3. To develop information on the composition and if its rating system and stress testing for of those exposures subject to classification. county-risk management are adequate and 4. To prepare report pages on all transfer reliable. risks subject to classification. 4. To determine if the bank’s board of directors oversees and regularly reviews its country- 5. To determine the effect of total transfer-risk risk management process, approves limits on classifications on the overall quality of the country exposure, provides for adequate capi- international loan portfolio, as well as on the tal that is commensurate with its direct and total bank. indirect country-risk exposures, and ensures that management is effectively controlling the risk. 5. To determine if management clearly commu- NONCLASSIFIED CREDITS nicates the bank’s country-risk management WARRANTING ATTENTION— policies, standards, and practices to the CONCENTRATIONS OF affected offices and staff. TRANSFER RISK WARRANTING 6. To determine if the scope of the bank’s audit SPECIAL COMMENT function is adequate and if the function is sufficiently comprehensive to ensure the 1. To identify and report any concentrations of integrity of the information senior manage- transfer risk warranting special comment. ment and the board use to monitor the bank’s 2. To develop information on the composition country-risk management process. To ensure of those concentrations for the report page. that the board of directors or its audit com- mittee has provided for adequate audit cov- erage of country-risk management functions. 7. To recommend corrective action if a bank’s country-risk management process and con- ANALYSIS OF THE COUNTRY- trols are deficient in relation to the level of RISK MANAGEMENT SYSTEM country-risk exposure. 8. To determine if the bank is properly pre- 1. To determine if the bank’s policies, practices, paring the Country Exposure Report, procedures, and internal controls for the FFIEC 009, which is required to be filed management of transfer risk are adequate. quarterly with the Federal Reserve Bank of 2. To determine if bank officers are operating in New York. conformance with established guidelines. 9. To identify and report individual country 3. To prepare narrative commentary on the exposures considered significant in relation bank’s country-exposure management sys- to the bank’s capital and the economic per- tem and on any noted deficiencies, in a formance of the country. concise reportable format.

Commercial Bank Examination Manual April 2009 Page 1 International—Country Risk and Transfer Risk Examination Procedures Effective date April 2009 Section 7040.3

COUNTRY RISK on aggregate outstandings, maturities, and cate- gories of risk exposures by country, which serve Country risk, which has an overarching effect on as a guide to operating management in the the realization of an institution’s foreign assets, development and servicing of the bank’s inter- encompasses all of the uncertainties arising national credit portfolio. from the economic, social, and political condi- The third component is the bank’s internal- tions in a country. It includes the possibility of reporting system designed to monitor and con- deteriorating economic conditions, political and trol country exposure. A comprehensive report- social upheaval, nationalization and expropria- ing system is required to accurately assign risk tion of assets, government repudiation of exter- exposures to the country of risk, ensure adher- nal indebtedness, exchange controls, and cur- ence to the directives of the board, provide for at rency depreciation or devaluation. least an annual review of portfolio composition in individual countries, and establish a clear-cut methodology for reporting exceptions to Analysis of the Country-Risk established limits. Management System A summary of the country-risk management system should be prepared. Set forth below are guidelines and procedures for examiners to use Generally, all banks have systems for apprais- in evaluating the systems banks use to monitor ing, monitoring, and controlling their foreign- and control country-risk elements in their lending activities. These systems differ from international loan portfolios. In assessing the bank to bank in terms of the measure of the quality of the country-risk management system, outstanding exposure, the independence of examiners should, as a matter of course, spot- transfer-risk assessments and control from mar- check the accuracy of the data submitted on the keting considerations, the capability to make Country Exposure Report, FFIEC 009. The country judgments on the basis of analytical review should include the exposures for at least factors and firsthand knowledge of the country, several countries. Material exceptions should be the centralization and formality of procedures, commented on. To prepare this summary, the and the level of in-depth review. When perform- examiner should perform the following ing and updating the bank’s risk assessment, the procedures: central point of contact for the institution should include an analysis of the institution’s direct and 1. Obtain any written policies, procedures, or indirect country-risk exposures (including any summaries of the bank’s country-risk man- significant country-risk concentrations) and the agement system. Determine whether the adequacy and reliability of its country-risk man- bank’s country-risk management system agement. Given the variations, banks’ country- includes— risk management systems should consist of three important components. a. effective oversight by the board of directors, One component is the provision for evalua- b. adequate risk-management policies and tion of economic trends, political developments, procedures, and the social fabric within countries where c. an accurate country-exposure reporting bank funds are at risk. These so-called country system, studies are derived from economic data supplied d. an effective country-risk analysis process, by the borrower or published by institutional e. a country-risk rating system, lenders; sociopolitical commentaries; on-site f. country-exposure limits, reports from bank branches, subsidiaries, or affiliates; or bank-officer visits to the country. g. ongoing monitoring of country condi- The second component involves the undertak- tions, ing by the board of directors and senior man- h. periodic stress testing of foreign expo- agement to define the level of country exposure sures, and the bank is willing to assume. This undertaking i. adequate internal controls and an audit normally includes the establishment of limits function. (See SR-02-5.)

Commercial Bank Examination Manual April 2009 Page 1 7040.3 International—Country Risk and Transfer Risk: Examination Procedures

2. Obtain the following from a review of the p. if there is regular, ongoing communica- minutes and reports of the board of directors: tion between senior management and the a. a copy of written policies covering trans- responsible country managers; fer risk q. if established procedures are in place for b. the name and composition of the commit- dealing with exposures in troubled coun- tee responsible for administration of trans- tries, including contingency plans for fer risk reducing risk and, if necessary, exiting the 3. Review international-lending policies and country; and determine— r. whether the bank periodically conducts a. if the board of directors regularly reviews stress tests (financial modeling or measur- and gives final approval to the limits on ing the impact of various scenarios on its country exposure at least annually (or country-risk profiles) of its foreign expo- quarterly, if the foreign exposures are high sures and if the results are reported to risk or the concentrations are significant); senior management and the board of b. who initiates the country ratings and coun- directors. try limits; 4. Review reports furnished to the board or c. how frequently and by whom country the appropriate committee to ensure that ratings and limits are reviewed and comprehensive and accurate information is changed; being submitted on a timely basis. d. how the bank defines the ratings assigned 5. Obtain the bank’s report on the general to the various countries; distribution and characteristics of the e. how country limits are determined; international loan portfolio and compare f. who is responsible for monitoring compli- loan-category distributions for adherence to ance with country limits; guidelines. g. if country-risk limits consider— • the overall strategy guiding the institu- 6. During discussion with senior management, tion’s international activities, direct inquiries to— • the country’s risk rating and the institu- a. gain insight into general management’s tion’s appetite for risk, international lending philosophy, and • perceived business opportunities in the b. elicit management responses for correc- country, and tion of deficiencies. • the desire to support the international business needs of domestic customers; When reporting on the bank’s country-risk h. to what extent country limits are viewed management system, the examiner should con- as guidelines that may be exceeded; sider factors such as— i. if the bank has different sublimits for private- and public-sector credits; 1. the quality of internal policies, practices, j. if separate limits are established for procedures, and controls over the private- and public-sector credits; international-lending functions; k. if the board of directors or a committee 2. the scope and adequacy of the internal loan- thereof periodically reviews country rat- review system as it pertains to country risk; ings and limits, and evaluates the bank’s 3. causes of existing problems; performance against those standards; 4. commitments from management for correc- l. to what extent comments or classifications tion of deficiencies; of bank supervisors are considered in establishing, increasing, or decreasing 5. expectations for continued sound inter- country limits; national lending or correction of existing m. how the system has been changed since deficiencies; the last examination; 6. the ability of management to monitor and n. if the bank has a reliable system for control transfer risk; capturing and categorizing the volume 7. the general level of adherence to internal and nature of foreign exposures; policies, practices, procedures, and controls; o. whether the bank has a system to monitor and current conditions in each of the countries 8. the scope and adequacy of the bank’s analy- where it is significantly exposed; sis of country conditions.

April 2009 Commercial Bank Examination Manual Page 2 International—Country Risk and Transfer Risk: Examination Procedures 7040.3

TRANSFER RISK To promote uniform and consistent applica- tion of these procedures, examiners should avoid Transfer risk is one facet of the more broadly ad hoc interpretations of the instructions and defined concept of country risk. Transfer risk should address all questions to their respective focuses more on the availability of foreign offices. The federal banking agencies have exchange to service a country’s external debt. developed a publication, Guide to the Inter- The transfer-risk examination procedures agency Country Exposure Review Committee emphasize diversification of exposure in relation Process, to clarify and make more transparent to a bank’s capital as the primary method of the role of the ICERC in the supervisory pro- moderating transfer risk. Where concentrations cess. (See SR-08-12.) are noted, the degree of risk inherent therein is assessed in light of the composition of the portfolio and the general economic and political Application of ICERC Ratings factors that may affect the debt-service capacity of the individual countries. ICERC transfer-risk ratings are applicable in—

• every U.S.-chartered insured commercial bank INTERAGENCY COUNTRY in the 50 states of the United States, the EXPOSURE REVIEW COMMITTEE District of Columbia, Puerto Rico, and U.S. territories and possessions; The Interagency Country Exposure Review • every U.S. bank holding company, including Committee (ICERC) is responsible for provid- its Edge and agreement corporations and other ing an assessment of the degree of transfer risk domestic and foreign nonbank subsidiaries; that is inherent in the cross-border and cross- and currency exposures of U.S. banks. The ICERC’s • the U.S. branches and agencies of foreign transfer-risk ratings are primarily a supervisory banks (however, the allocated transfer-risk tool and should not replace a bank’s own reserve (ATRR) requirement does not apply to country-risk analysis process. Supervisors these entities). expect institutions under their supervision to continue to monitor closely their cross-border ICERC ratings are generally applicable to all exposure to all countries; to have robust types of foreign assets held by an institution, country-risk assessment systems; to have with the exception of premises, other real estate appropriate sovereign exposure limits in place owned, and goodwill. For purposes of the ICERC for each sovereign entity; to perform solid rating, the determination of where the transfer financial analysis on the sovereign entities to risk for a particular exposure lies takes into which the institutions are exposed; and, gener- consideration the existence of any guarantees ally, to continue to apply sound risk manage- and is based on the country of residence of the ment to all of their cross-border exposures, not ultimate obligor. (See the instructions for the just to the countries rated by ICERC. Such risk- FFIEC 009.) management functions will continue to be The ICERC transfer-risk rating is the only evaluated during the course of regular rating applicable to sovereign exposures in a supervisory examinations. While banks are reviewed country (that is, direct or guaranteed advised of the results of the ICERC’s evalua- obligations of the country’s central government tions, this information is sensitive, and adequate or government-owned entities). However, if they safeguards should be established to ensure that are carried on the institution’s books as an it is not accessible to unauthorized personnel. investment, securities issued by a sovereign The chief executive officers of those banks fil- entity are also subject to the FFIEC’s Uniform ing the quarterly FFIEC 009 receive copies of Agreement on the Classification of Assets and the write-ups on classified countries for only Appraisal of Securities Held by Banks. The those classifications applicable to their own FFIEC agreement provides for specific, and bank. In no event should the complete listing of possibly more severe, classification treatment of country groupings be divulged. This approach sub-investment-quality securities. Furthermore, parallels that of the Shared National Credit except as noted in the next paragraph, the Program. ICERC transfer-risk rating is also the minimum

Commercial Bank Examination Manual April 2009 Page 3 7040.3 International—Country Risk and Transfer Risk: Examination Procedures risk rating applicable to all other cross-border • Performing short-term bank and performing and cross-currency exposures of U.S. banks in a short-term trade exposures.1 Short-term bank reviewed country. and trade exposures, which have maturities of Regardless of the currencies involved, to the one year or less, are generally considered to extent that an institution’s claims on local coun- have a lower level of transfer risk because, try residents are funded by liabilities to local historically, they have received priority in the country residents, the ICERC’s transfer-risk rat- allocation of a country’s foreign-exchange ings do not apply. For example, to the extent that resources. In recognition of their historical it has liabilities to local residents (such as performance, the ICERC usually assigns a sterling deposits), claims of the London branch more favorable rating to these types of of a U.S. bank on a public- or private-sector exposures. obligor in the United Kingdom (whether the • Securities held in trading accounts. Presum- claims are denominated in sterling, dollars, or ing that there is an active and liquid market for euros) are not subject to the ICERC transfer-risk the securities and that the bank has procedures rating. in place to appropriately value them, the The ICERC is not able to evaluate the credit ICERC may, on a case-by-case basis, assign a risk associated with individual, private-sector less severe transfer-risk rating to specific exposures in a country. Therefore, based on an securities held in the bank’s trading account. evaluation of credit-risk factors (including the In any case, because FASB Financial Account- effects of country risk), examiners may assign ing Standard No. 115 requires that they be credit-risk ratings to individual, private-sector marked-to-market, trading-account securities exposures that are more severe than the ICERC- are not subject to an ATRR requirement. assigned transfer-risk rating for the country. For • Direct-equity investments. The ICERC may, any given private-sector exposure, the applica- on a case-by-case basis, assign a less severe ble rating is the more severe of either the transfer-risk rating to specific direct-equity ICERC-assigned transfer-risk rating for the coun- investments when all of the following condi- try or the examiner-assigned credit-risk rating tions are met: (including ratings assigned as a result of the — The investment has been marked-to-market Shared National Credit Program). or is valued using the equity-accounting method. Questions sometimes arise concerning the — The institution has provided the ICERC consideration that examiners should give to with evidence that the foreign business is informal expressions of support by the central financially viable. government of a country for a particular bor- — The institution has provided the ICERC rower or sector of the economy (most often, with evidence of its ability to repatriate banking). Unless they constitute a guarantee or dividends, interest payments, and pro- other legally binding commitment, examiners ceeds from the sale of assets on a timely should view such expressions of support as no basis. more than a mitigating factor in their evaluation of the counterparty’s credit risk. Informal expressions of support by the central govern- ment would not cause the counterparty’s credit- EXAMINATION REPORTING OF risk rating to revert to the ICERC-assigned TRANSFER RISK transfer-risk rating for the country. The entire examination section dealing with transfer risk should be placed in an international

Special Categories of Exposure 1. A performing credit is current and has not been restructured to avoid delinquency or because of a deterioration Although the ICERC may have rated ordinary in the financial condition of the borrower. A credit is consid- ered ‘‘current’’ if it has not been reported as ‘‘past due’’ or short- and/or long-term exposures in a country ‘‘nonaccrual’’ for the bank call report. Trade credit consists of as substandard, value-impaired, or loss, several credit extensions that are directly related to imports or exports special categories of exposure in a country may and that will be liquidated through the proceeds of interna- receive a less severe transfer-risk rating if cer- tional trade. These credit extensions will include pre-export financing only when there is a firm export sales order and the tain conditions are met, as described below. proceeds of the order will pay off the indebtedness.

April 2009 Commercial Bank Examination Manual Page 4 International—Country Risk and Transfer Risk: Examination Procedures 7040.3 operations section of the commercial report of provisions of the International Lending examination. In addition, the discussion of Supervision Act of 1983. transfer-risk assets should be separated from the The ICERC’s assessment of transfer risk discussion of all other loans and assets classified reflects the committee’s application of the fol- or specially mentioned elsewhere in the report. lowing category definitions.

Selected Country Exposures Substandard This category applies when a country is not A list should be presented of those transfer- complying with its external debt-service obliga- risk exposures considered large relative to the tions, as evidenced by arrearages, forced restruc- bank’s own capital funds, after taking into turing, or rollovers; and if either of the two account the economic, social, and political following conditions exists: circumstances within a country. These exposures, which comprise total claims and • The country is not in the process of adopting contingencies, should be taken from the last an IMF or other suitable economic adjustment quarterly FFIEC 009 filed by the bank under program, or is not adequately adhering to such examination and compared with consolidated a program. bank capital as of the same date. For this pur- • The country and its bank creditors have not pose, capital is defined as tier 1 and tier 2, and it negotiated a viable rescheduling and are should be footnoted as such on this page. The unlikely to do so in the near future. examiner should also note that this report of country exposure and its comparison with bank capital may differ from actual exposure as of the Value-Impaired date of examination. The level at which exposure is listed is based on a review of the A country has protracted arrearages, as indicated performance of each country by the ICERC. by more than one of the following: Examiners are encouraged to review the instructions for preparing the country-exposure • The country has not fully paid its interest for report for further information concerning the six months. preparation of this page. While it is not • The country has not complied with IMF expected that examiners review the country- programs (and there is no immediate prospect exposure reports filed between examinations for for compliance). accuracy, a spot-check to verify that such • The country has not met rescheduling terms reports are being prepared properly should be for more than one year. made. Material reporting errors uncovered dur- • The country shows no definite prospects for ing the examination should be included in com- an orderly restoration of debt service in the ments on reporting exceptions elsewhere in the near future. report of examination. When bank manage- ment relies on the data generated for the country-exposure report, and when reporting Loss exceptions are noted, comments should be incorporated in the analysis of the country-risk A loan is considered uncollectible and of such management system. little value that its continuance as a bankable asset is not warranted. An example would be an outright repudiation by a country of its obli- Ratings and Classifications Due to gations to banks, the IMF, or other lenders. Transfer Risk The ICERC also prepares the write-ups sup- porting each classification. Examiners are to A list of exposures subject to classification as a provide commentary on the disaggregation of result of transfer-risk considerations should be each country exposure subject to classification. prepared. The decision to classify a bank’s Include comments relative to the bank’s country exposure to a particular country is made by the lending limit and any references to any ICERC based on criteria incorporated into the proposed increases or decreases to such limit.

Commercial Bank Examination Manual April 2009 Page 5 7040.3 International—Country Risk and Transfer Risk: Examination Procedures

The examiner’s commentary is to be followed the context of an IMF or other appropriate by a standardized write-up on each country for economic adjustment program, and when the which the bank has exposures, prepared by the lending generally enhances the debt-service ICERC. capability of the country concerned. Whether an ATRR is subsequently required for these new loans would be determined by the ICERC on the basis of performance and the continued inappli- ALLOCATED TRANSFER RISK cability of the established criteria. RESERVE To calculate the reserves, examiners must multiply the reserve percentage times the The responsibility for recognizing and account- amount of the adjusted exposure subject to ing for deterioration in the value of a bank’s transfer risk and the ATRR. This calculation assets, including a deterioration due to transfer- should be done on the face amount of each loan risk problems, rests with the management of a outstanding before deducting any previous write- bank and its auditors. The banking agencies also downs. For purposes of this computation (as have a responsibility to ensure that banks are noted above), interest payments that have been following reasonable and prudent policies in this applied to existing loan balances are tantamount regard, and that necessary adjustments are being to write-downs and are an acceptable alternative made consistently. To ensure this, the federal to the establishment of an ATRR. The number banking agencies, pursuant to the International derived after the calculation should be netted Lending Supervision Act, require U.S. banks to against previous write-downs to arrive at the establish an ATRR on a consolidated basis mandated ATRR. In accordance with SR-92-2, against the risks presented in certain interna- the resulting net exposure, after adjusting for the tional assets whose value has been found by the ATRR, is included in the total classified value- ICERC to have been significantly impaired by impaired, but is weighted like a substandard protracted transfer-risk problems. The ATRR credit only in determining the asset quality of should be applied to certain international assets the bank and other measures of financial sound- that have been classified for transfer-risk rea- ness. The resulting net exposure, after adjust- sons as value-impaired. The act also requires ment for the ATRR, is included in the total that the ATRR be established by a charge classified value-impaired and is looked on as a against current income, be segregated from the doubtful classification only in determining the bank’s allowance for loan and lease losses asset quality of the bank and other measures of (ALLL), be deducted from gross loans and financial soundness. When a shortfall exists, leases, and not be included as part of bank management should be apprised and be expected capital. to comply with the statute in establishing the The alternative to establishing an ATRR is the required reserve. Remarks relative to any short- direct charge to the ALLL or a reduction in the fall and management’s actions should be made principal amount of the asset by applying inter- in the Examination Conclusions and Comments. est payments or other collections on the asset. Although the general rule is that all exposures However, if this alternative accounting treat- rated value-impaired are subject to the ATRR ment is used, the institution may not write up the requirement, over the years there have been a value of the assets if the ATRR requirement is number of clarifications and refinements. (See later reduced or eliminated. No ATRR provi- 12 CFR 28, 211.43, and 347.) sions are required if the bank has previously Aggregate exposures rated ‘‘Substandard’’ are written down or charged off the requisite relevant to any assessment of possible concen- amounts. Furthermore, no ATRR will be required trations of risk, and should be factored into the on contingent liabilities. Instead, contingent evaluation of the adequacy of the bank’s capital liabilities to value-impaired countries will be and ALLL. reviewed on a case-by-case basis. The ATRR amounts mandated will be reviewed regularly by the ICERC to determine if additional reserves are required or whether downward adjustments need to be made. Ini- tially, special reserves would not apply to net new lending when additional loans are made in

April 2009 Commercial Bank Examination Manual Page 6 International—Country Risk and Transfer Risk: Examination Procedures 7040.3

OTHER MATTERS basis with state authorities, Federal Reserve examiners may share with state banking exam- iners information on those countries to which Discussion of Transfer Risk in the the bank under examination has exposures sub- Examiner’s Comments and ject to classification or comment. Conclusions

As a general rule, classifications due to transfer risk are included in the total assets classified and Country Categories discussed under a major heading, such as ‘‘Asset Quality.’’ Transfer-risk classifications of any The complete listing of countries as prepared significance should be highlighted. When the by the ICERC is highly confidential and for bank has other exposures of concern that war- internal use only. In discussions with bank rant not only senior management’s special atten- management, examiners should refer only to tion, but the attention of the bank’s board of countries that will be commented on in that directors, comments may be generated under a bank’s examination report. In this context, any separate caption entitled ‘‘Transfer Risks.’’ The reference to a ‘‘categorization’’ of countries examiner should include comments relative to should be couched in neutral terms. the classifications; the shortfall, if any, in the Examiners are to provide the examiner-in- mandatory reserves against exposures consid- charge with essential information that will help ered value-impaired; concentrations warranting facilitate future examinations. In addition, all special comment; and any other noted defi- workpapers should be maintained in an orderly ciency, such as an ineffective country-risk man- manner, properly labeled, and available for agement system. inspection when and if necessary.

Sharing Information with State Banking Examiners

When an examination of a state member bank is being conducted concurrently or on a joint

Commercial Bank Examination Manual April 2009 Page 7 International—Country Risk and Transfer Risk Internal Control Questionnaire Effective date April 2009 Section 7040.4

1. Has the board of directors, consistent with 6. Before granting additional advances or com- its duties and responsibilities, adopted writ- mitments, are outstanding advances or com- ten objectives and policies for international mitments checked against appropriate coun- loan portfolio management? Do these poli- try limits? cies and objectives— 7. Are lending officers cognizant of specific a. establish country-exposure limits for country limitations? credits, including sublimits for transfer 8. Are procedures for exceeding country limits risk? clearly defined? b. establish limits for distribution of credits 9. Does the bank have a periodic foreign call by type and maturity? program for countries? c. acknowledge concentrations of credit 10. Is there an internal-review system to deter- within countries, and acknowledge the mine that international risk assets outstand- need to employ personnel with appropriate ing and committed are within the bank’s specialized knowledge and experience to foreign-exposure limits? supervise those concentrations? 11. Are country-risk factors (economic, politi- cal, and social) and other factors in a 2. Are objectives and policies for international particular country considered in the bank’s loan portfolio management reviewed at least internal periodic review of its risk assets? annually to determine if they are compatible with changing market conditions? 12. Does the bank have an adequate, current system for country-risk analysis? Does the 3. Are significant changes in country condi- system consist of a regular, periodic quan- tions or levels of exposure promptly brought titative and qualitative assessment and to the attention of the board of directors or review of risk for each country in which the its designated committee? bank conducts or plans to conduct business, 4. Are country limits revised in response to and does this system include— substantive changes in economic, political, a. a review of country conditions on a and social conditions within particular regular basis (state the frequency and countries? indicate who performs analyses)? 5. Is a formal analysis of country risk pre- b. a continuing review of current country pared, and are country limits reviewed, data obtained from internal and external updated, and approved by the board of sources? directors at least annually? c. an analysis of economic, political, social, a. Does the analysis take into account all and other factors affecting country risk? aspects of the broadly defined concept of 13. Does the bank have a formal reporting country risk, as well as any unique risks system on country risk? associated with specific groups of coun- 14. Does the reporting system provide complete terparties the institution may have tar- exposure data quickly and in sufficient detail geted in its business strategy? to assess particular risks? b. Is the analysis adequately documented, 15. Does the bank’s country-risk evaluation and are conclusions concerning the level system accurately recognize exposure from of risk communicated in a way that country to country, on the basis of legally provides decision makers with a reason- binding guarantees, collateral, or realloca- able basis for determining the nature and tion by the office of responsibility? level of the institution’s exposures in a 16. Given the size and sophistication of the country? institution’s international activities, are the c. Are the bank’s conclusions concerning a resources devoted to the analysis of country country reasonable in light of informa- risk adequate? tion available from other sources, includ- 17. Is a regular determination made about each ing external research and rating services country’s transfer risk, including whether and the Interagency Country Exposure transfer risk is increased due to the bank’s Review Committee (ICERC)? heavy debt servicing or other financial

Commercial Bank Examination Manual April 2009 Page 1 7040.4 International—Country Risk and Transfer Risk: Internal Control Questionnaire

restraints, and whether the country has those international assets that are included exchange controls and hard-currency in the country exposures classified value- restrictions? impaired? 18. Has the bank adequately provided the required allocated transfer risk reserves for

April 2009 Commercial Bank Examination Manual Page 2 International—Financing Foreign Receivables Effective date May 1996 Section 7050.1

INTRODUCTION consequently, is not encountering foreign- exchange difficulties. Financing foreign receivables, a specialized area of commercial lending in an international bank- ing division, includes open-account financing, sales on consignment, advances against collec- SALES ON CONSIGNMENT tions, discounting trade acceptances, banker’s acceptances, factoring, and forfaiting. Certain Under a consignment arrangement, goods are foreign receivables are guaranteed or insured consigned to the importer (consignee) abroad, against cross-border risk by the Export-Import and the exporter (consignor) retains title to them Bank of the United States, the Foreign Credit until they are sold to a third party. However, Insurance Association, and other U.S. and for- unless the shipment is made to an exporter’s eign organizations. Factoring is discussed in overseas branch or subsidiary, the exporter’s section 2180 of this manual, and accounts credit risk may be considerable. As with open- receivable financing is discussed in section 2160 account sales, there is a lack of standard trade- (Asset-Based Lending) of this manual. financing documentation on which to base legal action if the consignee defaults. The exporter should thoroughly understand the inherent credit risks, especially when goods are consigned to an OPEN-ACCOUNT FINANCING agent, representative, or import house abroad. In countries with free ports or free trade The simplest method of financing foreign receiv- zones, consigned goods may be placed under ables is on open account. In this type of sale, the bonded warehouse control in the name of a buyer and seller agree on payment at a specified foreign bank or branch of the bank. Arrange- date without a negotiable instrument, such as a ments may then be made to release the con- draft or acceptance, evidencing the obligation. signed merchandise at the time it is sold. Mer- In most instances, the shipping documents are chandise is cleared through customs after the sent directly to the buyer rather than through a sale has been completed. However, that type of bank. The exporter may request that the buyer consignment should not be made and will not make payment to the bank at which the exporter usually be accepted by foreign banks until all maintains an account. The advantages of an pertinent conditions and regulations are verified open-account sale are its simplicity, lack of bank and storage facilities are arranged. The export- charges, and the avoidance of stamp duties that er’s bank also should verify that goods not sold certain countries apply to drafts. may be returned to the country of origin. Con- The financing of open-account sales does signment shipments financed by the bank should have certain risks. Neither the lending bank nor be limited to countries that do not have burden- the exporter have control over the shipping some foreign-exchange restrictions and that have documents, and the buyer (importer) may take sufficient foreign exchange available to pay for possession of the goods without the consent of imports. the bank or exporter. In addition, if the importer To overcome the disadvantages of financing does not register the goods with the proper shipments on an open-account or consignment authorities, the importer may not have access basis, exporters frequently ship goods against to the amount of foreign exchange necessary documentary collections. Consequently, the to pay for the imports at the time of payment. exporter, in the case of a time or arrival draft, or Perhaps the greatest risk in open-account the exporter and the importer jointly, in the case financing is the lack of standard trade-financing of a sight draft, finance the shipment. The documentation on which to base legal action exporter and the importer may have unused against the importer in the event of default. credit lines with their banks and be in a position Therefore, open-account sales are most appro- to borrow the needed money without tying the priate when the buyer is a subsidiary of a related financing to the trade transaction. However, company or is well known to the seller and often the exporter’s or the importer’s regular when the importing country has no significant bank lines are fully drawn down, so they may economic, political, or social problems and, seek bank financing in the form of advances

Commercial Bank Examination Manual May 1996 Page 1 7050.1 International—Financing Foreign Receivables against outward collections, discounting trade reputations and financial strength, the bank will acceptances, banker’s acceptances, factoring, or likely advance a larger percentage on collections forfaiting. directed to them. The bank will also likely advance a larger percentage of funds to import- ers in those countries in which importers promptly pay drafts drawn on them. In other ADVANCES AGAINST FOREIGN countries where payment is generally slow, COLLECTIONS perhaps because importers are financially weak or because U.S. dollar or other foreign-currency A manufacturer or merchant conducting a strictly exchange is hard to obtain, the bank will advance domestic business often obtains a loan from a a lower percentage on collections. The export- bank, finance company, factor, or forfaiter using er’s bank may be completely unwilling to finance accounts receivable as security. The same gen- collections directed to importers or countries eral type of financing vehicle is available to with reputations for habitually slow payments. exporters to finance their foreign receivables. When a bank advances against foreign receiv- A common method of financing foreign ables, it must carefully scrutinize the supporting receivables is through the exporter pledging all documents. Since the bank wishes to maintain outward collections to its bank. The exporter control of the merchandise, the bill of lading may then borrow from the bank up to a stated should be either ‘‘to the order of’’ the shipper maximum percentage of the total amount of and blank-endorsed or ‘‘to the order of’’ the receivables pledged at any one time. When notes bank. The bill of lading must not be consigned rather than drafts are used to finance foreign to the buyer (importer) since this gives the buyer receivables, they are usually paid on demand, control over the goods. Also, financed ship- enabling the exporter to increase or decrease the ments should be covered by adequate insurance. loan depending on its needs and the current amount of collections outstanding. Preferably, all of the collections lodged with the exporter’s bank should be pledged to the bank. When a DISCOUNTING TRADE particular collection is paid, it is remitted by a ACCEPTANCES foreign collecting bank to the exporter’s bank, which has already advanced the funds to the A draft accepted by the foreign importer becomes exporter. The exporter’s bank then uses the a trade acceptance carrying the full credit obli- proceeds of the collection to reduce the export- gation of the importer. These trade acceptances er’s loan. are also frequently called ‘‘trade bills’’ or ‘‘trade Some exporters have no need for a continuous paper.’’ The acceptance is returned to and financing arrangement but occasionally may becomes the property of the exporter, who will wish to obtain financing on only one large ask the collecting bank to present it to the foreign receivable. In these instances, the importer or acceptor for payment at maturity. exporter’s bank may be willing to advance funds The exporter is, therefore, providing the financ- to the exporter with only that one receivable as ing or ‘‘carrying’’ its own foreign receivables. security. Again, the bank establishes a maxi- However, if the exporter needs the funds before mum percentage of the amount of the receivable maturity of the trade acceptance, the exporter that it is willing to advance. When payment for may ask the bank to ‘‘discount’’ the draft. If the the receivable is obtained, the bank uses the primary obligor (the acceptor) is a well-known proceeds to liquidate the loan, crediting any company of good credit standing, the bank may excess to the exporter. Bank financing in the be willing to discount the draft without recourse form of advances against export receivables is to the exporter. More commonly, however, the an accepted practice in international trade and is lending bank looks to the exporter for recourse not considered factoring. should the primary obligor fail to pay the Besides having a lien on the exporter’s out- amount when due. ward collections, the bank usually retains When discounting a trade acceptance, the recourse to the exporter, whose credit strength bank applies a discount to the face amount of the and reputation are of prime importance. Other draft and advances the remainder to the exporter factors, however, are also significant. If the until the draft’s maturity. The bank is ‘‘buying’’ foreign importers are companies with strong the trade acceptance for value and is entitled to

May 1996 Commercial Bank Examination Manual Page 2 International—Financing Foreign Receivables 7050.1 any benefits from the primary obligor to which it goods, but gets the notes at a substantial dis- is due as a holder in due course of a negotiable count in exchange for cash. Zurich and Vienna instrument. This is also the case whenever the are the centers of forfaiting. Many large banks, bank advances against a single collection or a including U.S. institutions, provide forfaiting pool of collections. Any intermediary ‘‘collect- through either their branches or specialized ing’’ bank also has a financial interest in the subsidiaries in these cities. collection and has all the rights of a holder in Forfaiting is used when government export due course under the Uniform Commercial Code. credits or credit guarantees are not available or when a seller does not extend long-term credits to areas such as Eastern Europe. Forfaiting is BANKER’S ACCEPTANCES also an important method of financing for small CREATED AGAINST FOREIGN and medium-sized companies because it enables COLLECTIONS them to engage in transactions that would nor- mally exceed their financial capabilities. By During periods of tight money, banks may using forfaiting, small and medium-sized con- choose to finance foreign collections by using cerns can immediately sell their long-term banker’s acceptances. Banker’s acceptances are receivables without recourse. discussed in section 7060, ‘‘International— Forfaiting presents all of the risks associated Banker’s Acceptances,’’ so the following com- with factoring, along with the risks associated ments relate only to the financing of foreign with the long-term nature of purchased receiv- collections. ables. The examiner should review the bank’s As with all acceptance financing, the exporter forfaiting activities carefully to determine first submits a signed acceptance agreement to whether long-term receivables have been pur- its bank. To obtain acceptance financing for chased from countries prone to periodic political foreign receivables, the exporter draws two or economic turmoil and the resulting fluctua- drafts. The first is a time draft drawn on the tions in exchange rates. foreign buyer (the importer) that, along with the necessary documents, is sent for collection in the usual manner. The second draft, for the same U.S. AND FOREIGN or a smaller amount as agreed to by the bank and RECEIVABLES GUARANTEE AND the exporter, is drawn by the exporter on its bank INSURANCE PLANS and has the same tenor as the draft drawn on the importer. The bank accepts the second draft and To reduce credit, political, and other risks asso- discounts it, crediting the net amount to the ciated with foreign receivables financing, banks exporter’s account. The bank has now created a may avail themselves of a variety of guarantee banker’s acceptance that can be sold in the and insurance plans, both public and private, highly liquid acceptance market, provided the that are available in many countries. Because of bank’s reputation is solid. When payment is the complexity of the numerous plans available, received from the importer, the bank applies the an examiner must frequently rely on the techni- proceeds towards its own acceptance, which cal knowledge of the staff in a bank’s interna- will be presented for payment if sold in the tional division who handle these transactions. market. Should the drawee default, the bank has Nevertheless, the examiner should know the risk recourse to the drawer and can demand payment coverage and claim adjustment provisions of the from that source. major plans. Often a bank’s experience with its receivables insurance and guarantee plans is indicative of its effectiveness and of whether the FORFAITING bank has properly met its responsibilities under the programs. Forfaiting is basically nonrecourse financing of receivables, similar to factoring. However, although a factor normally purchases a compa- Export-Import Bank of the United ny’s short-term receivables, a forfait bank pur- States chases notes that are long-term receivables with maximum maturities of eight years. The forfait- The Export-Import Bank of the United States ing bank has no recourse to the seller of the (Eximbank) issues to commercial banks, for a

Commercial Bank Examination Manual May 1996 Page 3 7050.1 International—Financing Foreign Receivables fee, guarantees of payment for foreign receiv- competition, tariffs, or technical changes. Politi- ables that the bank purchases from exporters, cal risk coverage applies to defaults due to generally without recourse to the exporter. The government action, such as currency inconvert- maturities of the receivables range from 181 ibility, expropriation, and cancellation of import days to over five years. Generally, the foreign license, and to political disturbances, such as buyer must make a cash payment, either before war, revolution, and insurrection. or upon delivery, of at least 10 percent of the FCIA generally offers four basic types of invoice value, and the amount of receivables policies covering political and commercial risks: purchased by the bank without recourse to the exporter normally cannot exceed 90 percent of • Short-term policies covering shipments nor- the financed portion of the sale (invoice amount mally sold on terms up to 180 days. The usual less cash payment). This guarantee covers policy covers 100 percent of political risks political risks, such as inconvertibility of foreign and 90 percent of any losses from commercial currencies into U.S. dollars, governmental actions risk. preventing importation of goods, war, civil strife, • Medium-term policies insuring transactions expropriation, and confiscation by government from six months to five years. FCIA covers up action. Commercial risks, basically the credit to 100 percent of political risks and 90 percent risk of the foreign purchaser, usually are covered of commercial risks, with the remainder from six months to five years. retained by the exporter. • Combined short-term/medium-term policies for sales that pass through distributors before Foreign Credit Insurance Association reaching final buyers. • Master policies that include the basic insur- ance features of the previous policies plus The Foreign Credit Insurance Association (FCIA) discretionary and deductible provisions. Under is an association of leading marine, property, a master policy, usually only for short-term and casualty insurance companies. In coopera- transactions, exporters may obtain FCIA tion with Eximbank, FCIA offers a comprehen- authority to grant insured credit up to a certain sive selection of credit insurance policies that amount without seeking prior approval. The protect policyholders against loss from failure to deductible provision, used only for commer- receive payment from foreign buyers. cial risks and not political risks, requires the FCIA coverage protects the exporter against exporter to assume a fixed amount of the first the failure of the buyer to pay dollar obligations loss on total debts. for commercial or political reasons; enables the exporter to offer foreign buyers competitive (Source: Washington Agencies That Help to terms of payment; supports the exporter’s pru- Finance Foreign Trade, seventh edition, Bank- dent penetration of higher risk foreign markets; ers Trust Company, New York.) and gives the exporter greater liquidity and flexibility in administering a foreign receivables portfolio. The FCIA does not itself finance export sales. However, the exporter who insures Other Insurers account receivables against commercial and political risks is usually able to obtain financing Numerous other private and governmental insti- from commercial banks and other lending insti- tutions, both in the United States and overseas, tutions at lower rates and on more liberal terms guarantee or insure risks assumed by commer- than would otherwise be possible by assigning cial banks financing foreign receivables. Some the proceeds of the FCIA insurance to the examples of these institutions in other countries lenders. are the Export Credits Guarantee Department Comprehensive FCIA policies protect export- (ECGD) in the United Kingdom, COFACE in ers against nonpayment of receivables due to France, and HERMES in Germany. unforeseeable commercial and political occur- In the United States, the Overseas Private rences. Commercial risks covered include insol- Investment Corporation (OPIC), a corporation vency or protracted default, which may be wholly owned by the U.S. government, offers caused by economic deterioration in the buyer’s insurance against the political risks of inconvert- market area, shifts in demand, unanticipated ibility, expropriation, war, revolution, and insur-

May 1996 Commercial Bank Examination Manual Page 4 International—Financing Foreign Receivables 7050.1 rection and guarantees the repayment of private and foreign concerns that are at least 95 percent U.S. loans for U.S. citizens, U.S. concerns that owned by U.S. individuals or entities. are substantially and beneficially U.S.-owned,

Commercial Bank Examination Manual May 1996 Page 5 International—Financing Foreign Receivables Examination Objectives Effective date May 1996 Section 7050.2

1. To determine if the policies, practices, pro- audit function as it relates to the financing of cedures, and internal controls for the financ- foreign receivables. ing of foreign receivables are adequate. 5. To determine compliance with laws and 2. To determine if bank officers are operating regulations. in conformance with established bank guidelines. 6. To recommend corrective action when poli- 3. To evaluate the portfolio for credit quality, cies, practices, procedures, or internal con- collectibility, and collateral sufficiency. trols are deficient or when violations of laws 4. To determine the scope and adequacy of the and regulations are cited.

Commercial Bank Examination Manual May 1996 Page 1 International—Financing Foreign Receivables Examination Procedures Effective date November 2003 Section 7050.3

1. If selected for implementation, complete or (indicate which officers are considered update the international—financing foreign executive officers) receivables section of the internal control g. reports on the indebtedness of executive questionnaire. officers and principal shareholders and 2. Determine the scope of the examination on their related interests to correspondent the basis of the evaluation of internal con- banks trols and the work performed by internal or h. a list of correspondent banks external auditors. i. miscellaneous loan-debit and credit- 3. Test for compliance with policies, practices, suspense accounts procedures, and internal controls in j. Interagency Country Exposure Review conjunction with performing the remaining Committee determinations examination procedures. Also obtain a list- k. criticized Shared National Credits (appli- ing of any deficiencies noted in the latest cable international credits) reviews done by internal and external audi- l. loans considered ‘‘problem loans’’ by tors from the examiner assigned to the management audit review, and determine if appropriate m. background information on directors, corrections have been made. executive officers, principal sharehold- 4. Obtain trial balances of applicable customer ers, and their related interests liability records. n. specific guidelines in the lending policy a. Reconcile balances to department con- governing the financing of foreign trols and the general ledger. receivables b. Review reconciling items for reason- o. current lending authorities of officers and ableness. lending committee (or committees) 5. Using an appropriate technique, select bor- p. the current interest-rate structure rowers for examination. q. any useful information obtained from the 6. Prepare examiners’ credit line cards to review of the minutes of the loan include— and discount committee or any similar a. customers’ aggregate foreign receivables– committee financing liability and r. reports furnished to the loan and discount committee or any similar b. debt instruments aggregating customers’ committee total outstanding liability. s. relevant reports furnished to the board of 7. Obtain the following information: directors a. past-due, nonaccrual, and reduced-rate t. loans classified during the previous loans, advances, and acceptances examination b. loans whose terms have been modified 8. Review the information received and per- by a reduction in the interest rate or the form the following: principal payment or by a deferral of a. Loans transferred, either in whole or in interest or principal part, to or from another lending institu- c. loans transferred, either in whole or in tion as a result of a participation, sale or part, to another lending institution as a purchase, or asset swap. Perform pro- result of a sale, participation, or asset cedures in step 7a of section 7030.3, swap since the previous examination ‘‘International—Loans and Current d. loans acquired from another lending Account Advances: Examination institution as a result of a purchase, Procedures.’’ participation, or asset swap since the b. Miscellaneous loan-debit and credit- previous examination suspense accounts. e. loan commitments and other contingent • Discuss with management any large or liabilities old items. f. loans to principal shareholders, officers, • Perform additional procedures as con- and directors and to their related interests sidered appropriate.

Commercial Bank Examination Manual November 2003 Page 1 7050.3 International—Financing Foreign Receivables: Examination Procedures

c. Loan commitments and other contingent decide who will review the borrowing rela- liabilities. Analyze the commitments and tionship. Pass or retain completed credit contingent liabilities of the obligors line cards. together with the combined amounts of 12. Prepare collateral line cards for all borrow- their current loan balances. ers selected in the preceding steps. d. Loans criticized during the previous 13. Obtain credit files for all borrowers for examination. Determine disposition of whom examiner credit line cards were pre- loans so classified by transcribing the pared, and complete credit line cards, where current balance and payment status, or appropriate. To analyze foreign receivables the date the loan was repaid and the financed, perform the following procedures: source of repayment. a. Analyze the customers’ balance sheets • Investigate any situations in which all and profit-and-loss figures as shown in or part of the funds for the repayment current and preceding financial state- came from the proceeds of another ments, and determine the existence of loan at the bank or as a result of any favorable or adverse trends. a participation, sale, or swap with b. Review components of the balance sheet another lending institution. as shown in the current financial state- • If repayment was a result of a partici- ments, and determine the reasonableness pation, sale, or swap, refer of each item as it relates to the total to step 7a of ‘‘International—Loans financial structure. and Current Account Advances: c. Review supporting information for the Examination Procedures,’’ section major balance-sheet items and the tech- 7030.3, for the appropriate examina- niques used in consolidation, determine tion procedures. the primary sources of repayment, and e. Shared National Credits. evaluate their adequacy. • Compare the schedule of foreign receivables financed included in the d. Determine compliance with provisions uniform review of Shared National of loan agreements. Credits Program with the listing of e. Review digests of officers’ memoranda, credits selected for review to deter- mercantile reports, credit checks, and mine which loans in the sample are correspondence to determine the exist- portions of Shared National Credits. ence of any problems that might deter • For each loan so identified, transcribe the contractual repayment program. appropriate information from the sched- f. Obtain the following information: ule to line cards. No further examina- • Open-account financing. tion procedures are necessary in this — whether the shipment is directed to area. third parties or branches and sub- f. Interagency Country Exposure Review sidiaries of the borrower Committee credits. Identify any credits — the financial strength and trust- that were selected for review that are worthiness of the overseas buyer criticized for transfer-risk reasons by the — the extent of foreign-exchange con- Interagency Country Exposure Review trol and the availability of exchange Committee. for the importer to effect payment 9. Transcribe or compare information from — the bank’s past experience in deal- the above schedules to credit line cards, ing with the borrower who sells on where appropriate, and indicate any past- open account due status. 10. Prepare credit line cards for any loan not • Sales on consignment. in the sample that, on the basis of informa- — whether the shipment is directed to tion derived from the above schedules, third parties or branches and sub- requires an in-depth review. sidiaries of the obligor 11. Obtain liability and other information on — the financial strength and trustwor- common borrowers from examiners assigned thiness of the foreign consignee to international cash accounts, over- — the responsibilities of the foreign drafts, and other loan areas, and together sales agent, overseas representa-

November 2003 Commercial Bank Examination Manual Page 2 International—Financing Foreign Receivables: Examination Procedures 7050.3

tive, or import house under — the bank’s experience in dealing contract with the borrower who receives — the extent of foreign-exchange con- advances against collections trol and the availability of exchange • Discounted trade acceptances. for that type of transaction in the — the relationship between the amount country of destination collected in a month on the trade — whether the borrower’s goods, acceptances discounted and the bor- without a definite buyer, are con- rower’s credit limit signed abroad in the name of the — whether the bank discounted the borrower’s bank or a foreign bank trade acceptance with or without — whether the goods being shipped recourse are assigned to a responsible — whether the borrower retains a per- warehouseman centage of the trade acceptance — any arrangements that have been endorsed to the bank made whereby the selling agent — aging of trade acceptances negotiates for the sale of the goods — ineligible drawees, including house — the regulations in the country of bills destination regarding the return of — concentrations of drawees unsold consigned goods to the —financial strength of the drawees country of origin — unusual situations, such as dis- — the bank’s past experience in deal- putes, nonacceptance of goods, and ing with the borrower who sells on possession of goods without consignment payment • Advances against collections. — dishonor and protest instructions — the relationship between the — any special instructions amount collected in a month on the — the extent of foreign-exchange con- collections pledged as collateral trols and the availability of and the borrower’s credit limit exchange for that type of transac- — the tenor of sight drafts—a stated tion in the country of destination number of days after sight or a — the bank’s experience in dealing stated number of days after the with the borrower for whom its date of the draft trade acceptances are discounted — instructions regarding delivery of by the bank documents against payment (D/P) • Banker’s-acceptance financing. or documents against acceptance — the relationship between the (D/A) amount collected from the foreign — whether amounts advanced against buyer in a month and the borrow- collections are within the per- er’s credit limit centage of advance limitation — whether the discounted draft drawn established by the exporter (customer) on the — aging of drafts (collections) exporter’s bank has the same tenor — ineligible drawees, including house as the draft addressed to the for- bills eign buyer — concentrations of drawees — the procedures for applying pay- —financial strength of drawees ment received from the foreign — unusual situations such as disputes, buyer to pay the bank’s own nonacceptance of goods, acceptance and possession of goods without — aging of time drafts drawn on the payment importer (drawee) — dishonor and protest instructions — ineligible foreign buyers (draw- — any special instructions ees), including house bills — the extent of foreign-exchange con- — concentrations of foreign buyers trols and the availability of (drawees) exchange for that type of transac- —financial strength of the foreign tion in the country of destination buyers (drawees)

Commercial Bank Examination Manual November 2003 Page 3 7050.3 International—Financing Foreign Receivables: Examination Procedures

— disputes, nonacceptance of goods, sale (or signing of a sales contract) and possession of goods without creating a receivable payment — the financial strength of the debtor — dishonor and protest instructions accounts purchased — any special instructions — the capability of the exporter from — the extent of foreign-exchange con- whom receivables were purchased trol and the availability of to provide any required after-sales exchange for that type of transac- service and to honor warranties tion in the country of destination — disputes and returns — the bank’s experience in dealing — the extent of foreign exchange with the borrower restrictions, availability of • Factoring. exchange, and country risk involved — the extent the factor ‘‘guarantees’’ that could jeopardize collection of letters of credit opened by the bank receivables purchased in favor of overseas suppliers — the bank’s experience in dealing — whether the title documents on with both the debtors and the import transactions are consigned exporter to or endorsed over to the factor • U.S. and foreign receivables guarantee — whether the importer who receives and insurance plans. Determine goods under trust receipt agrees to whether foreign receivables coverage hold them in trust for the factor by FCIA, Eximbank, or other insur- — whether the imported goods held ance or guarantee programs is suffi- under warehouse receipt are stored cient, adequately identifies risks, and is in an independent warehouse for consistent with established limits. the account of the factor g. Analyze secondary support offered by — whether usance letters of credit are guarantors and endorsers. paid to the bank by the factor at h. Determine compliance with the bank’s maturity, and whether the resulting established international loan policy. acceptances are charged to the bank 14. For loans in the sample, check the central customer’s account for payment to liability file on borrowers indebted above the factor when due the cutoff line or borrowers displaying credit — whether the factor borrows from weaknesses or suspected of having addi- the bank or creates a banker’s tional liability in other loan areas. acceptance pending payment of 15. Transcribe significant liability and other accounts receivable resulting from information of officers, principals, and the sale of goods imported under affiliations of appropriate borrowers con- letters of credit tained in the sample. Cross-reference line — the financial strength of the cards to borrowers, where appropriate. importer for whom the bank opened 16. Determine compliance with laws and regu- the letter of credit lations pertaining to financing foreign — any disputes, nonacceptance of receivables by performing the following goods, and possession of goods steps. without payment a. Lending limits. Determine the bank’s — the bank’s experience in dealing lending limit as prescribed by state law, with the factor and note any exceptions. • Forfaiting. b. Section 23A, Relations with Affiliates (12 — agings of debtor accounts USC 371c), and section 23B, Restric- purchased tions on Transactions with Affiliates (12 — ineligible debtor accounts pur- USC 371c-1), of the Federal Reserve chased, including affiliate receiv- Act, and the Board’s Regulation W. Per- ables, if any form procedures in step 15b of — concentration of debtor accounts ‘‘International—Loans and Current purchased Account Advances: Examination Proce- — the adequacy of the bank’s credit dures,’’ section 7030.3. investigation before approving the c. 18 USC 215, Receipt of Commission or

November 2003 Commercial Bank Examination Manual Page 4 International—Financing Foreign Receivables: Examination Procedures 7050.3

Gift for Procuring Loans. mentation, and determine if the bank • While examining foreign receivables retains records of each extension of credit financing, determine the existence of over $10,000, specifying the name and any possible cases in which a bank address of the borrower, the amount of officer, director, employee, agent, or the credit, the nature and purpose of the attorney may have received anything loan, and the date thereof. (Loans se- of value for procuring or endeavoring cured by an interest in real property are to procure any extension of credit. exempt.) (See 31 CFR 1010.410.) • Investigate any such suspected 17. Perform the appropriate procedural steps in irregularities. ‘‘Concentrations of Credit: Examination Pro- d. Federal Election Campaign Act (2 USC cedures,’’ section 2050.3. 441b), Political Contributions. 18. Discuss with appropriate officers, and pre- • Determine the existence of any loans pare summaries in appropriate report form in connection with any political of— campaigns. a. delinquent loans; • Review each such credit to determine b. loans not supported by current and com- whether it is made in accordance with plete financial information; applicable banking laws and in the c. loans on which documentation is ordinary course of business. deficient; e. 12 USC 1972 and Regulation Y (12 CFR d. loans with credit weaknesses; 225.7), Tie-In Provisions and Exceptions. e. inadequately collateralized loans; Determine whether any credit extension f. criticized loans, including supporting is conditioned upon— commentaries; • obtaining or providing any additional g. concentrations of credit; credit, property, or service from or to h. extensions of credit to major sharehold- the bank or its holding company (or a ers, officers, and directors and to their subsidiary of its holding company), related interests; other than a loan, discount, deposit, or i. violations of laws and regulations; and trust service, or • the customer not obtaining a credit, j. other matters regarding the condition of property, or service from a competitor the department. of the bank or its holding company (or 19. Evaluate the bank for— a subsidiary of its holding company), a. the adequacy of written policies relating other than a reasonable condition to to financing foreign receivables; ensure the soundness of the credit b. the manner in which bank officers are f. Regulation O (12 CFR 215), Loans to operating in conformance with estab- Executive Officers, Directors, and Prin- lished policy; cipal Shareholders and Their Related c. adverse trends in those sections of Interests, and Title VIII of the Financial the international sector of the bank Institutions Regulatory and Interest Rate concerned with financing foreign Control Act of 1978 (FIRA) (12 USC receivables; 1972(2)), as amended by the Garn–St d. the accuracy and completeness of the Germain Depository Institutions Act of schedules obtained from ‘‘International— 1982, Loans to Executive Officers, Loan Portfolio Management,’’ section Directors, and Principal Shareholders of 7020.3; Correspondent Banks. Perform the Regu- e. recommended corrective action when lation O procedures of ‘‘International— policies, practices, or procedures are Loans and Current Account Advances: deficient; Examination Procedures,’’ section 7030.3. f. the competency of departmental manage- g. Financial Recordkeeping and Reporting ment; and of Currency and Foreign Transactions, g. other matters of significance. Retention of Credit Files. Review the 20. Update the workpapers with any informa- operating procedures and credit file docu- tion that will facilitate future examinations.

Commercial Bank Examination Manual April 2015 Page 5 International—Financing Foreign Receivables Internal Control Questionnaire Effective date March 1984 Section 7050.4

Review the bank’s internal controls, policies, 5. Are inquiries regarding foreign receiv- practices,andproceduresregardingforeignreceiv- ables financing loan balances received and ables financing. The bank’s system should be investigated by persons who do not nor- documented in a complete and concise manner mally process documents, handle settle- and include, where appropriate, narrative descrip- ments, or post records? tions, flowcharts, copies of forms used, and *6. Are bookkeeping adjustments checked and other pertinent information. Items marked with approved by an appropriate officer? an asterisk require substantiation by observation *7. Is a daily record maintained summarizing or testing. transaction details, i.e., loans made, pay- ments received, and interest collected to support applicable general ledger entries? POLICIES *8. Are frequent debt instrument and liability ledger trial balances prepared and recon- 1. Has the board of directors, consistent with ciled monthly with control accounts by its duties and responsibilities, adopted writ- employees who do not process or record ten foreign receivables financing policies loan transactions? that: a. Establish procedures for reviewing financing applications? DOCUMENTATION b. Establish standards for determining credit lines? 9. Are terms, dates, weights, description of c. Establish standards for determining the the merchandise, etc., shown on invoices, percentage of advances made against shipping documents, trust receipts, and acceptable collections (receivables)? bills of lading scrutinized for differences? d. Define acceptable receivables 10. Are procedures in effect to determine if the (collections)? signatures shown on the above documents e. Establish minimum requirements for are authentic? verification of borrower’s receivables 11. Are payments received from customers (collections)? scrutinized for differences in invoice dates, numbers, terms, etc.? f. Establish minimum standards for docu- mentation in accordance with the Uni- form Commercial Code? 2. Are foreign receivables financing policies LOAN INTEREST reviewed at least annually to determine if *12. Is the preparation and posting of loan they are compatible with changing market interest records performed or adequately conditions? reviewed by persons who do not also: a. Issue official checks or drafts? b. Handle cash? ACCOUNTING RECORDS 13. Are independent interest computations made and compared or adequately tested *3. Is the preparation and posting of subsid- to initial loan interest records by persons iary records performed or adequately who do not also: reviewed by persons who do not also: a. Issue official checks or drafts? a. Issue official checks or drafts? b. Handle cash? b. Handle cash? *4. Are subsidiary records reconciled, at least monthly, with the appropriate general led- COLLATERAL ger accounts and reconciling items ade- quately investigated by persons who do *14. Does the bank record on a timely basis a not normally handle foreign receivables first lien on assigned foreign receivables financing? for each borrower?

Commercial Bank Examination Manual March 1994 Page 1 7050.4 International—Financing Foreign Receivables: Internal Control Questionnaire

15. Do loans granted on the security of the U.S. banks forwarded directly to the bank foreign receivables also have an assign- and not through the exporter? ment of the inventory? 30. If the exporter accepts importer (drawee) 16. Does the bank verify the borrower’s receiv- payments directly, are controls established ables or require independent verification or audits of exporter’s books conducted (if on a periodic basis? so, explain briefly)? 17. Does the bank require the borrower to 31. Are employees handling collections peri- provide aged receivables schedules on a odically rotated, without advance notifica- periodic basis? tion, to other banking duties? 18. Are underlying bills of lading covering *32. Is the employee handling collection pro- shipments either to the order of the shipper ceeds required to apply them to the bor- or blank endorsed to the order of the bank rower’s advance on the same business day rather than the foreign buyer? that payment is received? 19. Are the shipments being financed covered 33. Is the disposition of each collection noted by adequate insurance? on the register so that verification of dis- position can be made? *34. Has a regular policy of following proce- dures been established for sending tracers ADVANCES AGAINST and inquiries on unpaid collections in the COLLECTIONS AND hands of correspondents? DISCOUNTED TRADE *35. Should the foreign drawee refuse to honor ACCEPTANCES the draft, are instructions clear as to what actions should be taken by the collecting 20. Are permanent registers kept for foreign bank? collections against which advances were 36. In the event of non-payment of the collec- made or trade acceptances discounted? tion, is the borrower promptly notified by 21. Are all collections indexed in a collection the bank? register? *37. Are collections against which advances 22. Do these registers furnish a complete have been made or trade acceptances dis- history of the origin and final disposition counted distinctly segregated from ordi- of each collection against which advances nary collection items? were made or trade acceptances *38. Are collections above maintained under discounted? memorandum control and is the control 23. Are receipts issued to loan customers for balanced regularly? all collections received from them? *39. Are collections against which advances 24. Are serial numbers or prenumbered forms have been made or trade acceptances dis- assigned to each collection item and all counted booked by persons other than related papers? employees handling those items? *25. Are all incoming tracers and inquiries *40. Are collections carried over to the next handled by an officer or employee business day adequately secured? not connected with the processing of 41. Does the customer for whom trade accep- collections? tances were discounted know whether they 26. Is a daily record maintained showing the were purchased with or without recourse various collections which have been paid to that customer? and credited to the borrower’s advance? *42. Do all parties, i.e., the seller (exporter), importer (buyer), and banks, clearly under- *27. Are proceeds of paid collections credited stand whether interest, discount, and col- to the correct customer’s advance? lection charges are to be absorbed by the 28. Is an itemized daily summary made of all seller or paid by the importer? interest charged and received from the exporter or importer (drawee) indicating underlying collection numbers and amounts? FACTORING 29. Are payments collected from importers (drawees) by foreign banks or branches of 43. Has the bank properly surrendered the

March 1994 Commercial Bank Examination Manual Page 2 International—Financing Foreign Receivables: Internal Control Questionnaire 7050.4

shipping documents to the factor either Eximbank guarantees or commitments cov- through endorsement or consignment? ering transactions? *44. Do bank advances or banker’s acceptances 53. If the bank has discretionary authority to the factor in payment of sight or time from Eximbank, does it nevertheless inform draft coincide with the expected payment Eximbank of each transaction thereunder? of the accounts receivable by the ultimate 54. If the bank has been issued an ‘‘equipment customer? political risk guarantee’’ by Eximbank, does it have a written statement from the government of the country in which the FOREIGN CREDIT INSURANCE equipment will be used indicating that it ASSOCIATION INSURANCE will permit the importation, use, and any subsequent exportation of the equipment? 45. Is the bank aware of risks not covered 55. Does the bank monitor whether loan agree- under its FCIA insurance? ments between applicable borrowers and 46. Does the bank monitor whether the bor- the bank are acceptable to Eximbank? rower exceeded its FCIA established credit 56. Does the bank report delinquencies to limits? Eximbank in a timely manner as specified 47. Does the bank monitor whether the bor- in its agreement with that agency? rower properly assigned the proceeds of its 57. If default occurs, does the bank file a FCIA insurance to the bank? proper claim with Eximbank? 48. Is the bank aware whether the FCIA insur- ance is on either ‘‘simple notice’’ or a ‘‘special assignment’’ basis? 49. Does the bank retain recourse to the CONCLUSION exporter under its FCIA arrangement? 50. Has the bank reported delinquencies to 58. Is the foregoing information an adequate FCIA in accordance with its agreement basis for evaluating internal control in that with the Association? there are no significant deficiencies in 51. If default occurs, does the bank file a areas not covered in this questionnaire proper claim with FCIA? that impair any controls? Explain negative answers briefly, and indicate any addi- tional examination procedures deemed EXPORT-IMPORT BANK OF THE necessary. UNITED STATES 59. Based on a composite evaluation, as evidenced by answers to the foregoing 52. Does the bank, financing under Eximbank questions, internal control is considered arrangements, have properly executed (adequate/inadequate).

Commercial Bank Examination Manual March 1994 Page 3 International—Banker’s Acceptances Effective date May 1996 Section 7060.1

One method of financing international trade is recorded with other loans and discounts. If the by the use of a banker’s acceptance. This accepting bank subsequently rediscounts (sells) instrument may be used to finance all of the the acceptance in the market, that acceptance is successive stages of the movement of goods rebooked as ‘‘Customer’s Liability on Accep- through the channels of trade from the point of tances’’ and ‘‘Bank’s Liability on Acceptances,’’ origin to the final destination. and the loan and discount accounts are reduced. A banker’s acceptance is an order in the form Rediscounted acceptances are not considered of a time draft (also referred to as a bill of borrowings. The customer’s liability on accep- exchange or a usance draft) drawn by one party tances is reduced by a customer’s prepayment or (the drawer) in favor of itself or another party anticipation of an acceptance outstanding. The (the payee), addressed to (drawn on) a bank (the bank’s liability is not similarly reduced by an drawee), and accepted by that bank to pay the anticipation. holder a certain sum on or before a specified The established market for banker’s accep- date. The bank’s acceptance of this order from tances in the United States is regulated by the the drawer, by stamping ‘‘ACCEPTED’’ across Federal Reserve System. Federal Reserve Banks the face of the draft and dating and signing the are authorized to discount or purchase eligible stamp, is a formal acknowledgment of the obli- banker’s acceptances subject to qualitative and gation and constitutes an unconditional promise quantitative limits, thus providing a source of by that bank to honor the time draft at maturity. liquidity to the selling banks. The creation of The drawee bank creating the acceptance is banker’s acceptances is governed by section 13 primarily liable for the instrument while the of the Federal Reserve Act, which establishes payee, as first endorser, is secondarily liable for criteria that must be met for the instrument to paying the holder in due course. If the drawee be eligible for either discount or purchase by (acceptor) is other than a bank, the instrument is a Federal Reserve Bank. The rules governing a trade acceptance, not a banker’s acceptance. whether an acceptance meets the eligibility re- Most banker’s acceptances are used to finance quirements for discount or purchase are impor- trade transactions. Accordingly, acceptances are tant for two major reasons. First, acceptances often created in connection with a letter of meeting the conditions of eligibility are more credit, although they may arise in connection readily salable in the market than acceptances with collection or open-account transactions. that do not satisfy these conditions and, as such, (See section 7080, ‘‘International—Letters of provide a greater degree of liquidity for the Credit.’’) In general, acceptance credit is con- accepting bank. Second, ineligible acceptances, sidered self-liquidating in that it must provide unlike those that are eligible, are subject to the means for its own payment at maturity. To reserve maintenance requirements, thus raising accomplish this, the acceptance must be based the cost to the borrower over that of an eligible on a specific trade transaction in which goods acceptance. The examiner must be familiar with are being shipped before entering the channels the criteria used for determining eligibility for of trade. There should be satisfactory evidence discount or purchase by a Federal Reserve Bank. to indicate that the draft, when created, is based Section 207 of the Bank Export Services Act on an actual shipment or storage and that, at (title II of P.L. 97-290), which amended section maturity of the draft, the proceeds from the sale 13 of the Federal Reserve Act (12 USC 372), of the goods will be used to settle the draft. To limits the aggregate amount of eligible banker’s a lesser extent, acceptances also finance the acceptances that may be created by a member domestic shipment of goods and domestic or bank to 150 percent (or 200 percent with the foreign storage of readily marketable staples. permission of the Board) of its paid-up and The payee of the acceptance may hold an unimpaired capital stock and surplus. In addi- acceptance until maturity, discount it with his or tion, a member bank is prohibited from creating her bank, or sell it in the acceptance market. eligible banker’s acceptances for any one person When a bank discounts (purchases) its own in the aggregate in excess of 10 percent of the acceptance for the payee, its ‘‘Customer’s Lia- institution’s capital. Eligible banker’s accep- bility on Acceptances’’ (asset) and ‘‘Bank’s tances growing out of domestic transactions are Liability on Acceptances’’ (liability) accounts not to exceed 50 percent of the aggregate of all are reduced, and the discounted acceptance is eligible acceptances authorized for a member

Commercial Bank Examination Manual May 1996 Page 1 7060.1 International—Banker’s Acceptances bank. All of the foregoing limitations are also borrowers, accepting banks, and investors alike. applicable to U.S. branches and agencies of Over the years, a banker’s acceptance has often foreign banks that are subject to reserve require- been a cheaper financing vehicle than a loan ments under section 7 of the International Bank- since it is readily marketable, considered an ing Act of 1978 (12 USC 3105). important secondary reserve for the accepting Banker’s acceptances as a source of financing bank, and a relatively secure investment to the and investment offer significant advantages to investor because of its two-name backing.

May 1996 Commercial Bank Examination Manual Page 2 International—Banker’s Acceptances Examination Objectives Effective date May 1996 Section 7060.2

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

Commercial Bank Examination Manual May 1996 Page 1 International—Banker’s Acceptances Examination Procedures Effective date March 1984 Section 7060.3

1. If selected for implementation, complete or a. Delinquencies. update the banker’s acceptance section of b. Participations purchased and sold (includ- the Internal Control Questionnaire. ing syndicate participations). 2. Determine the scope of the examination • Acceptance participations sold. based on the evaluation of internal controls • Acceptance pool participations and the work performed by internal and (borrowings). external auditors. c. Loan commitments and other contingent 3. Test for compliance with policies, practices, liabilities. procedures and internal controls in conjunc- d. Extensions of credit to major stockhold- tion with performing the remaining exami- ers, officers, directors and their interests. nation procedures. Also obtain a listing of e. Extensions of credit to executive offi- any deficiencies noted in the latest review cers, directors and their interests of cor- done by internal and external auditors from respondent banks. the examiner assigned to the audit review f. Miscellaneous loan debit and credit sus- and determine if appropriate corrections pense accounts. have been made. g. Criticized shared national credits (appli- 4. Obtain a trial balance of the customer lia- cable foreign credits). bility records and: h. Interagency Country Exposure Review a. Reconcile balances to department con- Committee determinations. trols and the general ledger. i. Extensions of credit considered ‘‘prob- b. Review reconciling items for reason- lem loans’’ by management. ableness. j. Information on directors, executive offi- 5. Using an appropriate technique, select bor- cers, principal shareholders and their rowers for examination. interests. 6. Prepare credit line cards to include: k. Specific guidelines in the lending policy a. Customer’s aggregate banker’s accep- pertaining to banker’s acceptances. tance liability. l. Each officer’s current lending authority. b. Banker’s acceptances aggregating the m. The current fee structure. customer’s total liability, listing: n. Any useful information resulting from • Current balance of the acceptance. the review of the minutes of the Loan — Indicate any prepayments (antici- and Discount Committee or any similar pations) and portions sold under committee. participation certificate. o. Reports furnished to the Loan and • Date the acceptance was created. Discount Committee or any similar • Tenor of the acceptance (give exact committee. maturity date, if specified). p. Reports furnished to the directorate. • Type of acceptance. q. Loans criticized during the previous — Import. examination. — Export. 8. Review the information received and per- — Third country shipment. form the following for: — Domestic shipment. a. Participations purchased and sold: — Storage. • Test participation certificates and — To create dollar exchange. records and determine that the parties — Working capital and/or pre-export. share in the risks and contractual pay- — Refinancing of sight letters of ments according to the agreement. credit. • Determine that the books and records — Current status of the acceptance. of the bank properly reflect the bank’s 7. Obtain the following information, if appli- liability. cable to banker’s acceptances, which may • Investigate any participations sold necessitate inclusion of additional custom- immediately prior to the date of exam- ers (borrowers) in the credit review: ination to determine if any were sold to

Commercial Bank Examination Manual March 1994 Page 1 7060.3 International—Banker’s Acceptances: Examination Procedures

avoid possible criticism during the 10. Prepare a credit line card for any banker’s examination. acceptance not in the sample which, based b. Loan commitments (including accep- on information derived from the above tance commitments) and contingent schedules, requires an in-depth review. liabilities. 11. Obtain liability and other information on • Analyze the commitment or contingent common borrowers from examiners as- liability if the borrower has been signed to cash items, overdrafts, and other advised of the commitment together loan areas and, together, decide who will with the combined amounts of the review the borrowing relationship. Pass or current loan balance, if any. retain completed credit line cards. c. Banker’s acceptances created for officers 12. Obtain credit files for all borrowers for and directors of other banks: whom credit line cards were prepared and • Investigate any circumstances which complete credit line cards, where appropri- indicate preferential treatment. ate. To analyze the loans, perform the fol- d. Miscellaneous loan debit and credit sus- lowing procedures: pense accounts: a. Analyze balance sheet and profit and loss • Discuss with management any large figures as shown in current and preced- or old items relating to banker’s ing financial statements, and determine acceptances. the existence of any unfavorable trends. e. Shared national credits: b. Relate items or groups of items in the • Compare the schedule of banker’s current financial statements to other acceptances included in the Uniform items or groups of items set forth in the Review of National Credits Program to statements, and determine the existence the sample selection to determine of any favorable or adverse ratios. which banker’s acceptances in the sam- c. Review components of the balance sheet ple are portions of shared national as shown in the current financial state- credits (including applicable foreign ments and determine the reasonableness credits). of each item as it relates to the total financial structure. • For each banker’s acceptance so d. Review supporting information for the identified, transcribe appropriate infor- major balance sheet items and the tech- mation from the schedule to line sheets niques used in consolidation and deter- and return the schedule. No further mine the primary sources of repayment examination procedures are necessary and evaluate their adequacy. for this area. e. Review compliance with the provisions f. Cross-border lending: of acceptance agreements. • Review credit risk without regard to f. Review the digest of officer’s memo- cross-border considerations which will randa, mercantile reports, credit checks be analyzed separately. No further and correspondence to determine the examination procedures are necessary existence of any problems which in this area. might deter the contractual liquidation g. Loans criticized during the previous program. examination: g. Relate any collateral values to outstand- • Determine disposition of banker’s ing debt, including margin and cash acceptances so criticized by collateral deposits. transcribing: h. Compare fees charged to the fee sched- — current balance and payment ule(s) and determine that the terms are status, or within established guidelines. — date the banker’s acceptance i. Compare the amount of banker’s accep- was repaid and the source of tances outstanding with the lending repayment. officer’s authority. 9. Transcribe or compare information from j. Analyze secondary support afforded by the above schedules to credit line cards, guarantors. where appropriate, and indicate any past- k. Ascertain compliance with the bank’s due status. established banker’s acceptance policy.

March 1994 Commercial Bank Examination Manual Page 2 International—Banker’s Acceptances: Examination Procedures 7060.3

13. For banker’s acceptances in the sample, the loan limitations imposed by state check the central liability file on borrowers law. indebted above the cutoff and on borrowers e. Determine if state law imposes loan displaying credit weaknesses or suspected limitations on eligible acceptances of of having additional liability in loan areas. other banks purchased. 14. Transcribe significant liability and other f. Review acceptance participation agree- information on officers, principals and affil- ments to determine if the purchaser has iations of appropriate obligors contained in recourse to the bank in the event of the sample. Cross-reference line sheets to default by the account party, in which borrowers, where appropriate. case the liability would be considered a 15. Determine compliance with laws, regula- borrowing. Such borrowings may be sub- tions, and eligibility requirements regarding ject to limitations on indebtedness of banker’s acceptance financing by perform- member banks imposed by state law. ing the following steps: g. Determine acceptances issued on behalf a. Determine bank compliance with state of an affiliate which constitute exten- limits or the aggregate amount of accep- sions of credit under section 23A of the tances that may be created for any one Federal Reserve Act. customer, and acceptances created to 16. Perform appropriate procedural steps in the furnish dollar exchange. Concentration of Credits section. b. Determine compliance with stipulated 17. Discuss with appropriate officer and prepare aggregate liability limitations on accep- summaries in appropriate report form of: tances outstanding. (See Federal Reserve a. Violations of laws and regulations. Act, section 13 for single person and b. Acceptances not supported by current aggregate limitation provisions.) and complete financial information. c. Determine which acceptances are ineli- c. Acceptances on which collateral docu- gible and therefore subject to loan limi- mentation is deficient. tations imposed by state law. In general, d. Concentrations of credit. an eligible banker’s acceptance is one e. Criticized loans. which must arise out of a transaction f. Inadequately collateralized acceptances, described in section 13 of the Federal if applicable. Reserve Act. For details of eligibility g. Banker’s acceptances created for major requirements, refer to the operating pro- shareholders, employees, officers, direc- visions of the Federal Open Market Com- tors and related interests. mittee and interpretations of the Board of h. Banker’s acceptances which, for any Governors of the Federal Reserve Sys- other reason, are questionable as to qual- tem. Eligibility can be determined by ity and ultimate collection. reviewing documentary evidence detail- 18. Evaluate the bank with respect to: ing the nature of the transaction under- a. The adequacy of written policies relating lying the credit extended. This evidence to banker’s acceptances. may be correspondence, title documents b. The manner in which bank officers are or document transmittal letters which operating in conformance with estab- provide sufficient detail to judge eligibil- lished policy. ity according to established criteria. c. Adverse trends within the banker’s accep- Details provided should cover: tance department. d. The accuracy and completeness of the • Value of merchandise. schedules obtained. • Description of merchandise. e. Internal control deficiencies or • Origin and destination of shipment. exceptions. • Date of shipment. f. Recommended corrective action when • Certification that the merchandise is policies, practices or procedures are not being financed elsewhere. deficient. d. Ensure that all of the bank’s own accep- g. The quality of departmental management. tances discounted that are not redis- h. Other matters of significance. counted, whether eligible or ineligible, 19. Update the workpapers with any informa- are booked as loans and thus subject to tion that will facilitate future examinations.

Commercial Bank Examination Manual March 1994 Page 3 International—Banker’s Acceptances Internal Control Questionnaire Effective date June 1985 Section 7060.4

Review the bank’s internal controls, policies, fees collected, to support applicable general practices and procedures for creating and servic- ledger account entries? ing banker’s acceptances. The bank’s system 9. Are acceptances of other banks that have should be documented in a complete and con- been purchased in the open market segre- cise manner and include, where appropriate, gated on the bank’s records from the bank’s narrative descriptions, flowcharts, copies of own acceptances created? forms used and other pertinent information. 10. Are prepayments (anticipations) on outstand- ing banker’s acceptances netted against the appropriate asset account ‘‘Customer Lia- POLICIES bility for Acceptances’’ (or loans and dis- counts, depending upon whether or not the 1. Has the board of directors, consistent with bank has discounted its own acceptance), its duties and responsibilities, adopted writ- and do they continue to be shown as a ten banker’s acceptance policies that: liability ‘‘Bank’s Liability on Acceptances’’? a. Establish procedures for reviewing bank- 11. Are banker’s acceptance record copies and er’s acceptance applications? liability ledger trial balances prepared and b. Define qualified customers? reconciled monthly with control accounts c. Establish minimum standards for docu- by employees who do not process or record mentation in accordance with the Uni- acceptance transactions? form Commercial Code? 2. Are banker’s acceptance policies reviewed at least annually to determine if they are compatible with changing market FEES conditions? 12. Is the preparation and posting of fees and discounts performed or reviewed by per- sons who do not also: RECORDS a. Issue official checks or drafts? b. Handle cash? 3. Is the preparation and posting of subsidiary 13. Are any independent fee and discount com- banker’s acceptance records performed or putations made and compared or adequately reviewed by persons who do not also: tested to initial fee and discount records by a. Issue official checks or drafts? persons who do not also: b. Handle cash? a. Issue official checks or drafts? 4. Are the subsidiary banker’s acceptance b. Handle cash? records balanced daily with the appropriate general ledger accounts and reconciling items adequately investigated by persons who do not normally handle acceptances COLLATERAL and post records? 5. Are acceptance delinquencies prepared for See International—Loans and Current Account and reviewed by management on a timely Advances section. basis? 6. Are inquiries about acceptance balances received and investigated by persons who do not normally handle settlements or post OTHER records? 7. Are bookkeeping adjustments checked and 14. Are acceptance record copies, own accep- approved by an appropriate officer? tances discounted (purchased), and accep- 8. Is a daily record maintained summarizing tances of other banks purchased safe- acceptance transactions details, i.e., bankers guarded during banking hours and locked in acceptances created, payments received and the vault overnight?

Commercial Bank Examination Manual March 1994 Page 1 7060.4 International—Banker’s Acceptances: Internal Control Questionnaire

15. Are blank (pre-signed) customer drafts prop- applicable letter of credit, to provide a erly safeguarded? proper audit trail? 16. Are any acceptance fee rebates approved by an officer? 17. Does the bank have an internal review CONCLUSION system that: a. Re-examines collateral and supporting 19. Is the foregoing information an adequate documentation held for negotiability and basis for evaluating internal control in that proper assignment? there are no significant deficiencies in areas b. Test checks the values assigned to col- not covered in this questionnaire that impair lateral at frequent intervals? any controls? Explain negative answers c. Determines that lending officers are per- briefly, and indicate any additional exami- iodically advised of maturing banker’s nation procedures deemed necessary. acceptances or acceptance lines. 20. Based on a composite evaluation, as evi- 18. Does the bank’s acceptance filing system denced by answers to the foregoing provide for the identification of each accep- questions, internal control is considered tance, e.g., by consecutive numbering and (adequate/inadequate).

March 1994 Commercial Bank Examination Manual Page 2 International—Due from Banks—Time Effective date May 1996 Section 7070.1

U.S. banks and their overseas branches maintain Eurodollar deposits are sometimes linked with interest-bearing time deposits, known as ‘‘due foreign-exchange transactions. As a result, the from banks—time,’’ with foreign banks and Eurocurrency deposit trader will frequently work overseas branches of U.S. banks. These assets closely with the foreign-exchange trader when may also be referred to as placements, placings, making the deposit decision. Foreign-exchange interbank placements (deposits), call money, brokers may act as intermediaries if warranted or redeposits. Due from banks—time deposits by market conditions, local customers, the size have maturities ranging from one day to several of the bank, or other factors. months or years. Certain examination proce- Due from banks—time deposits are treated as dures, internal control considerations, and veri- deposits in the Report of Condition, but contain fication procedures in the domestic due from the same credit and country risks as loans or banks section (section 2010) are relevant to extensions of credit. Consequently, a prudently international due from banks—time. However, managed bank should place deposits only with the specialized nature of foreign deposits neces- other sound and well-managed banks. The de- sitates additional examination procedures. posit traders should be provided with a list of Constraints are placed on the amount member approved banks with which funds can be depos- banks may deposit with domestic depository ited up to specific limits. Due from banks—time institutions. A member bank may not keep on deposits differ from other types of credit exten- deposit with any depository institution not hav- sions because they often represent deposits of ing access to the Federal Reserve discount relatively short maturity, which normally receive window more than 10 percent of its paid-in and first priority on repayment in case of insolvency. unimpaired capital and surplus funds. State Nevertheless, as credit and transfer risk exists, member banks may keep on deposit with foreign exposure limits are to be established by credit banks an amount exceeding that 10 percent officers and not by foreign-exchange or deposit limitation. traders. These limits must be reviewed regularly Due from banks—time deposit activities be- by credit officers, particularly during periods of came important with the growth of the Euro- money market uncertainty or rapidly changing dollar market. The bulk of due from banks— economic and political conditions. Incoming time deposits now consists of Eurodollars with confirmations of transactions from depository smaller amounts in other Eurocurrencies. Other institutions must be carefully verified against Eurocurrency time deposits are placed in sub- bank records to protect against fraud and error. stantially the same manner as Eurodollar depos- Similarly, a systematic follow-up on nonreceipt its, but may be subject to differing exchange of incoming confirmations should be closely control regulations depending on the location of monitored. the office making the deposit.

Commercial Bank Examination Manual May 1996 Page 1 International—Due from Banks—Time Examination Objectives Effective date May 1996 Section 7070.2

1. To determine if the policies, practices, pro- 5. To determine the scope and adequacy of the cedures, and internal controls for due from internal and external audit function as it banks—time (interbank placements and call applies to international due from banks— money) are adequate. time. 2. To determine if bank officers and employees 6. To determine compliance with laws and regu- are operating in conformance with the estab- lations. lished guidelines. 7. To recommend corrective action when poli- 3. To determine that all due from banks—time cies, practices, procedures, or internal con- accounts are reasonably stated and represent trols are deficient or when violations of laws, funds on deposit with other banks. rulings, or regulations have been cited. 4. To determine whether the bank evaluates the credit quality of banks with which time accounts are maintained.

Commercial Bank Examination Manual May 1996 Page 1 International—Due From Banks–Time Examination Procedures Effective date March 1984 Section 7070.3

1. If selected for implementation, complete or b. Banks and not finance companies or update the Due from Banks—Time (place- commercial borrowers. ment and call money) section of the Internal 9. Obtain and review the following informa- Control Questionnaire. tion, if applicable: 2. Determine the scope of the examination a. Matured and unpaid due from banks— based on the evaluation of internal controls time deposits. and the work performed by internal and b. Miscellaneous loan debit and credit sus- external auditors. pense accounts. 3. Test for compliance with policies, practices, c. Interagency Country Exposure Review procedures and internal controls in conjunc- Committee determinations. tion with performing the remaining exami- d. Due from banks—time deposit place- nation procedures. Also, obtain a listing of ments that are considered problem assets any deficiencies noted in the latest review by management. by internal and external auditors from the e. Specific guidelines stated in bank policy examiner assigned to the audit review and relating to due from banks—time. determine if appropriate corrections have f. A current listing of due from banks— been made. time approved customer lines. 4. Obtain a trial balance of the customer lia- g. The current interest rate structure. bility records pertaining to due from banks— h. Any useful information resulting from time by currency and maturity and: the review of the minutes of the Loan a. Reconcile balance to department con- and Discount Committee or any similar trols and general ledger. committee. b. Review reconciling items for reason- i. Reports furnished to the Board of ableness. Directors. 5. Determine those due from banks—time j. Due from banks—time deposit place- deposits that are unconfirmed as of exami- ments that were criticized during the nation date and: previous examination. • Determine why incoming matching k. A listing of due from banks—time depos- confirmations are lacking. its that were previously charged-off. • Review the extent of follow-up 10. Transcribe or compare information from the procedures. above schedules to credit line cards where 6. Using an appropriate technique, select appropriate, and indicate any cancelled bank deposit customers for examination. lines. 7. Prepare credit line cards on the customers 11. Prepare credit line cards for any due from selected for review to include the following: bank—time not in the sample which, based a. Name of bank and location. on information derived from the above b. Customer’s aggregate due from bank- schedules, requires an in-depth review. time liability. 12. Obtain liability and other information on c. For each due from bank—time deposit common borrowers from examiners as- placement comprising the customer’s signed to cash items, overdrafts, and loan total exposure to the bank, record the areas and decide who will review the bor- following information: rowing relationship. Pass or retain com- pleted credit line cards. • Amount. 13. Obtain credit files for all borrowers for • Currency. whom credit line cards were prepared and • Inception date. complete credit line cards where appropri- • Value date. ate. To analyze due from banks—time, • Maturity date. perform the following procedures: • Interest rate. a. Analyze balance sheet and profit and loss 8. Determine whether selected customers are: figures as shown in current and preced- a. Affiliates of the bank or other banks. ing financial statements, and determine

Commercial Bank Examination Manual March 1994 Page 1 7070.3 International—Due From Banks–Time: Examination Procedures

the existence of any favorable or adverse 16. Determine compliance with state laws and trends. regulations pertaining to due from banks— b. Relate items or groups of items in the time. current financial statements to other items 17. Determine the existence of any concentra- or groups of items set forth in the state- tion of time deposits with other banks. ments, and determine the existence of Include due from banks—demand (nostro), any favorable or adverse ratios. time deposits and any call money in com- c. Review components of the balance sheet putation. For concentrations exceeding as shown in the current financial state- 25 percent of the bank’s capital structure, ments, and determine the reasonableness forward information to examiners assigned of each item as it relates to the custom- ‘‘Concentrations of Credit’’ for possible er’s total financial structure. inclusion in the report of examination. d. Review supporting information for the 18. Discuss with appropriate officer(s) and pre- major balance sheet items and the tech- pare summaries in appropriate report form niques used in consolidation, and deter- of: mine the primary sources of repayment a. Matured and unpaid due from banks— and evaluate their adequacy. time deposits. e. Compare each bank’s balance sheet, b. Violations of laws and regulations. profit and loss items and ratios with c. Due from banks—time deposits not sup- those of comparable banks in the same ported by current and complete financial country to help identify banks which information. may be overextended. d. Due from banks—time deposits on which f. Review compliance with provisions of documentation is deficient. due from banks—time deposit e. Concentrations. agreements. f. Criticized credits (portions applicable to g. Review digest of officers’ memoranda, due from banks—time deposits). mercantile reports, credit checks and cor- g. Due from banks—time deposits which, respondence to determine the existence for any other reason, are questionable as of any problems which might deter the to quality and ultimate repayment. contractual liquidation program. h. Other matters regarding the condition of h. Compare interest rate(s) charged to the the department. interest rate schedule(s), and determine 19. Evaluate the bank with respect to: that the terms are within established a. The adequacy of written policies relating guidelines. to due from banks—time. i. Compare the amount of due from banks— b. The manner in which bank officers are time deposits with: operating in conformance with estab- • Lending officer’s authority. lished policy. • Depositor’s limit established by the c. Adverse trends within the due from bank. banks—time department. j. Detail the major owners of the bank and d. The accuracy and completeness of the whether there is any support by the schedules. government. e. Internal control deficiencies or exceptions. k. Ascertain compliance with established f. Recommended corrective action when bank policy. policies, practices or procedures are 14. For banks in the sample, check the customer found to be deficient. central liability reporting system for any g. The quality of departmental management. other indebtedness. h. Other matters of significance. 15. Transcribe significant liability and other 20. Update the workpapers with any informa- information on officers, principals and affil- tion that will facilitate future examinations. iates of banks contained in the sample. Cross-reference line cards to banks (borrow- ers), where appropriate.

March 1994 Commercial Bank Examination Manual Page 2 International—Due From Banks–Time Internal Control Questionnaire Effective date March 1984 Section 7070.4

Review the bank’s internal controls, policies, and due from bank—time activities relating to practices and procedures regarding due from those functions are combined.) banks—time. The bank’s system should be doc- umented in a complete and concise manner and 4. Are dealer slips and contract/confirmation include, where appropriate, narrative descrip- sets relating to due from banks—time tions, flowcharts, copies of forms used and other numbered sequentially and checked peri- pertinent information. Items marked with an odically? asterisk require substantiation by observation or 5. Is a positions clerk present in the dealing testing. room to maintain dealers’ memoranda records of due from bank—time deposits? 6. Is due from banks—time ‘‘instructions’’ POLICIES (operations) organizationally and physi- cally separate from the foreign exchange 1. Has the board of directors, consistent with dealers? its duties and responsibilities, adopted writ- *7. Do good communications appear to exist ten policies for international due from between the dealing room and instructions banks—time that: to assure: a. Establish maximum limits of the aggre- a. An effective working relationship with gate amount of due from bank—time operations and management to ensure deposits for each: adequate control and management • The bank? information? • The currency of deposit? b. Coordination with operations regarding • The country of deposit? correct delivery/settlement instructions? b. Restrict due from bank—time deposits *8. Does operations maintain all official to only those customers for whom lines accounting records relating to due from have been established? banks—time? c. Establish definite procedures for: *9. Does operations: • Balancing of accounts? a. Balance official records against dealing • Holdover deals? room memoranda records as scheduled • Rendering of reports to management, by management? external auditors and regulating b. Check confirmations for errors? agencies? c. Receive, review and control dealer’s • Accounting cutoff deadlines? slips? • Handling of interest? d. Handle all payments and receipts? *10. Are confirmations compared to the general ledger entries for accuracy? CERTIFICATES OF DEPOSIT 2. Are bank issued certificates of deposits CONFIRMATIONS safeguarded as other negotiable invest- ment instruments? *11. Does operations monitor follow-up on 3. Are safekeeping receipts for certificates non-receipt of incoming confirmations? of deposits issued, but held by others, *12. Are outgoing and incoming confirmations checked to the original purchase order for ever handled by dealers who initiate due accuracy? from bank—time transactions? *13. Does the bank check that there are no confirmation deals dated: DEALING ROOM INSTRUCTIONS a. Prior to the bank’s own due from bank— time deal dates? (Although dealing room and instructions func- b. After the bank’s own due from bank— tions must be separate, often foreign exchange time deal dates?

Commercial Bank Examination Manual March 1994 Page 1 7070.4 International—Due From Banks–Time: Internal Control Questionnaire

TESTING ARRANGEMENTS bank—time deposit controls to the general ledger? (See the Wire Transfer section.) 21. Are reconciliations reviewed by an officer independent of the reconciliation?

SIGNATURE BOOKS OTHER *14. Are customer signature books updated with regard to those with whom regular busi- 22. Are individual interest computations ness is transacted? checked or adequately tested by persons *15. Does the bank check signatures on incoming independent of those functions? confirmations for authenticity? (Many 23. Are accrual balances for due from banks— banks do not check signatures on incom- time verified periodically by an authorized ing confirmations.) official (if so, indicate frequency )? *16. Does the bank check signatures for deals 24. Do all internal entries require the approval with non-bank customers? of appropriate officials? *17. Are banks that do not sign confirmations asked to confirm such practice in writing over an authorized signature? CONCLUSION

25. Is the foregoing information an adequate ACCOUNT RECORDS basis for evaluating internal control in that there are no significant deficiencies in *18. Are subsidiary records reconciled with the areas not covered in this questionnaire that general ledger accounts and reconciling impair any controls? Explain negative items adequately investigated by persons answers briefly, and indicate any addi- who do not post transactions to such tional examination procedures deemed records? necessary. 19. Is a due from foreign bank—time deposit 26. Based on a composite evaluation, as evi- trial balance prepared on a periodic basis denced by answers to the foregoing (if so, indicate frequency )? questions, internal control is considered 20. Is a daily reconcilement made of due from (adequate/inadequate).

March 1994 Commercial Bank Examination Manual Page 2 International—Letters of Credit Effective date May 1996 Section 7080.1

INTRODUCTION amended by the issuing bank at any time with- out notice to or consent from the customer or the Letters of credit are the most widely used beneficiary. instrument to finance foreign transactions. The An irrevocable letter of credit constitutes a two major types of letters of credit are the definite commitment by the issuing bank to pay, commercial documentary letter of credit and the provided the beneficiary complies with the let- standby letter of credit. ter’s terms and conditions. In contrast, the revo- cable credit is not truly a bank credit but serves as a device that provides the buyer and seller with a means of settling payments. Since a COMMERCIAL DOCUMENTARY revocable credit can be canceled or changed LETTERS OF CREDIT without notice, the beneficiary should not rely on the credit but rather on the willingness and This type of letter of credit is used most com- ability of the buyer to meet the terms of the monly to finance a commercial contract for the underlying contract. shipment of goods from seller to buyer. A The letter of credit may be sent to the bene- commercial documentary letter of credit is a ficiary directly by the issuing bank or through letter addressed by a bank (issuing bank) on the issuing bank’s correspondent (advising bank) behalf of its customer, a buyer of merchandise located in the same place as the beneficiary. The (account party), to a seller (beneficiary) autho- advising bank gives notice of the issuance of a rizing the seller to draw drafts up to a stipulated letter of credit without assuming any obligation amount under specified terms. The beneficiary to honor demands for payment. Advised letters will be paid when the terms of the letter of credit of credit will bear a notation by the advising are met and the required documents are submit- bank that it makes ‘‘no engagement’’ or words ted to the paying bank. to that effect. An irrevocable advised letter of credit is, therefore, an undertaking to pay by the Generally, the issuance of letters of credit is issuing bank, but not by the advising bank. governed by article 5 of the Uniform Commer- Some beneficiaries (sellers), particularly those cial Code (UCC). However, if the credit is not familiar with the issuing bank, request the issued under New York law, the credit will be buyer to have the irrevocable credit issued in the governed instead by the Uniform Customs and buyer’s country and ‘‘confirmed’’ by a bank in Practice for Documentary Credits (UCP). The the seller’s country. Confirmed letters of credit parties may also stipulate that the UCP rather are evidenced by the confirming bank’s nota- than the UCC applies. Letters of credit may also tion: ‘‘We undertake that all drafts drawn... be governed by foreign law. Generally, letters of will be honored by us’’ or similar words. The credit are— beneficiary of a confirmed credit has a definite commitment to pay from a bank in his or her • signed and in writing, country and need not be concerned with the • in favor of a definite beneficiary, willingness or ability of the issuing bank to pay. • for a specific amount of money, and An advising bank may add its confirmation and • in a form clearly stating how payment to the be designated in 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 terms are sometimes used. The letter will specify on which bank drafts are to be drawn. If the draft In addition, they are issued with a definite is drawn at sight, the bank will effect payment expiration date. upon presentation of the draft, provided the Commercial letters of credit are issued in terms of the credit have been met. If the draft is either irrevocable or revocable form. Once the drawn on a time basis, the bank will accept beneficiary receives an irrevocable letter of the draft (by stamping ‘‘Accepted’’ on the face credit, it cannot be canceled or amended with- of the draft), which then can be held by the out the beneficiary’s consent. Conversely, a seller or the bank until maturity. Alternatively, revocable letter of credit can be canceled or the accepted draft can be sold or discounted.

Commercial Bank Examination Manual May 1996 Page 1 7080.1 International—Letters of Credit

(See section 7060, ‘‘International—Banker’s transaction, it is not linked directly to the Acceptances.’’) shipment of goods from seller to buyer. It may Certain categories of commercial letters of cover performance of a construction contract, credit, such as back-to-back and red clause serve as an assurance to a bank that the seller credits, contain an element of risk, and banks will honor his or her obligations under warran- should exercise caution in their negotiation. ties, or relate to the performance of a purely Similarly, deferred-payment letters of credit, monetary obligation, for example, when the which become direct assets and liabilities of a credit is used to guarantee payment of commer- bank after presentation and receipt of the ben- cial paper at maturity. eficiary’s documents, involve greater potential Under all letters of credit, the banker expects risk when coupled with the length of time the the customer to be financially able to meet his or credit is outstanding. her commitments. A banker’s payment under a A transferable letter of credit enables the commercial credit for the customer’s account is original beneficiary to transfer the rights of usually reimbursed immediately by the cus- payment to one or more beneficiaries. Fre- tomer and does not become a loan. However, the quently, the beneficiary is a middleman who bank makes payment on a standby letter of does not own the goods at the time the letter of credit only when the customer, having defaulted credit is issued. Thus, the beneficiary may seek on his or her primary obligation, is unable to to use the letter of credit to finance the acquisi- reimburse it. tion of the goods. Under the UCP, a transferable A standby letter of credit transaction involves letter of credit may be transferred only once greater potential risk for the issuing bank than a unless otherwise stated. commercial documentary letter of credit. Unless A revolving letter of credit allows for monthly the transaction is fully secured, the issuer of a shipments with payments being either cumula- standby letter of credit retains nothing of value tive or noncumulative. In the case of cumulative to protect against loss, whereas a commercial credits, undrawn amounts carry over to future documentary letter of credit provides the bank periods. However, most letters of credit are with title to the goods being shipped. To reduce nonrevolving and are valid for one transaction. the risk of a standby letter of credit, the issuing Since the maximum exposure under an irrevo- bank’s credit analysis of the account party cable revolving credit can be large, most revolv- should be equivalent to the analysis of a bor- ing credits are issued in revocable form. rower in an ordinary loan situation. Documentation is of paramount importance The standby letter of credit transactions of in all letter of credit transactions. The bank is state member banks are subject to the legal required to examine all documents with care to restrictions of Regulation H and section 23A of determine that they conform to all of the terms the Federal Reserve Act. For reporting purposes, and conditions of the letter of credit. Many standby letters of credit are shown as contingent letters of credit are part of continuous transac- liabilities in the issuer’s Report of Condition. tions, evolving from letters of credit to sight Under the revised capital/risk assets guide- drafts or acceptances or to notes and advances lines, banks now must allocate capital against covered by trust receipts or warehouse receipts. standby letters of credit. See the capital ade- Ultimate repayment often depends on the even- quacy guidelines of November 1995 for infor- tual sale of the goods involved. Thus, the proper mation concerning capital allocation require- handling and accuracy of the documents re- ments against standby letters of credit. quired under the letter of credit is of primary concern.

ANTI-BOYCOTT REGULATIONS STANDBY LETTERS OF CREDIT The Export Administration Act of 1973 prohib- A standby letter of credit guarantees payment to its banks from taking or knowingly agreeing to the beneficiary by the issuing bank in the event take actions that support any boycott against a of default or nonperformance by the account country friendly to the United States. Under party (the bank’s customer). Although a standby anti-boycott regulations (which are issued by the letter of credit may arise from a commercial Department of Commerce and enforced by the

May 1996 Commercial Bank Examination Manual Page 2 International—Letters of Credit 7080.1

Office of Anti-Boycott Compliance), U.S. banks may try to add improper language orally rather are required to report letters of credit they than in writing. Boycott language includes receive that include illegal boycott terms or clauses or requirements such as— conditions and should establish an ongoing program to review all letters of credit. These • certification that the goods are not of a par- regulations apply to both domestic and overseas ticular origin, such as Israeli or South African; branches of all U.S. banks. • certification that any supplier or provider of The anti-boycott provisions prohibit banks services does not appear on the Arab blacklist; from opening, negotiating, confirming, or pay- • the condition, ‘‘Do not negotiate with black- ing international letters of credit that contain listed banks,’’ or words to that effect; illegal terms or conditions. The improper lan- • a request not to ship goods on an 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 of and wire payments. Often, a bank’s customer the goods or the destination of the goods.

Commercial Bank Examination Manual May 1996 Page 3 International—Letters of Credit Examination Objectives Effective date May 1996 Section 7080.2

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

Commercial Bank Examination Manual May 1996 Page 1 International—Letters of Credit Examination Procedures Effective date March 1984 Section 7080.3

1. If selected for implementation, complete or Such information may necessitate inclusion update the Letters of Credit section of the of additional customers in the credit review. Internal Control Questionnaire. a. Delinquencies. 2. Based on the evaluation of internal controls b. Participations purchased and sold since and the work performed by internal and the preceding examination (including external auditors, determine the scope of the syndicate participations). examination. c. Loan commitments and other contingent 3. Test for compliance with policies, practices, liabilities. procedures and internal controls in conjunc- d. Letters of credit issued (or confirmed) tion with performing the remaining exami- for major shareholders, officers, directors nation procedures. Also obtain a listing of and their related interests. any deficiencies noted in the latest review done by internal and external auditors from e. Letters of credit issued (or confirmed) the examiner assigned to the audit review for employees, officers and directors of and determine if appropriate corrections other banks. have been made. f. Miscellaneous loan debit and credit sus- 4. Obtain a trial balance of the customer lia- pense accounts. bility records and: g. Criticized shared national credits (appli- a. Reconcile balances to department con- cable foreign credits). trols and the general ledger. h. Interagency Country Exposure Review b. Review reconciling items for reason- Committee determinations. ableness. i. Letters of credit considered problems by 5. Using an appropriate technique, select cus- management. tomers for examination. j. Information on directors, executive offi- 6. Prepare examiners’ credit line cards for cers, principal shareholders and their each customer selected to include: interests. a. Total line available for letters of credit. k. Specific guidelines in the lending b. Total outstanding letters of credit. policies. • Undrawn amount. l. Each officer’s current lending authority. • Date of issuance. m. Current letter of credit commission and • Expiration date of the credit. fee structure. • Name of the beneficiary. n. Any useful information obtained from • Tenor of the drafts to be drawn. the review of the minutes of the Loan • Purpose for the credit. and Discount Committee or any similar • Issued or confirmed. committee. • Revocable or irrevocable. o. Reports furnished to the Loan and • Negotiable or non-negotiable. Discount Committee or any similar • Revolving. committee. — Cumulative or noncumulative. p. Reports furnished to the board of • Transferable. directors. • Assignable. q. Loans criticized during the previous • Amendments. examination. • Issued on behalf of domestic banks. 8. Review the information received and per- • Application (with official approval) is form the following for: on file and in agreement with letter of a. Participations purchased and sold (includ- credit terms. ing syndicate participations). • Bank’s copy is initialed by the officer • Test participation certificates and who signed the original letter of credit. records and determine that the parties 7. Obtain the following information if it is share in the risks and contractual pay- applicable to the letter of credit department. ments according to the agreement.

Commercial Bank Examination Manual March 1994 Page 1 7080.3 International—Letters of Credit: Examination Procedures

• Determine that the books and records or cancelled, and the source of of the bank properly show the bank’s repayment. liability. 9. Transcribe or compare information from the • Investigate any participations sold im- above schedules to credit line cards, where mediately prior to the date of exami- appropriate, and indicate any past due status nation to determine if any were sold to relating to letters of credit. avoid possible criticism during the 10. Prepare credit line cards for any letter of examination. credit not in the sample which, based on b. Loan commitments and other contingent information derived from the above sched- liabilities: ules, requires an in-depth review. • Analyze the commitment or contingent 11. Obtain liability and other information on liability if the borrower has been ad- common borrowers from examiners vised of the commitment and the com- assigned to cash items, overdrafts, and loan bined amounts of the current loan areas and decide who will review the bor- balance (if any) and the commitment rowing relationship. Pass or retain exami- or other contingent liability exceeds nation credit line cards. the cutoff. 12. Obtain credit files for all bank customers for c. Letters of credit issued (or confirmed) whom credit line cards were prepared and for officers, directors and their interests: complete credit line cards, where appropri- • Investigate any circumstances which ate. To analyze the letters of credit, perform indicate preferential treatment. the following procedures: d. Letters of credit issued (or confirmed) a. Analyze balance sheet and profit and loss for officers and directors of other banks. items as shown in current and preceding • Investigate any circumstances which financial statements, and determine the indicate preferential treatment. existence of any favorable or adverse e. Miscellaneous loan debit and credit sus- trends. pense accounts relating to letters or credit. b. Relate items or groups of items in the • Determine liability to the bank on current financial statements to other items drafts paid under letters of credit for or groups of items set forth in the state- work which the bank has not been ments, and determine the existence of reimbursed by the customer. any favorable or adverse ratios. • Investigate any large or old items. c. Review components of the balance sheet f. Shared national credits: as shown in the current financial state- • Compare the schedule of letters of ments, and determine the reasonableness credit included in the program to the of each item as it relates to the total bank’s reports of unexpired letters of financial structure. credit. • For each letter of credit so identified, d. Review supporting information for the transcribe appropriate information to major balance sheet items and the tech- line cards. No further examination pro- niques used in consolidation, and deter- cedures are necessary in this area. mine the primary sources of repayment g. Interagency Country Exposure Review and evaluate their adequacy. Committee credits: e. Review compliance with provisions of • Identify any credits that were selected letter of credit agreements. for review that are criticized for trans- f. Review digest of officers’ memoranda, fer risk reasons by the Interagency mercantile reports, credit checkings and Country Exposure Review Committee. correspondence to determine the exist- h. Letters of credit criticized during the ence of any problems which might deter previous examination: the contractual liquidation program. • Determine disposition of letters of g. Relate any collateral values, including credit so criticized by transcribing: margin and cash collateral deposits, to — Current balance and payment outstanding letter of credit debt. status, or h. Compare fees charged to the fee sched- — Date the letter of credit was drawn ule(s), and determine that terms are down (refinanced), paid, expired within established guidelines.

March 1994 Commercial Bank Examination Manual Page 2 International—Letters of Credit: Examination Procedures 7080.3

i. Compare the amount of letters of credit backing letter of credit expires, outstanding with the lending officer’s and authority. — the beneficiary of the backing letter j. Analyze any secondary support afforded of credit is a regular customer of by guarantors. the bank opening the second letter k. Ascertain compliance with the bank’s of credit? established commercial loan policy. • For standby letters of credit— l. Analyze the following specific types of — do they represent undertakings to letters of credit (when applicable) to pay up to a specific amount on determine the following: presentation of a draft (or drafts) or • For red-clause letters of credit (pack- documents before a specified date? ing credits)— — do they represent obligations to a — is clean advance or anticipatory beneficiary on the part of the issuer drawing finance to the beneficiary to— (exporter or agent) authorized under • repay money borrowed by or the letter of credit? advanced to, or for the account — does the beneficiary undertake to of, a party; or deliver, within the expiration date, • make payment on account of any the shipping documents called for indebtedness undertaken by the in the letter of credit? account party, or make payment — does the foreign bank make on account of default by the advances to the beneficiary, and is account party in the performance it paid by drawing its own draft on of an obligation, for example, the opening bank, or is the benefi- default on loans, performance of ciary authorized to draw its draft contracts, or relating to maritime on the issuing bank, and are the liens? drafts received charged to the • For deferred-payment letters of credit importer? (trade-related)— • For traveler’s letters of credit— — does the letter of credit call for drawing of sight drafts with the — is a traveler’s letter of credit autho- provison that such drafts are not to rizing the issuing bank’s correspon- be presented until a specified period dent to negotiate drafts drawn by after presentation and surrender of the beneficiary named in the credit, shipping documents to the bank? up to a specified amount, upon — is the bank’s liability for outstand- proper identification? ing letters of credit calling for — is the customer furnished with a deferred payment reflected as a list of the issuing bank’s correspon- contingent liability until presenta- dents abroad? tion of such documents? — is the letter of credit prepaid in — has the bank received, approved, full? and acknowledged receipt of the • For back-to-back letters of credit— documents, thereby becoming — is the backing letter of credit prop- directly liable to pay the benefi- erly assigned as collateral to the ciary at a determinable future date bank issuing the letter of credit? (or dates)? — are the terms of the letter of credit — will payment be made to the bene- issued identical to the backing ficiary in a specified number of credit, except that— months or quarterly, semiannually, • the beneficiary and account party annually, or beyond? (If the bank are different, has advanced money to the benefi- • the amount may be less but not ciary against the deferred-payment more than the backing credit, letter of credit, with its proceeds • the expiration date is reduced by assigned as collateral to repay the sufficient time to allow comple- advance, the transaction should be tion of the transaction before the treated as a loan rather than a

Commercial Bank Examination Manual May 2002 Page 3 7080.3 International—Letters of Credit: Examination Procedures

deferred-payment letter of credit). — does the bank have an agency • For clean deferred-payment letters of agreement from Eximbank credit— stating— — do such deferred-payment credits • that Eximbank has entered into a call for future payment against line of credit with a foreign simple receipt without documents borrower, evidencing an underlying trade • the amount of the line, transaction? • that the bank has been desig- — are such letters of credit shown as nated to issue the letter of credit direct liabilities on the bank’s (or credits), and records when drafts are presented • that any payments made under by the beneficiary and received by an Eximbank-approved letter of the bank? credit will be reimbursed by • For authority to purchase— Eximbank? — is the authority to purchase with — has the bank checked to make sure recourse to the drawer, without that all documents, including those recourse to the drawer, or without presented by the beneficiary, recourse to the drawer but con- comply with the terms of both the firmed by the negotiating bank? letter of credit and the Eximbank • For Agency for International Develop- agreement? ment (AID) letters of credit— • For advised (notified) letters of credit— — does the bank have an AID letter of — is the bank only advising the bene- commitment authorizing the ficiary without responsibility on its transaction? part? (These banks should not be — has the bank checked to make examined unless the bank has sure that all documents, including notified the letter-of-credit terms those presented by the beneficiary, erroneously to the beneficiary, thus comply with the terms of both the resulting in a possible liability for letter of credit and the AID the bank.) commitment? • For other types of letters of credit— — does a letter of agreement between — do any of the following U.S. gov- the bank and the foreign govern- ernment agencies and international ment exist, whereby the bank has organizations reimburse the bank recourse if AID fails to reimburse for issuing letters of credit on their the bank? behalf: • For Commodity Credit Corporation • International Bank for (CCC) letters of credit— Reconstruction and — does the bank have a CCC letter of Development (World Bank) commitment authorizing the bank • Inter-American Development under examination to issue letters Bank of credit to beneficiaries supplying • Overseas Private Investment eligible commodities to foreign Corporation importers? 13. For loans in the sample, check the central — in instances where the bank has liability file on borrowers who are indebted issued standby letters of credit in above the cutoff, or on borrowers who favor of the CCC, have the follow- display credit weaknesses or are suspected ing requirements been met: of having additional liability in other loan • Has at least 10 percent of the areas. financed amount been confirmed, 14. Transcribe significant liability and other i.e., guaranteed by a U.S. bank, information on officers, principals, and for commercial credit risk? Is the affiliations of appropriate obligors con- total value of the credit advised tained in the sample. Cross-reference line through a U.S. bank? cards to borrowers, where appropriate. • For the Export-Import Bank (Exim- 15. Determine compliance with section 208.24 bank) of the United States— of Regulation H regarding standby letters of

May 2002 Commercial Bank Examination Manual Page 4 International—Letters of Credit: Examination Procedures 7080.3

credit by performing the following steps: potential borrower in an ordinary loan a. Determine which letters of credit are situation. standby letters of credit as defined by 16. Perform the appropriate procedural steps in section 208.24(a) of Regulation H. the ‘‘Concentration of Credits’’ section. b. Determine that the amount of standby 17. Discuss with the appropriate officer (or letters of credit does not exceed the legal officers) and prepare summaries in appro- limitations on loans imposed by the state priate report form of— (including limitations to any one cus- a. letters of credit not supported by current tomer or on aggregate extensions of and complete financial information, credit). b. letters of credit on which collateral docu- • Combine standby letters of credit with mentation is deficient, any other nonexcepted loans to the c. inadequately collateralized letters of account party by the issuing bank for credit, the purpose of applying state loan d. criticized letters of credit, limitations to any one customer. e. concentrations of credit, • A standby letter of credit is not subject f. letters of credit issued in favor of major to loan limitations imposed by state shareholders, employees, officers, direc- law in the following instances: tors, and their interests, — Before or at the time of issuance of g. letters of credit which, for any other the credit, the issuing bank is paid reason, are questionable in quality, an amount equal to the bank’s h. violations of laws and regulations, and maximum liability under the i. other matters regarding the condition of standby letter of credit. the letters-of-credit department. — Before or at the time of issuance, 18. Prepare and give to the examiner-in-charge the bank has set aside sufficient a written evaluation of the letters-of-credit funds in a segregated, clearly ear- department with respect to— marked deposit account to cover a. the adequacy of written policies relating the bank’s maximum liability to letters of credit; under the standby letter of credit. c. Determine, for standby letters of credit b. the manner in which bank officers are that constitute extensions of credit operating in conformance with estab- under section 23A of the Federal Reserve lished policies; Act when issued on behalf of an affiliate, c. delinquencies relating to letters of credit, that— segregating those considered ‘‘A’’ paper; • the legal lending limits pertaining to d. adverse trends within the letter-of-credit loans to affiliates have not been department; exceeded, and e. the accuracy and completeness of the • appropriate collateral requirements schedules obtained; have been met. f. internal-control deficiencies or d. Determine that the bank maintains exceptions; adequate control and clearly earmarked g. recommended corrective action when subsidiary records of its standby letters policies, practices, or procedures are of credit in conformance with section deficient; 208.24 of Regulation H. h. the quality of departmental management; e. Determine that the credit standing of the and account party under any standby letter of i. other matters of significance. credit is the subject of credit analysis that 19. Update the workpapers with any informa- is equivalent to that applicable to a tion that will facilitate future examinations.

Commercial Bank Examination Manual May 2002 Page 5 International—Letters of Credit Internal Control Questionnaire Effective date March 1984 Section 7080.4

Review the bank’s internal controls, policies, *8. Is a daily record maintained summarizing practices and procedures for letters of credit letter of credit transaction details, i.e., issued and confirmed. The bank’s system should letters of credit issued, payments received, be documented in a complete and concise man- and commissions and fees collected, to ner and include, where appropriate, narrative support applicable general ledger account descriptions, flowcharts, copies of forms used entries? and other pertinent information. Items marked 9. Are frequent letter of credit record copies with an asterisk require substantiation by obser- and liability ledger trial balances prepared vation or testing. and reconciled monthly with control accounts by employees who do not pro- cess or record letter of credit transactions? POLICIES 1. Has the board of directors, consistent with COMMISSIONS its duties and responsibilities, adopted writ- ten letter of credit policies that: *10. Is the preparation and posting of commis- a. Establish procedures for reviewing let- sion records performed or reviewed by ter of credit applications? persons who do not also: b. Define qualified customers? a. Issue official checks or drafts? c. Establish minimum standards for docu- b. Handle cash? mentation in accordance with the Uni- 11. Are any independent commission compu- form Commercial Code? tations made and compared or adequately 2. Are letter of credit policies reviewed at tested to initial commission records by least annually to determine if they are persons who do not also: compatible with changing market a. Issue official checks or drafts? conditions? b. Handle cash?

RECORDS DOCUMENTATION

*3. Is the preparation and posting of subsidi- 12. Are terms, dates, weights, description of ary letter of credit records performed or merchandise, etc. shown on invoices, ship- reviewed by persons who do not also: ping documents, delivery receipts and bills a. Issue official checks or drafts? of lading scrutinized for differences with b. Handle cash? those detailed in the letters of credit instru- *4. Are the subsidiary letter of credit records ments? (control totals) balanced daily with the 13. Are procedures in effect to determine if: appropriate general ledger accounts and a. The above documents are signed when reconciling items adequately investigated required? by persons who do not normally handle b. All copies of letters of credit are ini- letters of credit and post records? tialed by the officer who signed the *5. Are delinquencies arising from the non- original letter of credit? payment of instruments relating to letters c. All amendments to letters of credit are of credit prepared for and reviewed by approved by an officer? management on a timely basis? *6. Are inquiries regarding letter of credit balances received and investigated by per- sons who do not normally process docu- COLLATERAL ments, handle settlements or post records? *7. Are bookkeeping adjustments checked and (See International—Loans and Current Account approved by an apropriate officer? Advances section.)

Commercial Bank Examination Manual March 1994 Page 1 7080.4 International—Letters of Credit: Internal Control Questionnaire

DEFERRED PAYMENT LETTERS 20. Does the bank have an internal review OF CREDIT system that: a. Re-examines collateral items for nego- *14. Are deferred payment letters of credit: tiability and proper assignment? a. Recorded as direct liabilities of the b. Test check values assigned to collateral bank after it acknowledges receipt of when the letter of credit is issued or the beneficiary’s documents? confirmed and at frequent intervals b. Included in ‘‘Other Assets’’ and ‘‘Other thereafter? Liabilities’’ in the call report? c. Determines that customer payments of letters of credit issued are promptly posted? STANDBY LETTERS OF CREDIT d. Determines all delinquencies arising from the non-payment of instruments *15. Are standby letters of credit segregated or relating to letters of credit? readily identifiable from other types of 21. Are all letters of credit recorded and letters of credit and/or guarantees? assigned consecutive numbers? 22. Are lending officers frequently informed of maturing letters of credit and letter of OTHER credit lines?

16. Are outstanding letter of credit record copies and unissued forms safeguarded during banking hours and locked in the CONCLUSION vault overnight? *17. Are advised letters of credit recorded as 23. Is the foregoing information an adequate memoranda accounts separate from letters basis for evaluating internal control in that of credit issued or confirmed by the bank? there are no significant deficiencies in 18. Are letters of credit which have been areas not covered in this questionnaire issued with reliance upon a domestic bank, that impair any controls? Explain negative whether on behalf of, at the request of, answers briefly, and indicate any addi- or under an agency agreement with the tional examination procedures deemed domestic bank, recorded as contingent necessary. liabilities under the name of that domestic 24. Based on a composite evaluation, as bank? evidenced by answers to the foregoing 19. Are any commission rebates approved by questions, internal control is considered an officer? (adequate/inadequate).

March 1994 Commercial Bank Examination Manual Page 2 International—Guarantees Issued Effective date May 1996 Section 7090.1

State member banks may not issue guarantees monetary liability. The liabilities outstanding and sureties except for those that may be inci- are subject to loan limitations on any one dental or usual in conducting banking business, customer imposed by state law. such as when a bank has a substantial interest in A common example of a guarantee is a the performance of the transaction involved or shipside bond. Frequently, in an international has a segregated deposit sufficient in amount to sale of goods, the merchandise arrives at the cover its total potential liability. A state member importer’s (buyer’s) port before the arrival of bank also may guarantee or endorse notes or correct and complete bills of lading. In these other obligations sold by the bank for its own instances, it is customary for the importer (buyer) account. The amount of the obligations covered to obtain immediate possession of the goods by by the guaranty or endorsement is to be recorded providing the shipping company with a bank as a liability on the bank’s records. These guarantee, often called a shipside bond, that liabilities are included in computing the aggre- holds the shipping company blameless for dam- gate indebtedness of the bank, which may be age resulting from release of the goods without subject to limitations imposed by state law. proper or complete documents. Usually, the Furthermore, a state member bank is permitted bank’s guarantee relies on a counter-guarantee to guarantee the deposits and liabilities of its issued to the bank by the importer. Edge Act and agreement corporations and of its All types of guarantees issued are to be corporate instrumentalities in foreign countries. recorded as contingent liabilities by the bank. A foreign branch of a member bank may Usually, the party for whom the guarantee was engage in certain activities under Regulation K issued will reimburse the bank should it be (12 CFR 211) in addition to its general banking required to pay under the guarantee; however, in powers to the extent that they are consistent with certain situations, some other designated party its charter. Those additional activities include may reimburse the bank. That other party may guaranteeing a customer’s debts or agreeing to be designated in the guarantee agreement with make payment on the occurrence of readily the bank or in the guarantee instrument itself. ascertainable events, including, but not limited The bank may also be reimbursed from seg- to, nonpayment of taxes, rentals, customs duties, regated deposits held, from pledged collateral, the cost of transportation and loss, or the non- or by a counter-guarantor. Letters of credit, as conformance of shipping documents. The guar- distinguished from guarantees, are discussed in antee or agreement must specify maximum section 7080, ‘‘International—Letters of Credit.’’

Commercial Bank Examination Manual May 1996 Page 1 International—Guarantees Issued Examination Objectives Effective date May 1996 Section 7090.2

1. To determine if policies, practices, proce- 4. To determine the scope and adequacy of the dures, and internal controls for guarantees audit function as it applies to guarantees. issued are adequate. 5. To determine compliance with applicable 2. To determine if bank officers are operating in laws and regulations. conformance with established guidelines. 6. To recommend corrective action when objec- 3. To evaluate the portfolio of guarantees for tives, policies, practices, procedures, or inter- credit quality, collectibility, and collateral nal controls are deficient and when violations sufficiency. of laws and regulations have been cited.

Commercial Bank Examination Manual May 1996 Page 1 International—Guarantees Issued Examination Procedures Effective date March 1984 Section 7090.3

1. If selected for implementation, complete or 8. Review the information received and per- update the Guarantees Issued section of the form the following for: Internal Control Questionnaire. a. Miscellaneous loan debit and credit sus- 2. Determine the scope of the examination pense accounts: based upon the evaluation of internal con- • Determine any liability to the bank trols and the work performed by internal resulting from guarantees paid by the and external auditors. bank for which it has not been reim- 3. Test for compliance with policies, practices, bursed by an account party. procedures and internal controls in conjunc- • Discuss with management any large or tion with performing the remaining exami- old items. nation procedures. Also, obtain a listing of • Perform additional procedures as con- any deficiencies noted in the latest review sidered appropriate. done by internal and external auditors from b. Shared national credits: the examiner assigned to the audit review • Compare the schedule of guarantees and determine if appropriate corrections issued included in the program have been made. to the bank’s reports of unexpired 4. Obtain a trial balance of the customer guarantees. (account party) liability records and: • For each guarantee so identified, tran- a. Reconcile balances to department con- scribe appropriate information to line trols and the general ledger. cards. No further examination proce- b. Review reconciling items for reason- dures are necessary for these items. ableness. c. Interagency Country Exposure Review 5. Using an appropriate technique, select guar- Committee Credits: antee account parties for examination. • Identify any guarantees that were 6. Prepare credit line cards to include: selected for review that are criticized a. Total line available for guarantees. for transfer risk reason by the Inter- b. Total outstanding guarantees. agency Country Exposure Review 7. Obtain the following information if it is Committee. applicable to the guarantees issued area: 9. Transcribe or compare information from the a. Loan commitments and contingent above schedules to credit line cards, where liabilities. appropriate, and indicate any past due b. Miscellaneous loan debit and credit sus- status. pense accounts. 10. Prepare credit line cards for any guarantee c. Criticized shared national credits. not in the sample which, based on informa- d. Interagency Country Exposure Review tion derived from the above schedules, Committee determinations. requires an in-depth review. e. Loans considered ‘‘problem loans’’ by 11. Obtain liability and other information on management. common borrowers from examiners as- f. Specific guidelines in the lending policy. signed to cash items, overdrafts, loans and g. Each officer’s current lending authority. current account advances, due from foreign h. Any useful information resulting from banks—time, and other loan areas and the review of the minutes of the Loan decide who will review the borrowing rela- and Discount Committee or any similar tionship. Pass on or retain completed credit committee. line cards. i. Reports furnished to the Loan and 12. Obtain credit files for all customers (account Discount Committee or any similar parties) for whom credit line cards were committee. prepared and complete credit line cards, j. Reports furnished to the board of where appropriate. To analyze the guaran- directors. tees, perform the following procedures: k. Loans criticized during the previous a. Analyze balance sheet and profit and loss examination. figures as shown in current and preced-

Commercial Bank Examination Manual March 1994 Page 1 7090.3 International—Guarantees Issued: Examination Procedures

ing financial statements, and determine records and in the reports of condition of the existence of any favorable or adverse the bank and that such liabilities are trends. included in computing the aggregate b. Relate items or groups of items in the indebtedness of the bank, if such limita- current financial statements to other items tions are imposed by state law. or groups of items set forth in the state- b. Determine which guarantees are subject ments, and determine the existence of to individual loan limitations to any one any favorable or adverse ratios. customer by state law. Combine guaran- c. Review components of the balance sheet tees with any other extensions of credit as reflected in the current financial state- to the account party by the issuing bank ments, and determine the reasonableness subject to loan limitations imposed by of each item as it relates to the total state law. financial structure. 16. Perform appropriate procedural steps in d. Review supporting information for the the Concentration of Credits section, as major balance sheet items and the tech- applicable. niques used in consolidation. Determine 17. Discuss with appropriate officers and pre- the primary sources of repayment and pare summaries in appropriate report form evaluate the adequacy of those sources. of: e. Determine compliance with the provi- a. Guarantees not supported by current and sions of guarantee agreements. complete financial information. f. Review digest of officers’ memoranda, b. Guarantees on which collateral documen- mercantile reports, credit checkings and tation is deficient. correspondence to determine the exist- c. Concentrations of credit. ence of any problems which might deter d. Criticized guarantees. the contractual liquidation program. e. Inadequately collateraled guarantees, if g. Relate collateral values, if any, to out- applicable. standing guarantee. f. Guarantees issued in favor of major h. Compare fees charged to the bank’s fee shareholders, employees, officers, direc- schedule and determine that the terms tors and related interests. are within established guidelines. g. Guarantees, which for any other reason, i. Compare the original amount of the guar- are questionable as to quality and ulti- antee with the lending officer’s authority. mate collection. j. Analyze support afforded by counter- h. Violations of laws and regulations. guarantors. 18. Evaluate the bank with respect to: k. Ascertain compliance with the bank’s established guarantee issued policy. a. The adequacy of written policies relating 13. For guarantees issued in the sample, check to guarantees issued. central liability file on borrower(s) indebted b. The manner in which bank officers are above the cutoff or borrower(s) displaying operating in conformance with estab- credit weakness or suspected of having lished policy. additional liability in loan areas. c. Adverse trends within the guarantees 14. Transcribe significant liability and other issued department. information on officers, principals and affil- d. The accuracy and completeness of the iations of appropriate account parties con- schedules obtained. tained in the sample. Cross-reference line e. Internal control deficiencies or exceptions. cards to borrowers, where appropriate. f. Recommended corrective action when 15. Determine compliance with state laws and policies, practices or procedures are regulations pertaining to guarantees issued deficient. by performing the following steps: g. The quality of departmental management. a. Determine that the obligations covered h. Other matters of significance. by such guarantees or endorsements are 19. Update the workpapers with any informa- shown as contingent liabilities on the tion that will facilitate future examinations.

March 1994 Commercial Bank Examination Manual Page 2 International—Guarantees Issued Internal Control Questionnaire Effective date March 1984 Section 7090.4

Review the bank’s internal controls, policies, *8. Is a daily record maintained summarizing practices and procedures for issuing and servic- guarantee transaction details, i.e., guar- ing guarantees. The bank’s system should be antees issued, guarantees cancelled or documented in a complete and concise manner renewed, payment made under guarantees and should include, where appropriate, narrative and fees collected, which support general descriptions, flowcharts, copies of forms used ledger entries? and other pertinent information. Items marked 9. Are frequent guarantee instrument and with an asterisk require substantiation by obser- liability ledger trial balances prepared and vation or testing. are they reconciled monthly with control accounts by persons who do not process or record guarantee transactions? POLICIES 1. Has the board of directors, consistent with GUARANTEE FEES its duties and responsibilities, adopted writ- ten policies pertaining to guarantees issued *10. Is the preparation and posting of fees that: collected records performed or reviewed a. Establish procedures for reviewing guar- by persons who do not also: antee applications? a. Issue official checks or drafts? b. Define qualified guarantee account b. Handle cash? parties? 11. Are independent fee computations made, c. Establish minimum standards for docu- compared or adequately tested to initial mentation in accordance with the Uni- fee records by persons who do not also: form Commercial Code? a. Issue official checks or drafts? 2. Are guarantees issued policies reviewed at b. Handle cash? least annually to determine if they are compatible with changing market conditions? COLLATERAL

(See International—Loans and Current Account RECORDS Advances section.)

*3. Is the preparation and posting of subsidi- ary guarantee records performed or re- viewed by persons who do not also: OTHER a. Issue official checks or drafts? b. Handle cash? 12. Are guarantees issued instruments safe- *4. Are the subsidiary guarantees issued records guarded during banking hours and locked balanced daily with the general ledger and in the vault overnight? are reconciling items adequately investi- 13. Are all guarantees issued recorded as gated by persons who do not normally liabilities and assigned consecutive handle guarantees? numbers? *5. Are guarantee delinquencies prepared for 14. Are all guarantees issued recorded on and reviewed by management on a timely individual customer (account party) liabil- basis? ity ledgers? 6. Are inquiries regarding guarantee balances received and investigated by persons who do not normally handle guarantees or post CONCLUSION records? *7. Are bookkeeping adjustments checked and 15. Is the foregoing information an adequate approved by an appropriate officer? basis for evaluating internal control in that

Commercial Bank Examination Manual March 1994 Page 1 7090.4 International—Guarantees Issued: Internal Control Questionnaire

there are no significant deficiencies in 16. Based on a composite evaluation, as evi- areas not covered in this questionnaire denced by answers to the foregoing that impair any controls? Explain negative questions, internal control is considered answers briefly, and indicate any addi- (adequate/inadequate). tional examination procedures deemed necessary.

March 1994 Commercial Bank Examination Manual Page 2 International—Foreign Exchange Effective date April 2008 Section 7100.1

This section provides examiners with the basic in the local currency has the capability of principles and risks associated with foreign engaging in foreign exchange. The majority of exchange trading. By its very nature, foreign U.S. banks restrict foreign exchange to the exchange trading involves risk. The examiner’s servicing of their customers’ foreign currency primary function is to understand that risk and needs. The banks will simply sell the currency ensure that bank management, by means of at a rate slightly above the market and policies, limits, and systems, is controlling that subsequently offset the amount and maturity of risk in a prudent manner. For the purpose of this the transaction through a purchase from another section, foreign currency money market func- correspondent bank at market rates. This level tions will be combined with foreign exchange of activity involves virtually no exposure as cur- activities since the principles and risks are rency positions are covered within minutes. A virtually the same. small profit is usually generated from the rate In order to evaluate a bank’s foreign exchange differential, but the activity is clearly designated and controls, the examiner needs a basic under- as a service center. standing of the foreign exchange market, the Greater emphasis is placed on foreign exchange commercial bank’s role in the market, trading activity by regional banks. The servicing of the fundamentals, and the principal risks involved corporate customers’ needs is also a priority, but in trading. most regional banks also participate in the The foreign exchange market exists to service interbank market. These banks look at the trad- the foreign currency needs of importers, export- ing function as a profit center as well as a ers, manufacturers, and retailers. Foreign service. Such banks usually employ several exchange transactions arising from international experienced traders and, unlike the previous trade and investment are frequently large and group, will take positions in given currencies recurrent. based on anticipated rate movements. Large or small, all foreign exchange transac- Multinational banks assume, by far, the most tions represent the exchange of one country’s significant role in the foreign exchange market- money for another’s. The exchange rate is place. While still servicing customer needs, simply the price of one currency in terms of these banks are heavily engaged in the interbank another. market and look to their foreign exchange trad- Until the late 1970s, foreign exchange rates in ing operation for sizable profits. Such banks this country were normally expressed and quoted trade foreign exchange on a global basis through in dollars per unit of foreign currency, also international branch networks. known as ‘‘U.S. Terms.’’ Under this method, for A major aspect of any foreign exchange example, the rate for Swiss francs would be review is the ability of the examiner to deter- expressed as CHFl=U.S.$1.5500. However, mine if the bank has the capability to adequately because of vastly improved communications handle the level of its foreign exchange volume and a rapidly expanding market, it became and the extent of the exposures taken. This necessary for traders worldwide to quote rates in judgment is, by necessity, subjective; however, a uniform manner. As a result, American foreign it must take into consideration asset size, capital exchange traders began using foreign currency base, customer volume in foreign exchange, units per dollar or ‘‘European Terms’’ for most depth and experience of traders, and manage- rates. Using European terms, the quote in this ment understanding of and commitment to trad- example would be U.S.$1=CHF.64516. Thus, ing. The fundamental principles of foreign European terms represent the value of the U.S. exchange trading outlined below are designed to dollar in units of the foreign currency. A quote assist the examiner in this analysis. in European terms is simply the reciprocal of a quote in U.S. terms. One major exception to this shift is the British pound sterling which, for historical purposes, is always quoted in U.S. SPOT TRADING terms such as 1£=$1.7450.) Any commercial bank which maintains due Buying and selling foreign exchange at market from bank balances, commonly known as rates for immediate delivery represents spot ‘‘nostro’’ accounts, in banks in foreign countries trading. In reality, spot trades have a ‘‘value

Commercial Bank Examination Manual April 2008 Page 1 7100.1 International—Foreign Exchange date’’ (maturity or delivery date) of two to five and its liabilities, including spot and future business days (one for Canada and Mexico). contracts to sell, in that currency are not equal. Foreign exchange rates that represent the present An excess of assets over liabilities is called a market value for the currency are known as spot net ‘‘long’’ position and liabilities in excess of rates. The risk of spot trading results from rate assets a net ‘‘short’’ position. A ‘‘long’’ posi- movements occurring when the bank’s position tion in a foreign currency which is depreciat- in foreign currency is not balanced with regard ing will result in an exchange loss relative to to exchange bought and sold. Such unbalanced book value because, with each day, that posi- positions are referred to as net open positions tion (asset) is convertible into fewer units of and are defined as follows: local currency. Similarly, a ‘‘short’’ position in a foreign currency which is appreciating Net Open Positions—A bank has a net posi- represents an exchange loss relative to book tion in a foreign currency when its assets, value because, with each day, liquidation of that including spot and future contracts to purchase, position (liability) will cost more units of

CONSOLIDATED FOREIGN EXCHANGE POSITION, MAY 4, 20XX Amounts in thousands

Assets/Purchases Liabilities/Sales

U. S. $ U. S. $ Equivalent of Equivalent of Monetary Unit, Overnight Foreign Local Currency Foreign Local Currency Limit and Description Amount Book Value Amount Book Value

JAPANESE YEN ($3,000M) Ledger Accounts 563,437 239,461 645,013 274,310 Spot Contracts 23,502 9,802 15,973 6,709 Forward Contracts 790,250 331,905 712,533 296,342 1,377,189 581,168 1,373,519 577,361 Net Position (long) 3,670 3,807

CANADIAN DOLLARS ($6,000M) Ledger Accounts 1,016,076 1,017,525 1,029,835 1,030,057 Spot Contracts 330,021 328,972 216,225 217,246 Forward Contracts 1,202,013 1,203,226 1,301,279 1,302,522 2,548,110 2,549,723 2,547,339 2,549,825 Net Position (long) 771 102

SWISS FRANC ($250M) Ledger Accounts 1 31,768 11,932 36,052 13,571 Spot Contracts 1,526 593 2,566 969 Forward Contracts 11,174 4,274 6,545 2,521 44,468 16,799 45,163 17,061 Net Position (short) 2 695 262

1. Does not include a Swiss franc 1,000M (U.S. $386M) 2. Net overnight position in excess of established limit. unhedged investment in a Swiss subsidiary and Swiss franc Formally approved as a special situation by senior manage- 573M (U.S. $217M) unhedged investment in branch fixed ment prior to the transaction. assets. The unhedged term ‘‘long’’ position was approved by senior bank management.

April 2008 Commercial Bank Examination Manual Page 2 International—Foreign Exchange 7100.1 local currency. (Examples of net open position amount it sold to Bank B. However, in this case, schedules appropriate for use in preparing the as the calling bank, Bank A would buy its report of examination appear on the preceding sterling from the offered side of the quote it page.) receives and must buy it at $1.7125 or less to It is important to remember that the net open avoid a loss. position consists of both balance sheet accounts Banks engaging in interbank spot trading will and contingent liabilities. For most banks, the often be involved with sizable net open posi- nostro accounts represent the principal assets; tions, though many for just brief periods. No however, foreign currency loans as well as any matter how skilled the trader, each will encoun- other assets or liability accounts denominated in ter at least occasional losses. Knowing when to foreign currency that are sizable in certain close a position and take a small loss before it banks, must be included. All future foreign becomes large is a necessary trait for a compe- exchange contracts outstanding are contingents. tent trader. Many banks employ a ‘‘stop loss When a contract matures, the entries are posted policy’’ whereby a net open position must be to a nostro account in the appropriate currency. covered if losses from it reach a certain level. Each time a bank enters into a spot foreign While a trader’s forecast may ultimately prove exchange contract, its net open position is correct within a day or week, rapid rate move- changed. For example, assume that Bank A ments often force a loss within an hour or even opens its business day with a balanced net open minutes. Also, access to up-to-the-minute infor- position in pound sterling (assets plus purchased mation is vital for involvement in spot trading. contracts equal liabilities plus sold contracts). Banks who lack the vast informational resouces This is often referred to as a ‘‘flat’’ position. of the largest multinationals may be particularly Bank A then receives a telephone call from vulnerable to sudden spot rate movements Bank B requesting a ‘‘market’’ in sterling. prompted by inside information or even rumors. Because it is a participant in the interbank As a result, examiners should closely review foreign exchange trading market, Bank A is a banks where foreign exchange activities consist ‘‘market maker.’’ This means it will provide primarily of interbank spot trading. Bank B with a two-sided quote consisting of its bid and offer for sterling. If a different currency was requested, European terms would be the FORWARD TRADING opposite as the bid and offer would be for dollars instead of the foreign currency. In deter- A forward transaction differs from a spot trans- mining the market given, Bank A’s trader of action in that the value date is more than two to sterling will determine where the market pres- five business days in the future. The maturity of ently is (from brokers and/or other banks) and a forward foreign exchange contract can be a attempt to anticipate where it is headed and few days, months, or even years in some whether Bank B is planning to buy or sell instances. The exchange rate is fixed at the time sterling. the transaction is agreed. But nostro accounts When Bank A gives its quote on sterling, are not debited or credited, i.e., no money $1.7115–25 for example, it is saying that it actually changes hands, until the maturity date will buy sterling (its bid) at $1.7115 or sell of the contract. There will be a specific exchange sterling at $1.7125 (its offer). If Bank B’s rate for each forward maturity, and each of those interest is to buy sterling and the given quote is rates will generally differ from today’s spot appealing, it will buy sterling from Bank A at exhange rate. If the forward exchange rate for a $1.7125 (Bank A’s offer of sterling). Note, that currency is higher than the current spot rate, while Bank B may choose to buy, sell, or pass as dealers say the currency is trading at a ‘‘pre- it wishes, it must do business on the terms mium’’ for that forward maturity. If the forward established by Bank A. These terms will be in rate is below the spot rate, then the currency is Bank A’s favor. As soon as Bank B announces it said to be trading at a ‘‘discount.’’ For instance, will purchase sterling at $1.7125, Bank A sterling for value in three months is at a discount acquires a net open position (short) in sterling. if the spot rate is $1.75 and the three-month Bank A must then decide whether to hold its forward rate is $1.72. short position (in anticipation of a decline in Banks active in the foreign exchange market sterling) or cover its position. Should it wish to find that interbank currency trading for any cover, it may call another bank and purchase the specific value date in the future is inefficient and

Commercial Bank Examination Manual April 2008 Page 3 7100.1 International—Foreign Exchange engage in it only infrequently. Instead, for future back the sterling to Bank B, while B pays back maturities, banks trade among themselves as the dollars to A. In the meantime, Bank A has the well as with some corporate customers on the use of the sterling, in effect ‘‘borrowing’’ basis of a transaction known as a ‘‘swap.’’ A sterling, while giving up use of the dollars, in swap transaction is a simultaneous purchase and effect ‘‘lending’’ the dollars. Banks recognize sale of a certain amount of foreign currency for this close equivalence to actual short-term two different value dates. The key aspect is that borrowing and lending. Many fold in swap the bank arranges the swap as a single transac- transactions with other money market trans- tion with a single counterparty, either another actions in managing their global banking bank or a nonbank customer. This means that, activities. unlike outright spot or forward transactions, a Forward exchange rates can be expressed trader does not incur a net open position since in three ways. Like spot rates, outright for- the bank contracts both to pay and to receive the ward prices are expressed in dollars and same amount of currency at specified rates. cents per currency unit or vice versa. Traders A swap allows each party to use a currency for normally only quote forward prices to corporate a period in exchange for another currency that is customers or to small correspondent banks seek- not needed during that time. Thus, the swap ing to buy or sell a currency for a particular offers a useful investment facility for temporary future date. For instance, a trader may quote an idle currency balances of a corporation or a outright six-month rate to buy sterling of financial institution. Swaps also provide a $1.8450, while, by comparison, a quotation to mechanism for a bank to accommodate the buy spot sterling might be less ($1.8200) or outright forward transactions executed with more ($1.8625). customers or to bridge gaps in the maturity In swap transactions, the trader is only structure of its outstanding spot and forward interested in the difference between spot and contracts. forward rates, the premium or discount, rather The two value dates in a swap transaction can than the outright spot and forward rates them- be any two dates. But, in practice, markets exist selves. Premiums and discounts expressed in only for a limited number of standard maturities. points ($0.0001 per pound sterling or € 0.0001 One of these standard types is called a ‘‘spot per dollar) are called swap rates. For the first spot against forward’’ swap. In a spot against for- rate above, the premium is 250 points ($0.0250). ward swap transaction, a trader buys or sells a For the second, the discount is 175 points currency for the spot value date and simulta- ($0.0175). neously sells or buys it back for a value date a Since, in a swap, a trader is effectively week, a month, or three months later. borrowing one currency and lending the other for Another type of transaction of particular inter- the period between the two value dates, the est to professional market-making banks is called premium or discount is often evaluated in terms a ‘‘tomorrow-next’’ swap or a ‘‘rollover.’’ These of percent per annum. For the examples above, are transactions in which the dealer buys or sells the premium of 250 points is equivalent to 2.75 a currency for value the next business day and percent per annum, while the discount of 175 simultaneously sells or buys it back for value the points is equivalent to 1.88 percent per annum. day after. A more sophisticated type of swap is To calculate the percentage premium for the first called a ‘‘forward-forward’’ in which the dealer case: buys or sells currency for one future date and sells or buys it back for another future date. • Take the swap rate ($0.0250) Primarily, multinational banks specialize in • Multiply by 12 months and divide by 6 transactions of that type. months (a per annum basis) Any swap transaction can be thought of as if • Divide by the spot rate ($1.8200), and it were a simultaneous borrowing and lending • Multiply by 100 (to get a percent basis). operation. For example, on September 11, Bank A ‘‘swaps in’’ three-month sterling in a spot On a formula basis, this can be expressed as: against a forward transaction with Bank B. On Premium or Discount × 12 September 13, Bank A pays dollars to Bank B’s % per = × 100 account at a New York bank and Bank A receives annum 1 Spot rate × number of 2 sterling for its account at a bank in London. On months of forward contract December 13, the swap is reversed. Bank A pays

April 2008 Commercial Bank Examination Manual Page 4 International—Foreign Exchange 7100.1

As can be seen from the above, forward rates Thus, the dealer responsible for forward trad- (premiums or discounts) are solely influenced ing must be able to analyze and project dollar by the interest rate differentials between the two interest rates as well as interest rates for the countries involved. As a result, when the differ- currency traded. Additionally, because forward ential changes, forward contracts previously premiums or discounts are based on interest booked could now be covered at either a profit rates differentials, they do not reflect anticipated or loss. For example, assume an interest rate movements in spot rates. differential between sterling and dollars of 3 per- Active trading banks will, of course, have a cent (with the sterling rate lower). Using this large number of forward contracts outstanding. formula, with a spot rate of $1.80, the swap rate The portfolio of forward contracts is often called on a three month contract would be a premium a ‘‘forward book.’’ As a result, these forward of 135 points. Should that interest rate differen- positions must be managed on a gap basis. tial increase to 4 percent (by a drop in the Normally, banks will segment their forward sterling rate or an increase in the dollar rate), the books into 15-day periods and show the net premium would increase to 180 points. There- (purchased forward contracts less sold ones) fore, a trader who bought sterling three months balance for each period. A typical forward book forward sterling at 135 points premium could would look as follows: now sell it at 180 points premium, or at a profit of 45 points (expressed as .0045).

Net Foreign Maturity Position Currency Date Purchases Sales for Period

England Dec. 1–15 1 000 000 800 000 200 000 (amounts in) 16–31 700 000 900 000 (200 000) pound sterling) Jan. 1–15 1 500 000 500 000 1 000 000 16–31 1 400 000 600 000 800 000 Feb. 1–15 1 100 000 700 000 400 000 16–28 1 400 000 400 000 1 000 000 Mar. 1–31 200 000 1 300 000 (1 100 000) Apr. 1–30 400 000 1 600 000 (1 200 000) May 1–31 300 000 900 000 (600 000) June 1–30 350 000 450 000 (100 000) July 1–31 550 000 450 000 100 000 Aug. 1–31 1 000 000 1 000 000 — Sept. 1–30 500 000 600 000 (100 000) Oct. 1–31 600 000 500 000 100 000 Nov. 1–30 100 000 100 000 — Dec. 1–31 100 000 200 000 (100 000) Totals 11 200 000 11 000 000 200 000

In this forward book, volumes and net posi- ward sales. (Note: In the above forward book, tions are limited with only the first three months the net position is only £200,000.) What matters segregated into 15-day periods with the remain- in reviewing a forward book is the distribution der grouped monthly. The trader will use the of the positions by period. In the above example, forward book to manage his overall forward the forward sterling is long a net 3,200,000 for positions. the first three months (December through Feb- A forward book in an active currency may ruary) and short a net 3,000,000 for the next four consist of numerous large contracts but, because months (March through June). In this instance, of the risks in a net open position, total forward the forward book is structured for an anticipated purchases will approximately equal total for- decline in dollar interest rates as compared with

Commercial Bank Examination Manual March 1994 Page 5 7100.1 International—Foreign Exchange sterling interest rates since these sold positions the way different forward contracts mature each could be offset (purchase of a forward contract day, it is unusual for payments and receipts to to negate the sold forward position) at a lower balance perfectly until the traders arrange swaps price—either reduced premium or increased to achieve that result. Because some traders take discount. a view about the future movements of a cur- Trading forward foreign exchange thus rency, short or long positions are built up; and, involves projecting interest rate differentials and because of the changing influences on market managing a forward book to be compatible with developments and traders’ decisions, long or these projections. An understanding of these short positions can be altered any number of concepts is essential when looking at forward times each and every day. trading from risk and profitability aspects. In this kind of fluid trading environment, a bank needs to establish accounting procedures for calculating profits and losses which can COMPUTING FOREIGN handle the problem of maturity mismatches and EXCHANGE PROFITS open foreign currency positions. The principles AND LOSSES underlying the accounting procedures are much the same from bank to bank, although specific If traders did nothing but spot transactions and practices vary. The first principle is that banks never took open positions from day to day, do not formally calculate profits or losses daily; calculating profit or loss would be straightfor- most compute profits and losses monthly. Some ward. For example: on January 21, the traders banks do make these calculations more fre- buy £1,000,000 spot at $1.75 and £3,000,000 at quently for management information purposes. $1.74 and sell £2,000,000 at $1.7450 and The next principle is that banks calculate £2,000,000 at $1.7380. On the spot value dates, profits or losses on the entire foreign exchange two business days later, the bank’s nostro or book as of the calculation date. On any day, the clearing account in London is credited and book includes all spot and forward contracts debited by £4,000,000 from the maturing which have not yet matured, along with nostro transactions. balances in each currency. Each contract repre- sents a purchase or sale of a foreign currency at The sterling position is square, since debits a specified exchange rate. and credits are equal. In New York, the bank On the profit calculation date, the bank’s pays $6,970,000 but receives only $6,966,000. accountants revalue the foreign exchange book. There is a net loss of $4,000 on the four They use the latest market exchange rates, spot transactions. This is so because the bank’s and forward, for each value date on which accountant would calculate that the traders contracts are outstanding. For each contract, the acquired sterling at an average rate of $1.7425 = difference between the current market rate for the value date of the contract and the rate £1,000,000 × $1.75 + £3,000,000 × $1.74 specified in the contract is calculated. For exam- £4,000,000 ple, if the bank previously bought a currency, e.g., sterling at $1.75, and the current market Against that, the traders sold sterling at $1.7450, rate for the relevant maturity is higher, e.g., for a profit of $5,000 (i.e., $1.7450 − $1.7425 = sterling at $1.80, there is an unrealized profit. $0.0025 × 2,000,000 = $5,000). Traders also These calculated unrealized profits and losses sold another £2,000,000 at $1.7380 for a loss are amalgamated with the realized profits or of $9,000 ($1.7380 − $1.7425 = −$0.0045 rlosses that accrue every day as foreign exchange × £2,000,000 = −$9.000). In this instance, the contracts mature. The net profit or loss, realized computed net loss of $4,000 is precisely the plus unrealized, is then incorporated in bank same as the excess of dollar payments over operating income, reflecting the net contribution dollar receipts. of foreign exchange trading before expenses. In practice, computing profits and losses is far To recapitulate, a bank with a large number more complex for two basic reasons. Banks do of spot and forward contracts and possibly with not trade only for spot value—they also do open positions in one or more currencies needs forward contracts. Moreover, most major banks a formal method of computing unrealized profits do not operate from day to day with completely and losses at regular intervals. It uses a revalu- square positions in each currency. Because of ation procedure that, in effect, measures what

March 1994 Commercial Bank Examination Manual Page 6 International—Foreign Exchange 7100.1 the profits and losses would be if the bank Value dates range from the next day to a year or covered in the market all outstanding positions more in the future. Market exchange rates are that were not already covered. The revaluation readily available for the ‘‘even’’ dates—one, procedure ensures that the bank’s open positions two, three, six, twelve, and twenty-four months show changes in exchange rates as they occur, into the future. The Federal Reserve Bank of rather than when open positions are eventually New York publishes such a daily series which covered or when individual contracts mature. can be used by bank accountants and examiners. Periodic profit and loss calculations therefore But for ‘‘odd’’ dates, the accountant must approx- provide bank management with ongoing insights imate rates, possibly through a computer pro- into the performance of the trading function. gram that interpolates between even date Following is an illustration of the revaluation quotations. procedure. Assume that on the revaluation date, As contracts in the foreign exchange book January 15, Bank A had three outstanding con- mature, they affect the cash flow of the bank. tracts in its sterling book: Maturing purchase and sale contracts are treated asymmetrically. In a U.S. bank, which posts its • A sale of £1,000,000 at $1.75 for value profits and losses in dollars, maturing purchase March 15. contracts result in credits to its nostro account • A purchase of £3,000,000 at $1.70 for value in that currency. Each day, the bank’s accoun- May 15. tants compute a new average acquisition rate for • A sale of £1,000,000 at $1.65 for value the nostro account based on existing holdings August 15. and all flows into the account that day. Maturing sale contracts result in debits to the nostro The book is ‘‘long’’ £1,000,000 since pur- account. They yield a gain or loss measured chases of sterling are greater than sales. For against the average acquisition rate for funds now, the nostro account and the calculations of available in the nostro account. The net realized realized profits and losses are left aside. profit or loss is placed in a suspense account To revalue the book, the accountants find on which, at regular intervals, is incorporated into January 15 that two-month, four-month, and the bank’s income statement along with the seven-month forward rates in the market are unrealized profits or losses resulting from the $1.80, $1.75, and $1.70, respectively. They periodic revaluation of the foreign exchange proceed conceptually as if the traders were to book. In practice, the revaluation can be done on cover the contracts at the going market rates, a worksheet as long as net positions for time buying sterling to offset sales and selling ster- periods and present market rates are known. ling to offset purchases. On this basis, for the While banks will revalue monthly and make the first contract, they compute an urealized loss of appropriate entries to income accounts, traders $50,000 ($1.75 − $1.80 = −$0.05 × £1,000,000). will spot-check their profitability more fre- For the second contract, they compute an quently. Examiners should understand the reval- unrealized profit of $150,000 ($1.75 − $1.70 = uation procedure for the necessary test checking $0.05 × £3,000,000). For the third contract, they of reported profits, as time restrictions do not compute an unrealized loss of $50,000 normally allow for the proving of all of the ($1.65 − $1.70 = $0.05 × £1,000,000). The net is bank’s open positions. an unrealized profit of $50,000 which is entered To revalue the nostro accounts, which repre- on the income statement as the trading profit. sent realized profit or loss, the net foreign The accountant’s task actually is far more currency balance is multiplied by the current complicated. A foreign exchange book of a spot rate and the result, or market value, is major bank may include hundreds of outstand- compared to the U.S. $ equivalent on the books ing contracts in a dozen or more currencies. to determine profit or loss as shown below:

U.S. $ Equivalent Foreign Spot Market Book Value Profit Amount Rate Value of Ledger Accounts or Loss

15,172 $1.7155 26,028 21,229 +4,799

Commercial Bank Examination Manual March 1994 Page 7 7100.1 International—Foreign Exchange

The same principle holds true when compar- A worksheet revaluation of forward contracts, ing market value to book, even if credit balances for unrealized profits, is an expansion of the exist. (A market value of −19.055 and a book forward book previously shown. All rates must value of −20,155 would result in a profit of be expressed in ‘‘U.S. terms.’’ 1,100.)

FORWARD BOOK

Net D-Discount Foreign Maturity Position P-Premium Currency Date Purchases Sales for Period Rate Profit Loss

England Dec. 1–15 1 000 000 800 000 200 000 .0025 P 500 16–31 700 000 900 000 (200 000) 25 P 500 Jan. 1–15 1 500 000 500 000 1 000 000 15 P 1,500 16–31 1 400 000 600 000 800 000 15 P 1,200 Feb. 1–15 1 100 000 700 000 400 000 5 P 200 16–28 1 400 000 400 000 1 000 000 5 P 500 Mar. 1–31 200 000 1 300 000 (1 100 000) 5 D 550 Apr. 1–30 400 000 1 600 000 (1 200 000) 15 D 1,800 May 1–31 300 000 900 000 (600 000) 30 D 1,800 June 1–30 350 000 450 000 (100 000) 45 D 450 July 1–31 550 000 450 000 100 000 5 P 50 Aug. 1–31 1 000 000 1 000 000 — 25 D — Sept. 1–30 500 000 600 000 (100 000) 0 — Oct. 1–31 600 000 500 000 100 000 45 D 450 Nov. 1–30 100 000 100 000 — 25 D — Dec. 1–31 100 000 200 000 (100 000)5P 50 Totals 11 200 000 11 000 000 200 000 +7550

In completing a worksheet in the above format, the following must be kept in mind:

• A long position at a premium = profit resulting figure is only as accurate as the rates • A short position at a premium = loss applied. As a result, examiners should test- • A long position at a discount = loss check at least one major currency using inde- • A short position at a discount = profit pendent rates (supplied by the Federal Reserve Bank of New York or another independent The $7,550 is simply the profit that would be source). This should be done concurrently with obtained if the forward book positions were the bank’s own monthly revaluation. If a size- fully liquidated at this time, i.e., purchases offset able discrepancy results, rates and revaluation by sales. To calculate the profit, the unrealized methods used by the bank should be reviewed profit from the previous month ($6,400 in this with both management and the traders. example) must be reversed. Thus, the sterling profit for this month would be: DEFINING AND CONTROLLING $4,799 Nostro balance profit FOREIGN EXCHANGE RISKS 7,550 Forward book profit (unrealized) −6,400 Reversal of last month’s forward book Foreign exchange trading encompasses a variety $5,949 Sterling profit for the month of risks. Exchange rate risk, maturity gaps and interest rate risk relate to spot and forward Most automated systems will eliminate the trading. The latter two risks relate to exposures need for manual calculations. However, the inherent in all phases of international banking.

March 1994 Commercial Bank Examination Manual Page 8 International—Foreign Exchange 7100.1

Exchange Rate Risk For management and control purposes, most banks distinguish between positions arising from Exchange rate risk is an inevitable consequence actual foreign exchange transactions (trading of trading in a world in which foreign currency exposure) and the overall foreign currency expo- values move up and down in response to shifting sure of the bank. The former includes the market supply and demand. When a bank’s positions recorded by the bank’s trading opera- dealer buys or sells a foreign currency from tions at the head office and at branches abroad. another bank or nonbank customer, exposure In addition to trading exposure, overall exposure from a net open position is created. Until the incorporates all bank assets and liabilities denom- time that the position can be covered by selling inated in foreign currencies including loans, or buying an equivalent amount of the same investments, deposits, and the capital of foreign currency, the bank is exposed to the risk that branches. Control of overall foreign currency the exchange rate might move against it. That exposure usually is the responsibility of a senior risk exists even if the dealer immediately seeks officer accountable to the bank’s senior to cover the position because, in a market in management. which exchange rates are constantly changing, a gap of just a few moments can be long enough to transform a potentially profitable transaction Maturity Gaps and Interest Rate Risk into a loss. Since exchange rate movements can readily accumulate in one direction, a position Interest rate risk arises whenever there are carried overnight or over a number of days mismatches or gaps in the maturity structure of entails greater risk than one carried a few a bank’s foreign exchange forward book. Man- minutes or hours. Again, the acid test of a good aging maturity mismatches is an exacting task trader is to know when to take a small loss for a foreign exchange trader. before it becomes larger. In practice, the problem of handling mis- At any time, the trading function of a bank matches is involved. Eliminating maturity gaps may have long positions in some currencies and on a contract-by-contract basis is impossible for short positions in others. These positions do not an active trading bank. Its foreign exchange offset each other, even though, in practice, some book may include hundreds of outstanding con- currencies do tend to move more or less toge- tracts. Some will mature each business day. ther. The bank’s traders recognize the possibility Since the book is changing continually as new that the currencies in which they have long transactions are made, the maturity gap structure positions may fall in value and currencies in also changes constantly. which they have short positions may rise. Conse- While remaining alert to unusually large quently, gross trading exposure is measured by mismatches in maturities that call for special adding the absolute value of each currency action, traders generally balance the net daily position expressed in dollars. The individual cur- payments and receipts for each currency through rency positions and the gross dealing exposure the use of rollovers. Rollovers simplify the must be controlled to avoid unacceptable risks. handling of the flow of maturing contracts and To accomplish this, management limits the reduce the number of transactions needed to open positions dealers may take in each cur- balance the book. Reliance on day-to-day swaps rency. Practices vary among banks, but, at a is a relatively sound procedure as long as minimum, limits are established on the magni- interest rate changes are gradual and the size and tude of open positions which can be carried length of maturity gaps are controlled. However, from one day to the next (overnight limits). it does leave the bank exposed to sudden changes Several banks set separate limits on open posi- in relative interest rates between the United tions dealers may take during the day. These are States and other countries, which influence mar- called ‘‘daylight’’ limits. Formal limits on gross ket quotations for swap transactions and, conse- dealing exposure also are established by some quently, the cost of bridging the maturity gaps in banks, while others review gross exposure more the foreign exchange book. informally. The various limits may be adminis- The problem of containing interest rate risk is tered flexibly, but the authority to approve a familiar to major money market banks. Their temporary departure from the norm is typically business often involves borrowing short-term reserved for a senior officer. and lending longer-term to benefit from the

Commercial Bank Examination Manual March 1994 Page 9 7100.1 International—Foreign Exchange normal tendency of interest rates to be higher for pany may perform only contracts which are longer maturities. But in foreign exchange trad- advantageous to the company and disclaim those ing, it is not just the maturity pattern of interest contracts which are disadvantageous. rates for one currency that counts. Rather, in Another and potentially more pernicious form handling maturity gaps, the differential between of credit risk stems from the time zone differ- interest rates for two currencies is decisive. So ences between the United States and foreign the problem is more complex. nations. Inevitably, a bank selling sterling, for To control interest rate risk, senior manage- instance, must pay pounds to a counterparty ment generally imposes limits on the magnitude earlier in the day than it will be credited with of mismatches in the foreign exchange book. dollars in New York. In the intervening hours, a Procedures vary, but separate limits are often set company can go into bankruptcy or a bank can on a day-to-day basis for contracts maturing be declared insolvent. Thus, the dollars may during the following week or two and for each never be credited. consecutive half-monthly period for contracts Managing credit risk is the joint responsibility maturing later. At the same time, management of the bank’s trading department and its credit relies on branch officers abroad, domestic money officers. A bank normally deals with corpora- market experts, and its Economic Research tions and banks with which it has an established Department to provide an ongoing analysis of relationship. Dealing limits are set for each interest rate trends. counterparty and are adjusted in response to changes in its financial condition. In addition, some banks set separate limits on the value of contracts that may mature on a single day with a Credit Risk particular customer. Some banks, recognizing credit risk increases as maturities lengthen, When a bank books a foreign exchange contract, restrict dealings with certain customers to spot it faces a risk, however small, that the counter- transactions or require compensating balances party will not perform according to the terms of on forward transactions. A bank’s procedures the contract. In both instances, there is a credit for evaluating credit risk and minimizing expo- risk, although, in the foreign exchange case no sure are reviewed by supervisory authorities as extension of credit is intended. To limit credit part of the regular examination process. risk, a careful evaluation of the creditworthiness of the customer is essential. Just as no bank can lend unlimited amounts to a single customer, no bank would want to trade unlimited amounts of Transfer Risk foreign exchange with one counterparty. Credit risk arises whenever a bank’s counter- At one time or another, virtually every country party is unable or unwilling to fulfill its contrac- has interfered with international transactions in tual obligations. That happens most blatantly its currency. Interference might take the form of when a corporate customer enters bankruptcy or regulation of the local exchange market, restric- a bank counterparty is declared insolvent. In any tions on foreign investment by residents, or foreign exchange transaction, each counterparty limits on inflows of investment funds from agrees to deliver a certain amount of currency to abroad. Governments take such measures for a the other on a particular date. Every contract is variety of reasons: to improve control over the immediately entered into the bank’s foreign domestic banking system, or to influence the exchange book. In balancing its trading position, pattern of receipts and payments between resi- a bank counts on that contract being carried out dents and foreigners. Restrictions on the exchange in accordance with the agreed upon terms. If the market or on international transactions generally contract is not liquidated, then the bank’s posi- are intended to affect the level or movement of tion is unbalanced and the bank is exposed to the the exchange rate. risk of changes in the exchange rates. To put Changes in regulations or restrictions usually itself in the same position it would have been in do have an important exchange market impact. if the contract had been performed, a bank must From the viewpoint of a commercial bank’s arrange for a new transaction. The new transac- foreign currency traders, most disruptive are tion may have to be arranged at an adverse changes in rules which interfere with the normal exchange rate. The trustee for a bankrupt com- payments mechanism. Traders make foreign

March 1994 Commercial Bank Examination Manual Page 10 International—Foreign Exchange 7100.1 exchange contracts on the expectation that both accounting and audit and control systems to parties will perform according to the terms of provide for proper surveillance over those limits the contract. But if government regulations and exceptions thereto. change and a counterparty is either forbidden to Limits must be established for overnight net perform as expected or is required to do some- positions in each currency. Depending on the thing extra, then a trader might be left with an size of the limits and the manner in which they unintended open position or an unintended matur- are calculated, a smaller aggregate position limit ity mismatch. As described in the previous for all currencies may be desirable. An aggre- section, dealing with unintended long or short gate limit should not permit the netting of short positions can be costly. against long positions, but should require that Other changes in official regulations do not in they be added to determine conformance to that the first instance, affect the payments mecha- limit. Many U.S. banks consider whether to nism, but they do influence international invest- establish daylight (intraday) position limits only ment transactions. Consequently, when one of if efficient computerization and input systems the factors affecting the buying or selling of a are in effect to incorporate each trade into the currency changes, the exchange rate is likely to appropriate currency position at nearly the pre- respond. Currency traders usually try to limit cise moment it is transacted. open positions and maturity gap mismatches, Gap (net inflow and outflow) limits must be whenever modifications in official regulations instituted to control the risk of adverse rate appear likely. Nevertheless, changes in controls movement and liquidity pressures for each cur- often are unpredictable; and unanticipated rency for each daily, weekly, and biweekly changes in regulations can spark significant future time frame designated in the bank’s exchange rate response. maturity reports. Such limits might range from Monitoring and responding to changing of- stated absolute amounts for each time frame to ficial exchange controls abroad has to be done weighted limits that emphasize increasing rate by a well-run foreign exchange trading func- movement exposure applicable to the relative tion. Most U.S. banks have judged that the distance into the future in which the gap simplest approach is to avoid trading in those appears. currencies for which the market is heavily Aggregate trading and placement limits must regulated. This decision is reflected in turnover be established for each customer, based pri- statistics which show that trading is marily on the amount of business considered to concentrated in the major currencies subject to be appropriate to its creditworthiness and, sec- the fewest controls; generally the euro, Cana- ondly, on the volume of its foreign currency dian dollar, British pound sterling, Swiss franc, needs. In addition, absolute sub-limits should be and Japanese yen. placed upon the amount of that customer’s business that may be settled on one day. Should the customer be unable to meet obligations on one day, the trader will: POLICY • Be forewarned against delivery prior to receipt The relative importance of each of those risk of customer funds on the remaining contracts determinants varies with each currency traded outstanding, and and with the country of each counterparty. • Have an opportunity to determine whether Senior bank management must fully understand alternate cover must be obtained to meet the risks involved in foreign exchange and third-party transactions that may initially have money market operations and must establish, in provided cover for the remaining transactions writing, its goals and policies regarding those with that customer. risks. Management must be able to defend logically the basis upon which such policies are It is difficult to monitor aggregate volume formed. It is imperative that responsible officers, limits effectively and ensure compliance with traders, clerks and auditors fully understand the settlement limits for a large number of custom- intent as well as the detail set forth in those ers. An effective settlement limit program for at directives. least those relationships that possess a greater At a minimum, policies should define dealing potential for late delivery or default should be limits and reporting requirements as well as enacted by senior management.

Commercial Bank Examination Manual April 2008 Page 11 7100.1 International—Foreign Exchange

REPORTS REVALUATION AND ACCOUNTING SYSTEMS Properly designed reports are the most impor- tant supervisory tool available to management. Revaluation and accounting systems should be They must be prepared in a concise, uniform, in place to accurately determine actual as well as and accurate manner and submitted punctually. estimated future profits and losses and to present Management should receive daily net position them in such a manner as to facilitate proper reports for each currency traded. Normally, income analysis by management, bank supervi- position reports should include all foreign cur- sory personnel, and the public. A bank’s revalu- rency balance sheet items and future contracts as ation procedure should be test-checked at the well as afterhour and holdover transactions, time of monthly revaluation using indepen- excepting fixed assets and equity investments. dently obtained rates. While methods and sys- The hedging of those investments is usually a tems may vary to some degree within banks, all management decision outside the normal respon- revaluation systems should incorporate the fol- sibility of the traders. The reports should be lowing two aspects: prepared by the foreign exchange and money market bookkeeping section and reconciled daily • Actual realized profit or loss as determined by to the trader’s blotter. In the event that formal applying current spot rates to balance sheet accounts as well as contracts of near maturi- position reports cannot be submitted at the end ties. Adjustments to the local currency book of a business day, management should be values would either be allocated and posted to apprised of the traders estimated position at the each of the applicable local currency ledger end of each day and especially before weekends accounts or, for short interim periods, be and holidays. charged to a separate foreign exchange adjust- Gap or maturity reports are essential to the ment account with an offset to the profit and proper management of a bank’s liquidity in each loss account. foreign currency and significant maturity gaps • Unrealized (estimated future) profit or loss on may affect overall liquidity. Those reports should future transactions as determined by applying show daily gaps for at least the first two weeks the appropriate forward rates to the net posi- to one month. Beyond that time, gap periods of tions shown for each future period appearing a maximum of two weeks each are preferred. in the bank’s gap or maturity reports. An Gap reports are generally accurate only for the account such as ‘‘estimated profit (loss) on day on which they are prepared. Therefore, it is foreign exchange—futures’’ should be charged essential that banks have the capability to pro- or credited for the amount of the adjustment duce detailed management reports daily. Loans, with an offset to the profit and loss account. deposits, and future contracts, as well as com- Provided that the amount of that adjustment is mitments to take or place deposits should be the difference between the existing forward reflected in the periods in which they are sched- rates and the actual contract rates, each uled for rollover or interest adjustment. In most month’s entries merely involves reversing the instances, an additional report showing those adjustment from the prior revaluation and items at final maturity is desirable in analyzing entering the new figures. the bank’s medium- and longer-term depen- dence on money market funding sources. Exception reports must be promptly gener- ated upon the creation of excesses to position SPECIALIZED TRANSACTIONS limits, gap limits, and customer trading and settlement limits. Excesses over any established Financial Swaps limits should conform to overall policy guide- lines and should receive prior approval by the A financial swap is the combination of a spot responsible supervisory officers. If prior approval purchase or sale against a forward sale or is not possible, evidence of subsequent officer purchase of one currency in exchange for concurrence or disagreement as well as any another. It is merely trading one currency (lend- corrective action should be available for audit ing) for another currency (borrowing) for that review and management records. period of time between which the spot exchange

April 2008 Commercial Bank Examination Manual Page 12 International—Foreign Exchange 7100.1 is made and the forward contract matures. The Discount or Premium × 360 × 100 = % P.A. swap is the simple identification of one transac- Spot rate × No. of days tion contracted at the spot rate with another of future contract transaction contracted at the forward rate to establish the exchange cost or profit related to .0040 × 360 × 100 the temporary movement of funds into another =2%P.A. × currency and back again. That exchange (swap) 2.4000 30 profit or cost must then be applied to the rate of interest earned on the loan or investment for This results in a true yield incentive of 1 per- which the exchange was used. For example, the cent, 3 percent less the swap cost of true yield of an investment for 90 days in United 2 percent. Kingdom Treasury bills cannot be determined Unless the bank’s accounting system can without having considered the cost or profit identify swap costs or profits and allocate them resulting from the swap needed to make pounds to the investments for which they were entered, both the earnings on those investments and the sterling available for that investment. Likewise, earnings upon which the trader’s performance the trading profits or losses generated by the are measured will be misstated. trader cannot be determined if financial swap profits and expenses are charged to the exchange function rather than being allocated to the depart- Options ment whose loans or investments the swap actually funded. Option contracts permit a bank to contract to buy from or sell to a customer when that customer can only generally predict the dates Arbitrage when the currency will be required. The option contract specifies the dates, and the rate cited is that which, in the judgment of the trader at the As it pertains to money markets and foreign time of making the contract, contains the least exchange, arbitrage may take several forms. The exposure for the bank. This type of contract is creation of an open position in a currency in commonly requested by commercial customers anticipation of a favorable future movement in who wish to cover drafts drawn under letters of the exchange rate, in addition to being specula- credit denominated in a foreign currency. Such tive, is sometimes referred to as ‘‘arbitrage in contracts involve more risk as there is no way time.’’ Buying a currency in one market and for the bank to acquire a precisely matching simultaneously selling it for a profit in another cover. market is called ‘‘arbitrage in space.’’ Slightly more involved is the practice of interest arbi- trage which involves the movement of funds Compensated Contracts from one currency to another so they may be invested at a higher yield. The real yield advan- There are occasions when both parties are agree- tage in such a situation is not determined merely able to altering the terms of an existing contract. by the difference in interest rates between the Such alterations should be approved by a bank two investment choices, but rather by subtract- officer without responsibilities in the trading ing the cost of transferring funds into the desired room and the operations personnel must be currency and back again (the swap cost) from advised of each compromise to avoid settlement the interest differential. For example, there is no in accordance with the original instructions and arbitrage incentive involved in swapping from terms. dollars into the other currency at a 60 point per month discount (swap cost) which exactly off- sets the 3 percent gain in interest. However, OTHER RELATED MATTERS should the swap rate move to 40 points per month (or 480 points per year), the investment Departmental Organization and might become attractive. This can be tested by Control converting the swap rate to an annual percentage rate: It is imperative that there be a distinct separation

Commercial Bank Examination Manual April 2008 Page 13 7100.1 International—Foreign Exchange of duties and responsibilities between the trad- ties at the head office or elects to decentralize ing and the accounting and confirmation func- that control, the policies, systems, internal con- tions within the department. Many opportunities trols, and reporting procedures should not differ exist to avoid established limits and policies or among separate offices within the bank. for personal financial gain, whether by speculat- The bank should be apprised of its worldwide ing beyond loosely controlled limits, concealing positions by daily summary reports. Detailed net contracts because of poor confirmation proce- position and maturity gap reports should be dures or by simple fraud. Periodic audits and received periodically in order to prepare consoli- examinations are no substitute for the existence dated positions, as required, and to monitor of sound safeguards. individual unit trading volume and funding methods. Supervision of Branches and Subsidiaries

Whether a bank maintains central control over all foreign-exchange and money market activi-

April 2008 Commercial Bank Examination Manual Page 14 International—Foreign Exchange Examination Objectives Effective date March 1984 Section 7100.2

1. To determine if the policies, practices, pro- 5. To determine if the revaluation and account- cedures and internal controls regarding for- ing systems are adequate and accurately eign exchange activities are adequate. reflect the results of the trading operation. 2. To determine if bank officers, traders and 6. To determine compliance with laws and clerks are operating within the established regulations. guidelines. 7. To initiate corrective action when policies, 3. To determine the extent of risk attributable to practices, procedures or internal controls are net open positions, maturity gaps and coun- deficient, or when violations of laws or terparty credit weakness. regulations have been noted. 4. To determine the scope and adequacy of the audit function.

Commercial Bank Examination Manual March 1994 Page 1 International—Foreign Exchange Examination Procedures Effective date March 1984 Section 7100.3

1. If selected for implementation, complete or monthly foreign exchange profit and loss update the foreign exchange section of the entries. Internal Control Questionnaire. 9. Check the most recent revaluation workpa- 2. Based on the evaluation of internal controls pers and resultant accounting entries to and the work performed by internal and determine that: external auditors, determine the scope of the a. Foreign currency amounts and book val- examination. ues were properly reconciled to subsidi- 3. Test for compliance with policies, practices, ary ledger controls. procedures and internal controls in conjunc- b. Rates used are representative of market tion with the remaining examination proce- rates as of revaluation date. dures. Also obtain a listing of any deficien- c. Arithmetic is correct. cies noted in the latest review done by d. Profit and loss results are separately internal/external auditors, and determine if recorded and reported to management appropriate corrections have been made. for: 4. Obtain a trial balance, including local cur- • Realized profit or loss, i.e., that which rency book values, of customer spot and is determined through the application future contract liabilities by customer and of spot rates. by maturities and: • Unrealized (estimated future) profit a. Agree or reconcile balances to appropri- and loss, i.e., that which is determined ate subsidiary controls and to the general through the application of forward ledger. rates. b. Review reconciling items for reason- e. Financial swap related assets, liabilities ableness. and future contracts are excluded from 5. Review foreign currency and appropriate the normal revaluation process so that local currency subsidiary control ledgers to the results identified in step 9d reflect determine that for each local currency entry more accurately the trader’s outright there is an accompanying foreign currency dealing performance. entry unless they represent: f. Financial swap related costs and profits a. Brokerage charges to the local currency are: ledger. • Amortized over the life of the applica- b. Profit and loss adjustments to the local ble swap. currency ledger. • Appropriately accounted for as interest c. Correction of errors in either ledger. income and expense on loans, securi- 6. Provide liability and other information on ties, etc. Test financial swap income common borrowers to the examiner as- and expense calculations and verify signed to ‘‘International—Loans and Cur- the accounting entries. rent Account Advances.’’ 10. Review workpapers for selected revalua- 7. Identify those contracts with counterparties tions performed since last examination. Test- who are affiliates of or otherwise relatead to check and, if satisfied that they are accurate, the bank, its directors, officers, employees, a. Analyze combined realized earnings to or major shareholders, and determine that profits are commensurate a. Compare the contracted rates with avail- with risks taken. able rates for the same transaction date b. Analyze monthly unrealized revaluation or with other similar contracts entered as results (forecasts) to determine that: of the same transaction date. • The resulting amount for the last b. Investigate any instances involving off- revaluation, if loss, is not large. market rates. • An increasing loss trend over previous 8. Perform an independent revaluation of at revaluations does not exist. (Although least one major currency using rates obtained month-to-month variations are not from independent sources, and compare uncommon, an increasing unrealized results to the accounting department’s loss trend could indicate that a trader is

Commercial Bank Examination Manual March 1994 Page 1 7100.3 International—Foreign Exchange: Examination Procedures

caught in a loss position and is pursu- a. Net position schedules. ing a notion that a negative trend in the b. Maturity gap schedules. exchange rate for that currency will c. Frequent or sizeable excesses over any reverse and, if combined with an ever established limits. multiplying increase in volume, might d. Any limits deemed excessive relative to: eventually be able to repay accumu- • Management’s policy goals regarding lated losses.) the nature and volume of business 11. Obtain the percentage of total contracts intended. outstanding (dollar value of purchases plus • The bank’s capital structure. sales that are with corporate customers). • The creditworthiness of trading coun- Analyze this percentage in regard to trend terparties. and comparison, if possible, to banks with • Individual currencies which are sub- similar trading volume. Ascertain if corpo- ject to or are experiencing relatively rate volume is commensurate with written sporadic rate changes. policy in regards to purpose and scope of • Individual currencies for which limited the foreign exchange trading function. spot and future markets exist. 12. Determine compliance with laws and regu- • Experience of traders. lations pertaining to foreign exchange activ- • The bank’s foreign exchange earnings ities by performing the following for For- record. eign Currency Forms FC–1, FC–1a, FC–2, and FC–2a: e. The absence of any limits deemed a. Obtain the most recently prepared monthly appropriate in present and foreseeable and weekly reports and review for accu- circumstances. racy. f. Customers whose obligations are other- b. Select random bank-prepared daily net wise previously classified or intended to position reports for Wednesdays and be criticized. month-end business days and test to see g. Foreign exchange contracts which, for that: any other reason, are questionable in • Reports are being filed as required. quality or ultimate settlement. • Reports are accurate. h. Violations of laws and regulations. Be aware of instances in which net i. Deficiencies in internal controls. positions are generally large but reduced j. Other matters regarding the efficiency as of Wednesday and month-end report- and general condition of the foreign ing dates. exchange eepartment. 13. Discuss with appropriate officers and pre- 14. Update the workpapers with any informa- pare in appropriate report format: tion that will facilitate future examinations.

March 1994 Commercial Bank Examination Manual Page 2 International—Foreign Exchange Internal Control Questionnaire Effective date March 1984 Section 7100.4

A review of the bank’s internal controls, poli- 5. Is approval by a non-trading officer required cies, practices and procedures regarding foreign for all compensated transactions? exchange trading is essential to ensure no exces- 6. Do credit approval procedures exist for sive risk or exposures exist. The bank’s systems settlement (delivery) risk either in the should be documented in a complete and con- form of settlement limits or other specific cise manner and include, where appropriate, management controls? narrative descriptions, flowcharts, copies of 7. Does a policy procedure exist to ensure forms used and other pertinent information. that, in case of an uncertain or emergency Items marked with an asterisk are particularly situation, the bank’s delivery will not be significant and require substantiation by obser- made before receipt of counterpart funds? vation or testing. 8. Do the above policies apply to all branch offices as well as majority-owned or con- trolled subsidiaries of the bank? 9. Does the bank have written policies POLICIES covering: a. Foreign exchange transactions with its 1. Has the board of directors, consistent with own employees? its responsibilities, adopted written poli- b. Foreign exchange transactions with cies governing: members of its board of directors? a. Trading limits, including: c. Its traders’ personal foreign exchange • Overall trading volume? activities? • Overnight net position limits per d. Its employees’ personal business rela- currency? tionships with foreign exchange and • Intra-day net position limits per money brokers with whom the bank currency? trades? • Aggregate net position limit for all *10. Are the above policies understood and currencies combined? uniformly interpreted by all traders as well • Maturity gap limits per currency? as accounting and auditing personnel? • Individual customer aggregate trading limits, including spot transactions? TRADING FUNCTION • Written approval of excesses to above limits? 11. Is a trader’s position sheet maintained for b. Segregation of duties among traders, each currency traded? bookkeepers and confirmation *12. Does management receive a trader’s posi- personnel? tion report at the end of each trading day? c. Accounting and revaluation procedures? *13. Does the trader’s position report reflect the d. Management reporting requirements? same day’s holdover and after-hours 2. Do policies attempt to minimize: transactions? a. Undue pressure on traders to meet spe- 14. Are trader’s dealing tickets prenumbered? cific budgeted earnings goals? a. If so, are records and controls ade- b. Undue pressure on traders, by account quate to ascertain their proper sequen- officers, to provide preferred rates to tial and authorized use? certain customers? *b. Regardless of whether or not *3. Are traders prohibited from dealing with prenumbered, customers for whom trading lines have not • Are dealing tickets time date stamped, been established? as completed, or 4. Are all personnel, except perhaps the head • Are dealing tickets otherwise iden- trader, prohibited from effecting transac- tified with the number of the result- tions via off-premises communication ant contract to provide a proper facilities? audit trail?

Commercial Bank Examination Manual March 1994 Page 1 7100.4 International—Foreign Exchange: Internal Control Questionnaire

ACCOUNTING AND REPORTING *22. Are local currency equivalent subsidiary records for foreign exchange contracts bal- *15. Is there a definite segregation of duties, anced daily to the appropriate general responsibility and authority between the ledger account(s)? trading room and the accounting and *23. Are foreign exchange record copy and reporting functions within the division customer liability ledger trial balances pre- and/or branch? pared and reconciled monthly to subsidi- 16. Are contract forms prenumbered (if so, are ary control accounts by employees who do records and controls adequate to ensure not process or record foreign exchange their proper sequential and authorized use)? transactions? 17. Are contracts signed by personnel other 24. Do the accounting and filing systems pro- than the traders? vide for easy identification of ‘‘financial *18. Are after-hours or holdover contracts swap’’ related assets, liabilities and future posted as of the dates contracted? contracts by stamping contracts or main- *19. Do accounting personnel prepare a daily taining a control register? position report, for each applicable cur- rency, from the bank’s general ledger and: a. Do reports include all accounts denom- inated in foreign currency? CONFIRMATIONS b. Are those reports reconciled daily to the 25. Is there a designated ‘‘confirmation clerk’’ trader’s position reports? within the accounting section of the divi- c. Are identified or unreconciled differ- sion or branch? ences reported immediately to manage- *a. Incoming confirmations: ment and to the head trader? • Are incoming confirmations deliv- d. Are all counterparty non-deliveries on ered directly to the confirmation expected settlements reported immedi- clerk and not to trading personnel? ately to management and to the head trader? • Are signatures on incoming confir- mations verified with signature cards *20. Are maturity gap reports prepared for for: liquidity and foreign exchange managers at least biweekly to include: — Authenticity? a. Loans and deposits reflected in the — Compliance with advised sig- appropriate forward maturity periods natory authorizations of the along with foreign exchange contracts? counterparty? b. Loans, deposits and foreign exchange • Are all data on each incoming con- contracts (specify whether reflected in firmation verified with file copies of the maturity periods in which they fall contracts to include: due or in which they are scheduled for — Name? rollover )? — Currency denomination and c. Commitments to accept or place depos- amount? its reflected in the appropriate maturity — Rate? periods by both value and maturity — Transaction date? dates? — Preparation date if different from d. All those items (specify whether as of transaction date? the day on which they mature or — Maturity date? bi-weekly or monthly maturity periods — Delivery instructions, if )? applicable? e. All those items as of the day on which • Are discrepancies directed to an offi- they mature, if necessary, i.e., in the cer apart from the trading function event of a severe liquidity situation? for resolution? *21. Does the accounting system render excesses • Is a confirmation discrepancy log or of all limits identified at step 1 immedi- other record maintained to reflect ately to appropriate management and is the identity and disposition of each officer approval required? discrepancy?

March 1994 Commercial Bank Examination Manual Page 2 International—Foreign Exchange: Internal Control Questionnaire 7100.4

• Are telex tapes retained for at least the revaluation process so that the 90 days as ready reference to rates results identified in step 26a above and delivery instructions? more accurately reflect the trader’s *b. Outgoing confirmations: outright dealing performance? • Are outgoing confirmations mailed/ c. Are financial swap costs and profits: telexed on the day during which • Amortized over the life of the appli- each trade is effected? cable swap? • Are outgoing confirmations ad- • Appropriately accounted for as inter- dressed to the attention of persons est income and expense on loans, other than trading personnel at securities, etc? counterparty locations? d. Are rates provided by, or at least • Does the accounting and/or filing verified with, sources other than the system adequately segregate and/or traders? identify booked contracts for which no incoming confirmations have been received? • Are follow-up confirmations sent by OTHER the confirmation clerk if no corre- sponding, incoming confirmation is *27. Is the bank’s system capable of adequately received within a limited number of disclosing sudden increases in trading vol- days after the contract is effected (if ume by any one trader? so, specify )? 28. Do such increases require officer review to • Is involvement by the auditing insure that the trader is not doubling vol- department required if no confirma- ume in an attempt to regain losses in his or tion is received within a limited her positions? number of days after the transmittal 29. Does the bank retain information on, and of the second request referred to authorizations for, all overdraft charges above (if so, specify )? and brokerage bills within the last 12 • Are confirmation forms sent in months? duplicate to customers who do not 30. Does an appropriate officer review a com- normally confirm? parison of brokerage charges, monthly, to • Are return copies required to be determine if an inordinate share of the signed? bank’s business is directed to or handled by one broker?

REVALUATIONS CONCLUSION *26. Are revaluations of foreign currency accounts performed at least monthly? 31. Is the foregoing information an adequate a. Does the revaluation system provide for basis for evaluating internal control in that segregation of and separate accounting there are no significant deficiencies in for: areas not covered in this questionnaire that • Realized profits and losses, i.e., those impair any controls? Explain negative which are determined through the answers briefly, and indicate any addi- application of spot rates? tional examination procedures deemed • Unrealized profits and losses, i.e., necessary. those which are determined through 32. Based on a composite evaluation, as evi- the application of forward rates? denced by answers to the foregoing b. Are financial swap related assets, liabil- questions, internal control is considered ities and future contracts excluded from (adequate/inadequate).

Commercial Bank Examination Manual March 1994 Page 3 International—Purchases, Sales, Trading, Swaps, Rentals, and Options of LDC Assets Effective date September 1992 Section 7110.1

The prospects for full LDC debt repayment Prices (and liquidity) in the LDC debt market decreased during the mid-1980s because of are influenced by a multitude of factors such as depressed commodity prices and inflated inter- the ability/intent of public and private sector est rates. The market value of public and private borrowers to service the debt, availability of sector LDC loans fell sharply below book value debt-equity exchange programs, anticipated to the point where those loans became deeply refinancing of existing debt programs and the discounted. A secondary market for trading underlying political and economic conditions in LDC debt evolved and reached a degree of the developing countries. maturity in 1987 when banks significantly Banks generally participate in this market to increased their loan loss reserves for their expo- decrease their LDC exposures; however, some sures to LDCs. Financial institutions in the banks are also motivated to: United States and overseas, including commer- cial, merchant and investment banks, began to • Generate trading profits from the spread actively purchase, sell, swap and rent debt between the bid and offer prices obligations of less developed countries for their • Produce fee and commission revenues from own account and as intermediaries for others. acting as intermediaries for principals and U.S. multinational banks with significant LDC brokers loan exposures established LDC trading units • Participate in swap programs to facilitate which initially had the primary responsibility to debt/equity market development decrease the banks’ LDC portfolios. As the secondary market matured, these units not only Pricing, liquidity, potential conflicts of inter- traded for their own accounts but became mar- est, violation of U.S. and foreign country laws and operational inefficiencies are the major prob- ket makers and/or active participants in purchas- lems faced by banks which are active market ing, selling, swapping and renting LDC debt. An participants. The lack of liquidity in the second- options market based on LDC debt also is ary market for LDC paper could present a emerging. variety of risks to market participants. In the The LDC debt market, once dismissed as absence of depth in the market, the judgement of illiquid, has evolved from a trickle of activity the trader is a significant factor in determining between 1985 through 1988, to a turnover of the current price of thinly traded issues. The approximately $100 billion during 1990. This reliance on one individual to determine prices momentum is expected to continue as partici- and using those amounts to revalue the position, pants in this market have realized the potential could result in under or overstating the profit for generating substantial profits in trading LDC and loss and the valuation of the position itself. debt. The majority of this paper is Latin Amer- A conflict of interest could result in potential ican, followed by Eastern European and African future liability if there is no clear segregation of obligations. Debt of approximately 30 countries duties and responsibilities between a bank’s in 300 instruments may be handled by an active trading in LDC assets and its role on debt participant. renegotiation committees. The LDC trading arena includes a broad Access to LDC debt rescheduling information range of counterparties. Although multinational could give a bank unfair advantage over other banks with significant LDC debt exposures are creditor banks, which do not participate in the the most active participants in the market, the restructuring process. Another concern is the number of intermediaries and principals has potential for a bank or its employees to know- grown substantially. International financial ingly or inadvertently violate U.S. or foreign institutions, corporations, high net worth country laws or aid or abet violations by its individuals and public sector entities are pri- customers or trading partners. It is clear that marily engaged in buying, selling and renting banks have a responsibility to determine that LDC debt for their own account. they deal only with reputable counterparties. The price of LDC paper, which is almost The relative newness of the market and the always at a discount from face amount, may absence of industry guidelines pose challenges vary widely, depending on the issuer and matu- to both bank managements and the bank super- rity of the instrument and the country of risk. visory agencies.

Commercial Bank Examination Manual March 1993 Page 1 International—Purchases, Sales, Trading, Swaps, Rentals, and Options of LDC Assets Examination Objectives Effective date September 1992 Section 7110.2

The objectives of conducting an examination risk management as it relates to LDC activ- of LDC asset purchases, sales, trading, ities. Evaluate the bank’s ability to monitor swaps, rentals and options should include the and control the following risks: following: a. Market risk b. Credit risk 1. To determine if LDC asset purchases, c. Settlement risk sales, trading, swaps, rental and options d. Liquidity risk policies, procedures and internal controls e. Operational risk are adequate. f. Legal risk 2. To evaluate the ability of the bank’s 12. To review and assess the adequacy of the reporting system to adequately monitor com- audit coverage with respect to the frequency pliance to established policies, procedures and scope of the audit program, experience and limits. of auditors, quality of audit reports and 3. To review the bank’s reporting system to effectiveness of management follow-up. determine whether it is adequate and Determine the extent of the outside accoun- effective. tants involvement in reviewing these 4. To ascertain, to the extent possible, whether activities. LDC trading activities are in compliance 13. To determine if sufficient legal documenta- with applicable U.S. and local foreign laws. tion exists to establish an enforceable agree- 5. To determine the extent of involvement by ment, and to ascertain the nature of and committees responsible for LDC trading purpose behind the underlying transaction. activity in strategy and planning. For exam- ple, have contingency plans been developed 14. To review the bank’s procedures for con- if the need arises to liquidate a portfolio of ducting due diligence on nonbank parties. LDC paper. 15. To determine the sufficiency of the bank’s 6. To identify potential conflicts of interest transaction files. liability between those on committees for 16. To determine if the bank allows sales, debt renegotiations or those acting as agents borrowing or substitutions from its loan for the debtor country and those on the portfolio to its trading positions. If yes, how portfolio sales personnel and LDC debt is the pricing on the loan portfolio done? traders. Does the bank have the proper accounting 7. To determine whether accounting pro- and tracking procedures in place? cedures that have been established properly 17. To review any unusual charges/fees and any identify and account for loan sales, pur- split of fees or unusual destination of a chases, swaps, rentals and other LDC trad- payment. ing activity. Compare these accounting pro- 18. To review margin lending practices and cedures to industry practices. policies of banks offering financing to cus- 8. To ascertain that outstandings and traders’ tomers dealing in LDC debt. positions are reconciled to the official 19. To review bank’s policies and procedures records of the bank. regarding traders’ ability to trade in LDC 9. To evaluate the LDC asset purchases, sales, debt for their own personal account to trading, swaps or rentals for profitability. ensure that adequate controls are in place to 10. To review the revaluation process utilized avoid conflicts of interest and diversion of in determining profitability. bank’s corporate opportunities to traders’ 11. To determine the adequacy of the bank’s personal benefit.

Commercial Bank Examination Manual March 1994 Page 1 International—Purchases, Sales, Trading, Swaps, Rentals, and Options of LDC Assets Examination Procedures Effective date September 1992 Section 7110.3

An examination of a bank’s LDC asset pur- country on financial or economic matters. chases, sales, trading, swaps, rental, and options Are the same individuals participating as program should focus on written policies, members of a debt renegotiating committee accounting, management reporting, conflict of or acting in an agency capacity for the interest, risk management, and internal controls. debtor country also involved in or commu- In addition, the examiners should address the nicating with those trading, swapping and general nature, volume and importance of these renting LDC debt? activities. a. Does the policy address all the roles that the bank performs? Has management 1. Evaluate the adequacy of the bank’s written established procedures to identify the policies regarding its LDC trading activity responsibility of renegotiating commit- and determine whether: tee members, agency personnel, port- a. The objectives, strategy and philosophy folio sales personnel and LDC debt adhere to those approved by the bank’s traders? board of directors. 4. Review the bank’s procedures to ensure that b. All documentation and legal require- it is complying with local and sovereign ments (both local and foreign) regarding laws. this activity have been addressed. a. Is the bank aware of local and foreign c. An approval process has been estab- laws governing the trading of a particular lished to execute unusual or complex country’s debt? Are there records dem- transactions in LDC paper that lacks onstrating that legal personnel are review- liquidity or has some unusual feature. ing transactions to determine compliance d. The policy stipulates the options avail- with U.S. and foreign laws? To what able if the need arises to remove the asset extent is this information disseminated to from inventory. traders? 2. Review the bank’s accounting policy for b. Is the bank assuring itself that trading LDC transactions. partners are not violating these laws or a. Review the accounting and reporting are using the bank to circumvent guidelines to assure that all aspects of compliance with applicable laws and this activity are captured on the books of regulations? the bank. 5. Evaluate management’s understanding of b. Review the subsidiary ledgers and rec- the risks associated with LDC asset pur- oncile these with the general ledger and chases, sales, trading, swaps, options and contingent accounts. rentals. Determine whether all risks have c. Reconcile the traders position sheet with been considered and assess management’s the general ledger accounts. ability to monitor and control them. The d. Review the accounting procedures gov- following risks should be considered: erning the bank borrowing LDC debt a. Market Risk—The relevant risk interval from its own portfolio and purchasing for counterparty exposure is the time or borrowing from a third party. period from trade date to final settlement e. Determine if the revaluation process is date. The exposure is a function of the conducted separately from the trading change in the price during the risk inter- process and that the resultant gains or val. Determine how the bank monitors losses are properly recorded. and controls its exposure to an increase 3. Determine whether the bank has addressed in price, if it is buying, and decrease in the ‘‘conflict of interest’’ issue sufficiently, price, if selling. so that trading activities are not being influ- b. Credit Risk—Does the bank require credit enced by other areas of the bank that may be approval from appropriate lending offi- negotiating debt restructuring activities or cers for each counterparty? Review coun- that may have provided advice to such terparty credit lines for proper approval.

Commercial Bank Examination Manual March 1994 Page 1 7110.3 International—Purchases, Sales, Trading, Swaps, Rentals, and Options of LDC Assets: Examination Procedures

Review margin lending practices as d. What types of procedures and policies related to LDC debt sales. have the bank implemented to address c. Settlement Risk—While it occurs only self-dealing in LDC debt by traders? when purchasing LDC assets, examiners e. In what manner are the traders edu- should determine how the bank protects cated about the bank’s policies and itself from this risk. procedures? d. Liquidity Risk—Have restrictions been 9. Describe the type of LDC transactions placed on dealing in LDC debt which is entered into by the bank: not actively traded? a. Does the bank engage in fronting (i.e., e. Operating Risk—Review the bank’s pol- sales of participations, etc.) transactions? icies and procedures for deficiencies. When engaging in fronting transactions, Assure that all operating groups support- does the bank conduct the proper legal ing this activity are adhering to estab- analysis regarding whether such transac- lished guidelines. tion would violate any U.S. or foreign f. Legal Risk—Has counsel reviewed laws or restructuring agreements? Does all segments of this activity from a legal the bank inquire as to the customer’s perspective? purpose for acquiring LDC debt in front- 6. Determine whether the bank’s LDC trading ing transactions? activities are subject to regular audits. b. Does the bank engage in parking trans- a. Obtain copies of all recent audits and actions through a third party or another review their findings; banking unit? Does the bank permit other b. Determine whether the audit procedures financial institutions to park debt with it? covering these activities are sufficiently 10. Evaluate the private banking unit/ comprehensive; and group’s involvement in LDC transactions: c. Determine whether management has a. How are the private banking clients taken appropriate action to resolve sig- obtained? nificant audit concerns. b. What types of LDC transactions does the 7. Evaluate the bank’s internal control policies bank enter into for its private banking and procedures with emphasis on: clients? Does the bank inquire as to a. Are traders’ lines and LDC debt limits purpose of transactions entered into for established by country, type of paper and private banking clients? customer? b. Are limits established by credit officers c. What type of scrutiny is performed to who are independent of the LDC trading assure that the bank ‘‘knows its private function? banking clients?’’ c. Determine that exceptions to established 11. Describe the types of fees which the bank limits have been properly reported and pays when engaging in LDC transactions: approved. a. What are the amounts of broker fees? 8. Evaluate the policies and procedures gov- Are these fees easily determinable? erning traders’ behavior: Are these fees in line with the industry a. What type of controls are in place with practices? regard to after hour trading? b. Does the bank have any other type of fee b. Describe the bank’s procedures for arrangements (i.e., specially negotiated recording phone conversations. Are trad- fees, partnerships, etc.)? ers permitted to override the recording c. Has the bank diversified its use of brokers devices? How long are these recordings adequately? retained? 12. Evaluate broker involvement in the LDC c. Describe the bank’s policy regarding trading activity and review the fee structure traders’ remuneration. on transactions.

March 1994 Commercial Bank Examination Manual Page 2 International—Purchases, Sales, Trading, Swaps, Rentals, and Options of LDC Assets Effective date September 1992 Section 7110.4

FIRST-DAY LETTER 10. A listing of all limits, including the bank’s overall inventory limit, country limits, Please provide the following information regard- type of paper limit, customer settlement ing your bank’s LDC asset sales, purchases, limit and trader limits. Indicate the policy swaps, options, and rental programs as of regarding the review dates of limits. A list (examination date). of any exception reports to these limits and management’s responses to exceptions. 1. A complete inventory, broken down by 11. A listing of principal counterparties and country, of all LDC paper held in the approved counterparty lines. trading account and the investment account. 12. A list of brokers used and indicate the 2. A listing of all sales/purchases of LDC approximate percentage of total business paper that identifies the assets or com- conducted with each and the fees paid to mitments sold/bought and inventory by such brokers. (a) obligor, (b) face amount, (c) maturity, 13. Copies of any standard documents used by (d) price, (e) closing date, (f) counterparty the bank in its LDC asset sales, purchases, names, and (g) the names and address of the swaps and rentals. assignor and assignee. 14. A copy of trading policies. If the bank is a Sales from the bank’s own portfolio market maker, list the type of LDC debt in should be reported separately from transac- which it makes a market. tions of the LDC trading unit. 15. A listing of all general ledger contingency 3. Listing of all rentals of and options held on and memoranda accounts, income and ex- LDC paper. pense accounts to record LDC asset sales, 4. A copy of the bank’s specific policies and swaps and renting transactions. procedures for LDC asset purchases, sales, 16. Income and expenses of LDC trading activ- swaps, options and rentals. ities for the two prior years and year-to- 5. A copy of all rules of conduct, procedures date. and policies governing LDC activities. 6. An organizational chart and the names and 17. Copies of the most recent audit reports titles of individuals designated as responsi- conducted by both the internal and external ble for LDC trading activities. auditors, including management responses 7. A listing and brief description of all man- on the bank’s LDC asset trading activities. agement information reports covering these 18. A copy of the internal and external audit activities and copies of these reports. programs and procedures used for the audits 8. Describe accounting policies and operating of these activities. procedures if the LDC trading unit bor- 19. If conducted outside of the United States, rows from the bank’s loan portfolio to any information submitted to local regula- effect delivery or borrows/lends LDC debt tory authorities regarding the LDC trading from/to third parties. function should be requested. 9. Information broken down by trading loca- 20. Copies of any legal opinions rendered on tion/profit center showing the volume of specific transactions and a list of any pend- LDC assets purchased, sold, swapped and ing litigations. rented during the two prior years, the cur- 21. A copy of the industry association’s rules rent year to date and a projection of the and regulations. volume of activity for the balance of this year and next year.

Commercial Bank Examination Manual March 1994 Page 1