International Banking Activities Section 2100.0

2100.0.1 FOREIGN OPERATIONS OF banking and financing operations, some of U.S. BANKING ORGANIZATIONS which the parent banks themselves are not per- mitted to undertake under existing laws. These U.S. banking organizations may conduct a wide corporations may act as holding companies, pro- range of overseas activities. The Federal vide international banking services, and finance Reserve has broad discretionary powers to regu- industrial and financial projects abroad, among late the foreign activities of member banks and other activities. bank holding companies (BHCs) so that, in Sections 25 and 25A of the Federal Reserve financing U.S. trade and investments abroad, Act grant Edge Act and agreement corporations these U.S. banking organizations can be com- authority to engage in international banking and petitive with institutions of the host country foreign financial transactions. The Board’s without compromising the safety and soundness Regulation K (12 CFR 211.6) also outlines the of their U.S. operations. permissible activities of Edge and agreement Some of the Federal Reserve’s responsibili- corporations in the United States. Among other ties over the international operations of member activities, these corporations may (1) make for- banks (national and state member banks) and eign investments that are broader than those BHCs include permissible for member banks, and (2) conduct a deposit and loan business in states, including • authorizing the establishment of foreign those where the parent of the Edge or agreement branches of national banks and state member corporation does not conduct such banking banks and regulating the scope of their activi- activities, provided that the business is strictly ties; related to international or foreign business. For- • chartering and regulating the activities of eign banks may own Edge Act and agreement Edge Act and agreement corporations, which corporations. These corporations are examined are specialized institutions used for interna- by the Federal Reserve annually.1 tional and foreign business; • authorizing foreign investments of member banks, Edge Act and agreement corporations, 2100.0.3 SUPERVISION OF FOREIGN and BHCs and regulating the activities of BANKING ORGANIZATIONS foreign firms acquired by such investors; and OPERATING IN THE UNITED STATES • establishing supervisory policy and practices regarding foreign lending by state member Although foreign banks have been operating in banks. the United States for more than a century, before 1978 the U.S. branches and agencies of these The Federal Reserve examines the interna- banks were not subject to supervision or regula- tional operations of state member banks, Edge tion by any federal banking agency. The Interna- Act and agreement corporations, and BHCs tional Banking Act of 1978 (IBA) created a principally at the U.S. head offices of these federal regulatory structure for the activities of organizations. When appropriate, the Federal foreign banks with U.S. branches and agencies. Reserve conducts examinations at the foreign The IBA also established a policy of “national operations of a U.S. banking organization in treatment” for foreign banks operating in the order to review the accuracy of financial and United States to promote competitive equality operational information maintained at the head between them and domestic institutions. This office as well as to test the organization’s adher- policy generally gives foreign banking organiza- ence to safe and sound banking practices and to tions operating in the United States the same evaluate its efforts to implement corrective mea- powers as U.S. banking organizations and sub- sures. Examinations abroad are conducted in jects them to the same restrictions and obliga- cooperation with the responsible host-country tions that apply to the domestic operations of supervisor. U.S. banking organizations.

2100.0.2 EDGE ACT AND 1. 12 CFR 211.13(b). See also SR letter 90-21, “Rating AGREEMENT CORPORATIONS System for International Examinations.”

Edge Act and agreement corporations are U.S. BHC Supervision Manual February 2019 financial institutions that carry out international Page 1 International Banking Activities 2100.0

The Foreign Bank Supervision Enhancement dential standards for large U.S. BHCs) to Act of 1991 (FBSEA) increased the responsibil- strengthen supervision and regulation of foreign ity and the authority of the Federal Reserve to banking organizations.4 The final rule recog- regularly examine the U.S. operations of foreign nized that the U.S. operations of foreign banking banks. Under the FBSEA, U.S. branches and organizations had become increasingly com- agencies of foreign banks must be examined plex, interconnected, and concentrated, and on-site at least once every 12 months, although established a number of enhanced prudential this period may be extended to 18 months if the standards for foreign banking organizations to branch or agency meets certain criteria.2 Super- help increase the resiliency of their operations. visory actions resulting from examinations may The requirements of the final rule will bolster be taken by the Federal Reserve alone or in the capital and liquidity positions of the U.S. conjunction with other agencies. Representative operations of foreign banking organizations and offices of these institutions are also subject to promote a level playing field among all banking examination by the Federal Reserve.3 firms operating in the United States. A foreign The Federal Reserve coordinates the supervi- banking organization with U.S. non-branch sory program for the U.S. operations of foreign assets of $50 billion or more is required banking organizations with other federal and to establish an intermediate holding company state banking agencies. Since a foreign banking over its U.S. subsidiaries, which will facilitate organization may have both federally chartered consistent supervision and regulation of the and state-chartered offices in the United States, U.S. operations of the foreign bank.5 The the Federal Reserve plays a key role in assess- foreign-owned U.S. intermediate holding com- ing the condition of the organization’s entire pany is generally subject to the same risk-based U.S. operations and the foreign banking organi- and leverage capital standards applicable to U.S. zation’s ability to support its U.S. operations. BHCs. The intermediate holding companies In 2014, the Federal Reserve Board approved are also subject to the Federal Reserve’s rules a final rule required by section 165 of the Dodd- pertaining to regular capital plans and stress Frank Act (which also requires enhanced pru- testing.

4. See 79 Fed. Reg. 17,240 (March 27, 2014) and the Federal Reserve Board’s Regulation YY (12 CFR part 252); and Dodd-Frank Act, Pub. L. No. 111-203, July 21, 2010; 124 Stat. 1376. 5. The Economic Growth, Regulatory Relief, and Con- sumer Protection Act (EGRRCPA) increases the $50 billion asset threshold in section 165 in two stages. Immediately on the date of enactment, bank holding companies with total consolidated assets of less than $100 billion were no longer subject to section 165.6. Eighteen months after the date of enactment, the threshold is raised to $250 billion. EGRRCPA also provides that the Board may apply any enhanced pruden- 2. 12 CFR 211.26(c). tial standard to bank holding companies between $100 billion 3. 12 CFR 211.26(a)2. and $250 billion in total consolidated assets. See the Board’s July 6, 2018, “Statement regarding the impact of the Eco- BHC Supervision Manual February 2019 nomic Growth, Regulatory Relief, and Consumer Protection Page 2 Act (EGRRCPA).” Formal Corrective Actions Section 2110.0

WHAT’S NEW IN THIS REVISED 4. the elements of a corrective order SECTION 5. temporary orders 6. written agreements This section has been updated for the various 7. suspensions and removals types of formal supervisory actions—corrective 8. enforcement of orders actions (i.e., cease and desist orders (including 9. civil money penalties placing limits on the activities or functions of a 10. termination of certain nonbank subsidiary BHC or institution-affiliated party), written activities or ownership agreements, suspensions (also removals and prohibitions), nonbank activity termination, vio- lations of orders and written agreements, civil- 2110.0.2 TYPES OF CORRECTIVE money penalties (revised penalty amounts), etc. ACTIONS In addition, the cease-and-desist order dis- cussion has been expanded to include what an Generally, under section 8 of the Federal order may require from a BHC or person, and it Deposit Insurance Act (FDI Act), 12 U.S.C. provides a discussion of the nature of affirma- 1818(b), the Board may use its cease and desist tive actions by a BHC or person that may need authority and other enforcement tools against to be taken to restore the BHC to a safe and (1) a BHC1, (2) a nonbank subsidiary of a BHC, sound condition. The prohibition and removal and (3) any institution-affiliated party. The term discussion has been expanded to detail what ‘‘institution-affiliated party’’ includes any direc- entities or individuals that the Board may take tor, officer, employee, controlling shareholder action against. It also discusses the prohibition (other than a BHC), or agent, and any other against any individual who has been convicted person who has filed or is required to file a of a crime involving dishonesty, breach of trust, change in control notice. It also includes any or money laundering, from serving, participat- shareholder, consultant, joint venture partner, or ing in, or owning or controlling a BHC, bank or any other person who participates in the conduct nonbank subsidiary, or any affiliate thereof with- of the affairs of a BHC or nonbank subsidiary, out the prior approval of the FDIC or in certain as well as any independent contractor, including cases, the Federal Reserve Board. The discus- attorneys, appraisers, and accountants who sion on indemnifications and payments includes knowingly or recklessly participates in any vio- a detailed discussion of the provisions of section lation of law or regulation, breach of fiduciary 18(k) of the FDI Act and the FDIC’s regulation duty, or unsafe or unsound practice that causes on indemnification agreements and payments. (or is likely to cause) more than a minimal The definition of a prohibited indemnification financial loss to, or a significant adverse effect payment is included. on, an institution.2 The Board’s jurisdiction over an institution-affiliated party extends for up to six years after the party’s resignation, termina- 2110.0.1 STATUTORY TOOLS FOR tion of employment, or separation caused by the FORMAL SUPERVISORY ACTION closing of a financial institution, provided that any notice (such as a notice of intent to remove Statutory tools are available to the Federal from office and of prohibition) is served on the Reserve Board if formal supervisory action is party before the end of a six-year period. warranted against a bank holding company (BHC) or nonbank subsidiaries, or against cer- tain individuals associated with them. The objective of formal actions is to correct prac- tices that the regulators believe to be unlawful, 1. The Board’s authority under 12 U.S.C. 1818 also extends unsafe, or unsound. The initial consideration to savings and loan holding companies, their nonbank subsid- and determination of whether formal action is iaries, and their institution-affiliated parties. required usually results from an inspection. This 2. The Board is authorized to issue regulations further section discusses the following topics: defining which individuals should be considered institution- affiliated parties. Similarly, the Board may determine whether an individual is an institution-affiliated party on a case-by- 1. Board jurisdiction under the law case basis (see 12 U.S.C. 1813(u)). 2. actions or practices that may trigger the statutory remedies BHC Supervision Manual January 2013 3. Board staff procedures Page 1 Formal Corrective Actions 2110.0

2110.0.2.1 Cease and Desist Orders notice of charges and of hearing to the entity or party. The notice of charges contains a detailed Generally, under 12 U.S.C. 1818(b), the Board statement describing the facts constituting the may use its cease and desist authority against a alleged violations or unsafe or unsound prac- BHC and any institution-affiliated party when it tices. The issuance of the notice of charges and finds that the entity or party is engaging, has of hearing3 starts a formal process that includes engaged, or is about to engage in (1) a violation the convening of a public administrative hearing of law, rule, or regulation; (2) a violation of a to be conducted before an administrative law condition imposed in writing by the Board in judge, appointed by the Board. After the hear- connection with the granting of any application ing, the judge makes a recommended decision or any written agreement; or (3) an unsafe or to the Board. A hearing must be held within 30 unsound practice in conducting the business of to 60 days of service of the notice of charges, the institution. Section 12 U.S.C. 1818(b)(3) unless a later date is set by the administrative makes clear that the cease and desist authority law judge. After the Board considers the record applies to BHCs and Edge and agreement corpo- of the proceeding, including the administrative rations, as well as to all institution-affiliated law judge’s recommended decision, it deter- parties associated with them. mines whether to issue a final cease and desist A cease and desist order may require the order. BHCs and individuals who are subject to BHC or person subject to the order to (1) cease cease and desist orders that were issued as a and desist from the practices or violations or result of contested proceedings may appeal the (2) take affirmative action to correct the viola- Board’s issuance of the order to the appropriate tions or practices. Affirmative actions include federal court of appeals. actions necessary to restore the BHC to a safe and sound condition, such as measures to improve the BHC’s consolidated capital, 2110.0.2.2 Temporary Cease and Desist restricting dividends and new debt to conserve Orders the BHC’s assets so it can serve as a source of strength to the bank; employ qualified officers If a violation or threatened violation of law, or employees; and any other action the Board rule, or regulation, or if engaging in an unsafe or determines to be appropriate. An individual may unsound practice that is specified in the notice be required to reimburse the company for unau- of charges is likely to cause the insolvency of a thorized or improper payments received, or BHC or its subsidiary bank, weaken the condi- both. tion of the BHC, cause a significant dissipation Most cease and desist orders are issued by in earnings, or otherwise seriously prejudice the consent. When Board staff, in conjunction with interests of subsidiary bank’s depositors before the appropriate Reserve Bank, determines that a the completion of the proceedings (initiated by cease and desist action is necessary, the BHC or the issuance of the notice of charges), the Board party is permitted an opportunity to consent to may, in conjunction with issuing a notice of the issuance of the order without the need for charges, issue a temporary cease and desist the issuance of a notice of charges and a con- order against the BHC or an institution-affiliated tested administrative hearing. Board staff drafts party to effect immediate correction (pursuant to the proposed cease and desist order and, with 12 U.S.C. 1818(c)). Reserve Bank staff, presents it to the BHC or The Board may also issue a temporary order individual for consent. BHCs and individuals if it determines that a BHC’s or nonbank subsid- are advised that they may have legal counsel iary’s books and records are so incomplete or present at all meetings with Board or Reserve inaccurate that the Board is unable to determine, Bank staff concerning formal supervisory through the normal supervisory process, the actions. If the parties voluntarily agree to settle BHC’s or nonbank subsidiary’s financial condi- the case by the issuance of a consent cease and tion or the details or purpose of any transaction desist order, the proposed consent order will be that may have a material effect on the BHC’s presented to senior Board officials for approval, condition. The temporary order may require the at which time the order will be final and bind- BHC or nonbank subsidiary to take the same ing. corrective actions as a cease and desist order. When a BHC or person fails to consent to a The advantage of issuing a temporary cease and cease and desist order, the Board may issue a 3. A private hearing may be held if the Board determines BHC Supervision Manual January 2013 that holding a public hearing would be contrary to the public Page 2 interest. Formal Corrective Actions 2110.0 desist order is that it is effective immediately violation or practice; and after it is served on the BHC or individual. 3. such violation, practice, or breach— Within 10 days after being served with a tempo- a. involves personal dishonesty; or rary order, however, the BHC or individual may b. demonstrates a willful or continuing disre- appeal to a U.S. district court for relief from the gard for the safety or soundness of the order. Unless set aside by the district court, the institution. temporary order stays in effect until the Board issues a final cease and desist order or dismisses The statute also authorizes the Board to initi- the action. ate removal or prohibition actions against (1) any institution-affiliated party who has com- mitted a violation of any provision of the Bank 2110.0.2.3 Written Agreements Secrecy Act that was not inadvertent or uninten- tional, (2) any officer or director who has knowl- When circumstances warrant, a written agree- edge that an institution-affiliated party has vio- ment may be used. The provisions of a written lated the money-laundering statutes and did not agreement may relate to any of the problems take appropriate action to stop or prevent the found at the institution or involving institution- reoccurrence of such a violation, or (3) any affiliated parties. Written agreements are drafted officer or director who violates the prohibitions by Board staff, in consultation with Reserve on management interlocks. The removal or pro- Bank staff, and must be approved by the Board’s hibition actions for these violations do not Director of the Division of Banking Supervision require a finding of gain to the individual, loss and Regulation. After approval by the General to the institution, personal dishonesty, or willful Counsel before issuance, the Reserve Bank may or continuing disregard for the safety or sound- enter into the Written Agreement under del- ness of the institution.4 egated authority (12 C.F.R. 265.11(a)(15)). Like a cease and desist order, a removal or prohibition order may be issued either by con- sent or after an administrative process initiated 2110.0.2.4 Prohibition and Removal by the issuance of a notice of intent to remove Authority and prohibit. If an institution-affiliated party’s actions warrant immediate removal from the The Board is authorized by 12 U.S.C. 1818(e) to BHC, the Board is authorized to suspend the remove any current institution-affiliated party of person temporarily from the BHC pending the a BHC and its nonbank subsidiaries for certain outcome of the complete administrative process. violations and misconduct and to prohibit per- An institution-affiliated party currently associ- manently from the banking industry any current ated with a BHC may also be suspended or or former institution-affiliated party from future removed for cause based on actions taken while involvement with any insured depository institu- formerly associated with a different insured tion, bank or thrift holding company, and non- depository institution, BHC, or business institu- bank subsidiary. The Board is authorized to tion. ‘‘Business institution’’ is not specifically initiate removal or prohibition actions when defined in the statute so that it may be inter- preted to include any other business interests of 1. the institution-affiliated party has directly or the institution-affiliated party. indirectly— Under 12 U.S.C. 1818(g), the Board is autho- a. violated any law, regulation, cease and rized to suspend from office or prohibit from desist order, condition imposed in writing, further participation any institution-affiliated or any written agreement; party charged or indicted for the commission of b. engaged in any unsafe or unsound prac- a crime involving personal dishonesty or breach tice; or of trust that is punishable by imprisonment for a c. breached a fiduciary duty; and term exceeding one year under state or federal 2. the Board determines that, because of the law, if the continued participation might violation, unsafe or unsound practice, or threaten either the interests of depositors or pub- breach— lic confidence in the institution. The Board may a. the institution has suffered or will suffer also suspend or prohibit any individual charged financial loss or other damage; b. the interests of depositors have been or 4. See 12 U.S.C. 1818(e)(2). could be prejudiced; or c. the institution-affiliated party has received BHC Supervision Manual January 2013 financial gain or other benefit from the Page 3 Formal Corrective Actions 2110.0 with a violation of the money-laundering stat- 2110.0.2.6 Violations of Final Orders and utes. The suspension can remain in effect until Written Agreements the criminal action is disposed of or until the suspension is terminated by the Board. The When any final order or temporary cease and Board may also initiate a removal or prohibition desist order has been violated, the Board may action against an institution-affiliated party who apply to a U.S. district court for enforcement of has been convicted of, or pleaded to, a crime the action. Violations of final orders and written involving personal dishonesty or breach of trust agreements may also give rise to the assessment if his or her continued service would threaten of civil money penalties against the offending the interests of the depositor or impair public BHC or institution-affiliated parties, as circum- confidence in the institution. The Board is stances warrant. The civil money penalty is required to issue such an order against any assessed in the same manner as described in the institution-affiliated party who has been con- ‘‘Civil Money Penalties’’ section below. Any victed of, or pleaded to, a violation of the institution-affiliated party who violates a suspen- money-laundering statutes. sion or removal order is subject to a criminal Furthermore, 12 U.S.C. 1829 prohibits any fine of up to $1 million, imprisonment for up to individual who has been convicted of a crime five years, or both. involving dishonesty, breach of trust, or money laundering from (1) serving as an institution- affiliated party of, (2) directly or indirectly par- 2110.0.2.7 Civil Money Penalties ticipating in the affairs of, and (3) owning or controlling, directly or indirectly, an insured The Board may assess civil money penalties of depository institution without the FDIC’s prior up to $7,500 per day against any institution or approval. The statute also prohibits a convicted institution-affiliated party for a violation of person from holding a position at a BHC or (1) law or regulation; (2) a final cease-and- nonbank affiliate without the Board of Gover- desist, temporary cease and desist, suspension, nors of the Federal Reserve System’s prior removal, or prohibition order; (3) a condition approval. The penalty for violation of this law is imposed in writing by the Board in connection a potential fine for a knowing violation of up to with the granting of an application or other $1 million per day, imprisonment for up to five request; and (4) a written agreement. years, or both. The criminal penalty applies to A fine of up to $37,500 per day can be both the individual and the employing institu- assessed for a violation, an unsafe or unsound tion. practice recklessly engaged in, or a breach of fiduciary duty when the violation, practice, or breach is part of a pattern of misconduct, causes 2110.0.2.5 Termination of Nonbank or is likely to cause more than a minimal loss, or Activity results in pecuniary gain or other benefit for the offender. A civil money penalty of up to $1.375 The Board is authorized by 12 U.S.C. 1844(e) to million per day can be assessed for any knowing order a BHC to terminate certain activities of its violation, unsafe or unsound practice, or breach nonbank subsidiary (other than a nonbank sub- of any fiduciary duty when the offender know- sidiary of a bank) or to sell its shares of the ingly or recklessly caused a substantial loss to nonbank subsidiary. When the Board has rea- the financial institution or received substantial sonable cause to believe that the BHC’s continu- pecuniary gain or other benefit. Civil money ation of any activity or ownership or control of penalties may also be assessed, under the three- any of its nonbank subsidiaries constitutes a tier penalty framework described above, for any serious risk to the financial safety, soundness, or violation of the Change in Bank Control Act stability of the BHC, and if the activity, owner- and for violations of the anti-tying provisions of ship, or control is inconsistent with sound bank- federal banking law, among other provisions ing principles or inconsistent with the purposes (12 U.S.C. 1972). of the Bank Holding Company Act (BHC Act) The Board may also assess civil money penal- or the Financial Institutions Supervisory Act of ties for the submission of any late, false, or 1966, the Board may order the BHC to termi- misleading reports required by the BHC Act and nate the activity or sell control of the nonbank Regulation Y of the Board. If a BHC maintains subsidiary. procedures that are reasonably adapted to avoid inadvertent errors and unintentionally fails to BHC Supervision Manual January 2013 publish any report, submits any false or mislead- Page 4 ing report or information, or is minimally late Formal Corrective Actions 2110.0 with the report, it can be assessed a fine of up to in connection with any supervisory matter be $2,200 per day. The financial institution has the accurate and free of insupportable conclusions burden of proving that the error was inadvertent or opinions. under these circumstances. If the error was not inadvertent, a penalty of up to $32,000 per day can be assessed for all false or misleading 2110.0.2.8.3 Subpoena Power reports or information submitted to the Board. If the submission was done in a knowing manner Under 12 U.S.C. 1818(n), which is made appli- or with reckless disregard for the law, a fine of cable to BHCs by 12 U.S.C. 1818(b)(3) and up to $1.375 million or 1 percent of the BHC’s 1844(f), the Board has the authority to issue assets can be assessed for each day of the viola- subpoenas directly or through its delegated rep- tion. Notwithstanding the above, violations of resentatives, and it has the authority to adminis- the BHC Act (with the exception of late, false, ter oaths or take depositions in connection with or inaccurate report violations as described an examination or inspection. above) may be addressed by the assessment of civil money penalties of not more than $25,000 per day. 2110.0.3 INDEMNIFICATION PAYMENTS AND GOLDEN PARACHUTE PAYMENTS 2110.0.2.8 Administration of Formal Actions In general, an indemnification payment is a pay- ment that reimburses an insider for a specified 2110.0.2.8.1 Publication of Final Orders liability or cost that the person incurred in con- nection with a Federal Reserve investigation or Under 12 U.S.C. 1818(u), the Board is required enforcement action. Golden parachute payments to publish and make publicly available any final are severance payments or agreements to make order issued for any administrative enforcement severance payments that are paid or entered into proceeding it initiates. These orders include at a time when the BHC or its subsidiary bank is cease and desist, removal, prohibition, and civil in a troubled condition. These payments require money penalty assessments. The Board is also the prior written approval of the institution’s required to publish and make publicly available federal primary regulator and the concurrence of any written agreement or other written state- the FDIC. Although both types of payments fall ment that it may enforce, unless the Board deter- under the same statute, section 18(k) of the FDI mines that publication of the order or agreement Act (12 U.S.C. 1828(k)) and the FDIC’s accom- would be contrary to the public interest. panying regulations,5 the two types of payments are quite different and distinct. However, some of the restrictions on these payments are the 2110.0.2.8.2 Public Hearings same or similar.

Under 12 U.S.C. 1818(u), all formal hearings, including contested cease and desist, removal, 2110.0.3.1 Indemnification Agreements and civil money penalty proceedings, are open and Payments to the public unless the Board determines that a public hearing would be contrary to the public BHCs may seek to indemnify their officers, interest. Transcripts of all testimony; copies of directors, and employees from any judgments, all documents submitted as evidence in the hear- fines, claims, or settlements, whether civil, ing, which could include examination and criminal, or administrative. The bylaws of some inspection reports and supporting documents BHCs may have broadly worded indemnifica- (except those filed under seal); and all other tion provisions, or the BHC may have entered documents, such as the notice and the adminis- into separate indemnification agreements that trative law judge’s recommended decision, are cover the ongoing activities of its own available to the public. These documents could institution-affiliated parties. Such indemnifica- include examiner’s workpapers, file memoran- dums, reports of examination and inspection, 5. See the FDIC’s golden parachute regulations in 12 and correspondence between a problem institu- C.F.R. 359. tion or wrongdoer and the Federal Reserve Bank. Appropriate actions should always be BHC Supervision Manual January 2013 taken to ensure that all written material prepared Page 5 Formal Corrective Actions 2110.0 tion provisions may be inconsistent with federal safety-and-soundness perspective, a BHC banking law and regulations, as well as with should not divert its assets to pay a fine or other safe and sound banking practices. final judgment issued against an institution- Supervisory and examiner staff should be affiliated party for misconduct that presumably alert to the limitations and prohibitions on violates the BHC’s policy of compliance with indemnification imposed by section 18(k) of the applicable law, especially when the individual’s FDI Act6 and the regulations issued thereunder misconduct has already harmed the BHC. by the FDIC. The law and regulations apply to BHCs should review their bylaws and any indemnification agreements and payments made outstanding indemnification agreements, as well by a BHC to any institution-affiliated party, as insurance policies, to ensure that they con- regardless of the condition of the BHC. The form with the requirements of federal law and purpose of the law and regulations is to preserve regulations. If a BHC fails to take appropriate the deterrent effects of administrative enforce- action to bring its indemnification provisions ment actions (by ensuring that individuals sub- into compliance with federal laws and regula- ject to final enforcement actions bear the costs tions, appropriate follow-up supervisory action of any judgments, fines, and associated legal may be taken. As part of the supervisory pro- expenses) and to safeguard the assets of finan- cess, which will include merger and acquisition cial institutions. applications, the Federal Reserve’s supervisory A prohibited indemnification payment and examiner staff will review identified agree- includes any payment (or agreement to make a ments having indemnification-related issues for payment) by a BHC to an institution-affiliated compliance with federal laws and regulations. party to pay or reimburse such person for any (See SR-02-17.) liability or legal expense incurred in any Board administrative proceeding that results in a final order or settlement in which the institution- 2110.0.3.2 Golden Parachute Payments affiliated party is assessed a civil money penalty, is removed or prohibited from banking, or is The FDIC’s golden parachute regulations apply required to cease an action or take any affirma- to a BHC or its insured depository institution tive action, including making restitution, with subsidiary that is in a troubled condition as respect to the BHC.7 defined in Regulation Y. The purposes of the The FDIC’s regulations provide criteria for law and regulations are to safeguard the assets making permissible indemnification payments. of financial institutions and limit rewards to A BHC may make or agree to make a reason- institution-affiliated parties who contributed to able indemnification payment if all of the fol- the institution’s troubled condition. lowing conditions are met: (i) the institution’s In general, the FDIC’s regulations prohibit board of directors determines in writing that the BHCs and their insured depository institution institution-affiliated party acted in good faith subsidiaries from making golden parachute pay- and the best interests of the institution; (ii) the ments except in certain circumstances. A golden board of directors determines that the payment parachute payment means any payment in the will not materially affect the institution’s safety nature of compensation (or agreement to make and soundness; (iii) the payment does not fall such payment) for the benefit of any current or within the definition of a prohibited indemnifi- former institution-affiliated party of a BHC or cation payment; and (iv) the institution-affiliated its insured depository institution subsidiary that party agrees in writing to reimburse the institu- meets three criteria. First, the payment or agree- tion, to the extent not covered by permissible ment must be contingent on the termination of insurance, for payments made in the event that the institution-affiliated party’s employment or the institution-affiliated party does not prevail. association. Second, the agreement is made or The law and the FDIC’s regulations reinforce the payment received on or after, or made in the Federal Reserve’s long-standing policy that contemplation of, among other things, a deter- an institution-affiliated party who engages in mination that the BHC or its insured depository misconduct should not be insulated from the institution subsidiary is in a troubled condition consequences of his or her misconduct. From a under the regulations of the applicable banking agency.8 Third, the agreement is made or the

6. See 12 U.S.C. 1828(k). 7. See 12 C.F.R. 359. 8. See section 225.71 of Regulation Y (12 C.F.R. 225.71), which defines a ‘‘troubled condition’’ for a state member bank BHC Supervision Manual January 2013 or BHC as an institution that (1) has a composite rating of 4 or Page 6 5; (2) is subject to a cease and desist order or formal written Formal Corrective Actions 2110.0 payment is payable to an institution-affiliated the proposed payments and demonstrate that the party when a BHC or its insured depository BHC or state member bank does not possess institution subsidiary meets certain specific con- and is not aware of any evidence that there is ditions, including being subject to a determina- reasonable basis to believe, at the time the pay- tion that it is in a troubled condition. ment is proposed to be made, that (1) the The definition of a golden parachute payment institution-affiliated party receiving such a pay- also covers a payment made by a BHC that is ment has committed any fraud, breach of fidu- not in a troubled condition to an institution- ciary duty, or insider abuse or has materially affiliated party of an insured depository institu- violated any applicable banking law or regula- tion subsidiary that is in a troubled condition, if tion that had or is likely to have a material the other criteria in the definition are met. This adverse effect on the BHC or state member circumstance may arise when a BHC, as part of bank; (2) the individual is substantially respon- an agreement to acquire a troubled bank or sible for the institution’s insolvency or troubled savings association, proposes to make payments condition; and (3) the individual has violated to the troubled institution’s institution-affiliated specified banking or criminal laws. parties that are conditioned on their termination Requests regarding golden parachute pay- of employment.9 ments or agreements should be forwarded by A BHC or state member bank may make or the Reserve Bank to appropriate Board staff for enter into an agreement to make a golden para- a final determination on the permissibility of the chute payment only (1) if the Federal Reserve, payment. Golden parachute payments or agree- with the written concurrence of the FDIC, deter- ments must be approved by the Board’s Direc- mines that the payment or agreement is permis- tor of the Division of Banking Supervision and sible; (2) as part of an agreement to hire compe- Regulation and the General Counsel. Denials tent management in certain conditions, with the are not delegated by the Board of Governors to consent of the Federal Reserve and the FDIC as Board or Reserve Bank staffs. to the amount and terms of the proposed pay- If a state member bank or BHC makes or ment; or (3) pursuant to an agreement to provide enters into an agreement to make a golden para- a reasonable severance not to exceed 12 months’ chute payment without prior regulatory approval salary in the event of an unassisted change in when such approval is required, appropriate control of the depository institution, with the follow-up supervisory action should be taken. consent of the Federal Reserve. In determining This follow-up could include an enforcement the permissibility of the payment, the Federal action requiring the offending institution- Reserve may consider a variety of factors, affiliated party to reimburse the institution for including the individual’s degree of managerial the amount of the prohibited payment. When a responsibilities and length of service, the rea- BHC or state member bank is identified as hav- sonableness of the payment, and any other fac- ing golden parachute-related issues in the super- tors or circumstances that would indicate that visory process, those issues should be carefully the proposed payment would be contrary to the reviewed for compliance with the law and the purposes of the statute or regulations. FDIC’s regulations. The appropriate Reserve A BHC or state member bank requesting Bank supervisory staff and the appropriate staff approval to make a golden parachute payment of the Board’s Division of Banking Supervision or enter into an agreement to make such a and Regulation and Legal Division should be payment should submit its request simultane- notified and consulted on the golden parachute- ously to the appropriate FDIC regional office related issues. and the Reserve Bank. The request must detail agreement that requires action to improve the institution’s 2110.0.4 DISCIPLINARY ACTIONS financial condition, unless otherwise informed in writing by AGAINST ACCOUNTANTS AND the Federal Reserve; or (3) is informed in writing by the ACCOUNTING FIRMS PERFORMING Federal Reserve that it is in a troubled condition. CERTAIN AUDIT SERVICES 9. The FDIC’s regulations exclude from the definition of a golden parachute payment several types of payments, such as payments made pursuant to a qualified pension or retirement Section 36 of the FDI Act authorizes the federal plan; a benefit plan or bona fide deferred compensation plan bank regulatory agencies to take disciplinary (which are further defined in the FDIC’s regulations); or a actions against independent public accountants severance plan that provides benefits to all eligible employ- and accounting firms that perform audit services ees, does not exceed the base compensation paid over the preceding 12 months, and otherwise meets the regulatory definition of nondiscriminatory and other conditions in the BHC Supervision Manual January 2013 FDIC’s regulations. Page 7 Formal Corrective Actions 2110.0 covered by the act’s provisions. Section 36, as 2110.0.5 APPOINTMENT OF implemented by part 363 of the FDIC’s rules DIRECTORS AND SENIOR (12 C.F.R. 363), requires that each federally EXECUTIVE OFFICERS insured depository institution with total assets of $500 million or more obtain an audit of its Under section 32 of the FDI Act (12 U.S.C. financial statements and an attestation on man- 1831i) and subpart H of Regulation Y (12 C.F.R. agement’s assertions concerning internal con- 225.71 et seq.), any BHC or state member bank trols over financial reporting performed by an that is in troubled condition, or does not meet independent public accountant (the accountant). minimum capital standards, must provide 30 The insured depository institution must include days’ written notice to the Board before appoint- the accountant’s audit and attestation reports in ing any new director or senior executive offi- its annual report. cer,11 or changing the responsibilities of any The audit requirement can be fulfilled by an senior executive officer so that the officer would independent audit of a BHC where the insured assume a different senior officer position. Sub- subsidiary bank (1) has total assets of less than part H of Regulation Y sets forth the procedures $5 billion or (2) has total assets of $5 billion or for filing and the content of the notice. If a BHC more and has a composite CAMELS rating of 1 or state member bank that is in a troubled condi- or 2. tion appoints a director or senior officer without Section 36 and the rules enacted pursuant the required 30 days’ prior written notice, appro- thereto set forth the practices and procedures to priate follow-up supervisory action should be remove, suspend, or debar, for good cause,10 an taken. accountant or firm from performing audit and The Board may disapprove a notice if it finds attestation services for an insured state member that the competence, experience, character, or bank, or BHC that obtains audit services for an integrity of the proposed individual indicates insured subsidiary bank. Immediate suspensions that his or her service would not be in the best are permitted in limited circumstances. Also, an interest of the institution’s depositors or the accountant or accounting firm is prohibited from public. A disapproved individual or the institu- performing audit services for the covered insti- tion that filed the notice may appeal the Federal tution if an authorized agency has taken such a Reserve’s notice of disapproval under the proce- disciplinary action against the accountant or dures set forth in Regulation Y. While the appeal firm, or if the U.S. Securities and Exchange is pending, the individual may not serve as a Commission or the Public Company Account- director or senior executive officer of a BHC or ing Oversight Board has taken certain disciplin- a state member bank. ary action against the accountant or firm.

10. The rules provide that certain violations of law, negli- gent conduct, reckless violations of professional standards, or lack of qualifications to perform auditing services may be 11. The Board or Reserve Bank, under extraordinary cir- considered good cause. cumstances, may permit an individual to serve as a director or senior executive officer before a notice is provided; however, BHC Supervision Manual January 2013 this permission does not affect the Federal Reserve’s authority Page 8 to disapprove a notice within 30 days of its filing. Foreign Corrupt Practices Act and Federal Election Campaign Act Section 2120.0

2120.0.1 INTRODUCTION 2120.0.3 BANKS AND THE FECA

On January 17, 1978, the three federal bank National banks and other federally chartered supervisory agencies issued a joint policy state- corporations are specifically prohibited from ment to address their concern with regard to the making contributions or expenditures in connec- potential for improper payments by banks and tion with any election; other corporations, in- bank holding companies in violation of the For- cluding banks and bank holding companies, may eign Corrupt Practices Act and the Federal Elec- not make contributions or expenditures in con- tion Campaign Act. nection with federal elections. However, corpo- While not widespread, the federal bank super- rations may establish and solicit contributions visory agencies were concerned that such prac- to ‘‘separate segregated funds’’ to be used for tices could reflect adversely on the banking sys- political purposes; these are discussed in greater tem and constitute unsafe and unsound banking detail below. practices in addition to their possible illegality. State member banks and bank holding com- The potential devices for making political panies may make contributions or expenditures payments in violation of the law could include that are consistent with state and local law in compensatory bonuses to employees, designated connection with state or local elections. Because expense accounts, fees or salaries paid to offi- many states have laws that prohibit or limit cers, and preferential interest rate loans. In addi- political contributions or expenditures by banks, tion, political contributions could be made by familiarization with applicable state and local providing equipment and services without laws is a necessity. According to the joint policy charge to candidates for office. Refer to F.R.R.S. statement of the three banking agencies, a polit- at 3–447.1 and 4–875. ical contribution must meet not only the require- ment of legality but also the standards of safety and soundness. Thus, a contribution or expendi- 2120.0.2 SUMMARY OF THE ture, among other things, must be recorded FEDERAL ELECTION CAMPAIGN properly on the bank’s books, may not be exces- ACT sive relative to the bank’s size and condition, and may not involve self-dealing. The Federal Election Campaign Act (FECA), Banks may make loans to political candidates enacted in 1971, was designed to curb potential provided the loans satisfy the requirements set abuses in the area of federal election financing. out below. In general, FECA regulates the making of cam- paign contributions and expenditures in connec- tion with primary and general elections to fed- 2120.0.4 CONTRIBUTIONS AND eral offices. Since 1907, federal law has EXPENDITURES prohibited national banks from making contribu- tions in connection with political elections. The words ‘‘contribution’’ and ‘‘expenditure’’ FECA does not specifically address the making are defined broadly by FECA and the Commis- of contributions and expenditures by banks or sion’s regulations to include any loan, advance, other corporations to advocate positions on deposit, purchase, payment, distribution, sub- issues that are the subjects of public referenda. scription or gift of money or anything of value As originally enacted, FECA required disclo- which is made for the purpose of influencing the sure of contributions received or expenditures nomination or election of any person to federal made; however, amendments to the law in 1974 office. The payment by a third party of compen- and 1976 imposed additional limitations on con- sation for personal services rendered without tributions and expenditures as well. The 1974 charge to a candidate or political committee is amendments also established the Federal Elec- also treated as a contribution by FECA, al- tion Commission (Commission) to administer though the term does not include the value of FECA’s provisions. The Commission is respon- personal services provided by an individual sible for adopting rules to carry out FECA, for without compensation on a volunteer basis. rendering advisory opinions, and for enforcing Although loans are included in the definitions the Act. The Commission was reorganized as a of contribution and expenditure under FECA, a result of the FECA Amendments of 1976, and it has issued regulations interpreting the statute BHC Supervision Manual December 1992 (11 C.F.R.). Page 1 Foreign Corrupt Practices Act and Federal Election Campaign Act 2120.0 specific exemption is provided for bank loans In practice, most corporate segregated funds made in the ordinary course of business and in are administered by a group of corporate person- accordance with applicable banking laws and nel, which, if the fund receives any contribu- regulations. The Commission’s regulations pro- tions or makes any expenditures during a calen- vide, further, that in order for extensions of dar year, constitutes a ‘‘political committee,’’ as credit to a candidate, political committee or defined by FECA. As such, it is required to file a other person in connection with a federal elec- statement of organization with the Commission, tion to be treated as a loan and not a contribu- to keep detailed records of contributions and tion, they must be on terms substantially similar expenditures, and to file with the Commission to those made to non-political debtors and be reports identifying contributions in excess of similar in risk and amount. The regulations also $200 and candidates who are recipients of con- provide that a debt may be forgiven only if the tributions from the fund. creditor has treated it in a commercially reason- Solicitation of contributions to corporate seg- able manner, including making efforts to collect regated funds by political committees must be the debt which are similar to the efforts it would accomplished within the precise limits estab- make with a non-political debtor. In considering lished by FECA. All solicitations directed to whether a particular transaction is a contribution corporate employees must satisfy the following or a loan, it is expected that a factor would be requirements: (1) the contribution must be en- the extent to which the creditor may have de- tirely voluntary; (2) the employee must be in- parted from its customary credit risk analysis. formed of the political purposes of the fund at FECA and the implementing regulation per- the time of the solicitation; and (3) the em- mit certain limited payments to candidates or ployee must be informed of his right to refuse to their political committees. For example, pay- contribute without reprisal. Beyond those basic ment of compensation to a regular employee requirements, FECA distinguishes between ‘‘ex- who is providing a candidate or political com- ecutive and administrative’’ personnel and other mittee with legal or accounting services which employees. The former and their families may are solely for the purpose of compliance with be solicited any number of times, while the the provisions of the FECA is exempt from the latter and their families may only be solicited definitions of contribution and expenditure. The through a maximum of two written solicitations Commission’s regulations also permit occa- per year, and these solicitations must be ad- sional use of a corporation’s facilities by its dressed to the employees at their homes. Solici- shareholders and employees for volunteer polit- tations may also be directed to corporate stock- ical activity; however, reimbursement to the cor- holders and their families in the same manner as poration is required for the normal rental charge to executive and administrative personnel. for anything more than occasional or incidental Although a corporation, or a corporation and use. its subsidiaries, may form several political com- mittees, for purposes of determining the statu- tory limitations on contributions and expendi- 2120.0.5 SEPARATE SEGREGATED tures, all committees established by a FUNDS AND POLITICAL corporation and its subsidiaries are treated as COMMITTEES one. Thus, the total amount which all political committees of a corporation and its subsidiaries FECA allows the establishment and administra- may make to a single candidate is $5,000 in any tion by corporations of ‘‘separate segregated federal election (provided that the committees funds’’ to be utilized for political purposes. are qualified multicandidate committees under While corporate monies may not be used to FECA). make political contributions or expenditures, corporations may bear the costs of establishing and administering these separate segregated 2120.0.6 INSPECTION OBJECTIVES funds, including payment of rent for office space, utilities, supplies and salaries. These 1. To determine if the company has made costs need not be disclosed under FECA. Com- improper or illegal payments in violation of mission regulations also permit a corporation to either of these statutes, and regardless of legal- exercise control over its separate segregated ity, and whether they constitute an unsafe and fund. unsound banking practice. 2. To determine if controls have been estab- BHC Supervision Manual December 1992 lished to prevent unproper payments in viola- Page 2 tion of these statutes. Foreign Corrupt Practices Act and Federal Election Campaign Act 2120.0

2120.0.7 INSPECTION PROCEDURES course of business in accordance with applica- ble laws. 1. Determine whether the company and its b. Income and expense ledger accounts for nonbank subsidiaries have a policy prohibiting unusual entries including unusual debit entries improper or illegal payments, bribes, kickbacks, (reductions) in income accounts or unusual or loans covered by either the Foreign Corrupt credit entries (reductions) in expense accounts, Practices Act or the Federal Election Campaign significant deviations from the normal amount Act. of recurring entries, and significant entries from 2. Determine how the policy, if any, has been an unusual source, such as a journal entry. communicated to officers, employees, or agents Procedure 7, following here, should only be of the organization. undertaken in cases in which the examiner be- 3. Review any investigation or study per- lieves that there is some sufficient evidence indi- formed by, or on behalf of, the board of direc- cating that improper or illegal payments have tors that evaluates policy or operations associ- occurred. Such evidence would justify the imple- ated with the advancement of funds in possible mentation of these additional procedures. violation of the statutes mentioned above. In 7. Verification of audit programs and internal addition, ascertain whether the organization has controls. been investigated by any other government a. Randomly select charged-off loan files agency in connection with possible violations of and determine whether any charged-off loans the statutes and, if this is the case, review avail- were made to (i) foreign government officials or able materials associated with the investigation. other persons or organizations covered by the 4. Review and analyze any internal or exter- Foreign Corrupt Practices Act, or (ii) persons or nal audit program employed by the organization organizations covered under the Federal Elec- to determine whether the internal and external tion Campaign Act. auditors have established appropriate routines to b. For those significant income and ex- identify improper or illegal payments under the pense accounts on which verification procedures statutes. In connection with the evaluation of the have not been performed: (i) prepare an analysis adequacy of any audit program, the examiner of the account for the period since the last should: examination, preferably by month, and note any a. Determine whether the auditor is aware unusual fluctuations for which explanations of the provisions of the Foreign Corrupt Prac- should be obtained, and (ii) obtain an explana- tices Act and the Federal Election Campaign tion for significant fluctuations or any unusual Act and whether audit programs are in place items through discussions with organization per- which check for compliance with these laws; sonnel and review of supporting documents. b. Review such programs and the results of any audits; and c. Determine whether the program directs 2120.0.8 APPARENT VIOLATIONS OF the auditor to be alert to unusual entries or THE STATUTES charges which might indicate that improper or illegal payments have been made to persons or Where violations of law or unsafe and unsound organizations covered by the statutes. banking practices result from improper pay- 5. Analyze the general level of internal con- ments, the Federal Reserve System should exer- trol to determine whether there is sufficient pro- cise its full legal authority, including cease-and- tection against improper or illegal payments be- desist proceedings and referral to the appropriate ing irregularly recorded on the organization’s law enforcement agency for further action, to books. ensure that such practices are terminated. In 6. Both the examiner and assistants should appropriate circumstances, the fact that such be alert in the course of their usual inspection payments have been made may reflect so ad- procedures for any transactions, or the use of versely on an organization’s management as to organization services or equipment, which be a relevant factor in connection with the con- might indicate a violation of the statutes. Exam- sideration of applications submitted by the orga- ination personnel should pay particular attention nization. to: In addition, the Reserve Bank should forward a. Commercial and other loans (including any information on apparent violations of the participations), which may have been made in Federal Election Campaign Act to the Federal connection with a political campaign, to assure that any such loans were made in the ordinary BHC Supervision Manual December 1992 Page 3 Foreign Corrupt Practices Act and Federal Election Campaign Act 2120.0

Election Commission. The Federal Election of $10,000 or 200 percent of the amount of the Commission is authorized to enforce FECA. illegal payment may be imposed. Knowing and The Commission may be prompted to investi- willful violations involving over $1,000 may gate possible illegal payments by either a sworn subject the violator to a fine, up to the greater of statement submitted by an individual alleging a $25,000 or 300 percent of the illegal payment, violation of the law, or on its own initiative and imprisonment for up to one year. based on information it has obtained in the course of carrying out its supervisory responsi- bilities. When the Commission determines that 2120.0.9 ADVISORY OPINIONS there is probable cause to believe a violation has occurred or is about to occur, it endeavors to Any person, including a bank or a corporation, enter into a conciliation agreement with the may request an advisory opinion concerning the violator. If, however, it finds probable cause to application of FECA or of the Commission’s believe that a willful violation has occurred or is regulations to a specific transaction or activity about to occur, it may refer the matter directly to in which that person wishes to engage. The the Department of Justice for possible criminal Commission must render such advisory opinion prosecution, without having first attempted con- within 60 days from receipt of a complete re- ciliation. quest. Banks or bank employees wishing to If informal means of conciliation fail, the engage in activity which may be regulated by Commission may begin civil proceedings to ob- FECA are encouraged to request advisory opin- tain relief. Should the Commission prevail, a ions from the Commission. maximum penalty of a fine equal to the greater

BHC Supervision Manual December 1992 Page 4 Internal Credit-Risk Ratings at Large Banking Organizations Section 2122.0

Techniques, practices, and tools for credit-risk vide information as to the institution’s overall management are evolving rapidly, as are the appetite for risk, giving due consideration to the challenges that banking organizations face in uncertainties faced by lenders and the long-term their business-lending activities. For larger insti- viability of the institution. Accordingly, large tutions, the number and geographic dispersion banking organizations should have strong risk- of their borrowers make it increasingly difficult rating systems which should take proper account for such institutions to manage their loan port- of gradations in risk. They should also consider folios simply by remaining closely attuned to (1) the overall composition of portfolios in the performance of each borrower. As a result, originating new loans, (2) assessing overall port- one increasingly important component of the folio risks and concentrations, and (3) reporting systems for controlling credit risk at larger insti- on risk profiles to directors and management. tutions is the identification of gradations in Moreover, such rating systems should also play credit risk among their business loans, and the an important role in (1) establishing an appropri- assignment of internal credit-risk ratings to ate level for the allowance for loan and lease loans that correspond to these gradations.1 The losses, (2) conducting internal analyses of loan use of such an internal rating process is appro- and relationship profitability, (3) assessing capi- priate and necessary for sound risk management tal adequacy, and possibly (4) administering at large institutions. See SR-98-25. performance-based compensation. Certain elements of internal rating systems Examiners should evaluate the adequacy of are necessary to support sophisticated credit- internal credit-risk-rating systems, including risk management. Supervisors and examiners, ongoing development efforts, when assessing both in their on-site inspections and other con- both asset quality and the overall strength of tacts with banking organizations, need to risk management at large institutions. Recogniz- emphasize the importance of development and ing that a strong risk-rating system is an impor- implementation of effective internal credit- tant element of sound credit-risk management rating systems and the critical role such systems for such institutions, examiners should specifi- should play in the credit-risk-management pro- cally evaluate the adequacy of internal risk- cess at sound large institutions. See SR-98-18 rating systems at large institutions as one factor with regard to lending standards for commercial in determining the strength of credit-risk man- loans. agement. In doing so, examiners should be cog- Internal rating systems are currently being nizant that an internal risk-identification and used at large institutions for a range of purposes. -monitoring system should be consistent with At one end of this range, they are primarily used the nature, size, and complexity of the banking to determine approval requirements and identify organization’s activities. problem loans. At the other end, they are an integral element of credit-portfolio monitoring and management, capital allocation, the pricing of credit, profitability analysis, and the detailed 2122.0.1 APPLICATION TO LARGE analysis to support loan-loss reserving. Internal BANK HOLDING COMPANIES rating systems being used for these latter pur- poses should be significantly richer and more The guidance provided in this section should be robust than systems used for the purposes such applied to all ‘‘large’’ bank holding companies. as approval requirements and identifying prob- For this purpose, examiners should treat an insti- lem loans. tution as being ‘‘large’’ if its lending activities As with all material financial institutional are sufficient in scope and diversity such that activities, a sound risk-management process informal processes that rely on keeping track of should adequately illuminate the risks being the condition of individual borrowers are inad- taken. It should also cause management to ini- equate to manage its loan portfolio. In this con- tiate and apply appropriate controls that will text, those institutions with significant involve- allow the institution to balance risks against ment in relevant secondary-market credit returns. Furthermore, the process should pro- activities, such as securitization of business loans or credit derivatives, should have more elaborate and formal approaches for managing 1. For information on current practices in risk rating among large banking organizations, see ‘‘Credit Risk Rating at Large U.S. Banks,’’ Federal Reserve Bulletin, November 1998, BHC Supervision Manual December 1998 pp. 897–921. Page 1 Internal Credit-Risk Ratings at Large Banking Organizations 2122.0 the risks associated with these activities.2 system itself. Although assigning such risk Whether or not they are active in such ratings—as with ratings issued by public rating secondary-market credit activities, however, agencies—necessarily involves subjective judg- larger and complex institutions typically would ment and experience, a properly designed rating require a more structured and sophisticated set system will allow this judgment to be applied in of arrangements for managing credit risk than a structured, more or less formal manner. smaller regional or community institutions. In Credit-risk ratings are designed to reflect the performing their evaluation, examiners should quality of a loan or other credit exposure, and also consider whether other elements of the thus, explicitly or implicitly, the loss characteris- risk-management process might compensate for tics of that loan or exposure. Increasingly, large any specific weaknesses attributable to an inad- institutions link definitions to one or more mea- equate rating system. surable outcomes such as the probability of a In addition, examiners should review internal borrower’s default or expected loss (which management information system reports to couples the probability of default with some determine whether the portion of loans in lower- estimate of the amount of loss to be incurred in quality pass grades has grown significantly over the event a default occurs). In addition, credit- time, and whether any such change might have risk ratings may reflect not only the likelihood negative implications for the adequacy of risk or severity of loss but also the variability of loss management or capital at the institution. Exam- over time, particularly as this relates to the iners should also consider whether a significant effect of the business cycle. Linkage to these shift toward higher-risk pass grades, or an over- measurable outcomes gives greater clarity to all large proportion of loans in a higher-risk risk-rating analysis and allows for more consis- pass grade, should have negative implications tent evaluation of performance against relevant for the institution’s asset-quality rating, includ- benchmarks. The degree of linkage varies ing the adequacy of the loan-loss reserve. To among institutions, however. some extent, such reviews are already an infor- Although the degree of formality may vary, mal part of the current inspection process. most institutions distinguish the risks associated Examiners should also continue the long- with the borrowing entity (essentially default standing practice of evaluating trends in catego- risk) from the risks stemming from a particular ries associated with problem assets. transaction or structure (more oriented to loss in Examiners should discuss these issues, event of default). In documenting their credit- including plans to enhance existing credit-rating administration procedures, institutions should systems, with bank management and directors. clearly identify whether risk ratings reflect the Inspection comments on the adequacy of risk- risk of the borrower or the risk of the specific rating systems and the credit quality of the pass transaction. In this regard, many large institu- portfolio should be incorporated within the tions currently assign both a borrower and facil- inspection report, noting deficiencies where ity rating, requiring explicit analysis of both the appropriate. loan’s obligor and how the structure and terms of the particular loan being evaluated (that is, collateral or guarantees) might strengthen or 2122.0.2 SOUND PRACTICES IN weaken the quality of the loan. FUNCTION AND DESIGN OF The rating scale chosen should meaningfully INTERNAL RATING SYSTEMS distinguish gradations of risk within the institu- tion’s portfolio so that there is clear linkage to A consistent and meaningful internal risk-rating loan quality (and/or loss characteristics), rather system is a useful means of differentiating the than just to levels of administrative attention.3 degree of credit risk in loans and other sources of credit exposure. This consistency and mean- ing is rooted in the design of the risk-grading 3. See the December 1993 Interagency Policy Statement on the Allowance for Loan and Lease Losses in section 2010.7. The policy does not apply to bank holding companies 2. Secondary-market credit activities generally include directly. As they supervise their respective FDIC-insured loan syndications, loan sales and participations, credit deriva- financial institution subsidiaries, bank holding companies are tives, and asset securitizations, as well as the provision of advised to apply this supervisory guidance. Internal risk- credit enhancements and liquidity facilities to such transac- rating systems and/or supporting documentation should be tions. Such activities are described further in section 2129.05 sufficient to enable examiners to reconcile the totals for the and in SR-97-21. various internal risk ratings under the institution’s system to the federal banking agencies’ categories for those loans BHC Supervision Manual December 1998 graded below ‘‘pass’’ (that is, loans classified as special Page 2 mention, substandard, doubtful, or loss). Internal Credit-Risk Ratings at Large Banking Organizations 2122.0

To do so, the rating system should be designed allow for consistent assignment of risk grades to to address the range of risks typically encoun- similarly risky transactions. Such criteria should tered in the underlying businesses involving the include guidance both on the factors that should institution’s loan portfolio. One reflection of be considered in assigning a grade and how this degree of meaning is that there should be a these factors should be weighed in arriving at a fairly wide distribution of portfolio outstandings final grade. or exposure across grades, unless the portfolio is Such criteria can promote consistency in genuinely homogeneous. Many current rating assessing the financial condition of the borrower systems include grades intended solely to cap- and other objective indicators of the risk of the ture credits needing heightened administrative transaction. One vehicle for enhancing the attention, such as so-called ‘‘watch’’ grades. degree of consistency and accuracy is the use of Prompt and systematic tracking of credits in ‘‘guidance’’ or ‘‘target’’ financial ratios or other need of such attention is an essential element of objective indicators of the borrower’s financial managing credit risk. However, to the extent performance as a point of comparison when that loans in need of attention vary in the risk assigning grades. Banking organizations may they pose, isolating them in a single grade may also provide explicit linkages between internal detract from that system’s ability to indicate grades and credit ratings issued by external par- risk. One alternative is the use of separate or ties as a reference point, for example, senior auxiliary indicators for those loans needing such public debt ratings issued by one or more major administrative attention. ratings agencies. The use of default probability Institutions whose risk-rating systems are models, bankruptcy scoring, or other analytical least effective in distinguishing risk use them tools can also be useful as supporting analysis. primarily to identify loans that are classified for However, the use of such techniques requires supervisory purposes or that bank management institutions to identify the probability of default otherwise believes should be given increased that is ‘‘typical’’ of each grade. The borrower’s attention (that is, ‘‘watch’’ loans). Such systems primary industry may also be considered, both contribute little or nothing to evaluating the in terms of establishing the broad characteristics bulk of loans in the portfolio—that is, loans for of borrowers in an industry (for example, degree which no specific difficulties are present or fore- of vulnerability to economic cycles or long-term seen. In some cases these institutions might also favorable or unfavorable trends in the industry) establish one or two risk grades for loans having and of a borrower’s position within the industry. very little perceived risk, such as those collater- In addition to quantitative indications and alized by cash or liquid securities or those to tools, credit policies and ratings definitions ‘‘blue-chip’’ private firms. Although the forego- should also cite qualitative considerations that ing gradations are well-defined in terms of the should affect ratings. These might include fac- relative credit risk they represent, the conse- tors such as (1) the strength and experience of quence for these least effective systems is that the borrower’s management, (2) the quality of the bulk of the loan portfolio falls into one or financial information provided, and (3) the two remaining broad risk grades—representing access of the borrower to alternative sources of ‘‘pass’’ loans that are neither extremely low risk funding. Addressing qualitative considerations nor current or emerging problem credits—even in a structured and consistent manner when though such grades may encompass many dif- assigning a risk rating can be difficult. It requires ferent levels of underlying credit risk. experience and business judgment. Nonetheless, adequate consideration of these factors is impor- tant to assessing the risk of a transaction appro- 2122.0.3 SOUND PRACTICES IN priately. In this regard, institutions may choose ASSIGNING AND VALIDATING to cite significant and specific points of compari- INTERNAL RISK RATINGS son for qualitative factors in describing how such considerations can affect the rating (for Experience and judgment, as well as more example, whether a borrower’s financial state- objective elements, are critical both in making ments have been audited or merely compiled by the credit decision and in assigning internal risk its accountants, or whether collateral has been grades. Institutions should provide clear and independently valued). explicit criteria for each risk grade in their credit Although the rating process requires the exer- policies, as well as other guidance to promote cise of good business judgment and does not consistency in assigning and reviewing grades. Criteria should be specified, even when address- BHC Supervision Manual December 1998 ing subjective or qualitative considerations, that Page 3 Internal Credit-Risk Ratings at Large Banking Organizations 2122.0 lend itself to formulaic solutions, some formal- risk makeup, of the portfolio. Such consistency ization of the process can be helpful in promot- further permits risk grades to become a reliable ing accuracy and consistency. For example, the input into portfolio credit-risk models.5 use of a ‘‘risk-ratings analysis form’’ can be important (1) in providing a clear structure for identifying and addressing the relevant qualita- 2122.0.4 APPLICATION OF tive and quantitative elements to be considered INTERNAL RISK RATINGS TO in determining internal risk grades, and (2) for INTERNAL MANAGEMENT AND documenting how those grades were set by ANALYSIS requiring analysis or discussion of key quantita- tive and qualitative elements of a transaction. As noted earlier, robust internal credit-rating Risk ratings should be reviewed, if not systems are an important element in several key assigned, by independent credit-risk manage- areas of the risk-management process. Although ment or loan-review personnel both at the incep- nearly all large institutions currently use risk tion of a transaction and periodically over the ratings, many of the institutions need to further life of the loan.4 Such independent reviewers develop these systems so that they provide accu- should reflect a level of experience and business rate and consistent indications of risk and suffi- judgment that is comparable to that of the line cient granularity—finer distinctions among staff responsible for assigning and reviewing risks, especially for riskier assets. Described initial risk grades. Among the elements of such below are approaches to risk management and independent review should be whether risk- analysis that are based on robust internal risk- rating changes (and particularly downgrades) rating systems and that are currently being used have been timely and appropriate. Such inde- at some banking organizations. These tech- pendent reviews of individual ratings support niques appear to be emerging as sound practices the discipline of the rating assignments by in the use of risk ratings. allowing management to evaluate the perfor- mance of those individuals assigning and reviewing risk ratings. If an institution relies on 2122.0.4.1 Limits and Approval outside consultants, auditors, or other third par- Requirements ties to perform all or part of this review role, such individuals should have a clear understand- Many large institutions have different approval ing of the institution’s ‘‘credit culture’’ and its requirements and thresholds for different inter- risk-rating process, in addition to commensurate nal grades, allowing less scrutiny and greater experience and competence in making credit latitude in decision making for loans with lesser judgments. risk.6 While this appears reasonable, institutions Finally, institutions should track performance should also consider whether the degree of of grades over time to gauge migration, consis- eased approval requirements (or the degree to tency, and default/loss characteristics to allow which limits are higher) is supported by the for evaluation of how well risk grades are being degree of reduced risk and uncertainty associ- assigned. Such tracking also allows for ex post ated with these lower-risk loans. If not, lesser analysis of the loss characteristics of loans in requirements may provide incentives to rate each risk grade. loans too favorably, particularly in the current Because ratings are typically applied to differ- benign economic environment, with resulting ent types of loans—for example, to both com- underassessment of transaction risks. mercial real estate and commercial loans—it is important that each grade retains the same 2122.0.4.2 Reporting to Management on meaning to the institution (in terms of overall Credit-Risk Profile of the Portfolio risk) across the exposure types. Such compara- bility allows management to treat loans in high- As part of reports that analyze the overall credit risk grades as a potential concentration of credit risk in the institution’s portfolio, management risk and to manage them accordingly. It also allows management and supervisors to monitor the overall degree of risk, and changes in the 5. For a discussion of these models and the role played by internal credit-risk ratings, see the May 1998 Federal Reserve System report, ‘‘Credit Risk Models at Major U.S. Banking 4. See section 2010.10 regarding internal loan review. Institutions: Current State of the Art and Implications for Assessments of Capital Adequacy,’’ prepared by the Federal BHC Supervision Manual December 1998 Reserve System Task Force on Internal Credit-Risk Models. 6. See section 2160.0 for more general guidance involving Page 4 risk evaluation and control. Internal Credit-Risk Ratings at Large Banking Organizations 2122.0 and directors should receive information on the meaningful assessment of the risks inherent in profile of actual outstanding balances, expo- each transaction and in the portfolio as a whole, sures, or both by internal risk grade.7 Such can be important tools in avoiding competitive information can thus be one consideration future excessive practices. among others, such as concentrations in particu- lar industries or borrower types, in evaluating an institution’s appetite for originating various 2122.0.4.5 Internal Allocation of Capital types of new loans. Portfolio analysis may range from simple tallies of aggregates by risk grade Those institutions that choose to allocate capital to a formal model of portfolio behavior that may use their internal risk grades as important incorporates diversification and other elements inputs in identifying appropriate internal capital of the interaction among individual loan types. allocations. Use of appropriately allocated capi- In this more complex analysis, gradations of tal in evaluating profitability offers many advan- risk reflect only one among many dimensions of tages, including the incentive to consider both portfolio risk, along with potential industry con- risk and return in making lending decisions centrations, exposure to an unfavorable turn in rather than merely rewarding loan volume and the business cycle, geographical concentrations, short-term fee revenue. Under appropriate and other factors. circumstances—that is, where internal capital allocations are sufficiently consistent, rigorous, and well-documented—such allocations may 2122.0.4.3 Allowance for Loan and also be considered as a source of input for Lease Losses supervisory evaluations of capital adequacy.9 The makeup of the loan portfolio and the loss characteristics of each grade—including indi- 2122.0.5 INSPECTION OBJECTIVES vidual pass grades—should be considered, along with other factors, in determining the adequacy 1. To evaluate whether the internal risk- of an institution’s allowance for loan and lease identification and -monitoring systems are losses.8 consistent with— a. sound practices in the function and design 2122.0.4.4 Pricing and Profitability of internal rating systems; b. sound practices in assigning and review- In competitive marketplaces, it is properly the ing internal risk ratings; and role of bankers rather than supervisors to judge c. the nature, size, and complexity of activi- the appropriateness of pricing, particularly with ties within the banking organization. regard to any single transaction or group of 2. To determine whether the level and volume transactions. One way that some institutions of lower-quality pass grades of loans have choose to discipline their overall pricing prac- grown significantly over time and whether tices across their portfolio is by incorporating any such trends should— risk-rating-specific loss factors in the determina- a. have adverse implications for determining tion of the minimum profitability requirements the adequacy of risk management and (that is, ‘‘hurdle rates’’). Following this practice capital, and may render such institutions less likely to price b. materially alter the institution’s asset- loans well below the level indicated by the quality ratings and valuations, and the long-term risk of the transaction. Given that examiner’s evaluation of the adequacy of bank lending, particularly pricing, can be highly the allowance for loan and lease losses. competitive, the application of appropriate disci- 3. To determine whether improvements are plines to pricing, in conjunction with a clear and needed in the credit-risk-management pro- cess and to discuss them with the board of directors and senior management. 7. See section 2010.2 regarding a bank holding company’s 4. To document the extent to which the institu- supervision of its subsidiaries and loan administration. See tion has adopted current and emerging sound also the more general financial analysis sections 4020.2 and 4060.1 with regard to evaluating the asset quality of subsidi- ary financial institutions and evaluating the asset quality of 9. See sections 4060.3 and 4060.4 regarding the evaluation the holding company on a consolidated basis. of capital adequacy of bank holding companies. 8. See footnote 3. Section 2010.7 emphasizes the bank holding company’s responsibility as it supervises its subsidi- aries with respect to each entity maintaining an adequate BHC Supervision Manual December 1998 allowance for loan and lease losses. Page 5 Internal Credit-Risk Ratings at Large Banking Organizations 2122.0

practices in the use of internal ratings infor- with respect to— mation in internal risk management and — financial analysis, including analysis. whether reference financial ratios or 5. To incorporate the examiner’s evaluation of other objective indicators are used sound credit-risk-rating practices into the to indicate the borrower’s financial assessment of management and capital performance; adequacy. — explicit linkages between the inter- nal grades assigned and credit rat- ings issued by external parties (for 2122.0.6 INSPECTION PROCEDURES example, senior public debt ratings by major rating agencies); 1. Determine whether the institution is consid- — default probability models, bank- ered ‘‘large’’ for purposes of applying this ruptcy scoring, or other analytical section’s guidance and procedures. tools used; 2. Evaluate the adequacy of internal credit- — analysis of a borrower’s primary risk-rating systems, including ongoing devel- industry, considering both the opment efforts, when assessing the quality broad characteristics of borrowers and overall strength of risk management. within that industry and the borrow- Give particular attention to the following er’s position within that industry; practices: and a. Function and design of internal rating — qualitative factors (for example, the systems. quality of the financial information • Ascertain whether the rating scale that is provided, the borrower’s meaningfully distinguishes gradations access to alternative sources of of risk within the institution’s portfolio funding, whether the financial state- evidencing clear linkage to loan quality ments were audited or merely com- and/or loss characteristics. piled, or whether collateral was — Determine if the design of the rat- independently valued). ing system has an adequate number • Determine whether loan policies pro- of internal ratings to distinguish vide clear and explicit guidance as to among levels of risks in its port- how these risk factors should be folio, and whether the grades used weighed in arriving at a final grade. address the range of risks typically • Determine whether the ratings assign- encountered in the underlying busi- ment is well documented, possibly nesses of the institution. including the use of a risk-rating form — Determine whether loans or expo- to provide formalization and standard- sures are broadly distributed across ization of the quantitative and qualita- the internal grades. tive criteria elements used in rating bor- — Establish if there are ‘‘watch rowers and/or transactions. grades’’ that are intended to capture • Establish whether risk ratings are inde- loans needing heightened adminis- pendently reviewed at the inception of a trative attention, or whether sepa- loan and periodically over the life of a rate or auxiliary indicators are used loan, and whether risk-rating changes for such loans. have been timely and appropriate (par- • Determine whether credit-risk-rating ticularly downgrades). definitions are linked to one or more • Ascertain whether the performance of measurable outcomes (for example, the rating grades is tracked over time to probability of a borrower’s default or evaluate migration, consistency, and expected loss). default/loss characteristics and trends. b. Sound practices in assigning internal risk c. Application of internal risk ratings to ratings. internal management and analysis. • Determine whether loan policies pro- • Determine whether loan-approval vide clear and explicit criteria for each requirements for each grade appear to risk grade as to the risk factors that are be supported by the degree of risk and to be considered in assigning a grade uncertainty associated with the respec- tive loans. BHC Supervision Manual December 1998 • Review internal management informa- Page 6 tion system reports and determine Internal Credit-Risk Ratings at Large Banking Organizations 2122.0

whether such reporting is adequate for 5. Determine whether a significant shift toward the institution. higher-risk pass grades, or an overall large • Ascertain if the risk-rating-specific loss proportion of loans in a higher-risk pass factors are used to determine risk pric- grade, should have negative implications for ing, minimum profitability require- the institution’s asset-quality rating, includ- ments, and capital adequacy needs, and ing the adequacy of the loan-loss reserve. document the institution’s progress in 6. Evaluate trends in risk-rating categories asso- this regard. ciated with problem assets. 3. Determine whether other risk elements may 7. Discuss the results of the evaluations with compensate for any specific weaknesses management, including whether there are attributable to an inadequate rating system. any plans to enhance existing credit-rating systems. 4. Review internal management information 8. Prepare written comments for the inspection system reports to determine whether the por- report on the adequacy of risk-rating systems tion of loans in lower-quality pass grades has and the credit quality of the pass portfolio, grown significantly over time, and whether noting any deficiencies. any such change might have negative impli- cations for the adequacy of risk management or capital at the institution.

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