3000—CAPITAL, EARNINGS, LIQUIDITY, AND SENSITIVITY TO

The 3000 series of sections address the super- asset quality (see the 2000 series major head- visory assessment of a state member ’s ing), the CELS components represent the key Capital, Earnings, Liquidity, and Sensitivity to areas that examiners review in assessing the market risk (CELS). In addition to the review of overall financial condition of the bank.

Commercial Bank Examination Manual May 2021 Page 1 Assessment of Capital Adequacy Effective date November 2020 Section 3000.1

PURPOSE OF CAPITAL financial crisis by helping to ensure that the banking system is better able to absorb losses Although both bankers and bank regulators look and continue to lend in future periods of eco- carefully at the quality of bank assets and nomic stress. In addition, imple- management and at the ability of the bank to ments certain federal laws related to costs, evaluate risks, and maintain proper requirements and international regulatory capi- liquidity, capital adequacy is the area that trig- tal standards adopted by the Committee gers the most supervisory action, especially in on Banking Supervision (BCBS). view of the prompt-corrective-action (PCA) pro- vision of section 38 of the Federal Deposit Applicability of Regulation Q Insurance Act (FDIA), 12 U.S.C. 1831o. The primary function of capital is to fund the bank’s Regulation Q applies on a consolidated basis to operations, act as a cushion to absorb unantici- every Board-regulated institution (referred to as pated losses and declines in asset values that a “banking organization” in this section) that is may otherwise lead to material bank distress or failure, and provide protection to uninsured • a state member bank; depositors and debt holders if the bank were to • a bank holding company (BHC) domiciled in be placed in receivership. A bank’s solvency the United States that is not subject to 12 CFR promotes public confidence in the bank and the part 225, appendix C,2 or banking system as a whole by providing contin- • a covered savings and loan holding company ued assurance that the bank will continue to (SLHC) domiciled in the United States. honor its obligations and provide banking ser- vices. By exposing stockholders to a larger Regulation Q does not apply to SLHCs sub- percentage of any potential loss, higher capital stantially engaged in insurance underwriting or levels reduce the subsidy provided to by commercial activities, or to SLHCs that are the federal safety net. insurance underwriting companies. Capital regulation is particularly important because deposit insurance and other elements of Components of Capital the federal safety net provide banks with an incentive to increase their leverage beyond what Regulation Q provides a definition of capital and the market—in the absence of depositor a framework for calculating risk-weighted assets protection—would permit. Additionally, banks’ higher capital levels can reduce the need for certain supervisory activities, thereby lowering “Frequently Asked Questions on the Regulatory Capital Rule” the regulatory burden on supervised institutions. and the “New Capital Rule: Community Bank Guide” (July 2013). 2. 12 CFR part 225, appendix C is the “Small Bank Holding Company and Savings and Loan Holding Company Policy Statement,” and it applies to BHCs with pro forma OVERVIEW OF REGULATION Q consolidated assets of less than $3 billion that (1) are not (12 CFR Part 217) engaged in significant nonbanking activities either directly or through a nonbank subsidiary; (2) do not conduct significant In 2013, the Board, the Federal off-balance-sheet activities (including securitization and asset management or administration) either directly or through a Deposit Insurance Corporation (FDIC), and the nonbank subsidiary; and (3) do not have a material amount of Office of the Comptroller of the Currency (OCC) debt or equity securities outstanding (other than trust preferred (collectively the agencies) adopted a rule replac- securities) that are registered with the Securities and Exchange ing their general risk-based capital require- Commission. The Board may, in its discretion, exclude any BHC, regardless of asset size, from the policy statement if ments, advanced approaches capital require- such action is warranted for supervisory purposes. With some ments, market risk capital requirements, and exceptions, the policy statement applies to SLHCs as if they leverage capital requirements.1 The Federal were BHCs. See the Bank Holding Company Supervision Reserve’s capital rule, Regulation Q, addresses Manual for more information on the Small Bank Holding Company and Savings and Loan Holding Company Policy weaknesses highlighted during the 2008–09 Statement. The Board may, by order, apply any or all of Regulation Q to any BHC, based on an institution’s asset size, 1. See 12 CFR part 217 (Regulation Q). For more infor- level of complexity, risk profile, scope of operations, or mation on the implementation of Regulation Q, see SR-15-6, financial condition.

Commercial Bank Examination Manual November 2020 Page 1 3000.1 Assessment of Capital Adequacy by assigning assets and off-balance-sheet items Additional to broad categories of . A banking organization’s risk-based capital ratio is calcu- Additional tier 1 capital includes instruments lated by dividing its qualifying capital (the that satisfy the criteria set forth in Regulation Q numerator of the ratio) by its risk-weighted (12 CFR 217.20(c)). Additional tier 1 capital assets (the denominator). A summary of the also includes surplus related to the issuance of components of qualifying capital is outlined additional tier 1 capital instruments, and limited below, as are the procedures for calculating amounts of tier 1 minority interest that are not risk-weighted assets. For more comprehensive included in a banking organization’s common information on the definition of capital and risk equity tier 1 capital, less applicable regulatory weighted assets, see the Federal Reserve’s Regu- adjustments and deductions. The eligibility cri- lation Q. teria for additional tier 1 capital instruments are The risk-based capital requirements of Regu- designed to ensure that additional tier 1 capital lation Q are designed to be sensitive to differ- instruments would be available to absorb losses ences in credit-risk profiles among banking on a going-concern basis. Given the strict crite- organizations; factor off-balance-sheet expo- ria, in the United States the only instrument sures into the assessment of capital adequacy; includable in additional tier 1 capital is non- minimize disincentives to holding liquid, low- cumulative perpetual . Cumula- risk assets; and achieve consistency in the evalu- tive preferred stock and trust preferred securities ation of the capital adequacy of major banking are generally not included in additional tier 1 organizations worldwide. capital. The three components of regulatory capital are (1) common equity tier 1 capital, (2) addi- tional tier 1 capital, and (3) . Tier 2 Capital

Tier 2 capital consists of instruments that satisfy Common Equity Tier 1 Capital the criteria set forth in Regulation Q (12 CFR 217.20(d)). Tier 2 capital also includes Common equity tier 1 capital is defined as the surplus related to the issuance of tier 2 capital sum of a banking organization’s outstanding instruments; limited amounts of total capital common equity tier 1 capital instruments that minority interest not included in a banking satisfy the criteria set forth in Regulation Q (12 organization’s tier 1 capital; and limited amounts CFR 217.20(b)). Common equity tier 1 capital of the allowance for loan and lease losses represents the highest-quality and most loss (ALLL),3 or adjusted allowances for credit losses absorbing form of capital. The criteria for com- (AACL),4 as applicable, less applicable regula- mon equity tier 1 capital are designed to ensure that common equity tier 1 capital is available to 3. ALLL means valuation allowances that have been estab- absorb losses as they occur and that common lished through a charge against earnings to cover estimated equity tier 1 instruments do not possess features credit losses on loans, lease financing receivables, or other that would cause a banking organization’s con- extensions of credit as determined in accordance with GAAP. dition to weaken further during periods of eco- ALLL excludes “allocated transfer risk reserves.” For pur- poses of Regulation Q, ALLL includes allowances that have nomic and market stress. Common equity tier 1 been established through a charge against earnings to cover capital is primarily composed of common stock estimated credit losses associated with off-balance-sheet credit and retained earnings, plus limited amounts of exposures as determined in accordance with GAAP. minority interest in the form of common stock, 4. AACL means, with respect to a Board-regulated insti- tution that has adopted current expected credit losses (CECL) less certain regulatory adjustments and deduc- methodology, valuation allowances that have been established tions (e.g., goodwill). through a charge against earnings or retained earnings for Under the standardized approach of Regula- expected credit losses on financial assets measured at amor- tion Q, banking organizations are not required to tized cost and a lessor’s net investment in leases that have been established to reduce the amortized cost basis of the include all components of accumulated other assets to amounts expected to be collected as determined in comprehensive income (AOCI) in common accordance with GAAP. AACL includes allowances for ex- equity tier 1 capital. For advanced approaches pected credit losses on off-balance-sheet credit exposures not banking organizations, most AOCI components accounted for as insurance as determined in accordance with GAAP. AACL excludes “allocated transfer risk reserves” and are included in common equity tier 1 capital. allowances created that reflect credit losses on purchased credit deteriorated assets and available-for-sale debt securi-

November 2020 Commercial Bank Examination Manual Page 2 Assessment of Capital Adequacy 3000.1 tory adjustments and deductions. A banking by increasing the capital requirements for cer- organization calculating its total capital ratio tain assets. In addition, the standardized approach using the standardized approach may include in serves as a floor pursuant to section 171 of the tier 2 capital the amount of ALLL or AACL that Dodd-Frank Wall Street Reform and Consumer does not exceed 1.25 percent of its standardized Protection Act (the Dodd-Frank Act) with respect total risk-weighted assets. to risk-based capital requirements that the Fed- A banking organization calculating its total eral Reserve may establish for BHCs, any non- capital ratio using the advanced approaches may bank financial company designated by the Finan- include in tier 2 capital the excess of its eligible cial Stability Oversight Council, SLHCs, and credit reserves over its total expected credit loss, state member banks. provided the amount does not exceed 0.6 per- Under the standardized approach, higher risk cent of its credit risk-weighted assets. weights generally apply to high volatility com- mercial real estate loans, past due loans, and Deductions and Limits certain equity and securitization exposures. The standardized approach also provides recognition Deductions from common equity tier 1 capital of collateral and guarantees and incentives for include goodwill and other intangibles (except derivatives and repo-style transactions cleared mortgage servicing assets), deferred tax assets through central counterparties. (DTAs) that arise from net operating loss and tax Below is a list of some key assets and credit carryforwards (above certain levels), gains- exposures and the risk weights to which they are on-sale in connection with a securitization, any assigned under the standardized approach. defined benefit pension fund net asset (for bank- ing organizations that are not insured depository • Public sector entities and U.S. government institutions), investments in a banking organiza- sponsored entities. Exposures to the U.S. gov- tion’s own capital instruments, mortgage servic- ernment generally receive a zero percent risk ing assets (above certain levels) and investments weight, and exposures to U.S. public-sector in the capital of unconsolidated financial insti- entities (PSEs), U.S. government-sponsored tutions (above certain levels). Mortgage servic- entities (GSEs), and U.S. depository institu- ing assets, DTAs arising from temporary differ- tions generally receive a 20 percent risk ences that the banking organization could not weight. Exposures conditionally guaranteed realize through net operating loss carrybacks, by the U.S. government and its agencies and certain investments in financial institutions generally receive a 20 percent risk weight. are each limited to 10 percent of common equity tier 1 capital and in combination are limited to • Exposures to sovereign entities. Regulation Q 15 percent of common equity tier 1 capital. provides that Organization for Economic Co-operation and Development (OECD) mem- ber countries without a country risk classifi- Risk-Weighted Assets cations (CRC) rating receive a risk weight of zero percent while nonmember countries with- Regulation Q prescribes two approaches to risk out a CRC rating will receive a risk weight of weighting assets. The standardized approach is 100 percent. Exposures to sovereign entities generally designed for smaller banking organi- with a CRC rating are to be assigned the risk zations, while the advanced approaches are used weight that corresponds to the CRC ratings. by larger, more complex institutions. Additionally, if an event of sovereign default has occurred in the foreign bank’s home country within the last five years, a banking Standardized Approach organization must assign a 150 percent risk weight to the exposure. The standardized approach described in Regu- lation Q harmonizes the agencies’ calculation of risk-weighted assets and addresses shortcom- ings in previous risk-based capital requirements ties. For more information on CECL, see this manual’s section “Allowance for Credit Losses.”

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• High volatility commercial real estate loans indirectly references a securitization expo- (HVCRE).5 In general, HVCRE exposures sure. include any credit facility that finances or has financed the acquisition, development, or con- Regulation Q establishes risk weight ap- struction of real property, unless the facility proaches for securitization exposures and struc- finances one- to four-family residential mort- tured security exposures that are retained on- or gage property, loans to finance agricultural off-balance sheet. Typical examples of securiti- properties, or certain community development zation exposures include private label collater- projects, or commercial real estate projects alized mortgage obligations (CMOs), trust pre- that meet certain prudential criteria, including ferred collateralized debt obligations, and asset- the loan-to-value (LTV) ratio for a loan and backed securities, provided there is tranching of capital contributions or expense contributions credit risk. Generally, pass-through and govern- of the borrower. Supervisory experience has ment agency CMOs are excluded from the demonstrated that certain acquisition, devel- securitization exposure risk weight approaches. opment, and construction loans, which are a In general, Regulation Q requires banking orga- subset of commercial real estate exposures, nizations to calculate the risk weight of securi- present particular risks for banking organiza- tization exposures using either the gross-up tions. Accordingly, HVCRE is assigned a approach or the Simplified Supervisory Formula 150 percent risk weight under Regulation Q. Approach (SSFA) consistently across all securi- tization exposures, except in certain cases. For • Residential mortgage exposures. One-to four- instance, the bank can, at any time, risk-weight family residential mortgage exposures are gen- a securitization exposure at 1,250 percent. erally assigned a 50 percent risk weight under The gross-up approach is similar to earlier Regulation Q provided the exposures are pru- risk-based capital rules, where capital is required dently underwritten first lien mortgage loans on the credit exposure of the bank’s investment that are not past due, reported as nonaccrual, in a specific tranche as well as its pro rata share secured by a property that is either owner- of the more senior tranches that its tranche occupied or rented, and has not been restruc- supports. A bank calculates its capital require- tured or modified. A 100 percent risk weight ment based on the weighted-average risk weights is assigned for all other residential mortgages. of the underlying exposures in the securitization pool. • Structured securities and securitizations. The The SSFA is designed to assign a lower risk securitization framework in Regulation Q weight to more-senior-class securities and higher addresses the credit risk of exposures that risk weights to supporting tranches. The SSFA involve the tranching of credit risk of one or is both risk-sensitive and forward-looking. The more underlying financial exposures. Regula- formula adjusts the risk weight for a security tion Q defines a securitization exposure as an based on key risk factors such as incurred losses on- or off-balance-sheet credit exposure on the underlying assets, nonperforming loans, (including credit-enhancing representations and the ability of subordinate tranches to absorb and warranties) that arises from a traditional losses. In any case, a securitization exposure is or synthetic securitization (including a resecu- assigned a risk weight of no lower than 20 ritization), or an exposure that directly or percent.

5. Section 214 of the Economic Growth, Regulatory Relief, • Securitization due diligence. During the and Consumer Protection Act (EGRRCPA), Pub. L. No. 115- 2008-09 financial crisis, many banking orga- 174, 132 Stat. 1296, 1321–22 (2018), addressed the treatment of HVCRE by adding section 51 to the Federal Deposit nizations relied exclusively on ratings issued Insurance Act (FDIA), 12 U.S.C. 1831bb. FDIA section 51 by Nationally Recognized Statistical Rating provides a statutory definition of high volatility commercial Organizations (NRSROs) and did not perform real estate acquisition, development, or construction (HVCRE internal credit analysis of their securitization ADC) loans. Under FDIA section 51, the agencies may only require a depository institution to assign a heightened risk exposures. Consistent with the Basel capital weight to a HVCRE exposure, as defined under the capital framework and the agencies’ general expecta- rule, if such exposure is an HVCRE ADC loan. This statutory tions for investment analysis, Regulation Q change was effective upon enactment of EGRRCPA in outlines specific securitization exposure due May 2018. The agencies also amended their capital rules to reflect this statutory change. See 84 Fed. Reg. 68,019 (Decem- diligence requirements for banking organiza- ber 13, 2019). tions. As stated in Regulation Q, a banking

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organization is required to demonstrate, to the primary federal supervisor, the banking organi- satisfaction of its primary federal supervisor, a zation is required to assign a risk weight of comprehensive understanding of the features 1,250 percent to the exposure. of a securitization exposure that would mate- rially affect its performance. The banking • Equity exposures to investment funds. A bank- organization’s analysis must be commensu- ing organization determines the risk-weighted rate with the complexity of the exposure and asset amount for equity exposures to invest- the materiality of the exposure in relation to ment funds using one of three approaches: capital of the banking organization. On an (1) the full look-through approach, (2) the ongoing basis (no less frequently than quar- simple modified look-through approach, or terly), the banking organization must evaluate, (3) the alternative modified look-through review, and update as appropriate the analysis approach, unless the equity exposure to an required by Regulation Q (12 CFR investment fund is a community development 217.41(c)(1)) for each securitization exposure. equity exposure. The risk-weighted asset The analysis of the risk characteristics of the amount for such community development exposure prior to acquisition, and periodically equity exposures is the exposure’s adjusted thereafter, need to consider: carrying value. If a banking organization does not use the full look-through approach, and an — Structural features of the securitization equity exposure to an investment fund is part that materially impact the performance of of a hedge pair, a banking organization must the exposure. For example, the contractual use the ineffective portion of the hedge pair as cash-flow waterfall, waterfall-related trig- the adjusted carrying value for the equity gers, credit enhancements, liquidity en- exposure to the investment fund. The risk- hancements, market value triggers, the weighted asset amount of the effective portion performance of organizations that service of the hedge pair is equal to its adjusted the position, and deal-specific definitions carrying value. A banking organization may of default; choose which approach to apply for each — Relevant information regarding the perfor- equity exposure to an investment fund. mance of the underlying credit expo- sure(s). For example, the percentage of 1. Full Look-Through Approach. A banking loans 30, 60, and 90 days past due; default organization may use the full look-through rates; prepayment rates; loans in foreclo- approach only if the banking organization sure; property types; occupancy; average is able to calculate a risk-weighted asset credit score or other measures of credit- amount for each of the exposures held by worthiness; average LTV ratio; and indus- the investment fund. A banking organiza- try and geographic diversification data on tion using the full look-through approach the underlying exposure(s); is required to calculate the risk-weighted — Relevant market data of the securitization. asset amount for its proportionate owner- For example, bid-ask spread; most recent ship share of each of the exposures held by sales price and historical price volatility; the investment fund (as calculated under trading volume; implied market rating; the standardized approach) as if the pro- and size, depth, and concentration level of portionate ownership share of the adjusted the market for the securitization; and carrying value of each exposures were held — For resecuritization exposures, perfor- directly by the banking organization. The mance information on the underlying secu- banking organization’s risk-weighted asset ritization exposures. For example, the amount for the exposure to the fund is issuer name and credit quality, and the equal to (1) the aggregate risk-weighted characteristics and performance of the asset amount of the exposures held by the exposures underlying the securitization fund as if they were held directly by the exposures. banking organization multiplied by (2) the banking organization’s proportional own- If a banking organization is not able to meet ership share of the fund. these due diligence requirements and demon- strate a comprehensive understanding of a secu- 2. Simple Modified Look-Through Approach. ritization exposure to the satisfaction of its Under the simple modified look-through

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approach, a banking organization sets the • Collateralized transactions. Regulation Q risk-weighted asset amount for its equity recognizes a range of financial collateral as exposure to an investment fund equal to credit risk mitigants that may reduce the the adjusted carrying value of the equity risk-based capital requirements associated exposure multiplied by the highest appli- with a collateralized transaction. Financial cable risk weight under the standardized collateral includes approach to any exposure the fund is (1) cash on deposit with the banking orga- permitted to hold under the prospectus, nization (including cash held for the partnership agreement, or similar agree- banking organization by a third-party ment that defines the fund’s permissible custodian or trustee); investments. The banking organization may (2) gold bullion; exclude contracts held by the (3) short- and long-term debt securities fund that are used for hedging, rather than that are not resecuritization exposures for speculative purposes, and do not con- and that are investment grade; stitute a material portion of the fund’s (4) equity securities that are publicly exposures. traded; (5) convertible bonds that are publicly 3. Alternative Modified Look-Through Ap- traded; or proach. Under the alternative modified (6) money market fund shares and other look-through approach, a banking organi- mutual fund shares if a price for the zation may assign the adjusted carrying shares is publicly quoted daily. value of an equity exposure to an invest- With the exception of cash on deposit, the ment fund on a pro rata basis to different banking organization is also required to risk weight categories under the standard- have a perfected, first-priority security inter- ized approach based on the investment est or, outside of the United States, the limits in the fund’s prospectus, partnership legal equivalent thereof, notwithstanding agreement, or similar contract that defines the prior security interest of any custodial the fund’s permissible investments. The agent. Even if a banking organization has risk-weighted asset amount for the banking the legal right, it still must ensure it moni- organization’s equity exposure to the invest- tors or has a freeze on the account to ment fund is equal to the sum of each prevent a customer from withdrawing cash portion of the adjusted carrying value on deposit prior to defaulting. A banking assigned to an exposure type multiplied by organization is permitted to recognize par- the applicable risk weight. If the sum of the tial collateralization of an exposure. investment limits for all permissible invest- ments within the fund exceeds 100 percent, Under Regulation Q, a banking organi- the banking organization must assume that zation may recognize the risk-mitigating the fund invests to the maximum extent effects of financial collateral using the permitted under its investment limits in the “simple approach” for any exposure pro- exposure type with the highest applicable vided that the collateral meets certain risk weight under the standardized approach requirements. For repo-style transactions, and continues to make investments in the eligible margin loans, collateralized deriva- order of the exposure category with the tive contracts, and single-product netting next highest risk weight until the maxi- sets of such transactions, a banking orga- mum total investment level is reached. If nization could alternatively use the “collat- more than one exposure category applies eral haircut approach.” Most institutions to an exposure, the banking organization are likely to use the simple approach; must use the highest applicable risk weight. however, regardless of the approach cho- A banking organization may exclude de- sen, the institution must consistently apply rivative contracts held by the fund that are its approach for similar exposures or trans- used for hedging, rather than for specula- actions. tive purposes, and do not constitute a material portion of the fund’s exposures. • Simple approach. In the simple approach described in Regulation Q, the collateral- ized portion of the exposure receives the

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risk weight applicable to the collateral. The position of instruments and cash in a cur- collateral is required to meet the definition rency that is different from the settlement of financial collateral. For repurchase agree- currency multiplied by the haircut appro- ments, reverse repurchase agreements, and priate to the currency mismatch. securities lending and borrowing transac- For purposes of the collateral haircut tions, the collateral would be the instru- approach, a given instrument includes, for ments, gold, and cash that a banking orga- example, all securities with a single Com- nization has borrowed, purchased subject mittee on Uniform Securities Identification to resale, or taken as collateral from the Procedures (CUSIP) number and would counterparty under the transaction. In all not include securities with different CUSIP cases, (1) the collateral must be subject to numbers, even if issued by the same issuer a collateral agreement for at least the life of with the same maturity date. the exposure; (2) the banking organization must revalue the collateral at least every • Treatment of Guarantees. Under Regula- six months; and (3) the collateral (other tion Q, banking organizations have the than gold) and the exposure must be option to substitute the risk weight of an denominated in the same currency. Gener- eligible guarantee or guarantor for the risk ally, the risk weight assigned to the collat- weight of the underlying exposure. For eralized portion of the exposure must be no example, if the bank has a loan guaranteed less than 20 percent. However, the collat- by an eligible guarantor, the bank can use eralized portion of an exposure may be the risk weight of the guarantor. Eligible assigned a risk weight of less than 20 per- guarantors include entities such as deposi- cent in certain instances. tory institutions and holding companies, the International Monetary Fund, Federal • Collateral haircut approach. A banking Home Loan Banks, the Federal Agricul- organization may use the collateral haircut tural Mortgage Corporation, entities with approach to recognize the credit risk miti- investment grade debt, sovereign entities, gation benefits of financial collateral that and foreign banks. An eligible guarantee secures an eligible margin loan, repo-style must be written, be either unconditional or transaction, collateralized derivative con- a contingent obligation of the U.S. govern- tract, or single-product netting set of such ment or its agencies, cover all or a pro rata transactions. In addition, the banking orga- share of all contractual payments, give the nization may use the collateral haircut beneficiary a direct claim against the pro- approach with respect to any collateral that tection provider, and meet other require- secures a repo-style transaction that is ments outlined in the definition of eligible included in the banking organization’s guarantees in 12 CFR 217.2. value-at-risk (VaR)-based measure under the market risk rule, even if the collateral • Off-Balance-Sheet Exposures. Risk-weighted does not meet the definition of financial asset amounts for off-balance-sheet items collateral. To apply the collateral haircut are calculated using a two-step process: (1) approach, a banking organization must Multiplying the amount of the off-balance- determine the exposure amount and the sheet exposure by a credit conversion fac- relevant risk weight for the counterparty or tor to determine a credit equivalent amount, guarantor. The exposure amount for an and (2) assigning the credit equivalent eligible margin loan, repo-style transac- amount to a relevant risk-weight category. tion, collateralized derivative contract, or a This treatment applies to all off-balance- netting set of such transactions is equal to sheet items, such as commitments, contin- the greater of zero and the sum of the gent items, guarantees, certain repo-style following three quantities as described in transactions, financial standby letters of Regulation Q (12 CFR 217.37(c)): (1) the credit, and forward agreements. value of the exposure less the value of the collateral; (2) the absolute value of the net position in a given instrument or in gold; and (3) the absolute value of the net

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Table 1—SUMMARY OF STANDARDIZED APPROACH RISK WEIGHTS OF ASSETS IN 12 CFR 217

Category Risk weight Section of the rule (12 CFR 217) Cash 0% 217.32(1)(1) Direct and unconditional claims on 0% 217.32(a)(1)(i) the U.S. government, its agencies, and the Federal Reserve Claims on certain supranational 0% 217.32(b) entities and multilateral develop- ment banks Cash items in the process of 20% 217.32 collection Conditional claims on the 20% 217.32(a)(1)(ii) U.S. government Claims on government-sponsored 20% on exposures other than 217.32(c) enterprises (GSEs) equity exposures and preferred stock. 100% on GSE preferred stock. Claims on U.S. depository institu- 20% 217.32(d)(1) and (3) tions and National Credit Union 100% risk weight for an invest- Administration-insured credit ment in an instrument included in unions another banking organization’s regulatory capital unless the in- strument is an equity exposure or required to be deducted. Claims on U.S. public sector 20% for general obligations. 217.32(e)(1) entities 50% for revenue obligations. Industrial development bonds 100% 217.32(l)(5) Claims on qualifying securities 100% – See corporate exposures 217.32(f) firms below. One- to four-family loans 50% if first lien, prudently under- 217.32(g) written, owner occupied or rented, not 90 days or more past due or carried in nonaccrual status, is not restructured or modified. 100% otherwise. One- to four-family loans modified 50% and 100% 217.32(g)(3) under Home Affordable Modifica- The banking organization must tion Program use the same risk weight assigned to the loan prior to the modifica- tion so long as the loan continues to meet other applicable pruden- tial criteria.

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Category Risk weight Section of the rule (12 CFR 217) Loans to builders secured by 50% if the loan meets all criteria 217.32(h) one- to four-family properties pre- in the regulation. sold under firm contracts 100% if the contract is cancelled. 100% for loans not meeting the criteria. Loans on multifamily properties 50% if the loan meets all the 217.32(i) criteria in the regulation for a statutory multifamily property; 100% otherwise. Corporate exposures and consumer 100% unless the exposure is an 217.32(f) loans investment in an instrument included in the regulatory capital of another financial institution. Commercial real estate (CRE) 100% 217.32(j) and (l)(5) 150% for high volatility commer- cial real estate, which is, subject to certain exceptions, a credit facil- ity secured by land or improved real property that primarily fi- nances has financed, or refinances the acquisition, development, or construction of real property; has the purpose of providing financ- ing to acquire, develop, or improve such real property into income- producing real property; and is dependent upon future income or sales proceeds from, or refinanc- ing of, such real property for the repayment of such credit facility. Past-due exposures 150% for the portion that is not 217.32(k) guaranteed or secured (does not apply to sovereign exposures). However, one- to four-family loans that are past due 90 days or more are assigned a 100% risk weight. Assets not assigned to a risk weight 100% 217.32(l)(5) category, including fixed assets, premises, and other real estate owned Mortgage-backed securities, asset- Two general approaches— 217.42, .43, and .44 backed securities, and structured gross-up approach and simple securities supervisory formula approach. May also choose to risk weight a securitization exposure at 1,250%.

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Category Risk weight Section of the rule (12 CFR 217) Equity exposures Range of risk weights between 217.51 and .52 0% and 600%, depending on the entity and whether the equity is publicly traded Equity exposures There is a 20% risk weight floor 217.53 to investment funds on investment fund holdings. The following approaches are available: 1. Risk weight is the same as the highest risk weight investment the fund is permitted to hold (called the Simple Modified Look-Through Approach). 2. A banking organization may assign risk weight on a pro rata basis based on the investment limits in the fund’s prospectus (called the Alternative Modi- fied Look-Through Approach). 3. A third treatment (called the Full Look-Through Approach) risk weights each asset of the fund (as if owned directly) and multiplies by the banking orga- nization’s proportional owner- ship in the fund. Claims on foreign governments and Risk weight depends on Country 217.32(a)(2) to (6), their central banks, foreign banking Risk Classification (CRC) appli- (d)(2) and (e)(2) to (6) organizations, and foreign public cable to the sovereign, the sover- sector entities eign’s OECD status, and whether the sovereign entity has defaulted within the previous five years.

Advanced Approaches of the two ratios. The advanced approaches are supplemented by the market risk capital require- The advanced approaches framework6 provides ment. a risk-based and leverage capital framework that The advanced approaches in Regulation Q permit certain banking organizations to use an (12 CFR part 217) apply to a top-tier U.S. bank internal risk measurement approach to calculate holding companies or savings and loan holding capital requirements and advanced measurement company that is identified as a global systemi- approaches in order to calculate regulatory cally important bank holding company and a operational-risk capital requirements. An Category II banking organization as described in advanced approaches banking organization must the Federal Reserve’s Regulation YY (12 calculate its risk-based capital ratios using both CFR 252.5) or Regulation LL (12 CFR 238.10). the standardized and advanced approaches and The advanced approaches also apply to a state meet each minimum requirement with the lower member bank that is a subsidiary of a global systemically important bank holding company, a 6. See 12 CFR part 217 subpart E. Category II Board-regulated institution; or a

November 2020 Commercial Bank Examination Manual Page 10 Assessment of Capital Adequacy 3000.1 subsidiary of a bank, bank holding company, or mation on the calculation of these ratios. savings and loan holding company that uses the Most banking organizations are expected to advanced approaches to calculate its risk-based operate with capital levels above the minimum capital requirements. Advanced approaches bank- ratios. Banking organizations that are undertak- ing organizations also include those banking ing significant expansion or that are exposed to organizations that have elected to use the ad- high or unusual levels of risk are expected to vanced approaches to calculate their total risk- maintain capital well above the minimum ratios; weighted assets. in such cases, the Federal Reserve may specify a higher minimum requirement. In implementing Regulation Q, the Federal Market Risk Capital Requirement Reserve has reserved the authority to require banking organizations to hold more capital if the The market risk capital requirement7 applies to minimum requirements are not commensurate banking organizations with significant trading with the bank’s credit, market, operational, or activities to calculate regulatory capital require- other risks (see 12 CFR 217.1(d)). This is a ments for market risk. The purpose of the formal process that requires Federal Reserve market risk capital requirement is to establish approval, and an examiner alone cannot provide risk-based capital requirements for Board- this directive. Examiners may use the Matters regulated institutions with significant exposure Requiring Attention or Matters Requiring Imme- to market risk, provide methods for these Board- diate Attention section of the examination report regulated institutions to calculate their standard- to require a bank to maintain an appropriate ized measure for market risk and, if applicable, capital policy or plan that includes capital limits advanced measure for market risk, and establish that are consistent with the bank’s risk profile. public disclosure requirements. The market risk capital requirement applies to any Board- regu- lated institution with aggregate trading assets Community Bank Leverage Ratio and trading liabilities equal to 10 percent or Framework more of total assets or $1 billion or more.8 On a case-by-case basis, the Federal Reserve may In 2019, the agencies adopted a final rule10 that require an institution that does not meet these provides for a simple measure of capital criteria to comply with the market risk capital adequacy for certain community banking orga- requirement if deemed necessary for safety-and- nizations, consistent with section 201 of the soundness reasons. The Federal Reserve may EGRRCPA. This final rule established the com- also exclude an institution that meets the criteria munity bank leverage ratio (CBLR) framework, if such exclusion is deemed to be consistent with which provides an optional measure of capital safe and sound banking practices. adequacy for depository institutions and deposi- tory institution holding companies with the fol- lowing characteristics: Minimum Regulatory Capital Ratios • leverage ratio greater than 9 percent11 All banking organizations covered under Regu- • less than $10 billion in average total consoli- lation Q are subject to the following minimum dated assets regulatory capital requirements: a common • off-balance-sheet exposures of 25 percent or equity tier 1 capital ratio of 4.5 percent, a tier 1 less of total consolidated assets capital ratio of 6 percent, a total capital ratio of • trading assets plus trading liabilities of 5 per- 8 percent of risk-weighted assets, and a leverage cent or less of total consolidated assets ratio of 4 percent.9 See table 2 for more infor- • not an advanced approaches banking organi- zation.12 7. See 12 CFR part 217 subpart F. 8. As reported in the Board-regulated institution’s most sum of common equity tier 1, additional tier 1, and tier 2 recent quarterly Call Report, for a state member bank, or Form capital. FR Y-9C, for a BHC or SLHC, as applicable, any SLHC that 10. See 84 Fed. Reg. 61,797 (November 13, 2019) and 12 does not file the Form FR Y-9C should follow the instructions CFR 217.12. to the Form FR Y-9C. 11. From April 23, 2020, through December 31, 2021, 9. Tier 1 capital is equal to the sum of common equity a lower leverage ratio criterion applies. See 12 CFR 217.304. tier 1 capital and additional tier 1 capital. Total capital is the 12. For more detailed information on the applicability of

Commercial Bank Examination Manual November 2020 Page 11 3000.1 Assessment of Capital Adequacy

TABLE 2—CAPITAL RATIO CALCULATIONS AND MINIMUM RATIOS

Ratio Calculation Minimum

Common equity common equity tier 1 capital tier 1 4.5% capital ratio standardized total risk-weighted assets

Tier 1 tier 1 capital 6% capital ratio standardized total risk-weighted assets

Total capital total capital 8% ratio standardized total risk-weighted assets

Leverage tier 1 capital 4% ratio average total consolidated assets

A qualifying banking organization may opt Calculation of the CBLR is as follows: into the CBLR framework by completing the Tier 1 capital associated reporting line items that are required for such firms on its Call Report and/or Form Average total consolidated assets FR Y–9C, as applicable. A qualifying banking organization that elects to use the CBLR frame- The calculation of a Board-regulated institu- work and that maintains a leverage ratio of tion’s leverage ratio is described in the generally greater than 9 percent will be considered to have applicable requirement.14 However, the calcula- satisfied the generally applicable risk-based and tion of tier 1 capital for purposes of the CBLR leverage capital requirements in the agencies’ differs from the generally applicable require- capital rules (generally applicable requirement). ment. Because the CBLR framework does not If applicable, the qualifying banking organiza- have a total capital requirement, an electing tion will be considered to have met the well- banking organization is neither required to cal- capitalized ratio requirements for prompt correc- culate tier 2 capital nor make any deductions tive action purposes.13 that would have been taken from tier 2 capital A banking organization may opt out of the under the generally applicable requirement. CBLR framework and become subject to the generally applicable requirement by completing Grace Period the associated reporting requirements on its Call Report and/or Form FR Y–9C, as applicable. A If an electing banking organization fails to banking organization can opt out of the CBLR satisfy one or more of the qualifying criteria but framework between reporting periods by provid- maintains a leverage ratio of greater than 8 per- ing its capital ratios under the generally appli- cent, that banking organization has a “grace cable requirement to its appropriate regulators at period” of up to two quarters during which it that time. could continue to use the CBLR framework and be deemed to meet the “well capitalized” capital ratio requirements.15 As long as the banking organization is able to return to compliance with all the qualifying criteria within two quarters, it continues to be deemed to meet the “well capitalized” ratio requirements and to be in

the CBLR framework, see 12 CFR 217.12(a)(2). 14. 12 CFR 217.10. 13. See FDIA section 38, 12 U.S.C. 1831o, and the Board’s 15. From April 23, 2020, through December 31, 2021, Regulation H, 12 CFR part 208. lower grace period thresholds apply. See 12 CFR 217.304.

November 2020 Commercial Bank Examination Manual Page 12 Assessment of Capital Adequacy 3000.1 compliance with the generally applicable require- servicing activities generally involve holding ment. securities or other assets on behalf of clients, as A banking organization is required to comply well as activities such as transaction settlement, with and report under the generally applicable income processing, and related record keeping requirement and file the relevant regulatory and operational services. To qualify as a custo- reports if the banking organization (1) is unable dial banking organization, a depository institu- to restore compliance with all qualifying criteria tion holding company is required to have a ratio during the two-quarter grace period (including of assets under custody-to-total assets of at reporting a leverage ratio greater than 9 per- least 30:1, calculated as an average over the cent), (2) has a leverage ratio of 8 percent or prior four calendar quarters. less, or (3) ceases to satisfy the qualifying criteria due to consummation of a merger trans- action.16 Enhanced Supplementary Leverage Ratio In 2015, the Federal Reserve implemented an Supplementary Leverage Ratio enhanced supplemental leverage ratio require- ment.19 Banking organizations subject to Cate- The supplementary leverage ratio measures tier 1 gory I standards, which are the global systemi- capital relative to total leverage exposure, which cally important bank holding companies (U.S. includes on-balance sheet assets (including G-SIBs), as well as their depository institution deposits at central banks) and certain off- subsidiaries, are subject to enhanced supplemen- balance sheet exposures.17 tary leverage ratio standards. The enhanced Advanced approaches banking organizations supplementary ratio standards require each and Category III Board-regulated institutions U.S. G-SIB to maintain a supplementary lever- are also subject to a minimum supplementary age ratio above 5 percent to avoid limitations on leverage ratio of 3 percent. The denominator of the firm’s distributions and certain discretionary the supplementary leverage ratio incorporates bonus payments and also require each of its certain off-balance-sheet exposures such as com- insured depository institutions to maintain a mitments and derivative exposures. The Federal supplementary leverage ratio of at least 6 per- Reserve applies this to advanced approaches cent to be deemed “well capitalized” under the banking organizations and Category III Board- prompt corrective action framework of each regulated institutions because these firms typi- agency. The leverage buffer functions like the cally hold higher levels of off-balance-sheet capital conservation buffer for the risk-based exposure that are not captured by the leverage capital ratios, which is described in greater ratio. The supplementary leverage ratio also detail below. factors into a covered institution’s PCA capital ratio framework. De Novo Bank Leverage Ratio In January 2020, the Federal Reserve issued a final rule to implement EGRRCPA section 402, SR-20-16, “Supervision of De Novo State Mem- which requires the agencies to amend the supple- ber Banks,” provides additional supervisory 18 mentary leverage ratio. Under EGRRCPA sec- guidance on leverage ratio expectations for tion 402, the supplementary leverage ratio must de novo state member banks (de novo bank). As not take into account funds of a custodial bank noted in SR-20-16, an insured depository insti- that are deposited with certain central banks, tution is considered to be in the de novo stage provided that any amount that exceeds the value until it has been operating for at least three of deposits of the custodial bank that are linked years. A de novo bank should maintain capital to fiduciary or custodial and safekeeping accounts ratios commensurate with its risk profile and, must be taken into account when calculating the generally, well in excess of regulatory mini- supplementary leverage ratio as applied to the mums. Typically, as a condition of membership, custodial bank. Custody, safekeeping, and asset the Federal Reserve requires each de novo bank to maintain a Tier 1 leverage ratio of at least 16. From April 23, 2020, through December 31, 2021, 8 percent for the first three years of its exis- lower grace period thresholds apply. See 12 CFR 217.304. 17. 12 CFR 217.10(a)(5) and (c)(4). 18. 85 Fed. Reg. 4569 (January 27, 2020). 19. 80 Fed. Reg. 49,082 (August 14, 2015).

Commercial Bank Examination Manual November 2020 Page 13 3000.1 Assessment of Capital Adequacy tence.20 The Reserve Bank should consult Board Countercyclical Capital Buffer supervision staff when the Tier 1 leverage ratio of a de novo falls below 8 percent. Examiners The countercyclical capital buffer (CCyB) is a should also scrutinize de novo banks that rely on supplemental policy tool that the Federal Reserve additional capital infusions to meet this mini- can increase during periods of rising vulnerabili- mum requirement and understand the stability of ties in the financial system and reduce when the capital source. vulnerabilities recede. It is designed to increase the resilience of advanced approaches banking organizations or Category III Board-regulated Stress Capital Buffer institutions when there is an elevated risk of above-normal losses. Increasing the resilience During the 2008–09 financial crisis, some bank- of such organizations will, in turn, improve the ing organizations continued to pay dividends resilience of the broader financial system. The and substantial discretionary bonuses even as circumstances in which the Federal Reserve their financial condition weakened. Such capital would most likely begin to increase the CCyB distributions had a significant negative impact above zero percent to augment minimum capital on the overall strength of the banking sector. To requirements and other capital buffers would be encourage better capital conservation and to when systemic vulnerabilities are meaningfully enhance the resilience of the banking system, above normal. By requiring large banking orga- Regulation Q limits capital distributions and nizations to hold additional capital during a discretionary bonus payments for banking orga- period of excess and removing the requirement nizations that do not hold a specified amount of to hold additional capital when the vulnerabili- common equity tier 1 capital in addition to the ties have diminished, the CCyB is expected to amount of regulatory capital necessary to meet moderate fluctuations in the supply of credit the minimum risk-based capital requirements over time. (capital conservation buffer). A CCyB, if applicable, would expand the capital conservation buffer by up to 2.5 percent On March 4, 2020, the Federal Reserve approved of a banking organization’s total risk-weighted a final rule establishing a stress capital buffer for assets for advanced approaches banking organi- bank holding companies and U.S. intermediate zations or Category III Board-regulated institu- holding companies of foreign banking organiza- tions. The amount of the CCyB amount is tions that have $100 billion or more in total determined by a country’s bank supervisor and consolidated assets. The stress capital buffer will differ by jurisdiction . At any point in time, rule integrates the Federal Reserve’s stress test a country’s bank supervisor determines the results with its non-stress capital requirements.21 degree of excessive credit growth in its jurisdic- More specifically, the stress capital buffer rule tions. An advanced approaches Board-regulated integrates the Comprehensive Capital Analysis institution or a Category III Board-regulated and Review (CCAR) with the capital rule. institution must calculate a countercyclical capi- Under the stress capital buffer requirement, the tal buffer amount in accordance with Regula- Federal Reserve uses the results of its supervi- tion Q (12 CFR 217.11(b)) for purposes of sory stress test to establish the size of a firm’s determining its maximum payout ratio. The stress capital buffer requirement, which replaces payout ratio is set forth in Regulation Q as well the static 2.5 percent of risk-weighted assets as this manual’s section entitled “Dividends.” component of a firm’s capital conservation buf- fer requirement. A firm’s stress capital buffer requirement varies based on a firm’s risk. A firm that does not maintain capital ratios above its PROMPT CORRECTIVE ACTION minimums plus its buffer requirements faces restrictions on its capital distributions and dis- In 1991, Congress enacted a regulatory frame- cretionary bonus payments. work to address the problems associated with troubled insured depository institutions with the 20. Refer to 12 CFR 217.10(a). This expectation does not intent of minimizing the long-term cost to the prevent a de novo that is a qualifying community banking Deposit Insurance Fund. This legislation, the organization from electing to be subject to the community bank leverage ratio framework. See also 12 CFR 217.12. Federal Deposit Insurance Corporation Improve- 21. 85 Fed. Reg. 15,576 (March 18, 2020). ment Act of 1991, added section 38 to the

November 2020 Commercial Bank Examination Manual Page 14 Assessment of Capital Adequacy 3000.1

Federal Deposit Insurance Act (FDIA), codified Impact of Management at 12 U.S.C. 1831o; FDIA section 38 is known as the PCA statute. The Federal Reserve has Strategic capital planning. One of manage- implemented PCA as applicable to state member ment’s most important functions is to lead the banks in subpart D of Regulation H (12 organization by designing and implementing an CFR 208.40 to 208.45). PCA uses the total effective strategic plan that addresses the bank’s risk-based capital measure, tier 1 risk-based capital requirements to support its business goals capital measure, common equity tier 1 risk- and objectives. The strategic plan should clearly based capital measure, leverage ratio, supple- outline the bank’s capital base, anticipated capi- mentary leverage ratio, and tangible equity to tal expenditures, desirable capital level, and total assets ratio for assigning state member external capital sources.22 Effective strategic banks to the five capital categories. These five planning allows the institution to be proactive in PCA categories under FDIA section 38 and the addressing market changes and emerging risks PCA regulations are “well capitalized,” “ad- and, therefore, enables an institution to plan for equately capitalized,” “undercapitalized,” “sig- its capital needs. Strategic capital planning nificantly undercapitalized,” and “critically un- should address both a bank’s short-term and dercapitalized.” A qualifying community banking long-term capital needs in relation to its asset organization that has elected to use the commu- deployment, funding sources, capital formation, nity bank leverage ratio framework under 12 management, marketing, operations, and infor- CFR 217.12 is considered to have met the mation systems. capital ratio requirements for the well capital- ized capital category. The capital ratios trigger Growth. Capital is necessary to support a bank’s specific actions that are designed to restore a growth, and, therefore, a bank needs to monitor bank to financial health. See the “Prompt Cor- its capital ratios in relation to its strategic plan. rective Action” section for more information Because a bank has to maintain a minimum ratio on PCA. of capital to assets, there are limitations on a bank’s ability to grow. For example, a rapid growth in a bank’s loan portfolio may be a cause of concern, for it could indicate that a bank is EVALUATING CAPITAL altering its risk profile by reducing its underwrit- ADEQUACY ing standards.

Overall Assessment of Capital Dividends. State member banks are subject to Adequacy legal restrictions on reductions in capital result- ing from cash dividends, including out of the The following factors should be taken into capital surplus account, under 12 U.S.C. 324 and account in assessing the overall capital adequacy 12 CFR 208.5. The Federal Reserve has a of a bank. long-standing policy statement on the payment of cash dividends by state member banks and BHCs that are experiencing financial difficul- Regulatory Capital Ratios ties. The policy statement addresses the follow- ing practices that raises supervisory concerns Capital ratios should be compared with regula- when an institution is experiencing earnings tory minimums and with peer-group averages. weaknesses, or has other serious problems or Banking organizations are expected to maintain inadequate capital: minimum capital ratios described above. How- ever, because risk-based capital does not take • the payment of dividends not covered by explicit account of the quality of a bank’s asset earnings, portfolios or its risk exposures, such as interest- rate, liquidity, market, or operational risks, bank- ing organizations are generally expected to oper- 22. For more information about capital planning at the ate with capital positions above the minimum holding company level, see SR-09-4, “Applying Supervisory ratios. Institutions with high or inordinate levels Guidance and Regulations on the Payment of Dividends, Stock Redemptions, and Stock Repurchases at Bank Holding of risk are also expected to maintain capital well Companies,” and the Board’s Regulation Y on capital plan- above the minimum levels. ning and stress capital buffer requirements (12 CFR 225.8).

Commercial Bank Examination Manual November 2020 Page 15 3000.1 Assessment of Capital Adequacy

• the payment of dividends from borrowed new capital instruments because of the diluting funds, and effect of the new capital. In deciding whether to • the payment of dividends from unusual or raise additional capital in this manner, sharehold- nonrecurring gains, such as the sale of prop- ers should weigh the dilution against the possi- erty or other assets. bility that, without the additional funds, the institution may fail. When a bank is experiencing earnings weak- Under the FDI Act, a depository institution nesses or other financial pressures, the Federal holding company is required to serve as a source Reserve’s view is that of strength to its subsidiary depository institu- tions.25 A holding company can fulfill this • a bank’s level of cash dividends should not obligation by having enough liquidity to inject exceed its net income; funds into the depository institution or by hav- • dividends should be consistent with the orga- ing access to the same sources of additional nization’s capital position, and capital, that is, current or existing shareholders, • dividends should only be funded in ways that as outlined above. do not weaken the organization’s financial health. Financial Considerations In some instances, it may be appropriate to eliminate cash dividends altogether.23 Financial information can be found on Sched- Examiners should review historical and ule RC-R of the Report of Condition and Income planned cash-dividend payout ratios to deter- (Call Report) for banks; however, risks may not mine whether dividend payments are impairing always be reflected in the current financial capital adequacy. Excessive dividend payouts condition. Therefore, examiners should not rely may result from several sources: solely on an institution’s current financial con- dition when determining capital adequacy and • If the bank is owned by a holding company, should assess management’s ability to identify, the holding company may be requiring exces- measure, monitor, and control all material risks sive dividend payments from the bank to fund that may affect capital. Examiners should evalu- the holding company’s debt-repayment pro- ate a bank’s capital levels and ratios in view of gram, expansion goals, or other cash needs. the bank’s overall financial condition, including • The bank’s board of directors may be under the following areas: pressure from individual shareholders to pro- vide funds to repay bank stock debt or to use Asset quality. Examiners’ supervisory assess- for other purposes. ment on a bank’s capital adequacy may differ • Dividends may be paid or promised to support from conclusions based solely from the level of a proposed equity offering.24 a bank’s risk-based capital ratio. Generally, the main reason for this difference is the evaluation Access to additional capital. Banks that do not of asset quality. An examiner’s assessment a generate sufficient capital internally may require bank’s capital adequacy takes into account external sources of capital. Large, independent examination findings, particularly the severity institutions may seek additional funding from of problem and classified assets and investment the capital markets. Smaller institutions may or loan portfolio concentrations as well as he rely on its parent holding company, a principal adequacy of the bank’s allowance for loan and shareholder, or a control group to provide addi- lease losses or adjusted allowance for credit tional funds, or may rely on the issuance of new losses. capital instruments to existing or new investors. Current shareholders may resist efforts to issue Balance-sheet composition. A bank whose earn- ing assets are not diversified or whose credit 23. For the complete text of the policy statement on the culture is more risk-tolerant is generally expected payment of cash dividends by state member banks and BHCs to operate with higher capital levels than a that are experiencing financial difficulties see the Bank Hold- ing Company Supervision Manual and Attachment B to SR-09-4. 25. For more information, see the “Supervision of Subsid- 24. For more information, see the “Dividends” section of iaries” section in the Bank Holding Company Supervision this manual. Manual.

November 2020 Commercial Bank Examination Manual Page 16 Assessment of Capital Adequacy 3000.1 similar-sized institution with well-diversified, can be included in tier 2 capital is limited to less-risky investments. 1.25 percent of gross risk-weighted assets, an additional provision may increase the ALLL or Earnings. A bank’s earnings performance should AACL level above this limit, thereby resulting enable it to fund growth, compete in the mar- in the excess portion being excluded from tier 2 ketplace, and support its risk profile. An capital. adequately capitalized, growing bank should have a consistent pattern of capital augmenta- Ineligible Collateral and Guarantees. Regula- tion by earnings retention. Poor earnings can tion Q recognizes only limited types of collat- have a negative effect on bank’s capital adequacy eral and guarantees. Other types of collateral in two ways. First, any losses absorbed by and guarantees may support a bank’s asset mix, capital reduce the ability of the remaining capi- particularly within its loan portfolio. Such col- tal to absorb future losses. Second, the impact of lateral or guarantees may serve to improve losses on capital is magnified by the fact that a substantially the overall quality of a loan port- bank generating losses is incapable of replenish- folio and other credit exposures and should be ing its capital accounts internally. considered by examiners in their overall assess- ment of a bank’s capital adequacy. Funds management. A bank with undue levels of interest-rate risk may need to strengthen its Market Value of Bank Stock. Examiners should capital positions, even though it may meet the review trends in the market price of a bank’s minimum risk-based capital standards. The stock and whether its stock is trading at a adequacy and effectiveness of an institution’s reasonable multiple of earnings or a reasonable interest-rate process and the percentage (or multiple) of book value. A bank’s level of its interest-rate risk exposure are critical low stock price may merely be an indication that factors in the examiners’ evaluation of an insti- it is undervalued, or it may be indicative of tution’s sensitivity to changes in interest rates regional or industry-wide problems. However, a and capital adequacy. Examiners consider how a low-valued stock may also indicate that inves- bank manages its interest-rate exposures. A tors lack confidence in the institution; such lack bank’s funds management systems should be of support could impair the bank’s ability to commensurate with its earnings and capital raise additional capital in the capital markets. levels, complexity, business model, risk profile, and scope of operations. If a bank determines Other Real Estate Reserves. Other real estate that its core earnings and capital are insufficient reserves, whether considered general or specific to support its level of interest-rate risk, a , are not recognized as a component of should take steps to mitigate its risk exposure or regulatory capital. However, examiners should increase its capital, or take both steps. See consider these reserves when classifying an SR-10-1, “Interagency Advisory on other real estate (ORE) asset as a Loss. Exam- Risk,” for more information. iners should consider the existence of any gen- eral ORE reserves when determining the amount Off-balance-sheet items and activities. Once of the loss on an ORE asset. To the extent that funded, off-balance-sheet items become subject ORE reserves adequately cover the risks inher- to the same capital requirements as on-balance- ent in the ORE portfolio as a whole, including sheet items. A bank’s capital levels should be any individual ORE assets classified Loss, there sufficient to support the quality and quantity of would not be a deduction from common equity assets that would result from a significant por- tier 1 capital. The ORE Loss in excess of ORE tion of these items being funded within a short reserves should be deducted from common time. equity tier 1 capital under assets other than held-for-investment loans and leases classified Inadequate Allowance for Loan and Lease loss. Losses or Adjusted Allowances for Credit Losses. An inadequate ALLL or AACL will require an Unrealized Asset Values. Banks often have assets additional charge to current income. Any charge on their books that are carried at significant to current income will reduce the amount of discounts below current market values. The earnings available to supplement tier 1 capital. excess of the market value over the book value Because the amount of the ALLL or AACL that (historical cost or acquisition value) of assets

Commercial Bank Examination Manual November 2020 Page 17 3000.1 Assessment of Capital Adequacy such as investment securities or banking prem- risk factors remain subject to the supervisory ises may represent capital to the bank. These stress test requirements on an annual basis. unrealized asset values are not included in the risk-based capital calculation; however, examin- ers should consider these assets when assessing a bank’s capital adequacy. Further, as part of this RATING THE CAPITAL FACTOR assessment, examiners should consider the nature FOR STATE MEMBER BANKS of the asset, the reasonableness of its valuation, its marketability, and the likelihood of its sale. As stated in the Uniform Financial Institutions Rating System27 for commercial banks and thrifts, a financial institution is expected to Stress Testing and Capital Adequacy maintain capital commensurate with the nature and extent of risks to the institution and the Stress testing is a tool that helps both bank ability of management to identify, measure, supervisors and certain firms measure the suffi- monitor, and control these risks. Examiners ciency of capital available to support the firm’s should consider the effect of credit, market, and operations throughout periods of stress. The other risks on the institution’s financial condi- Federal Reserve and the other federal banking tion when evaluating the adequacy of capital. agencies have highlighted the use of stress The types and quantity of risk inherent in an testing as a means to better understand the range institution’s activities will determine the extent of a financial company’s potential risk expo- to which it may be necessary for an institution to sures. While stress tests are a valuable tool for maintain capital at levels above required regu- assessing the capital adequacy of a firm, stress latory minimums in order to reflect properly the tests may not necessarily capture a company’s potentially adverse consequences that these risks full range of risks, exposures, activities, and may have on the institution’s capital. vulnerabilities that have a potential effect on Examiners rate an institution’s capital ad- capital adequacy. equacy based upon, but not limited to, an The Federal Reserve has established frame- assessment of the following evaluation factors: works and programs for the supervision of its largest and most complex financial institutions • The level and quality of capital and the to achieve its supervisory objectives, incorporat- institution’s overall financial condition. ing lessons learned from the 2008–09 financial • The ability of management to address emerg- crisis and in the period since. As part of these ing needs for additional capital. supervisory frameworks and programs, the Fed- • The nature, trend, and volume of problem eral Reserve assesses whether bank holding assets, and the adequacy of allowances for companies with $100 billion or more in total loan and lease losses, adjusted allowances for consolidated assets and U.S. intermediate hold- credit losses, and other valuation reserves. ing companies are sufficiently capitalized to • Balance sheet composition, including the absorb losses during stressful conditions while nature and amount of intangible assets, market meeting obligations to creditors and counterpar- risk, concentration risk, and risks associated ties and continuing to be able to lend to house- with nontraditional activities. holds and businesses. On October 10, 2019, the Federal Reserve amended its prudential stan- • Risk exposure represented by off-balance- dards to exempt firms with total consolidated sheet activities. assets of less than $100 billion from the super- • The quality and strength of earnings, and the visory stress test and to subject certain firms reasonableness of dividends. with total consolidated assets between $100 bil- • Prospects and plans for growth as well as the lion and $250 billion to the supervisory stress institution’s past experience in managing test requirements on a two-year cycle.26 Bank growth. holding companies and intermediate holding • Access to capital markets and other sources of companies with $250 billion or more in total capital, including support provided by a par- consolidated assets or material levels of other ent holding company.

26. 84 Fed. Reg. 59,032 (November 1, 2019). 27. 61 Fed. Reg. 67,021 (December 19, 1996).

November 2020 Commercial Bank Examination Manual Page 18 Assessment of Capital Adequacy 3000.1

Ratings minimum regulatory and statutory require- ments. 1. A rating of “1” indicates a strong capital 4. A rating of “4” indicates a deficient level of capital. In light of the institution’s risk pro- level relative to the institution’s risk profile. file, viability of the institution may be threat- 2. A rating of “2” indicates a satisfactory capital ened. Assistance from shareholders or other level relative to the financial institution’s risk external sources of financial support may be profile. required. 3. A rating of “3” indicates a less than satisfac- 5. A rating of “5” indicates a critically deficient tory level of capital that does not fully level of capital such that the institution’s support the institution’s risk profile. The viability is threatened. Immediate assistance rating indicates a need for improvement, from shareholders or other external sources even if the institution’s capital level exceeds of financial support is required.

Commercial Bank Examination Manual November 2020 Page 19 Assessment of Capital Adequacy Examination Objectives Effective date October 2018 Section 3000.2

1. To determine the adequacy of capital. the Board’s established capital adequacy 2. To determine compliance with the risk-based rules. and leverage capital adequacy rules. 5. To evaluate the propriety and consistency of the bank’s present and planned level of 3. To determine if the policies, practices, and capitalization in light of the risk-based and procedures with regard to the capital adequacy leverage capital rules as well as existing rules are adequate. conditions and future plans. 4. To determine if the bank’s officers and 6. To initiate corrective action when policies, employees are operating in conformity with procedures, or capital are deficient.

Commercial Bank Examination Manual October 2018 Page 1 Assessment of Capital Adequacy Examination Procedures Effective date October 2018 Section 3000.3

1. Determine whether bank policies and prac- of capital planning. tices promote capital preservation and ad- 7. Determine whether audits or independent dress future capital needs. Consider the reviews include an assessment of bank poli- following: cies and procedures as well as regulatory • The strategic plan and its underlying requirements related to capital issues. assumptions, projected asset growth, divi- 8. Determine whether Board and management dend plans, asset quality, income, liquid- reports provide sufficient, timely, and accu- ity, funds management, deposit structure, rate information. parent-company relationship, contingent 9. Review the accuracy of the bank’s calcula- liabilities, expansion plans, competition, tion of Common Equity Tier 1 Capital, and economic conditions; Additional Tier 1, and Tier 2 Capital. • Findings from interviews with manage- Reviewing the bank’s calculations may ment regarding the strategic planning pro- involve some of the following procedures: cess (including any potential issues due to • Review Call Report Schedule RC-R and a change in prompt corrective action supporting documentation. (PCA) designation); • Determine whether the bank has chosen • Internal risk-monitoring policies and pro- to opt-out of the inclusion of accumulated cedures; other comprehensive income. • The availability of additional capital • Review applicable deductions and adjust- sources (such as funding provided by ments for each tier of capital, including insiders, external sources, or additional phase-in and phase-out provisions (refer debt at the parent level); and to 217.22 for capital adjustments and • The permissibility of current or planned deduction rules and 217.300 for transition components of capital to qualify as Com- provisions). mon Equity Tier 1 Capital or Additional • Consider whether the bank has non- Tier 1 Capital. qualifying capital instruments or non- 2. Review historical and planned dividend pay- qualifying minority interests subject to out ratios and other planned capital reduc- phase-out (refer to 217.20 for criteria for tions, including reductions subject to legal capital instruments for each tier of capi- restrictions and prior Board approval. For tal, 217.21 for minority interest rules, and planned capital stock retirements, ensure 217.300 for transition provisions). management requested prior regulatory 10. Review the accuracy of the bank’s calcula- approval. Also, determine whether manage- tion of risk-weighted assets reported on ment evaluated the impact of the capital Schedule RC-R, Part II. Review the bank’s conservation buffer, including reductions supporting documentation as appropriate. subject to legal restrictions and prior Board Reviewing the bank’s calculations may approval. involve some of the following procedures: 3. Determine whether entries to capital accounts • Determine whether risk weights for most are appropriate and properly authorized. assets conform to applicable requirements 4. Assess controls over off-balance sheet items (Part 217.32). (Schedule RC-L) and their overall impact to • As applicable, review risk weights for sufficiency of capital levels and needs. other categories of exposures, such as 5. Review board and management’s proce- — Off-balance sheet exposures (Part dures to prevent, detect, and respond to 217.33), policy exceptions that may affect capital. — Over-the-counter derivative contracts 6. Determine whether the audit function veri- (Part 217.34), fies the accuracy of the capital accounts and — Cleared transactions (Part 217.35), regulatory reports; assesses the appropriate- — Guarantees and credit derivatives (Part ness, accuracy, and timeliness of reports 217.35), produced for the board and executive man- — Collateralized transactions (Part agement; and evaluates the reasonableness 217.37)

Commercial Bank Examination Manual October 2018 Page 1 3000.3 Assessment of Capital Adequacy: Examination Procedures

— Securitizations (Part 217.41-45), assumed by the bank; — Equity exposures (Part 217.51-52), • The reasonableness of booked, future tax — Equity exposures to investment funds benefits; (Part 217.53), and • The accounting treatment and valuation — Other aspects of the revised capital of intangible assets; rules. • The extent of contingent liabilities asso- 11. Review the bank’s capital ratios under the ciated with trusts or other activities; revised PCA standards. If the bank is less • Dividend/repayment requirements for gov- than well capitalized under the revised stan- ernment capital programs (for example dards (or appears that it could become less the Troubled Asset Relief Program or than well capitalized due to the phase-in of Small Business Lending Fund); deductions or other aspects of the new • The extent of any other liabilities not capital rules), consider whether the bank shown on the bank’s books, including has a reasonable strategy to meet the fully contingent liabilities; phased-in requirements over the transition • The existence of pending litigation against period. the bank (and its subsidiaries) and the 12. Review the bank’s capital conservation buf- potential and estimated loss exposure; fer and the appropriateness of any distribu- • The volume and risk characteristics of tions and discretionary bonus payments. new business initiatives and higher risk 13. Determine whether earnings performance investment or lending strategies (for enables the bank to fund growth, compete in example, subprime lending or mobile the marketplace, and support the overall banking), or involvement in nontradi- risk profile. Consider the level and trend of tional activities such as non-deposit prod- equity capital in relation to asset levels, ucts, insurance sales, or discount broker- quality, and growth rates. age services; • Assess the impact of current and pro- • The extent to which higher-risk loans or jected provisions to the allowance for investments may require additional capi- loan and lease losses (ALLL) on capital tal under the revised regulatory capital retention and growth. rules’ risk-weights (for example, high- • Review whether the bank is relying on volatility commercial real estate loans, core earnings or non-recurring income. equity exposures, or certain structured or • Determine whether dividends are exces- securitized investments); sive compared to current earnings. (Con- • Compliance with state and federal capital sider applicable state and federal guid- level requirements; and ance.) • The level of operational and reputational 14. Determine whether the existing capital level risk. is adequate for the bank’s risk profile when 15. Assess the adequacy of management’s considering the following items: actions to correct criticisms related to capi- • The adequacy of capital-management poli- tal in previous examination reports and cies and controls; recent internal or external audits. • The level, type, and trend of adversely 16. Evaluate the effectiveness of management’s classified assets; internal processes and risk management • The adequacy of the ALLL; practices at preparing for and reacting to • The volume and trends of charged-off changes in economic, industry, and regula- loans and recoveries; tory environments, including the ability to • The balance sheet structure and liquidity assess capital needs under a range of rea- needs; sonably anticipated adverse events. • The level, type, and trend of concentra- 17. Determine whether management effectively tions; identifies and manages • The vulnerability of assets and liabilities • the institution’s overall risk profile, to adverse events; • factors that may change the institution’s • The volume of unrealized gains or losses risk profile, and on available-for-sale securities; • how a change in the risk profile will affect • The degree of interest rate risk exposure the sufficiency of capital levels.

October 2018 Commercial Bank Examination Manual Page 2 Assessment of Capital Adequacy: Examination Procedures 3000.3

18. Determine whether management effectively • adopting ways to measure capital based identifies and manages any changes to regu- on any revisions to the capital rule(s); and latory capital rules by • ensuring that the board is aware of these changes. • evaluating its prospective capital position pursuant to the revised rule(s);

Commercial Bank Examination Manual October 2018 Page 3 Dividends Effective date April 2020 Section 3025.1

Dividends are distributions of earnings to own- liabilities. Upon payment of the dividend, “divi- ers.1 Dividends can influence an investor’s will- dends declared not yet payable” is debited for ingness to purchase corporate stock since the the amount of the cash dividend with an offset- investor generally expects reasonable invest- ting credit, normally in an equal amount, to ment returns. Although dividends usually are “dividend checks outstanding” which is report- declared and paid in either cash or stock, occa- able in the “demand deposits” category of the sionally they are used to distribute real or bank’s deposit liabilities. For more information, personal property. Dividend payments may see the Call Report Instructions. reduce capital in some banks to the point of supervisory concern. As a result, certain statu- tory limitations apply to the payment of divi- SUPERVISORY GUIDANCE ON dends. DIVIDENDS If a bank is a subsidiary of a bank holding company, examiners should also be aware of a In addition to statutory limitations of the pay- bank’s parent company cash-flow needs. In ment of dividends, on November 14, 1985, the addition to the payment of dividends, the parent Federal Reserve Board issued a policy statement company may need cash for debt service or to on the payment of dividends by state member fund its operations. Parent company debt gener- banks and bank holding companies. The com- ally is primarily serviced through dividend pay- plete statement is available in the Federal ments by the subsidiary bank. When establish- Reserve Regulatory Service at 4–877, sec- ing dividend levels from a bank subsidiary, the tion 2020.5, “Intercompany Transactions (Divi- parent company should not set a dividend rate dends),” in the Bank Holding Company Super- that will place undue pressure on the bank’s vision Manual. A summary of the 1985 policy ability to maintain an adequate level of capital. statement on the payment of dividends is pro- Declaration of a dividend requires formal vided below. action by the board of directors to designate the In 2009, the Federal Reserve issued SR let- medium of payment, dividend rate, shareholder ter 09-4, “Applying Supervisory Guidance and record date, and date of payment. Dividends Regulations on the Payment of Dividends, Stock may be declared at the discretion of the board.2 Redemptions, and Stock Repurchases at Bank The bank should conduct appropriate capital Holding Companies,” which provides guidance planning and due diligence to ensure the divi- on the declaration and payment of dividends, dend payments will not place undue pressure on capital redemptions, and capital repurchases by the bank’s current and future capital levels. bank holding companies in the context of their Dividends are recorded by debiting “retained capital planning processes. While SR-09-4 earnings” and crediting “dividends declared not applies to bank holding companies, its prin- yet payable,” which is to be reported in other ciples are also broadly relevant to state member banks. In 2015, the Federal Reserve issued SR letter 15-18, “Federal Reserve Supervisory 1. Other payments not called dividends may also be distri- Assessment of Capital Planning and Positions butions of earnings to owners. These distributions or “con- structive dividends” may be termed fees, bonuses, or other for LISCC Firms and Large and Complex payments. Constructive dividends are distinct from legitimate Firms,” and SR letter 15-19, “Federal Reserve fees, bonuses, and other payments, which are reasonable, Supervisory Assessment of Capital Planning adequately documented, and for valuable goods and services and Positions for Large and Noncomplex Firms.” provided to the bank. Constructive dividends may create a potential tax liability and indicate control issues or insider While SR-15-18 and SR-15-19 generally apply self-dealing, and they may portend shareholder lawsuits against to the largest bank holding companies, the insiders, board members, and the bank. principles of the 1985 Policy Statement on the 2. At a minimum, board of directors minutes approving Payment of Dividends are incorporated into declaration and payment of a dividend should include three components: (1) the “as of” date to identify shareholders of these SR letters. Specifically, firms should have record to receive the dividend (date of record), (2) an amount comprehensive policies on dividend payments or description of the dividend, and (3) identification of the that clearly articulate their objectives and date on which the dividend payment is to take place (date of approaches for maintaining a strong capital payment). There may also be additional legal requirements that should be documented, depending on state laws and the position and achieving the principles of the nature of the dividend. policy statement.

Commercial Bank Examination Manual April 2020 Page 1 3025.1 Dividends

SUMMARY OF POLICY include the sale of assets, the effects of account- STATEMENT ON PAYMENT OF ing changes, the postponement of large expenses DIVIDENDS to future periods, or negative provisions to the allowance for loan and lease losses. Adequate capital is critical to the health of individual banking organizations and to the safety and stability of the banking system. A CAPITAL CONSERVATION major determinant of a financial institution’s BUFFER capital adequacy is earnings strength and whether earnings are retained or paid to shareholders as The Board’s Regulation Q (12 CFR 217) limits dividends. Dividends are a primary way that capital distributions and discretionary bonus banking organizations provide return to share- payments for banking organizations that do not holders on their investment. hold a specified amount of common equity tier 1 During profitable periods, dividends represent capital in addition to the amount of regulatory a return of a portion of a banking organization’s capital necessary to meet the minimum risk- net earnings to its shareholders. During less based capital requirements (capital conservation profitable periods, dividend rates are often buffer). A banking organization’s capital con- reduced or sometimes eliminated. The payment servation buffer must be greater than 2.5 percent of cash dividends that are not fully covered by of its total risk-weighted assets in order to avoid earnings, in effect, represents the return of a limitations on capital distributions and discre- portion of an organization’s capital at a time tionary bonus payments.3 when circumstances may indicate instead the If a banking organization’s capital conserva- need to strengthen capital and concentrate finan- tion buffer falls below 2.5 percent, its maximum cial resources on resolving the organization’s payout amount for capital distributions and dis- problems. cretionary payments declines to a set percentage Therefore, as a matter of prudent banking it is of eligible retained income based on the size of generally only appropriate for a bank or bank the bank’s buffer. Table 1 reflects the maximum holding company to continue its existing rate of payout ratio for the capital conservation buffer. cash dividends on common stock only if The types of payments subject to the restric- tions include dividends, share buybacks, discre- • the organization’s net income available to tionary payments on capital instruments, and common shareholders over the past year has discretionary bonus payments. It is important to been sufficient to fully fund the dividends; and note that the Board may require a Board- • the prospective rate of earnings retention regulated institution to hold an amount of regu- appears consistent with the organization’s capi- latory capital greater than otherwise required if tal needs, asset quality, and overall financial the Board determines that the banking organiza- condition. tion’s capital requirements are not commensu- rate with its credit, market, operational, or other Any banking organization whose cash divi- risks. For more information, see this manual’s dends are inconsistent with either of these cri- section entitled, “Assessment of Capital Ad- teria should seriously consider reducing or elimi- equacy,” and 12 CFR 217.11. nating its dividends. Such an action will help conserve the organization’s capital base and help it weather a period of adversity. It is generally inconsistent with prudent bank- ing practices for a banking organization that is experiencing financial problems or that has inad- equate capital to borrow to pay dividends; this 3. A banking organization may have a capital conservation would result in increased leverage at the very buffer greater than 2.5 percent under certain circumstances. time the organization needs to reduce its debt or For example, a global systemically important bank holding conserve its capital. Similarly, the payment of company (G-SIB) is subject to a G-SIB surcharge that dividends based solely or largely on gains result- expands the capital conservation buffer applicable to the company. G-SIBs are also subject to a buffer over the ing from unusual or nonrecurring events may be supplementary leverage ratio that imposes limits very similar imprudent. Unusual or nonrecurring events may to the capital conservation buffer.

April 2020 Commercial Bank Examination Manual Page 2 Dividends 3025.1

Table 1—Calculation of Maximum Payout Amount

Capital Conservation Buffer Maximum Payout Ratio (as a percentage of (as a percentage of the previous risk weighted assets) four quarters of net income) Greater than 2.5% No payout ratio limitation applies. Less than or equal to 2.5% 60% and greater than 1.875% Less than or equal to 1.875% 40% and greater than 1.25% Less than or equal to 1.25% 20% and greater than 0.625% Less than or equal to 0.625% 0%

STATUTORY LIMITATIONS payments may resume in accordance with fed- eral and state statutory limitations and guide- Three major federal statutory limitations govern lines. the payment of dividends by banks. These limitations, included in sections 1831o, 56, and 60 of title 12 of the United States Code (12 Sections 56 and 60 USC 1831o, 56, and 60), apply to cash divi- dends and non-stock property dividends. Com- Sections 56 and 60 (sections 5204 and 5199 of mon stock dividends (dividends payable in com- the Revised Statutes) were first adopted as part mon stock to all the common shareholders of the of the National Bank Act more than a century bank) may be paid regardless of these statutory ago. Although these sections were made appli- limitations since such dividends do not reduce cable to national banks, they also apply to state the bank’s capital. In addition, the examiner member banks under the provisions of section 9 needs to be aware of any state laws governing of the Federal Reserve Act.4 These sections are dividend payments. implemented through section 208.5 of Regula- tion H. Under section 56, prior regulatory and share- Prompt Corrective Action holder approval must be obtained if the dividend would exceed the bank’s undivided profits Section 1831o, also referred to as the prompt- (retained earnings), as reportable in its Reports corrective-action (PCA) provision, was adopted of Condition and Income (Call Reports).5 In in 1991 as part of the Federal Deposit Insurance addition, the bank may include amounts con- Corporation Improvement Act. Section 1831o tained in its surplus account, if the amounts applies to all insured depository institutions, reflect transfers made in prior periods of undi- including state member banks, and is imple- vided profits and if regulatory approval for the mented through section 208.40 of Regulation H. transfer back to undivided profits is obtained. This regulatory section prohibits the payment of dividends when a bank is deemed to be under- capitalized or when the payment of the dividend 4. State-chartered banks that are not members of the would make the bank undercapitalized in accor- Federal Reserve System (state nonmember banks) are not subject to sections 56 and 60. However, they may be subject dance with the PCA framework. An organiza- to similar dividend restrictions under state law. tion that is undercapitalized for purposes of 5. Although the language of section 56 could imply that a PCA must cease paying dividends for as long as dividend cannot be declared in excess of the limit even if it is deemed to be undercapitalized. Once earn- regulatory approval were obtained, a “return of capital” to shareholders is allowed under section 59 if the bank obtains ings have begun to improve and an adequate prior regulatory approval and the approval of at least two- capital position has been restored, dividend thirds of each class of shareholders.

Commercial Bank Examination Manual April 2020 Page 3 3025.1 Dividends

Under section 60, prior regulatory approval to sufficient capacity to declare the dividend by declare a dividend must be obtained if the total maintaining sufficient documentation to substan- of all dividends declared during the calendar tiate its earnings or losses on an accrual basis for year, including the proposed dividend, exceeds the period since the last Call Report date. the (1) sum of the net income earned during the year-to-date and (2) the retained net income of the prior two calendar years as reported in the bank’s Call Reports. In determining this limita- REQUEST FOR REGULATORY tion, any dividends declared on common or APPROVAL preferred stock during the period and any required transfers to surplus or a fund for the When regulatory approval is required for divi- retirement of any preferred stock must be dend payments under section 56 or 60, the deducted from net earnings to determine the net request should be submitted to the appropriate income and retained net income.6 Federal Reserve Bank. In section 265.11(e)(4) The statutory limitations are tied to the dec- of the Rules Regarding Delegation of Authority, laration date of the dividend because, at that the Reserve Banks have been delegated author- time, shareholders expect the dividends will be ity to permit a state member bank to declare paid, a liability is recorded, and the bank’s dividends in excess of section 60 limits. Before capital is reduced. If the bank’s board of direc- approving the request, the Reserve Bank should tors wishes to declare a dividend between Call consider if the proposed dividend is consistent Report dates, the earnings or losses incurred with the bank’s capital needs, asset quality, since the last Call Report date should be con- strength of management, and overall financial sidered in the calculation. Thus, if a bank’s condition. dividend-paying capacity might be limited under If applicable, examiners should verify that sections 56 or 60, the bank should ensure it has prior approval was obtained from the Federal Reserve Bank, and, if required, at least two- 6. In rare circumstances when the surplus of a state member bank is less than what applicable state law requires thirds of each class of stockholders before the the bank to maintain relative to its capital stock account, the dividend was paid. Violations of law or safety bank may be required to transfer amounts from its undivided and soundness concerns arising from nonconfor- profits account to surplus. This may arise, for example, mance with the Federal Reserve Board’s policy because some states require surplus to equal or exceed 100 percent of the capital stock account. Such required statement should be discussed with bank man- transfers would reduce the section 60 calculation. agement and noted in the examination report.

April 2020 Commercial Bank Examination Manual Page 4 Dividends Examination Procedures Effective date April 2020 Section 3025.3

1. Evaluate the bank’s dividend policies materially affect the capital accounts, (which may be in the overall capital plan- dividends, and capital adequacy; ning policy) and determine whether they • provide guidelines for setting dividends provide appropriate guidance for manag- at appropriate levels relative to the ing the bank’s dividends. Consider whether bank’s financial position; and policies • include processes for reporting and • are consistent with the board’s risk remediating breaches of dividend. appetite; 3. Review any relevant work performed by • are reviewed and approved by the board internal or external auditors. If any defi- at appropriate intervals; ciencies were noted in the latest internal • require maintenance of adequate records or external auditor reports, determine if and documentation of the stock accounts appropriate corrective action has been and shareholders, as applicable; taken. • provide for compliance with applicable 4. Review board or risk committee minutes laws and regulations; for discussions regarding internal risk • clearly and completely articulate the assessment activities that management uses bank’s objectives for maintaining a sat- to supervise dividends. isfactory capital position, including 5. Determine whether board and senior man- restricting dividends and other capital agement receives information about emerg- distributions when the bank does not, or ing issues in a timely manner. may not, meet required capital levels or 6. Determine whether there is undue pres- internal targets; sure to pay dividends. Items to consider • include appropriate targets, limits, or include floors for dividends; • the holding company’s financial condi- • incorporate measures to ensure that suf- tion and contractual obligations, ficient capital remains after the payment • the financial condition of affiliates, of dividends to support the bank’s busi- ness plans, growth, and business goals • stockholder or market pressure, and as stated in the bank’s strategic or • capital distribution and bonus limita- capital plans; tions under the capital conservation • address the authorization of capital buffer. account and dividend transactions; 7. Review historical and planned dividend • require adequate documentation of capi- payout ratios and other planned capital tal transactions with affiliates or related reductions. For planned capital stock organizations; retirements, ensure management requested • address the employment of an indepen- prior regulatory approval. Also, determine dent stock registrar or stock transfer whether management evaluated the impact agent (e.g., review policies for third- of the capital conservation buffer. party vendors), if applicable; and 8. Determine whether dividends are exces- • address the selection and use of a third- sive compared to current earnings. party dividend paying agent, if applica- 9. Determine whether the bank complies with ble. applicable laws and regulations related to 2. Determine whether policies establish lim- dividends. its on dividends and issuances of capital 10.a. If dividends were declared since the last instruments, redemptions, or repurchases, examination, complete the dividend- limi- and delineate prudent actions to be taken tations worksheets to determine whether if the limits are exceeded. Consider the bank was in compliance with the whether policies following sections of the U.S. Revised • include sufficient standards for detect- Statutes, as they are interpreted by sec- ing and preventing activities that could tion 208.5 of Regulation H:

Commercial Bank Examination Manual April 2020 Page 1 3025.3 Dividends: Examination Procedures

• section 5199 (12 USC 60), which estab- b. For the calculations in table 1, determine lishes a restriction based on the current whether the dividend exceeded the sec- and prior two years’ retained net income, tion 56 or 60 limits and, if so, whether the as adjusted for required transfers to dividend received prior approval. Divi- surplus or transfers to a fund for the dends declared in excess of the section 56 retirement of any preferred stock. Table 1 limitation must receive prior Federal on the next page may be used for the Reserve approval and approval by at least calculation. two-thirds of the shares of each class of • section 5204 (12 USC 56), which estab- stock outstanding, pursuant to 12 USC 59. lishes a restriction on dividends based Dividends declared in excess of the sec- on the bank’s retained earnings (undi- tion 60 limitation must receive prior Fed- vided profits), as adjusted for any sur- eral Reserve approval. plus transferred, with prior regulatory approval, as needed, back to undivided profits and the excess, if any, of credit deduct its credit losses from its undivided profits, this adjust- losses or other losses derived from ment is not generally necessary. Under generally accepted accounting principles, banks reserve for bad debts in the extensions of credit over the allowance ALLL, which reduces the bank’s undivided profits. Banks for loan and lease losses (ALLL).1 should deduct only the credit losses in excess of the bank’s ALLL, and such excess should rarely occur. The second part of table 1 illustrates the section 56 dividend-limitation calcu- 1. Although section 56 seems to indicate that a bank should lation.

April 2020 Commercial Bank Examination Manual Page 2 Dividends: Examination Procedures 3025.3

Table 1—Dividend-Limitation Computations References to schedules in this table are to the schedules in the Consolidated Reports of Condition and Income (bank Call Reports). Section 60 Computation Section 56 Computation

Year Year 20__ 20__ 20__ Total 20__ Net income (loss) Retained earnings (schedule RI, (undivided profits) item 12) ______(schedule RC, item 26a) _____

Less: Add: Required transfers Surplus in excess of state to surplus under regulatory requirements state law (generally that was earned and is zero) or transfers to transferred, with prior a fund for the regulatory approval, back retirement of any to undivided profits _____ preferred stock ______Less: Less: Loan losses or other Common and pre- losses derived from exten- ferred stock divi- sions of credit that are in dends declared excess of the allowance (schedule RI-A, for loan and lease losses _____ item 8 + item 9) ______Section 56 limitation _____ Retained net profits available for divi- dends before adjust- ments ______

Adjustments for divi- dends in excess of income (if any) 1 ______

Retained net profits available for divi- dends after adjust- ments ______2

1. Any excess may be attributed to the prior two years by first applying the excess to the earlier year, and then the immediately preceding year, net of any previous-year adjust- ments. See section 208.5 of Regulation H for further guidance. 2. This is the section 60 limitation.

Commercial Bank Examination Manual April 2020 Page 3 Overview of Asset-Backed Commercial Paper Programs Effective date October 2018 Section 3030.1

INTRODUCTION against receivables generated by multiple cor- porate clients of the sponsoring banking organi- Asset-backed commercial paper (ABCP) pro- zations. These programs are generally well diver- grams provide a means for corporations to sified across both sellers and asset types. obtain funding by selling or securitizing pools of homogenous assets (for example, trade receiv- Single-seller programs are generally established ables) to special-purpose entities (SPEs/ABCP to fund one or more types of assets originated by programs). The ABCP program raises funds for a single seller. The lack of diversification is purchase of these assets by issuing commercial generally compensated for by increased program- paper into the marketplace. The commercial- wide credit enhancement. paper investors are protected by structural enhancements provided by the seller (for exam- Loan-backed programs fund direct loans to ple, overcollateralization, spread accounts, or corporate customers of the ABCP program’s early-amortization triggers) and by credit en- sponsoring banking organization. These loans hancements (for example, subordinated loans or are generally closely managed by the banking guarantees) provided by banking organization organization and have a variety of covenants sponsors of the ABCP program and by other designed to reduce credit risk. third parties. In addition, liquidity facilities are also present to ensure the rapid and orderly Securities-arbitrage programs invest in securi- repayment of commercial paper should cash- ties that generally are rated AA- or higher. They flow difficulties emerge. ABCP programs are generally have no additional credit enhancement nominally capitalized SPEs that issue commer- at the seller/transaction level because the secu- cial paper. A sponsoring banking organization rities are highly rated. These programs are establishes the ABCP program but usually does typically well diversified across security types. not own the conduit’s equity, which is often held The arbitrage is mainly due to the difference by unaffiliated third-party management compa- between the yield on the securities and the nies that specialize in owning such entities, and funding cost of the commercial paper. are structured to be bankruptcy remote. Structured investment vehicles (SIVs) are a form of a securities-arbitrage program. These ABCP TYPICAL STRUCTURE programs invest in securities typically rated AA-or higher. SIVs operate on a market-value ABCP programs are funding vehicles that bank- basis similar to market-value collateralized debt ing organizations and other intermediaries estab- obligations in that they must maintain a dynamic lish to provide an alternative source of funding overcollateralization ratio determined by analy- to themselves or their customers. In contrast to sis of the potential price volatility on securities term securitizations, which tend to be amortiz- held in the portfolio. SIVs are monitored daily ing, ABCP programs are ongoing entities that and must meet strict liquidity, capitalization, usually issue new commercial paper to repay leverage, and concentration guidelines estab- maturing commercial paper. The majority of lished by the rating agencies. ABCP programs in the capital markets are established and managed by major international commercial banking organizations. As with tra- KEY PARTIES AND ROLES ditional commercial paper, which has a maxi- mum maturity of 270 days, ABCP is short-term Key parties for an ABCP program include the debt that may either pay interest or be issued at following: a discount. • program management/administrators TYPES OF ABCP PROGRAMS • credit-enhancement providers • liquidity-facility providers Multi-seller programs generally provide work- • seller/servicers ing capital financing by purchasing or advancing • commercial paper investors

Commercial Bank Examination Manual October 2018 Page 1 3030.1 Overview of Asset-Backed Commercial Paper Programs

Program Management pool-specific or program-wide liquidity facili- ties. These backup liquidity facilities ensure the The sponsor of an ABCP program initiates the timely repayment of commercial paper under creation of the program but typically does not certain conditions, such as when financial mar- own the equity of the ABCP program, which is ket disruptions or cash-flow timing mismatches provided by unaffiliated third-party investors. were to occur, but generally not under condi- Despite not owning the equity of the ABCP tions associated with the credit deterioration of program, sponsors usually retain a financial the underlying assets or the seller/servicer to the stake in the program by providing credit extent that such deterioration is beyond what is enhancement, liquidity support, or both, and permitted under the related asset-quality test. they play an active role in managing the pro- gram. Sponsors typically earn fees—such as credit-enhancement, liquidity-facility, and Commercial Paper Investors program-management fees—for services pro- vided to their ABCP programs. Commercial paper investors are typically insti- Typically, an ABCP program makes arrange- tutional investors, such as pension funds, money ments with various agents/servicers to conduct market mutual funds, bank trust departments, the administration and daily operation of the foreign banks, and investment companies. Com- ABCP program. This includes such activities as mercial paper maturities range from 1 day to purchasing and selling assets, maintaining oper- 270 days, but most frequently are issued for 30 ating accounts, and monitoring the ongoing days or less. There is a limited secondary market performance of each transaction. The sponsor is for commercial paper since issuers can closely also actively engaged in the management of the match the maturity of the paper to the investors’ ABCP program, including underwriting the needs. Commercial paper investors are gener- assets purchased by the ABCP program and the ally repaid from the reissuance of new commer- type/level of credit enhancements provided to cial paper or from cash flows stemming from the the ABCP program. underlying asset pools purchased by the pro- gram. In addition, to ensure timely repayment in the event that new commercial paper cannot be Credit-Enhancement Providers issued or if anticipated cash flows from the underlying assets do not occur, ABCP programs The sponsoring banking organization typically utilize backup liquidity facilities. Furthermore, provides pool-specific and program-wide backup the banking organization can purchase the ABCP liquidity facilities, and program-wide credit from the conduit if the commercial paper cannot enhancements, all of which are usually unrated be issued. Pool-specific and program-wide credit (pool-specific credit enhancement, such as over- enhancements also protect commercial paper collateralization, is provided by the seller of the investors from deterioration of the underlying assets). These enhancements are fundamental asset pools. for obtaining high investment-grade ratings on the commercial paper issued to the market by the ABCP program. Seller-provided credit enhancement may exist in various forms and is THE LOSS WATERFALL generally sized based on the type and credit quality of the underlying assets as well as the The loss waterfall diagram (on the next page) quality and financial strength of seller/servicers. for the exposures of a typical ABCP program Higher-quality assets may only need partial generally has four legally distinct layers. How- support to achieve a satisfactory rating for the ever, most legal documents do not specify commercial paper. Lower-quality assets may which form of credit or liquidity enhancement is need full support. in a priority position after pool-specific credit enhancement is exhausted due to defaults. For example, after becoming aware of weakness in Liquidity-Facility Providers the seller/servicer or in asset performance, an ABCP program sponsor may purchase assets The sponsoring banking organization and, in out of the conduit using pool-specific liquidity. some cases, unaffiliated third parties, provide Liquidity agreements must be subject to a valid

October 2018 Commercial Bank Examination Manual Page 2 Overview of Asset-Backed Commercial Paper Programs 3030.1

The Loss Waterfall

Last Loss

Program- Wide Liquidity

Pool-Specific Liquidity

Program-Wide Credit Enhancement

Pool-Specific Credit Enhancement First Loss

asset-quality test that prevents the purchase of asset pool. Pool-specific credit enhancement can defaulted or highly delinquent assets. Liquidity take several forms, including overcollateraliza- facilities that are not limited by such an asset- tion, cash reserves, seller/servicer guarantees quality test are to be viewed as credit enhance- (for only highly rated seller/servicers), and sub- ment and are subject to the risk-based capital ordination. Credit enhancement can be either requirements applicable to direct-credit dynamic (that is, increases as the asset pool’s substitutes. performance deteriorates) or static (that is, fixed percentage). Pool-specific credit enhancement is generally provided by the seller/servicer (or Pool-Specific Credit Enhancement carved out of the asset pool in the case of The form and size of credit enhancement for overcollateralization) but may be provided by each particular asset pool is dependent upon the other third parties. nature and quality of the asset pool and the The ABCP program sponsor or administrator seller/servicer’s risk profile. In determining the will generally set strict eligibility requirements level of credit enhancement, consideration is for the receivables to be included in the pur- given to the seller/servicer’s financial strength, chased asset pool. For example, receivable eli- quality as a servicer, obligor concentrations, and gibility requirements will establish minimum obligor credit quality, as well as the historic credit ratings or credit scores for the obligors performance of the asset pool. Credit enhance- and the maximum number of days the receivable ment is generally sized to cover a multiple level can be past due. of historical losses and dilution for the particular Usually the purchased asset pools are struc-

Commercial Bank Examination Manual October 2018 Page 3 3030.1 Overview of Asset-Backed Commercial Paper Programs tured (credit-enhanced) to achieve a credit- a specific asset pool, or (2) a loan to the ABCP quality equivalent of investment grade (that is, program, which is repaid solely by the cash BBB or higher). The sponsoring banking orga- flows from the underlying assets.1 Some older nization will typically utilize established rating ABCP programs may have both pool-specific agency criteria and structuring methodologies to liquidity and program-wide liquidity coverage, achieve the desired internal rating level. In while more-recent ABCP programs tend to uti- certain instances, such as when ABCP programs lize only pool-specific facilities. Typically, the purchase asset-backed securities (ABS), the pool- seller-provided credit enhancement continues to specific credit enhancement is already built into provide credit protection on an asset pool that is the purchased ABS and is reflected in the purchased by a liquidity banking organization so security’s credit rating. The internal rating on that the institution is protected against credit the pool-specific liquidity facility provided to losses that may arise due to subsequent deterio- support the purchased asset pool will reflect the ration of the pool. inclusion of the pool-specific credit enhance- Pool-specific liquidity, when drawn prior to ment and other structuring protections. the ABCP program’s credit enhancements, is subject to the credit risk of the underlying asset pool. However, the liquidity facility does not Program-Wide Credit Enhancement provide direct credit enhancement to the com- mercial paper holders. Thus, the pool-specific The second level of contractual credit protection liquidity facility generally is in an economic is the program-wide credit enhancement, which second-loss position after the seller-provided may take the form of an irrevocable loan facility, credit enhancements and prior to the program- a standby , a surety bond from a wide credit enhancement even when the legal monoline insurer, or an issuance of subordinated documents state that the program-wide credit debt. Program-wide credit enhancement protects enhancement would absorb losses prior to the commercial paper investors if one or more of the pool-specific liquidity facilities. This is because underlying transactions exhaust the pool-specific the sponsor of the ABCP program would most credit enhancement and other structural protec- likely manage the asset pools in such a way that tions. The sponsoring banking organization or deteriorating portfolios or assets would be put to third-party guarantors are providers of this type the liquidity banking organizations prior to any of credit protection. The program-wide credit defaults that would require a draw against the enhancement is generally sized by the rating program-wide credit enhancement.2 While the agencies to cover the potential of multiple liquidity banking organization is exposed to the defaults in the underlying portfolio of transac- credit risk of the underlying asset pool, the risk tions within ABCP conduits and takes into is mitigated by the seller-provided credit en- account concentration risk among seller/servicers hancement and the asset-quality test.3 At the and industry sectors. time that the asset pool is put to the liquidity banking organization, the facility is usually fully drawn because the entire amount of the pool that Pool-Specific Liquidity qualifies under the asset-quality test is pur-

Pool-specific liquidity facilities are an important 1. Direct-liquidity loans to an ABCP program may be structural feature in ABCP programs because termed a commissioning agreement (most likely in a foreign they ensure timely payment on the issued com- bank program) and may share in the security interest in the mercial paper by smoothing timing differences underlying assets when commercial paper ceases to be issued due to deterioration of the asset pool. in the payment of interest and principal on the 2. In fact, according to the contractual provisions of some pooled assets and ensuring payments in the conduits, a certain level of draws on the program-wide credit event of market disruptions. The types of liquid- enhancement is a condition for unwinding the conduit pro- ity facilities may differ among various ABCP gram, which means that this enhancement is never meant to be used. programs and may even differ among asset 3. An asset-quality test or liquidity-funding formula deter- pools purchased by a single ABCP program. For mines how much funding the liquidity banking organization instance, liquidity facilities may be structured in will extend to the conduit based on the quality of the the form of either (1) an asset-purchase agree- underlying asset pool at the time of the draw. Typically, liquidity banking organizations will fund against the conduit’s ment, which provides liquidity to the ABCP purchase price of the asset pool less the amount of defaulted program by purchasing nondefaulted assets from assets in the pool.

October 2018 Commercial Bank Examination Manual Page 4 Overview of Asset-Backed Commercial Paper Programs 3030.1 chased by the banking organization. However, amount of all the commercial paper that is with respect to revolving transactions (such as issued by the ABCP program that is necessary to credit card securitizations) it is possible to achieve the desired external rating on the issued average less than 100 percent of the commitment. paper. Program-wide liquidity also provides liquidity in the event of a short-term disruption in the commercial paper market. In some cases, Program-Wide Liquidity a liquidity banking organization that extends a direct liquidity loan to an ABCP program may The senior-most position in the waterfall, be able to access the program-wide credit program-wide liquidity, is provided in an amount enhancement to cover losses while funding the sufficient to support that portion of the face underlying asset pool.

Commercial Bank Examination Manual October 2018 Page 5 Prompt Corrective Action Effective date November 2020 Section 3035.1

INTRODUCTION FDIA provides for increasingly stringent correc- tive provisions. The Federal Reserve has main- In 1991, Congress enacted a regulatory frame- tained the general structure of the existing PCA work to address the problems associated with framework while incorporating increased mini- troubled insured depository institutions with the mum capital requirements, including intent of minimizing the long-term cost to the Deposit Insurance Fund. This legislation led to • In 2013, when the Federal Reserve Board the enactment of the prompt-corrective-action implemented higher minimum capital require- (PCA) statute, which is contained in the Federal ments and adjusted ratios in four of the five Deposit Insurance Corporation Improvement Act capital categories of the PCA framework.1 of 1991, and added section 38 to the Federal The rule includes a common equity tier 1 Deposit Insurance Act (FDIA), as amended capital requirement, and specifies criteria that (12 U.S.C. 1831o). instruments must meet in order to be consid- FDIA section 38 requires regulators to admin- ered common equity tier 1 capital, additional ister timely corrective action to insured deposi- tier 1 capital, or tier 2 capital. tory institutions when their capital position • In 2019, the Federal Reserve Board, Office of declines or is deemed to have declined below the Comptroller of the Currency, and Federal certain threshold levels as a result of an unsafe Deposit Insurance Corporation (FDIC) adopted or unsound condition or practice. The PCA a rule that provides for a simple measure of framework specifies mandatory actions that regu- capital adequacy for certain community bank- lators must take as well as discretionary actions ing organizations, consistent with section 201 they must consider taking. of the Economic Growth, Regulatory Relief, In order to implement PCA as it applies to and Consumer Protection Act. This 2019 rule state member banks (bank), the Federal Reserve established the community bank leverage ratio Board added subpart D to its Regulation H (CBLR) framework. A depository institution (12 CFR 208.40 to 208.45). While in practice or depository institution holding company that this discussion refers to the Federal Reserve qualifies and opts into the CBLR framework Board, actions taken within the PCA framework (12 CFR 217.12) will be considered to have involve consultation between the Reserve Bank met the “well capitalized” ratio requirements staff and the Federal Reserve Board staff. There- for PCA purposes. For more information on fore, inquiries relating to PCA should be directed the CBLR framework, see 84 Federal Regis- to appropriate Federal Reserve Board staff. The ter 61,797 (November 13, 2019) and this Federal Reserve Board also added subpart E to manual’s section on “Assessment of Capital its Rules of Practice for Hearings (12 CFR Adequacy.” 263.80 to 263.85) to establish procedures for the issuance of notices, directives, and other actions authorized under FDIA section 38 and Regula- PCA CATEGORIES tion H. PCA uses capital ratios to trigger specific PCA uses the total risk-based capital measure, actions that are designed to restore a bank to tier 1 risk-based capital measure, common equity financial health. One of the primary sources of tier 1 risk-based capital measure, leverage ratio, the financial information for these ratios is the and tangible equity to total assets ratio for Consolidated Reports of Condition and Income assigning banks to the five capital categories.2 (Call Report). This gives added importance to the review of a bank’s records for accuracy during an examination. Under the PCA statute a 1. See the Board’s Regulation Q (12 CFR 217) and 78 Fed. bank is assigned to one of five capital catego- Reg. 62,018 (October 11, 2013). 2. The total risk-based capital ratio is defined as the ratio of ries: (1) well capitalized, (2) adequately capital- qualifying total capital to standardized total risk-weighted ized, (3) undercapitalized, (4) significantly under- assets; the tier 1 capital ratio is the ratio of tier 1 capital to capitalized, and (5) critically undercapitalized. standardized total risk-weighted assets; the common equity See the table at the end of this section for a tier 1 risk-based capital ratio is defined as the ratio of common equity tier 1 capital to standardized total risk-weighted assets; summary of framework definitions. As a bank is and the tier 1 leverage ratio is the ratio of tier 1 capital to total placed in progressively lower capital categories, average consolidated assets (the Federal Reserve may use

Commercial Bank Examination Manual November 2020 Page 1 3035.1 Prompt Corrective Action

These ratios are defined in the Federal Reserve tive to meet and maintain a specific capital Board’s Regulation Q, “Capital Adequacy of level for any capital measure. A qualifying Bank Holding Companies, Savings and Loan community banking organization, as defined Holding Companies, and State Member Banks.”3 in 12 CFR 217.12, which has elected to use A bank’s PCA category is based upon capital the CBLR framework is considered to have ratios derived from items such as the Call met the capital ratio requirements for the well Report, examination report, bank applications, capitalized capital category. In order to qualify and reports filed by the bank under banking or for the CBLR framework, a depository insti- securities laws as well as other sources. In tutions or depository institution holding com- general, a bank is deemed to be notified of its pany must have (among other things) a PCA category based upon leverage ratio greater than 9.0 percent and less than $10 billion in average total consoli- • the Call Report: as of the date that a bank is dated assets.5 For the complete list of quali- required to file its Call Report, fying criteria for the CBLR framework, see • the Federal Reserve Board or state examina- 12 CFR 217.12. tion report: as of the third day following the 2. Adequately capitalized. The bank has a total date on the Federal Reserve or state transmit- risk-based capital ratio of 8.0 percent or tal letter to a bank that accompanies the greater, a tier 1 risk-based capital ratio of 6.0 examination report, and percent or greater, a common equity tier 1 • other information: the bank’s receipt of writ- risk-based capital ratio of 4.5 percent or ten notice by the Federal Reserve Board that greater; and a leverage ratio of 4.0 percent or the bank’s capital category has changed. greater (or a leverage ratio of 3.0 percent or greater if the bank is rated composite 1 under The Federal Reserve’s notification to a bank the CAMELS rating system in its most recent of its PCA category is important since any bank report of examination), and the bank is not assigned to the undercapitalized, significantly experiencing or anticipating significant growth undercapitalized, or critically undercapitalized and does not meet the definition of a “well- categories is subject to certain mandatory pro- capitalized” bank.6 visions, and may be subject to certain discre- 3. Undercapitalized. The bank has a total risk- tionary provisions, immediately upon notifica- based capital ratio that is less than 8.0 per- tion. These mandatory and discretionary cent, tier 1 risk-based capital ratio that is less provisions are described in detail later. than 6.0 percent, a common equity tier 1 The following are descriptions of the five risk-based capital ratio that is less than PCA capital categories: 4.5 percent or a leverage ratio that is less than 4.0 percent (or a leverage ratio that is 1. Well capitalized. The bank has a total risk- less than 3.0 percent if the bank is rated based capital ratio of 10.0 percent or greater, composite 1 under the CAMELS rating sys- a tier 1 risk-based capital ratio of 8.0 percent tem in its most recent report of examination), or greater, a common equity tier 1 risk-based and the bank is not experiencing or anticipat- capital ratio of 6.5 percent or greater; and a ing significant growth.7 leverage ratio of 5.0 percent or greater,4 and 4. Significantly undercapitalized. The bank has the bank is not subject to an order, written a total risk-based capital ratio that is less than agreement, capital directive, or PCA direc-

5. In March 2020, section 4012 of the Coronavirus Aid, period-end total consolidated total assets whenever necessary, Relief, and Economic Security Act provided the agencies with on a case-by-case basis). The tangible equity ratio is defined the authority to grant banks with temporary regulatory relief as core capital elements plus cumulative perpetual preferred for certain provisions of the CBLR framework. The agencies stock, net of all intangible assets except those amounts of issued an interim final rule to adopt these temporary regula- mortgage servicing assets allowable in tier 1 capital. See the tory changes. See 85 Fed. Reg. 22,924 (April 23, 2020) for the Assessment of Capital Adequacy section of this manual for details and timeframe for this regulatory relief. more detailed information. 6. For an advanced approaches bank or bank that is a 3. See 12 CFR 217. Category III Board-regulated institution (as defined in 12 4. Beginning on January 1, 2018, any bank that is a CFR 217.2), a supplementary leverage ratio of 3.0 percent or subsidiary of a global systemically important bank holding greater. company (referred to as a “G-SIB”) under the definition of 7. For an advanced approaches bank or bank that is a “subsidiary” in 12 CFR 217.2 has a supplementary leverage Category III Board-regulated institution, a supplementary ratio of 6.0 percent or greater. leverage ratio of less than 3.0 percent.

November 2020 Commercial Bank Examination Manual Page 2 Prompt Corrective Action 3035.1

6.0 percent, a tier 1 risk-based capital ratio RECLASSIFICATION that is less than 4.0 percent, a common equity tier 1 risk-based capital ratio that is less than In the majority of cases, a bank’s PCA category 3 percent or a leverage ratio that is less than is defined by its capital ratios indicated in the 3.0 percent. preceding definitions. The finding of an unsafe 5. Critically undercapitalized. The bank has a or unsound condition or practice, however, may ratio of tangible equity to total assets that is lead the Federal Reserve to reclassify a bank’s equal to or less than 2.0 percent.8 PCA category to the next lower PCA category than the bank would otherwise qualify for based solely on its capital ratios.9 In these circum- EXAMINATION CONSIDERATIONS stances, the Federal Reserve Board may

If a bank is deemed undercapitalized, signifi- • reclassify a well-capitalized bank to the cantly undercapitalized, or critically undercapi- adequately capitalized category. talized, examiners should discuss the PCA pro- • require an adequately capitalized bank to visions with the institution’s management during comply with one or more supervisory actions the examination. Additionally, examiners should specified by PCA as though the bank is an caution a bank when its capital ratios approach undercapitalized bank. those found in the undercapitalized category to • impose one or more supervisory actions on an ensure that proposed dividend or management undercapitalized bank that would be autho- fee payments do not cause the bank to violate rized for a significantly undercapitalized bank. the statute. Any PCA-related comments should be noted in the examination report. The com- While the latter two actions do not strictly ments should be limited to the mandatory pro- represent reclassifications from one category to visions of the statute, reflect the immediacy of another, they are nonetheless collectively referred these provisions, and clearly indicate that the to as “reclassifications” for PCA purposes. bank’s receipt of the report of examination FDIA section 38 does not automatically sub- serves as notification that the bank is subject to ject a bank that has been reclassified to the next PCA provisions. lower capital category to the mandatory restric- tions of the lower category. These mandatory restrictions can only be imposed through the use of a PCA directive, and only those mandatory Capital Adequacy Page and discretionary provisions deemed appropri- ate by the Federal Reserve Board will be In the report of examination for most commu- imposed. A bank can only be reclassified to the nity banks, the PCA capital ratios appear on the next lower capital category and cannot be “Capital Adequacy” section of the “Analysis of classified as critically undercapitalized on any Financial Factors” page and are generally calcu- basis other than its tangible equity ratio. lated using the bank’s most recent Call Report. The reclassification of a bank for PCA pur- In situations where the impact of examination poses may affect the bank’s ability to accept findings (for example, loan-loss-reserve adjust- brokered deposits. If a well- or adequately ments or other losses) cause the bank to fall into capitalized bank is reclassified, the bank must a lower PCA category, the narrative portion of obtain an FDIC waiver to accept brokered depos- this examination report page should explicitly its, regardless of its actual capital level. (This state the adjusted PCA ratios and reconcile the manual’s Deposit Accounts section contains a adjustments that examiners made. detailed discussion on the capital requirements relating to brokered deposit activities.) An “unsafe or unsound condition” is not defined in the PCA statute and assessment and, therefore is left to the discretion of the Federal Reserve Board. Banks determined by the Fed- eral Reserve to be in an unsafe or unsound 8. The Federal Reserve may, at its discretion, “calculate condition based on the results of the most recent total assets using a bank’s period-end assets rather than quarterly average assets.” 12 CFR 208.41(m). 9. See 12 CFR 208.43(c).

Commercial Bank Examination Manual November 2020 Page 3 3035.1 Prompt Corrective Action report of examination or Call Report will be PCA PROVISIONS reclassified. Examiners should consider a bank for reclassification if the imposition of the avail- able PCA provisions would assist the bank to Provisions Applicable to All Banks return to a safe or sound condition or the bank to institute safe or sound practices. In addition, an Two provisions are applicable to all banks “unsafe or unsound practice” is defined as a (including well capitalized and adequately capi- less-than-satisfactory rating for any of the talized banks): AMELS ratings for the Asset quality, Manage- ment, Earnings, Liquidity or Sensitivity to mar- 1. A bank may not pay dividends or make any ket risk components of the CAMELS rating in other capital distributions that would leave it the bank’s most recent examination report and undercapitalized.11 that has not been corrected since the examina- 2. A bank may not pay a management fee to a tion. controlling person if, after paying the fee, the The Federal Reserve Board recognizes that bank would be undercapitalized. Manage- certain banks that are candidates for reclassifi- ment fees subject to this restriction include cation may have taken favorable actions that are those relating to supervisory, executive, mana- 10 consistent with the purposes of PCA. In these gerial, or policymaking functions, other than cases, reclassification may not be warranted if compensation to an individual in the indi- vidual’s capacity as an officer or employee of • the bank has raised or can demonstrate current the bank. This does not include fees relating efforts to raise enough capital to become and to nonmanagerial services provided by the remain well capitalized for the foreseeable controlling person, such as data processing, future, and trust activities, mortgage services, audit and • the bank has attempted to be in substantial accounting, property management, or similar compliance with all provisions of any out- services. standing informal or formal enforcement action, management is addressing existing problems and is considered satisfactory, and the bank’s condition is stable and shows signs Restrictions on Advertising of improvement. The Federal Reserve Board prohibits banks Where reclassification is determined to be from advertising its PCA capital category.12 appropriate, the Federal Reserve Board will However, banks are not restricted from adver- provide the bank with a written notice specify- tising their capital levels or financial condition. ing its intention to reclassify the bank, along with an explanation of the reasons for the downgrade. The date of the reclassification and Provisions Applicable to the required PCA provisions can be made effec- Undercapitalized Banks tive either at a specified future date or, under certain circumstances, immediately, at the dis- A bank categorized as undercapitalized is sub- cretion of the Federal Reserve Board. A bank is ject to several mandatory provisions that become entitled to appeal a reclassification, which effective upon the Federal Reserve Board noti- includes the opportunity for an informal hear- ing, following the receipt of a written notice. The appeal and hearing procedures are set out in 11. FDIA section 38 (12 U.S.C. 1831o(d)(1)(B)) requires subpart H of the Federal Reserve Board’s Rules that the Federal Reserve Board consult with the FDIC before of Practice for Hearings in section 263.203 approving a capital distribution under this section. Section 38 (12 CFR 263.203). also contains a limited exception to the restrictions on capital distributions for certain types of stock redemptions that (1) the Federal Reserve Board has approved, (2) are made in connec- tion with an equivalent issue of additional shares or obliga- tions, and (3) will improve the bank’s financial condition. See 10. FDIA section 38 explains that the purpose of PCA “is 12 U.S.C. 1831o(d)(1)(B). The Federal Reserve Board may to resolve the problems of insured depository institutions at also impose restrictions on capital distributions on any com- the least possible long-term loss to the Deposit Insurance pany that controls a significantly undercapitalized bank. Fund.” 12 U.S.C. 1831o(a)(1). 12. See 12 CFR 208.40(d).

November 2020 Commercial Bank Examination Manual Page 4 Prompt Corrective Action 3035.1 fying the bank. Under the mandatory provisions, • requiring the bank or any of its subsidiaries to an undercapitalized bank terminate, reduce, or alter any activity deter- mined by the Federal Reserve Board to pose • must cease paying dividends. excessive risk to the bank. • is prohibited from paying management fees to • ordering a new election of the board of direc- a controlling person (see the previous subsec- tors, dismissing certain senior executive offi- tion for exceptions). cers, or hiring new officers. • is subject to increased monitoring by the • prohibiting the acceptance, renewal, and roll- Federal Reserve Board and periodic review of over of deposits from correspondent deposi- the bank’s efforts to restore its capital. tory institutions. • must file and implement a capital restoration • prohibiting any bank holding company that plan generally within 45 days. Undercapital- controls the bank from making any capital ized banks that fail to submit or implement a distribution, including but not limited to divi- capital restoration plan are also subject to the dend payment, without the prior approval of provisions applicable to significantly under- the Federal Reserve Board. capitalized banks. • requiring the bank to divest or liquidate any • may acquire interest in a company, open any subsidiary that is in danger of becoming new branch offices, or engage in a new line of insolvent and that poses a significant risk to business only if the following three require- the bank, or is likely to cause significant ments are met: dissipation of its assets or earnings. — the Federal Reserve Board has accepted its • requiring any company that controls the bank capital restoration plan, to divest or liquidate any affiliate of the bank — any increase in total assets is consistent (other than another insured depository institu- with the capital restoration plan, and tion) if the Federal Reserve Board determines — the bank’s ratio of tangible equity to assets that the affiliate is in danger of becoming increases during the calendar quarter at a insolvent and poses a significant risk to the rate sufficient to enable the bank to become bank, or is likely to cause significant dissipa- adequately capitalized within a reasonable tion of the bank’s assets or earnings. time. • requiring the bank to take any other action that would more effectively carry out the purpose In addition to the mandatory provisions, a num- of PCA than the above actions. ber of discretionary provisions may be imposed by the Federal Reserve Board on an undercapi- talized bank. These include Provisions Applicable to Significantly Undercapitalized Banks • requiring recapitalization by doing one or more of the following: The mandatory restrictions applicable to under- — That the bank sell enough additional capi- capitalized banks also apply to banks that are tal or debt to ensure that it would be significantly undercapitalized. In addition, a sig- adequately capitalized after the sale. nificantly undercapitalized bank is restricted in — That the aforementioned additional capital paying bonuses or raises to senior executive be voting shares. officers of the bank unless it receives prior — That the bank accept an offer to be acquired written approval from the Federal Reserve Board. by another institution or company, or that If a bank fails to submit an acceptable capital any company that controls the bank be restoration plan, however, no such bonuses or required to divest itself of the bank. raises may be paid until an acceptable plan has • restricting transactions between the bank and been submitted. its affiliates. The Federal Reserve Board must take the • restricting the interest rates paid on deposits following actions unless it is determined that collected by the bank to the prevailing rates these actions would not further the purpose of paid on comparable amounts in the region PCA (resolution at the least possible long-term where the bank is located. loss to the Deposit Insurance Fund): • restricting the bank’s asset growth or requir- ing the bank to reduce its total assets. • Require one or more of the following:

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— That the bank sell enough additional capi- • the bank has been in substantial compliance tal or debt to ensure that it would be with its capital restoration plan since the date adequately capitalized after the sale. of the plan’s approval. — That the aforementioned additional capital • the bank is profitable or has a sustainable be voting shares. upward trend in earnings. — That the bank accept an offer to be acquired • the bank is reducing its ratio of nonperforming by another institution or company, or that loans to total loans. any company that controls the bank be • the chair of the Federal Reserve Board and the required to divest itself of the bank. chair of the FDIC both certify that the bank is • Restrict the bank’s transactions with affiliates. viable and not expected to fail. • Restrict the interest rates paid on deposits collected by the bank to the prevailing rates Beginning 60 days after becoming critically paid on comparable amounts in the region undercapitalized, critically undercapitalized where the bank is located. banks are also prohibited from making any payment of principal or interest on subordinated In addition to these mandatory provisions, the debt issued by the bank without the prior Federal Reserve Board will impose one or more approval of the FDIC. Unpaid interest, however, of the discretionary provisions for undercapital- may continue to accrue on subordinated debt ized banks on a significantly undercapitalized under the terms of the debt instrument. The bank. Moreover, other measures (including the FDIC is also required, at a minimum, to prohibit provisions for critically undercapitalized banks) a critically undercapitalized bank from doing may be required if the Federal Reserve Board any of the following without the prior written determines that such actions will advance the approval of the FDIC: purpose of PCA.13 • entering into any material transaction not in the usual course of business. Such activities Provisions Applicable to Critically include any investment, expansion, acquisi- Undercapitalized Banks tion, sale of assets, or other similar action where the bank would have to notify the Federal Reserve. A critically undercapitalized bank must be placed in conservatorship (with the concurrence of the • extending credit for any highly leveraged FDIC) or receivership within 90 days, unless the transaction. Federal Reserve Board and the FDIC concur • amending the bank’s charter or bylaws, except that other action would better achieve the pur- to the extent necessary to carry out any other poses of PCA. The statute also addresses require- requirement of any law, regulation, or order. ments in deferring the placing of a critically • making any material change in accounting undercapitalized bank in conservatorship or methods. receivership.14 • engaging in any covered transaction under A bank must be placed in receivership if it section 23A(b) of the Federal Reserve Act. continues to be critically undercapitalized on • paying excessive compensation or bonuses. average15 during the fourth calendar quarter • paying interest on new or renewed liabilities following the period that it initially became that would increase the bank’s weighted critically undercapitalized, unless the Federal average cost of funds to a level significantly Reserve Board, with the FDIC’s concurrence, exceeding the prevailing rates of interest paid determines that on insured deposits in the bank’s normal market area. • the bank has a positive net worth.

13. 12 U.S.C. 1831o(f)(3). Capital Restoration Plans 14. 12 U.S.C. 1831o(h)(3). 15. The average is determined by adding the sum of the A bank that is undercapitalized, significantly total tangible equity ratio at the close of business on each day during the quarter and dividing that sum by the number of undercapitalized, or critically undercapitalized business days in that quarter. must submit an acceptable capital restoration

November 2020 Commercial Bank Examination Manual Page 6 Prompt Corrective Action 3035.1 plan to the Federal Reserve Board. This plan • provide written notice to the bank about must be submitted in writing and specify— whether it has approved or rejected the capital plan; and • the steps the bank will take to become • provide a copy of each acceptable capital adequately capitalized; restoration plan, and amendments thereto, to • the levels of capital the bank expects to attain the FDIC within 45 days of accepting the each year that the plan is in effect; plan. • how the bank will comply with the restrictions and requirements imposed on it under FDIA There are two cases where a capital restoration section 38; plan may not be required: • the types and levels of activities in which the bank will engage; and 1. When a bank has capital ratios consistent • any other information required by the Federal with those corresponding to the adequately Reserve Board. capitalized category but, due to unsafe or unsound conditions or practices, has been The Federal Reserve Board cannot accept a reclassified to the undercapitalized category. capital restoration plan unless the plan (If the Federal Reserve requires a plan solely due to such a reclassification, the plan should • contains the information required in the pre- specify the steps the bank will take to correct ceding five points; the unsafe or unsound condition or practice.) • is based on realistic assumptions and is likely to succeed in restoring the bank’s capital; 2. When a bank’s capital category changes, but • would not appreciably increase the risk the bank is already operating under a capital (including credit risk, interest-rate risk, and restoration plan accepted by the Federal other types of risk) to which the bank is Reserve. exposed; and • contains a guarantee from each company that The Federal Reserve Board will examine the controls the bank, specifying that the bank circumstances of each of the above cases to will comply with the plan until it has been determine whether a bank must submit a revised adequately capitalized on average during each plan. of four consecutive calendar quarters, and each company has provided appropriate assur- ances of performance. (See the subsequent Capital Restoration Plan Guarantee subsection, “Capital Restoration Plan Guaran- tee,” for additional information.) The Federal Reserve Board cannot approve a capital restoration plan unless each company that controls the bank has guaranteed the bank’s Submission and Review of Capital Plans compliance with the plan and has provided reasonable assurances of performance. The Fed- The Federal Reserve Board has established rules eral Reserve Board will consider on a case-by- regarding a uniform schedule for the filing and case basis the appropriate type of guarantee for review of capital restoration plans. These rules multi-tier holding companies, or parent hold- require a bank to submit a capital restoration ing companies that are shell companies or that plan within 45 days after the bank has received have limited resources. A guarantee that is notice, or has been deemed to have been noti- backed by a contractual pledge of resources fied, that it is undercapitalized, significantly from a parent company may satisfy the require- undercapitalized, or critically undercapitalized. ments of FDIA section 38, particularly in situ- The Federal Reserve Board may change this ations involving the ownership of an insured period in individual cases, provided it notifies bank by a foreign holding company through a the bank that a different schedule has been wholly owned domestic shell holding. In other adopted. The Federal Reserve Board must also situations, a third-party guarantee made by a party with adequate financial resources may be • review each capital restoration plan within satisfactory. 60 days of the bank’s submission of the plan PCA also contains several provisions that unless it extends the review time; clarify the capital restoration plan guarantee:

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• Limitation on liability. The aggregate amount indicate that immediate action is necessary to of liability under the guarantee for all compa- serve the purpose of PCA. These directives are nies that control a specific bank is limited to issued for reasons such as reclassifying a bank the lesser of (1) an amount equal to 5 percent and implementing discretionary provisions, the of the bank’s total assets, or (2) the amount latter of which includes the dismissal of direc- necessary to restore the relevant capital ratios tors or senior executive officers. of the bank to the level required for the bank A notice of intent to issue a directive should to be categorized as adequately capitalized. include • Limitation on duration. The guarantee and limit on liability expires after the Federal • a statement of the bank’s capital measures and Reserve Board notifies the bank that it has levels; remained adequately capitalized for each of the previous four consecutive calendar quar- ters. • a description of the restrictions, prohibitions, • Collection of guarantee. Each company that or affirmative actions that the Federal Reserve controls a given bank is jointly and severally Board proposes to impose or require; liable for the guarantee. • Failure to provide a guarantee. A bank will be • the proposed date when such restrictions or treated as if it had not submitted an acceptable prohibitions would be effective or the pro- capital restoration plan if its capital plan does posed date for completion of such affirmative not contain the required guarantee. actions; and • Failure to perform under a guarantee. A bank will be treated as if it failed to implement the capital restoration plan if any company • the date by which the bank or company that controls the bank fails to perform its subject to the directive may file with the guarantee. Federal Reserve Board a written response to the notice.

Failure to Submit an Acceptable When a directive becomes effective at a Capital Plan future date, the Federal Reserve Board must provide the bank or company an opportunity to An undercapitalized bank that fails to submit or appeal the directive before taking final action. implement, in any material respect, an accept- This requires the bank to submit information able capital restoration plan within the required relevant to the decision within the time period period is subject to the same provisions appli- set by the Federal Reserve Board, which must be cable to a bank that is significantly undercapi- at least 14 calendar days from the date of the talized. If a bank’s capital restoration plan is notice, unless the Federal Reserve Board deter- rejected by the Federal Reserve Board, the bank mines that a shorter period is appropriate in light is required to submit a new capital plan within of the financial condition of the bank or other the time period specified by the Federal Reserve relevant circumstances. Board. During the period following notice of the In the case of a directive that is immediately rejection, and before Federal Reserve Board effective upon notification of the bank, the approval of a new or revised capital plan, the Federal Reserve Board’s rules provide an oppor- bank is treated in the same manner as a signifi- tunity for the bank or company to seek an cantly undercapitalized bank. expedited modification or rescission of the direc- tive. A bank or company that appeals a directive effective immediately is required to file a written ISSUANCE OF PCA DIRECTIVES appeal within 14 days of receiving the notice, and the Federal Reserve Board will consider the The Federal Reserve Board must provide a appeal within 60 days of receiving it. During the bank, or company controlling a bank (com- period that the appeal is under review the pany), a written notice of proposed action under directive remains in effect, unless the Federal FDIA section 38 (referred to as a directive), Reserve Board stays the effectiveness of the unless the circumstances of a particular case directive.

November 2020 Commercial Bank Examination Manual Page 8 Prompt Corrective Action 3035.1

Dismissal of Directors or Senior or deny the request for reinstatement and notify Executive Officers the respondent of the Federal Reserve Board’s decision. The date for the hearing and for the The Federal Reserve Board’s rules establish a ultimate decision follows the same timeframe as special procedure permitting an opportunity for that indicated for the appeals process in the senior executive officers and directors dismissed preceding paragraph. from a bank as a result of a PCA directive to petition the Federal Reserve Board for reinstate- ment. A director or senior executive officer who Enforcement of Directives is required to be dismissed in compliance with a Federal Reserve Board directive may have the PCA directives may be enforced in the federal dismissal reviewed by filing, within 10 days, a courts, and may also subject any bank, com- request for reinstatement with the Federal pany, or institution-affiliated party that violates Reserve Board. The respondent will also be the directive to civil money penalties or other given the opportunity to submit written materi- enforcement actions. The failure of a bank to als in support of the petition and to appear at an implement a capital restoration plan, or the informal hearing before representatives of the failure of a company having control of a state Federal Reserve Board. Unless otherwise ordered member bank to fulfill a guarantee that the by the Federal Reserve Board, the dismissal company has given in connection with a capital remains in effect while a request for reinstate- plan accepted by the Federal Reserve Board, ment is pending. No later than 60 calendar days could subject the bank or company or any of after the date the record is closed or the date of their institution-affiliated parties to a civil money the response in a case where no hearing was penalty assessment. requested, the Federal Reserve Board shall grant

Commercial Bank Examination Manual November 2020 Page 9 3035.1 Prompt Corrective Action

TABLE 1—SUMMARY OF SPECIFICATIONS OF CAPITAL CATEGORIES FOR PROMPT CORRECTIVE ACTION FOR INSTITUTIONS NOT SUBJECT TO THE COMMUNITY BANK LEVERAGE RATIO FRAMEWORK

Total Common Risk-Based Equity Capital Tier 1 Tier 1 Capital (RBC) RBC RBC Leverage Category Measure Measure Measure Measure Well 10% or more 8% or more 6.5% or more 5% or more* Capitalized and and and and Adequately 8% or more 6% or more 4.5% or more 4% or more** Capitalized and and and Under- less than 8% less than 6% less than 4.5% less than 4%** capitalized or or or Significantly less than 6% less than 4% less than 3% less than 3% Under- or or or capitalized Critically tangible equity to total assets ratio of 2% or less Under- capitalized

* For a bank that is a subsidiary of a G-SIB, a supplementary leverage ratio of 6.0 percent or more. ** For an advanced approaches bank or bank that is a Category III Board-regulated institution, a supplementary leverage ratio of 3.0 percent or more.

November 2020 Commercial Bank Examination Manual Page 10 Prompt Corrective Action Examination Objectives Effective date November 2020 Section 3035.2

1. To assess whether prompt-corrective-action 3. To verify that undercapitalized, significantly (PCA) provisions are necessary. undercapitalized, and critically undercapital- 2. To assess whether the policies, practices, and ized banks have effective capital restoration procedures are in place to ensure compliance plans that comply with PCA. with PCA mandatory and discretionary provisions.

Commercial Bank Examination Manual November 2020 Page 1 Prompt Corrective Action Examination Procedures Effective date November 2020 Section 3035.3

1. During on-site examinations, validate the the undercapitalized levels, caution the board state member bank’s capital levels, risk- of directors and senior management about weighted assets, and capital ratios in compli- their ensuring that any proposed dividend or ance with primary capital provisions of sec- management fee payments do not cause the tion 38 of the Federal Deposit Insurance Act bank to violate FDIA section 38. (FDIA) and the Federal Reserve’s respective 4. When the impact of the bank’s examination capital adequacy rules. (See this manual’s findings (for example, loan-loss-reserve section on the Assessment of Capital Ad- adjustments or other losses) will cause the equacy and 12 CFR 217.) Verify that the bank to fall into a lower prompt-corrective- bank’s action category, explicitly state in the narra- a. capital instruments are appropriate for tive portion of the capital examination report inclusion in common equity tier 1, tier 1, page the adjusted prompt-corrective-action or tier 2 capital. capital ratios with a clear account of the b. assets were properly risk-weighted and adjustments that were made to the quarter- that the appropriate credit equivalent mea- end or period-end ratios. sure (for example, the credit-conversion factors, credit-rating factors) were assigned 5. Include in the appropriate report page of the for the bank’s off-balance-sheet assets or state member bank examination report any transactions. comments regarding the applicability of FDIA 2. When a state member bank is considered section 38 and Regulation H pertaining to undercapitalized, significantly undercapital- prompt corrective action. With regard to ized, or critically undercapitalized, discuss prompt corrective action, limit the comments with the bank’s management the prompt to the mandatory restrictions of the statute corrective action restrictions under FDIA and the immediacy of those provisions. State section 38 and the Board’s Regulation H that the receipt of the state member bank (12 CFR 208, subpart D). examination report serves as notification that 3. When a state member bank is operating with the bank is subject to prompt corrective an amount of consolidated capital that is near action.

Commercial Bank Examination Manual November 2020 Page 1 Earnings—Analytical Review of Income and Expense Effective date October 2018 Section 3100.1

INTRODUCTION related financial information that supports the source and trend in the bank’s earnings. A From a regulator’s standpoint, the essential well-performed analytical review provides exam- purpose of bank earnings, both current and iners with an understanding of the bank’s opera- accumulated, is to absorb losses and augment tions. An analytical review of bank earnings capital. Earnings is the initial safeguard against highlights matters of interest and potential prob- the risks that a bank incurs in the course of lem situations which, examiners will need to doing business, and represents a bank’s first line address with the bank. In reviewing and assess- of defense against capital depletion resulting ing a bank’s earning, examiners perform level from a decline in the value of its assets. This and trend analysis of financial report data and section is designed to provide a high-level ratios as well as reviewing other metrics. Ana- overview for examiners in assessing a bank’s lytical review is based on the assumption that earning through the use of analytical review period-to-period balances and ratios are free techniques. Examiners need to remain cognizant from significant error considering the proce- of the inextricable links among capital, asset dures relating to income and expenses, and quality, earnings, liquidity, and market risk sen- regulatory reports conducted by internal or exter- sitivity. nal auditors. (See the manual section entitled, “Internal Control and Audit Function, Over- sight, and Outsourcing,” for a discussion of factors to consider in reviewing the audit work GENERAL EXAMINATION of others.) APPROACH

As part of the off-site preparation for an on-site examination, examiners review and analyze a Analytical Tools bank’s financial condition. (See the manual sections entitled, “Examination Strategy and The UBPR and the bank’s financial statements Risk-Focused Examinations” and “Federal are key sources of analysis for examination Reserve System Bank Surveillance Program.”) staff. Bank-prepared statements and supplemen- This analysis is meant to identify potential tal schedules, if available, facilitate an in-depth problem areas and to develop the examination analytical review. The information from those scope so that proper staff levels and appropriate schedules may give examiners considerable examination procedures can be used. insight into the interpretation of the bank’s basic The analysis of earnings includes all bank financial statements. To properly understand and operations and activities. When evaluating earn- interpret a particular bank’s financial and statis- ings, examiners should develop an understand- tical data, examiners should be familiar with ing of the bank’s core business activities. Core current economic and industry conditions, includ- activities are those operations that are part of a ing any idiosyncratic cyclical or seasonal factors bank’s normal or continuing business. Examin- in the nation, region, and local area that may ers should understand a bank’s composition of have an affect on the bank’s earnings. Economic earnings and sustainability of the various earn- and industry information, reports, and journals ings components. This would include balance- are useful informational sources of industry sheet composition, particularly the volume and conditions and trends. Finally, examiners should type of earning assets and off-balance-sheet be knowledgeable about new banking laws and items, if applicable. new accounting standards or methodologies that could have a material effect on financial institu- tions’ business and earnings. ANALYTICAL REVIEW

In performing the analytical review of a bank, UBPR examiners should use the most recent Uniform Bank Performance Report (UBPR) as well as The information used to prepare UBPRs are the most recent financial statements and other largely based on the Consolidated Reports of

Commercial Bank Examination Manual October 2018 Page 1 3100.1 Earnings—Analytical Review of Income and Expense

Condition and Income (Call Report). Each UBPR other liquidity aspects, as they may affect also contains corresponding average data for the earnings; bank’s peer group (a group of banks of similar • yield or cost information, which may be asset size and reporting characteristics) and difficult to interpret from the report, is needed; percentile rankings for most ratios. The UBPR • certain income or expense items may need facilitates the evaluation of a bank’s current clarification, as well as normal examination condition, trends in its financial performance, validation; and comparisons with the performance of its • volume information, such as the number of peer group. demand deposits, certificates of deposit, and The user’s guide for the UBPR explains how other accounts, is not reported, and vulnerabil- a structured approach to financial analysis should ity in a bank subject to concentrations nor- be followed.1 This approach breaks down a mally should be considered; bank’s income stream into its major components of interest margin performance, overhead, non- • components of interest and fees on loans are interest income, loan-loss provisions, tax fac- not reported separately by category of loan; tors, and extraordinary items. These major com- thus, adverse trends in the loan portfolio may ponents can then be broken down into various not be detected (for example, the yield of a subcomponents. Also, examiners should analyze particular bank’s loan portfolio may be similar the balance-sheet composition along with eco- to those of its peer group, but examiners may nomic conditions to understand the source and detect an upward trend in yields for a specific future variability of a bank’s income stream. category of loans. That upward trend might be The dollar amounts displayed for most income partially or wholly offset by a downward trend and expense items in the UBPR are shown for of yields in another category of loans, and the year-to-date period. However, to allow com- examiners should consider further investigat- parison of ratios between quarters, income and ing the circumstances applicable to each of expense and related data used in certain ratios those loan categories. A change in yields are annualized for interim reporting periods. could be a result of a change in the bank’s Thus, the income or expense item is multiplied business model or risk “appetite” for certain by the indicated factor listed below before types of loans or may indicate a change in dividing it by the corresponding asset or liabil- loan underwriting standards.); or ity. The UBPR annualization factors are • income or expense resulting from a change in the bank’s operations, such as the opening of • March 4.0, a new branch or starting of a mortgage bank- • June 2.0, and ing activity or trust department, may skew • September 1.3333. performance ratios. (When there has been a significant change in a bank’s operations, Income and expense information reported on examiners should analyze the potential impact the December 31 Call Report is not annualized. of the change on future bank earnings.) Since the year-end UBPR represents a full fiscal year. Frequently, examiners need a more detailed Review of Management’s Budget and and current review of a bank’s financial condi- Financial Statements tion than that provided by the UBPR. Under certain circumstances, UBPR procedures may In addition to UBPR analysis, examiners should need to be supplemented because— incorporate a review of management’s budget and/or financial projections. In reviewing a • asset-quality information must be linked to the bank’s projections and individual variances from income stream; its operating budget, examiners should be able • more detailed information is necessary on to identify the sources and trends in the bank’s asset-liability maturities and matching; prior and future earnings. Examiners should also • more detailed information is necessary on verify the reasonableness of the budgeted amounts, frequency of budget review by bank management and the board of directors, and 1. The Federal Financial Institutions Examination Council (FFIEC) provides additional information on the UBPR, includ- level of involvement of key bank personnel in ing the UBPR User’s Guide at www.ffiec.gov/ubpr.htm. the budget process.

October 2018 Commercial Bank Examination Manual Page 2 Earnings—Analytical Review of Income and Expense 3100.1

In reviewing a bank’s financial statements, the rate of growth of retained earnings, and the examiners should be cognizant of new account- bank’s ability to cover losses and maintain ing standards or changes in accounting method- adequate capital. A bank’s earnings should also ologies. In addition, alternative accounting treat- be more than sufficiently adequate in relation to ments for similar transactions among peer banks its current dividend rate. In particular, examiners also should be considered because they may should consider whether a bank’s dividend rate produce significantly different results. The ana- is prudent relative to its financial position and lytical review must be based on figures derived not based on overly optimistic earnings sce- under valid accounting practices consistently narios. See SR-09-4, “Applying Supervisory applied, particularly in the accrual areas. Accord- Guidance and Regulations on the Payment of ingly, during the analytical review, examiners Dividends, Stock Redemptions, and Stock Re- should work with Reserve Bank accounting purchases at Bank Holding Companies.”2 Pru- specialists to determine any material inconsis- dent management dictates that a bank should tencies in the application of accounting prin- consider the curtailment of the dividend rate if ciples. capital is inadequate and greater earnings reten- tion is required. If it appears that a bank’s dividend payout isexcessive or that there is a Review of Nonrecurring and record of recent operating losses, examiners Extraordinary Items should refer to sections 5199(b) and 5204 of the United States Revised Statutes and section When assessing earnings, examiners should be 208.19 of Regulation H which restrict state aware of nonrecurring events or actions that member bank dividends. See also this manual’s have affected a bank’s earnings performance, section entitled, “Dividends.” positively or negatively, and should adjust earn- ings on a tax equivalent (TE) basis for compari- son purposes. Although the analysis should ASSIGNING THE EARNINGS reflect adjustments for non-recurring events, RATING examiners should also include within their analy- sis the impact that these items had on overall After performing the appropriate examination earnings performance. Examples of events that procedures and documenting the supervisory may affect earnings include adoption of new assessment of a bank, examiners assign a com- accounting standards, extraordinary items, or ponent Uniform Financial Institution Ratings other actions taken by management that are not System rating based on an evaluation of a banks considered part of a bank’s normal operations earnings. Examiners assign a rating that ad- such as sales of securities for tax purposes or for dresses the quantity and trend of a bank’s some other reason unrelated to active manage- earnings, as well as factors that may affect the ment of the securities portfolio. sustainability or quality of earnings. The quan- The exclusion of nonrecurring events from tity as well as the quality of a bank’s earnings the analysis allows examiners to analyze the can be affected by excessive or inadequately profitability of a bank’s core operations without managed credit risk that may result in loan the distortions caused by non-recurring items. losses and require additions to the allowance for By adjusting for these distortions, examiners are loan and lease losses, or by high levels of market better able to compare a bank’s current earnings risk that may unduly expose an institution’s performance against the bank’s past perfor- earnings to volatility in interest rates.3 The mance and industry norms (for example, peer quality of earnings may also be diminished by group data). undue reliance on extraordinary gains, nonrecur- ring events, or favorable tax effects. Future earnings may be adversely affected by an inabil- Compliance with Laws and Regulations Relating to Earnings and 2. See also the Bank Holding Company Supervision Manual Dividends for a discussion of the Board’s “Policy Statement on the Payment of Cash Dividends by State Member Banks and Bank Holding Companies.” Examiners should consider the interrelation- 3. See this manual’s section entitled, “Allowance for Loan ships that exist among the dividend-payout ratio, and Lease Losses,” for more information.

Commercial Bank Examination Manual October 2018 Page 3 3100.1 Earnings—Analytical Review of Income and Expense ity to forecast or control funding and operating • the quality and sources of earnings expenses, improperly executed or ill-advised • the level of expenses in relation to the bank’s business strategies, or poorly managed or uncon- operations trolled exposure to other risks. • the adequacy of the bank’s budgeting systems, Examiners base their rating of a bank’s earn- forecasting processes, and management infor- ings based upon, but not limited to, an assess- mation systems in general ment of the following evaluation factors: • the adequacy of the bank’s provisions for the • the level of earnings, including trends and allowance for loan and lease losses and other stability valuation allowance accounts • the bank’s ability to provide for adequate • the earnings exposure to market risk such as capital through retained earnings interest rate, foreign exchange, and price risks

October 2018 Commercial Bank Examination Manual Page 4 Earnings—Analytical Review of Income and Expense Examination Objectives Effective date October 2018 Section 3100.2

1. To determine whether profit planning and 5. To determine whether earnings are sufficient budgeting practices are adequate. to support operations, provide for funding of 2. To determine whether internal controls are the allowance for loan and lease losses and adequate. augment capital. 3. To assess whether the audit or independent 6. To assess whether earnings are sustainable. review functions adequate. 7. To determine whether board and senior man- 4. To determine whether information and com- agement effectively supervise this area. munication systems are adequate and accu- rate.

Commercial Bank Examination Manual October 2018 Page 1 Earnings—Analytical Review of Income and Expense Examination Procedures Effective date October 2018 Section 3100.3

1. Review previous reports of examination, • new products and business lines prior examination work papers, and file • asset and liability mix and pricing correspondence for an overview of any previously identified earnings concerns, • growth objectives strengths, or other considerations. • capital requirements 2. Review recent audits and independent 9. Assess the timeliness of preparing and reviews to identify deficiencies concerning approving the profit plans and budgets. the reliability of management information systems (MIS) that may affect the quality 10. Compare earnings performance to budget and reliability of reported earnings. forecasts. Determine whether management 3. Review management’s remedial actions to compares budgeted performance to actual correct examination and audit deficiencies. performance on a periodic basis, modifies 4. Discuss with management any recent or projections when interim circumstances planned changes in strategic objectives and change significantly, and evaluates budget their implications for profit plans. forecasts under multiple stress scenarios. 5. Review board and committee minutes and management reports to determine the adequacy/quality of MIS systems and re- ports. 6. Review recent Uniform Bank Performance INTERNAL CONTROLS Reports (UBPR) to develop an initial assess- 11. Review management’s procedures to pre- ment of overall earnings performance. Con- sider the impact of Chapter S tax filing vent, detect, and correct errors with respect status when selecting performance ratios to to MIS. review. 12. Determine whether the income and expense 7. Compare financial statements, UBPRs, and posting, reconcilement, and review func- Consolidated Reports of Condition and tions are independent of each other. Con- Income (Call Reports) to determine if there sider testing selected income, expense, and have been any significant changes that could balance sheet items to observe the opera- materially affect earnings performance. tional flow of transactions and to assess the potential for fraud from internal con- trol weaknesses. Areas commonly selected for review are PROFIT PLANNING AND • large volumes of other income (miscella- BUDGETING PRACTICES neous, service fees, or any other unusual accounts); 8. Review strategic plans, profit plans, and budgets to determine if the underlying • proper amortization of loan origination assumptions are realistic. Determine the fees; sources of input for profit plans and bud- • insider expense accounts; gets. Profit plans and budgets should con- • management fees or other payments to sider the following areas with detail appro- affiliates; priate for the size, complexity, and risk profile of the bank: • significant legal fees; • anticipated funding of the allowance for • prepaid accounts; loan and lease losses • stale items; and • anticipated level and volatility of interest • expenses accrued and unpaid. rates • interest rate and maturity mismatches 13. Determine whether significant or nonrecur- • local and national economic conditions ring income, expenses, and capital charges • funding strategies are reviewed and appropriately authorized.

Commercial Bank Examination Manual October 2018 Page 1 3100.3 Earnings—Analytical Review of Income and Expense: Examination Procedures

14. Determine whether insider or affiliate- verify the accuracy of the appropriate Call related income and expense items are rou- Report schedules. tinely reviewed for authorization, appropri- ateness, and compliance with laws and regulations. RATIO AND TREND ANALYSIS

AUDIT OR INDEPENDENT 19. Assess the level, trend, and sustainability of REVIEW the return on average assets relative to historical performance, peer comparisons, 15. Determine whether the audit or independent the organization’s risk profile, balance sheet review program provides sufficient cover- structure/composition, and local and national age of earnings activities relative to the economic conditions. Consideration should bank’s size, complexity, and risk profile. also be given to the amount and volatility of Consider the following: income from high-risk assets, asset concen- trations, non-recurring items, and account- • adherence with profit planning objectives, ing practices subject to management discre- accounting standards, and Consolidated tion (which could manipulate earnings). Report of Income Instructions Identify and assess any areas needing fur- • transaction testing completed to assure ther investigation. income and expenses are accurately re- 20. Evaluate the level, trend, and stability of the corded bank’s net interest margin. Discuss with • separation of duties and internal controls examiners reviewing credit, market, and • adequacy, accuracy, and timeliness of liquidity risks the impact to present and reports to senior management and the future earnings performance from potential board changes in asset quality, market fluctua- • recommended corrective action when war- tions, and interest rates. ranted 21. Evaluate the level and trend of overhead • verification of implementation and effec- expenses. Consider the impact of present tiveness of corrective action and future strategic initiatives (for example, branch openings/closings, increases/ decreases in operating staff or executive INFORMATION AND officers). COMMUNICATION SYSTEMS 22. Evaluate the level, trend, and sources of non-interest income. Discuss with manage- 16. Determine whether managerial reports pro- ment any projections for changes in fee vide sufficient information relative to the structures. Consider the impact of changes size and risk profile of the institution. in interest rates and market conditions on 17. Evaluate the accuracy and timeliness of mortgage banking income, securities gains, reports produced for the board and senior or other non-interest revenue sources. management. Reports may include 23. Review the level and trend of provisions for • periodic earnings results; loan and lease losses and the relationship to • budget variance analyses; actual loan losses to determine the impact of • income and expense projections; asset quality on earnings. Discuss with the • non-recurring or cyclical items; examiner(s) responsible for loan review the • exposure to interest rate/market risk; potential need for additional provision • large item reviews; expenses resulting from examination find- • insider related transaction disclosures; and ings. • tax planning analyses. 24. Review the level, trend, and expected fre- 18. Validate the accuracy of Call Reports as quency of non-operating gains and losses appropriate. Use bank work papers, the and their impact on earnings. general ledger, downloaded exception re- 25. Consider the impact to earnings from ports, and interviews with bank personnel to purchased-impaired accounting practices,

October 2018 Commercial Bank Examination Manual Page 2 Earnings—Analytical Review of Income and Expense: Examination Procedures 3100.3

and if applicable, discuss with an account- 29. Evaluate the earnings impact of activities ing specialist. with affiliated organizations. 26. Determine whether there have been or are expected to be any nonrecurring events and consider their impact to earnings perfor- mance. If necessary for comparison pur- BOARD AND SENIOR poses, evaluate this impact on a tax- MANAGEMENT SUPERVISION equivalent basis. 27. Evaluate the level and trend of income tax 30. Determine whether the board and senior payments recognizing the institution’s basis management review bank earnings and for filing taxes (for example, Subchapter S, appropriately responds to significant budget tax allocation agreement). deviations. 28. Assess the ability of earnings to support 31. Assess compliance with bank policies, appli- capital growth under current, projected, and cable regulations, and governing account- stressed conditions. Review the earnings ing standards. If applicable, determine com- retention rate in comparison to past and pliance with outstanding formal or informal forecasted growth rates. enforcement actions.

Commercial Bank Examination Manual October 2018 Page 3 Earnings—Analytical Review and Income and Expense Internal Control Questionnaire Effective date March 1984 Section 3100.4

Review the bank’s internal controls, policies, PURCHASES practices and procedures over income and expenses. The bank’s system should be docu- *13. If the bank has a separate purchasing mented in a complete and concise manner and department, is it independent of the account- should include, where appropriate, narrative ing and receiving departments? descriptions, flowcharts, copies of forms used *14. Are purchases made only on the basis and other pertinent information. Items marked of requisitions signed by authorized with an asterisk require substantiation by obser- individuals? vation or testing. *15. Are all purchases routed through a pur- chasing department or personnel function- GENERAL ing in that capacity? 16. Are all purchases made by means of pre- 1. Does the bank have a budget? If so: numbered purchase orders sent to a. Is it reviewed and approved by mana- vendors? gerial personnel and/or the board of 17. Are all invoices received checked against directors? purchase orders and receiving reports? b. Is it periodically reviewed and updated 18. Are all invoices tested for clerical accuracy? for changed conditions? 19. Are invoice amounts credited to their c. Are periodic statements compared to respective accounts and tested periodically budget and are explanations of vari- for accuracy? ances reviewed by managment? d. Is a separate budget prepared by the manager of each department or division? DISBURSEMENTS 2. Does the bank’s accounting system provide sufficiently detailed breakdowns of ac- *20. Is the payment for all purchases, except counts to enable it to analyze fluctuations? minor items, made by official checks? *3. Are the general books of the bank main- *21. Does the official signing the check review tained by someone who does not have all supporting documents? access to cash? *22. Are supporting vouchers and invoices can- 4. Are all general ledger entries processed celled to prevent re-use? through the proof department? *23. Are duties and responsibilities in the fol- 5. Are all entries to the general ledger sup- lowing areas segregated? ported by a general ledger ticket? a. Authorization to issue expense checks? 6. Do general ledger tickets, both debit and b. Preparation of expense checks? credit, bear complete approvals, descrip- c. Signing of expense checks? tions and an indication of the offset? d. Sending of expense checks? *7. Are all general ledger entries approved by e. Use and storage of facsimile signa- a responsible person other than the general tures? ledger bookkeeper or person associated f. General ledger posting? with its preparation? g. Subsidiary ledger posting? 8. Is the general ledger posted daily? 9. Is a daily statement of condition prepared? *10. Are corrections to ledgers made by posting PAYROLL a correcting entry and not by erasing (manual system) or deleting (computer- 24. Is the payroll department separate from the ized system) the incorrect entry? personnel department? 11. Are supporting worksheets or other records 25. Are signed authorizations on file for all maintained on accrued expenses and taxes? payroll deductions including W-4s for 12. Are those supporting records periodically withholding? reconciled with the appropriate general 26. Are salaries authorized by the board of ledger controls? directors or its designated committee?

Commercial Bank Examination Manual March 1994 Page 1 3100.4 Earnings—Analytical Review and Income and Expense: Internal Control Questionnaire

27. Are individual wage rates authorized in ment of the bank reported promptly, in writing by an authorized officer? writing, to the payroll department? 28. Are vacation and sick leave payments 36. Are payroll expense distributions recon- fixed or authorized? ciled with the general payroll payment 29. Are payrolls paid from a special bank records? account or directly credited to the employ- ee’s demand deposit account? 30. Are time records reviewed and signed by CONCLUSION the employee’s supervisor? 37. Is the foregoing information an adequate 31. Are double checks made of hours, rates, basis for evaluating internal control in that deductions, extension, and footings? there are no significant deficiencies in 32. Are payroll signers independent of the areas not covered in this questionnaire that persons approving hours worked and prepa- impair any controls? Explain negative ration of the payroll? answers briefly, and indicate any addi- 33. If a check signing machine is used, are tional examination procedures deemed controls over its use adequate (such as a necessary. dual control)? 38. Based on a composite evaluation, as evi- 34. Are payrolls subject to final officer denced by answers to the foregoing ques- approval? tions, internal control is considered (ad- 35. Are the names of persons leaving employ- equate, inadequate).

March 1994 Commercial Bank Examination Manual Page 2 Liquidity Risk Effective date October 2016 Section 3200.1

FACTORS INFLUENCING Effective liquidity management entails the LIQUIDITY MANAGEMENT AND following three elements: TYPES OF LIQUIDITY RISK • assessing, on an ongoing basis, the current Liquidity is a financial institution’s capacity to and expected future needs for funds, and meet its cash and collateral obligations without ensuring that sufficient funds or access to incurring unacceptable losses. Adequate liquid- funds exists to meet those needs at the ity is dependent upon the institution’s ability to appropriate time efficiently meet both expected and unexpected • providing for an adequate cushion of liquidity cash flows and collateral needs without with a stock of liquid assets to meet unantici- adversely affecting either daily operations or the pated cash-flow needs that may arise from a financial condition of the institution. An continuum of potential adverse circumstances institution’s obligations and the funding sources that can range from high-probability/low- used to meet them depend significantly on its severity events that occur in daily operations business mix, balance-sheet structure, and the to low-probability/high-severity events that cash-flow profiles of its on- and off-balance- occur less frequently but could significantly sheet obligations. In managing their cash flows, affect an institution’s safety and soundness institutions confront various situations that can • striking an appropriate balance between the give rise to increased liquidity risk. These benefits of providing for adequate liquidity to include funding mismatches, market constraints mitigate potential adverse events and the cost on the ability to convert assets into cash or in of that liquidity accessing sources of funds (i.e., market liquid- ity), and contingent liquidity events. Changes in The primary role of liquidity-risk manage- economic conditions or exposure to credit, ment is to (1) prospectively assess the need for market, operation, legal, and reputation risks funds to meet obligations and (2) ensure the also can affect an institution’s liquidity-risk availability of cash or collateral to fulfill those profile and should be considered in the assess- needs at the appropriate time by coordinating ment of liquidity and asset/liability manage- the various sources of funds available to the ment. institution under normal and stressed conditions. Liquidity risk is the risk to an institution’s Funds needs arise from the myriad of banking financial condition or safety and soundness aris- activities and financial transactions that create ing from its inability (whether real or perceived) contractual obligations to deliver funds, includ- to meet its contractual obligations. Because ing business initiatives for asset growth, the banking organizations employ a significant provision of various financial products and trans- amount of leverage in their business activities— action services, and expected and unexpected and need to meet contractual obligations in changes in assets and the liabilities used to fund order to maintain the confidence of customers assets. Liquidity managers have an array of and fund providers—adequate liquidity is criti- alternative sources of funds to meet their liquid- cal to an institution’s ongoing operation, profit- ity needs. These sources generally fall within ability, and safety and soundness. one of four broad categories: To ensure it has adequate liquidity, an insti- tution must balance the costs and benefits of • net operating cash flows liquidity: Too little liquidity can expose an • the liquidation of assets institution to an array of significant negative • the generation of liabilities repercussions arising from its inability to meet • an increase in capital funds contractual obligations. Conversely, too much liquidity can entail substantial opportunity costs Funds obtained from operating cash flows and have a negative impact on the firm’s arise from net interest payments on assets; net profitability. principal payments related to the amortization and maturity of assets; and the receipt of funds from various types of liabilities, transactions, Note: The guidance complements existing guidance in the Bank Holding Company Supervision Manual (section 4010.2) and service fees. Institutions obtain liquidity and various SR-letters (see the ‘‘References’’ section). from operating cash flows by managing the

Commercial Bank Examination Manual October 2016 Page 1 3200.1 Liquidity Risk timing and maturity of their asset and liability External Factors and Exposure to cash flows, including their ongoing borrowing Other Risks and debt-issuance programs. Funds can also be obtained by reducing or liquidating assets. Most institutions incorporate The liquidity needs of a financial institution and scheduled asset maturities and liquidations as the sources of liquidity available to meet those part of their ongoing management of operating needs depend significantly on the institution’s cash flows. They also use the potential liquida- business mix and balance-sheet structure, as tion of a portion of their assets (generally a well as on the cash-flow profiles of its on- and portion of the investment portfolio) as a contin- off-balance-sheet obligations. While manage- gent source of funds to meet cash needs under ment largely determines these internal attributes, adverse liquidity circumstances. Such contin- external factors and the institution’s exposure to gent funds need to be unencumbered for the various types of financial and operating risks, purposes of selling or lending the assets and are including interest-rate, credit, operational, legal, often termed liquidity reserves or liquidity ware- and reputational risks, also influence its liquidity houses and are a critical element of safe and profile. As a result, an institution should assess sound liquidity management. Assessments of and manage liquidity needs and sources by the value of unencumbered assets should repre- considering the potential consequences of sent the amount of cash that can be obtained changes in external factors along with the from monetized assets under normal as well as institution-specific determinants of its liquidity stressed conditions. profile. Asset securitization is another method that some institutions use to fund assets. Securitiza- tion involves the transformation of on-balance- Changes in Interest Rates sheet loans (e.g., auto, credit card, com- mercial, student, home equity, and mortgage The level of prevailing market interest rates, the loans) into packaged groups of loans in vari- term structure of interest rates, and changes in ous forms, which are subsequently sold to both the level and term structure of rates can investors. Depending on the business model significantly affect the cash-flow characteristics employed, securitization proceeds can be both a and costs of, and an institution’s demand for, material source of ongoing funding and a assets, liabilities, and off-balance-sheet (OBS) significant tool for meeting future funding positions. In turn, these factors significantly needs. Securitization markets may provide a affect an institution’s funding structure or liquid- good source of funding; however, institutions ity needs, as well as the relative attractiveness or should be cautious in relying too heavily on this price of alternative sources of liquidity available market as it has been known to shutdown under to it. Changes in the level of market interest market stress situations. rates can also result in the acceleration or Funds are also generated through deposit- deceleration of loan prepayments and deposit taking activities, borrowings, and overall liabil- flows. The availability of different types of ity management. Borrowed funds may include funds may also be affected, as a result of options secured lending and unsecured debt obligations embedded in the contractual structure of assets, across the maturity spectrum. In the short term, liabilities, and financial transactions. borrowed funds may include purchased fed funds and securities sold under agreements to repurchase (repos). Longer-term borrowed funds Economic Conditions may include various types of deposit products, collateralized loans, and the issuance of corpo- Cyclical and seasonal economic conditions can rate debt. Depending on their contractual char- also have an impact on the volume of an acteristics and the behavior of fund providers, institution’s assets, liabilities, and OBS borrowed funds can vary in maturity and avail- positions—and, accordingly, its cash-flow and ability because of their sensitivity to general liquidity profile. For example, during reces- market trends in interest rates and various other sions, business demand for credit may decline, market factors. Considerations specific to the which affects the growth of an organization and borrowing institution also affect the maturity its liquidity needs. At the same time, subpar and availability of borrowed funds. economic growth and its impact on employ-

October 2016 Commercial Bank Examination Manual Page 2 Liquidity Risk 3200.1 ment, bankruptcies, and business failures often tant determinant in its costs of funds and overall create direct and indirect incentives for retail liquidity-risk profile. customers to reduce their deposits; a recession Given the critical importance of liquidity to may also lead to higher loan delinquencies for financial institutions and the potential impact financial institutions. All of these conditions that other risk exposures and external factors have negative implications for an institution’s have on liquidity, effective liquidity managers cash flow and overall liquidity. On the other ensure that liquidity management is fully inte- hand, periods of economic growth may spur grated into the institution’s overall enterprise- asset or deposit growth, thus introducing differ- wide risk-management activities. Liquidity man- ent liquidity challenges. agement is therefore an important part of an institution’s strategic and tactical planning.

Credit-Risk Exposures of an Institution

An institution’s exposure to credit risk can have Types of Liquidity Risk a material impact on its liquidity. Nonperform- ing loans directly reduce otherwise expected Banking organizations encounter the following cash inflows. The reduced credit quality of three broad types of liquidity risk: problem assets impairs their marketability and potential use as a source of liquidity (either by • mismatch risk selling the assets or using them as collateral). • market liquidity risk Moreover, problem assets have a negative impact • contingent liquidity risk on overall cash flows by increasing the costs of loan-collection and -workout efforts. Mismatch risk is the risk that an institution will In addition, the price that a bank pays for not have sufficient cash to meet obligations in funds, especially wholesale and brokered bor- the normal course of business, as a result of rowed funds and deposits, will reflect the insti- ineffective matches between cash inflows and tution’s perceived level of risk exposure in the outflows. The management and control of fund- marketplace. Fund suppliers use a variety of ing mismatches depend greatly on the daily credit-quality indicators to judge credit risk and projections of operational cash flow, including determine the returns they require for the risk to those cash flows that may arise from seasonal be undertaken. Such indicators include an insti- business fluctuations, unanticipated new busi- tution’s loan-growth rates; the relative size of its ness, and other everyday situations. To accu- loan portfolio; and the levels of delinquent rately project operational cash flows, an institu- loans, nonperforming loans, and loan losses. For tion needs to estimate its expected cash-flow institutions that have issued public debt, the needs and ensure it has adequate liquidity to credit ratings of nationally recognized statistical meet small variations to those expectations. rating organizations (NRSOs) are particularly Occurrences of funding mismatches may be critical. frequent. If adequately managed, these mis- matches may have little to no impact on the financial health of the firm. Other Risk Exposures of an Institution Market liquidity risk is the risk that an insti- tution will encounter market constraints in its Importantly, exposures to operational, legal, efforts to convert assets into cash or to access reputational, and other risks can lead to adverse financial market sources of funds. liquidity conditions. Operating risks can mate- The planned conversion of assets into cash is rially disrupt the dispersal and receipt of obli- an important element in an institution’s ongoing gated cash flows and give rise to significant management of funding cash-flow mismatches. liquidity needs. Exposure to legal and reputa- In addition, converting assets into cash is often tional risks can lead fund providers to question a key strategic tool for addressing contingent an institution’s overall credit risk, safety and liquidity events. As a result, market constraints soundness, and ability to meet its obligations in on achieving planned, strategic, or contingent the future. A bank’s reputation for operating in conversions of assets into cash can exacerbate a safe and sound manner, particularly its ability the severity of potential funding mismatches and to meet its contractual obligations, is an impor- contingent liquidity problems.

Commercial Bank Examination Manual October 2010 Page 3 3200.1 Liquidity Risk

Contingent liquidity risk is the risk that arises market liquidity constraints, and contingent when unexpected events cause an institution to liquidity events. Both international and U.S. have insufficient funds to meet its obligations. banking supervisors have issued supervisory Unexpected events may be firm-specific or arise guidance on safe and sound practices for man- from external factors. External factors may be aging the liquidity risk of banking organiza- geographic, such as local economic factors that tions. Guidance on liquidity risk management affect the premiums required on deposits with was published by the Basel Committee on Bank- certain local, state, or commercial areas, or they ing Supervision, Bank for International Settle- may be market-oriented, such as increases in the ments, ‘‘Principles for Sound Liquidity Risk price volatility of certain types of securities in Management and Supervision,’’ in September response to financial market developments. 2008.1 The U.S. regulatory agencies imple- External factors may also be systemic, such as a mented these principles, jointly agreeing to payment-system disruption or major changes in incorporate those principles into their existing economic or financial market conditions. guidance. The revised guidance, ‘‘Interagency The nature and severity of contingent liquid- Policy Statement on Funding and Liquidity Risk ity events vary substantially. At one extreme, Management’’ was issued on March 10, 2010 contingent liquidity risk may arise from the need (see SR-10-6 and its attachment). to fund unexpected asset growth as a result of In summary, the critical elements of a sound commitment requests or the unexpected runoff liquidity-risk management process are— of liabilities that occurs in the normal course of business. At the other extreme, institution- • Effective corporate governance consisting of specific issues, such as the lowering of a public oversight by the board of directors and active debt rating or general financial market stress, involvement by management in an institu- may have a significant impact on an institution’s tion’s control of liquidity risk. liquidity and safety and soundness. As a result, • Appropriate strategies, policies, procedures, managing contingent liquidity risk requires an and limits used to manage and mitigate liquid- ongoing assessment of potential future events ity risk. and circumstances in order to ensure that obli- • Comprehensive liquidity-risk measurement gations are met and adequate sources of standby and monitoring systems (including assess- liquidity and/or liquidity reserves are readily ments of the current and prospective cash available and easily converted to cash. flows or sources and uses of funds) that are Diversification plays an important role in commensurate with the complexity and busi- managing liquidity and its various component ness activities of the institution. risks. Concentrations in particular types of assets, liabilities, OBS positions, or business activities • Active management of intraday liquidity and that give rise to unique types of funding needs or collateral. create an undue reliance on specific types of • An appropriately diverse mix of existing and funding sources can unduly expose an institu- potential future funding sources. tion to the risks of funding mismatches, contin- • Adequate levels of highly liquid marketable gent events, and market liquidity constraints. securities free of legal, regulatory, or opera- Therefore, diversification of both the sources tional impediments that can be used to meet and uses of liquidity is a critical component of liquidity needs in stressful situations. sound liquidity-risk management. • Comprehensive contingency funding plans (CFPs) that sufficiently address potential adverse liquidity events and emergency cash flow requirements. SOUND LIQUIDITY-RISK • Internal controls and internal audit processes MANAGEMENT PRACTICES sufficient to determine the adequacy of the institution’s liquidity-risk-management Like the management of any type of risk, sound process. liquidity-risk management involves effective oversight of a comprehensive process that adequately identifies, measures, monitors, and 1. Basel Committee on Banking Supervision, ‘‘Principles controls risk exposure. This process includes for Sound Liquidity Risk Management and Supervision,’’ oversight of exposures to funding mismatches, September 2008. See www.bis.org/publ/bcbs144.htm.

October 2010 Commercial Bank Examination Manual Page 4 Liquidity Risk 3200.1

Each of these elements should be customized to • understands the liquidity-risk profile of impor- account for the sophistication, complexity, and tant subsidiaries and affiliates and their influ- business activities of an institution. The follow- ence on the overall liquidity of the financial ing sections discuss supervisory expectations for institution, as appropriate. each of these critical elements.

Role of Senior Management

Corporate Governance and Oversight Senior management should ensure that liquidity- risk management strategies, policies, and proce- Effective liquidity-risk management requires the dures are adequate for the sophistication and coordinated efforts of both an informed board of complexity of the institution. Management directors and capable senior management. The should ensure that these policies and procedures board should establish and communicate the are appropriately executed on both a long-term institution’s liquidity-risk tolerance in such a and day-to-day basis, in accordance with board manner that all levels of management clearly delegations. Management should oversee the understand the institution’s approach to manag- development and implementation of— ing the trade-offs between management of liquid- ity risk and short-term profits. The board should • an appropriate risk-measurement system and ensure that the organizational structures and standards for measuring the institution’s staffing levels are appropriate, given the institu- liquidity risk; tion’s activities and the risks they present. • a comprehensive liquidity-risk reporting and monitoring process; Involvement of the Board of Directors • establishment and monitoring of liquid asset The board of directors is ultimately responsible buffers of unencumbered marketable securi- for the liquidity risk assumed by the institution. ties; The board should understand and guide the strategic direction of liquidity-risk management. • effective internal controls and review pro- Specifically, the board of directors or a del- cesses for the management of liquidity risk; egated committee of board members should and oversee the establishment and approval of liquid- • monitoring of liquidity risks for each entity ity management strategies, policies and proce- dures, and review them at least annually. In across the institution on an on-going basis addition, the board should ensure that it and; • an appropriate CFP, including (1) adequate • understands the nature of the institution’s assessments of the institution’s contingent liquidity risks and periodically reviews infor- liquidity risks under adverse circumstances mation necessary to maintain this and (2) fully developed strategies and plans understanding; for managing such events. • understands and approves those elements of liquidity-risk management policies that articu- Senior management should periodically review late the institution’s general strategy for man- the organization’s liquidity-risk management aging liquidity risk, and establishes acceptable strategies, policies, and procedures, as well as its risk tolerances; CFP, to ensure that they remain appropriate and • establishes executive-level lines of authority sound. Management should also coordinate the and responsibility for managing the institu- institution’s liquidity-risk management with its tion’s liquidity risk; efforts for disaster, contingency, and strategic • enforces management’s duties to identify, mea- planning, as well as with its business and sure, monitor, and control liquidity risk. risk-management objectives, strategies, and • understands and periodically reviews the insti- tactics. Senior management is also responsible tution’s CFP for handling potential adverse for regularly reporting to the board of directors liquidity events; and on the liquidity-risk profile of the institution.

Commercial Bank Examination Manual October 2010 Page 5 3200.1 Liquidity Risk

Strategies, Policies, Procedures, and • elements of the institution’s comprehensive Risk Tolerances CFP. Incorporating these elements of liquidity-risk Institutions should have documented strategies management into policies and procedures helps for managing liquidity and have formal written internal control and internal audit fulfill their policies and procedures for limiting and control- oversight role in the liquidity-risk management ling risk exposures. Strategies, policies, and process. Policies, procedures, and limits should procedures should translate the board’s goals, address liquidity separately for individual cur- objectives, and risk tolerances into operating rencies, where appropriate and material. All standards that are well understood by institu- liquidity-risk policies, procedures, and limits tional personnel and that are consistent with the should be reviewed periodically and revised as board’s intended risk tolerances. Policies should needed. also ensure that responsibility for managing liquidity is assigned throughout the corporate structure of the institution, including separate Delineating Clear Lines of Authority and legal entities and relevant operating subsidiaries Responsibility and affiliates, where appropriate. Strategies set out the institution’s general approach for man- Through formal written policies or clear operat- aging liquidity, articulate its liquidity-risk toler- ing procedures, management should delineate ances, and address the extent to which key managerial responsibilities and oversight, includ- elements of funds management are centralized ing lines of authority and responsibility for the or delegated throughout the institution. Strate- following: gies also communicate how much emphasis the institution places on using asset liquidity, liabili- • developing liquidity-risk management poli- ties, and operating cash flows to meet its day- cies, procedures, and limits to-day and contingent funding needs. Quantita- • developing and implementing strategies and tive and qualitative targets, such as the following, tactics for managing liquidity risk may also be included in policies: • conducting day-to-day management of the institution’s liquidity • guidelines or limits on the composition of • establishing and maintaining liquidity-risk assets and liabilities measurement and monitoring systems • the relative reliance on certain funding sources, • authorizing exceptions to policies and limits both on an ongoing basis and under contingent • identifying the potential liquidity risk associ- liquidity scenarios ated with the introduction of new products and activities • the marketability of assets to be used as contingent sources of liquidity Institutions should clearly identify the individu- als or committees responsible for liquidity-risk An institution’s strategies and policies should decisions. Less complex institutions often assign identify the primary objectives and methods for such responsibilities to the CFO or an equivalent (1) managing daily operating cash flows, (2) pro- senior management official. Other institutions viding for seasonal and cyclical cash-flow fluc- assign responsibility for liquidity-risk manage- tuations, and (3) addressing various adverse ment to a committee of senior managers, some- liquidity scenarios. The latter includes formulat- times called a finance committee or an asset/ ing plans and courses of actions for dealing with liability committee (ALCO). Policies should potential temporary, intermediate-term, and long- clearly identify individual or committee duties term liquidity disruptions. Policies and proce- and responsibilities, the extent of the decision- dures should formally document— making authority, and the form and frequency of periodic reports to senior management and the • lines of authority and responsibility for man- board of directors. In general, an ALCO (or a aging liquidity risk, similar senior-level committee) is responsible • liquidity-risk limits and guidelines, for ensuring that (1) measurement systems • the institution’s measurement and reporting adequately identify and quantify the institution’s systems, and liquidity-risk exposure and (2) reporting sys-

October 2010 Commercial Bank Examination Manual Page 6 Liquidity Risk 3200.1 tems communicate accurate and relevant infor- decentralizing various elements of liquidity-risk mation about the level and sources of that management. Such delegation and associated exposure. strategies, policies, and procedures should be When an institution uses an ALCO or other clearly articulated and understood throughout the senior management committee, the committee organization. Policies, procedures, and limits should actively monitor the liquidity profile of should also address liquidity separately for the institution and should have sufficiently broad individual currencies, legal entities, and business representation from the major institutional func- lines, when appropriate and material, as well as tions that influence liquidity risk (e.g., the lend- allow for legal, regulatory, and operational limits ing, investment, deposit, or funding functions). for the transferability of liquidity. Committee members should include senior man- agers who have authority over the units respon- sible for executing transactions and other activi- Diversified Funding ties that can affect liquidity. In addition, the committee should ensure that (1) the risk- An institution should establish a funding strat- measurement system adequately identifies and egy that provides effective diversification in the quantifies risk exposure and (2) the reporting sources and tenor of funding. It should maintain process communicates accurate, timely, and rel- an ongoing presence in its chosen funding mar- evant information about the level and sources of kets and strong relationships with funds provid- risk exposure. ers to promote effective diversification of fund- In general, committees overseeing liquidity- ing sources. An institution should regularly risk management delegate the day-to-day respon- gauge its capacity to raise funds quickly from sibilities to the institution’s treasury department each source. It should identify the main factors or, at less complex institutions, to the CFO, that affect its ability to raise funds and monitor treasurer, or other appropriate staff. The person- those factors closely to ensure that estimates of nel charged with measuring and monitoring the fund raising capacity remain valid. day-to-day management of liquidity risk should An institution should diversify available fund- have a well-founded understanding of all aspects ing sources in the short-, medium- and long- of the institution’s liquidity-risk profile. While term. Diversification targets should be part of the day-to-day management of liquidity may be the medium- to long-term funding plans and delegated, the oversight committee should not should be aligned with the budgeting and busi- be precluded from aggressively monitoring ness planning process. Funding plans should liquidity management. take into account correlations between sources In more-complex institutions that have sepa- of funds and market conditions. Funding should rate legal entities and operating subsidiaries or also be diversified across a full range of retail as affiliates, effective liquidity-risk management well as secured and unsecured wholesale sources requires senior managers and other key personnel of funds, consistent with the institution’s sophis- to have an understanding of the funding position tication and complexity. Management should and liquidity of any member of the corporate also consider the funding implications of any group that might provide or absorb liquid government programs or guarantees it utilizes. resources from another member. Centralized As with wholesale funding, the potential unavail- liquidity-risk assessment and management can ability of government programs over the provide significant operating efficiencies and intermediate- and long-term should be fully comprehensive views of the liquidity-risk profile considered in the development of liquidity risk of the integrated corporate entity as well as management strategies, tactics, and risk toler- members of the corporate group—including ances. Funding diversification should be imple- depository institutions. This integrated view is mented using limits addressing counterparties, particularly important for understanding the secured versus unsecured market funding, instru- impact other members of the group may have on ment type, securitization vehicle, and geo- insured depository entities. However, legal and graphic market. In general, funding concentra- regulatory restrictions on the flow of funds tions should be avoided. Undue over reliance on among members of a corporate group, in addition any one source of funding is considered an to differences in the liquidity characteristics and unsafe and unsound practice. dynamics of managing the liquidity of different An essential component of ensuring funding types of entities within a group, may call for diversity is maintaining market access. Market

Commercial Bank Examination Manual October 2010 Page 7 3200.1 Liquidity Risk access is critical for effective liquidity risk • Discrete or cumulative cash-flow mismatches management, as it affects both the ability to or gaps (sources and uses of funds) over raise new funds and to liquidate assets. Senior specified future short- and long-term time management should ensure that market access is horizons under both expected and adverse being actively managed, monitored, and tested business conditions. Often, these are expressed by the appropriate staff. Such efforts should be as cash-flow coverage ratios or as specific consistent with the institution’s liquidity-risk aggregate amounts. profile and sources of funding. For example, • Target amounts of unpledged liquid-asset access to the capital markets is an important reserves sufficient to meet liquidity needs consideration for most large complex institu- under normal and reasonably anticipated tions, whereas the availability of correspondent adverse business conditions. These targets are lines of credit and other sources of whole funds often expressed as aggregate amounts or as are critical for smaller, less complex institutions. ratios calculated in relation to, for example, An institution needs to identify alternative total assets, short-term assets, various types of sources of funding that strengthen its capacity to liabilities, or projected-scenario liquidity needs. withstand a variety of severe institution-specific • Volatile liability dependence and liquid-asset and market-wide liquidity shocks. Depending coverage of volatile liabilities under both upon the nature, severity, and duration of the normal and stress conditions. These guide- liquidity shock, potential sources of funding lines, for example, may include amounts of include, but are not limited to, the following: potentially volatile wholesale funding to total liabilities, volatile retail (e.g., high-cost or • Deposit growth. out-of-market) deposits to total deposits, poten- • Lengthening maturities of liabilities. tially volatile deposit-dependency measures, or short-term borrowings as a percent of total • Issuance of debt instruments. funding. • Sale of subsidiaries or lines of business. • Asset concentrations that could increase • Asset securitization. liquidity risk through a limited ability to • Sale (either outright or through repurchase convert to cash (e.g., complex financial instru- agreements) or pledging of liquid assets. ments, bank-owned (corporate-owned) life • Drawing-down committed facilities. insurance, and less-marketable loan port- • Borrowing. folios). • Funding concentrations that address diversi- fication issues, such as a large liability and Liquidity-Risk Limits and Guidelines dependency on borrowed funds, concentra- tions of single funds providers, funds provid- Liquidity-risk tolerances or limits should be ers by market segments, and types of volatile appropriate for the complexity and liquidity-risk deposit or volatile wholesale funding depen- profile of an institution. They should employ dency. For small community banks, funding both quantitative targets and qualitative guide- concentrations may be difficult to avoid. How- lines and should be consistent with the institu- ever, banks that rely on just a few primary tion’s overall approach and strategy for measur- sources should have appropriate systems in ing and managing liquidity. Policies should place to manage the concentrations of funding clearly articulate a liquidity-risk tolerance that is liquidity, including limit structures and report- appropriate for the business strategy of the ing mechanisms. institution, considering its complexity, business • Funding concentrations that address the term, mix, liquidity-risk profile, and its role in the re-pricing, and market characteristics of fund- financial system. Policies should also contain ing sources. This may include diversification provisions for documenting and periodically targets for short-, medium-, and long-term reviewing assumptions used in liquidity projec- funding, instrument type and securitization tions. Policy guidelines should employ both vehicles, and guidance on concentrations for quantitative targets and qualitative guidelines. currencies and geographical markets. These measurements, limits, and guidelines may • Contingent liabilities, such as unfunded loan be specified in terms of the following measures commitments and lines of credit supporting and conditions, as applicable: asset sales or securitizations, and collateral

October 2010 Commercial Bank Examination Manual Page 8 Liquidity Risk 3200.1

requirements for derivatives transactions and agement’s strategies are consistent with the various types of secured lending. board’s expressed risk tolerance. • The minimum and maximum average maturity of different categories of assets and liabilities. Policies on Contingency Funding Plans Institutions may use other risk indicators to specify their risk tolerances. Some institutions Policies should also provide for senior manage- may use ratios such as loans to deposits, loans ment to develop and maintain a written, com- to equity capital, purchased funds to total assets, prehensive, and up-to-date liquidity CFP. Poli- or other common measures. However, when cies should also ensure that, as part of ongoing developing and using such measures, institu- liquidity-risk management, senior management tions should be fully aware that some measures is alerted to early-warning indicators or triggers may not appropriately assess the timing and of potential liquidity problems. scenario-specific characteristics of the institution’s liquidity-risk profile. Liquidity-risk measures that are constructed using static Compliance with Laws and Regulations balance-sheet amounts may hide significant Institutions should ensure that their policies and liquidity risk that can occur in the future under procedures take into account compliance with both normal and adverse business conditions. appropriate laws and regulations that can have As a result, institutions should not rely solely on an impact on an institution’s liquidity-risk man- these static measures to monitor and manage agement and liquidity-risk profile. These laws liquidity. and regulations include the Federal Deposit Insurance Corporation Improvement Act (FDICIA) and its constraints on an institution’s Policies on Measuring and Managing use of brokered deposits, as well as pertinent Reporting Systems sections of Federal Reserve regulations A, D, F, and W. (See appendix 2, for a summary of some Policies and procedures should also identify the of the pertinent legal and regulatory issues that methods used to measure liquidity risk, as well should be factored into the management of as the form and frequency of reports to various liquidity risk.) levels of management and the board of directors. Policies should identify the nature and form of cash-flow projections and other liquidity mea- sures to be used. Policies should provide for the Liquidity-Risk Measurement Systems categorization, measurement, and monitoring of both stable and potentially volatile sources of The analysis and measurement of liquidity risk funds. Policies should also provide guidance on should be tailored to the complexity and risk the types of business-condition scenarios used to profile of an institution, incorporating the cash construct cash-flow projections and should con- flows and liquidity implications of all the insti- tain provisions for documenting and periodi- tution’s material assets, liabilities, off-balance- cally reviewing the assumptions used in liquid- sheet positions, and major business activities. ity projections. Liquidity-risk analysis should consider what Moreover, policies should explicitly provide effect options embedded in the institution’s for more-frequent reporting under adverse busi- sources and uses of funds may have on its cash ness or liquidity conditions. Under normal busi- flows and liquidity-risk measures. The analysis ness conditions, senior managers should receive of liquidity risk should also be forward-looking liquidity-risk reports at least monthly, while the and strive to identify potential future funding board of directors should receive liquidity-risk mismatches as well as current imbalances. reports at least quarterly. If the risk exposure is Liquidity-risk measures should advance manage- more complex, the reports should be more ment’s understanding of the institution’s expo- frequent. These reports should tell senior man- sure to mismatch, market, and contingent liquid- agement and the board how much liquidity risk ity risks. Measures should also assess the the bank is assuming, whether management is institution’s liquidity sources and needs in rela- complying with risk limits, and whether man- tion to the specific business environments it

Commercial Bank Examination Manual October 2010 Page 9 3200.1 Liquidity Risk operates in and the time frames involved in liquidity managers project cash flows under securing and using funds. expected and alternative liquidity scenarios. Such Adequate liquidity-risk measurement requires cash-flow-projection statements range from the ongoing review of an institution’s sources simple spreadsheets to very detailed reports, and uses of funds and generally includes analy- depending on the complexity and sophistication sis of the following: of the institution and its liquidity-risk profile. A sound practice is to project, on an ongoing • trends in balance-sheet structure and funding basis, an institution’s cash flows under normal vehicles business-as-usual conditions, incorporating • pro forma cash-flow statements and funding appropriate seasonal and business-growth con- mismatch gaps over varying time horizons siderations over varying time horizons. This • trends and expectations in the volume and cash-flow projection should be regularly reviewed pricing trends for assets, liabilities, and off- under both short-term and intermediate- to long- balance-sheet items that can have a significant term institution-specific contingent scenarios. impact on the institution’s liquidity Institutions that have more-complex liquidity- • trends in the relative costs of funds required risk profiles should also assess their exposure to by existing and alternative funds providers broad systemic and adverse financial market • the diversification of funding sources and events, as appropriate to their business mix and trends in funding concentrations overall liquidity-risk profile (e.g., securitization, • the adequacy of asset liquidity reserves, trends derivatives, trading, processing, international, in these reserves, and the market dynamics and other activities). that could influence their market liquidity The construction of pro forma cash-flow state- • the sensitivity of funds providers to both ments under alternative scenarios and the ongo- financial market and institution-specific trends ing monitoring of an institution’s liquidity-risk and events profile depend importantly on liquidity manage- • the institution’s exposure to both broad-based ment’s review of trends in the institution’s market and institution-specific contingent balance-sheet structure and its funding sources. liquidity events This review should consider past experience and include expectations for the volume and pricing The formality and sophistication of liquidity- of assets, liabilities, and off-balance-sheet items risk measurement, and the policies and proce- that may significantly affect the institution’s dures used to govern the measurement process, liquidity. depend on the sophistication of the institution, Effective liquidity-risk monitoring systems the nature and complexity of its funding struc- should assess (1) trends in the relative cost of tures and activities, and its overall liquidity-risk funds, as required by the institution’s existing profile. and alternative funds providers; (2) the (See appendix 1, for background information diversification or concentration of funding on the types of liquidity analysis and measures sources; (3) the adequacy of the institution’s of liquidity risk used by effective liquidity-risk asset liquidity reserves; and (4) the sensitivity of managers. The appendix also discusses the con- funds providers to both financial market and siderations for evaluating the liquidity-risk char- institution-specific trends and events. Detailed acteristics of various assets, liabilities, OBS examples and further discussion of cash-flows positions, and other activities, such as asset are included in appendix 1, section I, ‘‘Basic securitization, that can influence an institution’s Cash-Flow Projections.’’ liquidity.)

Assumptions Pro Forma Cash-Flow Analysis Given the critical importance of assumptions in Regardless of the size and complexity of an constructing liquidity-risk measures and projec- institution, pro forma cash-flow statements are a tions of future cash flows, institutions should critical tool for adequately managing liquidity ensure that all their assumptions are reasonable risk. In the normal course of measuring and and appropriate. Institutions should document managing liquidity risk and analyzing their and periodically review and approve key assump- institution’s sources and uses of funds, effective tions. Assumptions used in assessing the liquid-

October 2010 Commercial Bank Examination Manual Page 10 Liquidity Risk 3200.1 ity risk of complex instruments and assets; meaningful time horizons, including intraday, liabilities; and OBS positions that have uncer- day-to-day, short-term weekly and monthly hori- tain cash flows, market value, or maturities zons, medium-term horizons of up to one year, should be subject to rigorous documentation and and longer-term liquidity needs over one year. review. These assessments should include vulnerabili- Assumptions about the stability or volatility ties to events, activities, and strategies that can of retail deposits, brokered deposits, wholesale significantly strain the capability to generate or secondary-market borrowings, and other fund- internal cash. ing sources with uncertain cash flows are par- ticularly important—especially when such as- sumptions are used to evaluate alternative Stress Testing sources of funds under adverse contingent liquid- ity scenarios (such as a deterioration in asset Once normal operating cash-flow statements are quality or capital). When assumptions about the established then those tools can be used to performance of deposits and other sources of generate stress tests. Stress assumptions are funds are used in the computation of liquidity simply layered on top of the normal operating measures, these assumptions should be based on cash-flow projections. The quantitative results reasoned analysis considering such factors as provided by the stress test also serve as a key the following: component within the CFP. Institutions should conduct stress tests on a • the historical behavior of deposit customers regular basis for a variety of institution-specific and funds providers and market-wide events across multiple time • how current or future business conditions may horizons. The magnitude and frequency of stress change the historical responses and behaviors testing should be commensurate with the com- of customers and other funds providers plexity of the financial institution and the level • the general conditions and characteristics of of its risk exposures. Stress test outcomes should the institution’s market for various types of be used to identify and quantify sources of funds, including the degree of competition potential liquidity strain and to analyze possible • the anticipated pricing behavior of funds pro- impacts on the institution’s cash flows, liquidity viders (for instance, wholesale or retail) under position, profitability, and solvency. the scenario investigated Stress tests should also be used to ensure that • haircuts (that is, the reduction from the stated current exposures are consistent with the finan- value of an asset) applied to assets earmarked cial institution’s established liquidity-risk toler- as contingent liquidity reserves ance. The stress test serves as a key component of the CFP and the quantification of the risk to Further discussion of liquidity characteristics of which the institution may be exposed. Manage- assets, liabilities, and off-balance-sheet items is ment’s active involvement and support is critical included in appendix 1, section III, ‘‘Liquidity to the effectiveness of the stress-testing process. Characteristics of Assets, Liabilities, Off- Management should discuss the results of stress Balance-Sheet Positions, and Various Types of tests and take remedial or mitigating actions to Banking Activities.’’ Institutions that have com- limit the institution’s exposures, build up a plex liquidity profiles should perform sensitivity liquidity cushion, and adjust its liquidity profile tests to determine what effect any changes to its to fit its risk tolerance. The results of stress tests material assumptions will have on its liquidity. therefore play a key role in determining the Institutions should ensure that assets are prop- amount of buffer assets the institution should erly valued according to relevant financial report- maintain. ing and supervisory standards. An institution should fully factor into its risk management the consideration that valuations may deteriorate Cushion of Liquid Assets under market stress and take this into account in assessing the feasibility and impact of asset Liquid assets are an important source of both sales on its liquidity position during stress events. primary (operating liquidity) and secondary (con- Institutions should ensure that their vulner- tingent liquidity) funding at many institutions. abilities to changing liquidity needs and liquid- Indeed, a critical component of an institution’s ity capacities are appropriately assessed within ability to effectively respond to potential liquid-

Commercial Bank Examination Manual October 2010 Page 11 3200.1 Liquidity Risk ity stress is the availability of a cushion of that are highly dependent on wholesale funds highly liquid assets without legal, regulatory, or may need daily reports on the use of various operational impediments (i.e., unencumbered) funding sources, maturities of various instru- that can be sold or pledged to obtain funds in a ments, and rollover rates. Less complex institu- range of stress scenarios. These assets should be tions may require only simple maturity-gap or held as insurance against a range of liquidity cash-flow reports that depict rollovers and mis- stress scenarios, including those that involve the match risks; these reports may also include loss or impairment of typically available unse- pertinent liquidity ratios. Liquidity-risk reports cured and/or secured funding sources. The size can be customized to provide management with of the cushion of such high-quality liquid assets aggregate information that includes sufficient should be supported by estimates of liquidity supporting detail to enable them to assess the needs performed under an institution’s stress sensitivity of the institution to changes in market testing as well as aligned with the risk tolerance conditions, its own financial performance, and and risk profile of the institution. Management other important risk factors. Reportable items estimates of liquidity needs during periods of may include, but are not limited to— stress should incorporate both contractual and non-contractual cash flows, including the possi- • cash-flow gap-projection reports and forward- bility of funds being withdrawn. Such estimates looking summary measures that assess both should also assume the inability to obtain unse- business-as-usual and contingent liquidity cured funding as well as the loss or impairment scenarios; of access to funds secured by assets other than • asset and funding concentrations that high- the safest, most liquid assets. light the institution’s dependence on funds Management should ensure that unencum- that may be highly sensitive to institution- bered, highly liquid assets are readily available specific contingent liquidity or market liquid- and are not pledged to payment systems or ity risk (including information on the types clearing houses. The quality of unencumbered and amounts of negotiable certificates of liquid assets is important as it will ensure deposit (CDs) and other bank obligations, as accessibility during the time of most need. For well as information on major liquidity funds example, an institution could utilize its holdings providers); of high-quality U.S. Treasury securities, or simi- • critical assumptions used in cash-flow projec- lar instruments, and enter into repurchase agree- tions and other measures; ments in response to the most severe stress • the status of key early-warning signals or risk scenarios. indicators; • funding availability; • reports on the impact of new products and activities; Liquidity-Risk Monitoring and • reports documenting compliance with estab- Reporting Systems lished policies and procedures; and • where appropriate, both consolidated and Methods used to monitor and measure liquid- unconsolidated reports for institutions that ity risk should be sufficiently robust and flex- have multiple offices, international branches, ible to allow for the timely computation of the affiliates, or subsidiaries. metrics an institution uses in its ongoing • Institutions should also report on the use of liquidity-risk management. Risk monitoring and and availability of government support, such reporting systems should regularly provide as lending and guarantee programs, and impli- information on day-to-day liquidity manage- cations on liquidity positions, particularly since ment and risk control; this information should these programs are generally temporary or also be readily available during contingent reserved as a source for contingent funding. liquidity events. In keeping with the other elements of sound The types of reports or information and their liquidity-risk management, the complexity and timing should be tailored to the institution’s sophistication of management reporting and funding strategies and will vary according to the management information systems (MIS) should complexity of the institution’s operations and be consistent with the liquidity profile of the risk profile. For example, institutions relying on institution. For example, complex institutions investment securities for their primary source of

October 2010 Commercial Bank Examination Manual Page 12 Liquidity Risk 3200.1 contingent liquidity should employ reports on Assumptions regarding the transferability of the quality, pledging status, and maturity funds and collateral should be described in distribution of those assets. Similarly, institu- liquidity-risk management plans. tions conducting securitization activities, or placing significant emphasis on the sale of loans to meet contingent liquidity needs, should Intraday Liquidity Position Management customize their liquidity reports to target these activities. Intraday liquidity monitoring is an important component of the liquidity-risk management process for institutions engaged in significant Collateral-Position Management payment, settlement, and clearing activities. An institution’s failure to manage intraday liquidity An institution should have the ability to calcu- effectively, under normal and stressed condi- late all of its collateral positions in a timely tions, could leave it unable to meet payment and manner, including assets currently pledged rela- settlement obligations in a timely manner, tive to the amount of security required and adversely affecting its own liquidity position unencumbered assets available to be pledged. and that of its counterparties. Among large, An institution’s level of available collateral complex organizations, the interdependencies that exist among payment systems and the should be monitored by legal entity, by jurisdic- inability to meet certain critical payments has tion, and by currency exposure. Systems should the potential to lead to systemic disruptions that be capable of monitoring shifts between intra- can prevent the smooth functioning of all pay- day and overnight or term-collateral usage. An ment systems and money markets. Therefore, institution should be aware of the operational institutions with material payment, settlement and timing requirements associated with access- and clearing activities should actively manage ing the collateral given its physical location (i.e., their intraday liquidity positions and risks to the custodian institution or securities settlement meet payment and settlement obligations on a system with which the collateral is held). Insti- timely basis under both normal and stressed tutions should also fully understand the potential conditions. Senior management should develop demand on required and available collateral and adopt an intraday liquidity strategy that arising from various types of contractual contin- allows the institution to gencies during periods of both market-wide and institution-specific stress. • monitor and measure expected daily gross liquidity inflows and outflows. • manage and mobilize collateral when neces- Liquidity Across Legal Entities, and sary to obtain intraday credit. Business Lines • identify and prioritize time-specific and other critical obligations in order to meet them An institution should actively monitor and con- when expected. trol liquidity-risk exposures and funding needs • settle other less critical obligations as soon as within and across legal entities and business possible. lines, taking into account legal, regulatory, and • control credit to customers when necessary. operational limitations to the transferability of liquidity. Separately regulated entities will need to maintain liquidity commensurate with their own risk profiles on a stand-alone basis. Contingency Funding Plans Regardless of its organizational structure, it is important that an institution actively monitor A CFP is a compilation of policies, procedures, and control liquidity risks at the level of indi- and action plans for responding to contingent vidual legal entities, and the group as a whole, liquidity events. It is a sound practice for all incorporating processes that aggregate data institutions, regardless of size and complexity, across multiple systems in order to develop a to engage in comprehensive contingent liquidity group-wide view of liquidity-risk exposures and planning. The objectives of the CFP are to identify constraints on the transfer of liquidity provide a plan for responding to a liquidity within the group. crisis, identify a menu of contingent liquidity

Commercial Bank Examination Manual October 2010 Page 13 3200.1 Liquidity Risk sources that the institution can use under adverse cash-flow projections and provisioning for liquidity circumstances, and describe steps that adequate liquidity reserves in the normal course should be taken to ensure that the institution’s of business. sources of liquidity are sufficient to fund sched- Liquidity risks driven by lower-probability, uled operating requirements and meet the insti- higher-impact events should be addressed in the tution’s commitments with minimal costs and CFP, which should— disruption. CFPs should be commensurate with an institution’s complexity, risk profile, and • identify reasonably plausible stress events; scope of operations. • evaluate those stress events under different Contingent liquidity events are unexpected levels of severity; situations or business conditions that may • make a quantitative assessment of funding needs under the stress events; increase the risk that an institution will not have • identify potential funding sources in response sufficient funds to meet liquidity needs. These to a stress event; and events can negatively affect any institution, • provide for commensurate management pro- regardless of its size and complexity, by cesses, reporting, and external communication throughout a stress event. • interfering with or preventing the funding of asset growth, The CFP should address both the severity and • disrupting the institution’s ability to renew or duration of contingent liquidity events. The replace maturing funds. liquidity pressures resulting from low-probability, high-impact events may be immediate and short Contingent liquidity events may be institution- term, or they may present sustained situations specific or arise from external factors. Institution- that have long-term liquidity implications. The specific risks are determined by the risk profile potential length of an event should factor into and business activities of the institution. They decisions about sources of contingent liquidity. generally are a result of unique credit, market, operational, and strategic risks taken by the institution. A potential result of this type of Identifying Liquidity Stress Events event would be customers unexpectedly exercis- ing options to withdraw deposits or exercise Stress events are those events that may have a off-balance-sheet (OBS) commitments. significant impact on an institution’s liquidity, In contrast, external contingent events may be given its specific balance-sheet structure, busi- systemic financial-market occurrences, such as ness lines, organizational structure, and other characteristics. Possible stress events include • increases or decreases in the price volatility of changes in credit ratings, a deterioration in asset certain types of securities in response to quality, a prompt-corrective-action (PCA) down- market events; grade, and CAMELS ratings downgrade widen- ing of credit default spreads, operating losses, • major changes in economic conditions, mar- negative press coverage, or other events that call ket perception, or dislocations in financial into question an institution’s ability to meet its markets; obligations. • disturbances in payment and settlement sys- An institution should customize its CFP. Sepa- tems due to operational or local disasters. rate CFPs may be required for the parent com- pany and the consolidated banks in a multibank Contingent liquidity events range from high- holding company, for separate subsidiaries (when probability/low-impact events that occur during appropriate), or for each significant foreign the normal course of business to low-probability/ currency and global political entity, as neces- high-impact events that may have an adverse sary. These separate CFPs may be necessary impact on an institution’s safety and soundness. because of legal requirements and restrictions, Institutions should incorporate planning for high- or the lack thereof. Institutions that have signifi- probability/low-impact liquidity risks into their cant payment-system operations should have a daily management of the sources and uses of formal, written plan in place for managing the their funds. This objective is best accomplished risk of both intraday and end-of-day funding by assessing possible variations in expected failures. Failures may occur as a result of system

October 2010 Commercial Bank Examination Manual Page 14 Liquidity Risk 3200.1 failure at the institution or at an institution from event—and allow the institution to measure its which payments are expected. Clear, formal ability to fund operations over an extended communication channels should be established period. between the institution’s operational areas Common tools to assess funding mismatches responsible for handling payment-system include operations. • Liquidity-gap analysis—A cash-flow report that essentially represents a base case estimate Assessing Levels of Severity and Timing of where funding surpluses and shortfalls will occur over various future timeframes. The CFP should delineate the various levels of • Stress tests—A pro forma cash-flow report stress severity that can occur during a contingent with the ability to estimate future funding liquidity event and, for each type of event, surpluses and shortfalls under various liquid- identify the institution’s response plan at each ity stress scenarios and the institution’s ability stage of an event. (As an event unfolds, it often to fund expected asset growth projections or progresses through various stages and levels of sustain an orderly liquidation of assets under severity.) The events, stages, and severity levels various stress events. identified should include those that cause tem- porary disruptions, as well as those that may cause intermediate- or longer-term disruptions. Identify Potential Funding Sources Institutions can use the different stages or levels Because of the potential for liquidity pressures of severity to design early-warning indicators, to spread from one source of funding to another assess potential funding needs at various points during a significant liquidity event, institutions during a developing crisis, and specify compre- should identify, well in advance, alternative hensive action plans. sources of liquidity and ensure that they have ready access to contingent funding sources. These funding sources will rarely be used in the Assessing Funding Needs and Sources of normal course of business. Therefore, institu- Liquidity tions should conduct advance planning to ensure that contingent funding sources are readily avail- A critical element of the CFP is an institution’s able. For example, the sale, securitization, or quantitative projection and evaluation of its pledging of assets as collateral requires a review expected funding needs and funding capacity of these assets to determine the appropriate during a stress event. The institution should haircuts and to ensure compliance with the identify the sequence of responses that it will standards required for executing the strategy. mobilize during a stress event and commit Administrative procedures and agreements should sources of funds for contingent needs well in also be in place before the institution needs to advance of a stress-related event. To accomplish access the planned source of liquidity. Institu- this objective, the institution needs to analyze tions should identify what advance steps they potential erosion in its funding at alternative need to take to promote the readiness of each of stages or severity levels of the stress event, as their sources of standby liquidity. well as analyze the potential cash-flow mismatches that may occur during the various stress scenarios and levels. Institutions should Processes for Managing Liquidity Events base their analyses on realistic assessments of the behavior of funds providers during the The CFP should identify a reliable crisis- event; they should also incorporate alternative management team and an administrative contingency funding sources into their plans. structure for responding to a liquidity crisis, The analysis should also include all material on- including realistic action plans executing each and OBS cash flows and their related effects, element of the plan for each level of a stress which should result in a realistic analysis of the event. Frequent communication and reporting institution’s cash inflows, outflows, and funds among crisis team members, the board of direc- availability at different time intervals tors, and other affected managers optimizes the throughout the potential liquidity stress effectiveness of a contingency plan by ensur-

Commercial Bank Examination Manual October 2010 Page 15 3200.1 Liquidity Risk ing that business decisions are coordinated to • counterparties that begin requesting backup minimize further liquidity disruptions. Effec- collateral for credit exposures; and tive management of a stress event requires the • correspondent banks that eliminate or decrease daily computation of regular liquidity-risk their credit lines. reports and supplemental information. The CFP should provide for more-frequent and more- To mitigate the potential for reputation con- detailed reporting as a stress situation intensi- tagion when liquidity problems arise, effective fies. Reports that should be available in a fund- communication with counterparties, credit-rating ing crisis include— agencies, and other stakeholders is of vital • a CD breakage report to identify early redemp- importance. Smaller institutions that rarely inter- tions of CDs; act with the media should have plans in place for • funding-concentration reports; how they will manage press inquiries that may • cash-flow projections and run-off reports; arise during a liquidity event. In addition, group- • funding-availability or -capacity reports, by wide CFPs, liquidity cushions, and multiple types of funding; and sources of funding are mechanisms that may • reports on the status of contingent funding mitigate reputation concerns. sources. In addition to early-warning indicators, insti- tutions that issue public debt, use warehouse financing, securitize assets, or engage in mate- Framework for Monitoring Contingent rial OTC derivative transactions typically have Events exposure to event triggers that are embedded in the legal documentation governing these trans- Financial institutions should monitor for poten- actions. These triggers protect the investor or tial liquidity stress events by using early- counterparty if the institution, instrument, or warning indicators and event triggers. These underlying asset portfolio does not perform at indicators should be tailored to an institution’s certain predetermined levels. Institutions that specific liquidity-risk profile. By recognizing rely upon brokered deposits should also incor- potential stress events early, the institution can porate PCA-related downgrade triggers into their proactively position itself into progressive states CFPs since a change in PCA status could have a of readiness as an event evolves. This proactive material bearing on the availability of this fund- stance also provides the institution with a frame- ing source. Contingent event triggers should be work for reporting or communicating among an integral part of the liquidity-risk monitoring different institutional levels and to outside par- system. ties. Early-warning signals may include but are Asset-securitization programs pose height- not limited to— ened liquidity concerns because an early- • rapid asset growth that is funded with poten- amortization event could produce unexpected tially volatile liabilities; funding needs. Liquidity contingency plans • growing concentrations in assets or liabilities; should address this risk, if it is material to the • negative trends or heightened risk associated institution. The unexpected funding needs asso- with a particular product line; ciated with an early amortization of a securiti- • rating-agency actions (e.g., agencies watch- zation event pose liquidity concerns for the listing the institution or downgrading its credit originating bank. The triggering of an early- rating); amortization event can result in the securitiza- • negative publicity; tion trust immediately passing principal pay- • significant deterioration in the institution’s ments through to investors. As the holder of the earnings, asset quality, and overall financial underlying assets, the originating institution is condition; responsible for funding new charges that would • widening debt or credit-default-swap spreads; normally have been purchased by the trust. • difficulty accessing longer-term funding; Financial institutions that engage in asset secu- • increasing collateral margin requirements; ritization should have liquidity contingency plans • rising funding costs in a stable market; that address this potential unexpected funding • increasing redemptions of CDs before maturity; requirement. Management should receive and • counterparty resistance to OBS products; review reports showing the performance of the

October 2010 Commercial Bank Examination Manual Page 16 Liquidity Risk 3200.1 securitized portfolio in relation to the early- contingent liquidity event. It is prudent to test amortization triggers.2 the operational elements of a CFP that are Securitization covenants that cite supervisory associated with the securitization of assets, repur- thresholds or adverse supervisory actions as chase lines, Federal Reserve triggers for early-amortization events are con- borrowings, or other borrowings, since efficient sidered an unsafe and unsound banking practice collateral processing during a crisis is especially that undermines the objective of supervisory important for such sources. Institutions should actions. An early amortization triggered by a carefully consider whether to include unsecured supervisory action can create or exacerbate funding lines in their CFPs, since these lines liquidity and earnings problems that can lead to may be unavailable during a crisis. further deterioration in the financial condition of Larger, more-complex institutions can benefit the banking organization.3 from operational simulations that test commu- Securitizations of asset-backed commercial nications, coordination, and decision-making of paper programs (ABCPs) are generally sup- managers who have different responsibilities, ported by a liquidity facility or commitment to purchase assets from the trust if funds are who are in different geographic locations, or needed to repay the underlying obligations. who are located at different operating subsidi- Liquidity needs can result from either cash-flow aries. Simulations or tests run late in the day can mismatches between the underlying assets and highlight specific problems, such as late-day scheduled payments of the overriding security staffing deficiencies or difficulty selling assets or or from credit-quality deterioration of the under- borrowing new funds near the closing time of lying asset pool. Therefore, the use of liquidity the financial markets. facilities introduces additional risk to the insti- Larger, more-complex institutions can benefit tution, and a commensurate capital charge is from operational simulations that test commu- required.4 nications, coordination, and decisionmaking of Institutions that rely upon secured funding managers who have different responsibilities, sources also are subject to potentially higher who are in different geographic locations, or margin or collateral requirements that may be who are located at different operating subsidi- triggered upon the deterioration of a specific aries. Simulations or tests run late in the day can portfolio of exposures or the overall financial highlight specific problems, such as late-day condition of the institution. The ability of a staffing deficiencies or difficulty selling assets or financially stressed institution to meet calls for borrowing new funds near the closing time of additional collateral should be considered in the the financial markets. CFP. Potential collateral values also should be subject to stress tests since devaluations or market uncertainty could reduce the amount of contingent funding that can be obtained from Internal Controls pledging a given asset. An institution’s internal controls consist of poli- cies, procedures, approval processes, reconcili- Testing the CFP ations, reviews, and other types of controls to provide assurances that the institution manages Periodic testing of the operational elements of liquidity risk in accordance with the board’s the CFP is an important part of liquidity-risk strategic objectives and risk tolerances. Appro- management. By testing the various operational priate internal controls should address relevant elements of the CFP, institutions can prevent elements of the risk-management process, includ- unexpected impediments or complications in ing the institution’s adherence to policies and accessing standby sources of liquidity during a procedures; the adequacy of its risk identifica- tion, risk measurement, and risk reporting; and 2. See sections 2130.1, 3020.1, and 4030.1, and the OCC its compliance with applicable rules and regula- Handbook on Credit Card Lending, October 1996. tions. The results of reviews of the liquidity-risk 3. SR-02-14, ‘‘Covenants in Securitization Documents management process, along with any recommen- Linked to Supervisory Actions or Thresholds.’’ dations for improvement, should be reported to 4. SR-05-13, ‘‘Interagency Guidance on the Eligibility of ABCP Liquidity Facilities and the Resulting Risk-Based the board of directors, which should take appro- Capital Treatment.’’ priate and timely action.

Commercial Bank Examination Manual October 2010 Page 17 3200.1 Liquidity Risk

An important element of a bank’s internal LIQUIDITY-RISK MANAGEMENT controls is management’s comprehensive evalu- FOR BANK HOLDING ation and review. Management should ensure COMPANIES that an independent party regularly reviews and evaluates the components of the institution’s Bank holding companies (BHCs) should develop liquidity-risk management process. These and maintain liquidity-risk management pro- reviews should assess the extent to which the cesses and funding programs that are consistent institution’s liquidity-risk management with their level of sophistication and complex- complies with both supervisory guidance and ity. For BHCs (includes financial holding com- industry sound practices, taking into account the panies, which are BHCs) see the Bank Holding level of sophistication and complexity of the Company Supervision Manual, section 4066, institution’s liquidity-risk profile. In larger, ‘‘Funding and Liquidity Risk Management,’’ and complex institutions, an internal audit function sections 1050.0 and 1050.1, that discuss the usually performs this review. Smaller, less consolidated supervision of BHCs. See also complex institutions may assign the responsibil- SR-10-6, ‘‘Interagency Policy Statement on ity for conducting an independent evaluation Funding and Liquidity Risk Management.’’ Also and review to qualified individuals who are see sections 4010.0, ‘‘Parent Only—Debt Ser- independent of the function they are assigned to vicing Capacity/Cash Flow’’ and 4010.2 ‘‘Par- review. The independent review should report ent Only—Liquidity.’’ key issues requiring attention, including instances of noncompliance, to the appropriate level of management to initiate a prompt correc- tion of the issues, consistent with approved SUPERVISORY PROCESS FOR policies. EVALUATING LIQUIDITY RISK Periodic reviews of the liquidity-risk manage- ment process should address any significant Liquidity risk is a primary concern for all changes that have occurred since the last review, banking organizations and is an integral compo- such as changes in the institution’s types or nent of the CAMELS rating system. Examiners characteristics of funding sources, limits, and should consider liquidity risk during the prepa- internal controls. Reviews of liquidity-risk mea- ration and performance of all on-site safety-and- surement systems should include assessments of soundness examinations as well as during tar- the assumptions, parameters, and methodologies geted supervisory reviews. To meet examination used. These reviews should also seek to under- objectives efficiently and effectively and remain stand, test, and document the current risk- sensitive to potential burdens imposed on insti- measurement process; evaluate the system’s tutions, examiners should follow a structured, accuracy; and recommend solutions to any iden- risk-focused approach for the examination of tified weaknesses. liquidity risk. Key elements of this examination Controls for changes to the assumptions the process include off-site monitoring and a risk institution uses to make cash-flow projections assessment of the institution’s liquidity-risk pro- should require that the assumptions not be file. These elements will help the examiner altered without clear justification consistent with develop an appropriate plan and scope for the approved strategies. The name of the individual on-site examination, thus ensuring the exam is authorizing the change, along with the date of as efficient and productive as possible. A fun- the change, the nature of the change, and justi- damental tenet of the risk-focused examination fication for each change, should be fully docu- approach is the targeting of supervisory resources mented. Documentation for all assumptions used at functions, activities, and holdings that pose in cash-flow projections should be maintained in the most risk to the safety and soundness of an a readily accessible, understandable, and audit- institution. able form. Because liquidity-risk measurement For smaller institutions that have less com- systems may incorporate one or more subsidiary plex liquidity profiles, stable funding sources, systems or processes, institutions should ensure and low exposures to contingent liquidity cir- that multiple component systems are well inte- cumstances, the liquidity element of an exami- grated and consistent with each other. nation may be relatively simple and straightfor- ward. On the other hand, if an institution is experiencing significant asset and product growth;

October 2010 Commercial Bank Examination Manual Page 18 Liquidity Risk 3200.1 is highly dependent on potentially volatile funds; work includes assessing the bank’s overall or has a complex business mix, balance-sheet liquidity-risk profile and the potential for other structure, or liquidity-risk profile that exposes risk exposures, such as credit, market, opera- the institution to contingent liquidity risks, that tional, legal, and reputational risks, that may institution should generally receive greater have a negative impact on the institution’s supervisory attention. Given the contingent liquidity under adverse circumstances. These nature of liquidity risk, institutions whose cor- assessments can be conducted on a preliminary porate structure gives rise to inherent opera- basis using supervisory screens, examiner- tional risk, or institutions encountering difficul- constructed measures, internal bank measures, ties associated with their earnings, asset quality, and cash-flow projections obtained from man- capital adequacy, or market sensitivity, should agement reports received before the on-site be especially targeted for review of the adequacy engagement. Additional factors to be incorpo- of their liquidity-risk management. rated in the off-site risk assessment include the institution’s balance-sheet composition and the existence of funding concentrations, the market- Off-Site Risk Assessment ability of its assets (in the context of liquidation, securitization, or use of collateral), and the institution’s access to secondary markets of In off-site monitoring and analysis, a prelimi- liquidity. nary view, or risk assessment, is developed before initiating an on-site examination. Both The key to assessing the quality of manage- the inherent level of an institution’s liquidity- ment is an organized discovery process aimed at risk exposure and the quality of its liquidity-risk determining whether appropriate corporate- management should be assessed to the fullest governance structures, policies, procedures, lim- extent possible during the off-site phase of the its, reporting systems, CFPs, and internal con- examination process. The following information trols are in place. This discovery process should, can be helpful in this assessment: in particular, ascertain whether all the elements of sound liquidity-risk management are applied • organizational charts and policies that identify consistently. The results and reports of prior authorities and responsibilities for managing examinations, in addition to internal manage- liquidity risk ment reports, provide important information about the adequacy of the institution’s risk • liquidity policies, procedures, and limits management. • ALCO committee minutes and reports (min- utes and reports issued since the last exami- nation or going back at least six to twelve months before the examination) Examination Scope • board of directors reports on liquidity-risk exposures The off-site risk assessment provides the exam- • audit reports (both internal and external) iner with a preliminary view of both the • other available internal liquidity-risk manage- adequacy of liquidity management and the mag- ment reports, including cash-flow projections nitude of the institution’s exposure. The scope that detail key assumptions of the on-site liquidity-risk examination should • internal reports outlining funding concentra- be designed to confirm or reject the off-site tions, the marketability of assets, analysis that hypothesis and should target specific areas of identifies the relative stability or volatility of interest or concern. In this way, on-site exami- various types of liabilities, and various cash- nation procedures are tailored to the institution’s flow coverage ratios projected under adverse activities and risk profile and use flexible and liquidity scenarios targeted work-documentation programs. In gen- • supervisory surveillance reports and supervi- eral, if liquidity-risk management is identified as sory screens adequate, examiners can rely more heavily on a • external public debt ratings (if available) bank’s internal liquidity measures for assessing its inherent liquidity risk. Quantitative liquidity exposure should be The examination scope for assessing liquidity assessed by conducting as much of the supervi- risk should be commensurate with the complex- sory review off-site as practicable. This off-site ity of the institution and consistent with the

Commercial Bank Examination Manual October 2010 Page 19 3200.1 Liquidity Risk off-site risk assessment. For example, only base- system and its liquidity-risk profile. When high line examination procedures would be used for levels of liquidity-risk exposure are found, institutions whose off-site risk assessment indi- examiners should focus special attention on the cates that they have adequate liquidity-risk man- sources of this risk. When a risk assessment agement processes and low levels of inherent indicates an institution has high exposure and liquidity exposure. These institutions include weak risk-management systems, an extensive those that have noncomplex balance-sheet struc- work-documentation program is required. The tures and banking activities and that also meet institution’s internal measures should be used the following criteria: cautiously, if at all. Regardless of the sophistication or complex- • well capitalized; minimal issues with asset ity of an institution, examiners must use care quality, earnings, and market-risk-sensitive during the on-site phase of an examination to activities confirm the off-site risk assessment and identify • adequate reserves of marketable securities that issues that may have escaped off-site analysis. can serve as standby sources of liquidity Accordingly, the examination scope should be • minimal funding concentrations adjusted as on-site findings dictate. • funding structures that are principally com- posed of stable liabilities • few OBS items, such as loan commitments, that represent contingent liquidity draws Assessing CAMELS “L” Ratings • minimal potential exposure to legal and repu- tational risk The assignment of the “L” rating is integral to • formal adoption of well-documented liquidity- the CAMELS ratings process for commercial management policies, procedures, and CFPs banks. Examination findings on both (1) the inherent level of an institution’s liquidity risk For these and other institutions identified as and (2) the adequacy of its liquidity-risk man- potentially low risk, the scope of the on-site agement process should be incorporated in the examination would consist of only those exami- assignment of the “L” rating. Findings on the nation procedures necessary to confirm the risk- adequacy of liquidity-risk management should assessment hypothesis. The adequacy of liquidity- also be reflected in the CAMELS “M” rating for risk management could be verified through a risk management. basic review of the appropriateness of the insti- Examiners can develop an overall assessment tution’s policies, internal reports, and controls of an institution’s liquidity-risk exposure by and its adherence to them. The integrity and reviewing the various characteristics of its assets, reliability of the information used to assess the liabilities, OBS instruments, and material busi- quantitative level of risk could be confirmed ness activities. An institution’s asset credit qual- through limited sampling and testing. In general, ity, earnings integrity, and market risk may also if basic examination procedures validate the risk have significant implications for its liquidity- assessment, the examiner may conclude the risk exposure. Importantly, assessments of the examination process. adequacy of an institution’s liquidity- High levels of inherent liquidity risk may management practices may affect the assess- arise if an institution has concentrations in ment of its inherent level of liquidity risk. For specific business activities, products, and sec- institutions judged to have sound and timely tors, or if it has balance-sheet risks, such as liquidity-risk measurement and reporting sys- unstable liabilities, risky assets, or planned asset tems and CFPs, examiners may use the results of growth without an adequate plan for funding the the institution’s adverse-scenario cash-flow pro- asset growth. OBS items that have uncertain jections in order to gain insight into its level of cash inflows may also be a source of inherent inherent exposure. Institutions that have less- liquidity risk. Institutions for which a risk than-adequate measurement and reporting sys- assessment indicated high levels of inherent tems and CFPs may have higher exposure to liquidity-risk exposure and strong liquidity man- liquidity risk as a result of their potential inabil- agement may require a more extensive exami- ity to respond to adverse liquidity events. nation scope to confirm the assessment. These Elements of strong liquidity-risk management expanded procedures may entail more analysis are particularly important during stress events of the institution’s liquidity-risk measurement and include many of the items discussed previ-

October 2010 Commercial Bank Examination Manual Page 20 Liquidity Risk 3200.1 ously: communication among the departments • access to money markets and other sources of responsible for managing liquidity, reports that funding indicate a diversity of funding sources, standby • the level of diversification of funding sources, funding sources, cash-flow analyses, liquidity both on- and off-balance-sheet stress tests, and CFPs. Liquidity-risk manage- • the degree of reliance on short-term, volatile ment should also manage the ongoing costs of sources of funds, including borrowings and maintaining liquidity. brokered deposits, to fund longer-term assets Liquidity risk should be rated in accordance • the trend and stability of deposits with the Uniform Financial Institutions Rating • the ability to securitize and sell certain pools System (UFIRS).5 The assessment of the of assets adequacy of liquidity-risk management should • the capability of management to properly provide the primary basis for reaching an overall identify, measure, monitor, and control the assessment on the ‘‘L’’ component rating since it institution’s liquidity position, including the is a leading indicator of potential liquidity-risk effectiveness of funds-management strategies, exposure. Accordingly, overall ratings for liquidity policies, management information liquidity-risk sensitivity should be no greater systems, and CFPs than the rating given to liquidity-risk manage- ment. Ratings of liquidity-risk management should In evaluating the adequacy of a financial follow the general framework used to rate over- institution’s liquidity position, consideration all risk management: should be given to the current level and prospec- tive sources of liquidity compared with funding • A rating of 1 indicates strong liquidity levels needs, as well as to the adequacy of funds- and well-developed funds-management prac- management practices relative to the institu- tices. The institution has reliable access to tion’s size, complexity, and risk profile. In sufficient sources of funds on favorable terms general, funds-management practices should to meet present and anticipated liquidity needs. ensure that an institution is able to maintain a • A rating of 2 indicates satisfactory liquidity level of liquidity sufficient to meet its financial levels and funds-management practices. The obligations in a timely manner and to fulfill the institution has access to sufficient sources of legitimate banking needs of its community. funds on acceptable terms to meet present and Practices should reflect the ability of the insti- anticipated liquidity needs. Modest weak- tution to manage unplanned changes in funding nesses may be evident in funds-management sources, as well as react to changes in market practices. conditions that affect the ability to quickly • A rating of 3 indicates liquidity levels or liquidate assets with minimal loss. In addition, funds-management practices in need of im- funds-management practices should ensure that provement. Institutions rated 3 may lack ready liquidity is not maintained at a high cost or access to funds on reasonable terms or may through undue reliance on funding sources that evidence significant weaknesses in funds- may not be available in times of financial stress management practices. or adverse changes in market conditions. • A rating of 4 indicates deficient liquidity Liquidity is rated based upon, but not limited levels or inadequate funds-management prac- to, an assessment of the following evaluation tices. Institutions rated 4 may not have or be factors: able to obtain a sufficient volume of funds on reasonable terms to meet liquidity needs. • the adequacy of liquidity sources compared • A rating of 5 indicates liquidity levels or with present and future needs and the ability funds-management practices so critically of the institution to meet liquidity needs deficient that the continued viability of the without adversely affecting its operations or institution is threatened. Institutions rated 5 condition require immediate external financial assis- • the availability of assets readily convertible to tance to meet maturing obligations or other cash without undue loss liquidity needs.

Unsafe liquidity-risk exposures and weak- 5. SR-96-38, ‘‘Uniform Financial Institutions Rating nesses in managing liquidity risk should be fully System’’ and section A.5020.1. reflected in the overall liquidity-risk ratings.

Commercial Bank Examination Manual October 2010 Page 21 3200.1 Liquidity Risk

Unsafe exposures and unsound management Board of Governors of the Federal Reserve practices that are not resolved during the on-site System, March 17, 2010. examination should be addressed through sub- • Trading and Capital-Markets Activities sequent follow-up actions by the examiner and Manual, Board of Governors of the Federal other supervisory personnel. Reserve System.

REFERENCES APPENDIX 1—FUNDAMENTALS OF LIQUIDITY-RISK The following sources provide additional infor- MEASUREMENT mation on liquidity-risk management: Measuring a financial institution’s liquidity-risk • Bank Holding Company Supervision Manual, profile and identifying alternative sources of Board of Governors of the Federal Reserve funds to meet cash-flow needs are critical ele- System. ments of sound liquidity-risk management. The • Basel Committee on Banking Supervision, liquidity-measurement techniques and the liquid- ‘‘Sound Practices for Managing Liquidity in ity measures employed by depository institu- Banking Organisations,’’ publication 69, Feb- tions vary across a continuum of granularity, ruary 2000. specificity, and complexity, depending on the • ‘‘Determining Conformance With Interest Rate specific characteristics of the institution and the Restrictions for Less Than Well Capitalized intended users of the information. At one Institutions,’’ Federal Deposit Insurance Cor- extreme, highly granular cash-flow projections poration, November 3, 2009 (FIL 62-2009) under alternative scenarios are used by both • Federal Deposit Insurance Corporation, Risk complex and noncomplex firms to manage their Management Manual of Examination Poli- day-to-day funding mismatches in the normal cies, section 6.1—‘‘Liquidity and Funds course of business and for assessing their con- Management.’’ tingent liquidity-risk exposures. At the other end • Federal Financial Institutions Examination of the measurement spectrum, aggregate mea- Council, Uniform Bank Performance Report. sures and various types of liquidity ratios are often employed to convey summary views of an • Interagency Policy Statement on Funding and institution’s liquidity-risk profile to various lev- Liquidity Risk Management, March 17, 2010 els of management, the board of directors, and • Office of the Comptroller of the Currency, other stakeholders. As a result of this broad Comptroller’s Handbook (Safety & Sound- continuum, effective managers generally use a ness) , ‘‘Liquidity,’’ February 2001. combination of cash-flow analysis and summary • ‘‘Process for Determining If An Institution liquidity-risk measures in managing their Subject to Interest-Rate Restrictions is Oper- liquidity-risk exposures, since no one measure ating in a High-Rate Area,’’ Federal Deposit or measurement technique can adequately cap- Insurance Corporation, December 4, 2009 ture the full dynamics of a financial institution’s (FIL 69-2009) liquidity-risk exposure. • SR-01-08, ‘‘Supervisory Guidance on Com- This appendix provides background material plex Wholesale Borrowings,’’ Board of Gov- on the basic elements of liquidity-risk measure- ernors of the Federal Reserve System, April 5, ment and is intended to enhance examiners’ 2001. understanding of the key elements of liquidity- • SR-01-14, ‘‘Joint Agency Advisory on Rate- risk management. First, the fundamental struc- Sensitive Deposits,’’ Board of Governors of ture of cash-flow-projection worksheets and their the Federal Reserve System, May 31, 2001. use in assessing cash-flow mismatches under • SR-03-15, ‘‘Interagency Advisory on the Use both normal business conditions and contingent of the Federal Reserve’s Primary Credit Pro- liquidity events are discussed. The appendix gram in Effective Liquidity Management,’’ then discusses the key liquidity characteristics Board of Governors of the Federal Reserve of common depository institution assets, liabili- System, July 25, 2003. ties, off-balance-sheet (OBS) items, and other • SR-10-6, ‘‘Interagency Policy Statement on activities. These discussions also present key Funding and Liquidity-Risk Management,’’ management considerations surrounding various

October 2010 Commercial Bank Examination Manual Page 22 Liquidity Risk 3200.1 sources and uses of liquidity in constructing OBS items, often grouped by their cash-flow cash-flow worksheets and addressing funding characteristics. Different groupings may be used gaps under both normal and adverse conditions. to achieve different objectives of the cash-flow Finally, commonly used summary liquidity mea- projection. For each row, net cash flows arising sures and ratios are discussed, along with special from the particular asset, liability, or OBS activ- considerations that should enter into the con- ity are projected across the time buckets. struction and use of these summary measures.6 The detail and granularity of the rows, and thus the projections, depend on the sophistica- tion and complexity of the institution. Complex I. Basic Cash-Flow Projections banks generally favor more detail, while less complex banks may use higher levels of aggre- In measuring an institution’s liquidity-risk pro- gation. Static projections based only on the file, effective liquidity managers estimate cash contractual cash flows of assets, liabilities, and inflows and cash outflows over future periods. OBS items as of a point in time are helpful for For day-to-day operational purposes, cash-flow identifying gaps between needs and sources of projections for the next day and subsequent days liquidity. However, static projections may inad- out over the coming week are used in order to equately quantify important aspects of potential ensure that contractual obligations are met on liquidity risk because they ignore new business, time. Such daily projections can be extended out funding renewals, customer options, and other beyond a one-week horizon, although it should potential events that may have a significant be recognized that the further out such projec- impact on the institution’s liquidity profile. Since tions are made, the more susceptible they become liquidity managers are generally interested in to error arising from unexpected changes. evaluating how available liquidity sources may For planning purposes, effective liquidity man- cover both expected and potential unexpected agers project cash flows out for longer time liquidity needs, a dynamic analysis that includes horizons, employing various incremental time management’s projected changes in cash flows periods, or ‘‘buckets,’’ over a chosen horizon. is normally far more useful than a static projec- Such buckets may encompass forward weeks, tion based only on contractual cash flows as of a months, quarters, and, in some cases, years. For given projection date. example, an institution may plan its cash inflows In developing a cash-flow-projection work- and outflows on a daily basis for the next 5–10 sheet, cash inflows occurring within a given business days, on a weekly basis over the time horizon or time bucket are represented as coming month or quarter, on a monthly basis positive numbers, while outflows are repre- over the coming quarter or quarters, and on a sented as negative numbers. Cash inflows include quarterly basis over the next half-year or year. increases in liabilities as well as decreases in Such cash-flow bucketing is usually compiled assets, and cash outflows include decreases in into a single cash-flow-projection worksheet or liabilities as well as increases in assets. For each report that represents cash flows under a specific type of asset, liability, or OBS item, and in each future scenario. The goal of this bucketing time bucket, the values shown in the cells of the approach is a measurement system with suffi- projected worksheet are net cash-flow numbers. cient granularity to (1) reveal the time dimen- One format for a cash-flow-projection work- sion of the needs and sources of liquidity and sheet arrays sources of net cash inflows (such as (2) identify potential liquidity-risk exposure to loans and securities) in one group and sources of contingent events. net cash outflows (such as deposit runoffs) in In its most basic form, a cash-flow-projection another. For example, the entries across time worksheet is a table with columns denoting the buckets for a loan or loan category would net the selected time periods or buckets for which cash positives (cash inflows) of projected interest, flows are to be projected. The rows of this table scheduled principal payments, and prepayments consist of various types of assets, liabilities, and with the negatives (cash outflows) of customer draws on existing commitments and new loan growth in each appropriate time bucket. Sum- 6. Material presented in this appendix draws from the OCC ming the net cash flows within a given column Liquidity Handbook, FDIC guidance, Federal Reserve guid- or time bucket identifies the extent of maturity ance, findings from Federal Reserve supervision reviews, and other material developed for the Federal Reserve by consul- mismatches that may exist. Funding shortfalls tants and other outside parties. caused by mismatches in particular time frames

Commercial Bank Examination Manual October 2010 Page 23 3200.1 Liquidity Risk are revealed as a ‘‘negative gap,’’ while excess II. Scenario Dependency of funds within a time bucket denote a ‘‘positive Cash-Flow Projections gap.’’ Identifying such gaps early can help managers take the appropriate action to either Cash-flow-projection worksheets describe an fill a negative gap or reduce a positive gap. The institution’s liquidity profile under an estab- subtotals of the net inflows and net outflows lished set of assumptions about the future. may also be used to construct net cash-flow The set of assumptions used in the cash-flow coverage ratios or the ratio of net cash inflows to projection constitutes a specific scenario custom- net cash outflows. ized to meet the liquidity manager’s objective The specific worksheet formats used to array for the forecast. Effective liquidity managers sources and uses of cash can be customized to generally use multiple forecasts and scenarios to achieve multiple objectives. Exhibit 1 provides achieve an array of objectives over planning an example of one possible form of a cash-flow- time horizons. For example, they may use three projection worksheet. The time buckets (col- broad types of scenarios every time they make umns) and sources and uses (rows) are selected cash-flow projections: normal-course-of-business for illustrative purposes, as the specific selection scenarios; short-term, institution-specific stress will depend on the purpose of the particular scenarios; and more-severe, intermediate-term, cash-flow projection. In this example, assets and institution-specific stress scenarios. Larger, more liabilities are grouped into two broad categories: complex institutions that engage in significant those labeled ‘‘customer-driven cash flows’’ and capital-markets and derivatives activities also those labeled ‘‘management-controlled cash routinely project cash flows for various systemic flows.’’ This grouping arrays projected cash scenarios that may have an impact on the firm. flows on the basis of the relative extent to which Each scenario requires the liquidity manager to funding managers may have control over changes assess and plan for potential funding shortfalls. in the cash flows of various assets, liabilities, Importantly, no single cash-flow projection OBS items, and other activities that have an reflects the range of liquidity sources and needs impact on cash flow. For example, managers required for advance planning. generally have less control over loan and deposit Normal-course-of-business scenarios estab- cash flows (e.g., changes arising from either lish benchmarks for the ‘‘normal’’ behavior of growth or attrition) and more control over such cash flows of the institution. The cash flows items as fed funds sold, investment securities, projected for such scenarios are those the insti- and borrowings. tution expects under benign conditions and The net cash-flow gap illustrated in the next- should reflect seasonal fluctuations in loans or to-the-last row of exhibit 1 is the sum of the net deposit flows. In addition, expected growth in cash flows in each time-bucket column and assets and liabilities is generally incorporated to reflects the funding gap that will have to be provide a dynamic view of the institution’s liquidity needs under normal conditions. financed in that time period. For the daily time buckets, this gap represents the net overnight Adverse, institution-specific scenarios are position that needs to be funded in the unsecured those that subject the institution to constrained short-term (e.g., fed funds) market. The final liquidity conditions. Such scenarios are gener- row of the exhibit identifies a cumulative net ally defined by first specifying the type of cash-flow gap, which is constructed as the sum liquidity event to be considered and then iden- of the net cash flows in that particular time tifying various levels or stages of severity for bucket and all previous time buckets. It provides that type of event. For example, institutions that do not have publicly rated debt generally employ a running picture across time of the cumulative scenarios that entail a significant deterioration in funding sources and needs of the institution. The the credit quality of their loan and security worksheet presented in exhibit 1 is only one of holdings. Institutions that have publicly rated many alternative formats that can be used in debt generally include a debt-rating downgrade measuring liquidity gaps. scenario in their CFPs. The downgrade of an institution’s public debt rating might be speci- fied as one type of event, with successively lower ratings grades, including below- investment-grade ratings, to identify increasing

October 2010 Commercial Bank Examination Manual Page 24 Liquidity Risk 3200.1

Exhibit 1—Example Cash-Flow-Projection Worksheet

Day Week Week Week Month Month Months Months 1 1 2 3 1 3 4–6 7–12 Customer-driven cash flows Consumer loans Business loans Residential mortgage loans Fixed assets Other assets Noninterest-bearing deposits NOW accounts MMDAs Passbook savings Statement savings CDs under $100,000 Jumbo CDs Net noninterest income Miscellaneous and other liabilities Other Subtotal

Management-controlled cash flows Investment securities Repos, FFP, & other short- term borrowings FHLB & other borrowings Committed lines Uncommitted lines Other Subtotal

Net cash-flow gap Cumulative position

levels of severity. Each level of severity can be differently to accommodate a set of very differ- viewed as an individual scenario for planning ent assumptions from those used in the normal- purposes. Effective liquidity managers ensure course-of-business scenarios. Exhibit 2 presents that they choose potential adverse liquidity sce- a format in which accounts are organized by narios that entail appropriate degrees of severity those involving potential cash outflows and cash and model cash flows consistent with each level inflows. This format focuses the analysis first on of stress. Events that limit access to important liability erosion and potential off-balance-sheet sources of funding are the most common draws, followed by an evaluation of the bank’s institution-specific scenarios used. ability to cover potential runoff, primarily from The same type of cash-flow-projection work- assets that can be sold or pledged. Funding sheet format shown in exhibit 1 can be used for sources are arranged by their sensitivity to the adverse, institution-specific scenarios. However, chosen scenario. For example, deposits may be in making such cash-flow projections, some segregated into insured and uninsured portions. institutions find it useful to organize the accounts The time buckets used are generally of a shorter

Commercial Bank Examination Manual October 2010 Page 25 3200.1 Liquidity Risk

Exhibit 2—Example Cash-Flow-Projection Worksheet—Liquidity Under an Adverse Scenario

Potential outflows/funding Day Day Days Week Week Week Month Months erosion 1 2 3–7 2 3 4 2 2+ Federal funds purchased Uncollateralized borrowings (sub-debt, MTNs, etc.) Nonmaturity deposits: insured — Noninterest-bearing deposits — NOW accounts — MMDAs — Savings Nonmaturity deposits: uninsured — Retail CDs under $100,000 — Jumbo CDs — Brokered CDs — Miscellaneous and other liabilities Subtotal

Off-balance-sheet funding requirements Loan commitments Amortizing securitizations Out-of-the-money derivatives Backup lines

Total potential outflows

Potential sources to cover outflows Overnight funds sold Unencumbered investment securities (with appropriate haircut) Residential mortgage loans Consumer loans Business loans Fixed/other assets Unsecured borrowing capacity Brokered-funds capacity Total potential inflows

Net cash flows Coverage ratio (inflows/outflows) Cumulative coverage ratio

October 2010 Commercial Bank Examination Manual Page 26 Liquidity Risk 3200.1 term than those used under business-as-usual III. Liquidity Characteristics of scenarios, reflecting the speed at which deterio- Assets, Liabilities, Off-Balance-Sheet rating conditions can affect cash flows. Positions, and Various Types of A key goal of creating adverse-situation cash- Banking Activities flow projections is to alert management as to whether incremental funding resources available A full understanding of the liquidity and cash- under the constraints of each scenario are suffi- flow characteristics of the institution’s assets, cient to meet the incremental funding needs that liabilities, OBS items, and banking activities is result from that scenario. To the extent that critical to the identification and management of projected funding deficits are larger than (or mismatch risk, contingent liquidity risk, and projected funding surpluses are smaller than) market liquidity risk. This understanding is desired levels, management has the opportunity required for constructing meaningful cash-flow- to adjust its liquidity position or develop strat- projection worksheets under alternative sce- egies to bring the institution back within an narios, for developing and executing strategies acceptable level of risk. used in managing mismatches, and for custom- Adverse systemic scenarios entail macroeco- izing summary liquidity measures or ratios. nomic, financial market, or organizational events that can have an adverse impact on the institu- tion and its funding needs and sources. Such A. Assets scenarios are generally customized to the indi- vidual institution’s funding characteristics and The generation of assets is one of the primary business activities. For example, an institution uses of funds at banking organizations. Once involved in clearing and settlement activities acquired, assets provide cash inflows through may choose to model a payments-system dis- principal and interest payments. Moreover, the ruption, while a bank heavily involved in capital- liquidation of assets or their use as collateral for markets transactions may choose to model a borrowing purposes makes them an important capital-markets disruption. source of funds and, therefore, an integral tool in The number of cash-flow projections neces- managing liquidity risk. As a result, the objec- tives underlying an institution’s holdings of sary to fully assess potential adverse liquidity various types of assets range along a continuum scenarios can result in a wealth of information that balances the tradeoffs between maximizing that often requires summarization in order to risk-adjusted returns and ensuring the fulfill- appropriately communicate contingent liquidity- ment of an institution’s contractual obligations risk exposure to various levels of management. to deliver funds (ultimately in the form of cash). Exhibit 3 presents an example of a report format Assets vary by structure, maturity, credit quality, that assesses available sources of liquidity under marketability, and other characteristics that gen- alternative scenarios. The worksheet shows the erally reflect their relative ability to be convert- amount of anticipated funds erosion and poten- ible into cash. tial sources of funds under a number of stress Cash operating accounts that include vault scenarios, for a given time bucket (e.g., over- cash, cash items in process, correspondent night, one week, one month, etc.). In this exam- accounts, accounts with the Federal Reserve, ple, two rating-downgrade scenarios of different and other cash or ‘‘near-cash’’ instruments are severity are used, along with a scenario built on the primary tools institutions use to execute their low-earnings projections and a potential immediate cash-transaction obligations. They reputational-risk scenario. are generally not regarded as sources of addi- Exhibit 4 shows an alternative format for tional or incremental liquidity but act as the summarizing the results of multiple scenarios. operating levels of cash necessary for executing In this case, summary funding gaps are pre- day-to-day transactions. Accordingly, well- sented across various time horizons (columns) managed institutions maintain ongoing balances for each scenario (rows). Actual reports used in such accounts to meet daily business trans- should be tailored to the specific liquidity- actions. Because they generate no or very low risk profile and other institution-specific interest earnings, such holdings are generally characteristics. maintained at the minimum levels necessary to meet day-to-day transaction needs.

Commercial Bank Examination Manual October 2010 Page 27 3200.1 Liquidity Risk

Exhibit 3—Example Summary Contingent-Liquidity-Exposure Report (for an Assumed Time Horizon)

Repu- Events: Current Ratings downgrade Earnings tation Other (?) 1 cate- BBB Scenarios: gory to BB RoA = ? Potential funding erosion Large fund providers Fed funds CDs Eurotakings/foreign deposits Commercial paper Subtotal Other funds providers Fed funds CDs Eurotakings/foreign deposits Commercial paper DDAs Consumer MMDAs Savings Other

Total uninsured funds Total insured funds Total funding

Off-balance-sheet needs Letters of credit Loan commitments Securitizations Derivatives Total OBS items

Total funding erosion

Sources of funds Surplus money market Unpledged securities Securitizations Credit cards Autos Mortgages Loan sales Other Total internal sources

Borrowing capacity Brokered-funds capacity Fed discount borrowings Other

October 2010 Commercial Bank Examination Manual Page 28 Liquidity Risk 3200.1

Exhibit 4—Example Summary Contingent-Liquidity-Exposure Report (Across Various Time Horizons)

Projected liquidity cushion 1 week 2–4 weeks 2 months 3 months 4+ months Normal course of business Total cash inflows Total cash outflows Liquidity cushion (shortfall) Liquidity coverage ratio

Mild institution-specific Total cash inflows Total cash outflows Liquidity cushion (shortfall) Liquidity coverage ratio

Severe institution-specific Total cash inflows Total cash outflows Liquidity cushion (shortfall) Liquidity coverage ratio

Severe credit crunch Total cash inflows Total cash outflows Liquidity cushion (shortfall) Liquidity coverage ratio

Capital-markets disruption Total cash inflows Total cash outflows Liquidity cushion (shortfall) Liquidity coverage ratio

Custom scenario Total cash inflows Total cash outflows Liquidity cushion (shortfall) Liquidity coverage ratio

Beyond cash and near-cash instruments, the Structural cash-flow attributes of assets. Knowl- extent to which assets contribute to an institu- edge and understanding of the contractual and tion’s liquidity profile and the management of structural features of assets, such as their matu- liquidity risk depends heavily on the contractual rity, interest and amortization payment sched- and structural features that determine an asset’s ules, and any options (either explicit or embed- cash-flow profile, its marketability, and its abil- ded) that might affect contractual cash flows ity to be pledged to secure borrowings. The under alternative scenarios, is critical for the following sections discuss important aspects of adequate measurement and management of these asset characteristics that effective manag- liquidity risk. Clearly, the maturity of assets is a ers factor into their management of liquidity risk key input in cash-flow analysis. Indeed, the on an ongoing basis and during adverse liquidity management of asset maturities is a critical tool events. used in matching expected cash outflows and

Commercial Bank Examination Manual October 2010 Page 29 3200.1 Liquidity Risk inflows. This matching is generally accom- the market liquidity of an asset is not a static plished by ‘‘laddering’’ asset maturities in order attribute but is a function of conditions prevail- to meet scheduled cash needs out through short ing in the secondary markets for the particular and intermediate time horizons. asset. Bid-asked spreads, when they exist, gen- Short-term money market assets (MMAs) are erally vary with the volume and frequency of the primary ‘‘laddering’’ tools used to meet transactions in the particular type of assets. funding gaps over short-term time horizons. Larger volumes and greater frequency of trans- They provide vehicles for institutions to ensure actions are generally associated with narrower future cash availability while earning a return. bid-asked spreads. However, disruptions in the Given the relatively low return on such assets, marketplace, contractions in the number of mar- managers face important tradeoffs between earn- ket makers, the execution of large block trans- ings and the provision of liquidity in deploying actions in the asset, and other market factors such assets. In general, larger institutions employ may result in the widening of the bid-asked a variety of MMAs in making such tradeoffs, spread—and thus reduce the market liquidity of while smaller community organizations face an instrument. Large transactions, in particular, fewer potential sources of short-term investments. can constrain the market liquidity of an asset, The contractual and structural features, such especially if the market for the asset is not deep. as the maturity and payment streams of all The marketability of assets may also be con- financial assets, should be factored into both strained by the volatility of overall market prices cash-flow projections and the strategies devel- and the underlying rates, which may cause oped for filling negative funding gaps. This widening bid-asked spreads on marketable assets. practice includes the assessment of embedded Some assets may be more subject to this type of options in assets that can materially affect an market volatility than others. For example, secu- asset’s cash flow. Effective liquidity managers rities that have inherent credit or interest-rate incorporate the expected exercise of options in risk can become more difficult to trade during projecting cash flows for the various scenarios times when market participants have a low they use in measuring liquidity risk. For exam- tolerance for these risks. This may be the case ple, normal ‘‘business as usual’’ projections may when market uncertainties prompt investors include an estimate of the expected amount of to shun risky securities in favor of more-stable loan and security principal prepayments under investments, resulting in a so-called flight to prevailing market interest rates, while alternative- quality. In a flight to quality, investors become scenario projections may employ estimates of much more willing to sacrifice yield in exchange expected increases in prepayments (and cash for safety and liquidity. flows) arising from declining interest rates and In addition to reacting to prevailing market expected declines in prepayments or ‘‘maturity conditions, the market liquidity of an asset can extensions’’ resulting from rising market inter- be affected by other factors specific to individual est rates. investment positions. Small pieces of security issues, security issues from nonrated and obscure Market liquidity, or the ‘‘marketability’’ of assets. issuers, and other inactively traded securities Marketability is the ability to convert an asset may not be as liquid as other investments. While into cash through a quick ‘‘sale’’ and at a fair brokers and dealers buy and sell inactive secu- price. This ability is determined by the market in rities, price quotations may not be readily avail- which the sale transaction is conducted. In able, or when they are, bid-asked spreads may general, investment-grade securities are more be relatively wide. Bids for such securities are marketable than loans or other assets. Institu- unlikely to be as high as the bids for similar but tions generally view holdings of investment actively traded securities. Therefore, even though securities as a first line of defense for contin- sparsely traded securities can almost always be gency purposes, but banks need to fully assess sold, an unattractive price can make the seller the marketability of these holdings. The avail- unenthusiastic about selling or result in potential ability and size of a bid-asked spread for an losses in order to raise cash through the sale of asset provides a general indication of the market an asset. liquidity of that asset. The narrower the spread, Accounting conventions can also affect and the deeper and more liquid the market, the the market liquidity of assets. For example, more likely a seller will find a willing buyer at Accounting Standards Codification (ASC) 320, or near the asked price. Importantly, however, ‘‘Investments—Debt and Equity Securities,’’ (or

October 2010 Commercial Bank Examination Manual Page 30 Liquidity Risk 3200.1

Statement of Financial Accounting Standards need more time to close a loan sale than does an No. 115 (FAS 115)) requires investment securi- institution that makes such transactions ties to be categorized as held-to-maturity (HTM), regularly. Additionally, in systemic liquidity or available-for-sale (AFS), or trading, signifi- institution-specific credit-quality stress cantly affects the liquidity characteristics of scenarios, the ability to sell loans outright may investment holdings. Of the three categories, not be a realistic assumption. securities categorized as HTM provide the least Securitization can be a valuable method for liquidity, as they cannot be sold to meet liquidity converting otherwise illiquid assets into cash. needs without potentially onerous repercussions.7 Advances in the capital markets have made Securities categorized as AFS can be sold at residential mortgage, credit card, student, home any time to meet liquidity needs, but care must equity, automobile, and other loan types increas- be taken to avoid large swings in earnings or ingly amenable to securitization. As a result, the triggering impairment recognition of securities securitization of loans has become an important with unrealized losses. funds-management tool at many depository insti- Trading account securities are generally con- tutions. Many institutions have business lines sidered the most marketable from an accounting that originate assets specifically for securitiza- standpoint, since selling a trading account invest- tion in the capital markets. However, while ment has little or no income effect. securitization can play an important role in While securities are generally considered to managing liquidity, it can also increase liquidity have greater market liquidity than loans and risk—especially when excessive reliance is other assets, liquidity-risk managers increas- placed on securitization as a single source of ingly consider the ability to obtain cash from funding. the sale of loans as a potential source of liquid- Securitization can be regarded as an ongoing, ity. Many types of bank loans can be sold, reliable source of liquidity only for institutions securitized, or pledged as collateral for borrow- that have experience in securitizing the specific ings. For example, the portions of loans that are type of loans under consideration. The time and insured or guaranteed by the U.S. government effort involved in structuring loan securitiza- or by U.S. government–sponsored enterprises tions make them difficult to use as a source of are readily saleable under most market condi- asset liquidity for institutions that have limited tions. From a market liquidity perspective, the experience with this activity. Moreover, pecu- primary difference between loans and securi- liarities involved in the structures used to secu- ties is that the process of turning loans into cash ritize certain types of assets may introduce can be less efficient and more time-consuming. added complexity in managing an institution’s While securitizations of loan portfolios cash flows. For example, the securitization of (discussed below) are more common in practice, certain retail-credit receivables requires plan- commercial loans and portfolios of mortgages ning for the possible return of receivable bal- or retail loans can be, and often are, bought and ances arising from scheduled or early amortiza- sold by banking organizations. However, the tion, which may entail the funding of sizable due diligence and other requirements of these balances at unexpected or inopportune times. transactions generally take weeks or even Institutions using securitization as a source of months to complete, depending on the size and funding should have adequate monitoring sys- complexity of the loans being sold. Liquidity- tems and ensure that such activities are fully risk managers may include selling marketable incorporated into all aspects of their liquidity- loans as a potential source of cash in their risk management processes—which includes liquidity analyses, but they must be careful to assessing the liquidity impact of securitizations realistically time the expected receipt of cash under adverse scenarios. This assessment is and should carefully consider past experience especially important for institutions that origi- and market conditions at the expected time of nate assets specifically for securitization since sale. Institutions that do not have prior experi- market disruptions have the potential to impose ence selling a loan or a mortgage portfolio often the need for significant contingent liquidity if securitizations cannot be executed. As a result, 7. HTM securities can be pledged, however, so they do still effective liquidity managers ensure that the impli- provide a potential source of liquidity. Furthermore, since the cations of securitization activities are fully con- HTM-sale restriction is only an accounting standard (FAS 115)—not a market limitation—HTM securities can be sidered in both their day-to-day liquidity man- sold in cases of extreme need. agement and their liquidity contingency planning.

Commercial Bank Examination Manual October 2010 Page 31 3200.1 Liquidity Risk

Pledging of assets to secure borrowings. The protection if the value of that collateral declines. potential to pledge securities, loans, or other In this case, the haircut represents, in addition to assets to obtain funds is another important tool other factors, the portion of asset value that for converting assets into cash to meet funding cannot be converted to cash because secured needs. Since the market liquidity of assets is a lenders wish to have a collateral-protection significant concern to the lender of secured margin. funds, assets with greater market liquidity are When computing cash-flow projections under more easily pledged than less marketable assets. alternative scenarios and developing plans to An institution that has a largely unpledged meet cash shortfalls, liquidity managers ensure investment-securities portfolio has access to that they incorporate haircuts in order to reflect liquidity either through selling the investments the market liquidity of their assets. Such haircuts outright or through pledging the investments as are applied consistent with both the relative collateral for borrowings or public deposits. market liquidity of the assets and the specific However, once pledged, assets are generally scenario utilized. In general, longer-term, riskier unavailable for supplying contingent liquidity assets, as well as assets with less liquid markets, through their sale. When preparing cash-flow are assigned larger haircuts than are shorter- projections, liquidity-risk managers do not clas- term, less risky assets. For example, within the sify pledged assets as ‘‘liquid assets’’ that can be securities portfolio, different haircuts might be sold to generate cash since the liquidity avail- assigned to short-term and long-term Treasuries, able from these assets has already been ‘‘con- rated and unrated municipal bonds, and different sumed’’ by the institution. Accordingly, when types of mortgage securities (e.g., pass-throughs computing liquidity measures, effective liquid- versus CMOs). When available and appropriate, ity managers avoid double-counting unpledged historical price changes over specified time securities as both a source of cash from the horizons equal to the time until anticipated potential sale of the asset and as a source of new liquidation or the term of a borrowing are used liabilities from the potential collateralization of by liquidity-risk managers to establish such the same security. In more-sophisticated cash- haircuts. Haircuts used by nationally recognized flow projections, the tying of the pledged asset statistical ratings organizations (NRSROs) are a to the funding is made explicit. starting point for such calculations but should Similar to the pledging of securities, many not be unduly relied on since institution- and investments can be sold under an agreement to scenario-specific considerations may have impor- repurchase. This agreement provides the institu- tant implications. tion with temporary cash without having to sell Haircuts should be customized to the particu- the investment outright and avoids the potential lar projected or planned scenario. For example, earnings volatility and transaction costs that adverse scenarios that hypothesize a capital- buying and selling securities would entail. markets disruption would be expected to use larger haircuts than those used in projections Use of haircuts in measuring the funds that assuming normal markets. Under institution- can be raised through asset sales, securitiza- specific, adverse scenarios, certain assets, such tions, or repurchase agreements. The planned as loans anticipated for sale, securitization, use of asset sales, asset securitizations, or col- or pledging, may merit higher haircuts than lateralized borrowings to meet liquidity needs those used under normal business scenarios. necessarily involves some estimation of the Institutions should fully document the haircuts value of the asset at the future point in time they use to estimate the marketability of their when the asset is anticipated to be converted assets. into cash. Based on changes in market factors, Bank-owned life insurance (BOLI) is a popu- future asset values may be more or less than lar instrument offering tax benefits as well as life current values. As a result, liquidity managers insurance on bank employees. Some BOLI poli- generally apply discounts, or haircuts, to the cies are structured to provide liquidity; however, current value of assets to represent a conserva- most BOLI policies only generate cash in the tive estimate of the anticipated proceeds avail- event of a covered person’s death and impose able from asset sales or securitization in the substantial fees if redeemed. In general, BOLI capital markets. Similarly, lenders in secured should not be considered a liquid asset. If it is borrowings also apply haircuts to determine the included as a potential source of funds in a amount to lend against pledged collateral as cash-flow analysis, a severe haircut reflecting

October 2010 Commercial Bank Examination Manual Page 32 Liquidity Risk 3200.1 the terms of the BOLI contract and current • significant portions of assets pledged against market conditions should be applied. wholesale borrowings; and • impaired access to the capital markets. Liquid assets and liquidity reserves. Sound prac- tices for managing liquidity risk call for institu- tions to maintain an adequate reserve of liquid B. Liabilities assets to meet both normal and adverse liquidity situations. Such reserves should be structured Similar to its assets, a depository institution’s consistent with the considerations discussed liabilities present a complicated array of liquid- above regarding the marketability of different ity characteristics. Banking organizations obtain types of assets. Many institutions identify a funds from a wide variety of sources using an specific portion of their investment account to array of financial instruments. The primary serve as a liquidity reserve, or liquidity ware- characteristics that determine a liability’s house. The size of liquidity reserves should be liquidity-risk profile include its term, optional- based on the institution’s assessments of its ity, and counterparty risk tolerance (which liquidity-risk profile and potential liquidity needs includes the counterparty’s need for insurance under alternative scenarios, giving full consid- or collateral). These features help to determine eration to the costs of maintaining those assets. if an individual liability can be considered as In general, the amount of liquid assets held will stable or volatile. A stable liability is a reli- be a function of the stability of the institution’s able source of funds that is likely to remain available in adverse circumstances. A volatile funding structures and the potential for rapid liability is a less stable source of funds that may loan growth. If the sources of funds are stable, if disappear or be unavailable to the institution adverse-scenario cash-flow projections indicate under heavy price competition, deteriorating adequate sources of contingent liquidity (includ- credit or market- risk conditions, and other pos- ing sufficient sources of unused borrowing sible adverse events. Developing assumptions capacity), and if asset growth is predictable, on the relative stability or volatility of liabilities then a relatively low asset liquidity reserve may is a crucial step in forecasting a bank’s future be required. The availability of the liquidity cash flows under various scenarios and in reserves should be tested from time to time. Of constructing various summary liquidity course, liquidity reserves should be actively measures. As a result, effective liquidity manag- managed to reflect the liquidity-risk profile of ers segment their liabilities into volatile and the institution and current trends that might have stable components on the basis of the a negative impact on the institution’s liquidity, characteristics of the liability and on the risk such as— tolerance of the counterparty. These funds may be characterized as credit-sensitive, rate- • trading market, national, or financial market sensitive, or both. trends that might lead rate-sensitive customers to pursue investment alternatives away from Characteristics of stability and risk tolerance. the institution; The stability of an individual bank liability is • significant actual or planned growth in assets; closely related to the customer’s or counter- • trends evidencing a reduction in large liability party’s risk tolerance, or its willingness and accounts; ability to lend or deposit money for a given risk • a substantial portion of liabilities from and reward. Several factors affect the stability rate-sensitive and credit-quality-sensitive and risk tolerance of funds providers, including customers; the fiduciary responsibilities and obligations of • significant liability concentrations by product funds providers to their customers, the availabil- type or by large deposit account holders; ity of insurance on the funds advanced by customers to banking organizations, the reliance • a loan portfolio consisting of illiquid, nonmar- of customers on public debt ratings, and the ketable, or unpledgeable loans; relationships funds providers have with the • expectations for substantial draws on loan institution. commitments by customers; Institutional providers of funds to banking • significant loan concentrations by product, organizations, such as money market funds, industry, customer, and location; mutual funds, trust funds, public entities, and

Commercial Bank Examination Manual October 2010 Page 33 3200.1 Liquidity Risk other types of investment managers, have fidu- providers and for the instruments they use to ciary obligations and responsibilities to ade- place funds with the institution. Such assess- quately assess and monitor the relative risk-and- ments lead to general conclusions regarding reward tradeoffs of the investments they make each type of customer’s or counterparty’s risk for their customers, participants, or constituen- sensitivity and the stability of the funds pro- cies. These fund providers are especially sensi- vided by the instruments they use to place funds tive to receiving higher returns for higher risk, with the institution. Exhibit 5 provides a heuris- and they are more apt to withdraw funds tic schematic of how effective liquidity-risk if they sense that an institution has a deteriorat- managers conduct such an assessment regarding ing financial condition. In general, funds from the array of their different funds providers. It sources that lend or deposit money on behalf of uses a continuum to indicate the general level of others are less stable than funds from sources risk sensitivity (and thus the expected stability that lend their own funds. For example, a mutual of funds) expected for each type of depositor, fund purchaser of an institution’s negotiable CD customer, or investor in an institution’s debt may be expected to be less stable than a local obligations. Of course, individual customers and customer buying the same CD. counterparties may have various degrees of such Institutionally placed funds and other funds concerns, and greater granularity is generally providers often depend on the published evalu- required in practice. An additional instrument ations or ratings of NRSROs. Indeed, many such assessment of the stability or volatility of funds funds providers may have bylaws or internal raised using that instrument from each type of guidelines that prohibit placing funds with insti- fund provider is a logical next step in the tutions that have low ratings or, in the absence of process of evaluating the relative stability of actual guidelines, may simply be averse to various sources of funds to an institution. retaining funds at an institution whose rating is There are a variety of methods used to assess poor or whose financial condition shows dete- the relative stability of funds providers. Effec- rioration. As a result, funds provided by such tive liquidity managers generally review deposit investors can be highly unstable in adverse accounts by counterparty type, e.g., consumer, liquidity environments. small business, or municipality. For each type, The availability of insurance on deposits or an effective liquidity manager evaluates the collateral on borrowed funds are also important applicability of risk or stability factors, such as considerations in gauging the stability of funds whether the depositor has other relationships provided. Insured or collateralized funds are with the institution, whether the depositor owns usually more stable than uninsured or unsecured the funds on deposit or is acting as an agent or funds since the funds provider ultimately relies manager, or whether the depositor is likely to be on a third party or the value of collateral to more aware of and concerned by adverse news protect its investment. reports. The depositors and counterparties con- Clearly, the nature of a customer’s relation- sidered to have a significant relationship with ship with an institution has significant implica- the institution and who are less sensitive to tions for the potential stability or volatility of market interest rates can be viewed as providing various sources of funds. Customers who have stable funding. Statistical analysis of funds vola- a long-standing relationship with an institution tility is often used to separate total volumes into and a variety of accounts, or who otherwise use stable and nonstable segments. While such analy- multiple banking services at the institution, are sis can be very helpful, it is important to be usually more stable than other types of customers. mindful that historical volatility is unlikely to Finally, the sensitivity of a funds provider to include a period of acute liquidity stress. the rates paid on the specific instrument or The following discussions identify impor- transaction used by the banking organization to tant considerations that should be factored access funds is also critical for the appropriate into the assessment of the relative stability of assessment of the stability or volatility of funds. various sources of funds utilized by banking Customers that are very rate-driven are more organizations. likely not to advance funds or remove existing funds from an institution if more competitive Maturity of liabilities used to gather funds. An rates are available elsewhere. important factor in assessing the stability of All of these factors should be analyzed for the funds sources is the remaining contractual life of more common types of depositors and funds the liability. Longer-maturity liabilities obvi-

October 2010 Commercial Bank Examination Manual Page 34 Liquidity Risk 3200.1

Exhibit 5—General Characteristics of Stable and Volatile Liabilities

Characteristics of funds providers that affect the stability/ volatility of the funds provided Fiduciary Insured Reliance agent or or on public Stability Types of funds providers own funds secured information Relationship assessment Consumers owner yes low high high Small business owner in part low high medium Large corporate owner no medium medium low Banks agent no high medium medium Municipalities agent in part high medium medium Money market mutual funds quasi- no high low low fiduciary Other

ously provide more-stable funding than do require more in-depth analysis to determine shorter maturities. Extending liability maturities their relative stability. to reduce liquidity risk is a common manage- Assessment of the relative stability or volatil- ment technique and an important sound practice ity of deposits that have indeterminate maturi- used by most depository institutions. It is also a ties can be qualitative as well as quantitative, major part of the cost of liquidity management, consistent with the size, complexity, and sophis- since longer-term liabilities generally require tication of the institution. For example, at larger higher interest rates than are required for similar institutions, models based on statistical analysis short-term liabilities. can be used to estimate the stability of various subsets of such funds under alternative liquidity Indeterminate maturity deposits. Evaluations of environments. Such models can be used to the stability of deposits with indeterminate formulate expected behaviors in reaction to rate maturities, such as various types of transaction changes and other more-typical financial events. accounts (e.g., demand deposits, negotiable order As they do when using models to manage any of withdrawal accounts (NOWs) or money mar- type of risk, institutions should fully document ket demand accounts (MMDAs), and savings and understand the assumptions and methodolo- accounts) can be made using criteria similar to gies used. This is especially the case when those shown in exhibit 5. In doing so, effective external parties conduct such analysis. Effective liquidity managers recognize that the relative liquidity managers aggressively avoid ‘‘black- stability or volatility of these accounts derives box’’ estimates of funding behaviors. from the underlying characteristics of the cus- In most cases, insured deposits from consum- tomers that use them and not on the account type ers may be less likely to leave the institution itself. As a result, most institutions delineate the under many liquidity circumstances than are relative volatility or stability of various sub- funds supplied by more-institutional funds pro- groups of these account types on the basis of viders. Absent extenuating circumstances (e.g., customer characteristics. For example, MMDA the deposit contract prohibits early withdrawal), deposits of customers who have fiduciary obli- funds provided by agents and fiduciaries are gations may be less stable than those of indi- generally treated by banking organizations as vidual retail customers. Additionally, funds volatile liabilities. acquired through a higher pricing strategy for these types of deposit accounts are generally Certificates of deposit and time deposits. At less stable than are deposits from customers who maturity, certificates of deposit (CDs) and time have long-standing relationships with the insti- deposits are subject to the general factors regard- tution. Increasingly, liquidity managers recog- ing stability and volatility discussed above, nize that traditional measures of “core” deposits including rate sensitivity and relationship fac- may be inappropriate, and thus these deposits tors. Nonrelationship and highly-rate-sensitive

Commercial Bank Examination Manual October 2010 Page 35 3200.1 Liquidity Risk deposits tend to be less stable than deposits such deposits. Banks falling below the ade- placed by less-rate-sensitive customers who have quately capitalized range may not accept, renew, close relationships with the institution. Insured or roll over any brokered deposit, nor solicit CDs are generally considered more stable than deposits with an effective yield more than uninsured ‘‘jumbo’’ CDs in denominations of 75 basis points above the “national rate.” The more than $100,000. In general, jumbo CDs and national rate is defined as “a simple average of negotiable CDs are more volatile sources of rates paid by all insured depository institutions funds—especially during times of stress—since and branches for which data are available.” On they may be less relationship-driven and have a a weekly basis, the “national rate” is posted on higher sensitivity to potential credit problems. the FDIC’s website. If a depository institution believes that the “national rate” does not corre- Brokered deposits and other rate-sensitive depos- spond to the actual prevailing rate in the appli- its. Brokered deposits are funds a bank obtains, cable market, the institution may seek a deter- directly or indirectly, by or through any deposit mination from the FDIC that the institution is broker, for deposit into one or more accounts. operating in a “high-rate area.” If the FDIC Thus, brokered deposits include both those in makes such a determination, the bank will be which the entire beneficial interest in a given allowed to offer the actual prevailing rate plus bank deposit account or instrument is held by a 75 basis points. In any event, for deposits single depositor and those in which the deposit accepted outside the applicable market area, the broker pools funds from more than one investor bank will not be allowed to offer rates in excess for deposit in a given bank deposit account. of the “national rate” plus 75 basis points. Rates paid on brokered deposits are often higher These restrictions will reduce the availability than those paid for local-market-area retail of funding alternatives as a bank’s condition deposits since brokered-deposit customers are deteriorates. The FDIC is not authorized to grant generally focused on obtaining the highest FDIC- waivers for banks that are less than adequately insured rate available. These rate-sensitive cus- capitalized. Bank managers who use brokered tomers have easy access to, and are frequently deposits should be familiar with the regulations well informed about, alternative markets and governing brokered deposits and understand the investments, and they may have no other rela- requirements for requesting a waiver. Further tionship with or loyalty to the bank. If market detailed information regarding brokered depos- conditions change or more-attractive returns its can be found in the FDIC’s Financial Insti- become available, these customers may rapidly tution Letter (FIL), 69-2009. transfer their funds to new institutions or invest- Deposits attracted over the Internet, through ments. Accordingly, these rate-sensitive deposi- CD listing services, or through special advertis- tors may exhibit characteristics more typical of ing programs that offer premium rates to cus- wholesale investors, and liquidity-risk managers tomers who do not have another banking rela- should model brokered deposits accordingly. tionship with the institution also require special The use of brokered deposits is governed by monitoring. Although these deposits may not law and covered by the 2001 Joint Agency fall within the technical definition of ‘‘bro- Advisory on Brokered and Rate-Sensitive Depos- kered’’ in 12 USC 1831f and 12 CFR 337.6, its.8 Under 12 USC 1831f and 12 CFR 337.6, their inherent risk characteristics may be similar determination of ‘‘brokered’’ status is based to those of brokered deposits. That is, such initially on whether a bank actually obtains a deposits are typically attractive to rate-sensitive deposit directly or indirectly through a deposit customers who may not have significant loyalty broker. Banks that are considered only ‘‘ad- to the bank. Extensive reliance on funding equately capitalized’’ under the ‘‘prompt correc- products of this type, especially those obtained tive action’’ (PCA) standard must receive a from outside a bank’s geographic market area, waiver from the FDIC before they can accept, has the potential to weaken a bank’s funding renew, or roll over any brokered deposit. They position in times of stress. are also restricted in the rates they may offer on Under the 2001 joint agency advisory, banks are expected to perform adequate due diligence before entering any business relationship with 8. Board of Governors of the Federal Reserve System, a deposit broker; assess the potential risks to Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, and Office of Thrift Supervision. earnings and capital associated with brokered May 11, 2001. See SR-01-14. deposits; and fully incorporate the assessment

October 2010 Commercial Bank Examination Manual Page 36 Liquidity Risk 3200.1 and control of brokered deposits into all ele- similar locales. Eurodollar deposits are usually ments of their liquidity-risk management pro- negotiable CDs issued in amounts of $100,000 cesses, including CFPs. or more, with rates tied to LIBOR. Because they are negotiable, the considerations applicable to Public or government deposits. Public funds negotiable CDs set forth above also apply to generally represent deposits of the U.S. govern- Eurodollar deposits. ment, state governments, and local political subdivisions; they typically require collateral to Federal funds purchased. Federal funds (fed be pledged against them in the form of securi- funds) are excess reserves held at Federal ties. In most banks, deposits from the U.S. Reserve Banks. The most common type of government represent a much smaller portion of federal funds transaction is an overnight, unse- total public funds than that of funds obtained cured loan. Transactions that are for a period from states and local political subdivisions. longer than one day are called term fed funds. Liquidity-risk managers generally consider the The day-to-day use of fed funds is a common secured nature of these deposits as being a occurrence, and fed funds are considered an double-edged sword. On the one hand, they important money market instrument used in reduce contingent liquidity risk because secured managing daily liquidity needs and sources. funds providers are less credit-sensitive, and Many regional and money-center banks, act- therefore their deposits may be more stable than ing in the capacity of correspondents to smaller those of unsecured funds providers. On the other community banks, function as both providers hand, such deposits reduce standby liquidity by and purchasers of federal funds. Overnight fed ‘‘consuming’’ the potential liquidity in the funds purchased can pose a contingent liquidity pledged collateral. risk, particularly if a bank is unable to roll over Rather than pledge assets as collateral for or replace the maturing borrowing under stress public deposits, banks may also purchase an conditions. Term fed funds pose almost the insurance company’s surety bond as coverage same risk since the term is usually just a week or for public funds in excess of FDIC insurance two. Fed funds purchased should generally be limits. Here, the bank would not pledge assets to treated as a volatile source of funds. secure deposits, and the purchase of surety bonds would not affect the availability of funds Loans from correspondent banks. Small and to all depositors in the event of insolvency. The medium-sized banks often negotiate loans from costs associated with the purchase of a surety their principal correspondent banks. The loans bond must be taken into consideration when are usually for short periods and may be secured using this alternative. or unsecured. Correspondent banks are usually Deposits from taxing authorities (most school moderately credit-sensitive. Accordingly, cash- districts and municipalities) also tend to be flow projections for normal business conditions highly seasonal. The volume of public funds and mild adverse scenarios may often treat these rises around tax due dates and falls near the end funds as stable. However, given the credit sen- of the period before the next tax due date. This sitivity of such funds, projections computed for fluctuation is clearly a consideration for liquid- severe adverse liquidity scenarios should treat ity managers projecting cash flows for normal these funds as volatile. operations. State and local governments tend to be very rate-sensitive. Effective liquidity man- FHLB borrowings. The Federal Home Loan agers fully consider the contingent liquidity risk Banks (FHLBs) provide loans, referred to as these deposits entail, that is, the risk that the advances, to members. Advances must be deposits will not be maintained, renewed, or secured by collateral acceptable to the FHLB, replaced unless the bank is willing to offer very such as residential mortgage loans and mortgage- competitive rates. backed securities. Both short-term and long- term FHLB borrowings, with maturities ranging Eurodollar deposits. Eurodollar time deposits from overnight to 10 years, are available to are certificates of deposit issued by banks out- member institutions at generally competitive side of the United States. Large, internationally interest rates. For some small and medium-sized active U.S. banks may obtain Eurodollar funding banks, long-term FHLB advances may be a through their foreign branches—including off- significant or the only source of long-term shore branches in the Cayman Islands or other funding.

Commercial Bank Examination Manual October 2010 Page 37 3200.1 Liquidity Risk

It should be noted that FHLBs may also sell collateralized, the various FHLBs have histori- their excess cash into the market in the form of cally worked with regulators prior to exercising fed funds. This is a transaction where the FHLB their option to fully withdraw funding from is managing its excess funding and has chosen members. To this extent, FHLB borrowings are to invest that excess in short-term unsecured fed viewed by many liquidity managers as a rela- funds. This transaction is executed through the tively stable source of funding, barring the most capital markets and is not done with specific severe of adverse funding situations. members of the FHLB. Sound liquidity-risk management practices Some FHLB advances contain embedded call for institutions to fully document the pur- options or other features that may increase pose of any FHLB-borrowing transaction. Each funding risk. For example, some types of transaction should be analyzed on an ongoing advances, such as putable and convertible basis to determine whether the arrangement advances, provide the FHLB with the option to achieves the stated purpose or whether the either recall the advance or change the inter- borrowings are a sign of liquidity deficiencies. est rate on an advance from a fixed rate to a Some banks may use their FHLB line of credit floating rate under specified conditions. When to secure public funds; however, doing so will such optionality exists, institutions should fully reduce their available funds and may present assess the implications of this optionality on the problems if the FHLB reduces the institution’s liquidity-risk profile of the institution. credit line. Additionally, the institution should In general, an FHLB establishes a line of periodically review its borrowing agreement credit for each of its members. Members are with the FHLB to determine the assets collater- required to purchase FHLB stock before a line alizing the borrowings and the potential risks of credit is established, and the FHLB has the presented by the agreement. In some instances, ability to restrict the redemption of its stock. An the borrowing agreement may provide for col- FHLB may also limit or deny a member’s lateralization by all assets not already pledged request for an advance if the member engages in for other purposes. any unsafe or unsound practice, is inadequately capitalized, sustains operating losses, is defi- Repurchase agreements and dollar rolls. The cient with respect to financial or managerial terms repurchase agreement9 (repo) and reverse resources, or is otherwise deficient. repurchase agreement refer to transactions in Because FHLB advances are secured by col- which a bank acquires funds by selling securi- lateral, the unused FHLB borrowing capacity of ties and simultaneously agreeing to repurchase a bank is a function of both its eligible, the securities after a specified time at a given unpledged collateral and its unused line of credit price, which typically includes interest at an with its FHLB. agreed-on rate. A transaction is considered a FHLBs have access to bank regulatory infor- repo when viewed from the perspective of the mation not available to other lenders. The com- supplier of the securities (the borrower) and a posite rating of an institution is a factor in the reverse repo or matched sale–purchase agree- approval for obtaining an FHLB advance, as ment when described from the point of view of well as the level of collateral required and the the supplier of funds (the lender). continuance of line availability. Because of this A repo commonly has a near-term maturity access to regulatory data, an FHLB can react (overnight or a few days) with tenors rarely quickly to reduce its exposure to a troubled exceeding three months. Repos are also usu- institution by exercising options or not rolling ally arranged in large dollar amounts. Repos over unsecured lines of credit. Depending on the may be used to temporarily finance the purchase severity of a troubled institution’s condition, an of securities and dealer securities inventories. FHLB has the right to increase collateral require- Banking organizations also use repos as a ments or to discontinue or withdraw (at matu- substitute for direct borrowings. Bank securi- rity) its collateralized funding program because ties holdings as well as loans are often sold of concerns about the quality or reliability of the under repurchase agreements to generate collateral or other credit-related concerns. On temporary working funds. These types of agree- the one hand, this right may create liquidity ments are often used because the rate on this problems for an institution, especially if it has large amounts of short-term FHLB funding. At the same time, because FHLB advances are fully 9. See section 3010.1.

October 2010 Commercial Bank Examination Manual Page 38 Liquidity Risk 3200.1 type of borrowing is less than the rate on Because these instruments are usually very unsecured borrowings, such as federal funds short-term transactions, institutions using them purchased. incur contingent liquidity risk. Accordingly, U.S. government and agency securities are the cash-flow projections for normal and mild sce- most common type of instruments sold under narios usually treat these funds as stable. How- repurchase agreements, since they are exempt ever, projections computed for severe scenarios from reserve requirements. However, market generally treat these funds as volatile. participants sometimes alter various contract provisions to accommodate specific investment International borrowings. International borrow- needs or to provide flexibility in the designation ings may be direct or indirect. Common forms of direct international borrowings include loans of collateral. For example, some repo contracts and short-term call money from foreign banks, allow substitutions of the securities subject to borrowings from the Export-Import Bank of the the repurchase commitment. These transactions United States, and overdrawn nostro accounts are often referred to as dollar repurchase agree- (due from foreign bank demand accounts). ments (dollar rolls), and the initial seller’s obli- Indirect forms of borrowing include notes and gation is to repurchase securities that are sub- trade bills rediscounted with the central banks stantially similar, but not identical, to the of various countries; notes, acceptances, import securities originally sold. To qualify as a financ- drafts, or trade bills sold with the bank’s ing, these agreements require the return of endorsement or guarantee; notes and other “substantially similar securities” and cannot obligations sold subject to repurchase agree- exceed 12 months from the initiation of the ments; and acceptance pool participations. In transaction. The dollar-roll market primarily general, these borrowings are often considered consists of agreements that involve mortgage- to be highly volatile, nonstable sources of funds. backed securities. Another common repo arrangement is called Federal Reserve Bank borrowings. In 2003, the an open repo, which provides a flexible term to Federal Reserve Board revised Regulation A to maturity. An open repo is a term agreement provide for primary and secondary credit between a dealer and a major customer in which programs at the discount window.10 (See section the customer buys securities from the dealer and 4025.1.) Reserve Banks will extend primary may sell some of them back before the final credit at a rate above the target fed funds rate on maturity date. a short-term basis (typically, overnight) to Effective liquidity-risk managers ensure that eligible depository institutions, and acceptable they are aware of special considerations and collateral is required to secure all obligations. potential risks of repurchase agreements, espe- Discount window borrowings can be secured cially when the bank enters into large-dollar- with an array of collateral, including consumer volume transactions with institutional investors and commercial loans. Eligibility for primary or brokers. It is a fairly common practice to credit is based largely on an institution’s adjust the collateral value of the underlying examination rating and capital status. In gen- securities daily to reflect changes in market eral, institutions with composite CAMELS rat- prices and to maintain the agreed-on margin. ings of 1, 2, or 3 that are at least adequately Accordingly, if the market value of the repo-ed capitalized are eligible for primary credit unless securities declines appreciably, the borrower supplementary information indicates their may be asked to provide additional collateral. condition is not generally sound. Other condi- Conversely, if the market value of the securities tions exist to determine eligibility for 4- and rises substantially, the lender may be required to 5-rated institutions. return the excess collateral to the borrower. If An institution eligible for primary credit need the value of the underlying securities exceeds not exhaust other sources of funds before com- the price at which the repurchase agreement was ing to the discount window. However, because sold, the bank could be exposed to the risk of loss if the buyer is unable to perform and return 10. See the “Interagency Advisory on the Use of the the securities. This risk would increase if the Federal Reserve’s Primary Credit Program in Effective Liquid- securities were physically transferred to the ity Management,” Board of Governors of the Federal Reserve System, Office of the Comptroller of the Currency, Federal institution or broker with which the bank has Deposit Insurance Corporation, and Office of Thrift Supervi- entered into the repurchase agreement. sion, July 25, 2003, and SR-03-15. See also section 3010.1.

Commercial Bank Examination Manual October 2010 Page 39 3200.1 Liquidity Risk of the above-market price of primary credit, the C. Off-Balance-Sheet Obligations Reserve Banks expect institutions to mainly use the discount window as a backup source of Off-balance-sheet transactions have been one of liquidity rather than as a routine source. Gener- the fastest-growing areas of banking activity. ally, Reserve Banks extend primary credit on an While these activities may not be reflected on overnight basis with minimal administrative the balance sheet, they must be thoroughly requirements to eligible institutions. Reserve reviewed in assessing an institution’s liquidity- Banks may also extend primary credit to eligible risk profile, as they can expose the institution to institutions for periods of up to several weeks significant contingent liquidity risk. Effective if funding is not available from other sources. liquidity-risk managers pay particular attention These longer extensions of credit are subject to to potential liquidity risks in loan commitments, greater administrative oversight. Reserve Banks lines of credit, performance guarantees, and also offer secondary credit to institutions that do financial guarantees. Banks should estimate both not qualify for primary credit. Secondary credit the amount and the timing of potential cash is another short-term backup source of liquidity, flows from off-balance-sheet claims. although its availability is more limited and is generally used for emergency backup purposes. Effective liquidity managers ensure that they Reserve Banks extend secondary credit to assist consider the correlation of draws on various in an institution’s timely return to a reliance on types of commitments that can trend with mac- traditional funding sources or in the resolution roeconomic conditions. For example, standby of severe financial difficulties. This program letters of credit issued in lieu of construction entails a higher level of Reserve Bank adminis- completion bonds are often drawn when build- tration and oversight than primary credit. ers cannot fulfill their contracts. Some types of credit lines, such as those used to provide Treasury Tax and Loan deposits. Treasury Tax working capital to businesses, are most heavily and Loan accounts (TT&L accounts) are main- used when either the borrower’s accounts receiv- tained at banks by the U.S. Treasury to facilitate able or inventory is accumulating faster than its payments of federal withholding taxes. Banks collections of accounts payable or sales. may select either the ‘‘remittance-option’’ or the Liquidity-risk managers should work with the ‘‘note-option’’ method of forwarding deposited appropriate lending managers to track such funds to the U.S. Treasury. In the remittance trends. option, the bank remits the TT&L account In addition, funding requirements arising from deposits to the Federal Reserve Bank the next some types of commitments can be highly business day after deposit, and the remittance correlated with the counterparty’s credit quality. portion is not interest-bearing. The note option Financial standby letters of credit (SBLOCs) are permits the bank to retain the TT&L deposits. In often used to back the counterparty’s direct the note option, the bank debits the TT&L financial obligations, such as commercial paper, remittance account for the amount of the previ- tax-exempt securities, or the margin require- ous day’s deposit and simultaneously credits the ments of securities and derivatives exchanges. note-option account. Note-option accounts are At some institutions, a major portion of off- interest-bearing and can grow to a substantial balance-sheet claims consists of SBLOCs sup- size. porting commercial paper. If the institution’s TT&L funds are considered purchased funds, customer issues commercial paper supported by evidenced by an interest-bearing, variable-rate, an SBLOC and if the customer is unable to open-ended, secured note callable on demand repay the commercial paper at maturity, the by Treasury. As per 31 CFR 203.24, the TT&L holder of the commercial paper will request that balance requires pledged collateral, usually the institution perform under the SBLOC. from the bank’s investment portfolio. Because Liquidity-risk managers should work with the they are secured, TT&L balances reduce appropriate lending manager to (1) monitor the standby liquidity from investments, and because credit grade or default probability of such coun- they are callable, TT&L balances are considered terparties and (2) manage the industry diversifi- to be volatile and they must be carefully cation of these commitments in order to reduce monitored. However, in most banks, TT&L the probability that multiple counterparties will deposits constitute only a minor portion of total be forced to draw against the bank’s commit- liabilities. ments at the same time.

October 2010 Commercial Bank Examination Manual Page 40 Liquidity Risk 3200.1

Funding under some types of commitments D. Specialized Business Activities can also be highly correlated with changes in the institution’s own financial condition or per- Institutions that engage in specialized banking ceived credit quality. Commitments supporting activities should ensure that all elements of various types of asset-backed securities, asset- these activities are fully incorporated into their backed commercial paper, and derivatives can assessment of liquidity-risk exposure and their be subject to such contingent liquidity risk. The ongoing management of the firm’s liquidity. securitization of assets generally requires some Such activities may include mortgage servicing, form of credit enhancement, which can take trading and dealer activities, and various types many forms, including SBLOCs or other types of fee-income-generating businesses. of guarantees issued by a bank. Similarly, many Institutions engaged in significant payment, structures employ special-purpose entities (SPEs) clearing, and settlement activities face particular that own the collateral securing the asset-backed challenges. Institutions that are active in pay- paper. Bank SBLOCs or guarantees often sup- ment, settlement, or clearing activities should port those SPEs. As long as the institution’s ensure that they have mechanisms for measur- credit quality remains above defined minimums, ing, monitoring, and identifying the amount of which are usually based on ratings from NRS- liquidity they may need to settle obligations in ROs, few or none of the SBLOCs will fund. normal as well as stressed environments. These However, if the institution’s credit rating falls institutions should fully consider the unique below the minimum, a significant amount or all risks that may result from their participation in different payment-system activities and factor of such commitments may fund at the same these risks into their liquidity contingency plan- time. ning. Factors that banks should consider when Financial derivatives can also give rise to developing liquidity plans related to payment contingent liquidity risk arising from financial activities include— market disruptions and deteriorating credit qual- ity of the banking organization. Derivatives • the impact of pay-in rules of individual pay- contracts should be reviewed, and their potential ment systems, which may result in short- for early termination should be assessed and notice payment adjustments and the need to quantified, to determine the adequacy of the assess peak pay-in requirements that could institution’s available liquidity. Many forms of result from the failure of another participant; standardized derivatives contracts allow • the potential impact of operational disruptions counterparties to request collateral or to at a payment utility and the potential need to terminate contracts early if the institution move activity to another venue in which experiences an adverse credit event or deteriora- settlement is gross rather than net, thereby tion in its financial condition. In addition, under increasing liquidity requirements to settle; situations of market stress, a customer may ask • the impact that the deteriorating credit quality for early termination of some contracts. In such of the institution may have on collateral circumstances, an institution that owes money requirements, changes in intraday lending lim- on derivatives transactions may be required to its, and the institution’s intraday funding needs; deliver collateral or settle a contract early, when and the institution is encountering additional fund- • for clearing and nostro service providers, the ing and liquidity pressures. Early terminations impact of potential funding needs that could may also create additional, unintended market be generated by their clearing customers in exposures. Management and directors should be addition to the bank’s own needs. aware of these potential liquidity risks and ad- dress them in the institution’s CFP. All off- balance-sheet commitments and obligations IV. Summary Measures of should receive the focused attention of liquidity-risk managers throughout the liquidity- Liquidity-Risk Exposure risk management process. Cash-flow projections constructed assuming normal and adverse conditions provide a wealth of information about the liquidity profile of an institution. However, liquidity managers, bank

Commercial Bank Examination Manual October 2010 Page 41 3200.1 Liquidity Risk supervisors, rating agencies, and other cash-flow projections and forecasts. They are interested parties use a myriad of summary generally constructed as the ratio of total pro- measures of liquidity to identify potential jected cash inflows divided by total projected liquidity risk. These measures include various cash outflows for a particular time period or types of financial ratios. Many of these cash-flow-projection time bucket. The ratio for a measures attempt to achieve some of the same given time bucket indicates the relative amount insights provided by comprehensive cash-flow by which the projected sources of liquidity scenario analyses but use significantly less data. cover projected needs. For example, a ratio of When calculated using standard definitions and 1.20 indicates a liquidity ‘‘surplus’’ equal to comparable data, such measures provide the 20 percent of projected outflows. In general, ability to track trends over time and facilitate such coverage ratios are compiled for each comparisons across peers. At the same time, time bucket in the cash-flow projections used however, many summary measures necessarily to assess both normal and adverse liquidity entail simplifying assumptions regarding the circumstances. liquidity of assets, the relative stability or Some institutions also employ cumulative volatility of liabilities, and the ability of the cash-flow ratios that are computed as the ratio institution to meet potential funding needs. of the cumulative sum of cash inflows to the Supervisors, management, and other stakehold- cumulative sum of cash outflows for all time ers that use these summary measures should buckets up to a given time bucket. However, fully understand the effect of these assump- care should be taken to recognize that cumula- tions and the limitations associated with sum- tive cash-flow ratios used alone and without the mary measures. benefit of assessing the individual time-period Although general industry conventions may exposures for each of their component time be used to compute various summary measures, buckets may mask liquidity-risk exposures that liquidity managers should ensure that the spe- can exist at intervals up to the cumulative time cific measures they use for internal purposes are horizons chosen. suitably customized for their particular institu- tion. Importantly, effective liquidity managers recognize that no single summary measure or B. Other Summary Liquidity Measures ratio captures all of the available sources and uses of liquidity for all situations and for all time Other common summary liquidity measures periods. Different ratios capture different facets employ assumptions about, and depend heavily of liquidity and liquidity risk. Moreover, the on, the assessment and characterization of the same summary measure or ratio calculated using relative marketability and liquidity of assets and different assumptions can also capture different the relative stability or volatility of funding facets of liquidity. This is an especially impor- needs and sources, consistent with the consider- tant point since, by definition, many liquidity ations discussed in the prior section. Liquidity ratios are scenario-specific. Measures con- managers use these other measures to review structed using normal-course-of-business historical trends, summarize their projections of assumptions can portray liquidity profiles that potential liquidity-risk exposures under adverse are significantly different from those constructed liquidity conditions, and develop strategies to assuming stress contingency events. Indeed, address contingent liquidity events. In selecting many liquidity managers use the same summary from the myriad of available measures, effective measures and financial ratios computed under liquidity managers focus primarily on those alternative scenarios and assumptions to evalu- measures that are most related to the liquidity- ate and communicate to senior management and management strategies pursued by the institu- the board of directors the institution’s liquidity- tion. For example, institutions that focus on risk profile and the adequacy of its CFPs. managing asset liquidity place greater emphasis on measures that gauge such conditions, while institutions placing greater emphasis on manag- A. Cash-Flow Ratios ing liability liquidity emphasize measures that address those aspects of their liquidity-risk Cash-flow ratios are especially valuable sum- profile. mary liquidity measures. These measures sum- The following discussions briefly describe marize the information contained in detailed some of the more common summary measures

October 2010 Commercial Bank Examination Manual Page 42 Liquidity Risk 3200.1 of liquidity and liquidity risk. Some of these Other measures within this category attempt to measures are employed by liquidity managers, assess the expected time period over which rating agencies, and supervisors using defini- longer-term, illiquid assets may need to be tions and calculation methods amenable to pub- funded. These measures, which use broad asset licly available Call Report or BHC Performance categories and employ strong assumptions on Report data. Because such data require the use the liquidity of these assets, include— of assumptions on the liquidity of broad classes of assets and on the stability of various types of • loans and leases as a percent of total assets, aggregated liabilities, liquidity managers and and supervisors should take full advantage of the • long-term assets (defined as maturing beyond available granularity of internal data to custom- a specified time period) as a percent of total ize the summary measures they are using. Incor- assets. porating internal data ensures that summary measures fit the specific liquidity profile of the To better gauge the potential for assets to be institution. Such customization permits a more used as sources of liquidity to meet uncertain robust assessment of the institution’s liquidity- future cash needs, effective liquidity managers risk profile. use additional ‘‘liquid asset’’ summary measures In general, most common summary measures that are customized to take into account the of liquidity and liquidity risk can be grouped ability (or inability) to convert assets into cash into the following three broad categories: or borrowed funds. Such measures attempt to summarize the potential for sale, securitization, 1. those that portray the array of assets along a or use as collateral of different types of assets, continuum of liquidity and cash-flow charac- subject to appropriate scenario-specific haircuts. teristics for normal and potentially adverse Such measures also attempt to recognize the circumstances constraints on potential securitization and on those assets that have already been pledged as 2. those that portray the array of liabilities along collateral for existing borrowings. Examples of a continuum of potential volatility and stabil- these measures include— ity characteristics under normal and poten- tially adverse circumstances • marketable securities (as determined by the 3. those that assess the balance between fund- assessment of cash-flow, accounting, and hair- ing needs and sources based on assumptions cut considerations discussed in the previous about both the relative liquidity of assets and section) to total securities; the relative stability of liabilities • marketable securities as a percent of total assets; Relative liquidity of assets. Summary measures • marketable assets (as determined by the assess- that address the liquidity of assets usually start ment of cash-flow, accounting, and haircut with assessments of the maturity or type of considerations discussed in the previous sec- assets in an effort to gauge their contributions to tion) to total assets; actual cash inflows over various time horizons. • pledgable assets (e.g., unpledged securities In general, they represent an attempt to summa- and loans) as a percent of total assets; rize and characterize the expected cash inflows • pledged securities (or pledged assets) to total from assets that are estimated in more-detailed pledgable securities (or pledgable assets); cash-flow-projection worksheets assuming nor- • securitizable assets to total assets (sometimes mal business conditions. Summary measures computed to include some assessment of the assessing the liquidity of assets include such time frame that may be involved); and measures as— • liquid assets to total assets with the measure of liquid assets being some combination of short- • short-term investments (defined as maturing term assets, marketable securities, and securi- within a specified time period, such as 3 tizable and pledgable assets (ensuring that any months, 6 months, or 1 year) as a percent of pledged assets are not double-counted). total investments, and • short-term assets (defined as maturing within Relative stability or volatility of liabilities as a a specified time period) as a percent of total source of funding. Summary measures used to assets. assess the relative stability or volatility of lia-

Commercial Bank Examination Manual October 2010 Page 43 3200.1 Liquidity Risk bilities as sources of funding often start with ized traditional measures of core deposits. Break- assessments of the maturity of liabilities and outs that use such a greater granularity include— their ability to be ‘‘rolled-over’’ or renewed under both normal business and potentially • various breakouts of retail deposits to total adverse circumstances. These measures also deposits based on product type (MMDA, represent an attempt to summarize and demand deposit, savings account, etc.) and characterize the use of actual and potential customer segmentation to total deposits or sources of funds, which are estimated in more- liabilities; detailed cash-flow-projection worksheets. In • breakouts of various types of institutional fact, proper construction of many of these sum- deposits (e.g., collateralized deposits of mary measures requires the same analytical municipal and government entities) as a per- assessments required for cash-flow projections. cent of deposits; and Such measures attempt to gauge and array the • various breakouts of brokered deposits (by relative sensitivity and availability of different size, types of fund providers, and maturity). sources of funds on the basis of the anticipated behavior of various types of transactions, busi- At the other end of the stability/volatility ness activities, funds providers, or other continuum, some summary measures focus on attributes. identifying those sources of funding that need to Given the difficulties involved in portraying be rolled over in the short term under normal funding sources across the entire continuum of business conditions and those whose rollover or stability and volatility characteristics, along with usage in the future may be especially sensitive the complexity of overlaying alternative contin- to institution-specific contingent liquidity events. gent scenarios on such portrayals, some com- These measures include— mon summary measures attempt to group fund- ing sources as falling on one side or the other • short-term liabilities (defined as fund sources of this continuum. Financial ratios that attempt maturing within a specified time period, such to portray the extent to which an institution’s as 3 months, 6 months, or 1 year) as a percent funding sources are stable include— of total liabilities; • short-term brokered deposits as a percent of • total deposits as a percent of total liabilities or total deposits; total assets; • insured short-term brokered deposits as a • insured deposits as a percent of total deposits; percent of total deposits; • deposits with indeterminate maturities as a • purchased funds (including short-term percent of total deposits; and liabilities such as fed funds purchased, repos, • long-term liabilities (defined as maturing FHLB borrowings, and other funds raised in beyond a specified time period) to total secondary markets) as a percent of total liabilities. liabilities; • uncollateralized purchased funds as a percent These measures necessarily employ assump- of total liabilities; and tions about the stability of an institution’s deposit • short-term purchased funds to total purchased base in an attempt to define a set of relatively funds. stable or core funding sources. Liquidity man- agers and examiners should take care in con- When computing measures to assess the avail- structing their estimates of stable or core liabili- ability of potential sources of funds under con- ties for use in such measures. This caution has tingent liquidity scenarios, institutions may adjust become especially important as changes in the carrying values of their liabilities in order to customer sophistication and interest-rate sensi- develop best estimates of available funding tivity have altered behavioral patterns and, there- sources. Similar to the haircuts applied when fore, the stability characteristics traditionally assessing marketable securities and liquid assets, assumed for retail and other types of deposits such adjustments endeavor to identify more- traditionally termed ‘‘core.’’ As a result, exam- realistic rollover rates on current and potential iners, liquidity managers, and other parties funding sources. should use more-granular breakouts of funding sources to assess the relative stability of deposits Balance between funding needs and sources. and should not place undue reliance on standard- Measures used to assess the relationship between

October 2010 Commercial Bank Examination Manual Page 44 Liquidity Risk 3200.1 actual or potential funding needs and funding • short-term investments (defined as invest- sources are constructed across a continuum that ments maturing within a specified time arrays both the tenor or relative liquidity of period, such as 3 months, 6 months, or 1 year) assets and the potential volatility or stability of as a percent of short-term liabilities (defined liabilities. Many of these measures use concepts as liabilities maturing within a specified time discussed earlier regarding the liquidity of assets period, such as 3 months, 6 months, or 1 and the relative stability or volatility of liabili- year). ties as funding sources. Some measures express various definitions of short-term liquid assets to Other summary liquidity measures take a total liabilities or alternative definitions of vola- more expansive approach to assessing the tile or stable liabilities to total assets. Such continuum of liquid assets and volatile liabilities measures may include— by including more items or expanding the breadth of analysis. Such measures include— • net short-term liabilities (short-term liabilities minus short-term assets) as a percent of total • liquid assets (defined as a combination of assets; short-term assets, marketable securities, and • stable deposits as a percent of total assets; securitizable and pledgable assets—ensuring • total purchased funds as a percent of total that any pledged assets are not double- assets; counted—over a certain specified time frame) as a percent of liabilities judged to be volatile • uncollateralized borrowings as a percent of (over the same time period); total assets; and • liquidity-surplus measures, such as liquid • liquid assets as a percent of total liabilities. assets minus short-dated or volatile liabilities; and Other measures attempt to identify the • liquid assets as a percent of purchased funds. relationships between different classifications of liquid or illiquid assets and stable or volatile Other common summary measures of liquid- liabilities. Exhibit 6 provides a conceptual ity focus on the potential mismatch of using schematic of the range of relationships that are short-term or potentially volatile liabilities to often addressed in such assessments. fund illiquid assets (upper-right-hand quadrant Some commonly used summary liquidity mea- of exhibit 6). Often these measures factor only sures and ratios focus on the amount of different those volatile liabilities in excess of short-term types of liquid assets that are funded by various and highly liquid assets or marketable invest- types of short-term and potentially volatile lia- ment securities into this assessment. Such bilities (upper-left quadrant of exhibit 6). One of volatile-liability-dependence measures provide the most common measures of this type is the insights as to the extent to which alternative ‘‘net short-term position’’ (used by some NRS- funding sources might be needed to fund long- ROs). Liquidity managers, bank supervisors, term liquidity needs under adverse liquidity and rating agencies use this measure to assess an conditions. These measures include— institution’s ability to meet its potential cash obligations over a specified period of time. It is • net short-term noncore-funding-dependence computed as an institution’s liquid assets (incor- measures, such as short-term volatile funding porating appropriate haircuts on marketable minus short-term investments as a percent of assets) minus the potential cash obligations illiquid assets; and expected over the specified time period (e.g., 3 • net volatile-funding-dependence measures, months, 6 months, or 1 year). Other measures such as volatile funding minus liquid assets as used to assess the relationship or coverage of a percent of illiquid assets. potentially volatile liabilities by liquid assets include— Another set of summary liquidity ratios can be constructed to focus on the extent to which • short-term investments (defined as invest- illiquid assets are match-funded by stable liabili- ments maturing within a specified time period, ties (lower-right quadrant of exhibit 6). Com- such as 3 months, 6 months, or 1 year) as a mon examples of such measures include tradi- percent of short-term and potentially volatile tional loan-to-deposit ratios (which incorrectly liabilities; and assume all deposits are stable) and loan-to-core-

Commercial Bank Examination Manual October 2010 Page 45 3200.1 Liquidity Risk

Exhibit 6—Relationships Between Liquid or Illiquid Assets and Stable or Volatile Liabilities

Asset Liquidity/Marketability/Maturity Liabilities Liquid Illiquid

Volatile

Liquid Asset Illiquid Assets Coverage of Volatile Funded by Volatile Liabilities Liabilities

Liquid Assets Matching of Illiquid Funded by Stable Assets with Stable Liabilities Liabilities Stable deposit ratios (which often take a product- funding sources are used to fund short-term and specific approach to defining the stability of liquid assets (lower-left quadrant of exhibit 6). certain types of deposits). However, since such Since short-term liquid assets generally entail traditional measures necessarily require the use relatively lower returns than longer-term less- of broad assumptions on the stability of depos- liquid assets, measures assessing such potential its, they should not be relied on to provide mismatches focus liquidity managers on the cost meaningful insights regarding potential funding of carrying liquid assets. mismatches between stable funding sources and illiquid assets. One meaningful measure used to gauge such V. Liquidity-Measurement relationships is the concept of “net cash capital” Considerations for Bank Holding (which is also used by some NRSROs). This measure is the dollar amount by which stable Companies sources of funds exceed illiquid assets; it can be Liquidity-risk measurement considerations for computed as a percent of total assets to facilitate BHCs can be found in the Bank Holding Com- comparisons across institutions. In addition, it pany Supervision Manual, sections 4000.1, 4010, can be computed using customized assessments and 4020. of the relative stability of different types of liabilities and the ability to convert assets into cash through sale, securitization, or collateral- ization. For example, firms may choose to APPENDIX 2—SUMMARY OF exclude portions of loans sold regularly (e.g., MAJOR LEGAL AND loans conforming to secondary-market stan- REGULATORY CONSIDERATIONS dards) as illiquid assets, or they may choose to include long-term debt as stable liabilities. The following discussions summarize some of A final set of summary measures are used by the major legal and regulatory considerations liquidity managers to optimize the liquidity that should be taken into account in managing profiles of their institutions. These measures the liquidity risk of banking organizations. The assess the extent to which relatively stable discussions are presented only to highlight

October 2010 Commercial Bank Examination Manual Page 46 Liquidity Risk 3200.1 potential issues and to direct bankers and found in section 23A of the Federal Reserve supervisors to source documents on those Act, 70 years of Board interpretations of sec- issues. tion 23A, section 23B of the Federal Reserve Act, and portions of the Gramm-Leach-Bliley Act of 1999. Covered transactions include pur- A. Federal Reserve Regulation A chases of assets from an affiliate, extensions of credit to an affiliate, investments in securities issued by an affiliate, guarantees on behalf of an Federal Reserve Regulation A addresses bor- affiliate, and certain other transactions that rowing from the discount window. Rules defin- expose the member bank to an affiliate’s credit ing eligible collateral can be found in this or investment risk. Derivatives transactions and regulation. intraday extensions of credit are also covered. The intentions of the regulation are (1) to protect the depository institution, (2) to ensure B. Federal Reserve Regulation D that all transactions between the bank and its affiliates are on terms and conditions that are Federal Reserve Regulation D addresses required consistent with safe and sound banking prac- reserves for deposits. One portion of the regu- tices, and (3) to limit the ability of a depository lation, however, restricts the type of eligible institution to transfer to its affiliates the subsidy collateral that can be pledged for repurchase- arising from the institution’s access to the fed- agreement borrowings. eral safety net. The regulation achieves these goals in four major ways:

C. Federal Reserve Regulation F 1. It limits a member bank’s covered transac- tions with any single affiliate to no more than Federal Reserve Regulation F imposes limits on 10 percent of the bank’s capital stock and interbank liabilities. This regulation implements surplus, and limits transactions with all affili- section 308 of the Federal Deposit Insurance ates combined to no more than 20 percent of Corporation Improvement Act (FDICIA). Banks the bank’s capital stock and surplus. that sell funds to other banks must have written 2. It requires all transactions between a member policies to limit excessive exposure, must review bank and its affiliates to be on terms and the financial condition or credit rating of the conditions that are consistent with safe and debtor, must have internal limits on the size of sound banking practices. exposures that are consistent with the credit risk, 3. It prohibits a member bank from purchasing may not lend more than 25 percent of their low-quality assets from its affiliates. capital to a single borrowing bank, and must 4. It requires that a member bank’s extensions undertake other steps. of credit to affiliates and guarantees on behalf of affiliates be appropriately secured by a Banks that borrow federal funds or other statutorily defined amount of collateral. borrowings from correspondent banks may find, as a result of the seller’s compliance with Section 23B protects member banks by Regulation F, that the amount they may borrow requiring that certain transactions between the has suddenly declined as a result of a reduction bank and its affiliates occur on market terms, in their credit rating or credit quality. Regulation that is, on terms and under circumstances that F may make it harder for a bank to use borrow- are substantially the same, or at least as favor- ings as a liquidity source for a bank-specific able to the bank, as those prevailing at the time liquidity crisis. for comparable transactions with unaffiliated companies. Section 23B applies the market- terms restriction to any covered transaction (as D. Federal Reserve Regulation W defined in section 23A) with an affiliate as well as certain other transactions, such as (1) any sale Federal Reserve Regulation W governs transac- of assets by the member bank to an affiliate, tions between an insured bank or thrift and its (2) any payment of money or furnishing of affiliates. The regulation establishes a consistent services by the member bank to an affiliate, and and comprehensive compilation of requirements (3) any transaction by the member bank with a

Commercial Bank Examination Manual October 2010 Page 47 3200.1 Liquidity Risk third party if an affiliate has a financial interest F. Statutory Restriction on the Use of in the third party or if an affiliate is a participant Brokered Deposits in the transaction. Liquidity-risk managers working in banks The use of brokered deposits is restricted by that have affiliates must give careful attention to 12 CFR 337.6. Well-capitalized banks may Regulation W, which addresses transactions accept brokered deposits without restriction. between banks and their affiliates. In the normal Adequately capitalized banks must obtain a course of business, the prohibition on unsecured waiver from the FDIC to solicit, renew, or roll funding can tie up collateral, complicate collat- over brokered deposits. Adequately capitalized eral management, and restrict the availability of banks must also comply with restrictions on the funding from affiliates. In stressed conditions, rates that they pay for these deposits. Banks that all of those problems—plus the size limit and have capital levels below adequately capitalized the prohibition on sales of low-quality assets to are prohibited from using brokered deposits. In affiliates—effectively close down many transac- addition to these restrictions, banking regulators tions with affiliates. have also issued detailed guidance, discussed in section H below, on the use of brokered deposits.

E. Statutory Restriction of FHLB Advances G. Legal Restrictions on Dividends

The Federal Home Loan Banks (FHLBs) pro- A number of statutory restrictions limit the vide a number of different advance programs amount of dividends that a bank may pay to its with very attractive terms to member banks. stockholders. As a result, a bank holding com- Many banks now use the FHLBs for term pany that depends on cash from its bank sub- funding. The FHLBs are very credit-sensitive sidiaries can find this source of funds limited or lenders. closed. This risk is particularly significant for bank holding companies with nonbank sub- A federal regulation (12 CFR 935, Federal sidiaries that require funding or debt service. Housing Finance Board—Advances) requires the FHLBs to be credit-sensitive. In addition to monitoring the general financial condition of commercial banks and using rating informa- H. Restrictions on Investments That tion provided by bank rating agencies, the Affect Liquidity-Risk Management FHLBs have access to nonpublic regulatory information and supervisory actions taken Interagency guidance issued in 1998 by the against banks. The FHLBs often react quickly, FFIEC, ‘‘Supervisory Policy Statement on Invest- sometimes before other funds providers, to ment Securities and End-User Activities,’’ con- reduce exposure to a troubled bank by not roll- tains provisions that may affect liquidity and ing over unsecured borrowing lines. Depend- liquidity management. (See SR-98-12.) The fol- ing on the severity of a troubled bank’s condi- lowing points summarize some of these poten- tion, even the collateralized funding program tial impacts, although readers should review the may be discontinued or withdrawn at maturity entire rule for more-complete information. because of concerns about the quality or relia- bility of the collateral or other credit-related 1. When banks specify permissible instruments concerns. Contractual provisions requiring for accomplishing established objectives, they increases in collateral may also be invoked. Any must take into account the liquidity of the of these changes in FHLB-loan availability or market for those investments and the effect terms can create significant liquidity problems, that liquidity may have on achieving their especially in banks that use large amounts of objective. short-term FHLB funding. 2. Banks are required to consider the effects that market risk can have on the liquidity of different types of instruments under various scenarios.

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3. Banks are required to clearly articulate risks (FTP costs and benefits), as measured at the liquidity characteristics of the instru- transaction or trade inception, to a firm’s busi- ments they use to accomplish institutional ness lines, products, and activities. While this objectives. guidance specifically addresses FTP practices related to funding and contingent liquidity risks, In addition, the policy statement specifically firms may incorporate other risks in their overall highlights the greater liquidity risk inherent in FTP frameworks. complex and less actively traded instruments. FTP is an important tool for managing a firm’s balance sheet structure and measuring risk-adjusted profitability. By allocating funding APPENDIX 3—INTERAGENCY and contingent liquidity risks to business lines, GUIDANCE ON FUNDS products, and activities within a firm, FTP influences the volume and terms of new busi- TRANSFER PRICING RELATED ness and ongoing portfolio composition. This TO FUNDING AND CONTINGENT process helps align a firm’s funding and contin- LIQUIDITY RISKS gent liquidity risk profile and risk appetite and complements, but does not replace, broader The Board of Governors of the Federal Reserve liquidity and interest rate risk-management pro- System (FRB), the Federal Deposit Insurance grams (for example, stress testing) that a firm Corporation (FDIC), and the Office of the Comp- uses to capture certain risks (for example, basis troller of the Currency (OCC) issued this guid- risk). If done effectively, FTP promotes more ance on funds transfer pricing (FTP) practices resilient, sustainable business models. FTP is related to funding risk (including interest rate also an important tool for centralizing the man- and liquidity components) and contingent liquid- agement of funding and contingent liquidity ity risk at large financial institutions (hereafter risks for all exposures. Through FTP, a firm can referred to as “firms”) to address weaknesses 11 transfer these risks to a central management observed in some firms’ FTP practices. The function that can take advantage of natural guidance builds on the principles of sound offsets, centralized hedging activities, and a liquidity risk management described in the broader view of the firm. “Interagency Policy Statement on Funding and 12 Failure to consistently and effectively apply Liquidity Risk Management,” and incorpo- FTP can misalign the risk-taking incentives of rates elements of the international statement individual business lines with the firm’s risk issued by the Basel Committee on Banking appetite, resulting in a misallocation of financial Supervision titled “Principles for Sound Liquid- 13 resources. This misallocation can arise in new ity Risk Management and Supervision.” business and ongoing portfolio composition For purposes of this guidance, FTP refers to a where the business metrics do not reflect risks process performed by a firm’s central manage- taken, thereby undermining the business model. ment function that allocates costs and benefits Examples include entering into excessive off- associated with funding and contingent liquidity balance sheet commitments and on-balance sheet asset growth because of mispriced funding and contingent liquidity risks. 11. For purposes of this guidance, large financial institu- tions includes national banks, federal savings associations and The 2008 financial crisis exposed weak risk- state-chartered banks with consolidated assets of $250 billion management practices for allocating liquidity or more, domestic bank and savings and loan holding com- costs and benefits across business lines. Several panies with consolidated assets of $250 billion or more or firms “acknowledged that if robust FTP prac- foreign exposure of $10 billion or more, and foreign banking organizations with combined U.S. assets of $250 billion or tices had been in place earlier, and if the systems more. had charged not just for funding but for liquidity 12. Refer to FRB’s SR-10-6, “Interagency Policy State- risks, they would not have carried the significant ment on Funding and Liquidity Risk Management”; FDIC’s levels of illiquid assets and the significant risks FIL-13-2010, “Funding and Liquidity Risk Management Inter- agency Guidance”; and OCC Bulletin 2010-13, “Final Policy that were held off-balance sheet that ultimately 14 Statement: Interagency Policy Statement on Funding and led to sizable losses.” Refer to SR-16-3. Liquidity Management.” 13. The Basel Committee on Banking Supervision state- ment on “Principles for Sound Liquidity Risk Management 14. Senior Supervisors Group report on “Risk Management and Supervision” (September 2008) is available at www.bis.org/ Lessons from the Global of 2008” (Octo- publ/bcbs144.htm. ber 21, 2009) is available at www.newyorkfed.org/medialibrary/

Commercial Bank Examination Manual October 2016 Page 49 3200.1 Liquidity Risk

Funds Transfer Pricing Principles Principle 2: A firm should have a consistent and transparent FTP A firm should have an FTP framework to framework for identifying and allocating support its broader risk-management and gover- FTP costs and benefits on a timely basis nance processes that incorporates the general and at a sufficiently granular level, principles described in this section and is com- commensurate with the firm’s size, mensurate with its size, complexity, business complexity, business activities, and overall risk profile. activities, and overall risk profile. The frame- work should incorporate FTP costs and benefits FTP costs and benefits should be allocated based into product pricing, business metrics, and new on methodologies that are set forth by a firm’s product approval for all material business lines, FTP framework. The methodologies should be products, and activities to align risk-taking incen- transparent, repeatable, and sufficiently granular tives with the firm’s risk appetite. such that they align business decisions with the firm’s desired funding and contingent liquidity risk appetite. To the extent a firm applies FTP at Principle 1: A firm should allocate FTP an aggregated level to similar products and costs and benefits based on funding risk activities, the firm should include the aggregat- and contingent liquidity risk. ing criteria in the report on FTP.15 Additionally, the senior management group that oversees FTP A firm should have an FTP framework that should review the basis for the FTP methodolo- allocates costs and benefits based on the follow- gies. The attachment to this interagency guid- ing risks. ance describes illustrative FTP methodologies that a firm may consider when implementing its • Funding risk, measured as the cost or benefit FTP framework.16 (including liquidity and interest rate compo- A firm should allocate FTP costs and benefits, nents) of raising funds to finance ongoing as measured at transaction or trade inception, to business operations, should be allocated based the appropriate business line, product, or activ- on the characteristics of the business lines, ity. If a firm retains any FTP costs or benefits in products, and activities that give rise to those a centrally managed pool pursuant to its FTP costs or benefits (for example, higher costs framework, it should analyze the implications of allocated to assets that will be held over a such decisions on business line incentives and longer time horizon and greater benefits allo- the firm’s overall risk profile. The firm custom- cated to stable sources of funding). arily would include its findings in the report on FTP. • Contingent liquidity risk, measured as the cost The FTP framework should be implemented of holding standby liquidity composed of consistently across the firm to appropriately unencumbered, highly liquid assets, should be align risk-taking incentives. While it is possible allocated to the business lines, products, and to apply different FTP methodologies within a activities that pose risk of contingent funding firm due to, among other things, legal entity type needs during a stress event (for example, or specific jurisdictional circumstances, a firm draws on credit commitments, collateral calls, should generally implement the FTP framework deposit run-off, and increasing haircuts on in a consistent manner across its corporate secured funding). structure to reduce the likelihood of misaligned incentives. If there are implementation differ- ences across the firm, management should ana- lyze the implications of such differences on business line incentives and the firm’s overall funding and contingent liquidity risk profile.

15. See Principle 3 for a discussion of the report on FTP. 16. The FRB, the FDIC, and the OCC will monitor evolving FTP practices in the market and may update or add to the illustrative methodologies in the interagency guidance media/newsevents/news/banking/2009/SSG_report.pdf. attachment.

October 2016 Commercial Bank Examination Manual Page 50 Liquidity Risk 3200.1

The firm customarily would include its findings structure or scope of activities undergoes a in the report on FTP. material change. Further, senior management A firm should allocate, report, and update with oversight responsibility for FTP should data on FTP costs and benefits at a frequency periodically, but no less frequently than quar- that is appropriate for the business line, product, terly, review the report on FTP to ensure that the or activity. Allocating, reporting, and updating established FTP framework is being properly of data should occur more frequently for trading implemented. exposures (for example, on a daily basis). Infre- A firm should also establish a central man- quent allocation, reporting, or updating of data agement function tasked with implementing the for trading exposures (for example, based on FTP framework. The central management func- month-end positions) may not fully capture a tion should have visibility over the entire firm’s firm’s day-to-day funding and contingent liquid- on- and off-balance sheet exposures. Among its ity risks. For example, a firm should monitor the responsibilities, the central management func- age of its trading exposures, and those held tion should regularly produce and analyze a longer than originally intended should be reas- sessed and FTP costs and benefits should be report on FTP generated from accurate and reallocated based on the modified holding period. reliable management information systems. The A firm’s FTP framework should address report on FTP should be at a sufficiently granu- derivative activities commensurate with the size lar level to enable the senior management group and complexity of those activities. The FTP and central management function to effectively framework may consider the fair value of cur- monitor the FTP framework (for example, at the rent positions, the rights of rehypothecation for business line, product, or activity level, as appro- collateral received, and contingent outflows that priate). Among other items, all material approv- may occur during a stress event. als, such as those related to any exception to the To avoid a misalignment of risk-taking incen- FTP framework, including the reason for the tives, a firm should adjust its FTP costs and exception, would customarily be documented in benefits as appropriate based on both market- the report on FTP. The report on FTP may be wide and idiosyncratic conditions, such as standalone or included within a broader risk- trapped liquidity, reserve requirements, regula- management report. tory requirements, illiquid currencies, and settle- Independent risk and control functions and ment or clearing costs. These idiosyncratic con- internal audit should provide oversight of the ditions should be contemplated in the FTP FTP process and assess the report on FTP, which framework, and the firm customarily would should be reviewed as appropriate to reflect include a discussion of the implications in the changing business and financial market condi- report on FTP. tions and to maintain the appropriate alignment of incentives. Lastly, consistent with existing supervisory guidance on model risk manage- Principle 3: A firm should have a robust ment,17 models used in FTP implementation governance structure for FTP, including should be independently validated and regularly the production of a report on FTP and reviewed to ensure that the models continue to oversight from a senior management perform as expected, that all assumptions remain group and central management function. appropriate, and that limitations are understood and appropriately mitigated. A firm should have a senior management group that oversees FTP, which should include a broad range of stakeholders, such as representatives from the firm’s asset-liability committee (if separate from the senior management group), the treasury function, and business line and risk management functions. This group should de- velop the policy underlying the FTP framework, which should identify assumptions, responsibili- ties, procedures, and authorities for FTP. The 17. Refer to FRB’s SR-11-7, “Guidance on Model Risk policy should be reviewed and updated on a Management” and OCC Bulletin 2011-12, “Supervisory Guid- regular basis or when the firm’s asset-liability ance on Model Risk Management.”

Commercial Bank Examination Manual October 2016 Page 51 3200.1 Liquidity Risk

Principle 4: A firm should align business Conclusion incentives with risk-management and strategic objectives by incorporating FTP A firm should use the principles laid out in this costs and benefits into product pricing, guidance to develop, implement, and maintain business metrics, and new product an effective FTP framework. In doing so, a approval. firm’s risk-taking incentives should better align with its risk-management and strategic objec- Through its FTP framework, a firm should tives. The framework should be adequately incorporate FTP costs and benefits into product tailored to a firm’s size, complexity, business pricing, business metrics, and new product activities, and overall risk profile. approval for all material business lines, prod- ucts, and activities (both on- and off-balance sheet). The framework, the report on FTP, and Interagency Guidance Attachment any associated management information sys- Illustrative Funds Transfer Pricing tems should be designed to provide decision Methodologies makers sufficient and timely information about FTP costs and benefits so that risk-taking incen- March 1, 2016 tives align with the firm’s strategic objectives. The information may be either at the transac- The FTP methodologies described below are tion level or, if the transactions have homog- intended for illustrative purposes only and pro- enous funding and contingent liquidity risk char- vide examples for addressing principles set forth acteristics, at an aggregated level. In deciding in the guidance. A firm’s FTP framework should whether to allocate FTP costs and benefits at the be commensurate with its size, complexity, busi- transaction or aggregated level, firms should ness activities, and overall risk profile. In design- consider advantages and disadvantages of both ing its FTP framework, a firm may utilize other approaches when developing the FTP frame- methodologies that are consistent with the prin- work. Although transaction-level FTP alloca- ciples set forth in the guidance. Therefore, these tions may add complexity and involve higher illustrative methodologies should not be inter- implementation and maintenance costs, such preted as directives for implementing any par- allocations may provide a more accurate mea- ticular FTP methodology. sure of risk-adjusted profitability. A firm assign- ing FTP allocations at an aggregated level should have aggregation criteria based on funding and Non-Trading Exposures contingent liquidity risk characteristics that are transparent. For non-trading exposures, a firm’s FTP meth- There should be ongoing dialogue between odology may vary based on its business activi- the business lines and the central function respon- ties and specific exposures. For example, certain sible for allocating FTP costs and benefits to firms may have higher concentrations of expo- ensure that funding and contingent liquidity sures that have less predictable time horizons, risks are being captured and are well-understood such as non-maturity loans and non-maturity for product pricing, business metrics, and new deposits. product approval. The business lines should understand the rationale for the FTP costs and benefits, and the central function should under- Matched-Maturity Marginal Cost of stand the funding and contingent liquidity risks Funding implicated by the business lines’ transactions. Matched-maturity marginal cost of funding is a Decisions by senior management to incentivize commonly used methodology for non-trading certain behaviors through FTP costs and benefits exposures. Under this methodology, FTP costs customarily would be documented and included and benefits are based on a firm’s market cost of in the report on FTP. funds across the term structure (for example, wholesale long-term debt curve adjusted based on the composition of the firm’s alternate sources of funding such as Federal Home Loan Bank

October 2016 Commercial Bank Examination Manual Page 52 Liquidity Risk 3200.1 advances and customer deposits). This method- Trading Exposures ology incentivizes business lines to generate stable funding (for example, core deposits) by For trading exposures, a firm could consider a crediting them the benefit or premium associ- variety of factors, including the type of funding ated with such funding. It also ensures that source (for example, secured or unsecured), the business lines are appropriately charged the cost market liquidity of the exposure (for example, of funding for the life of longer-dated assets (for the size of the haircut relative to the overall example, a five-year commercial loan). Given exposure), the holding period of the position, the that funding costs can change over time, the prevailing market conditions, and any potential market cost of funds across the term structure impact the chosen approach could have on firm should be derived from reliable and readily incentives and overall risk profile. If a firm’s available data sources and be well understood trading activities are not material, its FTP frame- by FTP users. work may require a less complex methodology FTP rates should, as closely as possible, for trading exposures. The following FTP meth- match the characteristics of the transaction or odologies have been observed for allocating the aggregated transactions to which they are FTP costs for trading exposures. applied. In determining the appropriate point on the derived FTP curve for a transaction or pool of transactions, a firm could consider a variety Weighted Average Cost of Debt (WACD) of characteristics, including the holding period, cash flow, re-pricing, prepayments, and expected WACD is the weighted average cost of outstand- life of the transaction or pool. For example, for ing firm debt, usually expressed as a spread over a five-year commercial loan that has a rate that an index. Some firms’ practices apply this rate to resets every three months and will be held to the amount of an asset expected to be funded maturity, the interest rate component of the unsecured (repurchase agreement market hair- funding risk could be based on a three-month cuts may be used to delineate between the horizon for determining the FTP cost, and the amount being funded secured and the amount liquidity component of the funding risk could be being funded unsecured). A firm using WACD based on a five-year horizon for determining the should analyze whether the methodology mis- FTP cost. Thus, the total FTP cost for holding aligns risk-taking incentives and document such the five-year commercial loan would be the analyses in the report on FTP. combination of these two components.

Marginal Cost of Funding Contingent Liquidity Risk Marginal cost of funding sets the FTP costs at A firm may calculate the FTP cost related to the appropriate incremental borrowing rate of a non-trading exposure contingent liquidity risk firm. Some firms’ practices apply a marginal using models based on behavioral assumptions. secured borrowing rate to the amount of an asset For example, charges for contingent commit- expected to be funded secured and a marginal ments could be based on their modeled likeli- unsecured borrowing rate to the amount of an hood of drawdown, considering customer draw- asset expected to be funded unsecured (repur- down history, credit quality, and other factors; chase agreement market haircuts may be used to whereas, credits applied to deposits could be delineate between the amount being funded based on volatility and modeled behavioral matu- secured and the amount being funded unse- rity. A firm should document and include all cured). A firm using marginal cost of funding modeling analyses and assumptions in the report should analyze whether the methodology mis- on FTP. If behavioral assumptions used in a aligns risk-taking incentives, considering current firm’s FTP framework do not align with behav- market rates compared to historical rates, and ioral assumptions used in its internal stress test document such analyses in the report on FTP. for similar types of non-trading exposures, the firm should document and include in the report on FTP these inconsistencies.

Commercial Bank Examination Manual October 2016 Page 53 3200.1 Liquidity Risk

Contingent Liquidity Risk in the report on FTP these inconsistencies. Haircuts should be updated at a frequency that is A firm may calculate the FTP costs related to appropriate for a firm’s trading activities and contingent liquidity risk from trading exposures market conditions. by considering the unencumbered liquid assets A firm may also include the FTP costs related that are held to cover the potential for widening to contingent liquidity risk from potential deriva- haircuts of trading exposures that are funded tive outflows in stressed market conditions, secured. If haircuts used in a firm’s FTP frame- which may be due to, for example, credit rating work do not align with haircuts used in its downgrades, additional termination rights, or internal stress test for similar types of trading market shocks and volatility. exposures, the firm should document and include

October 2016 Commercial Bank Examination Manual Page 54 Liquidity Risk Examination Objectives Effective date October 2010 Section 3200.2

1. To appropriately risk-focus the scope of the 8. To determine whether the institution’s poli- examination (that is, ensure that the scope is cies, procedures, and limits are adequate, appropriate, given the institution’s activities given its size, complexity, and sophistication. and the risks they present). 9. To determine if management is adequately 2. To assess the relative volatility or stability planning for intermediate-term and longer- of the institution’s liability funding sources. term liquidity or funding needs. 3. To assess the institution’s access to liquidity. 10. To assess the adequacy of the institution’s 4. To assess the institution’s potential liquidity liquidity-risk measurement systems. needs. 11. To assess the adequacy of the institution’s 5. To assess (1) the institution’s exposure to liquidity-risk management information mismatched risk under normal business con- systems. ditions and (2) its planned strategies for 12. To assess the adequacy of the institution’s addressing this risk. contingency funding plans. 6. To assess the institution’s exposure to con- 13. To assess the adequacy of the institution’s tingent liquidity risk. internal controls for its liquidity-risk man- 7. To assess the appropriateness and integrity agement process. of the institution’s corporate-governance 14. To determine whether the institution is com- policies for management of liquidity risk. plying with applicable laws and regulations.

Commercial Bank Examination Manual October 2010 Page 1 Liquidity Risk Examination Procedures Effective date October 2010 Section 3200.3

EXAMINATION SCOPE ASSESSMENT OF INHERENT LIQUIDITY RISK 1. Review the following documents to identify issues that may require follow-up: 1. Review the institution’s deposit structure. a. prior examination findings and workpa- Discuss the following issues with manage- pers ment: the institution’s customer base, costs, b. audit reports, and and pricing strategies, as well as the stabil- c. ongoing monitoring risk assessments (if ity of various types of deposits. This review available) should include— 2. Review appropriate surveillance material, a. assumptions about deposit behaviors the including the Uniform Bank Performance institution uses in making its cash-flow Report (UBPR), BHC Performance Report, projections and in conducting its IRR and other reports, to identify liquidity trends analyses; and the liquidity-risk profile of the institu- b. the competitiveness of rates paid on tion. This review should include assess- deposits, from both a national and local- ments of the marketability of assets and the market-area perspective; relative stability or volatility of funding c. lists of large depositors, potential deposit sources. concentrations, and large deposit 3. Request and review internal reports man- maturities; agement uses to monitor liquidity risk, d. the institution’s use of brokered deposits including the following reports: and deposits from entities that may be a. senior management, asset/liability com- especially sensitive to market rates and mittee (ALCO), and for the board of credit quality; and directors’ meetings e. public fund deposits, including pledging b. cash-flow-projection reports requirements and pricing policies. c. contingency funding plans (CFPs) 2. Review the institution’s use of nondeposit d. funding-concentration reports liabilities. Discuss with management its 4. Request and review organizational charts strategies for employing such funds, the and liquidity-risk management policies and sensitivity of such funds to market rates, procedures. and the credit quality of the institution. This 5. Review the potential liquidity-risk exposure review should include— arising from the financial condition of the a. the types, costs, amounts, and concentra- institution or other trends, such as asset tions of nondeposit liabilities used by the growth, asset quality, earnings trends, capi- institution; tal adequacy, market-risk exposures (interest- b. the strategies underlying the use of any rate risk (IRR) exposures for both the bank- Federal Home Loan Bank (FHLB) ing book and the trading book), business- advances and the specific features of line operational considerations, and the those borrowings, including the exis- potential for legal and reputational risk. tence of any options, to determine if the institution adequately understands the risk On the basis of the hypothesis developed for profile of these borrowings; both the institution’s inherent liquidity-risk exposure and the adequacy of its liquidity man- c. the activities the institution funds with agement, select the steps necessary to meet nondeposit liabilities; examination objectives from the following d. the institution’s use of short-term liabili- procedures. ties; and e. compliance with the written agreements for borrowings. 3. Review the institution’s holdings of market- able assets as liquidity reserves. This review should include— a. the quality, maturity, marketability, and

Commercial Bank Examination Manual October 2010 Page 1 3200.3 Liquidity Risk: Examination Procedures

amount of unpledged investment levels of stress those events entail. Deter- securities; mine if the chosen scenarios are appropri- b. pledgable and securitizable loans and ate, given the institution’s business activi- existing activities in this area; and ties and funding structure. c. a discussion with management on its 9. Review cash-flow projections the institution strategies for maintaining liquid asset has constructed for selected contingent reserves. liquidity events. Review the assumptions 4. When applicable, review the institution’s underlying the projections, including sources access to debt markets as a source of of funds to be used in a contingent liquidity liquidity. This review should include— event and the reports and assumptions on a. the strength of current short- and longer- behavioral cash flows. term debt ratings, including an assess- 10. Review the assumptions and trends in the ment of the potential for ‘‘watch-listing’’ institution’s liquidity-risk ‘‘triggers.’’ or downgrades; 11. Review CFPs. b. the breadth of the investor base for the 12. When appropriate, review reports on company’s debt; liquidity-risk triggers in the institution’s c. current and future issuance plans; securitization activities. d. concentrations of borrowed funds; 13. On the basis of the above procedures, deter- e. the availability to utilize FHLB or other mine if the institution’s inherent liquidity wholesale funds providers; and risk is low, limited, moderate, considerable, f. the institution’s reputation in the capital or high. markets and with major funds providers. 5. Review the institution’s business activities that may have a significant impact on its liquidity needs. This review should include— ASSESSMENT OF THE QUALITY a. the institution’s ability to securitize assets OF LIQUIDITY-RISK and the amount of its current and antici- MANAGEMENT pated securitization activities; b. payments- or securities-processing activi- 1. Review formally adopted policies and pro- ties and other activities that may heighten cedures, as well as reports to the board of the impact of on the directors and senior management, to deter- liquidity of the firm; mine the adequacy of their oversight. This c. the amount and nature of trading and review should include whether the board over-the-counter (OTC) derivative activi- and senior management— ties that may have an impact on liquidity; a. have identified lines of authority and d. the extent of off-balance-sheet (OBS) responsibility; loan commitments; b. have articulated the institution’s general e. the balance-sheet composition, including liquidity strategies and its approach to significant concentrations that may have liquidity risk; an impact on liquidity; and f. operational risks associated with the c. understand the institution’s liquidity institution’s business activities, risks CFPs; and inherent in the corporate structure, or d. periodically review the institution’s external factors that may have an impact liquidity-risk profile. on liquidity. 2. Review senior management structures in 6. Review the institution’s cash-flow order to determine their adequacy for over- projections. seeing and managing the institution’s liquid- 7. Discuss with management the institution’s ity. This review should include— strategies for dealing with seasonal, cycli- a. whether the institution has designated an cal, and planned asset-growth funding strat- ALCO or other management decision- egies, including its assessment of alterna- making body; tive funding sources. b. the frequency of ALCO meetings and the 8. Review and discuss with management the adequacy of the reports presented; institution’s identification of potential con- c. decisions made by the ALCO and vali- tingent liquidity events and the various dation of follow-up on those decisions,

October 2010 Commercial Bank Examination Manual Page 2 Liquidity Risk: Examination Procedures 3200.3

including ongoing assessment of open Determine if management has identified issues; alternative sources of funds if plans are not d. the technical and managerial expertise of met. management and personnel involved in 5. Review the reasonableness of bank- liquidity management; and established parameters for the use of vola- e. whether the institution has clearly delin- tile liabilities. eated centralized and decentralized 6. Review liquidity-risk measurement poli- liquidity-management responsibilities. cies, procedures, methodologies, models, 3. Review and discuss with management the assumptions, and other documentation. Dis- institution’s liquidity-risk policies, proce- cuss with management the— dures, and limits, and determine their a. adequacy and comprehensiveness of appropriateness, comprehensiveness, and cash-flow projections and supporting accuracy. Policies, procedures, and limits analysis used to manage liquidity; should— b. appropriateness of summary measures a. identify the objectives and strategies of and ratios to adequately reflect the the institution’s liquidity management liquidity-risk profile of the institution; and its expected and preferred reliance c. appropriateness of the identification of on various sources of funds to meet stable and volatile sources of funding; liquidity needs under alternative d. comprehensiveness of alternative contin- scenarios; gent liquidity scenarios incorporated in b. delineate clear lines of responsibility and the ongoing estimation of liquidity needs; accountability over liquidity-risk man- and agement and management decision- e. the validity and appropriateness of making; assumptions used in constructing c. be consistent with institution practices; liquidity-risk measures. d. identify the process for setting and reas- 7. Review liquidity-risk management policies, sessing limits, and communicate the procedures, and reports. Discuss with man- rationale for the limit structure; agement the frequency and comprehensive- e. specify quantitative limits and guidelines ness of liquidity-risk reporting for the vari- that define the acceptable level of risk for ous levels of management that are responsible the institution, such as the use of maxi- for monitoring and managing liquidity risk. mum and targeted amounts of cash-flow These considerations should include the mismatches, liquidity reserves, volatile following: liabilities, and funding concentrations; a. management’s need to receive reports f. specify the frequency and methods used that— to measure, monitor, and control liquid- • determine compliance with limits and ity risk; and controls; g. define the specific procedures and • evaluate the results of past strategies; approvals necessary for exceptions to • assess the potential risks and returns of policies, limits, and authorizations. proposed strategies; 4. Review and discuss with management the • identify the major changes in a bank’s bank’s budget projections for the appropri- liquidity-risk profile; and ate planning period. Ascertain if manage- • consolidate holding company and bank ment has adequately— subsidiary information. a. planned the future direction of the bank, b. the need for the reporting system to be noting the projected growth, the source flexible enough to— of funding for the growth, and any pro- • quickly collect and edit data, summa- jected changes in its asset or liability rize results, and adapt to changing mix; circumstances or issues without com- b. developed future plans for meeting promising data integrity; and ongoing liquidity needs; and • increase the frequency of report c. assessed the reasonableness of its plans preparation as business conditions to achieve (1) the amounts and types of deteriorate. funding projected and (2) the amounts c. the need for reports to properly focus on and types of asset growth projected. monitoring liquidity and supporting

Commercial Bank Examination Manual October 2010 Page 3 3200.3 Liquidity Risk: Examination Procedures

decisionmaking. These reports often help h. identification and use of contingent bank management to monitor— liquidity-risk triggers to monitor, on an • sources and uses of cash flows (i.e., ongoing basis, the potential for contin- cash flows from operating, investing, gent liquidity events; and and financing activities), facilitating i. testing of the operational elements of the the evaluation of trends and structural CFP. balance-sheet changes; 9. Determine whether the board and senior • CFPs; management have established clear lines of • projected cash-flow or maturity gaps, authority and responsibility for monitoring identifying potential future liquidity adherence to policies, procedures, and lim- needs (reports should show projections its. Review policies, procedures, and reports using both contractual principal and to ascertain whether the institution’s— interest runoffs and maturities (origi- a. measurement system adequately cap- nal maturity dates) and behavioral prin- tures and quantifies risk; cipal and interest runoffs and maturi- b. limits are comprehensive, appropriately ties (maturities attributable to the defined, and communicated to manage- expected behaviors of customers)); ment in a timely manner; and • consolidated large funds providers, c. risk reports are regularly and formally identifying customer concentrations discussed by management and whether (reports should identify and aggregate meeting minutes are adequately major liability instruments used by documented. large customers across all banks in the 10. Determine whether internal controls and holding company); and information systems are adequately tested • the cost of funds from all significant and reviewed by ascertaining if the funding sources, enabling manage- institution’s— ment to quickly compare costs. a. risk-measurement tools are accurate, 8. Review the liquidity CFP and the minutes independent, and reliable; of ALCO meetings and board meetings. b. testing of controls is adequate and fre- Discuss with management the adequacy of quent enough, given the level of risk and the institution’s— sophistication of risk-management deci- a. customization of its CFP to fit its sions; and liquidity-risk profile; c. reports provide relevant information, b. identification of potential stress events including comments on major changes in and the various levels of stress that can risk profiles. occur under those events; 11. Determine whether the liquidity-management c. quantitative assessment of its short-term function is audited internally or is evaluated and intermediate-term funding needs dur- by the risk-management function. Deter- ing stress events, particularly the reason- mine whether the audit and/or evaluation is ableness of the assumptions the institu- independent and of sufficient scope. tion used to forecast its potential liquidity 12. Determine whether audit findings and man- needs; agement responses to those findings are d. comprehensiveness in forecasting cash fully documented and tracked for adequate flows under stress conditions (forecasts follow-up. should incorporate OBS and payment 13. Determine whether line management is held systems and the operational implications accountable for unsatisfactory or ineffective of cash-flow forecasts); follow-up. e. identification of potential sources of 14. Determine whether risk managers give iden- liquidity under stress events; tified material weaknesses appropriate and f. operating policies and procedures, includ- timely attention. ing the delineation of responsibilities, 15. Assess whether actions taken by manage- to be implemented in stress events, ment to deal with material weaknesses have for communicating with various been verified and reviewed for objectivity stakeholders; and adequacy by senior management or the g. prioritization of actions for responding to board. stress situations; 16. Determine whether the board and senior

October 2010 Commercial Bank Examination Manual Page 4 Liquidity Risk: Examination Procedures 3200.3

management have established adequate pro- 19. Assess the institution’s compliance with cedures for ensuring compliance with appli- regulations A, D, F, and W; statutory cable laws and regulations. restrictions on the use of brokered deposits; 17. Assess the institution’s compliance with and legal restrictions on dividends. Assess applicable laws and regulations as they whether CFPs comply with these regula- pertain to deposit accounts. tions and restrictions. 18. Assess the institution’s compliance with 20. On the basis of the above procedures, deter- laws and regulations, as well as potential mine whether the quality of the institution’s risk exposures arising from interbank credit liquidity-risk management is unsatisfactory, exposure. marginal, fair, satisfactory, or strong.

Commercial Bank Examination Manual October 2010 Page 5 Liquidity Risk Internal Control Questionnaire Effective date October 2010 Section 3200.4

Review the bank’s internal controls, policies, liquidity management appropriate for the practices, and procedures for managing funding institution? liquidity risk. The bank’s system should be g. Are senior management’s centralized and documented completely and concisely and decentralized liquidity-management re- should include, when appropriate, narrative sponsibilities clearly delineated? descriptions, flow charts, copies of forms used, 3. Are the institution’s policies, procedures, and and other pertinent information. limits for liquidity risk appropriate and suf- ficiently comprehensive to adequately con- 1. Has the board of directors, consistent with its trol the range of liquidity risk for the level of duties and responsibilities, reviewed and rati- the institution’s activity? fied funds-management policies, practices, a. Do the policies and procedures identify and procedures that include— the objectives and strategies of the insti- a. clear lines of authority, responsibility, and tution’s liquidity management, and do accountability for liquidity-risk manage- they include the institution’s expected and ment decisions? preferred reliance on various sources of b. an articulated general liquidity strategy funds to meet liquidity needs under alter- and approach to liquidity-risk manage- native scenarios? ment? b. Are policies and procedures consistent c. the review and approval of policies, includ- with institution practices? ing liquidity contingency funding plans? c. Are the limits comprehensive and appro- d. the specific procedures and approvals nec- priately defined for the institution’s level essary for exceptions to policies, limits, of activity? Are limit exceptions commu- and authorizations? nicated to management in a timely manner? e. established procedures for ensuring com- d. Is there a formal process for setting, pliance with applicable laws and reassessing, and communicating the ratio- regulations? nale for the limit structure? 2. Does senior management provide adequate e. Do quantitative limits and guidelines oversight to manage the institution’s liquid- define the acceptable level of risk for the ity risk? institution (i.e., maximum and targeted a. Has senior management established clear amounts of cash-flow mismatches, liquid- lines of authority and responsibility for ity reserves, volatile liabilities, funding monitoring adherence to policies, proce- concentrations, etc.)? dures, and limits? f. Are the frequency and methods used to b. Are clear lines of responsibility and measure, monitor, and control liquidity accountability delineated over liquidity- risk specified? risk management and management deci- 4. Are liquidity-risk measurement methodolo- sionmaking? gies, models, assumptions, and reports, as c. Is there a designated asset/liability com- well as other liquidity-risk management docu- mittee (ALCO) or other management mentation, sufficiently adequate, comprehen- decisionmaking body in which liquidity sive, and appropriate? risk is appropriately discussed? Does the a. Is liquidity-risk management involved in institution have a separate liquidity-risk the financial institution’s new-product management function? discussions? d. Is the frequency of ALCO meetings appro- b. Has the institution developed future growth priate, and are the reports presented at plans and ongoing funding needs, and the meetings adequate? sources of funding to meet those needs? e. Does management regularly and formally c. Has the institution developed alternative discuss risk reports, and are meeting min- sources of funds to be used if its future utes and decisions adequately documented? plans are not met? f. Is the technical and managerial expertise d. Does management adequately utilize com- of management and personnel involved in prehensive cash-flow projections and

Commercial Bank Examination Manual October 2010 Page 1 3200.4 Liquidity Risk: Internal Control Questionnaire

supporting analysis in order to manage the mented and tracked for adequate institution’s liquidity? follow-up? e. Does the institution utilize appropriate c. Do the internal controls and internal audit summary measures and ratios that ad- reviews ensure compliance with internal equately reflect its liquidity-risk profile? liquidity-management policies and f. Do the above reports provide relevant procedures? information, including comments on major d. Is line management held accountable for changes in risk profiles? unsatisfactory or ineffective follow-up? g. Does the planning and budgeting function e. Do risk managers give identified material consider liquidity requirements? weaknesses appropriate and timely atten- h. Are internal management reports concern- tion? Are their actions verified and ing liquidity needs and sources of funds to reviewed for objectivity and adequacy by meet those needs prepared regularly and senior management or the board? reviewed, as appropriate, by senior man- agement and the board of directors? 6. Are internal controls and information sys- 5. Does an independent party regularly review tems adequately tested and reviewed? and evaluate the components of the liquidity- a. Are risk-measurement tools accurate, inde- risk management function? pendent, and reliable? a. Is the liquidity-risk management function b. Is the frequency for the testing of controls audited internally, or is it evaluated by the adequate, given the level of risk and risk-management function? Are the audit sophistication of risk-management deci- and/or evaluation of the liquidity-risk man- sions? agement process and controls independent 7. On the basis of a composite evaluation, as and of sufficient scope? evidenced by answers to the foregoing ques- b. Are audit findings and management tions, are the internal controls and internal responses to those findings fully docu- audit procedures considered adequate?

October 2010 Commercial Bank Examination Manual Page 2 Short-Term Liquidity Management (Federal Reserve’s Primary Credit Program) Effective date October 2009 Section 3210.1

LIQUIDITY-RISK MANAGEMENT significant processing or lead time for pledg- USING THE FEDERAL ing to the Reserve Bank. RESERVE’S PRIMARY CREDIT It is a long-established sound practice for PROGRAM institutions to periodically test all sources of contingency funding. Accordingly, if an institu- The Federal Reserve’s primary credit program tion incorporates primary credit in its contin- (discount window) offers depository institu- gency plans, management should occasionally tions an additional source of available funds (at test the institution’s ability to borrow at the a rate above the target federal funds rate) for discount window. The goal of such testing is to managing short-term liquidity risks.1 Manage- ensure that there are no unexpected impedi- ment should fully assess the potential role that ments or complications in the case that such the Federal Reserve’s primary credit program contingency lines need to be used. might play in managing their institution’s Institutions should ensure that any planned liquidity. The primary credit program can be a use of primary credit is consistent with the viable source of very short-term backup funds. stated purposes and objectives of the program. Management may find it appropriate to Under the primary credit program, the Federal incorporate the availability of the primary credit Reserve generally expects to extend funds on a program into their institution’s diversified very short-term basis, usually overnight. There- liquidity-management policies, procedures, and fore, as with any other type of short-term contingency plans. The primary credit program contingency funding, institutions should ensure has the following attributes that make the that any use of primary credit facilities for discount window a viable source of backup or short-term liquidity contingencies is accompa- contingency funding for short-term purposes: nied by viable take-out or exit strategies to replace this funding expeditiously with other • Primary credit provides a simpler, less- sources of funding. Institutions should factor burdensome administrative process and a more into their contingency plans an analysis of their accessible source of backup, short-term eligibility for primary credit under various sce- funding. narios, recognizing that if their financial condi- • Primary credit can enhance diversification in tion were to deteriorate, primary credit may not short-term funding contingency plans. be available. Under those scenarios, secondary • Borrowings can be secured with an array of credit may be available. collateral, including consumer and commer- Another critical element of liquidity manage- cial loans. ment is an appropriate assessment of the costs • Requests for primary credit advances can be and benefits of various sources of potential made anytime during the day.2 liquidity. This assessment is particularly impor- • There are no restrictions on the use of short- tant in managing short-term and day-to-day term primary credit. sources and uses of funds. Given the above- market rates charged on primary credit, institu- If an institution incorporates primary credit tions should ensure that they adequately assess into its contingency plans, the institution should the higher costs of this form of credit relative to ensure that it has in place with the appropriate other available sources. Extended use of any Reserve Bank the necessary collateral arrange- type of relatively expensive source of funds can ments and documentation. This is particularly give rise to significant earnings implications important when the intended collateral consists which, in turn, may lead to supervisory concerns. of loans or other assets that may involve It is also important to note that the Federal Reserve’s primary credit facility is only one of many tools institutions may use in managing 1. See section 3010.1 for further discussion of the Federal their liquidity-risk profiles. An institution’s man- Reserve’s credit programs that are available to qualifying agement should ensure that the institution main- institutions. 2. Advances generally are booked at the end of the busi- tains adequate access to a diversified array of ness day. readily available and confirmed funding sources,

Commercial Bank Examination Manual October 2009 Page 1 3210.1 Short-Term Liquidity Management (Federal Reserve’s Primary Credit Program) including liquid assets such as high-grade invest- examiners should be cognizant of the implica- ment securities and a diversified mix of whole- tions that too-frequent use of this source of sale and retail borrowings. (See SR-03-15.) relatively expensive funds may have for the earnings, financial condition, and overall safety and soundness of the institution. Overreliance Supervisory and Examiner on primary credit borrowings, or any one source Considerations of short-term contingency funds, regardless of the relative costs, may be symptomatic of deeper Because primary credit can serve as a viable operational or financial difficulties. Importantly, source of backup, short-term funds, supervisors the use of primary credit, as with the use of any and examiners should view the occasional use of potential sources of contingency funding, is a primary credit as appropriate and unexceptional. management decision that must be made in the At the same time, however, supervisors and context of safe and sound banking practices.

October 2009 Commercial Bank Examination Manual Page 2 Borrowed Funds Effective date October 2008 Section 3220.1

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

Commercial Bank Examination Manual October 2008 Page 1 3220.1 Borrowed Funds

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

October 2008 Commercial Bank Examination Manual Page 2 Borrowed Funds 3220.1 since those types of repos are exempt from brokers with whom they engage in repurchase reserve requirements. transactions. Although standard overnight and term repo ‘‘Retail repurchase agreements’’ (retail repos)2 arrangements in Treasury and federally related for a time were a popular vehicle for some agency securities are most prevalent, market commercial banks to raise short-term funds and participants sometimes alter various contract compete with certain instruments offered by provisions to accommodate specific investment nonbanking competitors. For booking purposes, needs or to provide flexibility in the designation a retail repo is a debt incurred by the issuing of collateral. For example, some repo contracts bank that is collateralized by an interest in a allow substitutions of the securities subject to security that is either a direct obligation of or the repurchase commitment. These are called guaranteed as to principal and interest by the ‘‘dollar repurchase agreements’’ (dollar rolls), U.S. government or an agency thereof. Retail and the initial seller’s obligation is to repurchase repos are issued in amounts not exceeding securities that are substantially similar, but not $100,000 for periods of less than 90 days. With identical, to the securities originally sold. the advent of money market certificates issued Another common repo arrangement is called a by commercial banks, the popularity of the retail ‘‘flex repo,’’ which, as implied by the name, repo declined. provides a flexible term to maturity. A flex repo Both retail and large-denomination, whole- is a term agreement between a dealer and a sale repurchase agreements are in many respects major customer in which the customer buys equivalent to short-term borrowings at market securities from the dealer and may sell some of rates of interest. Therefore, banks engaging in them back before the final maturity date. repurchase agreements should carefully evaluate Bank management should be aware of certain their interest-rate-risk exposure at various matu- considerations and potential risks of repurchase rity levels, formulate policy objectives in light agreements, especially when entering into large- of the institution’s entire asset and liability mix, dollar-volume transactions with institutional and adopt procedures to control mismatches investors or brokers. Both parties in a term repo between assets and liabilities. The degree to arrangement are exposed to interest-rate risk. It which a bank borrows through repurchase agree- is a fairly common practice to have the collateral ments also should be analyzed with respect to its value of the underlying securities adjusted daily liquidity needs, and contingency plans should to reflect changes in market prices and to main- provide for alternative sources of funds. tain the agreed-on margin. Accordingly, if the market value of the repo securities declines appreciably, the borrower may be asked to Negotiable Certificates of Deposit provide additional collateral. Conversely, if the market value of the securities rises substantially, Certificates of deposit (CDs) have not been the lender may be required to return the excess legally defined as borrowings and continue to be collateral to the borrower. If the value of the reflected as deposits for reporting purposes. underlying securities exceeds the price at which However, the fundamental distinction between a the repurchase agreement was sold, the bank negotiable money market CD as a deposit or as could be exposed to the risk of loss if the buyer a borrowing is nebulous at best; in fact, the is unable to perform and return the securities. negotiable money market CD is widely recog- This risk would obviously increase if the secu- nized as the primary borrowing vehicle for rities are physically transferred to the institution many banks. Dependence on CDs as sources of or broker with which the bank has entered into funds is discussed in ‘‘Deposit Accounts,’’ sec- the repurchase agreement. Moreover, if the tion 3000.1. securities are not returned, the bank could be exposed to the possibility of a significant write- off, to the extent that the book value of the securities exceeds the price at which the securi- Borrowings from the Federal Reserve ties were originally sold under the repurchase agreement. For this reason, banks should avoid In accordance with the Board’s Regulation A pledging excessive collateral and obtain suffi- (12 CFR 201), the Federal Reserve Banks gen- cient financial information on and analyze the financial condition of those institutions and 2. See sections 2015.1, 2020.1, and 4170.1.

Commercial Bank Examination Manual October 2008 Page 3 3220.1 Borrowed Funds erally make credit available through the pri- judge to be in generally sound financial condi- mary, secondary, and seasonal credit programs tion. Reserve Banks extend primary credit at a to any depository institution that maintains trans- rate above the target federal funds rate of the action accounts or nonpersonal time deposits.3 Federal Open Market Committee. Minimal However, the Federal Reserve expects deposi- administrative requirements apply to requests tory institutions to rely on market sources of for overnight primary credit, unless some aspect funds for their ongoing funding needs and to use of the credit request appears inconsistent with these credit programs as a backup source of the conditions of primary credit (for example, if funding rather than a routine one. An institution a pattern of behavior indicates strongly that an that borrows primary credit may use those funds institution is using primary credit other than as a to finance sales of federal funds, but secondary backup source of funding). Reserve Banks also and seasonal credit borrowers may not act as the may extend primary credit to eligible institu- medium or agent of another depository institu- tions for periods of up to several weeks if such tion in receiving Federal Reserve credit except funding is not available from other sources. with the permission of the lending Federal However, longer-term extensions of primary Reserve Bank. credit will be subject to greater administration A Federal Reserve Bank is not obligated to than are overnight loans. extend credit to any depository institution but Reserve Banks determine eligibility for pri- may lend to a depository institution either by mary credit according to a uniform set of criteria making an advance secured by acceptable col- that also is used to determine eligibility for lateral or by discounting certain types of paper daylight credit under the Board’s Policy State- described in the Federal Reserve Act. Although ment on Payments System Risk. These criteria Reserve Banks now always extend credit in the are based mainly on examination ratings and form of an advance, the Federal Reserve’s credit capitalization, although Reserve Banks also may facility nonetheless is known colloquially as the use supplementary information, including market- ‘‘discount window.’’ Before lending to a deposi- based information when available. Specifically, tory institution, a Reserve Bank can require any an institution that is at least adequately capital- information it believes is appropriate to ensure ized and rated CAMELS 1 or 2 (or SOSA 1 and that the assets tendered as collateral are accept- ROCA 1, 2, or 3) almost certainly would be able. A Reserve Bank also should determine eligible for primary credit. An institution that is prior to lending whether the borrowing institu- at least adequately capitalized and rated CAMELS tion is undercapitalized or critically undercapi- 3 (or SOSA 2 and ROCA 1, 2, or 3) generally talized. Operating Circular No. 10, ‘‘Lending,’’ would be eligible. An institution that is at least establishes the credit and security terms for adequately capitalized and rated CAMELS 4 (or borrowings from the Federal Reserve. SOSA 1 or 2 and ROCA 4 or 5) would be eligible only if an ongoing examination indi- cated a substantial improvement in condition. Primary Credit An institution that is not at least adequately capitalized, or that is rated CAMELS 5 (or Reserve Banks may extend primary credit on a SOSA 3 regardless of the ROCA rating), would very short term basis (typically overnight) to not be eligible for primary credit. depository institutions that the Reserve Banks

Secondary Credit 3. In unusual and exigent circumstances and after consul- tation with the Board, a Reserve Bank may extend credit to individuals, partnerships, and corporations that are not deposi- Secondary credit is available to institutions that tory institutions if, in the judgment of the Reserve Bank, credit do not qualify for primary credit. Secondary is not available from other sources and failure to obtain credit credit is available as a backup source of liquidity would adversely affect the economy. A Reserve Bank may on a very short term basis, provided that the loan extend credit to a nondepository entity in the form of an advance only if the advance is secured by a direct obligation is consistent with a timely return to a reliance on of the United States or a direct obligation of, or an obligation market sources of funds. Longer-term secondary that is fully guaranteed as to principal and interest by, any credit is available if necessary for the orderly agency of the United States. An extension of credit secured by resolution of a troubled institution, although any any other type of collateral must be in the form of a discount and must be authorized by an affirmative vote of at least five such loan would have to comply with additional members of the Board. requirements for lending to undercapitalized and

October 2008 Commercial Bank Examination Manual Page 4 Borrowed Funds 3220.1 critically undercapitalized institutions. Unlike properly assigned and endorsed. the primary credit program, secondary credit is not a minimal administration facility because Reserve Banks must obtain sufficient informa- Lending to Undercapitalized and tion about a borrower’s financial situation to Critically Undercapitalized Depository ensure that an extension of credit complies with Institutions the conditions of the program. Secondary credit is available at a rate above the primary credit Credit from any Reserve Bank to an institution rate. that is ‘‘undercapitalized’’ may be extended or outstanding for no more than 60 days during which the institution is undercapitalized in any Seasonal Credit 120-day period.4 An institution is considered undercapitalized if it is not critically undercapi- Seasonal credit is available under limited con- talized under section 38 of the Federal Deposit ditions to meet the needs of depository institu- Insurance Act (the FDI Act) but is either deemed tions that have seasonal patterns of movement in undercapitalized under that provision and its deposits and loans but that lack ready access to implementing regulations or has received a com- national money markets. In determining a deposi- posite CAMELS rating of 5 as of the most tory institution’s eligibility for seasonal credit, recent examination. A Reserve Bank may make Reserve Banks consider not only the institu- or have outstanding advances or discounts to an tion’s historical record of seasonal fluctuations institution that is deemed ‘‘critically undercapi- in loans and deposits, but also the institution’s talized’’ under section 38 of the FDI Act and its recent and prospective needs for funds and its implementing regulations only during the five- liquidity conditions. Generally, only very small day period beginning on the date the institution institutions with pronounced seasonal funding became critically undercapitalized or after con- needs will qualify for seasonal credit. Seasonal sultation with the Board. credit is available at a flexible rate that takes into account the rate for market sources of funds. INTERNATIONAL BORROWINGS

Collateral Requirements International borrowings may be direct or indi- rect. Common forms of direct international bor- All loans advanced by the Reserve Bank must rowings include loans and short-term call money be secured to the satisfaction of the Reserve from foreign banks, borrowings from the Export- Bank. Collateral requirements are governed by Import Bank of the United States, and over- Operating Circular No. 8. Reserve Banks require drawn nostro (due from foreign banks—demand) a perfected security interest in all collateral accounts. Indirect forms of borrowing include pledged to secure loans. Satisfactory collateral notes and trade bills rediscounted with the generally includes U.S. government and federal- central banks of various countries; notes, accep- agency securities, and, if they are of acceptable tances, import drafts, or trade bills sold with the quality, mortgage notes covering one- to four- bank’s endorsement or guarantee; notes and family residences; state and local government other obligations sold subject to repurchase securities; and business, consumer, and other agreements; and acceptance pool participations. customer notes. Traditionally, collateral is held in the Reserve Bank vault. Under certain cir- cumstances, collateral may be retained on the borrower’s premises under a borrower-in- ANALYZING BORROWINGS custody arrangement, or it may be held on the borrower’s premises under the Reserve Bank’s If a bank borrows extensively or in large exclusive custody and control in a field ware- amounts, the examiner should thoroughly ana- house arrangement. Collateral may also be held lyze the borrowing activity. An effective analy- at the borrowing institution’s correspondent or another third party. All book-entry collateral 4. Generally, a Reserve Bank also may lend to an under- capitalized institution during 60 calendar days after receipt of must be held at the Federal Reserve Bank. a certificate of viability from the Chairman of the Board of Definitive collateral, not in bearer form, must be Governors or after consultation with the Board.

Commercial Bank Examination Manual October 2008 Page 5 3220.1 Borrowed Funds sis includes a review of the bank’s reserve through the money and capital markets. Bro- records, both required and maintained, to deter- kered deposits generally carry higher interest mine the frequency of deficiencies at the closing rates than alternative sources, and they tend to of reserve periods. The principal sources of be particularly susceptible to interest-rate changes borrowings, range of amounts, frequency, length in the overall financial market. For further of time indebted, cost, and reasons for the discussion of brokered deposits, see ‘‘Deposit borrowings should be explored. The actual use Accounts,’’ section 3000.1. of the funds should be verified. Other indicators of deterioration in a bank’s Examiners should also analyze changes in a borrowing ability and overall creditworthiness bank’s borrowing position for signs of deterio- include, but are not limited to, requests for ration in its borrowing ability and overall cred- collateral on previously unsecured credit lines or itworthiness. One indication of deterioration is increases in collateral margins, the payment of the payment of large fees to money brokers to above-market interest rates, or a shortening of obtain funds because the bank is having diffi- maturities that is inconsistent with manage- culty obtaining access to conventional sources ment’s articulated balance-sheet strategies. If of borrowings. These ‘‘brokered deposits’’ are the examiner finds that a bank’s borrowing usually associated with small banks since they position is not properly managed, appropriate do not generally have ready access to alternative comments should be included in the report of sources of funds available to larger institutions examination.

October 2008 Commercial Bank Examination Manual Page 6 Borrowed Funds Examination Objectives Effective date May 1996 Section 3220.2

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

Commercial Bank Examination Manual May 1996 Page 1 Borrowed Funds Examination Procedures Effective date October 2008 Section 3220.3

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

Commercial Bank Examination Manual October 2008 Page 1 3220.3 Borrowed Funds: Examination Procedures

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

October 2008 Commercial Bank Examination Manual Page 2 Borrowed Funds Internal Control Questionnaire Effective date March 1984 Section 3220.4

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

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

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

Commercial Bank Examination Manual March 1994 Page 1 Interest Rate Risk Management Effective date November 2020 Section 3300.1

INTRODUCTION TYPES AND SOURCES OF MARKET RISK Market risk reflects the degree to which changes in interest rates, foreign exchange rates, com- Market risk can arise from a variety of sources, modity prices, or equity prices can adversely including affect a financial institution’s earnings or capi- tal. For most community banks, market risk • the overall structure of an institution’s balance primarily reflects exposure to interest rate risk sheet, especially its loans, investments, and (IRR). While this risk is a normal part of funding structure; banking and can be an important source of • its use of off-balance-sheet instruments (such profitability and shareholder value, excessive as derivatives) for speculation; and levels of IRR can pose a significant threat to an • its trading activities, if any. institution’s earnings and capital base. Accord- ingly, effective risk management that maintains While IRR is the most common form of IRR at prudent levels is essential to the safety market risk, market risk also arises from expo- and soundness of institutions. sure to foreign exchange rates, commodity prices, The Interagency Guidelines Establishing Stan- and equity prices. dards for Safety and Soundness (12 CFR 208, appendix D-1) require an institution to manage Foreign exchange risk surfaces when an insti- IRR in a manner that is appropriate to the size of tution, typically a larger or internationally active the institution and the complexity of its assets institution, performs foreign currency transac- and liabilities; and provide for periodic report- tions on behalf of its customers, through either ing to management and the board of directors wire transfer activity or forward currency con- regarding interest rate risk with adequate infor- tracts. Institutions also may be exposed to cur- mation for management and the board of direc- rency fluctuations if they have a significant tors to assess the level of risk. As a result, an amount of investments denominated in foreign important element of examinations and the super- currencies. Institutions can be adversely affected visory process is the evaluation of an institu- when currencies in which they hold assets tion’s exposure to changes in interest rates. weaken or when currencies in which they have Examiners evaluate both the adequacy of the obligations strengthen. Foreign exchange risk management process used to control IRR and also arises indirectly when changes in exchange the quantitative level of exposure. In addition, rates affect the competitive position of an insti- examiners should assess the existing and poten- tution that operates in different countries. tial future effects of changes in interest rates on Commodity price risk is similar to equity risk an institution’s financial condition, including the and encompasses the changes in an institution’s effect on the institution’s capital adequacy, earn- earnings and asset values resulting from fluctua- ings, liquidity, and asset quality. tions in commodity prices. Some institutions are This section incorporates and builds upon the active in the commodity derivative market, offer- principles and guidance provided in four Super- ing derivative contracts linked to commodity vision & Regulation (SR) letters: prices. In addition, an institution’s borrowers can be affected significantly by changes in • SR-93-69, “Examining Risk Management and commodity prices, such as the effect of fluctu- Internal Controls for Trading Activities of ating oil prices on airlines or in the realm of Banking Organizations”; agricultural lending. • SR-96-13, “Joint Policy Statement on Interest Equity price risk is the variation in profit or Rate Risk”;1 net worth caused by the changes in the prices of • SR-10-1, “Interagency Advisory on Interest individual shares or the level of stock markets as Rate Risk”; and a whole. Equity risk has both direct and indirect • SR-12-2, “Questions and Answers on Inter- results. Fluctuations in stock prices will directly agency Advisory on Interest Rate Risk Man- affect the value of shares, portfolios, and equity agement.” derivatives held by an institution. There also may be an indirect effect when declining equity 1. See also 61 Fed. Reg. 33,166 (June 26, 1996). prices affect the viability of a company to which

Commercial Bank Examination Manual November 2020 Page 1 3300.1 Interest Rate Risk Management the bank has loaned money. Banks generally do with the period of time for which the hedge is not hold equity investments. arranged, for example, when a three-month interest risk in a revolving Eurodollar loan is hedged with a six-month futures contract in Eurodollars. A change in the shape of the yield TYPES OF INTEREST RATE RISK curve can bring about nonparallel movements in interest rates for the two different maturities. As previously discussed, IRR is the most com- Options risk is the risk arising from the mon form of market risk for banking institu- options in assets, liabilities, and OBS instru- tions. IRR can arise from a variety of sources, ments. An option provides the holder with the including repricing risk, yield curve risk, basis right, but not the obligation, to buy, sell, or, in risk, options risk, and price risk. Various assets some manner, alter the cash flow of an instru- and liabilities may be exposed to more than one ment or financial contract. Options may be type of IRR. distinct instruments, such as exchange-traded Repricing risk is the primary and most dis- and over-the-counter contracts, or they may be cussed source of IRR and is the risk that the embedded within the contractual terms of other institution’s assets, liabilities, and off-balance- instruments. Instruments with embedded options sheet (OBS) instruments will reprice at different include bonds and notes with call or put provi- times or amounts. Repricing mismatches are sions (e.g., callable U.S. agency notes), loans fundamental to the business of banking and that give borrowers the right to prepay balances generally occur from either short term liabilities without penalty (e.g., residential mortgage loans), funding longer-term assets or long term liabili- and various types of non-maturity deposit instru- ties funding shorter-term assets. Institutions ments that give depositors the right to withdraw whose liabilities reprice faster than their assets funds at any time without penalty (e.g., demand reprice are considered to be liability sensitive. deposits). The earnings of a liability sensitive institution Price risk is the risk that the fair value of generally increase when interest rates fall and financial instruments will change when interest decrease when rates rise. Conversely, an asset rates change. For example, trading portfolios, sensitive institution’s assets reprice more quickly held-for-sale loan portfolios, and mortgage ser- than their liabilities. These institutions’ earnings vicing assets contain price risk. generally benefit from a rising rate environment and are harmed by a falling rate environment. Yield curve risk is the relationship between changing rates for the same instrument across a spectrum of maturities. It arises when assets and EFFECTS OF INTEREST funding sources are linked to similar indexes RATE RISK with different maturities and the shape or slope of the yield curve changes by flattening, steep- IRR can expose an institution’s earnings and ening, or inverting. For example, a 30-year capital to adverse changes in market interest Treasury bond’s yield may change by 200 basis rates. points; however, the three-year Treasury note’s In assessing the effects of changing rates on yield only changed by 50 basis points during the earnings, institutions’ measurement systems may same time period. focus on either net interest income or net income. Basis risk arises from a change in the rela- In general, institutions focus primarily on net tionship or spread between different market interest income—the difference between total indexes. It occurs when the market indexes used interest income and total interest expense. How- to price assets and liabilities change by different ever, interest rates can affect other income amounts or at different times. For example, components, especially fee-based income. In assume an operator uses a Treasury bill (T-bill) particular, non-interest income generated by loan to hedge an interest rate risk in Eurodollars. The servicing and various asset-securitization pro- interest rates for T-bills and Eurodollars do not grams can be highly sensitive to changes in always move exactly parallel to each other. The market interest rates. Institutions with signifi- risk of this lack of parallel movement is basis cant non-interest income that is sensitive to risk. The second occurs when the period of time changing rates should have measurement sys- for which a financial risk exists is not identical tems in place that focus on net income.

November 2020 Commercial Bank Examination Manual Page 2 Interest Rate Risk Management 3300.1

Market interest rates also affect the value of • appropriate risk-measurement, monitoring, and an institution’s assets, liabilities, and OBS instru- reporting systems; and ments and, thus, effect the value of an institu- • effective internal controls that include an inde- tion’s equity capital. The economic value of an pendent review and/or audit of key elements instrument is an assessment of the present value of the risk-management process. of its expected net future cash flows, discounted to reflect market rates.2 Interest rate changes can The formality and sophistication used in man- have a material effect on the economic value of aging IRR often varies by size and sophistica- an instrument. For example, the economic value tion of the institution, the nature and complexity of a bond with a fixed coupon rate generally of its holdings and activities, and the overall falls in a rising rate environment. By evaluating level of its IRR. Less complex practices may be changes in the institution’s economic value for a adequate for well-managed institutions with non- given change in interest rates, institution man- complex activities and holdings that present a agement can identify risk arising from long-term low IRR profile. repricing or maturity gaps as the interest rate More complex institutions and those with environment may affect the institution’s future higher IRR exposures or holdings of compli- earnings or capital values. cated instruments likely require sophisticated Historically, banks have managed their IRR and formal IRR management systems to address exposures adequately and few have failed solely their broader range of financial activities. In as a result of adverse interest rate movements. addition, formal IRR management systems gen- Changes in interest rates can have negative erally will provide an institution’s senior man- effects on profitability and need to be carefully agement with the needed information to monitor managed, especially given the rapid pace of and direct day-to-day activities. The more com- financial innovation and the heightened level of plex IRR management processes often employed competition among all types of financial insti- at these institutions may warrant a more thor- tutions. ough independent review and validation process of the IRR model utilized. Individuals involved in the risk-management ORGANIZATIONAL PROCESSES process should be sufficiently independent of AND CONTROLS FOR business lines to ensure adequate separation of MANAGEMENT OF INTEREST duties and avoid potential conflicts of interest. RATE RISK The degree of autonomy these individuals have may be a function of the size and complexity of the institution. In smaller institutions with lim- Risk-Management Framework ited resources, it may not be possible to com- pletely remove individuals with business-line As is the case in managing other types of risk, responsibilities from the risk-management pro- sound IRR management involves effective over- cess. In these situations, and assuming the insti- sight and a comprehensive risk-management tution engages in less complex activities, the process that includes the following elements: institution’s focus should be directed towards ensuring that risk-management functions are • effective policies and procedures designed to conducted appropriately. Larger, more complex control the nature and amount of IRR, includ- institutions should have separate and indepen- ing clearly defined IRR limits and lines of dent risk-management units. responsibility and authority;

2. For some instruments, the economic value of an instru- Board of Directors and Senior ment may be the same or differ from its fair value depending Management Oversight on the facts and circumstances. The fair value is an accounting term and is generally considered to be the price that would be received to sell an asset or paid to transfer a liability in an The board of directors and senior management orderly transaction between market participants at the mea- have unique yet complementary responsibilities surement date. For more information on fair value and the fair value measurement of derivatives, see ASC Topic 820, “Fair related to the oversight and management of the Value Measurement” as well as the Call Report instructions. institution’s IRR risk profile.

Commercial Bank Examination Manual November 2020 Page 3 3300.1 Interest Rate Risk Management

Board of Directors risk limits. Senior management should be respon- sible for overseeing institution personnel to The board of directors is ultimately responsible confirm that operating standards are being fol- for establishing the institution’s level of IRR. lowed. Further, senior management should assure The board of directors or a board committee that institution personnel who perform analysis should oversee the establishment, approval, and and risk-management activities related to IRR periodic review of IRR management strategies, have the technical knowledge, depth, and expe- policies, procedures, and limits (or risk toler- rience commensurate with the nature and scope ances). In addition, the board or a board com- of the institution’s activities. mittee should understand the implications of the Reports to senior management should provide IRR strategies that the institution pursues, includ- aggregate information as well as sufficient sup- ing their potential impact on market, liquidity, porting detail, so that management can assess credit, and operational risks. To be appropriately the sensitivity of the institution to changes in informed about the institution’s IRR exposure, market conditions and other important risk fac- the nature of risks in current and proposed new activities, and the adequacy of the institution’s tors. Effective IRR reports generally include risk-management process, the board or its com- measurement of IRR exposures relative to limits mittee should receive reports from senior man- and disclosure of key assumptions. Senior man- agement that contain sufficient detail to assist in agement should also periodically review the making informed policy decisions. The fre- institution’s IRR management policies and pro- quency of board reports depends on the com- cedures to assess the appropriateness of its risk plexity of the institution’s holdings and the management. Senior management should also materiality of changes in its holdings. discuss risk-measurement, reporting, and man- Unlike senior management, the members of agement procedures with risk-management staff. an institution’s board of directors do not neces- These discussions will assist senior management sarily need to have detailed technical knowledge in developing and providing IRR reports to the of complex financial instruments, legal issues, board of directors that contain sufficient detail to or sophisticated risk-management techniques. assist in making informed policy decisions for However, the institution’s board of directors the institution. should oversee and hold senior management accountable for appropriately measuring, moni- toring, and controlling IRR. Policies, Procedures, and Limits

Senior Management Institutions should have clear policies and pro- cedures for limiting and controlling IRR. In Senior management should be responsible for general, these policies and procedures should implementing • delineate lines of responsibility and account- • adequate systems and standards for measuring ability over IRR management decisions, risk, • clearly define authorized instruments and per- • standards for valuing positions and measuring missible hedging and position-taking strategies, performance, • identify the frequency and method for mea- • a comprehensive IRR reporting and monitor- suring and monitoring IRR, and ing process, and • specify quantitative limits that define the • effective internal controls and review pro- acceptable level of risk for the institution. cesses. In addition, management should define the Senior management should be responsible for specific procedures and approvals necessary for implementing board-approved strategies, poli- exceptions to policies, limits, and authoriza- cies, and procedures as well as managing IRR tions. All IRR risk policies should be reviewed within the designated lines of authority and by management and approved by the board of responsibility. Senior management should de- directors at least annually and revised as needed. velop and implement policies and procedures that align with the board’s goals, objectives, and

November 2020 Commercial Bank Examination Manual Page 4 Interest Rate Risk Management 3300.1

Clear Lines of Authority Authorized Activities

Whether through formal written policies or oper- Institutions should clearly identify the types of ating procedures, management should define the financial instruments that are permissible for structure of managerial responsibilities, over- managing IRR, either specifically or by their sight, and lines of authority in the following characteristics. As appropriate to its size and areas: complexity, the institution should delineate pro- cedures for acquiring specific instruments, man- • developing and implementing strategies and aging individual portfolios, and controlling the tactics used in managing IRR institution’s aggregate IRR exposure. Major • establishing and maintaining an IRR measure- hedging or risk-management initiatives should ment and monitoring system that is commen- be approved by the board or board committee surate with the institution’s size and complexity before being implemented. Before introducing new products, hedging, or • identifying potential IRR and related issues position-taking initiatives, management should arising from the use of new products also determine whether there are adequate opera- • developing IRR management policies, proce- tional procedures and risk-control systems in dures and limits, and authorizing exceptions place and whether procedures need to be revised. to policies and limits

Individuals and management committees re- Risk Limits sponsible for making decisions about IRR man- agement should be clearly identified. Most insti- The goal of IRR management is to maintain an tutions delegate IRR management responsibilities institution’s IRR exposure within self-imposed to a committee of senior managers, sometimes parameters over a range of possible changes in called an asset/liability committee (ALCO). At interest rates. A system of IRR limits and these institutions, policies identify the ALCO risk-taking guidelines assists an institution in membership, the committee’s duties and respon- achieving that goal. Such a system should set sibilities, the extent of its decisionmaking author- limits for the institution’s level of IRR and, ity, and the form and frequency of its reports to where appropriate, provide the capability to senior management and the board of directors. allocate these limits to individual portfolios or An ALCO should have sufficiently broad par- activities. Systems should also identify for man- ticipation across major banking functions (for agement when a limit is violated to allow for example, lending, investment, deposits, and prompt management attention. Further, in the funding) so that its decisions can be executed event of a limit violation, an institution’s pro- effectively throughout the institution. In many cesses should address specific escalation proce- large institutions, the ALCO delegates day-to- dures outlining designated responsible person- day responsibilities for IRR management to an nel and risk mitigation procedures. independent risk-management department or Risk limits should be appropriate to the size, function. complexity, and financial condition of the insti- Individuals involved in the IRR management tution. Depending on the nature of an institu- process (including separate risk-management tion’s holdings and general sophistication, limits units, if present) should be sufficiently indepen- can be identified for individual business units, dent from the business lines, including through portfolios, instrument types, or specific instru- the reporting structure, to provide for adequate ments.3 The level of detail of risk limits should separation of duties and avoid potential conflicts reflect the characteristics of the institution’s of interest. Also, personnel charged with mea- holdings, including the various sources of IRR suring and monitoring IRR should have a well- to which the institution is exposed. Limits founded understanding of the institution’s IRR applied to portfolio categories and individual profile. Compensation policies for these indi- instruments should be consistent with and viduals should be adequate enough to attract and complementary to consolidated limits. For exam- retain personnel who are well qualified to assess the risks of the institution’s activities, and are 3. This manual’s section on “Investment Securities and compatible with effective controls and risk man- End-User Activities” discusses issues in setting price volatil- agement. ity limits in the acquisition of securities and derivatives.

Commercial Bank Examination Manual November 2020 Page 5 3300.1 Interest Rate Risk Management ple, an institution should consider whether • have well-supported assumptions and param- eters. • IRR limits are consistent with the institution’s overall approach to measuring and managing In many cases, the interest rate characteristics IRR and address the potential impact of of an institution’s largest holdings will dominate changes in market interest rates on both its aggregate risk profile. While all of an insti- reported earnings and the institution’s eco- tution’s holdings should receive appropriate nomic value of equity (EVE); treatment, measurement systems should provide • limits are consistent with the risk tolerance of more detailed information on the major holdings the board of directors; and instruments whose values are especially • IRR tolerances address the potential impact of sensitive to rate changes. The IRR measurement changing interest rates on capital and earnings system should have sufficient functionality and from a short-term and a long-term perspec- sophistication to properly identify and value tive; instruments with significant embedded or explicit • limits on the IRR exposure of earnings, which option characteristics. primarily address short term exposure, are An accurate, informative, and timely manage- broadly consistent with those used to control ment information system is essential for manag- the exposure of an institution’s economic ing IRR exposure, and ensuring risks and activi- value, which reflects long term exposure; ties align with the institution’s policies and risk • IRR limits and risk tolerances consider spe- tolerance. Reporting of risk measures should be cific scenarios of market interest rate move- regular and clearly compare current exposure ments, such as an increase or decrease of a with the institution’s internal risk limits. In particular magnitude; and general, senior management should receive quar- • the rate movements used in developing these terly reports on the institution’s IRR profile. The limits represent meaningful stress situations, reports should utilize current and accurate data. taking into account historic rate volatility and More frequent reporting may be appropriate the time required for management to address depending on the institution’s exposure to IRR exposures. and the potential for significant changes to the institution’s capital and earnings. In addition, past forecasts or risk estimates should be com- pared with actual results as one tool to identify Interest Rate Risk Monitoring and any potential shortcomings in modeling tech- Reporting niques.4 The types of reports prepared for the board An effective process of measuring, monitoring, and for various levels of management will vary and reporting exposures is essential for ad- based on the institution’s IRR profile. Effective equately managing IRR. The sophistication and IRR reports enable senior management to complexity of this process should be appropriate to the size, complexity, nature, and mix of an • evaluate the level of and trends in the institu- institution’s business lines and its IRR charac- tion’s aggregate IRR exposure; teristics. • demonstrate and verify compliance with the Effective IRR measurement systems monitor institution’s policies and limits; the effect of rate changes on both earnings and • evaluate the sensitivity and reasonableness of economic value. The latter is particularly impor- key assumptions; tant for institutions with significant holdings of • assess the results and future implications of intermediate and long-term instruments or instru- major hedging or position-taking initiatives ments with embedded options because their that have been taken or are being actively market values can be particularly sensitive to considered; changes in market interest rates. • understand the implications of various stress IRR measurement systems should scenarios, including those involving break- downs of key assumptions and parameters; • assess material IRR associated with an insti- • review IRR policies, procedures, and the tution’s assets, liabilities, and OBS positions; • use generally accepted financial concepts and 4. For more information, see SR-11-7, “Guidance on Model risk-measurement techniques; and Risk Management.”

November 2020 Commercial Bank Examination Manual Page 6 Interest Rate Risk Management 3300.1

adequacy of the IRR measurement systems; Table 1—Interest Rate Exposures by and Measurement Systems • determine whether the institution holds suffi- cient capital for the level of risk being taken. Earnings Economic Gap Simulation Value of Analysis Analysis Equity IRR Measurement Methods Short-term There are a number of techniques to measure the earnings Yes Yes Limited* IRR exposure of both earnings and economic exposure value. Their complexity ranges from simple Long-term Yes Limited* Yes calculations and static simulations using current exposure holdings to highly sophisticated dynamic mod- eling techniques that reflect potential future Repricing Yes Yes Yes business and business decisions. Regardless of risk the methods used, an institution’s IRR measure- Yield curve Limited* Yes Yes ment system should be sufficiently robust to risk capture material on and off-balance-sheet posi- tions and incorporate a stress-testing process to Basis risk Limited* Yes Limited* identify and quantify the institution’s IRR expo- sure and potential problem areas. Option risk Limited* Limited* Yes The most common types of IRR measurement Price risk Limited* Limited* Yes systems are *Depending on the sophistication of the model and the manner in which it is used • Gap Analysis • Earnings Simulation Analysis • Economic Value of Equity (EVE) ment and analysis of the institution. Gap analysis can be used to generate rough Each risk-measurement system has limita- indicators of the IRR sensitivity of both earnings tions and vary in the degree of its ability to and economic values to changing interest rates. capture various components of IRR. The follow- To evaluate earnings exposures, liabilities ar- ing exhibit demonstrates the types of interest rayed in each time band can be subtracted from rate exposures that each measurement system the assets arrayed in the same time band to yield generally addresses. While different methodolo- a dollar amount of maturity/repricing mismatch gies capture different risk exposures, outputs or gap in each time band. The direction and from all models should generally provide a magnitude of the gaps in various time bands can consistent view of IRR trends. If divergent demonstrate potential earnings volatility arising outcomes occur, they are typically due to the from changes in market interest rates. A maturity/ structure of the balance sheet, the interest rate repricing schedule also can evaluate the effects environment, the timing of asset/liability mis- of changing rates on an institution’s economic matches, the sensitivity of funding sources to value. interest rate changes, or the volume of fixed or Typically, gap analysis includes ratios of floating rate assets. Institution management rate-sensitive assets to rate-sensitive liabilities should understand the nature and underlying in given time periods. Within a given time band, reasons for material differences in outputs. an institution may have a positive, negative, or Gap analysis is a basic IRR measurement neutral gap. An institution with a positive gap is technique utilizing a maturity/repricing sched- “asset sensitive” for the given time band because ule, which distributes assets, liabilities, and more assets than liabilities are subject to repric- OBS holdings into time bands according to their ing. An institution with a negative gap is “lia- final maturity (if fixed rate) or time remaining to bility sensitive” for the given time band because their next repricing (if floating). The choice of more liabilities than assets are subject to repric- time bands may vary from institution to institu- ing. An institution with a neutral gap (a ratio of tion. Those assets and liabilities lacking contrac- rate-sensitive assets to rate-sensitive liabilities tual repricing intervals or maturities are assigned equal to one) is neither asset nor liability sensi- to repricing time bands according to the judg- tive for the given time band.

Commercial Bank Examination Manual November 2020 Page 7 3300.1 Interest Rate Risk Management

At the most basic level, mismatches or gaps in Therefore, static and dynamic simulations, in long-dated time bands can provide insights into tandem, should be used to provide a more the potential vulnerability of the economic value complete description of the institution’s IRR of relatively noncomplex institutions. However, exposure. gap analysis alone is generally not suitable for Economic value of equity (EVE) models con- adequately assessing the institution’s risk profile sider the present value of expected cash flow for the large majority of institutions. Long-term over the entire expected life of the institution’s gap calculations, along with simple maturity holdings. EVE models simulate various interest distributions of holdings, may be sufficient for rate scenarios to estimate the changes in an relatively noncomplex institutions with basic institution’s economic value of capital as a balance sheets, minimal optionality, and mainly result of changes in interest rates. This approach repricing risk. focuses on a longer-term time horizon, captures Earnings simulation analysis estimates cash future cash flows expected from existing assets flows and resulting earnings streams over a and liabilities, and is effective in considering specific time period under various interest rate embedded options in a typical institution’s port- scenarios to estimate the effect of interest rate folio. changes on net interest income or net income. For assessing the exposure of earnings, simula- Most EVE models use a static approach by tions estimating cash flows and resulting earn- providing a snapshot in time of the risk inherent ings streams over a specific period are con- in the portfolio or balance sheet. However, some ducted based on existing holdings and assumed institutions incorporate dynamic modeling tech- interest rate scenarios. A simulation model’s niques that provide forward-looking estimates accuracy depends on the use of accurate assump- of economic value. tions and data. When utilizing EVE methods, institution man- A key aspect of IRR simulation involves the agement should establish appropriate EVE risk selection of an appropriate time horizon(s) over limits. Appropriate limits generally are based on which to assess IRR exposures. Simulations can the change of rather than be performed over any time horizon and often absolute levels of economic capital. The accu- are used to analyze multiple horizons identify- racy of the assumptions in the model are criti- ing short-term, intermediate-term, and long- cally important in the EVE model’s ability to term risk. Utilizing a two-year time period calculate the future cash flows of the institu- generally is effective when using earnings simu- tion’s instruments. Unreasonable assumptions lation models. A two-year time frame effec- can lead to pronounced output errors in EVE tively captures an institution’s important trans- models. As such, institution management should actions, tactics, and strategies to increase understand the significance and accuracy of revenues, which can be hidden by viewing assumptions by conducting sensitivity testing. projected results within shorter time horizons. However, to assess the effects of certain prod- ucts with embedded options, IRR simulations IRR Scenarios over longer time horizons (five-to-seven years) are typically needed. IRR exposure estimates, whether linked to earn- Income simulations are static or dynamic. ings or economic value, use some form of Static simulations are based on current holdings forecasts or scenarios of possible changes in and assume a constant balance sheet with no market interest rates. Institution management new growth. Dynamic simulations include as- should measure IRR exposure estimates over a sumptions of asset growth, changes in existing probable range of potential interest rate sce- business lines, new business, or changes in narios, including meaningful stress situations. management or customer behaviors. Dynamic The scenarios should adequately cover the insti- earnings simulation models can be useful for tution’s meaningful sources of IRR associated business planning and budgeting purposes. How- with its holdings. In developing appropriate ever, dynamic simulations are highly dependent scenarios, institution management should con- on key variables and assumptions and can be sider the current level and term structure of rates inaccurate over an extended period. Further- and possible changes to that environment, given more, model assumptions, such as growth, can the historical and expected future volatility of potentially hide underlying risk exposures. market rates.

November 2020 Commercial Bank Examination Manual Page 8 Interest Rate Risk Management 3300.1

There are various common rate scenarios, The integrity of data on current positions is an including rate shock, rate ramp, stair step, and important component of the risk-measurement non-parallel yield curve shifts. A rate-shock process. Management should ensure that all scenario is the most commonly used. In this material positions are represented in IRR mea- scenario, rate changes are instantaneous and sures, and that the data used are accurate and sustained. For instance, a plus 300 basis-point, meaningful. IRR measurement techniques should rate-shock scenario would consist of the full reflect relevant repricing and maturity character- 300 basis-point interest rate increase occurring istics on key holdings. When applicable, data in the first period measured and remain in effect should include information on the contractual for all measured periods. A rate ramp scenario coupon rates and cash flows of associated instru- consists of rate changes applied gradually over a ments and contracts. Manual adjustments to measured period, such as a 300 basis-point rate underlying data should be supported and con- increase during a 12-month period with rates trolled. rising 25 basis points each month. A stair-step scenario also consists of rate changes applied Account Aggregation gradually; however, the changes are adminis- tered at less frequent intervals. For example, a Account aggregation is the process of grouping 300 basis-point increase might be measured and measuring accounts of similar types and over a two-year period with rates increasing cash flow characteristics. The account aggrega- 50 basis points per quarter the first year and tion process should be supported and periodi- 25 basis points per quarter the second year. cally reviewed. The level of account aggregation Nonparallel yield curve shifts are scenarios in from transaction systems into the IRR model which the yields do not change by the same will vary from one institution to another based number of basis points for every maturity, such the complexity of the accounts and the sophis- as flattening, steepening, or inversion of the tication of the IRR model. Institutions should yield curve. appropriately aggregate current account posi- Effective scenarios conducted by institution tions by meaningful characteristics (for exam- management typically include an instantaneous ple, by instrument type, coupon rate, or repric- plus or minus 200 basis-point parallel shift in ing characteristic). This allows the institution to market rates (rate shock). However, those sce- appropriately measure material types and sources narios alone may not adequately assess an insti- of IRR, including those arising from explicit or tution’s IRR exposure. As such, institutions embedded options. Both contractual and behav- should also consider utilizing changes in rates of ioral characteristics should be considered when greater magnitude, such as plus or minus 300 and determining the cash flow patterns of accounts 400 basis-point shocks. More sophisticated to aggregate. analyses involve the use of multiple scenarios, including the potential effects of changes in the relationships among interest rates (option risk Assumptions and basis risk) and changes in the general level of interest rates and changes in the shape of the Assumptions should be documented and their yield curve. effects should be well understood by manage- ment. Management should review the assump- tions used in assessing the interest rate sensitiv- ity of complex instruments, such as those with Data Integrity embedded options, and instruments with uncer- tain maturities. Management should assess the In addition to validity of the underlying assump- consistent replacement growth rate assumptions tions, and IRR scenarios used to model IRR ex- if the ban uses dynamic simulations of future posures, the usefulness of IRR measurements growth and business assumptions. Assumptions depends on the integrity of the data on current about customer behavior and new business holdings. Simulation techniques that rely heav- should consider historical patterns and be con- ily on specific assumptions should be used sistent with the interest rate scenarios used. carefully because they rely on specific assump- Institutions should review the reasonableness of tions and parameters, which can lead to inaccu- assumptions covering asset prepayments, non- rate reports if the underlying data is inaccurate. maturity deposit price sensitivity and decay

Commercial Bank Examination Manual November 2020 Page 9 3300.1 Interest Rate Risk Management rates, and key rate drivers for each interest rate the degree of competition it faces or likely to shock scenario.5 face; and anticipated pricing behavior under the The following discussion provides back- scenario investigated. ground information on the types of assumptions As non-maturity deposits have no contractual used in IRR models. maturity date, institutions should utilize assump- Driver rates and betas. Driver rates are uti- tions that determine the maturity of the accounts. lized in most earnings simulations and economic The most common assumption utilized is a value models and represent the rate or rates decay rate. Also, institutions experiencing or which drive the re-pricing characteristics of projecting capital levels that trigger brokered assets and liabilities. Examples of driver rates and high interest rate deposit restrictions should include the fed funds rate, U.S. Treasury yields, adjust deposit assumptions accordingly.6 and the Wall Street Journal Prime rate. Depend- Assumptions, including deposit betas and ing on the sophistication of the model, a variety decay rates, should be supported to the fullest of driver rates may be tailored to the different extent practicable. Treatment of non-maturity products the institution offers. While institution deposits within the measurement system may, of rates generally move in relation to a driver rate, course, change from time-to-time based on mar- the movement may be less or more than the ket and economic conditions. Such changes movement in the driver rate depending on man- should be well founded and documented. Treat- agement’s pricing strategies. Most models uti- ments used in constructing earnings simulation lize a beta factor to serve as a proxy for assessments should be conceptually and empiri- management’s reaction to market changes. A cally consistent with those used in developing beta factor represents the magnitude of the EVE assessments of IRR. changes in the rates of bank products compared Asset prepayment. Prepayment assumptions to the changes in the driver rates. For example, reflect the optionality and prepayment risk asso- management may be expected to only increase ciated with loans and mortgage-related securi- deposit rates by 40 basis points for every ties and are critical as cash flows may be 100 basis points move in the fed funds rate, received more quickly or more slowly than resulting in a beta factor of 40 percent. Beta anticipated. Prepayments are highly influenced factors should be based on an analysis of the by the direction of interest rates as loan prepay- relationship between the product and the driver ments generally slow during periods of rising rate. To help determine the beta, management rates. Prepayment assumptions should take into can perform correlation or regression analysis to consideration various factors, such as aging, quantify the historical relationship between the geographic location, loan size, and fixed versus product and the drivers. variable rates. Non-maturity deposits. Assumptions about non-maturity deposits are critical as non-maturity deposits represent a large portion of the indus- Stress Testing try’s funding base. An institution’s IRR mea- surement system should consider the sensitivity Stress testing, which includes both scenario and of non-maturity deposits, including demand sensitivity analysis, is an important part of deposits, negotiable order of withdrawal accounts, IRR management. An institution’s risk- savings deposits, and money market deposit measurement system for IRR should contain a accounts. There are a variety of techniques used meaningful evaluation of the effect of stressful to analyze IRR characteristics, and each institu- market conditions on the institution. Stress sce- tion should use a technique that is commensu- narios should be designed to provide informa- rate to the size, sophistication, and complexity tion on the kinds of conditions under which the of the institution. In general, treatment of non- institution’s strategies or positions would be maturity deposits should consider the historical behavior of the institution’s deposits; general 6. Section 38 of the FDI Act (12 U.S.C. 1831o) requires conditions in the institution’s markets, including insured depository institutions that are undercapitalized to receive approval before engaging in certain activities, and 5. A decay rate estimates the amount of existing non- further restricts interest rates paid on deposits by institutions maturity deposit that will run off over a given time period. that are not well capitalized. Section 38 restricts or prohibits Generally, rate-sensitive and higher-cost deposits, such as certain activities and requires an insured depository institution brokered and Internet deposits, should reflect higher decay to submit a capital restoration plan when it becomes under- rates than other types of deposits. capitalized.

November 2020 Commercial Bank Examination Manual Page 10 Interest Rate Risk Management 3300.1 most vulnerable; thus, testing may be tailored to risk-measurement methodologies, limits, and the risk characteristics of the institution. Pos- internal controls. sible stress scenarios might include more severe Validating IRR models is a fundamental part changes in the term structure of interest rates, of any institution’s system of internal controls. substantial rate changes over time, relationships An important element of model validation is among key market rates (basis risk), or volatility independent review of the model’s logical and of market rates. The stress testing of assump- conceptual soundness. The scope of the inde- tions used for illiquid instruments and instru- pendent review should assess the institution’s ments with uncertain contractual maturities, such measurement of IRR, including the reasonable- as core deposits, is particularly critical to achiev- ness of assumptions, the process used in deter- ing an understanding of the institution’s risk mining assumptions, and the back testing of profile. Therefore, stress scenarios may include assumptions and results. Management also extremes of observed market conditions and should implement adequate follow-up proce- plausible worst-case scenarios. dures to monitor the institution’s corrective Management should conduct sensitivity analy- actions. The results of these reviews should be sis of the assumptions having the largest influ- available for the relevant supervisory authori- ence on an institution’s model output under ties. stressful situations. This sensitivity analysis may Smaller institutions that do not have the consist of testing key assumptions or variables resources to staff an independent review func- by changing the variable in question while tion should have processes in place to ensure the keeping all other variables constant and compar- integrity of the various elements of their ing the results to the base-case scenario. Based IRR management processes. Often, smaller insti- on the results of sensitivity analysis, manage- tutions will use an internal party that is suffi- ment should be able to identify the assumptions ciently removed from the primary IRR functions which have the most impact on model output. or an external auditor to independently verify This enables management to focus their efforts the integrity of the IRR models used. More in verifying the most salient assumptions. Addi- robust model validations processes for measure- tionally, sensitivity analysis can be used to ment systems are appropriate for institutions determine the conditions under which key busi- with complex risk exposures. These processes ness assumptions and model parameters or when should include review by external auditors or IRR may be exacerbated by other risks or other knowledgeable outside parties to ensure earnings pressures. the IRR models’ adequacy and integrity. Since measurement systems may incorporate one or more subsidiary systems or processes, institu- tions should ensure that multiple component Internal Controls systems are well integrated and consistent in all critical respects. An important element of an institution’s internal The frequency and extent to which an insti- controls for IRR is senior management’s com- tution should reevaluate its risk-measurement prehensive evaluation and review of the various methodologies and models depends, in part, on components of the IRR management process. the specific IRR exposures created by their Although procedures for establishing limits and holdings and activities, the pace and nature of adhering to them may vary among institutions, changes in market interest rates, and the extent periodic control reviews should be conducted to to which there are new developments in mea- determine whether the organization enforces its suring and managing IRR. In general, an insti- IRR policies and procedures. Senior manage- tution should review its underlying IRR mea- ment should promptly address situations where surement methodologies and IRR management interest rate positions exceed established inter- process annually, and more frequently as insti- nal risk limits. Issues should be resolved based tution behaviors and market conditions dictate. on processes described in approved policies. The institution should conduct periodic reviews of IRR management process. Reviews should also be conducted in light of significant changes since the last review, such as the nature of instruments acquired, as well as modifications to

Commercial Bank Examination Manual November 2020 Page 11 3300.1 Interest Rate Risk Management

SUPERVISORY CONSIDERATIONS level of earnings and the potential length of time IN ASSESSING IRR SENSITIVITY such exposure might persist. TO MARKET RISK Exposures that would result in a significant decline in net interest margins or net income should prompt further investigation of the adequacy and stability of earnings and the Quantitative Level of IRR Exposure adequacy of the institution’s risk-management and Effect on Earnings and Capital process. Specifically, in institutions exhibiting significant earnings exposures, examiners should Examiners evaluating the quantitative level of emphasize the results of the institution’s stress IRR should review and assess the effects of past tests to determine the extent to which more and potential changes in interest rates on an significant and stressful rate moves might mag- institution’s financial condition, particularly its nify the erosion in earnings identified in the earnings, capital, liquidity, and, in some cases, more modest rate scenario. asset quality. This assessment involves a broad When determining the amount of IRR expo- analysis of an institution’s business mix, balance- sure in context of capital, examiners will con- sheet composition, OBS holdings, and holdings sider the effect of changes in market interest of interest rate-sensitive instruments. Examiners rates on the economic value of equity, level of should understand the institution’s material hold- embedded losses in the bank’s financial struc- ings, and assess how changes in interest rates ture, and impact of potential rate changes on the might affect the institution’s financial perfor- institution’s earnings. mance. While the scope of the assessment should Examiners should take into account the abso- reflect the size, sophistication, and nature of the lute level of an institution’s earnings or capital institution’s holdings, primary areas of review both before and after the estimated IRR shock. include Institutions with strong earnings and capital can withstand greater shocks, whereas institutions • major on- and off-balance-sheet positions, with already less than satisfactory earnings or • concentrations in interest-sensitive instru- capital may warrant greater supervisory concern ments, at relatively small IRR shocks. • the existence of highly volatile instruments, and • significant sources of noninterest income that Qualitative Assessment of Interest may be sensitive to changes in interest rates. Rate Risk Management

When evaluating interest rate risk management at an institution, examiners should place pri- IRR Exposure to Earnings and Capital mary consideration on the following elements of a sound risk-management system: An institution’s IRR exposure should be assessed in terms of the potential effects on the institu- • board of directors and senior management tion’s earnings and capital. When evaluating the oversight; potential effects of changing rates on an institu- • policies, procedures, and limits; tion’s earnings, examiners will assess the key • risk monitoring and management information determinants of the net interest margin, the systems; and effect that fluctuations in net interest margins • internal controls.7 can have on overall net income, and the rate sensitivity of non-interest income and expense. Through discussions with appropriate institu- Analyzing the historical behavior of the net tion personnel, examiners should determine interest margin, including the yields on major whether the institution has established appropri- assets, liabilities, and off-balance-sheet posi- ate corporate governance processes (internal tions that make up that margin, can provide useful insights into the relative stability of an institution’s earnings. Examiners should evalu- 7. These elements are consistent with the guidance pro- vided in SR-16-11, “Supervisory Guidance for Assessing Risk ate the exposure of earnings to changes in Management at Supervised Institutions with Total Consoli- interest rates relative to the institution’s overall dated Assets Less than $50 Billion.”

November 2020 Commercial Bank Examination Manual Page 12 Interest Rate Risk Management 3300.1 policies, procedures, risk limits, and strategies), choose to take and manage that risk explicitly— and whether the board of directors, or a com- often with complex financial instruments. These mittee thereof, is regularly informed about the banks, along with banks that have a wide array level and trend of IRR, and reviews confor- of activities or complex holdings, generally mance with internal IRR policy limits and risk should receive greater supervisory attention. tolerances. If inadequacies are noted, examiners should communicate these findings to the insti- tution and discuss strategies to improve the Examination Scope and Off-Site institution’s corporate governance processes. Analysis Examiners should determine whether internal measurement processes and systems are ad- During the examination scoping process prior to equate. In particular, examiners should review the on-site examination, examiners should use the institution’s input process by focusing on the surveillance metrics and supervisory judgment, procedures for entering and reconciling system to determine bank’s risk tier (low, moderate, or data, categorizing and aggregating account data, high). The scope of the examination work pro- ensuring the completeness of account data, and gram should align with the bank’s risk classifi- assessing the effectiveness of internal controls. cation. More information on the use of surveil- In addition, examiners should review the results lance metrics during the examination scoping of the audit or independent reviews, and deter- process is discussed in this manual’s section mine whether the results were appropriately entitled, “Community Bank Supervision Pro- reported to the board of directors, or a commit- cess.” tee thereof, and whether the results revealed Additionally, examiners should assess the significant deficiencies. level of IRR exposure and the quality of IRR management to the fullest extent possible during the scoping process by reviewing the EXAMINATION PROCESS following:

Examiners should assess and assign a rating to • organizational charts and policies identifying the sensitivity to market risk component, or “S” authorities and responsibilities for manag- component, of the CAMELS rating system, at ing IRR; each full-scope examination.8 To meet examina- • IRR policies, procedures, and limits; tion objectives efficiently and effectively while • ALCO committee minutes and reports (from remaining sensitive to potential burdens imposed 6 to 12 months before the scope visit); on institutions, the examination of sensitivity to • board of director reports on IRR exposures; market risk should follow a structured, risk- • audit reports (both internal and external); focused approach. A fundamental tenet of this • most recent IRR report, including assump- approach is that supervisory resources are tar- tions used in the model; and geted at functions, activities, and holdings that • Federal Reserve surveillance reports and super- pose the most risk to the safety and soundness of visory screens. an institution. Accordingly, institutions with low levels of IRR would be expected to receive If the examiners’ assessment of the risk tier relatively less supervisory attention than those differs from the initial quantitative risk tier, with more severe IRR exposures. examiners should adjust the risk tier. Adjust- Many institutions have become especially ments to the risk tier during the scoping process skilled in managing and limiting the exposure of based on examiner judgement should be ratio- their earnings to changes in interest rates. nalized and documented in the appropriate work Accordingly, for most banks and especially for papers. smaller institutions with less complex holdings, the IRR element of the examination may be relatively simple and straightforward. On the other hand, some banks consider IRR an intended During the Examination consequence of their business strategies and Examiners should complete the appropriate 8. There may be instances where the assessment of sensi- examination procedures based on the bank’s tivity to market risk is a topic of a targeted examination. assigned risk tier. During the examination, the

Commercial Bank Examination Manual November 2020 Page 13 3300.1 Interest Rate Risk Management examiner-in-charger and the examiner working on an assessment of the following evaluation the IRR portion of the examination should factors: confirm the risk classifications on which planned work programs were based and, if needed, • the sensitivity of the bank’s earnings or the adjust or expand the work programs. If initial economic value of its capital to adverse discussions with management or additional infor- changes in interest rates; mation obtained during the examination indi- • the ability of management to identify, mea- cates significant weakness in the bank’s risk sure, monitor, and control exposure to interest management or higher-than-anticipated risk, rate risk given the bank’s size, complexity, examiners should modify the examination’s and risk profile; scope and work programs accordingly. All • the nature and complexity of interest rate risk examination work programs are to include the exposure arising from non-trading positions; review and verification of corrective action taken and to address any outstanding Matters Requiring • where appropriate, the nature and complexity Immediate Attention (MRIAs) or Matters Re- of market-risk exposure arising from trading quiring Attention (MRAs). and foreign operations. Material weakness in risk management or high levels of IRR exposure relative to earnings In addition to these listed factors, there may and capital may require corrective action. If an be additional factors that may be appropriate for examiner determines that an IRR weakness the examiner to evaluate as part of determining warrants corrective action based on safety and the “S” rating for a bank. soundness, the examiner, in consultation with the examiner-in-charge, should outline any The “S” component rating definitions of the MRIAs or MRAs. CAMELS rating system are as follows: When issuing a supervisory finding (includ- ing through the issuance of an MRIA or MRA), 1. A rating of “1” indicates that interest rate risk examiners will not criticize an institution for a sensitivity is well controlled and that there is “violation” of supervisory guidance (as supervi- minimal potential that the earnings perfor- sory guidance is not legally binding). When mance or capital position will be adversely appropriate, examiners may reference (includ- affected. Risk-management practices are ing in writing) supervisory guidance (such as strong for the size, sophistication, and market interagency statements, advisories, bulletins, and risk accepted by the institution. The level of policy statements) to provide examples of safe- earnings and capital provide substantial sup- and-sound conduct, appropriate risk-management port for the degree of interest rate risk taken practices, and other approaches to addressing by the institution. compliance with laws or regulations.9 2. A rating of “2” indicates that interest rate risk sensitivity is adequately controlled and that there is only moderate potential that the Assessing CAMELS Ratings earnings performance or capital position will be adversely affected. Risk-management prac- For most banks, IRR is the primary market risk tices are satisfactory for the size, sophistica- exposure. Accordingly, the CAMELS market- tion, and interest rate risk accepted by the risk sensitivity or “S” rating for most banks institution. The level of earnings and capital should be based on assessments of the adequacy provide adequate support for the degree of of IRR management practices and the quantita- interest rate risk taken by the institution. tive level of IRR exposure.10 In particular, the 3. A rating of “3” indicates that control of “S” rating for most banks where IRR is the interest rate risk sensitivity needs improve- primary market risk exposure should be based ment or that there is significant potential that the earnings performance or capital position will be adversely affected. Risk-management 9. SR-18-5/CA-18-7, “Interagency Statement Clarifying practices need to be improved given the size, the Role of Supervisory Guidance.” sophistication, and level of risk accepted by 10. “Overall Conclusions Regarding Condition of the Bank: the institution. The level of earnings and Uniform Financial Institutions Rating System,” provides guid- ance on the market-risk sensitivity component of the CAM- capital may not adequately support the degree ELS rating system. of interest rate risk taken by the institution.

November 2020 Commercial Bank Examination Manual Page 14 Interest Rate Risk Management 3300.1

4. A rating of “4” indicates that control of of interest rate risk accepted by the institu- interest rate risk sensitivity is unacceptable tion. or that there is high potential that the earn- ings performance or capital position will be The adequacy of a bank’s IRR management is adversely affected. Risk-management prac- a leading indicator of its potential IRR exposure. tices are deficient for the size, sophistication, Therefore, assessment of IRR management prac- and level of risk accepted by the institution. tices should be the basis for the overall assess- The level of earnings and capital provide ment of a bank’s IRR. Unsafe exposures and inadequate support for the degree of interest management weaknesses should be fully re- rate risk taken by the institution. flected in “S” ratings. Unsafe exposures and 5. A rating of “5” indicates that control of unsound management practices that are not interest rate risk sensitivity is unacceptable resolved during the on-site examination should or that the level of risk taken by the institu- be addressed through subsequent follow-up tion is an imminent threat to its viability. actions by the examiner and other supervisory Risk-management practices are wholly inad- personnel. equate for the size, sophistication, and level

Commercial Bank Examination Manual November 2020 Page 15 Interest Rate Risk Management Examination Objectives Effective date November 2020 Section 3300.2

1. Do the bank’s assets, investments, deposits, 5. Are the audit and internal control functions other funding sources, and financial deriva- adequate? tives present a low or well-controlled level 6. Has an effective independent review func- of interest rate risk? tion been established? 2. Have adequate corporate governance pro- 7. Are management information systems and cesses (policies, procedures, risk limits, and reporting adequate? strategies) been established? 3. Are internal measurement processes and 8. Is the level of risk reasonable relative to systems adequate? capital and earnings levels? 4. Are model inputs and management’s as- 9. Do the board and senior management effec- sumption development process adequate? tively supervise this area?

Commercial Bank Examination Manual November 2020 Page 1 Interest Rate Risk Management Examination Procedures Effective date November 2020 Section 3300.3

PRELIMINARY REVIEW level of the bank’s risk and the complexity of its holdings and activities. In general, 1. Review prior examination reports, supervi- satisfactory policies sory reviews, and file correspondence to • assign authority and responsibility to identify prior rate-sensitivity concerns. Also, an individual(s) or committee for estab- review internal, or third party, audits and lishing and maintaining an effective reviews to identify any concerns or recom- IRR management program that identi- mendations. fies, measures, monitors, and controls 2. Review board or committee minutes and IRR within board-approved risk limits; information packets for evidence of over- • identify the types of instruments and sight, responsibility, routine management activities that may be used to manage reports, and any identified rate sensitivity IRR exposure; concerns. • provide for comprehensive measure- 3. Determine whether there are any recent or ment systems that are commensurate planned changes in strategic direction and with the size and complexity of the discuss with management the implications institution for valuing positions and for rate sensitivity risks. assessing performance, including pro- 4. Review offsite analytical reports to develop cedures for updating model scenarios a preliminary assessment of rate sensitivity and underlying key assumptions; trends and risks. • require regular, detailed reporting that 5. Review the Uniform Bank Performance informs management and the board of Report, Call Report, balance sheet, and IRR exposures; income statement data to develop an initial • outline the process and responsibility rate sensitivity profile. Note common risk for sensitivity testing of critical model areas such as assumptions; • shifts in long term assets and long term • require periodic back testing of IRR liabilities; projections and analysis of significant • mortgage-loan exposure (direct or indi- variances; rect through mortgage backed invest- • establish earnings and capital exposure ments); limits commensurate with the risk tol- • mortgage servicing assets; erance of the board; • significant securities depreciation; • require management to factor IRR into • structured notes; broader risk management consider- • fluctuations in non-maturity deposits; ations and strategic decisions to ensure and interrelationships between IRR and • hedging activities, such as rate swaps, other risks are considered and ad- forwards, futures, options, or other dressed; derivative products. • require the board or a designated com- mittee to periodically review and approve the policy, risk limits, and strategies; POLICIES, PROCEDURES, AND • assign responsibility for authorizing RISK LIMITS policy exceptions, and require docu- mentation of the rationale for authoriz- 6. Review rate sensitivity policies. Policy guid- ing such exceptions; and ance may be incorporated in liquidity, loan, • provide that the asset/liability commit- investment, interest rate risk (IRR), or other tee (ALCO), or a similar committee, policies, but taken as a whole, should pro- has sufficient representation across vide sufficient guidance to management rela- major functions that influence IRR tive to the board’s risk tolerances and over- exposure. sight responsibilities. Policy formality and sophistication will vary, depending upon the

Commercial Bank Examination Manual November 2020 Page 1 3300.3 Interest Rate Risk Management: Examination Procedures

7. Determine whether the board or a delegated • names of individuals authorized to ini- committee oversees the establishment, ap- tiate hedging transactions and their proval, implementation, and annual review limits of authority; of IRR management strategies, policies, • requirements for monitoring hedging procedures, and limits (or risk tolerances). activity and ensuring activities fall 8. Discuss IRR management processes and within approved limits and lines of practices with management. Review ALCO authority; and meeting minutes and packages to evaluate • descriptions of how management will the process. Potential topics for discussion ensure compliance with technical include accounting guidance that governs hedg- • lines of responsibility and authority for ing activity, most notably ASC IRR exposure management; Topic 815. • development of IRR policies and prac- 10. Determine whether management uses static tices; balance sheet modeling to assess baseline • adequacy of IRR measurement system IRR exposure. Refer to the 1996 Joint used (e.g., gap, income simulation, Agency Policy Statement on IRR and the economic value of equity); 2010 FFIEC Advisory on IRR Management • assumptions used in the IRR measure- for further discussion of balance sheet mod- ment system (e.g., asset prepayments, eling. deposit price sensitivity, decay rates, 11. Determine whether management uses IRR growth rates) and any adjustments to modeling to evaluate large-scale shifts in key assumptions; strategies, product offerings, or significant • management’s understanding of the concentrations. underlying analytics and methodolo- 12. Determine whether procedures and risk lim- gies of IRR models; its are reasonable relative to current eco- • board/management understanding of nomic conditions and the overall condition model assumptions, particularly if de- of the bank. Determine whether manage- veloped by third parties; ment • strategies to manage IRR (e.g., cash flow or duration matching, altering • evaluates the potential effect on income balance sheet composition, hedging and capital levels when establishing with derivatives); risk limits; • technical expertise of staff relative to • reviews limits at least annually (and the complexity of products used and more frequently if the bank’s financial the complexity of the IRR measure- condition, strategic direction, or prod- ment system; and, ucts and services are changing); and • board and management understanding • considers the risks and potential re- of the specific embedded risk charac- wards of adverse/favorable rate move- teristics of the institution, (e.g., basis ments when establishing an IRR posi- risk, option risk). tion or strategy. 9. If IRR management processes include hedg- ing with derivatives, determine whether poli- cies outlining hedging strategies include • requirements for analysis of market, MEASUREMENT SYSTEM liquidity, credit, and operating risks; CAPABILITIES • requirements regarding the expertise/ experience of personnel involved in 13. Determine whether the measurement sys- implementing and monitoring deriva- tem contains the functionality (and is tive hedging strategies; updated as needed) to adequately assess risk • permissible strategies and types of exposures. derivative contracts; 14. Determine whether the IRR measurement • risk limits for hedging activity such as system captures and reports all material on- position limits (gross and net), matu- and off-balance-sheet positions. Consider rity parameters, and counterparty credit the level of detail in charts of account, data guidelines; input, and output reports.

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15. Determine whether the system measures the reasons for variances, and any actions plans potential effect of changes in market rates initiated. If applicable, discuss the board’s on both earnings and capital. oversight and approval of variances and any 16. Determine whether the IRR measurement related mitigating actions. system has capabilities to provide meaning- ful stress-test simulations applicable to the institution. Consider the following: AUDIT OR INDEPENDENT • instantaneous and significant rate shocks REVIEW (considering the current rate environ- ment); 23. Determine whether management provides • substantial changes in rates over time for an adequate audit of the IRR measure- (prolonged rate shocks exceeding ment process. periods of one year); 24. Determine whether the independent review • changes in the relationships between includes an adequate scope (certain aspects key market rates (i.e., basis risk); of which may have been completed by • various scenarios (e.g., base case, worst internal audit or an external model valida- case, static, dynamic); and tion). Adequate scoping generally includes • nonparallel yield curve shifts (e.g., an assessment of items such as the steepened, flattened, and inverted yield • adequacy of, and compliance with, curves). policies and procedures; • suitability of the bank’s measurement system given the size and complexity ASSUMPTIONS AND of activities; DATA INPUTS • appropriateness of rate scenarios used; • validity of risk measurement calcula- 17. Assess management’s process for develop- tions; and ing and reviewing key scenarios and assump- • reasonableness and accuracy of assump- tions. Consider the institution’s documenta- tions and data inputs including back tion, monitoring, and update procedures. testing. Typical key assumptions include 25. Ensure that the results of annual indepen- • asset prepayment speeds, dent reviews are promptly reported to the • non-maturity deposit price board, or committee thereof. Determine sensitivities, whether management reviewed and reported • non-maturity deposit decay rates or the results of any validation performed on average life, and the IRR model used. • key/driver rates. 26. If recent reviews disclosed any deficiencies, 18. Review the reasonableness and support for or if back testing has shown past estimates management’s key assumptions. deviated significantly from actual perfor- 19. Review the institution’s sensitivity analysis mance, determine whether management on key assumptions. responses are reasonable and timely.

INTERNAL CONTROLS REPORTING AND COMMUNICATION SYSTEMS 20. Determine whether management estab- lished sufficient lines of authority and sepa- 27. Determine whether internal reports provide ration of duties, or comparable controls, sufficient information for ongoing IRR man- over the development and use of measure- agement decisions and for monitoring the ment systems and monitoring tools. results of those decisions. Reports should 21. Determine whether IRR reports are reviewed contain sufficient detail for the board and by senior management and the board at least senior management to quarterly. • analyze IRR levels and trends and 22. Determine whether management complies estimate the potential effect on earn- with policy parameters and documents the ings and capital;

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• identify material risk exposures and • fundamental changes in liability mix sources; between core deposits and other fund- • evaluate key assumptions, including ing sources; interest rate forecasts, deposit behav- • unexpected changes in level or trend of iors, and loan prepayments; securities appreciation and deprecia- • make pricing decisions; tion; and • verify compliance with risk limits/ • adoption of, or an increase in, the policy guidelines and to monitor pol- volume of derivative or hedging instru- icy exceptions; ments. • assess the institution’s IRR sensitivity 33. Analyze changes in the net interest margin in base-case and changing-rate sce- and net operating income relative to nario; and • market interest rate fluctuations, • assess important assumptions under- • reliance on rate sensitive noninterest lying the measurement systems. income activities (such as mortgage 28. Determine whether interest rate risks are banking activities), communicated to all relevant operational • earnings and capital levels, and and oversight personnel. • strategies to manage the effect of the 29. Consider testing reports for accuracy by changes on earnings and capital. comparing results with regulatory reports and internal records. OVERSIGHT AND RISK MITIGATION RISK EXPOSURE CONSIDERATIONS 34. Determine whether the board understands and is regularly informed about the level 30. Determine the level of IRR and assess the and trend of IRR exposure. Consider the potential effect on the institution’s risk pro- following board responsibilities: file. Consider IRR trends that, while still • setting the bank’s tolerance level for within established risk tolerances, may indi- interest rate risk, cate an increasing risk profile. • identifying lines of authority and 31. Compare the earnings projections used in responsibility for managing risk, the IRR measurement systems to manage- • ensuring adequate resources are de- ment’s budget. Determine the magnitude of voted to IRR management, any differences and the reason for the dif- • monitoring the overall IRR profile, and ferences. Determine the extent to which • ensuring that IRR is maintained at management relies on IRR projections and prudent levels. uses them in strategic and capital planning. 35. Determine whether senior management 32. Determine whether recent or anticipated ensures that board-approved strategies, poli- changes or trends in the balance sheet cies, and procedures for managing IRR are composition alter the IRR profile relative to appropriately executed within the desig- historical data. When significant structural nated lines of authority and responsibility. changes have or are expected to occur, Consider the following management respon- de-emphasize historical analysis and focus sibilities: on current and forecasted balance sheet • implementing detailed reporting pro- composition. Significant structural changes cesses to inform senior management may include and the board of the level of IRR • major shift in the maturity (repricing) exposure; characteristics of the investment port- • maintaining comprehensive systems folio, loans, borrowings, or deposit and standards for measuring IRR, valu- accounts; ing positions, and assessing perfor- • increased holdings of financial instru- mance, including procedures for updat- ments such as mortgage securities, call- ing IRR measurement scenarios and able securities, fixed-rate residential key underlying assumptions driving loans, and structured notes; the institution’s IRR analysis;

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• developing and implementing proce- dations of the IRR program are regu- dures that translate the board’s goals, larly completed. objectives, and risk limits into operat- 36. Determine whether historical performance ing standards that are understood and indicates weakness in board and senior followed by bank personnel; management oversight. • providing sufficient staff to operate 37. Determine whether the board effectively measurement systems, including oversees and management effectively imple- back-up personnel who possess requi- ments planned initiatives and strategies. site technical expertise; 38. If risk limits were breached, determine what • establishing adequate training and steps management took, or plans to take, to development programs; remedy, or mitigate exposures. If manage- • implementing internal controls over ment decides against corrective action, deter- the IRR process; and mine whether such decisions are reasonable • ensuring independent reviews and vali- and appropriately reported and documented.

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