Trading and Capital-Markets Activities Manual First Printing, February 1998 Prepared by: Federal Reserve System Send comments to: Director, Division of Banking Supervision and Regulation Board of Governors of the Federal Reserve System Washington, D.C. 20551 Copies of this manual may be obtained from: Publications Services Division of Support Services Board of Governors of the Federal Reserve System Washington, D.C. 20551 Updates are available at an additional charge. For information about updates or to order by credit card, call 202-452-3244. Trading and Capital-Markets Activities Manual Supplement 8—September 2002 Nature of Changes how a banking organization can mitigate the risk that may arise if a counterparty claims that a Trading Activities bank-recommended or -structured derivatives transaction was unsuitable for it. Other changes In section 2020.1, ‘‘Counterparty Credit Risk discuss the new-product approval process in and Presettlement Risk,’’ a new subsection on banking organizations, including the role of off-market or prefunded derivatives transactions in-house or outside legal counsel in defining and has been added to provide examples of deriva- approving new products. The examination tives transactions that are the functional equiva- objectives and examination procedures, sections lent of extensions of credit to counterparties and 2070.2 and 2070.3, respectively, have also been to describe the risks associated with them. The updated. discussion of assessment of counterparty credit risk has been revised to specify that banking Capital-Markets Activities organizations should understand and confirm with their counterparties the business purpose of Section 3040.1, ‘‘Equity Investment and Mer- derivatives transactions. chant Banking Activities,’’ has been completely A more detailed discussion of contingency revised. The accounting, valuation, and risk funding plans has been added to section 2030.1, management of equity investments in banking ‘‘Liquidity Risk.’’ The characteristics of effec- organizations are summarized. In addition, the tive contingency funding plans, such as forming section explains the legal and regulatory com- a crisis-management team and establishing action pliance requirements for these transactions— plans for different levels of liquidity stress, are including the January 2002 rule establishing described. Specific information on contingency minimum regulatory capital requirements for liquidity for bank holding companies is also equity investments in nonfinancial companies. provided. Examination objectives and examination proce- Section 2070.1, ‘‘Legal Risk,’’ has been reor- dures, sections 3040.2 and 3040.3, respectively, ganized and updated. A new subsection describes have been added. Filing Instructions Remove pages Insert pages 2020.1, pages 8.1–8.2 2020.1, pages 8.1–8.2 pages 11–13 pages 11–15 2030.1, pages 1–2 2030.1, pages 1–2, 2.1–2.3 2070.1, pages 1–6 2070.1, pages 1–7 2070.2, page 1 2070.2, page 1 2070.3, pages 1–3 2070.3, pages 1–3 3040.1, pages 1–14 3040.1, pages 1–19 3040.2, page 1 3040.3, pages 1–5 Subject Index, pages 1–7 Subject Index, pages 1–7 Trading and Capital-Markets Activities Manual September 2002 Page 1 Trading and Capital-Markets Activities Manual Supplement 7—April 2002 Nature of Changes its affiliates are subject to the market-terms requirement of section 23B. Section 3000.1, ‘‘Investment Securities and End- User Activities,’’ has been revised to explain In Section 3020.1, ‘‘Securitization and recent interpretations of sections 23A and 23B Secondary-Market Credit Activities,’’ the discus- of the Federal Reserve Act. The internal control sion of risk-based provisions affecting asset questionnaire, section 3000.4, has also been securitizations has been updated to include a updated. final rule on the capital treatment of recourse obligations, residual interests, and direct-credit • A final rule, effective June 11, 2001, provides substitutes resulting from asset securitizations. three exemptions from the quantitative limits The new rule treats recourse obligations and and collateral requirements of section 23A. direct-credit substitutes more consistently than The exemptions apply to certain loans an the current risk-based capital standards, adds insured depository institution makes to third new standards for the treatment of residual parties that use the proceeds to purchase interests, and introduces a ratings-based approach securities or assets through an affiliate of the to assigning risk weights within a securitization. depository institution. There is a one-year transition period for apply- • A final rule, effective June 11, 2001, exempts ing the new rules to existing transactions. All from section 23A an insured depository insti- transactions settled on or after January 1, 2002, tution’s purchase of a security from an affili- are subject to the revised rules. ated broker-dealer registered with the Securi- Revisions to section 3040.1, ‘‘Equity Invest- ties and Exchange Commission (SEC), ment and Merchant Banking Activities,’’ incor- provided several conditions are met. Among porate a final rule establishing special minimum other conditions, the purchased security must regulatory capital requirements for equity invest- have a ready market, as defined by the SEC, ments in nonfinancial companies. The new and a publicly available market quotation. requirements, effective April 1, 2002, impose a • An interim rule, effective January 1, 2002, series of marginal capital charges on covered confirms that (1) derivative transactions equity investments. The charges increase with between an insured depository institution and the level of a banking organization’s overall its affiliates and (2) intraday extensions of exposure to equity investments relative to tier 1 credit by an insured depository institution to capital. Filing Instructions Remove pages Insert pages 2120.1, pages 1–2 2120.1, pages 1–2 pages 7–8 pages 7–8 2120.2, page 1 2120.2, page 1 2120.3, page 1 2120.3, page 1 2120.4, page 1 2120.4, page 1 2120.5, pages 1–3 2120.5, pages 1–3 3000.1, pages 1–8 3000.1, pages 1–8, 8.1 pages 15–19 pages 15–20 Trading and Capital-Markets Activities Manual April 2002 Page 1 Supplement 7—April 2002 Remove pages Insert pages 3000.4, pages 1–3 3000.4, pages 1–3 3020.1, pages 7–10 3020.1, pages 7–10 pages 10.1–10.2 pages 10.1–10.4 pages 13–14 pages 13–14 3040.1, pages 1–2 3040.1, pages 1–2 pages 5–6 pages 5–6, 6.1–6.3 4020.1, pages 1–2 4020.1, pages 1–2 Subject Index, pages 1–7 Subject Index, pages 1–7 April 2002 Trading and Capital-Markets Activities Manual Page 2 Trading and Capital-Markets Activities Manual Supplement 6—September 2001 Nature of Changes Standards No. 140 (FAS 140). Section 2120.1 was further corrected to replace a reference to Sections 2120.1, ‘‘Accounting,’’ and 3020.1, Accounting Principles Board (APB) Opinion ‘‘Securitization and Secondary-Market Credit No.16 with Statement of Financial Accounting Activities,’’ have been corrected to remove ref- Standards No. 141 (FAS 141), ‘‘Business Com- erences to Statement of Financial Accounting binations.’’ References to FAS 125 have also Standards No. 125 (FAS 125), which has been been removed from the instrument profiles (sec- replaced by Statement of Financial Accounting tions 4010.1 through 4255.1 and section 4353.1). Filing Instructions Remove pages Insert pages 2120.1, pages 3–12 2120.1, pages 3–12 3020.1, pages 3–4 3020.1, pages 3–4 pages 9–10 pages 9–10 pages 10.1–10.2 pages 10.1–10.2 4010.1, pages 3–4 4010.1, pages 3–4 4015.1, pages 3–4 4015.1, pages 3–4 4020.1, pages 3–4 4020.1, pages 3–4 4025.1, pages 1–3 4025.1, pages 1–3 4030.1, pages 1–3 4030.1, pages 1–3 4035.1, page 3 4035.1, page 3 4040.1, pages 9–10 4040.1, pages 9–10 4045.1, pages 5–6 4045.1, pages 5–6 4050.1, pages 3–5 4050.1, pages 3–5 4055.1, pages 1–2 4055.1, pages 1–2 4105.1, pages 5–7 4105.1, pages 5–7 4110.1, pages 13–14 4110.1, pages 13–14 4205.1, pages 1–3 4205.1, pages 1–3 4210.1, page 3 4210.1, page 3 4215.1, pages 3–4 4215.1, pages 3–4 Trading and Capital-Markets Activities Manual September 2001 Page 1 Supplement 6—September 2001 Remove pages Insert pages 4220.1, pages 3–4 4220.1, pages 3–4 4225.1, pages 1–2 4225.1, pages 1–2 4230.1, pages 3–4 4230.1, pages 3–4 4235.1, pages 3–4 4235.1, pages 3–4 4240.1, page 3 4240.1, page 3 4245.1, pages 1–3 4245.1, pages 1–3 4250.1, pages 3–4 4250.1, pages 3–4 4255.1, pages 3–4 4255.1, pages 3–4 4353.1, pages 3–4 4353.1, pages 3–4 pages 9–10 pages 9–10 September 2001 Trading and Capital-Markets Activities Manual Page 2 Trading and Capital-Markets Activities Manual Supplement 5—April 2001 Nature of Changes regulator of securities firms. Section 2140.1, ‘‘Regulatory Compliance,’’ has been revised to Trading Activities incorporate these provisions of the GLB Act. Section 2120.1, ‘‘Accounting,’’ has been revised to incorporate the following recent guidance Capital-Markets Activities from the Financial Accounting Standards Board: Statement of Financial Accounting Standards New information on the valuation of retained (SFAS) No. 133, ‘‘Accounting for Derivative interests, including SR-99-37 and its related Instruments and Hedging Activities,’’ and SFAS interagency guidance, has been added to section No. 140, ‘‘Accounting for Transfers and Servic- 3020.1, ‘‘Securitization and Secondary-Market ing of Financial Assets and Extinguishments of Credit Activities.’’ The subsection on internal Liabilities." (SFAS 140 supersedes SFAS 125, controls has also been expanded to include the which had the same title).